Note 5 – Loans and Allowance for Credit Losses

The Company makes residential mortgage, commercial and consumer loans to customers primarily in Talbot County, Queen Anne’s County, Kent County, Caroline County, Dorchester County, Wicomico County, Baltimore County and Howard County in Maryland, Kent County, Delaware and Accomack County, Virginia. The following table provides information about the principal classes of the loan portfolio at March 31, 2020 and December 31, 2019.


(Dollars in thousands)	March 31, 2020		December 31, 2019
Construction	$	109,608	$	99,829
Residential real estate		437,197		442,506
Commercial real estate		610,889		586,562
Commercial		96,905		102,020
Consumer		22,394		17,737
Total loans		1,276,993		1,248,654
Allowance for credit losses		(10,378)		(10,507)
Total loans, net	$	1,266,615	$	1,238,147

Loans are stated at their principal amount outstanding net of any purchase premiums/discounts, deferred fees and costs. Loans included deferred costs, net of deferred fees, of $1.8 million and discounts on acquired loans of $967 thousand at March 31, 2020. Loans included deferred costs, net of deferred fees, of $1.8 million and discounts on acquired loans of $1.1 million at December 31, 2019. At March 31, 2020 and December 31, 2019, included in total loans were $76.5 million and $79.2 million in loans, respectively, acquired as part of the NWBI branch acquisition. Interest income on loans is accrued at the contractual rate based on the principal amount outstanding. Fees charged and costs capitalized for originating loans are being amortized substantially on the interest method over the term of the loan. A loan is placed on nonaccrual (i.e., interest income is no longer accrued) when it is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more, unless the loan is well secured and in the process of collection. Any unpaid interest previously accrued on those loans is reversed from income.

Interest payments received on nonaccrual loans are applied as a reduction of the loan principal balance unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

A loan is considered impaired if it is probable that the Company will not collect all principal and interest payments according to the loan’s contractual terms when due. An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. The impairment of a loan is measured at the present value of expected future cash flows using the loan’s effective interest rate, or at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Generally, the Company measures impairment on such loans by reference to the fair value of the collateral. Once the amount of impairment has been determined, the uncollectible portion is charged off. Loan payments received on nonaccrual impaired loans are generally applied to the outstanding principal balance. In certain circumstances, income may be recognized on a cash basis. Generally, interest income is not recognized on impaired loans unless the likelihood of further loss is remote. The allowance for credit losses may include specific reserves related to impaired loans. Specific reserves remain until charge offs are made. Impaired loans do not include groups of smaller balance homogenous loans such as residential mortgage and consumer installment loans that are evaluated collectively for impairment. Reserves for probable credit losses related to these loans are based on historical loss ratios and are included in the formula portion of the allowance for credit losses. See additional discussion under the caption “Critical Accounting Policies” in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

A loan is considered a troubled debt restructuring (“TDR”) if a borrower is experiencing financial difficulties and a creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. Loans are identified to be restructured when signs of impairment arise such as borrower interest rate reduction request, slowness to pay, or when an inability to repay becomes evident. The terms being offered are evaluated to determine if they are more liberal than those that would be indicated by policy or industry standards for similar, untroubled credits. In those situations where the terms or the interest rates are considered to be more favorable than industry standards or the current underwriting guidelines of the Company’s banking subsidiary, Shore United Bank (the “Bank”), the loan is classified as a TDR. All loans designated as TDRs are considered impaired loans and may be on either accrual or nonaccrual status. In instances where the loan has been placed on nonaccrual status, six consecutive months of timely payments are required prior to returning the loan to accrual status.

All loans classified as TDRs which are restructured and accrue interest under revised terms require a full and comprehensive review of the borrower’s financial condition, capacity for repayment, realistic assessment of collateral values, and the assessment of risk entered into any workout agreement. Current financial information on the borrower, guarantor, and underlying collateral is analyzed to determine if it supports the ultimate collection of principal and interest. For commercial loans, the cash flows are analyzed, both for the underlying project and globally. For consumer loans, updated salary, credit history and cash flow information is obtained. Current market conditions are also considered. Following a full analysis, the determination of the appropriate loan structure is made.

In the normal course of banking business, risks related to specific loan categories are as follows:

Construction loans – Construction loans are offered primarily to builders and individuals to finance the construction of single-family dwellings. In addition, the Bank periodically finances the construction of commercial projects. Credit risk factors include the borrower’s ability to successfully complete the construction on time and within budget, changing market conditions which could affect the value and marketability of projects, changes in the borrower’s ability or willingness to repay the loan and potentially rising interest rates which can impact both the borrower’s ability to repay and the collateral value.

Residential real estate – Residential real estate loans are typically made to consumers and are secured by residential real estate. Credit risk arises from the borrower’s continuing financial stability, which can be adversely impacted by job loss, divorce, illness, or personal bankruptcy, among other factors. Also impacting credit risk would be a shortfall in the value of the residential real estate in relation to the outstanding loan balance in the event of a default or subsequent liquidation of the real estate collateral.

Commercial real estate – Commercial real estate loans consist of both loans secured by owner occupied properties and nonowner occupied properties where an established banking relationship exists and involves investment properties for warehouse, retail, and office space with a history of occupancy and cash flow. These loans are subject to adverse changes in the local economy and commercial real estate markets. Credit risk associated with owner occupied properties arises from the borrower’s financial stability and the ability of the borrower and the business to repay the loan. Nonowner occupied properties carry the risk of a tenant’s deteriorating credit strength, lease expirations in soft markets and sustained vacancies which can adversely impact cash flow.

Commercial – Commercial loans are secured or unsecured loans for business purposes. Loans are typically secured by accounts receivable, inventory, equipment and/or other assets of the business. Credit risk arises from the successful operation of the business which may be affected by competition, rising interest rates, regulatory changes and adverse conditions in the local and regional economy.

Consumer – Consumer loans include home equity loans and lines, installment loans and personal lines of credit. Credit risk is similar to residential real estate loans above as it is subject to the borrower’s continuing financial stability and the value of the collateral securing the loan.

The following tables include impairment information relating to loans and the allowance for credit losses as of March 31, 2020 and December 31, 2019.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
March 31, 2020
Loans individually evaluated for impairment	$	335	$	7,652	$	11,161	$	557	$	—	$	19,705
Loans collectively evaluated for impairment		109,273		429,545		599,728		96,348		22,394		1,257,288
Total loans	$	109,608	$	437,197	$	610,889	$	96,905	$	22,394	$	1,276,993

Allowance for credit losses allocated to:
Loans individually evaluated for impairment	$	—	$	268	$	85	$	—	$	—	$	353
Loans collectively evaluated for impairment		1,128		2,214		3,880		2,263		540		10,025
Total allowance	$	1,128	$	2,482	$	3,965	$	2,263	$	540	$	10,378


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
December 31, 2019
Loans individually evaluated for impairment	$	41	$	7,072	$	12,006	$	298	$	—	$	19,417
Loans collectively evaluated for impairment		99,788		435,434		574,556		101,722		17,737		1,229,237
Total loans	$	99,829	$	442,506	$	586,562	$	102,020	$	17,737	$	1,248,654

Allowance for credit losses allocated to:
Loans individually evaluated for impairment	$	—	$	395	$	580	$	—	$	—	$	975
Loans collectively evaluated for impairment		1,576		2,106		3,452		1,929		469		9,532
Total allowance	$	1,576	$	2,501	$	4,032	$	1,929	$	469	$	10,507

In the first quarter of 2020, the Company transitioned from its in-house allowance model to an external vendor's allowance model software for the calculation of the allowance for loan losses. Prior to the adoption of the new model, the Company ran both models parallel for multiple periods to confirm the reasonableness of the new model's output as compared to the old. The primary motivation for the change was to increase efficiencies in the calculation of the allowance estimate under the current incurred loss standard and also allow for a more seamless transition for the Company's eventual adoption of the CECL standard in 2023. The Company's processes for loan segmentation, assessing qualitative factors, and determining specific reserves for impaired loans remained substantially unchanged when comparing the models. As part of the new model, more precise averages are utilized in the calculation of the net charge-off ratios used in the historical loss analysis and the historical loss rates are applied to all pools of loans accounted for under ASC 450. Additionally, the historical look-back periods for retail loan pools were adjusted to four years in the new model as compared to two years under the prior in-house model. While there were some variances between loan pools when comparing the two models, the Company's ending recorded allowance and provision for loan losses during the first quarter of 2020 were unchanged as a result of the transition.

The following tables provide information on impaired loans and any related allowance by loan class as of March 31, 2020 and December 31, 2019. The difference between the unpaid principal balance and the recorded investment is the amount of partial charge-offs that have been taken and interest paid on nonaccrual loans that has been applied to principal.



			Recorded		Recorded
	Unpaid		investment		investment				Year-to-date		Interest
	principal		with no		with an		Related		average recorded		recorded
(Dollars in thousands)	balance		allowance		allowance		allowance		investment		investment
March 31, 2020
Impaired nonaccrual loans:
Construction	$	297		297		—		—		99		—
Residential real estate		3,854		2,083		1,367		94		2,871		—
Commercial real estate		7,932		7,169		67		67		7,352		—
Commercial		684		557		—		—		382		—
Consumer		—		—		—		—		—		—
Total	$	12,767	$	10,106	$	1,434	$	161	$	10,704	$	—

Impaired accruing TDRs:
Construction	$	38	$	38	$	—	$	—	$	39	$	1
Residential real estate		4,013		2,563		1,450		174		4,023		38
Commercial real estate		3,393		2,728		665		18		3,406		24
Commercial		—		—		—		—		—		—
Consumer		—		—		—		—		—		—
Total	$	7,444	$	5,329	$	2,115	$	192	$	7,468	$	63

Other Impaired accruing loans:
Construction	$	—	$	—	$	—	$	—	$	—	$	—
Residential real estate		189		189		—		—		—		—
Commercial real estate		532		532		—		—		—		—
Commercial		—		—		—		—		—		—
Consumer		—		—		—		—		—		—
Total	$	721	$	721	$	—	$	—	$	—	$	—

Total impaired loans:
Construction	$	335	$	335	$	—	$	—	$	138	$	1
Residential real estate		8,056		4,835		2,817		268		6,894		38
Commercial real estate		11,857		10,429		732		85		10,758		24
Commercial		684		557		—		—		382		—
Consumer		—		—		—		—		—		—
Total	$	20,932	$	16,156	$	3,549	$	353	$	18,172	$	63



			Recorded		Recorded				March 31, 2019
	Unpaid		investment		investment				Year-to-date		Interest
	principal		with no		with an		Related		average recorded		income
(Dollars in thousands)	balance		allowance		allowance		allowance		investment		recognized
December 31, 2019
Impaired nonaccrual loans:
Construction	$	—	$	—	$	—	$	—	$	2,791	$	—
Residential real estate		2,660		678		1,797		215		3,338		—
Commercial real estate		8,242		5,680		2,137		561		9,318		—
Commercial		421		298		—		—		325		—
Consumer		—		—		—		—		—		—
Total	$	11,323	$	6,656	$	3,934	$	776	$	15,772	$	—

Impaired accruing TDRs:
Construction	$	41	$	41	$	—	$	—	$	50	$	7
Residential real estate		4,041		2,583		1,458		180		4,308		39
Commercial real estate		3,419		2,748		671		19		3,550		39
Commercial		—		—		—		—		—		—
Consumer		—		—		—		—		—		—
Total	$	7,501	$	5,372	$	2,129	$	199	$	7,908	$	85

Other impaired accruing loans:
Construction	$	—	$	—	$	—	$	—	$	—	$	—
Residential real estate		556		556		—		—		—		—
Commercial real estate		770		770		—		—		—		—
Commercial		—		—		—		—		—		—
Consumer		—		—		—		—		—		—
Total	$	1,326	$	1,326	$	—	$	—	$	—	$	—

Total impaired loans:
Construction	$	41	$	41	$	—	$	—	$	2,841	$	7
Residential real estate		7,257		3,817		3,255		395		7,646		39
Commercial real estate		12,431		9,198		2,808		580		12,868		39
Commercial		421		298		—		—		325		—
Consumer		—		—		—		—		—		—
Total	$	20,150	$	13,354	$	6,063	$	975	$	23,680	$	85

The following tables provide a roll-forward for TDRs as of March 31, 2020 and March 31, 2019.


	1/1/2020												3/31/2020
	TDR		New		Disbursements		Charge-		Reclassifications/				TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)		Payoffs		Balance		Allowance
For three months ended
March 31, 2020
Accruing TDRs
Construction	$	41	$	—	$	(3)	$	—	$	—	$	—	$	38	$	—
Residential real estate		4,041		—		(28)		—		—		—		4,013		174
Commercial real estate		3,419		—		(26)		—		—		—		3,393		18
Commercial		—		—		—		—		—		—		—		—
Consumer		—		—		—		—		—		—		—		—
Total	$	7,501	$	—	$	(57)	$	—	$	—	$	—	$	7,444	$	192

Nonaccrual TDRs
Construction	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Residential real estate		1,393		—		(26)		—		—		—		1,367		94
Commercial real estate		—		1,506		(344)		—		—		—		1,162		—
Commercial		299		—		(10)		—		—		—		289		—
Consumer		—		—		—		—		—		—		—		—
Total	$	1,692	$	1,506	$	(380)	$	—	$	—	$	—	$	2,818	$	94

Total	$	9,193	$	1,506	$	(437)	$	—	$	—	$	—	$	10,262	$	286


	1/1/2019												3/31/2019
	TDR		New		Disbursements		Charge-		Reclassifications/				TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)		Payoffs		Balance		Allowance
For three months ended
March 31, 2019
Accruing TDRs
Construction	$	51	$	—	$	(2)	$	—	$	—	$	—	$	49	$	—
Residential real estate		4,454		—		(23)		—		—		(197)		4,234		174
Commercial real estate		4,158		—		(613)		—		—		—		3,545		27
Commercial		—		—		—		—		—		—		—		—
Consumer		—		—		—		—		—		—		—		—
Total	$	8,663	$	—	$	(638)	$	—	$	—	$	(197)	$	7,828	$	201

Nonaccrual TDRs
Construction	$	2,798	$	—	$	(33)	$	—	$	—	$	—	$	2,765	$	279
Residential real estate		—		—		—		—		—		—		—		—
Commercial real estate		—		—		—		—		—		—		—		—
Commercial		320		—		(5)		—		—		—		315		12
Consumer		—		—		—		—		—		—		—		—
Total	$	3,118	$	—	$	(38)	$	—	$	—	$	—	$	3,080	$	291

Total	$	11,781	$	—	$	(676)	$	—	$	—	$	(197)	$	10,908	$	492

The following tables provide information on loans that were modified and considered TDRs during the three months ended March 31, 2020 and March 31, 2019.


		Premodification		Postmodification
		outstanding		outstanding
	Number of	recorded		recorded		Related
(Dollars in thousands)	contracts	investment		investment		allowance
TDRs:
For three months ended
March 31, 2020
Construction	—	$	—	$	—	$	—
Residential real estate	—		—		—		—
Commercial real estate	1		1,535		1,162		—
Commercial	—		—		—		—
Consumer	—		—		—		—
Total	1	$	1,535	$	1,162	$	—

For three months ended
March 31, 2019
Construction	—	$	—	$	—	$	—
Residential real estate	—		—		—		—
Commercial real estate	—		—		—		—
Commercial	—		—		—		—
Consumer	—		—		—		—
Total	—	$	—	$	—	$	—

As of March 31, 2020, the Company had executed principal and/or interest deferrals on outstanding loan balances of $131 million during the first quarter of 2020. These deferrals were no more than six months in duration and were for loans not more than 30 days past due as of December 31, 2019. As such, they were not considered troubled debt restructurings based on the relief provisions of the CARES Act and recent interagency regulatory guidance.

There were no defaults for the three months ended March 31, 2020 and 2019. Generally, a loan is considered in default when principal or interest is past due 90 days or more, the loan is placed on nonaccrual, the loan is charged off, or there is a transfer to OREO or repossessed assets.


	Number of	Recorded		Related
(Dollars in thousands)	contracts	investment		allowance
TDRs that subsequently defaulted:
For three months ended
March 31, 2020
Construction	—	$	—	$	—
Residential real estate	—		—		—
Commercial real estate	—		—		—
Commercial	—		—		—
Consumer	—		—		—
Total	—	$	—	$	—

For three months ended
March 31, 2019
Construction	—	$	—	$	—
Residential real estate	—		—		—
Commercial real estate	—		—		—
Commercial	—		—		—
Consumer	—		—		—
Total	—	$	—	$	—

Management uses risk ratings as part of its monitoring of the credit quality in the Company’s loan portfolio. Loans that are identified as special mention, substandard or doubtful are adversely rated. These loans and the pass/watch loans are assigned higher qualitative factors than favorably rated loans in the calculation of the formula portion of the allowance for credit losses. At March 31, 2020, there were no nonaccrual loans classified as special mention or doubtful and $11.5 million of nonaccrual loans were classified as substandard. Similarly, at December 31, 2019, there were no nonaccrual loans classified as special mention or doubtful and $10.6 million of nonaccrual loans were classified as substandard.

The following tables provide information on loan risk ratings as of March 31, 2020 and December 31, 2019.


					Special
(Dollars in thousands)	Pass/Performing		Pass/Watch		Mention		Substandard		Doubtful		Total
March 31, 2020
Construction	$	91,507	$	15,730	$	2,074	$	297	$	—	$	109,608
Residential real estate		399,006		29,645		4,550		3,996		—		437,197
Commercial real estate		470,751		123,013		6,568		10,557		—		610,889
Commercial		63,627		32,236		454		588		—		96,905
Consumer		22,033		355		2		4		—		22,394
Total	$	1,046,924	$	200,979	$	13,648	$	15,442	$	—	$	1,276,993


					Special
(Dollars in thousands)	Pass/Performing		Pass/Watch		Mention		Substandard		Doubtful		Total
December 31, 2019
Construction	$	84,357	$	13,068	$	2,404	$	—	$	—	$	99,829
Residential real estate		404,500		29,223		5,549		3,234		—		442,506
Commercial real estate		455,388		115,190		4,822		11,162		—		586,562
Commercial		80,816		20,130		746		328		—		102,020
Consumer		17,347		383		2		5		—		17,737
Total	$	1,042,408	$	177,994	$	13,523	$	14,729	$	—	$	1,248,654

The following tables provide information on the aging of the loan portfolio as of March 31, 2020 and December 31, 2019.


	Accruing
				30‑59 days			60‑89 days			Greater than			Total
(Dollars in thousands)	Current			past due			past due			90 days			past due			Nonaccrual			Total
March 31, 2020
Construction	$	109,101		$	210		$	—		$	—		$	210		$	297		$	109,608
Residential real estate		428,930			4,073			555			189			4,817			3,450			437,197
Commercial real estate		600,382			2,249			490			532			3,271			7,236			610,889
Commercial		96,024			95			229			—			324			557			96,905
Consumer		22,331			63			—			—			63			—			22,394
Total	$	1,256,768		$	6,690		$	1,274		$	721		$	8,685		$	11,540		$	1,276,993
Percent of total loans		98.4	%		0.5	%		0.1	%		0.1	%		0.7	%		0.9	%		100.0	%


	Accruing
				30‑59 days			60‑89 days			Greater than			Total
(Dollars in thousands)	Current			past due			past due			90 days			past due			Nonaccrual			Total
December 31, 2019
Construction	$	99,234		$	595		$	—		$	—		$	595		$	—		$	99,829
Residential real estate		435,671			3,021			783			556			4,360			2,475			442,506
Commercial real estate		577,015			743			217			770			1,730			7,817			586,562
Commercial		101,476			246			—			—			246			298			102,020
Consumer		17,680			57			—			—			57			—			17,737
Total	$	1,231,076		$	4,662		$	1,000		$	1,326		$	6,988		$	10,590		$	1,248,654
Percent of total loans		98.6	%		0.4	%		0.1	%		0.1	%		0.6	%		0.8	%		100.0	%

The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for the three months ended March 31, 2020 and March 31, 2019. Allocation of a portion of the allowance to one loan class does not preclude its availability to absorb losses in other loan classes.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
For three months ended
March 31, 2020
Allowance for credit losses:
Beginning Balance	$	1,576	$	2,501	$	4,032	$	1,929	$	469	$	10,507

Charge-offs		—		(191)		(271)		(82)		(7)		(551)
Recoveries		3		3		1		63		2		72
Net charge-offs		3		(188)		(270)		(19)		(5)		(479)

Provision		(451)		169		203		353		76		350
Ending Balance	$	1,128	$	2,482	$	3,965	$	2,263	$	540	$	10,378


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
For three months ended
March 31, 2019
Allowance for credit losses:
Beginning Balance	$	2,662	$	2,353	$	3,077	$	1,949	$	302	$	10,343

Charge-offs		—		(123)		—		(81)		(6)		(210)
Recoveries		3		8		99		75		—		185
Net charge-offs		3		(115)		99		(6)		(6)		(25)

Provision		(8)		195		(119)		66		(34)		100
Ending Balance	$	2,657	$	2,433	$	3,057	$	2,009	$	262	$	10,418

Foreclosure Proceedings

Consumer mortgage loans collateralized by residential real estate property that were in the process of foreclosure totaled $23 thousand as of March 31, 2020 and December 31, 2019, respectively. There were no residential real estate properties included in the balance of other real estate owned at March 31, 2020 and December 31, 2019.

All accruing TDRs were in compliance with their modified terms. Both performing and non-performing TDRs had no further commitments associated with them as of March 31, 2020 and December 31, 2019.