Summary of PORTER BANCORP, INC.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation

Management's discussion and analysis of financial condition and results of operations analyzes the consolidated financial condition and results of operations of Porter Bancorp, Inc. and its wholly owned subsidiary, PBI Bank. Porter Bancorp, Inc. is a Louisville, Kentucky-based bank holding company which operates 18 full-service banking offices in twelve counties through its wholly-owned subsidiary, PBI Bank. Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt, and extend south along the Interstate 65 corridor to Tennessee. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio, and Daviess Counties. We also have an office in Lexington, the second largest city in Kentucky. The Bank is both a traditional community bank with a wide range of commercial and personal banking products and an online bank which delivers competitive deposit products and services through an on-line banking division operating under the name of Ascencia.

Historically, we have focused on commercial and commercial real estate lending, both in markets where we have banking offices and other growing markets in our region. Commercial, commercial real estate and real estate construction loans accounted for 58.6% of our total loan portfolio as of December 31, 2012, and 60.5% as of December 31, 2011. Commercial lending generally produces higher yields than residential lending, but involves greater risk and requires more rigorous underwriting standards and credit quality monitoring.

Overview

The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes and other schedules presented elsewhere in the report.

For the year ended December 31, 2012, we reported a net loss of $32.9 million compared with net loss of $107.3 million for the year ended December 31, 2011. After deductions for dividends on preferred stock, accretion on preferred stock, and allocating losses to participating securities, the net loss to common shareholders was $33.4 million for the year ended December 31, 2012, compared with net loss to common shareholders of $105.2 million for the year ended December 31, 2011. Basic and diluted loss per common share were $(2.85) for the year ended December 31, 2012, compared with loss per common share of $(8.98) for 2011.

Our financial performance in 2012 continued to be negatively impacted by the Bank's high level of nonperforming loans and other real estate owned. Asset quality remediation, capital restoration, and lowering the risk profile of the Company are our major objectives for 2013.

Non-performing loans were 10.52% of total loans, and nonperforming assets stood at 11.89% of total assets at December 31, 2012. We remain diligent in the management of our portfolio and are striving to improve credit quality by working throughout our markets with our clients to balance selective new customer acquisition, customer service for our existing clients and prudent risk management.

Significant developments for the year ended December 31, 2012 were:

? John T. Taylor joined the management team in July as President of Porter Bancorp and CEO of PBI Bank. Mr. Taylor is a seasoned banking veteran with deep and broad experience in our Kentucky markets, community banking, and problem asset resolution. Additionally, John R. Davis joined the management team in August and was appointed Chief Credit Officer of PBI Bank with responsibility for establishing and executing the credit quality policies and overseeing credit administration for the organization.

? In October 2012, PBI Bank entered into a new Consent Order with the FDIC and KDFI. Under the new order, the Bank agreed to maintain the capital levels required by the June 2011 order and also agreed should the capital levels not be reached, and if directed in writing by the FDIC, the Bank would develop a plan to immediately raise sufficient capital, or to sell or merge itself into another FDIC insured institution. The new Consent Order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 Consent Order, and includes the substantive provisions of the June 2011 order.

? In order to comply with the capital requirements of the Consent Order, management and the Board of Directors are evaluating appropriate strategies for increasing the Company's capital. These include, among other things, a possible public offering or private placement of common stock to new and existing shareholders. We have engaged Sandler O'Neill & Partners, LP to act as our financial advisor and to assist our Board in this evaluation and to assist in evaluating our options for the redemption of our Series A preferred stock issued to the US Treasury in 2008 under the Capital Purchase Program.

? Total assets decreased 20.1% to $1.2 billion at December 31, 2012 compared with $1.5 billion at the 2011 year-end.

? Loans decreased 20.9% to $899.1 million compared with $1.1 billion at December 31, 2011.

? Deposits declined 19.5% to $1.1 billion compared with $1.3 billion at December 31, 2011. Certificate of deposit balances declined $263.8 million to $760.6 million at December 31, 2012, from $1.0 billion at December 31, 2011. Loan proceeds received from the repayment of our commercial real estate and construction and development loans were used primarily to redeem maturing certificates of deposit during the year. Demand deposits increased 2.9% to $114.3 million during 2012 compared with $111.1 million at December 31, 2011.

? Net interest margin decreased to 3.31% for 2012 compared with 3.40% for 2011.
The decrease in margin between periods was due primarily to a reduction in interest earning assets, primarily loans, coupled with lower rates on those assets and elevated non-accrual loan levels. Average loans decreased 16.9% to $1.0 billion in 2012 compared with $1.2 billion in 2011.

? Non-performing loans increased $1.2 million to $94.6 million at December 31, 2012, compared with $93.4 million at December 31, 2011. The increase was primarily in the commercial real estate segment of our portfolio, partially offset by decreases in the construction and development, and 1-4 family residential real estate segments. Non-performing assets increased from $134.8 million at December 31, 2011, to $138.3 million at December 31, 2012.

? Provision for loan losses decreased $22.4 million in 2012 compared with 2011 as the result of shrinking the loan portfolio and lower net loan charge-offs of $36.1 million, or 3.50% of average loans for 2012, compared with $44.3 million, or 3.56% of average loans for 2011. Although lower than the prior year, our provision for loan losses was elevated in 2012 by a strategy change during the third quarter of 2012 related to classified loans which we expect to more quickly remediate by litigation or foreclosure. For loans subject to this expectation, we applied an additional fair value discount ranging from 10% to 33% to the underlying collateral in our impairment analysis estimates as resolution of this nature generally results in receiving lower values for real estate collateral in a more aggressive sales environment. This resulted in a provision for loan loss of approximately $5.1 million related to these loans. Additionally, the provision for loan losses was negatively impacted by the high level of loan charge-offs in our historical loss experience factors, which we use to estimate the general component of our allowance for loan losses as well as additional downgrades within the loan portfolio.

? We continue to execute on our strategy to reduce our commercial real estate and construction and development loans. We reduced construction and development loans by $31.2 million to $70.3 million, or 82% of total risk-based capital, at December 31, 2012 compared with $101.5 million, or 85% of total risk-based capital, at December 31, 2011. Non-owner occupied commercial real estate loans, construction and development loans, and multi-family residential real estate loans as a group were reduced by $103.5 million to $311.1 million, or 362% of total risk-based capital, at December 31, 2012 compared with $414.6 million, or 349% of total risk-based capital, at December 31, 2011.

? Loans past due 30-59 days increased from $17.3 million at December 31, 2011 to $38.2 million at December 31, 2012 and loans past due 60-89 days increased from $3.9 million at December 31, 2011, to $20.3 million at December 31, 2012. These increases were primarily in the commercial real estate, construction and development, and multi-family residential real estate segments of our portfolio.

? Foreclosed properties were $43.7 million at December 31, 2012, compared with $41.4 million at December 31, 2011. The Company acquired $33.5 million of OREO and sold $24.2 million of OREO during 2012. In addition, fair value write-downs of $7.7 million were recorded during 2012 to reflect declining values as evidenced by new appraisals and reduced marketing prices in connection with our sales strategies. Our ratio of non-performing assets to total assets increased to 11.9% at December 31, 2012, compared with 9.3% at December 31, 2011.

These items are discussed in further detail throughout this "Management's Discussion and Analysis of Financial Condition and Results of Operations" Section.

Going Concern Considerations and Future Plans

The consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business for the foreseeable future. However, the events and circumstances described in this discussion create an uncertainty about the Company's ability to continue as a going concern.

For the year ended December 31, 2012, we reported net loss to common shareholders of $33.4 million. This loss was attributable primarily to $40.3 million of provision for loan losses expense due to continued decline in credit trends in our portfolio that resulted in net charge-offs of $36.1 million, OREO expense of $10.5 million resulting from fair value write-downs driven by new appraisals and reduced marketing prices, net loss on sales, and ongoing operating expense. We also had lower net interest margin due to lower average loans outstanding, loans re-pricing at lower rates, and the level of non-performing loans in our portfolio. Net loss to common shareholders of $33.4 million, for the year ended December 31, 2012, compares with net loss to common shareholders of $105.2 million for year ended December 31, 2011.

During the year ended December 31, 2011, we recorded a net loss to common shareholders of $105.2 million. This loss was attributable to a $23.8 million goodwill impairment charge, the establishment of a $31.7 million valuation allowance on our deferred tax assets, OREO expense of $47.5 million related to valuation adjustments reflecting our change in strategy related to certain OREO properties, fair value write-downs related to new appraisals received for properties in the portfolio during 2011, net loss on the sale of OREO properties, and increase in carrying costs associated with carrying these higher levels of assets. We also recorded a provision for loan losses expense of $62.6 million due to the continued decline in credit trends within our portfolio.

In June 2011, the Bank entered into a Consent Order with the FDIC and KDFI in which the Bank agreed, among other things, to improve asset quality, reduce loan concentrations, and maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Consent Order was included in our Current Report on 8-K filed on June 30, 2011. In October 2012, the Bank entered into a new Consent Order with the FDIC and KDFI, again agreeing to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Bank also agreed that if it should be unable to reach the required capital levels, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise immediately obtain a sufficient capital investment into the Bank to fully meet the capital requirements.

We expect to continue to work with our regulators toward capital ratio compliance as outlined in the written capital plan submitted by the Bank in December 2012. The new Consent Order also requires the Bank to continue to adhere to the plans implemented in response to the June 2011 Consent Order, and includes the substantive provisions of the June 2011 Consent Order. The new Consent Order was included in our Current Report on 8-K filed on September 19, 2012. As of December 31, 2012, the capital ratios required by the Consent Order were not met.

In order to meet these capital requirements, the Board of Directors and management are continuing to evaluate strategies to achieve the following objectives:

? Increasing capital through a possible public offering or private placement of common stock to new and existing shareholders. We have engaged Sandler O'Neill & Partners, LP to act as our financial advisor and to assist our Board in this evaluation and to assist in evaluating our options for the redemption of our Series A preferred stock issued to the US Treasury in 2008 under the Capital Purchase Program.

? Continuing to operate the Company and Bank in a safe and sound manner. This strategy will require us to reduce our lending concentrations, remediate non-performing loans, and reduce other noninterest expense through the disposition of OREO.

? Continuing with succession planning and adding resources to the management team. John T. Taylor was named President and CEO for PBI Bank and appointed to our board of directors in July 2012. Additionally, John R. Davis was appointed Chief Credit Officer of PBI Bank in August 2012, with responsibility for establishing and executing the credit quality policies and overseeing credit administration for the organization.

? Evaluating our internal processes and procedures, distribution of labor, and work-flow to ensure we have adequately and appropriately deployed resources in an efficient manner in the current environment. To this end, we believe the opportunity exists for the centralization of key processes which will lead to improved execution and cost savings.

? Executing on our commitment to improve credit quality and reduce loan concentrations and balance sheet risk.

o We have reduced the size of our loan portfolio significantly from $1.3 billion at December 31, 2010 to $1.1 billion at December 31, 2011, and $899.1 million at December 31, 2012. We have significantly improved our staffing in the commercial lending area which is now led by John R. Davis, who joined the management team in August 2012 and now serves as Chief Credit Officer.

o Our Consent Order calls for us to reduce our construction and development loans to not more than 75% of total risk-based capital. We were not in compliance at December 31, 2012 with construction and development loans representing 82% of total risk-based capital. These loans totaled $70.3 million, or 82% of total risk-based capital, at December 31, 2012 and $101.5 million, or 85% of total risk-based capital, at December 31, 2011.

o Our Consent Order also requires us to reduce non-owner occupied commercial real estate loans, construction and development loans, and multi-family residential real estate loans as a group, to not more than 250% of total risk-based capital. While we have made significant improvements over the last year, we were not in compliance with this concentration limit at December 31, 2012. These loans totaled $311.1 million, or 362% of total risk-based capital, at December 31, 2012 compared with $414.6 million, or 349% of total risk-based capital, at December 31, 2011.

o We are working to reduce non-owner occupied commercial real estate loans, construction and development loans, and multi-family residential real estate loans by curtailing new construction and development lending and new non-owner occupied commercial real estate lending. We are also receiving principal reductions from amortizing credits and pay-downs from our customers who sell properties built for resale. We have reduced the construction loan portfolio from $199.5 million at December 31, 2010 to $70.3 million at December 31, 2012. Our non-owner occupied commercial real estate loans declined from $293.3 million at December 31, 2010 to $189.8 million at December 31, 2012.

? Executing on our commitment to sell other real estate owned and reinvest in quality income producing assets.

o The remediation process for loans secured by real estate has led the Bank to acquire significant levels of OREO in 2012, 2011, and 2010. The Bank acquired $33.5 million, $41.9 million, and $90.8 million of OREO during 2012, 2011, and 2010, respectively.

o We have incurred significant losses in disposing of OREO. We incurred losses totaling $9.3 million, $42.8 million, and $13.9 million in 2012, 2011, and 2010, respectively, from sales and fair value write-downs attributable to declining valuations as evidenced by new appraisals and from changes in our sales strategies.

o To ensure that we maximize the value we receive upon the sale of OREO, we continue to evaluate sales opportunities and channels. We are targeting multiple sales opportunities and channels through internal marketing and the use of brokers, auctions, and technology sales platforms. Proceeds from the sale of OREO totaled $22.5 million during 2012, $26.0 in 2011, and $25.0 million in 2010.

o At December 31, 2011, the OREO portfolio consisted of 75% construction, development, and land assets. At December 31, 2012, this concentration had declined to 51%. This is consistent with our reduction of construction, development and other land loans, which have declined to $70.3 million at December 31, 2012, compared to $101.5 million at December 31, 2011. Over the past year, the composition of our OREO portfolio has shifted to be more heavily weighted towards commercial real estate properties with a cash flow opportunity and 1-4 family residential properties, which we have found to be more liquid than construction, development, and land assets. Commercial real estate properties represent 35% of the OREO portfolio at December 31, 2012, compared with 15% at December 31, 2011. 1-4 family residential properties represent 12% of the OREO portfolio at December 31, 2012, compared with 7% at December 31, 2011.

? Evaluating other strategic alternatives, such as the sale of assets or branches.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order. Based on individual circumstances, the agencies may issue mandatory directives, impose monetary penalties, initiate changes in management, or take more serious adverse actions.

These financial statements do not include any adjustments that may result should the Company be unable to continue as a going concern.

Application of Critical Accounting Policies

Our accounting and reporting policies comply with GAAP and conform to general practices within the banking industry. We believe that of our significant accounting policies, the following may involve a higher degree of management assumptions and judgments that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.

Allowance for Loan Losses - PBI Bank maintains an allowance for loan losses believed to be sufficient to absorb probable incurred credit losses existing in the loan portfolio, and the board of directors evaluates the adequacy of the allowance for loan losses on a quarterly basis. We evaluate the adequacy of the allowance using, among other things, historical loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of the underlying collateral and current economic conditions and trends. The allowance may be allocated for specific loans or loan categories, but the entire allowance is available for any loan that, in management's judgment, should be charged off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component is based on historical loss experience adjusted for environmental factors. We develop allowance estimates based on actual loss experience adjusted for current economic conditions and trends. Allowance estimates are a prudent measurement of the risk in the loan portfolio which we apply to individual loans based on loan type. If the mix and amount of future charge-off percentages differ significantly from those assumptions used by management in making its determination, we may be required to materially increase our allowance for loan losses and provision for loan losses, which could adversely affect our results.

Other Real Estate Owned - Other real estate owned (OREO) is real estate acquired as a result of foreclosure or by deed in lieu of foreclosure. It is classified as real estate owned until such time as it is sold. When property is acquired as a result of foreclosure or by deed in lieu of foreclosure, it is recorded at its fair market value less estimated cost to sell. Any write-down of the property at the time of acquisition is charged to the allowance for loan losses. Subsequent reductions in fair value are recorded as non-interest expense. To determine the fair value of OREO for smaller dollar single family homes, we consult with internal real estate sales staff and external realtors, investors, and appraisers. If the internally evaluated market price is below our underlying investment in the property, appropriate write-downs are recorded. For larger dollar commercial real estate properties, we obtain a new appraisal of the subject property in connection with the transfer to other real estate owned. We do not obtain updated appraisals on a quarterly basis after the receipt of the initial appraisal. Rather, we internally review the fair value of the other real estate owned in our portfolio on a quarterly basis to determine if a new appraisal is warranted based on the specific circumstances of each property. We obtain updated appraisals each year on the anniversary of ownership unless a sale is imminent.

Goodwill and Intangible Assets - We evaluate goodwill and intangible assets that have indefinite useful lives for impairment at least annually and more frequently if circumstances indicate their value may not be recoverable. We evaluate goodwill for impairment by comparing the fair value of the reporting unit to the book value of the reporting unit. If the fair value, net of goodwill, exceeds book value, then goodwill is not considered to be impaired. We evaluated goodwill for impairment during the second quarter of 2011 because our common stock, which trades publicly on the NASDAQ, experienced a significant drop in value throughout the months of May and June 2011. Our stock trended downward during the first quarter of 2011 and continued downward throughout the months of May and June 2011. The stock closed on June 30, 2011 at $4.98 per share and has regularly traded at a market price less than book value per common share since the second quarter of 2010.

We evaluated the potential negative impact on the value of our common stock from being removed from the Russell 3000 Index during June 2011, the trend of lower earnings in 2011 compared to historical performance due to the continuing impact on earnings from loan loss provisions, non-performing loans, and foreclosed properties, and recent regulatory agreements entered into by the Company. Our goodwill impairment testing completed during the fourth quarter of 2010 included, among other things, future projections of earnings at levels exceeding actual results for 2011. The level of loan loss provisions and the cost of foreclosed properties continue to exceed our prior expectations as we work through issues with our non-performing loan levels and other real estate owned portfolio.

The fair value of our goodwill was determined utilizing our market capitalization based upon recent common stock price levels. We also considered market comparison transactions and control premiums for institutions of a similar size and performance. Based on this analysis, we determined that our goodwill was impaired and recorded an impairment charge of $23.8 million in the quarter ended June 30, 2011. The impairment charge had no impact on the Company's liquidity, cash flows, or regulatory capital ratios.

Intangible assets that are not amortized are evaluated for impairment at least annually by comparing the fair values of those assets to their carrying values. Other identifiable intangible assets that are subject to amortization are amortized on an accelerated basis over the years expected to be benefited, which we believe is 10 years. We review these amortizable intangible assets for impairment if circumstances indicate their value may not be recoverable based on a comparison of fair value to carrying value. Based on our annual review, management does not believe our intangible assets are impaired at December 31, 2012.

Stock-based Compensation - Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. We utilize a Black-Scholes model, which requires the input of highly subjective assumptions, such as volatility, risk-free interest rates and dividend pay-out rates, to estimate the fair value of stock options, while the market price of the Company's common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

Valuation of Deferred Tax Asset - We evaluate deferred tax assets for impairment on a quarterly basis. We established a 100% deferred tax valuation allowance of $31.7 million in December 2011 based upon the analysis of our past performance and our expected future performance. We considered all evidence currently available, both positive and negative, in determining, based on the weight of that evidence, the likelihood that the deferred tax asset would be realized. During that review, we determined that the level of our recent historical losses, the level of our non-performing assets, our inability to meet our forecasted levels of earnings in 2011, our intent to defer payment of dividends on our subordinated debentures and Series A Preferred Stock, and our non-compliance with the capital requirements of our Consent Order outweighed our forecasted taxable earnings levels for the near and long term. As such, we established a 100% deferred tax valuation allowance. When evaluating our deferred tax assets for realizability during 2012, we concluded that a full valuation allowance was still necessary at December 31, 2012, due to the additional losses incurred during the year. A return to profitability would enable us to reduce the valuation allowance and thereby offset income tax expense that would otherwise be recognized. Examinations of our income tax returns or changes in tax law may impact our deferred tax assets and liabilities as well as our provision for income taxes.

Contingencies - In the normal course of operations, we are defendants in various legal proceedings. We record contingent liabilities resulting from claims against us when a loss is assessed to be probable and the amount of the loss is reasonably estimable. Assessing probability of loss and estimating probable losses requires analysis of multiple factors, including in some cases judgments about the potential actions of third party claimants and courts. Recorded . . .