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, 2019
AQR Pass		$394,107		$34,132		$61,808		$129,959		$295,482		$38,771		$15,860		$24,464		$994,583
AQR Special Mention	2,279		3,337		—		3,828		17,478		2,559		179		—		29,660
AQR Substandard	16,304		1,349		—		5,104		—		1,176		159		121		24,213
Subtotal		$412,690		$38,818		$61,808		$138,891		$312,960		$42,506		$16,198		$24,585		$1,048,456
Less: Unearned origination fees, net of origination costs																	(5,085		)
Total loans																		$1,043,371
December 31, 2018
AQR Pass		$315,112		$33,729		$72,256		$117,174		$307,126		$40,792		$18,768		$23,595		$928,552
AQR Special Mention	5,116		3,382		—		3,987		18,129		670		140		2		31,426
AQR Substandard	22,192		—		—		5,253		465		577		320		47		28,854
AQR Doubtful	—		—		—		—		—		—		—		1		1
Subtotal		$342,420		$37,111		$72,256		$126,414		$325,720		$42,039		$19,228		$23,645		$988,833
Less: Unearned origination fees, net of origination costs																	(4,487		)
Total loans																		$984,346

At December 31, 2019, approximately 70% of the Company’s loans are secured by real estate and 3% are unsecured. Approximately 27% 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 $14.0 million and $14.7 million at December 31, 2019 and December 31, 2018, respectively. Interest income which would have been earned on nonaccrual loans for 2019, 2018, and 2017 amounted to $1.3 million, $1.3 million, and $1.4 million, respectively. Additionally, the Company recognized interest income of $301,000, $159,000, and $120,000 in 2019, 2018, and 2017, 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, 2019
Commercial		$270			$385		$2,862		$5,636			$9,153
Real estate construction one-to-four family	—			—		1,349		—			1,349
Real estate term owner occupied	1,641			—		623		1,225			3,489
Real estate term other	—			—		1,176		—			1,176
Consumer secured by 1st deeds of trust	—			—		—		68			68
Consumer other	26			89		—		6			121
Total nonaccrual loans	1,937			474		6,010		6,935			15,356
Government guarantees on nonaccrual loans	(268		)	—		—		(1,137		)	(1,405		)
Net nonaccrual loans		$1,669			$474		$6,010		$5,798			$13,951
December 31, 2018
Commercial		$1,329			$324		$1,287		$9,731			$12,671
Real estate term owner occupied	—			—		1,694		—			1,694
Real estate term other	—			—		577		—			577
Consumer secured by 1st deeds of trust	—			—		—		220			220
Consumer other	—			—		39		9			48
Total nonaccrual loans	1,329			324		3,597		9,960			15,210
Government guarantees on nonaccrual loans	(269		)	—		—		(247		)	(516		)
Net nonaccrual loans		$1,060			$324		$3,597		$9,713			$14,694

Past Due Loans

There were zero past due loans greater than 90 days and still accruing interest at December 31, 2019 and 2018, 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, 2019
Commercial		$270		$—		$—		$270		$9,153		$403,267		$412,690
Real estate construction one-to-four family	—		—		—		—		1,349		37,469		38,818
Real estate construction other	—		—		—		—		—		61,808		61,808
Real estate term owner occupied	338		—		—		338		3,489		135,064		138,891
Real estate term non-owner occupied	—		—		—		—		—		312,960		312,960
Real estate term other	26		—		—		26		1,176		41,304		42,506
Consumer secured by 1st deed of trust	750		—		—		750		68		15,380		16,198
Consumer other	150		—		—		150		121		24,314		24,585
Subtotal		$1,534		$—		$—		$1,534		$15,356		$1,031,566		$1,048,456
Less: Unearned origination fees, net of origination costs													(5,085		)
Total														$1,043,371
December 31, 2018
Commercial		$872		$857		$—		$1,729		$12,671		$328,020		$342,420
Real estate construction one-to-four family	—		—		—		—		—		37,111		37,111
Real estate construction other	—		—		—		—		—		72,256		72,256
Real estate term owner occupied	1,197		—		—		1,197		1,694		123,523		126,414
Real estate term non-owner occupied	—		—		—		—		—		325,720		325,720
Real estate term other	—		—		—		—		577		41,462		42,039
Consumer secured by 1st deed of trust	224		100		—		324		220		18,684		19,228
Consumer other	190		—		—		190		48		23,407		23,645
Subtotal		$2,483		$957		$—		$3,440		$15,210		$970,183		$988,833
Less: Unearned origination fees, net of origination costs													(4,487		)
Total														$984,346

Impaired Loans

At December 31, 2019 and 2018, the recorded investment in loans that are considered to be impaired was $24.7 million and $31.7 million, respectively. The following table presents information about impaired loans by class for the years ended December 31, 2019 and 2018:



(In Thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
December 31, 2019
With no related allowance recorded
Commercial - AQR substandard		$15,517		$15,582		$—
Real estate construction one-to-four family - AQR substandard	1,349		1,349		—
Real estate term owner occupied - AQR substandard	5,104		5,104		—
Real estate term non-owner occupied - AQR pass	178		178		—
Real estate term other - AQR pass	417		417		—
Real estate term other - AQR substandard	1,176		1,176		—
Consumer secured by 1st deeds of trust - AQR pass	122		122		—
Consumer secured by 1st deeds of trust - AQR substandard	159		163		—
Consumer other - AQR substandard	90		94		—
Subtotal		$24,112		$24,185		$—



With an allowance recorded
Commercial - AQR substandard	$561	$561	$17
Subtotal	$561	$561	$17



Commercial - AQR substandard		$16,078		$16,143		$17
Real estate construction one-to-four family - AQR substandard	1,349		1,349		—
Real estate term owner-occupied - AQR substandard	5,104		5,104		—
Real estate term non-owner occupied - AQR pass	178		178		—
Real estate term other - AQR pass	417		417		—
Real estate term other - AQR substandard	1,176		1,176		—
Consumer secured by 1st deeds of trust - AQR pass	122		122		—
Consumer secured by 1st deeds of trust - AQR substandard	159		163		—
Consumer other - AQR substandard	90		94		—
Total		$24,673		$24,746		$17



(In Thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
December 31, 2018
With no related allowance recorded
Commercial - AQR pass		$80		$80		$—
Commercial - AQR special mention	2,009		2,009		—
Commercial - AQR substandard	21,252		22,303		—
Real estate term owner occupied - AQR substandard	5,253		5,253		—
Real estate term non-owner occupied - AQR pass	295		295		—
Real estate term non-owner occupied - AQR substandard	465		465		—
Real estate term other - AQR pass	486		486		—
Real estate term other - AQR substandard	577		577		—
Consumer secured by 1st deeds of trust - AQR pass	129		129		—
Consumer secured by 1st deeds of trust - AQR substandard	320		320		—
Subtotal		$30,866		$31,917		$—



With an allowance recorded
Commercial - AQR substandard	$848	$1,352	$14
Subtotal	$848	$1,352	$14



Commercial - AQR pass		$80		$80		$—
Commercial - AQR special mention	2,009		2,009		—
Commercial - AQR substandard	22,100		23,655		14
Real estate term owner-occupied - AQR substandard	5,253		5,253		—
Real estate term non-owner occupied - AQR pass	295		295		—
Real estate term non-owner occupied - AQR substandard	465		465		—
Real estate term other - AQR pass	486		486		—
Real estate term other - AQR substandard	577		577		—
Consumer secured by 1st deeds of trust - AQR pass	129		129		—
Consumer secured by 1st deeds of trust - AQR substandard	320		320		—
Total		$31,714		$33,269		$14

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, 2019 and 2018, respectively:



Year Ended December 31,	2019						2018
(In Thousands)	Average Recorded Investment		Interest Income Recognized			Average Recorded Investment			Interest Income Recognized
With no related allowance recorded
Commercial - AQR pass		$532			$35			$21			$2
Commercial - AQR special mention	—			—			2,146			128
Commercial - AQR substandard	16,892			405			24,548			381
Real estate construction one-to-four family - AQR substandard	1,933			—			—			—
Real estate term owner occupied - AQR special mention	—			—			155			—
Real estate term owner occupied - AQR substandard	5,747			113			3,813			201
Real estate term non-owner occupied - AQR pass	251			19			265			24
Real estate term non-owner occupied - AQR special mention	—			—			22			2
Real estate term non-owner occupied - AQR substandard	230			—			381			30
Real estate term other - AQR pass	448			31			421			36
Real estate term other - AQR substandard	1,046			—			176			—
Consumer secured by 1st deeds of trust - AQR pass	126			13			135			13
Consumer secured by 1st deeds of trust - AQR substandard	202			7			175			10
Consumer other - AQR substandard	70			—			—			—
Subtotal		$27,477			$623			$32,258			$827



With an allowance recorded
Commercial - AQR substandard		$683		$—		$2,323		$20
Commercial - AQR doubtful	—		—		14		—
Real estate term other - AQR substandard	163		—		—		—
Consumer secured by 1st deeds of trust - AQR substandard	72		—		94		—
Subtotal		$918		$—		$2,431		$20



Total
Commercial - AQR pass		$532		$35		$21		$2
Commercial - AQR special mention	—		—		2,146		128
Commercial - AQR substandard	17,575		405		26,871		401
Commercial - AQR doubtful	—		—		14		—
Real estate construction one-to-four family - AQR substandard	1,933		—		—		—
Real estate term owner-occupied - AQR special mention	—		—		155		—
Real estate term owner-occupied - AQR substandard	5,747		113		3,813		201
Real estate term non-owner occupied - AQR pass	251		19		265		24
Real estate term non-owner occupied - AQR special mention	—		—		22		2
Real estate term non-owner occupied - AQR substandard	230		—		381		30
Real estate term other - AQR pass	448		31		421		36
Real estate term other - AQR substandard	1,209		—		176		—
Consumer secured by 1st deeds of trust - AQR pass	126		13		135		13
Consumer secured by 1st deeds of trust - AQR substandard	274		7		269		10
Consumer other - AQR substandard	70		—		—		—
Total Impaired Loans		$28,395		$623		$34,689		$847

The average recorded investment was $36.9 million, and interest income recognized on impaired loans was $983,000 for the year ended December 31, 2017.

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, 2019 and 2018 was $201,000 and $235,000, respectively.

Troubled Debt Restructurings

Loans classified as TDRs totaled $10.1 million and $14.8 million at December 31, 2019 and December 31, 2018, respectively. A TDR 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 the breakout between newly restructured loans that occurred during 2019 and restructured loans that occurred prior to 2019 that are still included in portfolio loans:



	Accrual Status		Nonaccrual Status		Total Modifications
(In Thousands)	Accrual Status		Nonaccrual Status		Total Modifications
New Troubled Debt Restructurings
Commercial - AQR substandard		$318		$2,651		$2,969
Real estate owner occupied - AQR substandard	—		182		182
Subtotal		$318		$2,833		$3,151
Existing Troubled Debt Restructurings	1,130		5,825		6,955
Total		$1,448		$8,658		$10,106

The following tables present newly restructured loans that occurred during 2019 and 2018, by concession (terms modified):



	December 31, 2019
(In Thousands)	Number of Contracts	Rate Modification		Term Modification		Payment Modification		Combination Modification		Total Modifications
Pre-Modification Outstanding Recorded Investment:
Commercial - AQR substandard	7		$—		$—		$509		$2,585		$3,094
Real estate term owner occupied - AQR substandard	1	—		—		192		—		192
Total	8		$—		$—		$701		$2,585		$3,286
Post-Modification Outstanding Recorded Investment:
Commercial - AQR substandard	7		$—		$—		$408		$2,561		$2,969
Real estate term owner occupied - AQR substandard	1	—		—		182		—		182
Total	8		$—		$—		$590		$2,561		$3,151



	December 31, 2018
(In Thousands)	Number of Contracts	Rate Modification		Term Modification		Payment Modification		Combination Modification		Total Modifications
Pre-Modification Outstanding Recorded Investment:
Commercial - AQR substandard	4		$—		$—		$2,704		$—		$2,704
Real estate term owner occupied - AQR substandard	3	—		—		1,921		—		1,921
Total	7		$—		$—		$4,625		$—		$4,625
Post-Modification Outstanding Recorded Investment:
Commercial - AQR substandard	4		$—		$—		$1,166		$—		$1,166
Real estate term owner occupied - AQR substandard	3	—		—		1,921		—		1,921
Total	7		$—		$—		$3,087		$—		$3,087

The Company had no commitments to extend additional credit to borrowers owing receivables whose terms have been modified in TDRs at December 31, 2019. There were $64,000 of charge-offs in 2019 on loans that were later classified as a TDR and there were $1.3 million of charge-offs in 2018 on loans that were later classified as a TDR in 2018.

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 was no TDR with specific impairment at December 31, 2019 and one at December 31, 2018, respectively.

There were no loans that were restructured during 2019 or 2017, that also subsequently defaulted within the first twelve months of restructure in those same periods. The following table presents TDRs that occurred during 2018 that subsequently defaulted during the twelve-months ended December 31, 2018:



		December 31, 2018
	Number of Contracts	Recorded Investment
(In Thousands)	Number of Contracts	Recorded Investment
Troubled Debt Restructurings that Subsequently Defaulted:
Commercial - AQR substandard	4	$1,166
Real estate term owner occupied - AQR substandard	2	1,694
Total	6	$2,860

Loans to Related Parties

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)	2019		2018		2017
Balance, beginning of the year		$—		$—		$90
Loans made	309		—		—
Repayments	—		—		90
Balance, end of year		$309		$—		$—

The Company had $15,000 of unfunded loan commitments to these directors or their related interests on December 31, 2019 and 2018.

Pledged Loans

At December 31, 2019 and 2018, there were no loans pledged as collateral to secure public deposits.