LOANS

Major classifications of loans at December 31 were as follows (in thousands):



	2014		2013
Commercial and industrial	$	35,424	29,337
Commercial, secured by real estate	379,141		314,252
Residential real estate	254,087		215,587
Consumer	18,006		12,643
Agricultural	11,472		2,472
Other loans, including deposit overdrafts	680		91
	698,810		574,382
Deferred origination costs (fees), net	146		(28	)
	698,956		574,354
Less allowance for loan losses	3,121		3,588
Loans-net	$	695,835	570,766

Loans acquired from the mergers with First Capital and Eaton National 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. Management estimated the cash flows expected to be collected at acquisition using a third-party risk model, which incorporated the estimate of current key assumptions, such as default rates, severity, and prepayment speeds.

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 Eaton National, 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 impaired loans obtained through the merger with Eaton National 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 at December 31 were as follows (in thousands):



	2014			2013
Non-accrual loans:
Commercial and industrial	$	—		144
Commercial, secured by real estate	4,277			1,418
Agricultural	70			—
Residential real estate	1,252			1,399
Total non-accrual loans	5,599			2,961
Past-due 90 days or more and still accruing	203			250
Total non-accrual and past-due 90 days or more and still accruing	5,802			3,211
Accruing restructured loans	14,269			15,151
Total	$	20,071		18,362

Percentage of total non-accrual and past-due 90 days or more and still accruing to total loans	0.83		%	0.56	%

Percentage of total non-accrual, past-due 90 days or more and still accruing, and accruing restructured loans to total loans	2.87		%	3.20	%

Interest income that would have been recorded during 2014 and 2013 if loans on non-accrual status at December 31, 2014 and 2013 had been current and in accordance with their original terms was approximately $665,000 and $229,000, respectively.

The Company is not committed to lend additional funds to debtors whose loans have been modified to provide a reduction or deferral of principal or interest because of deterioration in the financial position of the borrower.

The allowance for loan losses and recorded investment in loans for the years ended December 31 were as follows (in thousands):



	Commercial & Industrial			Commercial, Secured by Real Estate		Residential Real Estate		Consumer		Agricultural	Other		Total
December 31, 2014
Allowance for loan losses:
Balance, beginning of year	$	175		2,520		826		66		—	1		3,588
Provision charged to expenses	173			(20	)	712		18		11	36		930
Losses charged off	(261		)	(573	)	(652	)	(129	)	—	(79	)	(1,694	)
Recoveries	42			63		40		108		—	44		297
Balance, end of year	$	129		1,990		926		63		11	2		3,121

Individually evaluated for impairment	$	10		415		89		—		—	—		514
Collectively evaluated for impairment	119			1,273		836		63		11	2		2,304
Acquired credit impaired loans	—			302		1		—		—	—		303
Balance, end of year	$	129		1,990		926		63		11	2		3,121

Loans:
Individually evaluated for impairment	$	401		13,022		1,701		55		—	—		15,179
Collectively evaluated for impairment	33,941			352,774		249,374		17,954		11,371	167		665,581
Acquired credit impaired loans	1,092			12,984		3,425		81		101	513		18,196
Balance, end of year	$	35,434		378,780		254,500		18,090		11,472	680		698,956

December 31, 2013
Allowance for loan losses:
Balance, beginning of year	$	320		2,296		712		108		—	1		3,437
Provision charged to expenses	(30		)	256		327		12		—	23		588
Losses charged off	(119		)	(58	)	(244	)	(181	)	—	(67	)	(669	)
Recoveries	4			26		31		127		—	44		232
Balance, end of year	$	175		2,520		826		66		—	1		3,588

Individually evaluated for impairment	$	2		760		270		—		—	—		1,032
Collectively evaluated for impairment	173			1,760		556		66		—	1		2,556
Acquired credit impaired loans	—			—		—		—		—	—		—
Balance, end of year	$	175		2,520		826		66		—	1		3,588

Loans:
Individually evaluated for impairment	$	165		14,522		2,132		27		—	—		16,846
Collectively evaluated for impairment	28,809			295,028		212,378		12,703		2,472	91		551,481
Acquired credit impaired loans	332			4,363		1,332		—		—	—		6,027
Balance, end of year	$	29,306		313,913		215,842		12,730		2,472	91		574,354



	Commercial & Industrial			Commercial, Secured by Real Estate		Residential Real Estate		Consumer		Agricultural	Other		Total
December 31, 2012
Allowance for loan losses:
Balance, beginning of year	$	162		1,941		656		166		—	6		2,931
Change in classification	18			(18	)	—		—		—	—		—
Provision charged to expenses	299			536		535		(47	)	—	28		1,351
Losses charged off	(159		)	(234	)	(486	)	(134	)	—	(85	)	(1,098	)
Recoveries	—			71		7		123		—	52		253
Balance, end of year	$	320		2,296		712		108		—	1		3,437

Individually evaluated for impairment	$	159		607		138		—		—	—		904
Collectively evaluated for impairment	161			1,689		574		108		—	1		2,533
Balance, end of year	$	320		2,296		712		108		—	1		3,437

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 lines 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% 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 collectibility 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.

The Company 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 the Company 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.

An analysis of the Company’s loan portfolio by credit quality indicators at December 31 is as follows (in thousands):



	Pass		OAEM	Substandard	Doubtful	Total
December 31, 2014
Commercial & industrial	$	34,322	—	1,112	—	35,434
Commercial, secured by real estate	353,957		6,421	18,402	—	378,780
Residential real estate	246,335		920	7,245	—	254,500
Consumer	17,979		—	111	—	18,090
Agricultural	11,273		—	199	—	11,472
Other	680		—	—	—	680
Total	$	664,546	7,341	27,069	—	698,956

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

The Company evaluates the loan risk grading system definitions and allowance for loan loss methodology on an ongoing basis. No significant changes were made to either during the past year.

A loan portfolio aging analysis at December 31 is as follows (in thousands):



	30-59 Days Past Due		60-89 Days Past Due	Greater Than 90 Days	Total Past Due	Current	Total Loans Receivable	Total Loans Greater Than 90 Days and Accruing
December 31, 2014
Commercial & industrial	$	4	—	—	4	35,430	35,434	—
Commercial, secured by real estate	1,000		83	3,179	4,262	374,518	378,780	9
Residential real estate	648		297	1,289	2,234	252,266	254,500	177
Consumer	59		28	17	104	17,986	18,090	17
Agricultural	73		70	—	143	11,329	11,472	—
Other	106		—	—	106	574	680	—
Total	$	1,890	478	4,485	6,853	692,103	698,956	203

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 for the years ended December 31 were as follows (in thousands):



	Recorded Investment		Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
December 31, 2014
With no related allowance recorded:
Commercial & industrial	$	1,092	2,077	—	1,823	161
Commercial, secured by real estate	21,987		26,715	—	23,360	1,373
Residential real estate	4,074		5,549	—	4,645	379
Consumer	117		178	—	179	14
Agricultural	101		619	—	121	20
Other	513		744	—	550	43
Total	$	27,884	35,882	—	30,678	1,990

With an allowance recorded:
Commercial & industrial	$	401	406	10	319	19
Commercial, secured by real estate	4,019		4,538	717	4,108	117
Residential real estate	1,052		1,265	90	1,026	44
Consumer	19		20	—	18	2
Agricultural	—		—	—	—	—
Other	—		—	—	—	—
Total	$	5,491	6,229	817	5,471	182

Total:
Commercial & industrial	$	1,493	2,483	10	2,142	180
Commercial, secured by real estate	26,006		31,253	717	27,468	1,490
Residential real estate	5,126		6,814	90	5,671	423
Consumer	136		198	—	197	16
Agricultural	101		619	—	121	20
Other	513		744	—	550	43
Total	$	33,375	42,111	817	36,149	2,172



	Recorded Investment		Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
December 31, 2013
With no related allowance recorded:
Commercial & industrial	$	332	531	—	700	35
Commercial, secured by real estate	10,883		12,317	—	11,612	748
Residential real estate	2,096		2,967	—	2,345	182
Consumer	—		—	—	7	—
Agricultural	—		—	—	13	6
Total	$	13,311	15,815	—	14,677	971

With an allowance recorded:
Commercial & industrial	$	165	270	2	186	2
Commercial, secured by real estate	7,725		7,725	760	7,368	252
Residential real estate	1,645		1,663	270	1,123	44
Consumer	27		27	—	17	2
Agricultural	—		—	—	—	—
Total	$	9,562	9,685	1,032	8,694	300

Total:
Commercial & industrial	$	497	801	2	886	37
Commercial, secured by real estate	18,608		20,042	760	18,980	1,000
Residential real estate	3,741		4,630	270	3,468	226
Consumer	27		27	—	24	2
Agricultural	—		—	—	13	6
Total	$	22,873	25,500	1,032	23,371	1,271



	Recorded Investment		Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
December 31, 2012
With no related allowance recorded:
Commercial & industrial	$	—	—	—	975	43
Commercial, secured by real estate	9,541		9,936	—	9,310	350
Residential real estate	417		417	—	397	5
Consumer	20		20	—	23	2
Agricultural	—		—	—	—	—
Total	$	9,978	10,373	—	10,705	400

With an allowance recorded:
Commercial & industrial	$	264	822	159	374	—
Commercial, secured by real estate	4,258		4,360	660	4,765	171
Residential real estate	658		853	85	707	2
Consumer	—		—	—	4	—
Agricultural	—		—	—	—	—
Total	$	5,180	6,035	904	5,850	173

Total:
Commercial & industrial	$	264	822	159	1,349	43
Commercial, secured by real estate	13,799		14,296	660	14,075	521
Residential real estate	1,075		1,270	85	1,104	7
Consumer	20		20	—	27	2
Agricultural	—		—	—	—	—
Total	$	15,158	16,408	904	16,555	573

Of the $2,172,000, $1,271,000, and $573,000 of interest income recognized on impaired loans during 2014, 2013, and 2012, respectively, $8,000 was recognized on a cash basis during 2014 and none was recognized on a cash basis during 2013 and 2012. The Company continued to accrue interest on certain loans classified as impaired during 2014, 2013, and 2012 because they were restructured or considered well secured and in the process of collection.

Loan modifications that were classified as troubled debt restructurings during the years ended December 31 were as follows (dollars in thousands):



	2014					2013
	Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance		Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance
Commercial and industrial	8	$	658	$	340	1	$	22	$	22
Commercial, secured by real estate	2	896		1,214		3	1,594		1,594
Residential real estate	2	82		82		6	508		508
Consumer	3	40		40		2	27		27
	15	$	1,676	$	1,676	12	$	2,151	$	2,151

The pre-modification and post-modification recorded balances for the commercial and industrial and commercial, secured by real estate categories in 2014 changed because a borrower had multiple loans classified as commercial and industrial and a loan classified as commercial, secured by real estate, which were all modified into a loan classified as commercial, secured by real estate.

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 years ended December 31, 2014 and 2013.

All troubled debt restructurings are considered impaired loans. The allowance for loan loss on such restructured loans is based on the present value of future expected cash flows.

Approximately $1,329,000 of impaired loans without a valuation allowance and $299,000 of impaired loans with a valuation allowance at December 31, 2014 consisted of loans that were modified during 2014 and were determined to be troubled debt restructurings. Approximately $327,000 of impaired loans, excluding acquired credit impaired loans, without a valuation allowance and $1,141,000 of impaired loans with a valuation allowance at December 31, 2013 consisted of loans that were modified during 2013 and were determined to be troubled debt restructurings.

Mortgage loans sold to and serviced for the Federal Home Loan Mortgage Corporation and other investors are not included in the accompanying consolidated balance sheets. The unpaid principal balances of those loans at December 31, 2014, 2013 and 2012 were approximately $120,433,000, $90,343,000, and $71,568,000 respectively.

Mortgage servicing right assets are included in other assets in the consolidated balance sheets. Amortization of mortgage servicing rights is an adjustment to loan servicing income, which is included with other operating income in the consolidated statements of income. Activity in the mortgage servicing rights portfolio during the years ended December 31 was as follows (in thousands):



	2014			2013		2012
Balance, beginning of year	$	498		475		418
Amount capitalized to mortgage servicing rights	292			191		283
Amortization of mortgage servicing rights	(199		)	(168	)	(226	)
Balance, end of year	$	591		498		475