NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES

Loans as of September 30, 2014 and December 31, 2013 were as follows:

(Dollars in thousands)	September 30, 2014			December 31, 2013
Commercial loans	$	48,113		$	43,855
Real estate mortgage loans:
Residential		72,113			71,192
Commercial		217,346			223,182
Construction and land		21,614			30,355
Consumer and other loans		1,883			2,041
Loans, gross		361,069			370,625
Less:
Net deferred loan fees		(407	)		(273	)
Allowance for loan losses		(15,170	)		(15,760	)
Loans, net	$	345,492		$	354,592

Loans acquired as a result of the merger with ABI were recorded at fair value on the date of acquisition. The amounts reported in the table above are net of the fair value adjustments. The table below reflects the contractual amount of purchased loans less the discount to principal balances remaining from these fair value adjustments by class of loan as of September 30, 2014 and December 31, 2013. This discount will be accreted into interest income as deemed appropriate over the remaining term of the related loans.

(Dollars in thousands)
September 30, 2014	Gross Contractual Amount Receivable		Discount		Carrying Balance
Commercial loans	$	1,817	$	152	$	1,665
Real estate mortgage loans:
Residential		16,363		881		15,482
Commercial		38,121		2,229		35,892
Construction and land		3,622		347		3,275
Consumer and other loans		409		4		405
Total	$	60,332	$	3,613	$	56,719

December 31, 2013	Gross Contractual Amount Receivable		Discount		Carrying Balance
Commercial loans	$	2,165	$	175	$	1,990
Real estate mortgage loans:
Residential		20,614		1,282		19,332
Commercial		44,249		3,026		41,223
Construction and land		4,763		412		4,351
Consumer and other loans		468		6		462
Total	$	72,259	$	4,901	$	67,358

The Company has divided the loan portfolio into three portfolio segments, each with different risk characteristics and methodologies for assessing risk. The three portfolio segments identified by the Company are described below.

Commercial Loans:

Commercial loans are primarily underwritten on the basis of the borrowers’ ability to service such debt from operating cash flows. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. As a general practice, loans are secured by a security interest in any available real estate, equipment, or other chattel, although loans may also be made on an unsecured basis. Collateralized working capital loans typically are secured with short-term assets whereas long-term loans are primarily secured with long-term assets. Credit risk is mitigated by the diversity and number of borrowers as well as loan type within the commercial portfolio.

Real Estate Mortgage Loans:

Real estate mortgage loans are typically segmented into three classes: commercial real estate, residential real estate and construction and land development. Commercial real estate loans are secured by the subject property and are underwritten based upon standards set forth in the policies approved by the Bank’s Board. Such standards include, among other factors, loan-to-value limits, debt service coverage and general creditworthiness of the obligors. Residential real estate loans are underwritten in accordance with policies set forth and approved by the Bank’s Board, including repayment capacity and source, value of the underlying property, credit history, stability and purchaser guidelines. Construction loans to borrowers are to finance the construction of owner occupied and lease properties. These loans are categorized as construction loans during the construction period, later converting to commercial or residential real estate loans after the construction is complete and amortization of the loan begins. Real estate development and construction loans are approved based on an analysis of the borrower and guarantor, the viability of the project and on an acceptable percentage of the appraised value of the property securing the loan. Real estate development and construction loan funds are disbursed periodically based on the percentage of construction completed. The Bank carefully monitors these loans with on-site inspections and requires the receipt of invoices and lien waivers prior to advancing funds. Development and construction loans are typically secured by the properties under development or construction, and personal guarantees are typically obtained. Further, to assure that reliance is not placed solely on the value of the underlying property, the Bank considers the market conditions and feasibility of proposed projects, the financial condition and reputation of the borrower and guarantors, the amount of the borrower’s equity in the project, independent appraisals, cost estimates and pre-construction sale information. The Bank also makes loans on occasion for the purchase of land for future development by the borrower. Land loans are extended for the future development of either commercial or residential use by the borrower. The Bank carefully analyzes the intended use of the property and the viability thereof.

Repayment of real estate loans is primarily dependent upon the personal income or business income generated by the secured property of the borrowers, which can be impacted by the economic conditions in their market area. Risk is mitigated by the fact that the properties securing the Company’s real estate loan portfolio are diverse in type and spread over a large number of borrowers.

Consumer and Other Loans:

Consumer and other loans are extended for various purposes, including purchases of automobiles, recreational vehicles, and boats. The Company also offers home improvement loans, lines of credit, personal loans, and deposit account collateralized loans. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas, such as unemployment levels. Loans to consumers are extended after a credit evaluation, including the creditworthiness of the borrower(s), the purpose of the credit, and the secondary source of repayment. Consumer loans are made at fixed and variable interest rates and may be made on terms of up to ten years. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

Activity in the allowance for loan losses by portfolio segment for the three and nine months ended September 30, 2014 and 2013 was as follows:

	Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in thousands)	2014			2013			2014			2013
Allowance at beginning of period	$	14,616		$	17,303		$	15,760		$	20,198

Charge-offs:
Commercial loans		70			57			272			121
Real estate mortgage loans		545			724			2,034			3,313
Consumer and other loans		154			1			170			174
Total charge-offs		769			782			2,476			3,608

Recoveries:
Commercial loans		10			11			37			81
Real estate mortgage loans		1,306			68			1,545			165
Consumer and other loans		7			7			17			38
Total recoveries		1,323			86			1,599			284

Net charge-offs		(554	)		696			877			3,324

Provision for loan losses charged to operating expenses:
Commercial loans		(26	)		(70	)		102			145
Real estate mortgage loans		(312	)		436			(73	)		(193	)
Consumer and other loans		338			1			258			148
Total provision		-			367			287			100

Allowance at end of period	$	15,170		$	16,974		$	15,170		$	16,974

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on the impairment method as of September 30, 2014 and December 31, 2013:

(Dollars in thousands)
September 30, 2014	Commercial Loans		Real Estate Mortgage Loans		Consumer and Other Loans		Total
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	17	$	1,920	$	302	$	2,239
Collectively evaluated for impairment		1,064		11,343		430		12,837
Loans acquired with deteriorated credit quality		-		94		-		94
Total ending allowance balance	$	1,081	$	13,357	$	732	$	15,170
Loans:
Loans individually evaluated for impairment	$	58	$	21,093	$	332	$	21,483
Loans collectively evaluated for impairment		47,951		275,374		1,551		324,876
Loans acquired with deteriorated credit quality		104		14,606		-		14,710
Total ending loans balance	$	48,113	$	311,073	$	1,883	$	361,069

December 31, 2013	Commercial Loans		Real Estate Mortgage Loans		Consumer and Other Loans		Total
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	223	$	1,608	$	323	$	2,154
Collectively evaluated for impairment		992		11,919		303		13,214
Loans acquired with deteriorated credit quality		-		392		-		392
Total ending allowance balance	$	1,215	$	13,919	$	626	$	15,760
Loans:
Loans individually evaluated for impairment	$	304	$	19,783	$	364	$	20,451
Loans collectively evaluated for impairment		43,449		286,188		1,676		331,313
Loans acquired with deteriorated credit quality		102		18,758		1		18,861
Total ending loans balance	$	43,855	$	324,729	$	2,041	$	370,625

The following table presents loans individually evaluated for impairment, by class of loans as of September 30, 2014 and December 31, 2013:

	September 30, 2014						December 31, 2013
(Dollars in thousands)	Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated		Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated
With no related allowance recorded:
Commercial loans	$	43	$	41	$	-	$	43	$	43	$	-
Real estate mortgage loans:
Residential		2,037		1,972		-		2,341		2,286		-
Commercial		12,909		10,235		-		4,643		4,395		-
Construction and land		1,498		1,227		-		8,586		4,806		-
Consumer and other loans		32		30		-		40		40		-
With an allowance recorded:
Commercial loans	$	18	$	17	$	17	$	264	$	261	$	223
Real estate mortgage loans:
Residential		940		871		173		1,597		1,574		209
Commercial		6,386		6,198		1,466		7,910		6,062		1,001
Construction and land		601		590		281		667		660		398
Consumer and other loans		335		302		302		341		324		323

Total	$	24,799	$	21,483	$	2,239	$	26,432	$	20,451	$	2,154

The following tables present the average recorded investment in impaired loans and the related interest income recognized during impairment for the three and nine months ended September 30, 2014 and 2013.

	Three Months Ended September 30, 2014						Nine Months Ended September 30, 2014
(Dollars in thousands)	Average Impaired Loans		Interest Income		Cash-Basis		Average Impaired Loans		Interest Income		Cash-Basis
Commercial loans	$	84	$	-	$	-	$	209	$	-	$	-
Real estate mortgage loans:
Residential		2,893		25		25		3,237		84		84
Commercial		16,052		55		55		14,943		164		164
Construction and land		3,094		10		10		4,663		31		31
Consumer and other loans		340		-		-		349		-		-
Total	$	22,463	$	90	$	90	$	23,401	$	279	$	279

	Three Months Ended September 30, 2013						Nine Months Ended September 30, 2013
(Dollars in thousands)	Average Impaired Loans		Interest Income		Cash-Basis		Average Impaired Loans		Interest Income		Cash-Basis
Commercial loans	$	266	$	-	$	-	$	218	$	-	$	-
Real estate mortgage loans:
Residential		2,735		-		-		2,069		-		-
Commercial		8,675		50		50		9,144		149		150
Construction and land		5,344		6		6		4,609		15		14
Consumer and other loans		232		-		-		240		-		-
Total	$	17,252	$	56	$	56	$	16,280	$	164	$	164

The following table presents the recorded investment in nonaccrual loans by class of loans as of September 30, 2014 and December 31, 2013:

(Dollars in thousands)	September 30, 2014		December 31, 2013
Commercial loans	$	58	$	304
Real estate mortgage loans:
Residential		773		3,716
Commercial		12,180		7,105
Construction and land		787		5,517
Consumer and other loans		332		366
Total⁽¹⁾	$	14,130	$	17,008

⁽¹⁾	Includes loans acquired in the merger with ABI. As of September 30, 2014 and December 31, 2013, these amounts totaled $3,678 and $4,537, respectively.

The following table presents the aging of the recorded investment in past due loans by class of loans as of September 30, 2014 and December 31, 2013:

	Past Due Loans
(Dollars in thousands) September 30, 2014	30-59 Days		60-89 Days		90 Days and Greater		Total		Loans Not Past Due		Total
Commercial loans	$	-	$	-	$	-	$	-	$	48,113	$	48,113
Real estate mortgage loans:
Residential		523		57		295		875		71,238		72,113
Commercial		118		1,922		4,729		6,769		210,577		217,346
Construction and land		-		218		405		623		20,991		21,614
Consumer and other loans		-		75		-		75		1,808		1,883
Total	$	641	$	2,272	$	5,429	$	8,342	$	352,727	$	361,069

	Past Due Loans
December 31, 2013	30-59 Days		60-89 Days		90 Days and Greater		Total		Loans Not Past Due		Total
Commercial loans	$	-	$	138	$	86	$	224	$	43,631	$	43,855
Real estate mortgage loans:
Residential		359		134		1,648		2,141		69,051		71,192
Commercial		2,558		3,103		6,475		12,136		211,046		223,182
Construction and land		-		119		4,470		4,589		25,766		30,355
Consumer and other loans		321		10		39		370		1,671		2,041
Total	$	3,238	$	3,504	$	12,718	$	19,460	$	351,165	$	370,625

Included in the past due loan table above are loans acquired in the merger with ABI. As of September 30, 2014 and December 31, 2013, the amounts of such loans were as follows:

(Dollars in thousands)	September 30, 2014		December 31, 2013
30-59 days past due	$	236	$	87
60-89 days past due		-		167
90 days past due and greater		532		2,709
Total past due	$	768	$	2,963

The delinquency status of purchased credit impaired loans that resulted from our acquisition of ABI is based on the contractual terms of the loan. In effect, past due status of an acquired loan is determined in the same manner as loans originated by the Bank.

Troubled Debt Restructurings

During the normal course of business, the Company may restructure or modify the terms of a loan for various reasons. The restructuring of a loan is considered a troubled debt restructuring if both (i) the borrower is experiencing financial difficulties and (ii) a concession is granted that otherwise would not have occurred under normal circumstances.

The following table presents the recorded investment and specific reserves allocated to loans modified as troubled debt restructurings (“TDRs”) as of September 30, 2014 and December 31, 2013.

(Dollars in thousands)	September 30, 2014		December 31, 2013
Recorded investment⁽¹⁾	$	11,544	$	12,535
Specific reserves allocated⁽²⁾		504		953

⁽¹⁾	Of the total recorded investment in loans modified as TDRs, $1,160 and $1,256, respectively, were for customers whose loans were collateral dependent with collateral shortfalls.

⁽²⁾	Of the specific reserves allocated to customers whose loan terms were modified as TDRs, $222 and $622, respectively, were allocated to customers whose loans were collateral dependent with collateral shortfalls.

The following table represents loans by class modified as TDRs that occurred during the three and nine months ended September 30, 2014 and 2013, respectively:

	Three Months Ended September 30, 2014						Nine Months Ended September 30, 2014
(Dollars in thousands)	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Commercial loans		-	$	-	$	-		1	$	62		62
Real estate mortgage loans:
Residential		-		-		-		2		171		151
Commercial		-		-		-		6		3,579		3,629
Construction and land		-		-		-		2		281		219
Consumer and other loans		1		208		208		2		447		447
Total		1	$	208	$	208		13	$	4,540		4,508

	Three Months Ended September 30, 2013						Nine Months Ended September 30, 2013
	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Commercial loans		-	$	-	$	-		1	$	66		66
Real estate mortgage loans:
Residential		-		-		-		2		1,277		1,474
Commercial		1		341		341		1		341		341
Construction and land		2		996		996		4		4,280		4,260
Consumer and other loans		-		-		-		-		-		-
Total		3	$	1,337	$	1,337		8	$	5,964		6,141

During the three and nine months ended September 30, 2014, there were one and thirteen loans, respectively, modified as TDRs. The terms of these loans were modified as TDRs because the borrowers were experiencing financial difficulties. The loan modifications allowed the borrowers to make reduced payments, and included terms such as (i) reduced fixed interest rate through maturity and an advance to cover a deficiency from sale of a separate foreclosed property, (ii) change from principal and interest payments to interest only payments for a limited period of time, (iii) reduced principal and interest payments through maturity, (iv) change from variable rate interest only payments through maturity to fixed rate interest only payments for a limited period of time and reduced principal and interest payments through maturity, (v) change from variable rate interest only payments through maturity to fixed rate and reduced principal and interest payments through maturity, (vi) proposed forgiveness of principal contingent upon the satisfaction of the modified terms, (vii) extension of maturity date with an amortization amount beyond market terms, (viii) forgiveness of principal, or (ix) modification of terms as a result of a Chapter 11 bankruptcy court approved plan. The TDRs described above did not increase the allowance for loan losses as of September 30, 2014 and resulted in charge-offs of $0 and $256 for the three and nine months ended September 30, 2014, respectively. For the three and nine months ended September 30, 2014, there were none and eight collateral-impaired loans modified as TDRs, respectively.

During the three and nine months ended September 30, 2013, the number of loans modified as TDRs were three and eight, respectively. The loan modifications allowed the borrowers to make reduced payments, and included terms such as (i) forbearance of payments for a limited period of time with revised payment schedules to coordinate with periods of forbearance, (ii) change from principal and interest payments to interest only payments through maturity, (iii) reduced principal and interest payments through maturity, (iv) forgiveness of principal, (v) reduced principal and interest payments through maturity with an assumption of additional debt to protect the Bank’s collateral position, (vi) change from variable rate interest only payments through maturity to fixed rate interest only payments for a limited period of time and reduced principal payments through maturity, (vii) change from variable rate interest only payments through maturity to fixed rate and reduced principal and interest payments through maturity, or (viii) proposed forgiveness of principal contingent upon the satisfaction of the modified terms. Principal forgiven in the amount of $565 was offset by existing reserves from purchase accounting adjustments in the amount of $545 which resulted in a net charge-off of $20. The TDRs described above increased the allowance for loan losses by $273 and $400 for the three and nine months ended September 30, 2013, respectively, and resulted in no charge-offs for the three months ended September 30, 2013 and charge-offs of $233 for the nine months ended September 30, 2013. For the three and nine months ended September 30, 2013, the number of collateral-impaired loans modified as TDRs were one and three, respectively.

As of September 30, 2014 and December 31, 2013, the Company had extended additional credit of $245 and $483, respectively, to customers with outstanding loans whose terms have been modified as TDRs.

There were no TDRs for which there was a payment default within twelve months following the modification during the three and nine months ended September 30, 2014 and 2013, respectively. A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.

The terms of certain other loans that did not meet the definition of a TDR were modified during the three and nine months ended September 30, 2014 and 2013. These loans had a total recorded investment of $1,947 and $12,056 for the three and nine months ended September 30, 2014, respectively, and $1,387 and $7,152 for the three and nine months ended September 30, 2013, respectively. These modifications involved loans to borrowers who were not experiencing financial difficulties and included (i) allowing the borrowers to make interest-only payments for a limited period of time, (ii) adjusting the interest rate to a market interest rate through maturity, (iii) extension of interest-only payments for a limited period of time, (iv) extension of maturity date, or (v) extension of amortization period.

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under the Company’s internal underwriting policy.

Credit Quality Indicators

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.

The Company analyzes loans individually by classifying the loans as to credit risk. All loans are graded upon initial issuance. Loans classified as substandard or special mention are reviewed at least quarterly by the Company for further deterioration or improvement to determine if they are appropriately classified and whether there is any impairment. Further, commercial loans are typically reviewed at least annually to determine the appropriate loan grading. In addition, during the renewal process of any loan, as well as if a loan becomes past due, the Company determines the appropriate loan grade.

Loans excluded from the review process above are generally classified as pass credits until: (i) they become past due; (ii) management becomes aware of a deterioration in the credit worthiness of the borrower; or (iii) the customer contacts the Company for a modification. In these circumstances, the loan is specifically evaluated for potential classification to special mention, substandard or doubtful. The Company uses the following definitions for risk ratings:

Special Mention:

Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.

Substandard:

Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful:

Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

Loans not meeting the criteria above that are analyzed individually as part of the above-described process are considered to be pass-rated loans. As of September 30, 2014 and December 31, 2013, and based on the most recent analysis performed, the risk category of loans by class of loans was as follows:

(Dollars in thousands)
September 30, 2014	Pass		Special Mention		Substandard		Doubtful		Total
Commercial loans	$	47,943	$	51	$	119	$	-	$	48,113
Real estate mortgage loans:
Residential		62,943		4,331		4,839		-		72,113
Commercial		191,267		4,088		21,991		-		217,346
Construction and land		19,881		-		1,733		-		21,614
Consumer and other loans		1,522		29		332		-		1,883
Total	$	323,556	$	8,499	$	29,014	$	-	$	361,069

December 31, 2013	Pass		Special Mention		Substandard		Doubtful		Total
Commercial loans	$	42,945	$	295	$	615	$	-	$	43,855
Real estate mortgage loans:
Residential		59,003		5,301		6,888		-		71,192
Commercial		198,447		10,836		13,899		-		223,182
Construction and land		21,652		350		8,353		-		30,355
Consumer and other loans		1,633		32		376		-		2,041
Total	$	323,680	$	16,814	$	30,131	$	-	$	370,625

Included in the risk category of loans by class of loans table above are loans acquired in the merger with ABI. As of September 30, 2014 and December 31, 2013, the amounts of such loans were as follows:

(Dollars in thousands)	September 30, 2014		December 31, 2013
Special mention	$	351	$	711
Substandard		7,718		9,170
Doubtful		-		-
Total	$	8,069	$	9,881

Loans Sold

On December 28, 2012, the Bank entered into an Asset Purchase Agreement with a real estate investment firm for the sale of $25,134 in assets, including non-accrual loans, loans with a history of being past due, and other loans that were part of an overall customer relationship for a total of $24,601 and other real estate owned (“OREO”) of $533, for a purchase price of $11,705. The Asset Sale was completed on December 31, 2012, immediately prior to the closing of the Private Placement. The carrying amount and composition of loans sold in the Asset Sale, as well as total net charge-offs that occurred on the date of sale, were as follows:

(Dollars in thousands)	Recorded Investment		Total Net Charge-Offs⁽¹⁾

Loans originated by the Company:
Commercial loans	$	113	$	(53	)
Real estate mortgage loans:
Residential		2,584		1,435
Commercial		13,159		7,394
Construction and land		3,162		2,042
Consumer and other loans		-		-

Loans acquired:
Commercial loans	$	111	$	46
Real estate mortgage loans:
Residential		546		185
Commercial		4,926		2,157
Construction and land		-		-
Consumer and other loans		-		-

Total loans:
Commercial loans	$	224	$	(7	)
Real estate mortgage loans:
Residential		3,130		1,620
Commercial		18,085		9,551
Construction and land		3,162		2,042
Consumer and other loans		-		-

Total loans sold	$	24,601	$	13,206

⁽¹⁾	Includes any specific reserve that existed prior to the date of sale (if applicable).

Purchased Loans

The Company has purchased loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected. The carrying amounts of these loans were as follows as of September 30, 2014 and December 31, 2013:

(Dollars in thousands)	September 30, 2014		December 31, 2013
Commercial loans	$	151	$	160
Real estate mortgage loans:
Residential		3,653		5,137
Commercial		12,042		14,359
Construction and land		370		1,398
Consumer and other loans		-		2
Unpaid principal balance	$	16,216	$	21,056

Carrying amount	$	14,710	$	18,861

Accretable yield, or income collected, from these loans was as follows:

(Dollars in thousands)
Balance as of December 31, 2012	$	11,827
New loans purchased, including loans classified as held for sale		-
Accretion of income		(1,548	)
Reduction for loans sold, paid off and other		(1,018	)
Loans charged off		(935	)
Reclassifications from nonaccretable difference		-
Disposals		-
Balance as of September 30, 2013	$	8,326
Balance as of December 31, 2013	$	8,993
New loans purchased, including loans classified as held for sale		-
Accretion of income		(766	)
Reduction for loans sold, paid off and other		(1,837	)
Loans charged off		(28	)
Reclassifications from nonaccretable difference		-
Disposals		-
Balance as of September 30, 2014	$	6,362

For those purchased loans disclosed above, the Company decreased the allowance for loan losses to $94 from $392 as of September 30, 2014 and December 31, 2013, respectively.