Loans

Major classifications of loans at September 30, 2017 and December 31, 2016 are as follows (in thousands):



	September 30, 2017		December 31, 2016
Commercial and industrial	$	36,049	$	41,878
Commercial, secured by real estate	510,158		477,275
Residential real estate	253,530		265,788
Consumer	17,956		19,173
Agricultural	15,677		14,802
Other loans, including deposit overdrafts	570		633
	833,940		819,549
Deferred origination costs (fees), net	264		254
	834,204		819,803
Less allowance for loan losses	3,407		3,575
Loans, net	$	830,797	$	816,228

Loans acquired through mergers 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 Accounting Standards Codification ("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.

Non-accrual, past-due, and accruing restructured loans as of September 30, 2017 and December 31, 2016 are as follows (in thousands):



	September 30, 2017		December 31, 2016
Non-accrual loans:
Commercial and industrial	$	—	$	—
Commercial, secured by real estate	2,840		4,312
Residential real estate	1,180		1,079
Consumer	—		—
Agricultural	367		334
Total non-accrual loans	4,387		5,725
Past-due 90 days or more and still accruing	95		23
Total non-accrual and past-due 90 days or more and still accruing	4,482		5,748
Accruing restructured loans	10,791		11,731
Total	$	15,273	$	17,479

The allowance for loan losses for the three and nine months ended September 30, 2017 and 2016 are as follows (in thousands):



	Commercial & Industrial			Commercial, Secured by Real Estate			Residential Real Estate			Consumer			Agricultural		Other			Total
Three Months Ended September 30, 2017
Balance, beginning of period	$	273		$	2,136		$	822		$	86		$	61	$	4		$	3,382
Provision charged to expenses	8			(9		)	(139		)	(6		)	113		21			(12		)
Losses charged off	—			(118		)	—			(30		)	—		(37		)	(185		)
Recoveries	19			106			38			44			—		15			222
Balance, end of period	$	300		$	2,115		$	721		$	94		$	174	$	3		$	3,407

Nine Months Ended September 30, 2017
Balance, beginning of year	$	350		$	2,179		$	885		$	96		$	60	$	5		$	3,575
Provision charged to expenses	(84		)	287			(137		)	(3		)	114		48			225
Losses charged off	—			(462		)	(135		)	(84		)	—		(98		)	(779		)
Recoveries	34			111			108			85			—		48			386
Balance, end of period	$	300		$	2,115		$	721		$	94		$	174	$	3		$	3,407

Three Months Ended September 30, 2016
Balance, beginning of period	$	273		$	2,071		$	885		$	80		$	62	$	2		$	3,373
Provision charged to expenses	162			193			(46		)	36			6		21			372
Losses charged off	—			(19		)	(21		)	(30		)	—		(33		)	(103		)
Recoveries	12			80			43			9			—		12			156
Balance, end of period	$	447		$	2,325		$	861		$	95		$	68	$	2		$	3,798

Nine Months Ended September 30, 2016
Balance, beginning of year	$	244		$	1,908		$	854		$	54		$	66	$	3		3,129
Provision charged to expenses	236			478			19			85			2		38			858
Losses charged off	(49		)	(159		)	(63		)	(83		)	—		(75		)	(429		)
Recoveries	16			98			51			39			—		36			240
Balance, end of period	$	447		$	2,325		$	861		$	95		$	68	$	2		$	3,798

A breakdown of the allowance for loan losses and the loan portfolio by loan segment at September 30, 2017 and December 31, 2016 are as follows (in thousands):



	Commercial & Industrial		Commercial, Secured by Real Estate		Residential Real Estate		Consumer		Agricultural		Other		Total
September 30, 2017
Allowance for loan losses:
Individually evaluated for impairment	$	7	$	182	$	49	$	9	$	121	$	—	$	368
Collectively evaluated for impairment	293		1,933		672		85		53		3		3,039
Acquired credit impaired loans	—		—		—		—		—		—		—
Balance, end of period	$	300	$	2,115	$	721	$	94	$	174	$	3	$	3,407

Loans:
Individually evaluated for impairment	$	311	$	12,416	$	1,519	$	50	$	367	$	—	$	14,663
Collectively evaluated for impairment	34,771		493,124		250,117		18,008		15,325		127		811,472
Acquired credit impaired loans	1,008		4,264		2,351		3		—		443		8,069
Balance, end of period	$	36,090	$	509,804	$	253,987	$	18,061	$	15,692	$	570	$	834,204

December 31, 2016
Allowance for loan losses:
Individually evaluated for impairment	$	9	$	55	$	100	$	13	$	—	$	—	$	177
Collectively evaluated for impairment	341		1,832		785		83		60		5		3,106
Acquired credit impaired loans	—		292		—		—		—		—		292
Balance, end of period	$	350	$	2,179	$	885	$	96	$	60	$	5	$	3,575

Loans:
Individually evaluated for impairment	$	337	$	12,580	$	1,518	$	52	$	334	$	—	$	14,821
Collectively evaluated for impairment	41,466		458,059		262,266		19,192		14,475		178		795,636
Acquired credit impaired loans	98		6,305		2,471		17		—		455		9,346
Balance, end of period	$	41,901	$	476,944	$	266,255	$	19,261	$	14,809	$	633	$	819,803

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 adjustment periods ranging from one month to 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 an 80% 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 generally 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 84 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 agricultural 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 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.

A breakdown of the loan portfolio by credit quality indicators at September 30, 2017 and December 31, 2016 is as follows (in thousands):



	Pass		OAEM		Substandard		Doubtful		Total
September 30, 2017
Commercial & industrial	$	35,586	$	197	$	307	$	—	$	36,090
Commercial, secured by real estate	484,670		4,451		20,683		—		509,804
Residential real estate	251,393		—		2,594		—		253,987
Consumer	18,028		—		33		—		18,061
Agricultural	14,475		—		1,217		—		15,692
Other	570		—		—		—		570
Total	$	804,722	$	4,648	$	24,834	$	—	$	834,204

December 31, 2016
Commercial & industrial	$	41,178	$	304	$	419	$	—	$	41,901
Commercial, secured by real estate	443,781		5,479		27,684		—		476,944
Residential real estate	261,839		442		3,974		—		266,255
Consumer	19,182		—		79		—		19,261
Agricultural	13,311		—		1,498		—		14,809
Other	633		—		—		—		633
Total	$	779,924	$	6,225	$	33,654	$	—	$	819,803

A loan portfolio aging analysis at September 30, 2017 and December 31, 2016 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
September 30, 2017
Commercial & industrial	$	4	$	—	$	—	$	4	$	36,086	$	36,090	$	—
Commercial, secured by real estate	781		—		795		1,576		508,228		509,804		—
Residential real estate	514		26		1,178		1,718		252,269		253,987		95
Consumer	4		3		—		7		18,054		18,061		—
Agricultural	—		—		367		367		15,325		15,692		—
Other	69		—		—		69		501		570		—
Total	$	1,372	$	29	$	2,340	$	3,741	$	830,463	$	834,204	$	95

December 31, 2016
Commercial & industrial	$	19	$	—	$	—	$	19	$	41,882	$	41,901	$	—
Commercial, secured by real estate	99		69		127		295		476,649		476,944		—
Residential real estate	686		80		727		1,493		264,762		266,255		20
Consumer	59		16		3		78		19,183		19,261		3
Agricultural	125		—		—		125		14,684		14,809		—
Other	115		—		—		115		518		633		—
Total	$	1,103	$	165	$	857	$	2,125	$	817,678	$	819,803	$	23

Impaired loans, including acquired credit impaired loans, at September 30, 2017 and December 31, 2016 are as follows (in thousands):



	September 30, 2017						December 31, 2016
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:
Commercial & industrial	$	1,016	$	1,154	$	—	$	109	$	263	$	—
Commercial, secured by real estate	13,722		14,854		—		14,195		15,522		—
Residential real estate	3,272		4,341		—		3,238		4,286		—
Consumer	10		10		—		26		27		—
Agricultural	190		190		—		334		334		—
Other	443		591		—		455		629		—
Total	$	18,653	$	21,140	$	—	$	18,357	$	21,061	$	—

With an allowance recorded:
Commercial & industrial	$	303	$	308	$	7	$	326	$	326	$	9
Commercial, secured by real estate	2,958		2,957		182		4,690		4,946		347
Residential real estate	598		624		49		751		751		100
Consumer	43		43		9		43		43		13
Agricultural	177		177		121		—		—		—
Other	—		—		—		—		—		—
Total	$	4,079	$	4,109	$	368	$	5,810	$	6,066	$	469

Total:
Commercial & industrial	$	1,319	$	1,462	$	7	$	435	$	589	$	9
Commercial, secured by real estate	16,680		17,811		182		18,885		20,468		347
Residential real estate	3,870		4,965		49		3,989		5,037		100
Consumer	53		53		9		69		70		13
Agricultural	367		367		121		334		334		—
Other	443		591		—		455		629		—
Total	$	22,732	$	25,249	$	368	$	24,167	$	27,127	$	469

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 nine months ended September 30, 2017 and 2016 (in thousands):



	2017				2016
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
Three Months Ended September 30,
With no related allowance recorded:
Commercial & industrial	$	945	$	10	$	1,356	$	34
Commercial, secured by real estate	13,671		184		15,594		236
Residential real estate	3,268		45		3,769		113
Consumer	16		—		29		7
Agricultural	142		—		384		—
Other	438		12		480		18
Total	$	18,480	$	251	$	21,612	$	408

With an allowance recorded:
Commercial & industrial	$	306	$	4	$	476	$	5
Commercial, secured by real estate	2,970		11		3,383		41
Residential real estate	604		7		695		8
Consumer	43		1		45		1
Agricultural	178		—		—		—
Other	—		—		—		—
Total	$	4,101	$	23	$	4,599	$	55

Total:
Commercial & industrial	$	1,251	$	14	$	1,832	$	39
Commercial, secured by real estate	16,641		195		18,977		277
Residential real estate	3,872		52		4,464		121
Consumer	59		1		74		8
Agricultural	320		—		384		—
Other	438		12		480		18
Total	$	22,581	$	274	$	26,211	$	463

Nine Months Ended September 30,
With no related allowance recorded:
Commercial & industrial	$	603	$	46	$	1,167	$	89
Commercial, secured by real estate	14,099		685		16,654		897
Residential real estate	3,280		180		3,809		306
Consumer	24		2		41		22
Agricultural	57		—		403		135
Other	450		43		488		58
Total	$	18,513	$	956	$	22,562	$	1,507

With an allowance recorded:
Commercial & industrial	$	314	$	13	$	400	$	15
Commercial, secured by real estate	3,085		35		2,960		82
Residential real estate	634		23		680		24
Consumer	43		2		43		2
Agricultural	240		—		—		—
Other	—		—		—		—
Total	$	4,316	$	73	$	4,083	$	123

Total:
Commercial & industrial	$	917	$	59	$	1,567	$	104
Commercial, secured by real estate	17,184		720		19,614		979
Residential real estate	3,914		203		4,489		330
Consumer	67		4		84		24
Agricultural	297		—		403		135
Other	450		43		488		58
Total	$	22,829	1,029		$	26,645	$	1,630

Of the interest income recognized on impaired loans during the nine months ended September 30, 2017 and 2016, approximately $1,000 and $48,000, respectively, were recognized on a cash basis.

Loan modifications that were classified as troubled debt restructurings during the three and nine months ended September 30, 2017 and 2016 are as follows (dollars in thousands):



	2017					2016
	Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance		Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance
Three Months Ended September 30,
Commercial & industrial	—	$	—	$	—	—	$	—	$	—
Commercial, secured by real estate	—	—		—		1	304		304
Residential real estate	—	—		—		1	27		27
Consumer	—	—		—		1	11		11
Total	—	$	—	$	—	3	$	342	$	342

Nine Months Ended September 30,
Commercial & industrial	—	$	—	$	—	—	$	—	$	—
Commercial, secured by real estate	—	—		—		2	603		676
Residential real estate	1	18		9		3	72		72
Consumer	1	14		14		3	38		38
Total	2	$	32	$	23	8	$	713	$	786

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, forgiveness of principal, or extensions of the maturity date. Post-modification balances of newly restructured troubled debt by type of modification for the three and nine months ended September 30, 2017 and 2016 were as follows (dollars in thousands):



	Term Modification		Rate Modification		Interest Only		Principal Forgiveness		Combination		Total Modifications
Three Months Ended September 30, 2017
Commercial & industrial	$	—	$	—	$	—	$	—	$	—	$	—
Commercial, secured by real estate	—		—		—		—		—		—
Residential real estate	—		—		—		—		—		—
Consumer	—		—		—		—		—		—
Total	$	—	$	—	$	—	$	—	$	—	$	—

Nine Months Ended September 30, 2017
Commercial & industrial	$	—	$	—	$	—	$	—	$	—	$	—
Commercial, secured by real estate	—		—		—		—		—		—
Residential real estate	—		—		—		9		—		9
Consumer	14		—		—		—		—		14
Total	$	14	$	—	$	—	$	9	$	—	$	23

Three Months Ended September 30, 2016
Commercial & industrial	$	—	$	—	$	—	$	—	$	—	$	—
Commercial, secured by real estate	—		—		304		—		—		304
Residential real estate	—		—		—		—		27		27
Consumer	—		—		—		—		11		11
Total	$	—	$	—	$	304	$	—	$	38	$	342

Nine Months Ended September 30, 2016
Commercial & industrial	$	—	$	—	$	—	$	—	$	—	$	—
Commercial, secured by real estate	—		—		304		—		372		676
Residential real estate	18		27		—		—		27		72
Consumer	—		27		—		—		11		38
Total	$	18	$	54	$	304	$	—	$	410	$	786

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

Two commercial, secured by real estate loans to the same borrower totaling $1,236,000 that were modified during the fourth quarter 2016 subsequently defaulted in February 2017. There were no troubled debt restructurings that subsequently defaulted within twelve months of the restructuring date for the nine months ended September 30, 2016 and that remained in default at period end.

No impaired loans without a valuation allowance and approximately $22,000 of impaired loans with a valuation allowance at September 30, 2017 consisted of loans that were modified during the nine months ended September 30, 2017 and were determined to be troubled debt restructurings. Approximately $681,000 of impaired loans without a valuation allowance and $78,000 of impaired loans with a valuation allowance at September 30, 2016 consisted of loans that were modified during the nine months ended September 30, 2016 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 September 30, 2017 and December 31, 2016 were approximately $96,241,000 and $100,982,000, respectively.

The total recorded investment in residential consumer mortgage loans secured by residential real estate that were in the process of foreclosure at September 30, 2017 was $688,000.