Loans and Credit Quality

As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends in past due and nonaccrual loans, gross and net charge offs, and movement in loan balances within the risk classifications. The Company utilizes a loan risk grading system called the Asset Quality Rating (“AQR”) system to assign a risk classification to each of its loans. Loans are graded on a scale of 1 to 10 and, loans graded 1 – 6 are considered “pass” grade loans. A description of the general characteristics of the AQR risk classifications are as follows:

Pass grade loans – 1 through 6: The borrower demonstrates sufficient cash flow to fund debt service, including acceptable profit margins, cash flows, liquidity and other balance sheet ratios. Historic and projected performance indicates that the borrower is able to meet obligations under most economic circumstances. The company has competent management with an acceptable track record. The category does not include loans with undue or unwarranted credit risks that constitute identifiable weaknesses.

Special Mention – 7: A "special mention" credit has weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of either the repayment prospects for the asset or the Bank's credit position at some future date. Special mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification. Loans are currently protected, but are weak due to negative trends in the balance sheet and income statement. Current cash flow may be insufficient to meet debt service, with prospects that the condition may not be temporary. Profitability and key balance sheet ratios are below peers. There is a lack of effective control over collateral or there are documentation deficiencies as well as a potential risk of payment default. Collateral coverage is minimal in gross dollars or due to quality issues. Financial information may be inadequate to show the recent condition of borrower. The loan would not be approved as a new credit, and new loans would not be granted. Management may not be adequately qualified or may have very limited prior experience with similar activities or markets. The ability of management to cope with current conditions is questionable. Internal conflict and turnover in key positions may be present. Succession is unclear. The borrower's asset quality is below average. The capital base may be insufficient to cover capital losses. Leverage is above average or increasing. The industry outlook is generally negative but there are reasonable expectations of a turnaround within 12-18 months. The firm may be new, resulting in competitive deficiencies in comparison to the older, more established firms in the industry. Over-capacity may be evident in the industry. Collateral and guarantor strength are comparable to Management Attention-6, but agings and certifications of accounts receivable and inventory are required and are not being provided on a regular basis.

Substandard – 8: A "substandard" credit is inadequately protected by the current sound worth and paying capacity of the obligor or by 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 distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans have well-defined weaknesses where a payment default and/or a loss are possible, but not yet probable. Cash flow is insufficient to service debt, with prospects that the condition is permanent. Assets classified as substandard are inadequately protected by the current net worth and paying capacity of the borrower, and there is a likelihood that collateral will have to be liquidated and/or the guarantor called upon to repay the debt. Generally, the loan is considered collectible as to both principal and interest, primarily because of collateral coverage. Loan(s) may have been restructured at less than market terms or have been partially charged off. If deficiencies are not corrected quickly, there is a probability of loss and the borrower’s ability to operate as a going concern may be deemed questionable/is questionable. Management has no prior experience with similar activities, demonstrating inability to realistically address problems and meet commitments. The borrower’s asset quality is poor. The capital base is weak and insufficient to absorb continuing losses, and leverage is significantly above peers. Liquidity is poor with significant reliance on short-term borrowing to support trade debt. Key balance sheet ratios are substantially inferior to industry norms. The industry is currently trending downward or demonstrating recovery from an adverse cycle. The outlook is generally negative at this time. Timing of recovery is unclear, but expectations are that market conditions will improve within 18-24 months. The borrower has substantial competitive deficiencies when compared to other firms, such as excess capacity and over-supply, resulting in frequent and significant concessions and discounting. Business failures are prevalent. Collateral coverage is marginal or non-existent. Collateral may be located outside the borrower’s market area. There are no agings or certifications of accounts receivable and inventory being received from the borrower, and collateral has doubtful marketability/convertibility. If guaranteed, the guarantor has limited outside worth and is highly leveraged with a poor credit report, which may reflect liens, collection problems, or lawsuits.

Doubtful – 9: An asset classified "doubtful" has all the weaknesses inherent in one that is classified "substandard-8" with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions, and values, highly questionable and improbable. The loan has substandard characteristics, and available information suggests that it is unlikely that the loan will be repaid in its entirety. Cash flow is insufficient to service debt. The company has had a series of substantial losses. If the current material adverse trends continue, it is unlikely the borrower will have the ability to meet the terms of the loan agreement. It may be difficult to predict the exact amount of loss, but the probability of some loss is greater than 50%. Loans are to be placed on non-accrual status when any portion is classified as doubtful. Non-accrual loans would not be classified "doubtful" as long as the collateral appears adequate to retire the outstanding balance. Management is clearly unable to address problems and meet commitments, and there is little expectation either of improvement or for sustaining the relationship with current management. The company is highly illiquid with excessive leverage. Key balance sheet ratios are at unacceptable levels, and downturn is severe. Timing of recovery is undeterminable. The company is unable to compete; collateral and guarantees provide limited support.

Loss – 10: An asset classified "loss" is considered uncollectable and of such little value that its continuance on the books is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this basically worthless asset, even though partial recovery may be affected in the future. The loan has doubtful characteristics, but the loan will definitely not be repaid in full. Debt service coverage clearly reflects the company's inability to service debt. The borrower cannot generate sufficient cash flow to cover fixed charges. All near-term and long-term trends concerning cash flow and earnings are negative. The damage to the financial condition of the company cannot be reversed at this point in time. Collateral and guarantees provide no support.

The composition of the loan portfolio as of the periods indicated is as follows:



(In Thousands)	Commercial		Real estate construction one-to-four family		Real estate construction other		Real estate term owner occupied		Real estate term non-owner occupied		Real estate term other		Consumer secured by 1st deeds of trust		Consumer other		Total
December 31, 2015
AQR Pass		$313,689		$44,488		$74,931		$112,248		$313,710		$37,938		$26,015		$28,882		$951,901
AQR Special Mention	536		—		—		—		—		91		171		10		808
AQR Substandard	15,309		—		—		16,515		359		—		487		20		32,690
Subtotal		$329,534		$44,488		$74,931		$128,763		$314,069		$38,029		$26,673		$28,912		$985,399
Less: Unearned origination fees, net of origination costs																	(4,612		)
Total loans																		$980,787
December 31, 2014
AQR Pass		$291,020		$34,651		$91,195		$103,049		$282,774		$36,705		$31,118		$31,399		$901,911
AQR Special Mention	11,618		—		—		5,817		2,095		39		396		47		20,012
AQR Substandard	3,905		191		—		606		1,747		150		486		47		7,132
Subtotal		$306,543		$34,842		$91,195		$109,472		$286,616		$36,894		$32,000		$31,493		$929,055
Less: Unearned origination fees, net of origination costs																	(4,551		)
Total loans																		$924,504

At December 31, 2015, approximately 76% of the Company’s loans are secured by real estate and 3% are unsecured. Approximately 21% are for general commercial uses, including professional, retail, and small businesses. Repayment is expected from the borrowers’ cash flow or, secondarily, the collateral. The Company’s exposure to credit loss, if any, is the outstanding amount of the loan if the collateral is proved to be of no value.

Nonaccrual Loans

Nonaccrual loans net of government guarantees totaled $2.1 million and $3.5 million December 31, 2015 and December 31, 2014, respectively. Interest income which would have been earned on nonaccrual loans for 2015, 2014, and 2013 amounted to $276,000, $218,000, and $188,000, respectively. Additionally, the Company recognized interest income of $484,000, $350,000, and $250,000 in 2015, 2014, and 2013, respectively, related to interest collected on nonaccrual loans whose principal has been paid down to zero. Nonaccrual loans at the periods indicated, by segment are presented below:



(In Thousands)	December 31, 2015			December 31, 2014
Commercial		$3,013			$2,031
Real estate construction one-to-four family	—			191
Real estate term owner occupied	38			135
Real estate term non-owner occupied	359			1,746
Real estate term other	—			39
Consumer secured by 1st deeds of trust	256			485
Consumer other	20			47
Total nonaccrual loans	3,686			4,674
Government guarantees on nonperforming loans	(1,561		)	(1,178		)
Net nonaccrual loans		$2,125			$3,496

Past Due Loans

There were no past due loans greater than 90 days and still accruing interest at either December 31, 2015 or 2014. Past due loans and nonaccrual loans at the periods indicated are presented below by loan class:



(In Thousands)	30-59 Days Past Due Still Accruing		60-89 Days Past Due Still Accruing		Greater Than 90 Days Still Accruing		Nonaccrual		Total Past Due		Current		Total
December 31, 2015
AQR Pass		$601		$—		$—		$—		$601		$951,300		$951,901
AQR Special Mention	312		—		—		—		312		496		808
AQR Substandard	216		21		—		3,686		3,923		28,767		32,690
Subtotal		$1,129		$21		$—		$3,686		$4,836		$980,563		$985,399
Less: Unearned origination fees, net of origination costs													(4,612		)
Total														$980,787
December 31, 2014
AQR Pass		$696		$545		$—		$—		$1,241		$900,670		$901,911
AQR Special Mention	—		—		—		—		—		20,012		20,012
AQR Substandard	40		—		—		4,674		4,714		2,418		7,132
Subtotal		$736		$545		$—		$4,674		$5,955		$923,100		$929,055
Less: Unearned origination fees, net of origination costs													(4,551		)
Total														$924,504

Impaired Loans

At December 31, 2015 and 2014, the recorded investment in loans that are considered to be impaired was $34.6 million and $11.3 million, respectively. The following table presents information about impaired loans by class for the years ended December 31, 2015 and 2014:



(In Thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
December 31, 2015
With no related allowance recorded
Commercial - AQR special mention		$157		$157		$—
Commercial - AQR substandard	14,030		14,443		—
Real estate term owner occupied - AQR pass	753		753		—
Real estate term owner occupied - AQR substandard	16,476		16,476		—
Real estate term non-owner occupied - AQR pass	473		473		—
Real estate term non-owner occupied - AQR substandard	352		352		—
Real estate term other - AQR pass	699		699		—
Real estate term other - AQR special mention	91		91		—
Consumer secured by 1st deeds of trust - AQR pass	76		76		—
Consumer secured by 1st deeds of trust - AQR substandard	472		472		—
Subtotal		$33,579		$33,992		$—



With an allowance recorded
Commercial - AQR substandard	$1,061	$1,061	$344
Subtotal	$1,061	$1,061	$344



Commercial - AQR special mention		$157		$157		$—
Commercial - AQR substandard	15,091		15,504		344
Real estate term owner-occupied - AQR pass	753		753		—
Real estate term owner-occupied - AQR substandard	16,476		16,476		—
Real estate term non-owner occupied - AQR pass	473		473		—
Real estate term non-owner occupied - AQR substandard	352		352		—
Real estate term other - AQR pass	699		699		—
Real estate term other - AQR special mention	91		91		—
Consumer secured by 1st deeds of trust - AQR pass	76		76		—
Consumer secured by 1st deeds of trust - AQR special mention	472		472		—
Total		$34,640		$35,053		$344



(In Thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
December 31, 2014
With no related allowance recorded
Commercial - AQR special mention		$170		$170		$—
Commercial - AQR substandard	3,000		3,045		—
Real estate construction one-to-four family - AQR special mention	191		191		—
Real estate construction other - AQR pass	772		772		—
Real estate term owner occupied - AQR pass	501		501		—
Real estate term owner occupied - AQR special mention	273		273		—
Real estate term owner occupied - AQR substandard	558		558		—
Real estate term non-owner occupied - AQR pass	549		549		—
Real estate term non-owner occupied - AQR special mention	2,088		2,088		—
Real estate term non-owner occupied - AQR substandard	1,709		1,709		—
Real estate term other - AQR substandard	150		150		—
Consumer secured by 1st deeds of trust - AQR pass	82		82		—
Consumer secured by 1st deeds of trust - AQR special mention	448		461		—
Subtotal		$10,491		$10,549		$—



With an allowance recorded
Commercial - AQR substandard	$806	$806	$75
Subtotal	$806	$806	$75



Commercial - AQR special mention		$170		$170		$—
Commercial - AQR substandard	3,806		3,851		75
Real estate construction one-to-four family - AQR special mention	191		191		—
Real estate construction other - AQR pass	772		772		—
Real estate term owner-occupied - AQR pass	501		501		—
Real estate term owner occupied - AQR special mention	273		273		—
Real estate term owner-occupied - AQR substandard	558		558		—
Real estate term non-owner occupied - AQR pass	549		549		—
Real estate term non-owner occupied - AQR special mention	2,088		2,088		—
Real estate term non-owner occupied - AQR substandard	1,709		1,709		—
Real estate term other - AQR substandard	150		150		—
Consumer secured by 1st deeds of trust - AQR pass	82		82		—
Consumer secured by 1st deeds of trust - AQR special mention	448		461		—
Total		$11,297		$11,355		$75

The unpaid principal balance included in the table above represents the recorded investment at the dates indicated, plus amounts charged off for book purposes.

The following table summarizes our average recorded investment and interest income recognized on impaired loans for years ended December 31, 2015 and 2014, respectively:



Year Ended December 31,	2015						2014
(In Thousands)	Average Recorded Investment		Interest Income Recognized			Average Recorded Investment			Interest Income Recognized
With no related allowance recorded
Commercial - AQR pass		$—			$—			$97			$2
Commercial - AQR special mention	163			13			254			23
Commercial - AQR substandard	10,738			421			1,912			94
Real estate construction one-to-four family - AQR special mention	—			—			175			11
Real estate construction one-to-four family - AQR substandard	—			—			117			—
Real estate construction other - AQR pass	557			72			196			30
Real estate construction other - AQR special mention	—			—			605			101
Real estate construction other - AQR substandard	1,431			—			—			—
Real estate term owner occupied - AQR pass	696			63			507			50
Real estate term owner occupied - AQR special mention	67			5			299			20
Real estate term owner occupied - AQR substandard	6,941			355			1,018			60
Real estate term non-owner occupied - AQR pass	521			75			595			94
Real estate term non-owner occupied - AQR special mention	1,080			97			2,360			253
Real estate term non-owner occupied - AQR substandard	1,141			—			1,229			—
Real estate term other - AQR pass	179			13			—			—
Real estate term other - AQR special mention	68			6			—			—
Real estate term other - AQR substandard	74			7			152			14
Consumer secured by 1st deeds of trust - AQR pass	79			4			85			4
Consumer secured by 1st deeds of trust - AQR substandard	514			9			326			—
Consumer other - AQR substandard	—			—			29			—
Subtotal		$24,249			$1,140			$9,956			$756



With an allowance recorded
Commercial - AQR special mention		$—		$—		$46		$6
Commercial - AQR substandard	1,668		—		356		—
Real estate term other - AQR substandard	70		—		—		—
Consumer secured by 1st deeds of trust - AQR substandard	—		—		175		—
Consumer other - AQR substandard	10		—		—		—
Subtotal		$1,748		$—		$577		$6



Total
Commercial - AQR pass		$—		$—		$97		$2
Commercial - AQR special mention	163		13		300		29
Commercial - AQR substandard	12,406		421		2,268		94
Real estate construction one-to-four family - AQR special mention	—		—		175		11
Real estate construction one-to-four family - AQR substandard	—		—		117		—
Real estate construction other - AQR pass	557		72		196		30
Real estate construction other - AQR special mention	—		—		605		101
Real estate construction other - AQR substandard	1,431		—		—		—
Real estate term owner-occupied - AQR pass	696		63		507		50
Real estate term owner-occupied - AQR special mention	67		5		299		20
Real estate term owner-occupied - AQR substandard	6,941		355		1,018		60
Real estate term non-owner occupied - AQR pass	521		75		595		94
Real estate term non-owner occupied - AQR special mention	1,080		97		2,360		253
Real estate term non-owner occupied - AQR substandard	1,141		—		1,229		—
Real estate term other - AQR pass	179		13		—		—
Real estate term other - AQR special mention	68		6		—		—
Real estate term other - AQR substandard	144		7		152		14
Consumer secured by 1st deeds of trust - AQR pass	79		4		85		4
Consumer secured by 1st deeds of trust - AQR substandard	514		9		501		—
Consumer other - AQR substandard	10		—		29		—
Total Impaired Loans		$25,997		$1,140		$10,533		$762

The average recorded investment was $10.9 million, and interest income recognized on impaired loans was $461,000 for the year ended December 31, 2013.

Purchased Credit Impaired Loans

As described in Note 2 above, the Company acquired eighteen purchased credit impaired loans from Alaska Pacific on April 1, 2014 subject to the requirements of FASB ASC 310-30 Loans and Debt Securities Acquired with Deteriorated Credit Quality. This group of loans consists primarily of commercial and commercial real estate loans, and unlike a pool of consumer mortgages, it is not practicable for the Company to analyze the accretable yield of these loans. As such, the Company has elected the cost recovery method of income recognition for these loans, and thus no accretable difference has been identified for these loans. At the acquisition date, April 1, 2014, the fair value of this group of loans was $3.9 million. The carrying value of these loans as of December 31, 2015 and 2014 were $1.6 million and $3.0 million, respectively.

Troubled Debt Restructurings

Loans classified as troubled debt restructurings (“TDR”) totaled $13.7 million and $7.7 million at December 31, 2015 and December 31, 2014, respectively. A troubled debt restructuring is a loan to a borrower that is experiencing financial difficulty that has been modified from its original terms and conditions in such a way that the Company is granting the borrower a concession of some kind. The Company has granted a variety of concessions to borrowers in the form of loan modifications. The modifications granted can generally be described in the following categories:

Rate Modification: A modification in which the interest rate is changed.

Term Modification: A modification in which the maturity date, timing of payments or frequency of payments is changed.

Payment Modification: A modification in which the dollar amount of the payment is changed, or in which a loan is converted to interest only payments for a period of time is included in this category.

Combination Modification: Any other type of modification, including the use of multiple categories above.

AQR pass graded loans included above in the impaired loan data are loans classified as TDRs. By definition, TDRs are considered impaired loans. All of the Company’s TDRs are included in impaired loans.

The following table presents December 31, 2015 balances of loans that were restructured during 2015:



	Accrual Status		Nonaccrual Status		Total Modifications
(In Thousands)	Accrual Status		Nonaccrual Status		Total Modifications
New Troubled Debt Restructurings
Commercial - AQR substandard		$8,891		$1,287		$10,178
Subtotal		$8,891		$1,287		$10,178
Existing Troubled Debt Restructurings	2,914		648		3,562
Total		$11,805		$1,935		$13,740



(In Thousands)	Number of Contracts	Rate Modification		Term Modification		Payment Modification		Combination Modification		Total Modifications
Pre-Modification Outstanding Recorded Investment:
Commercial - AQR substandard	6		$—		$8,891		$—		$1,173		$10,064
Total	6		$—		$8,891		$—		$1,173		$10,064
Post-Modification Outstanding Recorded Investment:
Commercial - AQR substandard	6		$—		$8,891		$—		$1,287		$10,178
Total	6		$—		$8,891		$—		$1,287		$10,178

The Company had no commitments to extend additional credit to borrowers owing receivables whose terms have been modified in troubled debt restructurings at December 31, 2015. There was a $304,000 charge-off on a loan that was later classified as a TDR in 2015 and were no charge offs on loans that were later classified as TDRs in 2014.

All TDRs are also classified as impaired loans and are included in the loans individually evaluated for impairment in the calculation of the Allowance. There were no TDRs with specific impairment at December 31, 2015 or 2014.

There were no loans that were restructured during 2015, 2014, and 2013, respectively, that also subsequently defaulted within the first twelve months of restructure in those same periods.

At December 31, 2015 and 2014, there were no loans pledged as collateral to secure public deposits.

Certain directors, and companies of which directors are principal owners, have loans and other transactions such as architectural fees with the Company. Such transactions are made on substantially the same terms, including interest rates and collateral required, as those prevailing for similar transactions of unrelated parties. An analysis of the loan transactions for the years indicated follows:



(In Thousands)	2015		2014
Balance, beginning of the year		$2,262		$2,336
Loans made	—		—
Repayments	2,145		74
Balance, end of year		$117		$2,262

The Company’s amount of unfunded loan commitments to these directors or their related interests on December 31, 2015 and 2014, was $0, respectively.