LOANS AND ALLOWANCE FOR LOAN LOSSES

The Company routinely generates 1-4 family mortgages for sale into the secondary market. During 2017, 2016 and 2015, the Company recognized sales proceeds of $1.4 billion, $1.7 billion and $1.3 billion, resulting in mortgage fee income of $37.1 million, $35.7 million and $29.5 million, respectively.

The components of loans in the Consolidated Balance Sheet at December 31, were as follows:



(Dollars in thousands)	2017		2016
Commercial and Non-Residential Real Estate	$	783,909	$	756,619
Residential Real Estate	246,214		215,452
Home Equity	62,400		65,386
Consumer	12,783		14,511
Total Loans	1,105,306		1,051,968
Deferred loan origination fees and costs, net	635		897
Loans receivable	$	1,105,941	$	1,052,865

The following table summarizes the primary segments of the loan portfolio as of December 31, 2017 and 2016:



(Dollars in thousands)	Commercial		Residential		Home Equity		Consumer		Total
December 31, 2017
Individually evaluated for impairment	$	13,796	$	1,569	$	13	$	178	$	15,556
Collectively evaluated for impairment	770,113		244,645		62,387		12,605		1,089,750
Total Loans	$	783,909	$	246,214	$	62,400	$	12,783	$	1,105,306
December 31, 2016
Individually evaluated for impairment	$	10,781	$	1,161	$	132	$	78	$	12,152
Collectively evaluated for impairment	745,838		214,291		65,254		14,433		1,039,816
Total Loans	$	756,619	$	215,452	$	65,386	$	14,511	$	1,051,968

Loans are considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in evaluating impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. The Company also separately evaluates individual consumer loans for impairment. The Chief Credit Officer identifies these loans individually by monitoring the delinquency status of the Bank’s portfolio. Once identified, the Bank’s ongoing communications with the borrower allow Management to evaluate the significance of the payment delays and the circumstances surrounding the loan and the borrower.

Once the determination has been made that a loan is impaired, the amount of the impairment is measured using one of three valuation methods: (a) the present value of expected future cash flows discounted at the loan’s effective interest rate; (b) the loan’s observable market price; or (c) the fair value of the collateral less selling costs. The method is selected on a loan-by-loan basis, with management primarily utilizing the fair value of collateral method. The evaluation of the need and amount of a specific allocation of the allowance and whether a loan can be removed from impairment status is made on a quarterly basis.

The following table presents impaired loans by class, segregated by those for which a specific allowance was required and those for which a specific allowance was not necessary as of December 31, 2017 and 2016:



	Impaired Loans with Specific Allowance				Impaired Loans with No Specific Allowance		Total Impaired Loans
(Dollars in thousands)	Recorded Investment		Related Allowance		Recorded Investment		Recorded Investment		Unpaid Principal Balance
December 31, 2017
Commercial
Commercial Business	$	3,283	$	22	$	979	$	4,262	$	4,275
Commercial Real Estate	4,603		1,150		2,814		7,417		7,921
Acquisition & Development	—		—		2,117		2,117		4,090
Total Commercial	7,886		1,172		5,910		13,796		16,286
Residential	—		—		1,569		1,569		1,601
Home Equity	—		—		13		13		13
Consumer	69		16		109		178		475
Total Impaired Loans	$	7,955	$	1,188	$	7,601	$	15,556	$	18,375

December 31, 2016
Commercial
Commercial Business	$	—	$	—	$	3,342	$	3,342	$	4,102
Commercial Real Estate	2,757		302		892		3,649		3,676
Acquisition & Development	264		74		3,526		3,790		6,059
Total Commercial	3,021		376		7,760		10,781		13,837
Residential	783		122		378		1,161		1,166
Home Equity	62		36		70		132		135
Consumer	16		9		62		78		285
Total Impaired Loans	$	3,882	$	543	$	8,270	$	12,152	$	15,423

Impaired loans have increased by $3.4 million, or 28%, during 2017, primarily the result of the net impact of multiple factors including increases due to the identification of $7.6 million of recently impaired loans less, principal curtailments of $2.1 million, partial charge-offs of $360 thousand, foreclosure and reclassification to other real estate owned of $1.3 million, reclassification of $150 thousand of previously reported impaired loans to performing loans, and normal loan amortization of $213 thousand.

The $7.6 million total of recently identified impaired loans includes $6.7 million, or 88.2%, of commercial loans, $783 thousand, or 10.3%, of residential mortgage loans, and $129 thousand, or 1.5%, of consumer loans. The commercial loans are primarily concentrated in just three relationships, including a $3.4 million purchased participation note secured by a senior healthcare facility, a $1.2 million commercial real estate loan, net of a $579 thousand sold participation, secured by a retail strip center, and a $810 thousand development loan secured by a developed commercial pad site. These three loans represent 80.0% of the recently impaired commercial loans, while the remaining $1.3 million represent fifteen additional commercial loans ranging from $6 thousand to $457 thousand in outstanding balances.

The following table presents the average recorded investment in impaired loans and related interest income recognized for the years ended:

	December 31, 2017						December 31, 2016						December 31, 2015
(Dollars in thousands)	Average Investment in Impaired Loans		Interest Income Recognized on Accrual Basis		Interest Income Recognized on Cash Basis		Average Investment in Impaired Loans		Interest Income Recognized on Accrual Basis		Interest Income Recognized on Cash Basis		Average Investment in Impaired Loans		Interest Income Recognized on Accrual Basis		Interest Income Recognized on Cash Basis
Commercial
Commercial Business	$	3,718	$	155	$	113	$	4,027	$	155	$	104	$	3,153	$	156	$	114
Commercial Real Estate	3,199		100		98		3,590		100		75		6,618		63		61
Acquisition & Development	3,429		9		13		3,983		9		112		2,408		9		10
Total Commercial	10,346		264		224		11,600		264		291		12,179		228		185
Residential	1,424		13		53		928		20		28		920		12		13
Home Equity	538		1		1		50		1		1		28		1		1
Consumer	187		—		—		245		—		—		1		—		—
Total	$	12,495	$	278	$	278	$	12,823	$	285	$	320	$	13,128	$	241	$	199

As of December 31, 2017, the Bank held sixteen foreclosed residential real estate properties representing $1.0 million, or 78%, of the total balance of other real estate owned. These properties are held as a result of the foreclosures of primarily two commercial loan relationships, one of which included six properties for a total of $538 thousand, while the other included seven properties for a total of $178 thousand. The three remaining properties, totaling $329 thousand, were result of the foreclosure of three unrelated borrowers. There is one additional consumer mortgage loan collateralized by residential real estate property in the process of foreclosure. The total recorded investment in this loan was $132 thousand as of December 31, 2017. This loan is included in the table above and has a total of $0 in specific allowance allocated to it.

Bank management uses a nine point internal risk rating system to monitor the credit quality of the overall loan portfolio. The first six categories are considered not criticized, and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The Special Mention category includes assets that are currently protected but are potentially weak, resulting in an undue and unwarranted credit risk, but not to the point of justifying a Substandard classification. Loans in the Substandard category have well-defined weaknesses that jeopardize the liquidation of the debt, and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected. Any portion of a loan that has been or is expected to be charged off is placed in the Loss category.

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay a loan as agreed, the Bank has a structured loan rating process with several layers of internal and external oversight. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as past due status, bankruptcy, repossession, or death occurs to raise awareness of a possible credit event. The Bank’s Chief Credit Officer is responsible for the timely and accurate risk rating of the loans in the portfolio at origination and on an ongoing basis. The Credit Department ensures that a review of all commercial relationships of one million dollars or greater is performed annually.

Review of the appropriate risk grade is included in both the internal and external loan review process, and on an ongoing basis. The Bank has an experienced Credit Department that continually reviews and assesses loans within the portfolio. The Bank engages an external consultant to conduct independent loan reviews on at least an annual basis. Generally, the external consultant reviews larger commercial relationships or criticized relationships. The Bank’s Credit Department compiles detailed reviews, including plans for resolution, on loans classified as Substandard on a quarterly basis. Loans in the Special Mention and Substandard categories that are collectively evaluated for impairment are given separate consideration in the determination of the allowance.

The following table represents the classes of the loan portfolio summarized by the aggregate Pass and the criticized categories of Special Mention, Substandard and Doubtful within the internal risk rating system as of December 31, 2017 and 2016:



(Dollars in thousands)	Pass		Special Mention		Substandard		Doubtful		Total
December 31, 2017
Commercial
Commercial Business	$	371,041	$	4,816	$	4,506	$	—	$	380,363
Commercial Real Estate	271,751		22,995		5,961		1,149		301,856
Acquisition & Development	96,712		931		2,230		1,817		101,690
Total Commercial	739,504		28,742		12,697		2,966		783,909
Residential	242,823		3,036		223		132		246,214
Home Equity	61,037		1,311		52		—		62,400
Consumer	12,453		174		25		131		12,783
Total Loans	$	1,055,817	$	33,263	$	12,997	$	3,229	$	1,105,306

December 31, 2016
Commercial
Commercial Business	$	376,734	$	2,933	$	6,833	$	69	$	386,569
Commercial Real Estate	240,851		26,340		3,532		737		271,460
Acquisition & Development	90,875		1,905		2,584		3,226		98,590
Total Commercial	708,460		31,178		12,949		4,032		756,619
Residential	212,869		1,664		787		132		215,452
Home Equity	64,706		582		98		—		65,386
Consumer	14,134		302		13		62		14,511
Total Loans	$	1,000,169	$	33,726	$	13,847	$	4,226	$	1,051,968

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due.

A loan that has deteriorated and requires additional collection efforts by the Bank could warrant non-accrual status. A thorough review is presented to the Chief Credit Officer and or the Management Loan Committee ("MLC"), as required with respect to any loan which is in a collection process and to make a determination as to whether the loan should be placed on non-accrual status. The placement of loans on non-accrual status is subject to applicable regulatory restrictions and guidelines. Generally, loans should be placed in non-accrual status when the loan reaches 90 days past due, when it becomes likely the borrower cannot or will not make scheduled principal or interest payments, when full repayment of principal and interest is not expected, or when the loan displays potential loss characteristics. Normally, all accrued interest is charged off when a loan is placed in non-accrual status, unless Management believes it is likely the accrued interest will be collected. Any payments subsequently received are applied to principal. To remove a loan from non-accrual status, all principal and interest due must be paid up to date and the Bank is reasonably sure of future satisfactory payment performance. Usually, this requires a six-month recent history of payments due. Removal of a loan from non-accrual status will require the approval of the Chief Credit Officer and or MLC.

The following table presents the classes of the loan portfolio summarized by aging categories of performing loans and nonaccrual loans as of December 31, 2017 and 2016:



(Dollars in thousands)	Current		30-59 Days Past Due		60-89 Days Past Due		90+ Days Past Due		Total Past Due		Total Loans		Non-Accrual		90+ Days Still Accruing
December 31, 2017
Commercial
Commercial Business	$	377,901	$	512	$	1,368	$	582	$	2,462	$	380,363	$	1,027	$	—
Commercial Real Estate	300,282		45		1,149		380		1,574		301,856		5,206		—
Acquisition & Development	99,573		—		874		1,243		2,117		101,690		2,117		—
Total Commercial	777,756		557		3,391		2,205		6,153		783,909		8,350		—
Residential	243,177		1,879		707		451		3,037		246,214		1,157		—
Home Equity	61,907		240		240		13		493		62,400		13		—
Consumer	12,634		11		—		138		149		12,783		179		—
Total Loans	$	1,095,474	$	2,687	$	4,338	$	2,807	$	9,832	$	1,105,306	$	9,699	$	—

December 31, 2016
Commercial
Commercial Business	$	386,311	$	15	$	169	$	74	$	258	$	386,569	$	74	$	—
Commercial Real Estate	270,339		229		—		892		1,121		271,460		1,375		—
Acquisition & Development	96,014		—		—		2,576		2,576		98,590		3,526		—
Total Commercial	752,664		244		169		3,542		3,955		756,619		4,975		—
Residential	212,502		2,067		419		464		2,950		215,452		1,072		—
Home Equity	64,791		525		—		70		595		65,386		104		—
Consumer	14,354		55		34		68		157		14,511		78		—
Total Loans	$	1,044,311	$	2,891	$	622	$	4,144	$	7,657	$	1,051,968	$	6,229	$	—

An allowance for loan losses (“ALL”) is maintained to absorb losses from the loan portfolio. The ALL is based on management’s continuing evaluation of the risk characteristics and credit quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.

Interest income on loans would have increased by approximately $423 thousand, $396 thousand and $639 thousand for 2017, 2016 and 2015, respectively, if loans had performed in accordance with their terms.

The Bank’s methodology for determining the ALL is based on the requirements of ASC Section 310-10-35 for loans individually evaluated for impairment (discussed above) and ASC Subtopic 450-20 for loans collectively evaluated for impairment, as well as the Interagency Policy Statements on the Allowance for Loan and Lease Losses and other bank regulatory guidance. The total of the two components represents the Bank’s ALL. As of the quarter ended September 30, 2017, the Bank adjusted its methodology to allow for the analysis of certain impaired loans in homogeneous pools, rather than on an individual basis, when those loans are below specific thresholds based on outstanding principal balance. More specifically, residential mortgage loans, home equity lines of credit, and consumer loans, when considered impaired, are evaluated collectively for impairment by applying allocation rates derived from the Bank’s historical losses specific to impaired loans and the reserve totaled $1.3 million and $0 as of December 31, 2017 and 2016.

Loans that are collectively evaluated for impairment are analyzed with general allowances being made as appropriate. For general allowances, historical loss trends are used in the estimation of losses in the current portfolio. These historical loss amounts are modified by qualified factors.

The segments described above, which are based on the Federal call code assigned to each loan, provide the starting point for the ALL analysis. Company and bank management tracks the historical net charge-off activity at the call code level. A historical charge-off factor is calculated utilizing a defined number of consecutive historical quarters. All pools currently utilize a rolling 12 quarters.

“Pass” rated credits are segregated from “Criticized” credits for the application of qualitative factors. Loans in the criticized pools, which possess certain qualities or characteristics that may lead to collection and loss issues, are closely monitored by management and subject to additional qualitative factors.

Company and Bank management have identified a number of additional qualitative factors which it uses to supplement the historical charge-off factor because these factors are likely to cause estimated credit losses associated with the existing loan pools to differ from historical loss experience. The additional factors that are evaluated quarterly and updated using information obtained from internal, regulatory, and governmental sources are: lending policies and procedures, nature and volume of the portfolio, experience and ability of lending management and staff, volume and severity of problem credits, conclusion of loan reviews, audits, and exams, changes in the value of underlying collateral, effect of concentrations of credit from a loan type, industry and/or geographic standpoint, changes in economic and business conditions, consumer sentiment, and other external factors. The combination of historical charge-off and qualitative factors are then weighted for each risk grade. These weightings are determined internally based upon the likelihood of loss as a loan risk grading deteriorates.

To estimate the liability for off-balance sheet credit exposures, Bank management analyzed the portfolios of letters of credit, non-revolving lines of credit, and revolving lines of credit, and based its calculation on the expectation of future advances of each loan category. Letters of credit were determined to be highly unlikely to advance since they are generally in place only to ensure various forms of performance of the borrowers. In the Bank’s history, there have been no letters of credit drawn upon. In addition, many of the letters of credit are cash secured and do not warrant an allocation. Non-revolving lines of credit were determined to be highly likely to advance as these are typically construction lines. Meanwhile, the likelihood of revolving lines of credit advancing varies with each individual borrower. Therefore, the future usage of each line was estimated based on the average line utilization of the revolving line of credit portfolio as a whole.

Once the estimated future advances were calculated, an allocation rate, which was derived from the Bank’s historical losses and qualitative environmental factors, was applied in the similar manner as those used for the allowance for loan loss calculation. The resulting estimated loss allocations were totaled to determine the liability for unfunded commitments related to these loans, which Management considers necessary to anticipate potential losses on those commitments that have a reasonable probability of funding. The liability for unfunded commitments was $284 thousand as of December 31, 2017 and 2016.

Bank management reviews the loan portfolio on a quarterly basis using a defined, consistently applied process in order to make appropriate and timely adjustments to the ALL. When information confirms all or part of specific loans to be uncollectible, these amounts are promptly charged off against the ALL.

The following tables summarize the primary segments of the ALL, segregated into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of December 31, 2017, 2016, and 2015. Activity in the allowance is presented for the periods indicated:



(Dollars in thousands)	Commercial			Residential			Home Equity			Consumer			Total
ALL balance at December 31, 2016	$	7,181		$	990		$	728		$	202		$	9,101
Charge-offs	(1,138		)	(141		)	(109		)	(109		)	(1,497		)
Recoveries	39			40			4			18			101
Provision	1,722			230			82			139			2,173
ALL balance at December 31, 2017	$	7,804		$	1,119		$	705		$	250		$	9,878
Individually evaluated for impairment	$	1,172		$	—		$	—		$	16		$	1,188
Collectively evaluated for impairment	$	6,632		$	1,119		$	705		$	234		$	8,690



(Dollars in thousands)	Commercial			Residential			Home Equity			Consumer			Total
ALL balance at December 31, 2015	$	6,066		$	1,095		$	715		$	130		$	8,006
Charge-offs	(1,995		)	(124		)	(100		)	(338		)	(2,557		)
Recoveries	8			2			9			1			20
Provision	3,102			17			104			409			3,632
ALL balance at December 31, 2016	$	7,181		$	990		$	728		$	202		$	9,101
Individually evaluated for impairment	$	376		$	122		$	36		$	9		$	543
Collectively evaluated for impairment	$	6,805		$	868		$	692		$	193		$	8,558



(Dollars in thousands)	Commercial			Residential			Home Equity			Consumer			Total
ALL balance at December 31, 2014	$	4,363		$	962		$	691		$	207		$	6,223
Charge-offs	(708		)	(28		)	(5		)	(6		)	(747		)
Recoveries	20			2			4			11			37
Provision	2,391			159			25			(82		)	2,493
ALL balance at December 31, 2015	$	6,066		$	1,095		$	715		$	130		$	8,006
Individually evaluated for impairment	$	708		$	276		$	28		$	1		$	1,013
Collectively evaluated for impairment	$	5,358		$	819		$	687		$	129		$	6,993

The allowance for loan losses is based on estimates, and actual losses will vary from current estimates. Management believes that the granularity of the homogeneous pools and the related historical loss ratios and other qualitative factors, as well as the consistency in the application of assumptions, result in an ALL that is representative of the risk found in the components of the portfolio at any given date.

Troubled Debt Restructurings

The restructuring of a loan is considered a troubled debt restructuring (“TDR”) if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. At December 31, 2017 and 2016, the Bank had specific reserve allocations for TDR’s of $439 thousand and $348 thousand, respectively.

Loans considered to be troubled debt restructured loans totaled $6.4 million and $8.8 million as of December 31, 2017 and December 31, 2016, respectively. Of these totals, $5.9 million and $5.9 million, respectively, represent accruing troubled debt restructured loans and represent 38% and 49%, respectively of total impaired loans. Meanwhile, as of December 31, 2017, $432 thousand represent two loans to one borrower that have defaulted under the restructured terms. Both loans are commercial acquisition and development loans that were considered TDR's due to extended interest only periods and/or unsatisfactory repayment structures once transitioned to principal and interest payments. These borrowers have experienced continued financial difficulty and are considered non-performing loans as of December 31, 2017. These two loans, in addition to a third loan to a second borrower that defaulted under the restructured terms, totaled $2.3 million as of December 31, 2016. All three loans are commercial acquisition and development loans that were considered TDR's due to extended interest only periods and/or unsatisfactory repayment structures once transitioned to principal and interest payments. These borrowers have experienced continued financial difficulty and are considered non-performing loans as of December 31, 2016. Two additional restructured loans, a $214 thousand commercial real estate loan and a $348 thousand mortgage loan, were considered non-performing as of December 31, 2016. Both of these were also considered TDR's due to interest only periods and/or unsatisfactory repayment structures.

The following table presents details related to loans identified as Troubled Debt Restructurings during the years ended December 31, 2017 and 2016.



	New TDR's ¹
	December 31, 2017					December 31, 2016
(Dollars in thousands)	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Commercial
Commercial Business	1	$	147	$	147	—	$	—	$	—
Commercial Real Estate	—	—		—		—	—		—
Acquisition & Development	—	—		—		—	—		—
Total Commercial	1	147		147		—	—		—
Residential	—	—		—		—	—		—
Home Equity	—	—		—		—	—		—
Consumer	—	—		—		—	—		—
Total	1	$	147	$	147	—	$	—	$	—

¹ The pre-modification and post-modification balances represent the balances outstanding immediately before and after modification of the loan.