Credit Quality of Loans and the Allowance for Loan Losses

3 Months Ended

Mar. 31, 2014

Credit Quality Of Loans And Allowance For Loan Losses

Credit Quality of Loans and the Allowance for Loan Losses

Note 4: Credit Quality of Loans and the Allowance for Loan Losses

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoffs are reported at their outstanding principal balances adjusted for unearned income, chargeoffs, the allowance for loan losses, any unamortized deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans.

For loans amortized at cost, interest income is accrued based on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, as well as premiums and discounts, are deferred and amortized as a level yield adjustment over the respective term of the loan. 

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days past due unless the credit is well secured and in process of collection. Past due status is determined based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current for a period of six months and future payments are reasonably assured.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to income. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of allocated and general components. The allocated component relates to loans that are classified as impaired. For those loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers nonclassified loans and is based on historical chargeoff experience and expected loss given default derived from the Company’s internal risk rating process. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by using the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogenous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment measurements, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.

The risk characteristics of each portfolio segment are as follows:

Residential Real Estate Loans

For residential mortgage loans that are secured by one-to-four family residences and are generally owner occupied, the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in one-to-four family residences. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

All Other Mortgage Loans

All other mortgage loans consist of residential construction loans, nonresidential real estate loans, land loans and multi-family real estate loans.

Residential construction loan proceeds are disbursed in increments as construction progresses and as inspections warrant. Construction loans are typically structured as permanent one-to-four family loans originated by the Company with a 12-month construction phase. Accordingly, upon completion of the construction phase, there is no change in interest rate or term to maturity of the original construction loan, nor is a new permanent loan originated. These loans are generally owner occupied and the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded.

Nonresidential real estate loans are negotiated on a case-by-case basis. Loans secured by nonresidential real estate generally involve a greater degree of risk than one-to-four family residential mortgage loans and carry larger loan balances. This increased credit risk is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income-producing properties, and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by nonresidential real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired.

The Company also originates a limited number of land loans secured by individual improved and unimproved lots for future residential construction. In addition, the Company originates loans to commercial customers with land held as the collateral.

Multi-family real estate loans generally involve a greater degree of credit risk than one-to-four family residential mortgage loans and carry larger loan balances. This increased credit risk is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income-producing properties, and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multi-family real estate is typically dependent upon the successful operation of the related real estate property. If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired.

Commercial Business Loans

Commercial business loans carry a higher degree of risk than one-to-four family residential loans. Such lending typically involves large loan balances concentrated in a single borrower or groups of related borrowers for rental or business properties. In addition, the payment experience on loans secured by income-producing properties is typically dependent on the success of the operation of the related project and thus is typically affected by adverse conditions in the real estate market and in the economy. The Company originates commercial loans generally in the $50,000 to $1,000,000 range with the majority of these loans being under $500,000. Commercial loans are generally underwritten based on the borrower’s ability to pay and assets such as buildings, land and equipment are taken as additional loan collateral. Each loan is evaluated for a level of risk and assigned a rating from “1” (the highest quality rating) to “7” (the lowest quality rating).

Consumer Loans

Consumer loans entail greater credit risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly, such as automobiles, mobile homes, boats, and recreational vehicles. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In particular, amounts realizable on the sale of repossessed automobiles may be significantly reduced based upon the condition of the automobiles and the lack of demand for used automobiles.

The following presents by portfolio segment, the activity in the allowance for loan losses for the three months ended March 31, 2014 and 2013:

Three months ended March 31, 2014	One-to-four family residential			All other mortgage loans			Commercial business loans		Consumer loans			Total
	(In thousands)
Beginning balance	$	1,017		$	1,526		$	271	$	5		$	2,819
Provision charged to expense		(135	)		127			17		(1	)		8
Losses charged off		—			(260	)		—		—			(260	)
Recoveries		7			—			—		—			7
Ending balance	$	889		$	1,393		$	288	$	4		$	2,574

Three months ended March 31, 2013	One-to-four family residential			All other mortgage loans			Commercial business loans			Consumer loans			Total
	(In thousands)
Beginning balance	$	1,122		$	1,925		$	275		$	6		$	3,328
Provision (credit) charged to expense		(61	)		(18	)		(63	)		1			(141	)
Losses charged off		(34	)		(176	)		—			(2	)		(212	)
Recoveries		—			—			1			1			2
Ending balance	$	1,027		$	1,731		$	213		$	6		$	2,977

The following tables present the balance in the allowance for loan losses and the recorded investment in loans based on the portfolio segment and impairment method as of March 31, 2014 and December 31, 2013:

March 31, 2014	One-to-four family residential		All other mortgage loans		Commercial business loans		Consumer loans		Total
	(In thousands)
Allowance Balances:
Ending balance:
Individually evaluated for impairment	$	153	$	359	$	61	$	—	$	573
Collectively evaluated for impairment		736		1,034		227		4		2,001
Total allowance for loan losses	$	889	$	1,393	$	288	$	4	$	2,574
Loan Balances:
Ending balance:
Individually evaluated for impairment	$	6,317	$	3,371	$	137	$	—	$	9,825
Collectively evaluated for impairment		160,648		82,469		14,064		1,939		259,120
Total balance	$	166,965	$	85,840	$	14,201	$	1,939	$	268,945

December 31, 2013	One-to-four family residential		All other mortgage loans		Commercial business loans		Consumer loans		Total
	(In thousands)
Allowance Balances:
Ending balance:
Individually evaluated for impairment	$	226	$	618	$	65	$	—	$	909
Collectively evaluated for impairment		791		908		206		5		1,910
Total allowance for loan losses	$	1,017	$	1,526	$	271	$	5	$	2,819
Loan Balances:
Ending balance:
Individually evaluated for impairment	$	6,411	$	3,661	$	142	$	—	$	10,214
Collectively evaluated for impairment		160,317		82,434		14,773		1,110		258,634
Total balance	$	166,728	$	86,095	$	14,915	$	1,110	$	268,848

Total loans in the above tables do not include deferred loan origination fees of $682 and $682 or loans in process of $3.1 million and $4.2 million, respectively, for March 31, 2014 and December 31, 2013.

The following tables present the credit risk profile of the Bank’s loan portfolio based on rating category and payment activity as of March 31, 2014 and December 31, 2013:

March 31, 2014	One-to-four family residential		All other mortgage loans		Commercial business loans		Consumer loans
	(In thousands)
Rating *
Pass (Risk 1-4)	$	158,883	$	81,400	$	13,730	$	1,937
Special Mention (Risk 5)		487		1,579		335		—
Substandard (Risk 6)		7,595		2,861		136		2
Total	$	166,965	$	85,840	$	14,201	$	1,939

December 31, 2013	One-to-four family residential		All other mortgage loans		Commercial business loans		Consumer loans
	(In thousands)
Rating *
Pass (Risk 1-4)	$	158,518	$	81,362	$	14,328	$	1,108
Special Mention (Risk 5)		419		1,587		445		—
Substandard (Risk 6)		7,791		3,146		142		2
Total	$	166,728	$	86,095	$	14,915	$	1,110

* Ratings are generally assigned to consumer and residential mortgage loans on a “pass” or “fail” basis, where “fail” results in a substandard classification. Commercial loans, both secured by real estate or other assets or unsecured, are analyzed in accordance with an analytical matrix codified in the Bank’s loan policy that produces a risk rating as described below.

Risk 1 is unquestioned credit quality for any credit product. Loans are secured by cash and near cash collateral with immediate access to proceeds.

Risk 2 is very low risk with strong credit and repayment sources. Borrower is well capitalized in a stable industry, financial ratios exceed peers and financial trends are positive.

Risk 3 is very favorable risk with highly adequate credit strength and repayment sources. Borrower has good overall financial condition and adequate capitalization.

Risk 4 is acceptable, average risk with adequate credit strength and repayment sources. Collateral positions must be within Bank policies.

Risk 5 or “Special Mention,” also known as “watch,” has potential weakness that deserves Management’s close attention. This risk includes loans where the borrower has developed financial uncertainties or the borrower is resolving the financial uncertainties. Bank credits have been secured or negotiations will be ongoing to secure further collateral.

Risk 6 or “Substandard” loans are inadequately protected by the current net worth and paying capacity of the borrower or of the collateral pledged. This risk category contains loans that exhibit a weakening of the borrower’s credit strength with limited credit access and all nonperforming loans.

Risk 7 or “Doubtful” loans are significantly under protected by the current net worth and paying capacity of the borrower or of the collateral pledged. This risk category contains loans that are likely to experience a loss of some magnitude, but where the amount of the expected loss is not known with enough certainty to allow for an accurate calculation of a loss amount for charge off. This category is considered to be temporary until a chargeoff amount can be reasonably determined.

The following tables present the Bank’s loan portfolio aging analysis for March 31, 2014 and December 31, 2013:

March 31, 2014	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Total Loans > 90 Days and Accruing
	(In thousands)
One-to-four family      residential loans	$	2,118	$	586	$	287	$	2,991	$	163,974	$	166,965	$	—
All other mortgage      loans		52		—		766		818		85,022		85,840		—
Commercial      business loans		39		—		—		39		14,162		14,201		—
Consumer loans		1		—		—		1		1,938		1,939		—
Total	$	2,210	$	586	$	1,053	$	3,849	$	265,096	$	268,945	$	—

December 31, 2013	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Total Loans > 90 Days and Accruing
	(In thousands)
One-to-four family      residential loans	$	679	$	228	$	624	$	1,531	$	165,197	$	166,728	$	—
All other mortgage      loans		150		64		811		1,025		85,070		86,095		—
Commercial      business loans		—		—		—		—		14,915		14,915		—
Consumer loans		79		—		—		79		1,031		1,110		—
Total	$	908	$	292	$	1,435	$	2,635	$	266,213	$	268,848	$	—

Nonaccrual loans were comprised of the following at:

Nonaccrual loans	March 31, 2014		December 31, 2013
	(In thousands)
One-to-four family residential loans	$	1,571	$	1,851
Nonresidential real estate loans		766		1,045
All other mortgage loans		—		—
Commercial business loans		—		2
Consumer loans		2		—
Total	$	2,339	$	2,898

A loan is considered impaired, in accordance with the impairment accounting guidance (ASC 310-10-35-16), 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. Information with respect to the Company’s impaired loans at March 31, 2014 and December 31, 2013 in combination with activity for the three months ended March 31, 2014 and 2013 is presented below:

	As of March 31, 2014						Three months ended March 31, 2014
	Recorded Balance		Unpaid Principal Balance		Specific Allowance		Average Investment in Impaired Loans		Interest Income Recognized
	(In thousands)
Loans without a specific valuation allowance
One-to-four family residential loans	$	5,596	$	5,596	$	—	$	5,583	$	64
All other mortgage loans		2,027		2,027		—		2,039		20
Commercial business loans		76		76		—		77		1
Loans with a specific valuation allowance
One-to-four family residential loans		721		721		153		782		9
All other mortgage loans		1,344		2,070		359		1,477		14
Commercial business loans		61		61		61		63		1
Total:
One-to-four family residential loans	$	6,317	$	6,317	$	153	$	6,365	$	73
All other mortgage loans		3,371		4,097		359		3,516		34
Commercial business loans		137		137		61		140		2
	$	9,825	$	10,551	$	573	$	10,021	$	109

	As of December 31, 2013						Three months ended March 31, 2013
	Recorded Balance		Unpaid Principal Balance		Specific Allowance		Average Investment in Impaired Loans		Interest Income Recognized
	(In thousands)
Loans without a specific valuation allowance
One-to-four family residential loans	$	5,569	$	5,569	$	—	$	5,620	$	78
All other mortgage loans		2,051		2,051		—		2,578		29
Commercial business loans		77		77		—		85		1
Loans with a specific valuation allowance
One-to-four family residential loans		842		842		226		1,324		13
All other mortgage loans		1,610		2,076		618		2,956		9
Commercial business loans		65		65		65		94		1
Total:
One-to-four family residential loans	$	6,411	$	6,411	$	226	$	6,944	$	91
All other mortgage loans		3,661		4,127		618		5,534		38
Commercial business loans		142		142		65		179		2
	$	10,214	$	10,680	$	909	$	12,657	$	131

The interest income recognized in the above tables reflects interest income recognized and is not materially different from the cash basis method.

All the TDR classifications listed below occurred as concessions were granted to borrowers experiencing financial difficulties. Concessions to borrowers can include exceptions to loan policy including high loan-to-value ratios, no private mortgage insurance (“PMI”) and high debt-to-income ratios, as well as term and rate exceptions. The TDR classification that occurred in the 2014 period included an extension of the maturity date. In 2013, the concessions made to the borrowers included both a reduction in the stated interest rate below the market rate of similar debt and an extension of the maturity date. Each TDR has been individually evaluated for impairment with the appropriate specific valuation allowance included in the allowance for loan losses calculation.There were no TDR classifications which defaulted during the three month periods ended March 31, 2014 and 2013. The Company considers TDRs that become 90 days or more past due under modified terms as subsequently defaulted.

	Quarter-to-Date
Troubled Debt Restructurings	Number of loans		Pre-modification Unpaid Principal Balance		Post-modification Unpaid Principal Balance
	(dollars in thousands)
March 31, 2014
One-to-four family residential loans			$	—	$	—
All other mortgage loans		1		261		261
March 31, 2013
One-to-four family residential loans		1	$	113	$	113
All other mortgage loans		1		576		576