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. The risk classification is a dual rating system that contemplates both probability of default and risk of loss given default. 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, 2016
AQR Pass		$257,639		$26,061		$72,159		$135,359		$355,903		$44,733		$22,568		$25,151		$939,573
AQR Special Mention	1,950		—		—		57		—		—		501		78		2,586
AQR Substandard	18,589		—		—		16,762		698		669		520		52		37,290
Subtotal		$278,178		$26,061		$72,159		$152,178		$356,601		$45,402		$23,589		$25,281		$979,449
Less: Unearned origination fees, net of origination costs																	(4,434		)
Total loans																		$975,015
December 31, 2015
AQR Pass		$257,293		$44,488		$74,956		$127,226		$347,157		$45,884		$26,015		$28,882		$951,901
AQR Special Mention	536		—		—		—		—		91		171		10		808
AQR Substandard	14,612		—		—		16,515		359		697		487		20		32,690
Subtotal		$272,441		$44,488		$74,956		$143,741		$347,516		$46,672		$26,673		$28,912		$985,399
Less: Unearned origination fees, net of origination costs																	(4,612		)
Total loans																		$980,787

At December 31, 2016, approximately 74% of the Company’s loans are secured by real estate and 3% are unsecured. Approximately 23% 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 determined to be of no value.

Nonaccrual Loans

Nonaccrual loans net of government guarantees totaled $12.5 million and $2.1 million December 31, 2016 and December 31, 2015, respectively. Interest income which would have been earned on nonaccrual loans for 2016, 2015, and 2014 amounted to $676,000, $276,000, and $218,000, respectively. Additionally, the Company recognized interest income of $181,000, $617,000, and $350,000 in 2016, 2015, and 2014, 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)	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days Past Due			Current			Total
December 31, 2016
Commercial		$8,750		$—		$4,208			$542			$13,500
Real estate term owner occupied	—		—		—			29			29
Real estate term non-owner occupied	—		—		—			197			197
Consumer secured by 1st deeds of trust	—		—		167			—			167
Total nonaccrual loans	8,750		—		4,375			768			13,893
Government guarantees on nonaccrual loans	—		—		(1,413		)	—			(1,413		)
Net nonaccrual loans		$8,750		$—		$2,962			$768			$12,480
December 31, 2015
Commercial		$—		$82		$290			$2,641			$3,013
Real estate term owner occupied	—		—		—			38			38
Real estate term non-owner occupied	—		—		108			251			359
Consumer secured by 1st deeds of trust	—		—		—			256			256
Consumer other	—		—		20			—			20
Total nonaccrual loans	—		82		418			3,186			3,686
Government guarantees on nonaccrual loans	—		—		—			(1,561		)	(1,561		)
Net nonaccrual loans		$—		$82		$418			$1,625			$2,125

Past Due Loans

There were $456,000 and zero past due loans greater than 90 days and still accruing interest at December 31, 2016 and 2015, respectively. 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		Total Past Due		Nonaccrual		Current		Total
December 31, 2016
Commercial		$—		$141		$404		$545		$13,500		$264,133		$278,178
Real estate construction one-to-four family	—		—		—		—		—		26,061		26,061
Real estate construction other	—		—		—		—		—		72,159		72,159
Real estate term owner occupied	887		—		—		887		29		151,262		152,178
Real estate term non-owner occupied	—		—		—		—		197		356,404		356,601
Real estate term other	—		—		—		—		—		45,402		45,402
Consumer secured by 1st deed of trust	390		518		—		908		167		22,514		23,589
Consumer other	171		80		52		303		—		24,978		25,281
Subtotal		$1,448		$739		$456		$2,643		$13,893		$962,913		$979,449
Less: Unearned origination fees, net of origination costs													(4,434		)
Total														$975,015
December 31, 2015
Commercial		$242		$21		$—		$263		$3,013		$269,165		$272,441
Real estate construction one-to-four family	—		—		—		—		—		44,488		44,488
Real estate construction other	—		—		—		—		—		74,956		74,956
Real estate term owner occupied	—		—		—		—		38		143,703		143,741
Real estate term non-owner occupied	—		—		—		—		359		347,157		347,516
Real estate term other	289		—		—		289		—		46,383		46,672
Consumer secured by 1st deed of trust	568		—		—		568		256		25,849		26,673
Consumer other	30		—		—		30		20		28,862		28,912
Subtotal		$1,129		$21		$—		$1,150		$3,686		$980,563		$985,399
Less: Unearned origination fees, net of origination costs													(4,612		)
Total														$980,787

Impaired Loans

At December 31, 2016 and 2015, the recorded investment in loans that are considered to be impaired was $38.7 million and $34.6 million, respectively. The following table presents information about impaired loans by class for the years ended December 31, 2016 and 2015:



(In Thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
December 31, 2016
With no related allowance recorded
Commercial - AQR special mention		$223		$223		$—
Commercial - AQR substandard	9,213		9,893		—
Real estate construction other - AQR substandard	—		—		—
Real estate term owner occupied - AQR pass	252		252		—
Real estate term owner occupied - AQR substandard	16,694		16,694		—
Real estate term non-owner occupied - AQR pass	391		391		—
Real estate term non-owner occupied - AQR substandard	693		693		—
Real estate term other - AQR pass	633		633		—
Real estate term other - AQR substandard	669		669		—
Consumer secured by 1st deeds of trust - AQR special mention	143		143		—
Consumer secured by 1st deeds of trust - AQR substandard	472		488		—
Consumer other - AQR substandard	52		52		—
Subtotal		$29,435		$30,131		$—



With an allowance recorded
Commercial - AQR substandard	$9,221	$9,221	$614
Subtotal	$9,221	$9,221	$614



Commercial - AQR special mention		$223		$223		$—
Commercial - AQR substandard	18,434		19,114		614
Real estate construction other - AQR substandard	—		—		—
Real estate term owner-occupied - AQR pass	252		252		—
Real estate term owner-occupied - AQR substandard	16,694		16,694		—
Real estate term non-owner occupied - AQR pass	391		391		—
Real estate term non-owner occupied - AQR substandard	693		693		—
Real estate term other - AQR pass	633		633		—
Real estate term other - AQR substandard	669		669		—
Consumer secured by 1st deeds of trust - AQR special mention	143		143		—
Consumer secured by 1st deeds of trust - AQR substandard	472		488		—
Consumer other - AQR substandard	52		52		—
Total		$38,656		$39,352		$614



(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	13,333		13,746		—
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		—
Real estate term other - AQR substandard	697		697		—
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	14,394		14,807		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		—
Real estate term other - AQR substandard	697		697		—
Consumer secured by 1st deeds of trust - AQR pass	76		76		—
Consumer secured by 1st deeds of trust - AQR substandard	472		472		—
Total		$34,640		$35,053		$344

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, 2016 and 2015, respectively:



Year Ended December 31,	2016						2015
(In Thousands)	Average Recorded Investment		Interest Income Recognized			Average Recorded Investment			Interest Income Recognized
With no related allowance recorded
Commercial - AQR special mention		$170			$13			$163			$13
Commercial - AQR substandard	15,522			840			9,996			378
Real estate construction one-to-four family - AQR substandard	988			—			—			—
Real estate construction other - AQR pass	—			—			557			72
Real estate construction other - AQR substandard	1,431			—			1,431			—
Real estate term owner occupied - AQR pass	378			34			696			63
Real estate term owner occupied - AQR special mention	—			—			67			5
Real estate term owner occupied - AQR substandard	16,551			1,202			6,941			355
Real estate term non-owner occupied - AQR pass	442			91			521			75
Real estate term non-owner occupied - AQR special mention	—			—			1,080			97
Real estate term non-owner occupied - AQR substandard	599			28			1,141			—
Real estate term other - AQR pass	627			58			179			13
Real estate term other - AQR special mention	43			4			68			6
Real estate term other - AQR substandard	683			55			816			50
Consumer secured by 1st deeds of trust - AQR pass	38			2			79			4
Consumer secured by 1st deeds of trust - AQR special mention	36			3			—			—
Consumer secured by 1st deeds of trust - AQR substandard	568			24			514			9
Consumer other - AQR substandard	13			—			—			—
Subtotal		$38,089			$2,354			$24,249			$1,140



With an allowance recorded
Commercial - AQR substandard		$2,451		$—		$1,668		$—
Real estate construction one-to-four family - AQR substandard	1,986		—		—		—
Real estate term other - AQR substandard	—		—		70		—
Consumer secured by 1st deeds of trust - AQR substandard	73		—		—		—
Consumer other - AQR substandard	—		—		10		—
Subtotal		$4,510		$—		$1,748		$—



Total
Commercial - AQR special mention		$170		$13		$163		$13
Commercial - AQR substandard	17,973		840		11,664		378
Real estate construction one-to-four family - AQR substandard	2,974		—		—		—
Real estate construction other - AQR pass	—		—		557		72
Real estate construction other - AQR substandard	1,431		—		1,431		—
Real estate term owner-occupied - AQR pass	378		34		696		63
Real estate term owner-occupied - AQR special mention	—		—		67		5
Real estate term owner-occupied - AQR substandard	16,551		1,202		6,941		355
Real estate term non-owner occupied - AQR pass	442		91		521		75
Real estate term non-owner occupied - AQR special mention	—		—		1,080		97
Real estate term non-owner occupied - AQR substandard	599		28		1,141		—
Real estate term other - AQR pass	627		58		179		13
Real estate term other - AQR special mention	43		4		68		6
Real estate term other - AQR substandard	683		55		886		50
Consumer secured by 1st deeds of trust - AQR pass	38		2		79		4
Consumer secured by 1st deeds of trust - AQR special mention	36		3		—		—
Consumer secured by 1st deeds of trust - AQR substandard	641		24		514		9
Consumer other - AQR substandard	13		—		10		—
Total Impaired Loans		$42,599		$2,354		$25,997		$1,140

The average recorded investment was $10.5 million, and interest income recognized on impaired loans was $762,000 for the year ended December 31, 2014.

Purchased Credit Impaired Loans

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, 2016 and 2015 were $1.1 million and $1.6 million, respectively.

Troubled Debt Restructurings

Loans classified as troubled debt restructurings (“TDR”) totaled $16.2 million and $13.7 million at December 31, 2016 and December 31, 2015, 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 identifies the portion of TDR balances as of December 31, 2016 that were restructured during 2016:



	Accrual Status		Nonaccrual Status		Total Modifications
(In Thousands)	Accrual Status		Nonaccrual Status		Total Modifications
New Troubled Debt Restructurings
Commercial - AQR substandard		$4,234		$134		$4,368
Subtotal		$4,234		$134		$4,368
Existing Troubled Debt Restructurings	1,897		9,954		11,851
Total		$6,131		$10,088		$16,219

The following table provides additional information about loans that were restructured in 2016:



(In Thousands)	Number of Contracts	Rate Modification		Term Modification		Payment Modification		Combination Modification		Total Modifications
Pre-Modification Outstanding Recorded Investment:
Commercial - AQR substandard	2		$—		$135		$4,234		$—		$4,369
Total	2		$—		$135		$4,234		$—		$4,369
Post-Modification Outstanding Recorded Investment:
Commercial - AQR substandard	2		$—		$134		$4,233		$—		$4,367
Total	2		$—		$134		$4,233		$—		$4,367

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, 2016. There were no chargeoffs in 2016 on loans that were later classified as a TDR, and there was a $304,000 chargeoff in 2015 on a loan that was later classified as a TDR in 2015.

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 four TDRs with specific impairment at December 31, 2016 and none at December 31, 2015, respectively.

There were no loans that were restructured during 2016, 2015, and 2014, respectively, that also subsequently defaulted within the first twelve months of restructure in those same periods.

At December 31, 2016 and 2015, 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)	2016		2015
Balance, beginning of the year		$117		$2,262
Loans made	—		—
Repayments	27		2,145
Balance, end of year		$90		$117

The Company’s amount of unfunded loan commitments to these directors or their related interests on December 31, 2016 and 2015, was $15,000 and $0, respectively.