Loans

Major classifications of loans at June 30, 2014 and December 31, 2013 are as follows (in thousands):



	June 30, 2014		December 31, 2013
Commercial and industrial	38,919		29,337
Commercial, secured by real estate	377,806		314,252
Residential real estate	243,966		215,587
Consumer	20,015		12,643
Agricultural	8,466		2,472
Other loans, including deposit overdrafts	2,594		91
	691,766		574,382
Deferred net origination costs (fees)	(47	)	(28	)
	691,719		574,354
Less allowance for loan losses	3,394		3,588
Loans, net	688,325		570,766

All advances from the FHLB are secured by a blanket pledge of LCNB's 1-4 family first lien mortgage loans in the amount of approximately $203 million and $183 million at June 30, 2014 and December 31, 2013, respectively. Additionally, LCNB is required to hold minimum levels of FHLB stock, based on the outstanding borrowings.

Loans acquired from the mergers with First Capital and ENB are recorded at fair value with no carryover of the acquired entity's previously established allowance for loan losses. The excess of expected cash flows over the estimated fair value of acquired loans is recognized as interest income over the remaining contractual lives of the loans using the level yield method.

Subsequent decreases in expected cash flows will require additions to the allowance for loan losses. Subsequent improvements in expected cash flows result in the recognition of additional interest income over the then-remaining contractual lives of the loans.

Impaired loans acquired are accounted for under FASB ASC 310-30. Factors considered in evaluating whether an acquired loan was impaired include delinquency status and history, updated borrower credit status, collateral information, and updated loan-to-value information. The difference between contractually required payments at the time of acquisition and the cash flows expected to be collected is referred to as the nonaccretable difference. The interest component of the cash flows expected to be collected is referred to as the accretable yield and is recognized as interest income over the remaining contractual life of the loan using the level yield method. Subsequent decreases in expected cash flows will require additions to the allowance for loan losses. Subsequent improvements in expected cash flows will result in a reclassification from the nonaccretable difference to the accretable yield.

The following table provides certain information at the acquisition date on loans acquired from ENB, not including loans considered to be impaired (in thousands):



Contractually required principal at acquisition	$	102,483
Less fair value adjustment	1,347
Fair value of acquired loans	$	101,136

Contractual cash flows not expected to be collected	$	1,702

The following table provides details on acquired credit impaired loans obtained through the merger with ENB that are accounted for in accordance with FASB ASC 310-30 (in thousands):



Contractually required principal at acquisition	$	23,414
Contractual cash flows not expected to be collected (nonaccretable difference)	(6,088		)
Expected cash flows at acquisition	17,326
Interest component of expected cash flows (accretable discount)	(2,163		)
Fair value of acquired impaired loans	$	15,163

Non-accrual, past-due, and accruing restructured loans as of June 30, 2014 and December 31, 2013 are as follows (in thousands):



	June 30, 2014	December 31, 2013
Non-accrual loans:
Commercial and industrial	262	144
Commercial, secured by real estate	4,596	1,418
Agricultural	67	—
Residential real estate	1,318	1,399
Total non-accrual loans	6,243	2,961
Past-due 90 days or more and still accruing	130	250
Total non-accrual and past-due 90 days or more and still accruing	6,373	3,211
Accruing restructured loans	14,512	15,151
Total	20,885	18,362

The allowance for loan losses and recorded investment in loans for the six months ended June 30, 2014 and 2013 are as follows (in thousands):



	Commercial & Industrial			Commercial, Secured by Real Estate		Residential Real Estate		Consumer		Agricultural	Other		Total
June 30, 2014
Allowance for loan losses:
Balance, beginning of year	$	175		2,520		826		66		—	1		3,588
Provision charged to expenses	146			(81	)	239		14		8	10		336
Losses charged off	—			(371	)	(175	)	(61	)	—	(33	)	(640	)
Recoveries	10			—		26		50		—	24		110
Balance, end of period	$	331		2,068		916		69		8	2		3,394

Individually evaluated for impairment	$	1		437		136		—		—	—		574
Collectively evaluated for impairment	66			1,516		744		69		8	2		2,405
Acquired credit impaired loans	264			115		36		—		—	—		415
Balance, end of period	$	331		2,068		916		69		8	2		3,394

Loans:
Individually evaluated for impairment	$	324		13,707		1,833		18		—	—		15,882
Collectively evaluated for impairment	36,057			350,271		238,484		19,858		8,351	2,056		655,077
Acquired credit impaired loans	2,501			13,461		3,930		215		115	538		20,760
Balance, end of period	$	38,882		377,439		244,247		20,091		8,466	2,594		691,719

June 30, 2013
Allowance for loan losses:
Balance, beginning of year	$	320		2,296		712		108		—	1		3,437
Provision charged to expenses	(32		)	100		118		(6	)	—	11		191
Losses charged off	(119		)	(34	)	(39	)	(85	)	—	(33	)	(310	)
Recoveries	—			11		13		61		—	23		108
Balance, end of period	$	169		2,373		804		78		—	2		3,426

Individually evaluated for impairment	$	1		684		269		—		—	—		954
Collectively evaluated for impairment	168			1,689		535		78		—	2		2,472
Acquired credit impaired loans	—			—		—		—		—	—		—
Balance, end of period	$	169		2,373		804		78		—	2		3,426

Loans:
Individually evaluated for impairment	$	166		13,858		1,742		34		—	—		15,800
Collectively evaluated for impairment	32,755			276,741		206,817		13,402		2,838	400		532,953
Acquired credit impaired loans	356			5,614		1,591		—		—	—		7,561
Balance, end of period	$	33,277		296,213		210,150		13,436		2,838	400		556,314

The risk characteristics of LCNB's material loan portfolio segments are as follows:

Commercial and Industrial Loans. LCNB’s commercial and industrial loan portfolio consists of loans for various purposes, including loans to fund working capital requirements (such as inventory and receivables financing) and purchases of machinery and equipment. LCNB offers a variety of commercial and industrial loan arrangements, including term loans, balloon loans, and line of credit. Most commercial and industrial loans have a variable rate, with adjustments occurring monthly, annually, every three years, or every five years. Adjustments are generally based on a publicly available index rate plus a margin. The margin varies based on the terms and collateral securing the loan. Commercial and industrial loans are offered to businesses and professionals for short and medium terms on both a collateralized and uncollateralized basis. Commercial and industrial loans typically are underwritten on the basis of the borrower’s ability to make repayment from the cash flow of the business. Collateral, when obtained, may include liens on furniture, fixtures, equipment, inventory, receivables, or other assets. As a result, such loans involve complexities, variables, and risks that require thorough underwriting and more robust servicing than other types of loans.

Commercial, Secured by Real Estate Loans. Commercial real estate loans include loans secured by a variety of commercial, retail, and office buildings, religious facilities, multifamily (more than two-family) residential properties, construction and land development loans, and other land loans. Commercial real estate loan products generally amortize over five to twenty-five years and are payable in monthly principal and interest installments. Some have balloon payments due within one to ten years after the origination date. Many have adjustable interest rates with adjustment periods ranging from one to ten years, some of which are subject to established “floor” interest rates.

Commercial real estate loans are underwritten based on the ability of the property, in the case of income producing property, or the borrower’s business to generate sufficient cash flow to amortize the debt. Secondary emphasis is placed upon global debt service, collateral value, financial strength of any guarantors, and other factors. Commercial real estate loans are generally originated with a 75 percent maximum loan to appraised value ratio.

Residential Real Estate Loans. Residential real estate loans include loans secured by first or second mortgage liens on one-to-two family residential property. Home equity lines of credit and mortgage loans secured by owner-occupied agricultural property are included in this category. First and second mortgage loans are generally amortized over five to thirty years with monthly principal and interest payments. Home equity lines of credit generally have a five year draw period with interest only payments followed by a repayment period with monthly payments based on the amount outstanding. LCNB offers both fixed and adjustable rate mortgage loans. Adjustable rate loans are available with adjustment periods ranging between one to ten years and adjust according to an established index plus a margin, subject to certain floor and ceiling rates. Home equity lines of credit have a variable rate based on the Wall Street Journal prime rate plus a margin.

LCNB does not originate reverse mortgage loans or residential real estate loans generally considered to be “subprime.”

Residential real estate loans are underwritten primarily based on the borrower’s ability to repay, prior credit history, and the value of the collateral. LCNB requires private mortgage insurance for first mortgage loans that have a loan to appraised value ratio of greater than 80%.

Consumer Loans. LCNB’s portfolio of consumer loans generally includes secured and unsecured loans to individuals for household, family and other personal expenditures. Secured loans include loans to fund the purchase of automobiles, recreational vehicles, boats, and similar acquisitions. Consumer loans made by LCNB generally have fixed rates and terms ranging up to 72 months, depending upon the nature of the collateral, size of the loan, and other relevant factors.

Consumer loans generally have higher interest rates, but pose additional risks of collectability and loss when compared to certain other types of loans. Collateral, if present, is generally subject to damage, wear, and depreciation. The borrower’s ability to repay is of primary importance in the underwriting of consumer loans.

Agricultural Loans. LCNB’s portfolio of agricultural loans includes loans for financing agricultural production or for financing the purchase of equipment used in the production of agricultural products. LCNB’s agricultural loans are generally secured by farm machinery, livestock, crops, vehicles, or other agri-related collateral.

LCNB uses a risk-rating system to quantify loan quality. A loan is assigned to a risk category based on relevant information about the ability of the borrower to service the debt including, but not limited to, current financial information, historical payment experience, credit documentation, public information, and current economic trends. The categories used are:


•	Pass – loans categorized in this category are higher quality loans that do not fit any of the other categories described below.


•	Other Assets Especially Mentioned (OAEM) - loans in this category are currently protected but are potentially weak. These loans constitute a risk but not to the point of justifying a classification of substandard. The credit risk may be relatively minor yet constitute an undue risk in light of the circumstances surrounding a specific asset.


•	Substandard – loans in this category are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the possibility that LCNB will sustain some loss if the deficiencies are not corrected.


•	Doubtful – loans classified in this category have all the weaknesses inherent in loans classified 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.

A breakdown of the loan portfolio by credit quality indicators at June 30, 2014 and December 31, 2013 is as follows (in thousands):



	Pass		OAEM	Substandard	Doubtful	Total
June 30, 2014
Commercial & industrial	$	37,151	20	1,711	—	38,882
Commercial, secured by real estate	349,487		2,916	25,036	—	377,439
Residential real estate	235,402		127	8,718	—	244,247
Consumer	19,874		—	217	—	20,091
Agricultural	8,351		—	115	—	8,466
Other	2,056		—	538	—	2,594
Total	$	652,321	3,063	36,335	—	691,719

December 31, 2013
Commercial & industrial	$	27,563	44	1,699	—	29,306
Commercial, secured by real estate	295,189		3,967	14,757	—	313,913
Residential real estate	208,881		1,136	5,825	—	215,842
Consumer	12,681		—	49	—	12,730
Agricultural	2,472		—	—	—	2,472
Other	91		—	—	—	91
Total	$	546,877	5,147	22,330	—	574,354

A loan portfolio aging analysis at June 30, 2014 and December 31, 2013 is as follows (in thousands):



	30-59 Days Past Due		60-89 Days Past Due	Greater Than 90 Days Past Due	Total Past Due	Current	Total Loans Receivable	Total Loans Greater Than 90 Days and Accruing
June 30, 2014
Commercial & industrial	$	963	—	261	1,224	37,658	38,882	—
Commercial, secured by real estate	878		377	3,055	4,310	373,129	377,439	69
Residential real estate	1,141		184	974	2,299	241,948	244,247	45
Consumer	52		47	16	115	19,976	20,091	16
Agricultural	—		—	67	67	8,399	8,466	—
Other	57		—	—	57	2,537	2,594	—
Total	$	3,091	608	4,373	8,072	683,647	691,719	130

December 31, 2013
Commercial & industrial	$	277	—	144	421	28,885	29,306	—
Commercial, secured by real estate	951		582	1,174	2,707	311,206	313,913	—
Residential real estate	1,131		299	1,604	3,034	212,808	215,842	236
Consumer	38		35	13	86	12,644	12,730	14
Agricultural	—		—	—	—	2,472	2,472	—
Other	91		—	—	91	—	91	—
Total	$	2,488	916	2,935	6,339	568,015	574,354	250

Impaired loans, including acquired credit impaired loans, at June 30, 2014 and December 31, 2013 are as follows (in thousands):



	Recorded Investment		Unpaid Principal Balance	Related Allowance
June 30, 2014
With no related allowance recorded:
Commercial & industrial	$	2,240	3,627	—
Commercial, secured by real estate	22,810		28,337	—
Residential real estate	4,394		6,535	—
Consumer	233		393	—
Agricultural	115		639	—
Other	538		774	—
Total	$	30,330	40,305	—

With an allowance recorded:
Commercial & industrial	$	585	647	265
Commercial, secured by real estate	4,358		4,723	552
Residential real estate	1,369		1,476	172
Total	$	6,312	6,846	989

Total:
Commercial & industrial	$	2,825	4,274	265
Commercial, secured by real estate	27,168		33,060	552
Residential real estate	5,763		8,011	172
Consumer	233		393	—
Agricultural	115		639	—
Other	538		774	—
Total	$	36,642	47,151	989

December 31, 2013
With no related allowance recorded:
Commercial & industrial	$	332	531	—
Commercial, secured by real estate	10,883		12,317	—
Residential real estate	2,096		2,967	—
Consumer	—		—	—
Total	$	13,311	15,815	—

With an allowance recorded:
Commercial & industrial	$	165	270	2
Commercial, secured by real estate	7,725		7,725	760
Residential real estate	1,645		1,663	270
Consumer	27		27	—
Total	$	9,562	9,685	1,032

Total:
Commercial & industrial	$	497	801	2
Commercial, secured by real estate	18,608		20,042	760
Residential real estate	3,741		4,630	270
Consumer	27		27	—
Total	$	22,873	25,500	1,032

The following presents information related to the average recorded investment and interest income recognized on impaired loans, including acquired credit impaired loans, for the three and six months ended June 30, 2014 and 2013 (in thousands):



	2014			2013
	Average Recorded Investment		Interest Income Recognized	Average Recorded Investment	Interest Income Recognized
Three Months Ended June 30,
With no related allowance recorded:
Commercial & industrial	$	2,057	38	774	9
Commercial, secured by real estate	23,282		327	11,965	155
Residential real estate	4,528		101	1,986	42
Consumer	234		2	—	—
Agricultural	118		7	16	6
Other	560		10	—	—
Total	$	30,779	485	14,741	212

With an allowance recorded:
Commercial & industrial	$	494	2	185	—
Commercial, secured by real estate	4,344		—	7,581	60
Residential real estate	1,352		11	1,255	8
Consumer	—		—	22	1
Agricultural	—		—	—	—
Other	—		—	—	—
Total	$	6,190	13	9,043	69

Total:
Commercial & industrial	$	2,551	40	959	9
Commercial, secured by real estate	27,626		327	19,546	215
Residential real estate	5,880		112	3,241	50
Consumer	234		2	22	1
Agricultural	118		7	16	6
Other	560		10	—	—
Total	$	36,969	498	23,784	281

Six Months Ended June 30,
With no related allowance recorded:
Commercial & industrial	$	2,088	70	943	24
Commercial, secured by real estate	23,839		616	12,001	300
Residential real estate	4,682		177	2,085	86
Consumer	246		9	—	—
Agricultural	129		9	21	6
Other	564		17	—	—
Total	$	31,548	898	15,050	416

With an allowance recorded:
Commercial & industrial	$	291	13	204	1
Commercial, secured by real estate	4,228		50	7,485	123
Residential real estate	1,296		23	1,185	15
Consumer	—		—	18	1
Agricultural	—		—	—	—
Other	—		—	—	—
Total	$	5,815	86	8,892	140

Total:
Commercial & industrial	$	2,379	83	1,147	25
Commercial, secured by real estate	28,067		666	19,486	423
Residential real estate	5,978		200	3,270	101
Consumer	246		9	18	1
Agricultural	129		9	21	6
Other	564		17	—	—
Total	$	37,363	984	23,942	556

Loan modifications that were classified as troubled debt restructurings during the three and six months ended June 30, 2014 and 2013 are as follows (dollars in thousands):



	2014			2013
	Number of Loans	Balance at Modification		Number of Loans	Balance at Modification
Three Months Ended June 30,
Commercial and industrial	6	$	628	1	$	22
Commercial, secured by real estate	1	818		—	—
Residential real estate	1	78		2	335
Consumer	—	—		2	27
Total	8	$	1,524	5	$	384

Six Months Ended June 30,
Commercial and industrial	7	$	638	1	$	22
Commercial, secured by real estate	1	818		—	—
Residential real estate	1	78		2	335
Consumer	1	2		2	27
Total	10	$	1,536	5	$	384

Each restructured loan is separately negotiated with the borrower and includes terms and conditions that reflect the borrower's ability to pay the debt as modified. Modifications may include interest only payments for a period of time, temporary or permanent reduction of the loan's interest rate, capitalization of delinquent interest, or extensions of the maturity date.

LCNB is not committed to lend additional funds to borrowers whose loan terms were modified in a troubled debt restructuring.

A restructured automobile loan with a balance of $13,000 was charged off during the first quarter 2013, which was within twelve months of the loan's modification date. There were no other troubled debt restructurings that subsequently defaulted within twelve months of the restructuring date for the six months ended June 30, 2014 and 2013.