NOTE 4 – LOANS AND THE ALLOWANCE FOR LOAN LOSSES

The following table presents the composition of the loans held for investment portfolio at June 30, 2011 and December 31, 2010:

Composition of Loan Portfolio

(In Thousands)

	June 30, 2011					December 31, 2010
	Amount		Percentage of Total			Amount		Percentage of Total
Commercial real estate	$	237,821		45.67	%	$	217,999		44.35	%
Residential real estate		128,820		24.74			137,752		28.03
Commercial		116,660		22.41			94,798		19.28
Real estate construction		34,446		6.62			38,093		7.75
Consumer		2,927		0.56			2,887		0.59
Total loans	$	520,674		100.00	%	$	491,529		100.00	%
Less allowance for loan losses		11,057					10,527
Total net loans	$	509,617				$	481,002

Allowance for Loan Losses

The allowance for loan losses totaled approximately $11.1 million at June 30, 2011 compared to $10.5 million at year end December 31, 2010. The allowance for loan losses was equivalent to approximately 2.12% of total loans held for investment at June 30, 2011 and 2.14% at December 31, 2010. Adequacy of the allowance is assessed and the allowance is increased by provisions for loan losses charged to expense no less than quarterly. Charge-offs are taken when a loan is identified as uncollectible.

The methodology by which we systematically determine the amount of our allowance is set forth by the Board of Directors in our Loan Policy and implemented by management. The results of the analysis are documented, reviewed, and approved by the Board of Directors no less than quarterly.

The level of the allowance for loan losses is determined by management through an ongoing, detailed analysis of historical loss rates and risk characteristics. During each quarter, management evaluates the collectability of all loans in the portfolio and ensures an accurate risk rating is assigned to each loan. The risk rating scale and definitions commonly adopted by the Federal Banking Agencies is contained within the framework prescribed by the bank’s Loan Policy. Any loan that is deemed to have potential or well defined weaknesses that may jeopardize collection in full is then analyzed to ascertain its level of weakness. If appropriate, the loan may be charged-off or a specific reserve may be assigned if the loan is deemed to be impaired.

During the risk rating verification process, each loan identified as inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged is considered impaired and is placed on non-accrual status. On these loans, management analyzes the potential impairment of the individual loan and may set aside a specific reserve. Any amounts deemed uncollectible during that analysis are charged-off.

For the remaining loans in each segment, the bank calculates the probability of loss as a group using the risk rating for each of the following loan types: Commercial Real Estate, Residential Real Estate, Commercial, Real Estate Construction, and Consumer. Management calculates the historical loss rate in each group by risk rating using a period of at least three years. This historical loss rate may then be adjusted based on management’s assessment of internal and external environmental factors. This adjustment is meant to account for changes between the historical economic environment and current conditions, and for changes in the ongoing management of the portfolio which affects the loans’ potential losses.

Once complete, management compares the condition of the portfolio using several different characteristics, as well as its experience, to the experience of other banks in its peer group in order to determine if it is directionally consistent with others’ experience in our area and line of business. Based on that analysis, management aggregates the probabilities of loss of the remaining portfolio based on the specific and general allowances and may provide additional amounts to the allowance for loan losses as needed. Since this process involves estimates, the allowance for loan losses may also contain an amount that is non material which is not allocated to a specific loan or to a group of loans but is deemed necessary to absorb additional losses in the portfolio.

Management and the Board of Directors subject the reserve adequacy and methodology to a review on a regular basis by internal auditors, external auditors and bank regulators, and such reviews have not resulted in any material adjustment to the reserve.

The following tables provide detailed information about the allowance for loan losses as of and for the periods indicated.

	Allowance for Loan Losses and Recorded Investment in Loans
For the Six Months Ended June 30, 2011	Commercial Real Estate			Residential Real Estate			Commercial			Real Estate Construction			Consumer		Total
Allowance for loan losses:	(In Thousands)

Beginning Balance	$	5,316		$	2,925		$	1,506		$	757		$	23	$	10,527
Charge-offs		(161	)		(363	)		(29	)		-			-		(553	)
Recoveries		592			38			232			-			-		862
Provisions		(648	)		643			373			(158	)		11		221
Ending Balance	$	5,099		$	3,243		$	2,082		$	599		$	34	$	11,057

Ending balance: individually evaluated for impairment	$	3,600		$	3,260		$	621		$	-		$	-	$	7,481
Ending balance: collectively evaluated for impairment	$	1,499		$	(17	)	$	1,461		$	599		$	34	$	3,576
Ending balance: loans acquired with deteriorated credit quality	$	-		$	-		$	-		$	-		$	-	$	-

Loans
Ending balance	$	237,821		$	128,820		$	116,660		$	34,446		$	2,927	$	520,674
Ending balance: individually evaluated for impairment	$	3,600		$	2,868		$	874		$	-		$	-	$	7,342
Ending balance: collectively evaluated for impairment	$	234,221		$	125,952		$	115,786		$	34,446		$	2,927	$	513,332
Ending balance: loans acquired with deteriorated credit quality	$	-		$	-		$	-		$	-		$	-	$	-

For the Year Ended December 31, 2010	Commercial Real Estate			Residential Real Estate			Commercial			Real Estate Construction			Consumer		Total
Allowance for loan losses:	(In Thousands)

Beginning Balance	$	4,407		$	2,606		$	1,562		$	539		$	13	$	9,127
Charge-offs		(624	)		(875	)		(501	)		(48	)		-		(2,048	)
Recoveries		109			38			385			99			1		632
Provisions		1,424			1,156			60			167			9		2,816
Ending Balance	$	5,316		$	2,925		$	1,506		$	757		$	23	$	10,527

Ending balance: individually evaluated for impairment	$	960		$	283		$	-		$	-		$	-	$	1,243
Ending balance: collectively evaluated for impairment	$	4,356		$	2,642		$	1,506		$	757		$	23	$	9,284
Ending balance: loans acquired with deteriorated credit quality	$	-		$	-		$	-		$	-		$	-	$	-

Loans
Ending balance	$	217,999		$	137,752		$	94,798		$	38,093		$	2,887	$	491,529
Ending balance: individually evaluated for impairment	$	6,712		$	949		$	900		$	-		$	-	$	8,561
Ending balance: collectively evaluated for impairment	$	211,287		$	136,803		$	93,898		$	38,093		$	2,887	$	482,968
Ending balance: loans acquired with deteriorated credit quality	$	-		$	-		$	-		$	-		$	-	$	-

Identifying and Classifying Portfolio Risks by Risk Rating

Management evaluates the collectability of all loans in the portfolio and assigns a proprietary risk rating. Ratings range from the highest to lowest quality based on factors including measurements of ability to pay, collateral type and value, borrower stability, management experience, and credit enhancements. These ratings are consistent with the bank regulatory rating system.

A loan may have portions of its balance in one rating and other portions in a different rating. The Bank may use these “split ratings” when factors cause loan loss risk to exist for part but not all of the principal balance. Split ratings may also be used where cash collateral has been pledged or a government agency has provided a guaranty that partially covers a loan.

For clarity of presentation, the Corporation’s loan portfolio is profiled below in accordance with the risk rating framework that has been commonly adopted by the federal banking agencies. The definitions of the various risk rating categories are as follows:

Pass - The condition of the borrower and the performance of the loan is satisfactory or better.

Special mention - A special mention asset has one or more potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date.

Substandard - A substandard asset is inadequately protected by the current sound 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 distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

Doubtful - An asset classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss - Assets classified loss are considered uncollectible and their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value and partial recovery may be effected in the future.

The Bank did not have any loans classified as loss at June 30, 2011 or December 31, 2010. It is the Bank’s policy to charge-off any loan once the risk rating is classified as loss.

The profile of the portfolio, as indicated by risk rating, as of June 30, 2011 and December 31, 2010 is shown below.

Credit Quality Indicators

As of June 30, 2011 and December 31, 2010

Credit Risk Profile by Regulatory Risk Rating

	Commercial Real Estate						Residential Real Estate						Commercial						Real Estate Construction						Consumer				Totals
	6/30/11			12/31/10			6/30/11			12/31/10			6/30/11			12/31/10			6/30/11			12/31/10			6/30/11		12/31/10		6/30/11			12/31/10
	(In Thousands)
Pass	$	205,549		$	173,101		$	120,310		$	125,808		$	103,471		$	87,883		$	34,545		$	36,343		$	2,926	$	2,887	$	466,801			426,022
Special mention		15,666			26,016			2,359			4,828			10,104			4,827			-			1,585			-		-		28,129			37,256
Substandard		17,461			19,613			6,221			7,218			3,522			2,498			-			310			-		-		27,204			29,639
Doubtful		-			143			-			-			-			-			-			-			-		-		-			143
Loss		-			-			-			-			-			-			-			-			-		-		-			-
Unearned income		(855	)		(874	)		(70	)		(102	)		(437	)		(410	)		(99	)		(145	)		1		-	$	(1,460	)		(1,531	)
Total	$	237,821		$	217,999		$	128,820		$	137,752		$	116,660		$	94,798		$	34,446		$	38,093		$	2,927	$	2,887	$	520,674		$	491,529

Loans listed as non-performing are also placed on non-accrual status. The accrual of interest is discontinued at the time a loan is 90 days delinquent or when the credit deteriorates and there is doubt that the credit will be paid as agreed, unless the credit is well-secured and in process of collection. Once the loan is on non-accrual status, all accrued but unpaid interest is also charged-off, and all payments are used to reduce the principal balance. Once the principal balance is repaid in full, additional payments are taken into income. A loan may be returned to accrual status if the borrower shows renewed willingness and ability to repay under the term of the loan agreement. The risk profile based upon payment activity is shown below.

Credit Risk Profile Based on Payment Activity

	Commercial Real Estate				Residential Real Estate				Commercial				Real Estate Construction				Consumer				Totals
	6/30/11		12/31/10		6/30/11		12/31/10		6/30/11		12/31/10		6/30/11		12/31/10		6/30/11		12/31/10		6/30/11		12/31/10
	(In Thousands)
Performing	$	234,221		211,287	$	125,560		136,803	$	116,039		93,898	$	34,446		38,093	$	2,927		2,887	$	513,193		482,968
Non-performing	$	3,600		6,712	$	3,260		949	$	621		900	$	-		-	$	-		-	$	7,481		8,561
Total	$	237,821	$	217,999	$	128,820	$	137,752	$	116,660	$	94,798	$	34,446	$	38,093	$	2,927	$	2,887	$	520,674	$	491,529

Loans are considered past due if a contractual payment is not made by the calendar day after the payment is due. However, for reporting purposes loans past due 1 to 29 days are excluded from loans past due and are included in the total for current loans in the table below. The delinquency status of the loans in the portfolio is shown below as of June 30, 2011 and December 31, 2010. Loans that were on non-accrual status are not included in any past due amounts.

	Age Analysis of Past Due Loans
	As of June 30, 2011
	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Non-accrual Loans		Current Loans		Total Loans
	(In Thousands)
Commercial real estate	$	-	$	-	$	-	$	-	$	3,600	$	234,221	$	237,821
Residential real estate		-		-		-		-		3,260		125,560		128,820
Commercial		171		-		-		171		621		115,868		116,660
Real estate construction		-		-		-		-		-		34,446		34,446
Consumer		-		-		-		-		-		2,927		2,927
Total	$	171	$	-	$	-	$	171	$	7,481	$	513,022	$	520,674

	As of December 31, 2010
	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Non-accrual Loans		Current Loans		Total Loans
	(In Thousands)
Commercial real estate	$	-	$	1,487	$	-	$	1,487	$	6,712	$	209,800	$	217,999
Residential real estate		569		382		333		1,284		949		135,519		137,752
Commercial		-		-		-		-		900		93,898		94,798
Real estate construction		-		-		-		-		-		38,093		38,093
Consumer		-		-		-		-		-		2,887		2,887
Total	$	569	$	1,869	$	333	$	2,771	$	8,561	$	480,197	$	491,529

Impaired Loans

A loan is classified as impaired when it is deemed probable by management’s analysis that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement, or the recorded investment in the impaired loan is greater than the present value of expected future cash flows, discounted at the loan's effective interest rate. In the case of an impaired loan, management conducts an analysis which identifies if a quantifiable potential loss exists, and takes the necessary steps to record that loss when it has been identified as uncollectible. The table below shows the results of management’s analysis as of June 30, 2011 and December 31, 2010.

	Impaired Loans
	As of June 30, 2011

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
	(In Thousands)
With no specific related allowance recorded:
Commercial real estate	$	-	$	-	$	-	$	-	$	-
Residential real estate		392		392		-		392		-
Commercial		621		799		-		628		-
Real estate construction		-		-		-		-		-
Consumer		-		-		-		-		-
With a specific allowance recorded:
Commercial real estate		3,600		3,827		798		3,628		-
Residential real estate		2,868		3,410		750		2,965		-
Commercial		-		-		-		-		-
Real estate construction		-		-		-		-		-
Consumer		-		-		-		-		-
Total:
Commercial real estate	$	3,600	$	3,827	$	798	$	3,628	$	-
Residential real estate	$	3,260	$	3,802	$	750	$	3,357	$	-
Commercial	$	621	$	799	$	-	$	628	$	-
Real estate construction	$	-	$	-	$	-	$	-	$	-
Consumer	$	-	$	-	$	-	$	-	$	-

	Impaired Loans
	Year Ended December 31, 2010

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
	(In Thousands)
With no specific related allowance recorded:
Commercial real estate	$	3,041	$	3,041	$	-	$	3,110	$	-
Residential real estate		-		-		-		-		-
Commercial		900		900		-		306		-
Real estate construction		-		-		-		-		-
Consumer		-		-		-		-		-
With a specific allowance recorded:
Commercial real estate		3,671		3,671		960		3,722		-
Residential real estate		949		949		283		1,020		-
Commercial		-		-		-		-		-
Real estate construction		-		-		-		-		-
Consumer		-		-		-		-		-
Total:
Commercial real estate	$	6,712	$	6,712	$	960	$	6,832	$	-
Residential real estate	$	949	$	949	$	283	$	1,020	$	-
Commercial	$	900	$	900	$	-	$	306	$	-
Real estate construction	$	-	$	-	$	-	$	-	$	-
Consumer	$	-	$	-	$	-	$	-	$	-