NOTE 4 – CREDIT QUALITY

Allowance for Credit Losses

The Corporation’s methodology for estimating probable future losses on loans utilizes a combination of probability of loss by loan grade and loss given defaults for its portfolios. The probability of default is based on both market data from a third-party independent source and actual historical default rates within the Corporation’s portfolio. A loan is impaired when full payment of interest and principal under the original contractual loan terms is not expected. Commercial and industrial loans, commercial real estate, including construction and land development, and multi-family real estate loans are individually evaluated for impairment. If a loan is impaired, the loan amount exceeding fair value, based on the most current information available is reserved. Management has developed a process by which commercial and commercial real estate loans receiving an internal grade of substandard or doubtful are individually evaluated for impairment through a loan quality review (LQR). The LQR details the various attributes of the relationship and collateral and determines based on the most recent available information if a specific reserve needs to be applied and at what level. The LQR process for all loans meeting the specific review criteria is completed on a quarterly basis. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, such loans are not separately identified for impairment disclosures. This methodology recognizes portfolio behavior while allowing for reasonable loss ratios on which to estimate allowance calculations.

Further, the process for estimating probable loan losses is divided into reviewing impaired loans on an individual basis for probable losses and, as noted above, calculating probable future losses based on historical and market data for homogenous loan portfolios. As the Corporation’s troubled loan portfolios have been reduced through charge-off, the remaining loan portfolios possess better overall credit characteristics, and based on the Corporation’s methodology require lower rates of reserving than historical levels.

The table below presents allowance for credit losses by loan portfolio. As presented within this note, commercial real estate includes real estate construction and land development loans.

Three Months Ended June 30, 2013

	Consumer and Credit Card			Commercial and Industrial			Commercial Real Estate			Residential Real Estate and Home Equity			Total
Beginning balance	$	287		$	1,586		$	4,724		$	161		$	6,758

Charge-offs		(98	)		(15	)		(28	)		(46	)		(187	)
Recoveries		50			86			13			22			172
Provision		129			(85	)		(346	)		63			(240	)

Ending balance	$	368		$	1,572		$	4,363		$	200		$	6,503

Individually evaluated for impairment	$	-		$	733		$	2,532		$	-		$	3,265
Collectively evaluated for impairment		368			839			1,831			200			3,238

Ending balance	$	368		$	1,572		$	4,363		$	200		$	6,503

Loans

Individually evaluated for impairment	$	-		$	5,586		$	20,980		$	-		$	26,566
Collectively evaluated for impairment		29,277			119,723			86,518			83,472			318,990

Total	$	29,277		$	125,309		$	107,498		$	83,472		$	345,556

Three Months Ended June 30, 2012

	Consumer and Credit Card			Commercial and Industrial			Commercial Real Estate			Residential Real Estate and Home Equity			Total
Beginning balance	$	393		$	2214		$	6,524		$	212		$	9,343

Charge-offs		(88	)		(30	)		(414	)		(20	)		(552	)
Recoveries		47			43			5			7			102
Provision		21			(95	)		321			8			255

Ending balance	$	373		$	2132		$	6,436		$	207		$	9,148

Individually evaluated for impairment	$	-		$	494		$	5,353		$	-		$	5,847
Collectively evaluated for impairment		373			1,638			1,083			207			3,301

Ending balance	$	373		$	2,132		$	6,436		$	207		$	9,148

Loans

Individually evaluated for impairment	$	-		$	11,079		$	27,443		$	-		$	38,522
Collectively evaluated for impairment		18,312			100,727			89,744			75,437			284,220

Total	$	18,312		$	111,806		$	117,187		$	75,437		$	322,742

Six months ended June 30, 2013

	Consumer and Credit Card			Commercial and Industrial			Commercial Real Estate			Residential Real Estate and Home Equity			Total
Beginning balance	$	365		$	1,621		$	4,692		$	204		$	6,882

Charge-offs		(136	)		(79	)		(130	)		(89	)		(434	)
Recoveries		110			774			23			38			945
Provision		29			(744	)		(222	)		47			(890	)

Ending balance	$	368		$	1,572		$	4,363		$	200		$	6,503

Six months ended June 30, 2012

	Consumer and Credit Card			Commercial and Industrial			Commercial Real Estate			Residential Real Estate and Home Equity			Total
Beginning balance	$	425		$	1,952		$	6,916		$	291		$	9,584

Charge-offs		(212	)		(147	)		(1,074	)		(19	)		(1,451	)
Recoveries		111			151			13			11			285
Provision		49			176			581			(76	)		730

Ending balance	$	373		$	2,132		$	6,436		$	207		$	9,148

Impaired Loans

A loan is considered impaired when based on current information and events it is probable the Bank will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming commercial loans but also include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. Commercial and commercial real estate loans with risk grades Substandard, Vulnerable, Doubtful, or Loss are evaluated for impairment.

The following presents by class, information related to the Corporation’s impaired loans as of June 30, 2013 and December 31, 2012.

At June 30, 2013

	Recorded Investment		Unpaid Principal Balance		Related Allowance		6 Months Average Recorded Investment		6 Months Interest Income Recognized		3 Months Average Recorded Investment		3 Months Interest Income Recognized
With No Related Allowance
Recorded
Consumer and Credit Card	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Commercial and Industrial		3,050		3,127		-		3,532		73		3,233		40
Commercial Real Estate		11,068		13,152		-		9,221		333		9,751		166
Residential RE and Home Equity		-		-		-		-		-		-		-

With Allowance Recorded
Consumer and Credit Card		-		-		-		-		-		-		-
Commercial and Industrial		2,536		4,179		733		1,957		111		2,393		85
Commercial Real Estate		9,912		10,837		2,532		11,792		164		11,005		78
Residential RE and Home Equity		-		-		-		-		-		-		-

Total
Consumer and Credit Card	$	-	$	-	$	-	$	-	$	-	$	-		-
Commercial and Industrial		5,586		7,306		733		5,489		184		5,626		125
Commercial Real Estate		20,980		23,989		2,532		21,013		497		20,756		244
Residential RE and Home Equity		-		-		-		-		-		-		-

Total	$	26,566	$	31,295	$	3,265	$	26,502	$	681	$	26,382		369

At December 31, 2012

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With No Related Allowance
Recorded
Consumer and Credit Card	$	-	$	-	$	-	$	-	$	-
Commercial and Industrial		4,288		4,437		-		3,557		268
Commercial Real Estate		5,507		5,998		-		10,067		241
Residential RE and Home Equity		-		-		-		-		-

With Allowance Recorded
Consumer and Credit Card		-		-		-		-		-
Commercial and Industrial		1,183		1,248		340		6,208		65
Commercial Real Estate		16,376		20,008		3,400		15,965		820
Residential RE and Home Equity		-		-		-		-		-

Total
Consumer and Credit Card	$	-	$	-	$	-	$	-	$	-
Commercial and Industrial		5,471		5,685		340		9,765		333
Commercial Real Estate		21,883		26,006		3,400		26,032		1,061
Residential RE and Home Equity		-		-		-		-		-

Total	$	27,354	$	31,691	$	3,740	$	35,797	$	1,394

The allowance for impaired loans is included in the Corporation’s overall allowance for loan losses. The provision necessary to increase this allowance is included in the Corporation’s overall provision for losses on loans.

Loans on nonaccrual status at June 30, 2013 and December 31, 2012 are as follows:

	June 30,		December 31,
	2013		2012
Consumer and credit card	$	-	$	-
Commercial and industrial		1,794		2,815
Commercial real estate		3,632		2,195
Residential real estate and home equity		271		321

Total	$	5,697	$	5,331

Credit Quality Indicators

Corporate risk exposure by risk profile was as follows at June 30, 2013:

Category	Commercial and Industrial		Commercial Real Estate

Pass-1-4	$	104,963	$	76,539
Vulnerable-5		11,195		13,704
Substandard-6		9,151		17,255
Doubtful-7		-		-
Loss-8		-		-

Total	$	125,309	$	107,498

Corporate risk exposure by risk profile was as follows at December 31, 2012:

Category	Commercial and Industrial		Commercial Real Estate

Pass-1-4	$	90,516	$	76,708
Vulnerable-5		12,240		12,289
Substandard-6		9,544		22,420
Doubtful-7		-		-
Loss-8		-		-

Total	$	112,300	$	111,417

Risk Category Descriptions

Pass (Prime – 1, Good – 2, Fair – 3, Compromised – 4)

Loans with a pass grade have a higher likelihood that the borrower will be able to service its obligations in accordance with the terms of the loan than those loans graded 5, 6, 7, or 8. The borrower’s ability to meet its future debt service obligations is the primary focus for this determination. Generally, a borrower’s expected performance is based on the borrower’s financial strength as reflected by its historical and projected balance sheet and income statement proportions, its performance, and its future prospects in light of conditions that may occur during the term of the loan.

Vulnerable (Special Mention) – 5

Loans which possess some credit deficiency or potential weakness which deserves close attention, but which do not yet warrant substandard classification. Such loans pose unwarranted financial risk that, if not corrected, could weaken the loan and increase risk in the future. The key distinctions of a 5 (Special Mention) classification are that (1) it is indicative of an unwarranted level of risk, and (2) weaknesses are considered “potential”, versus “well-defined”, impairments to the primary source of loan repayment.

Substandard – 6

Loans that are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. One or more of the following characteristics may be exhibited in loans classified Substandard:

⋅

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

⋅

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

⋅

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

⋅

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

⋅

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

⋅

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

⋅

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

⋅

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

⋅

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

⋅

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

Doubtful – 7

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

⋅

Loans have all of the weaknesses of those classified as Substandard. Additionally, however, these weaknesses make collection or liquidation in full based on existing conditions improbable.

⋅

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

⋅

The possibility of loss is high, but, because of certain important pending factors, which may strengthen the loan, loss classification is deferred until its exact status is known. A Doubtful classification is established during this period of deferring the realization of the loss.

Loss – 8

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

Consumer Risk

Consumer risk based on payment activity at June 30, 2013 is as follows.

Payment Category	Consumer and Credit Card		Residential Real Estate and Home Equity

Performing	$	29,201	$	83,201
Non-performing		76		271

Total	$	29,277	$	83,472

Consumer risk based on payment activity at December 31, 2012 is as follows.

Payment Category	Consumer and Credit Card		Residential Real Estate and Home Equity

Performing	$	21,592	$	71,816
Non-Performing		28		321

Total	$	21,620	$	72,137

Age Analysis of Past Due Loans

The following table presents past due loans aged as of June 30, 2013.

Category	30-59 Days Past Due		60-89 Days Past Due		90 Days or more Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 days and Accruing

Consumer and credit card	$	59	$	43	$	76	$	178	$	29,099	$	29,277	$	76
Commercial and industrial		1,296		289		-		1,585		123,724		125,309		-
Commercial real estate		-		212		2,586		2,798		104,700		107,498		-
Residential real estate and home equity		281		40		271		592		82,880		83,472		-
Total	$	1,636	$	584	$	2,933	$	5,153	$	340,403	$	345,556	$	76

The following table presents past due loans aged as of December 31, 2012.

Category	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 days and Accruing

Consumer and Credit Card	$	37	$	101	$	28	$	166	$	21,454	$	21,620	$	28
Commercial and Industrial		20		-		26		46		112,254		112,300		-
Commercial Real Estate		538		114		2,195		2,847		108,570		111,417		-
Residential Real Estate and Home Equity		444		289		321		1,054		71,083		72,137		-
Total	$	1,039	$	504	$	2,570	$	4,113	$	313,361	$	317,474	$	28

Troubled Debt Restructurings

Information regarding Troubled Debt Restructuring (“TDR”) loans for the three and six month periods ended June 30, 2013 and 2012 is as follows:

	Three Months Ended				Six Months Ended
	June 30, 2013				June 30, 2013
	Number of Contracts		Recorded Investment (as of period end)		Number of Contracts		Recorded Investment (as of period end)
Consumer and Credit Card		1	$	1		1	$	1
Commercial and Industrial		-		-		3		903
Commercial Real Estate		3		163		5		3,600
Residential Real Estate and Home Equity		-		-		-		-

Total		4	$	164		9	$	4,504

	Three Months Ended				Six Months Ended
	June 30, 2012				June 30, 2012
	Number of Contracts		Recorded Investment (as of period end)		Number of Contracts		Recorded Investment (as of period end)
Consumer and Credit Card		5	$	92		6	$	93
Commercial and Industrial		-		-		-		-
Commercial Real Estate		2		3,929		2		3,929
Residential Real Estate and Home Equity		-		-		-		-

Total		7	$	4,021		8	$	4,022

TDRs that defaulted during the period, within twelve months of their modification date

The following presents by class loans modified in a TDR from July 1, 2012 through June 30, 2013 that subsequently defaulted (i.e. 60 days or more past due following a modification) during the three and six month periods ended June 30, 2013.

	Three Months Ended				Six Months Ended
	June 30, 2013				June 30, 2013
	Number of Contracts		Recorded Investment as of period end (1)		Number of Contracts		Recorded Investment as of period end (1)
Consumer and Credit Card		1	$	8		1	$	8
Commercial and Industrial		-		-		-		-
Commercial Real Estate		2		114		2		114
Residential Real Estate and Home Equity		-		-		-		-

Total		3	$	122		3	$	122

The following presents class loans modified in a TDR from July 1, 2011 through June 30, 2012 that subsequently defaulted (i.e. 60 days or more past due following a modification) during the three and six month periods ended June 30, 2012.

	Three Months Ended				Six Months Ended
	June 30, 2012				June 30, 2012
	Number of Contracts		Recorded Investment as of period end (1)		Number of Contracts		Recorded Investment as of period end (1)
Consumer and Credit Card		-	$	-		-		-
Commercial and Industrial		-		-		-		-
Commercial Real Estate		1		1,540		1		1,540
Residential Real Estate and Home Equity		-		-		-		-

Total		1	$	1,540		1	$	1,540

(1)

Period end balances are inclusive of all partial pay downs and charge-offs since the modification date. Loans modified in a TDR that were fully paid down, charged off, or foreclosed upon by period end are not reported.

A modification of a loan constitutes a TDR when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Corporation offers various types of concessions when modifying a loan; however, forgiveness of principal is rarely granted. Depending on the financial condition of the borrower, the purpose of the loan and the type of collateral supporting the loan structure; modifications can be either short-term (12 months of less) or long term (greater than one year). Commercial loans modified in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Additional collateral, a co-borrower, or a guarantor may be requested. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period.

Land loans are also included in the class of commercial real estate loans. Land loans are typically structured as interest-only monthly payments with a balloon payment due at maturity. Land loans modified in a TDR typically involve extending the balloon payment by one to three years, changing the monthly payments from interest-only to principal and interest, while leaving the interest rate unchanged.

Loans modified in a TDR are typically already on nonaccrual status and partial charge-offs have in some cases already been taken against the outstanding loan balance. As a result, loans modified in a TDR for the Corporation may have the financial effect of increasing the specific allowance associated with the loan. The allowance for impaired loans that have been modified in a TDR is measured based on the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent or on the present value of expected future cash flows discounted at the loan’s effective interest rate. Management exercises significant judgment in developing these estimates.

As mentioned above, an individual loan is placed on a non-accruing status if, in the judgment of Management, it is unlikely that all principal and interest will be received according to the terms of the note. Loans on non-accrual may be eligible to be returned to an accruing status after six months of compliance with the modified terms. However, there are number of factors that could prevent a loan from returning to accruing status, even after remaining in compliance with loan terms for the aforementioned six month period. For example: deteriorating collateral, negative cash flow changes and inability to reduce debt to income ratios.