Note 4 – Loans and Allowance for Loan Losses

The components of loans in the Consolidated Balance Sheet at March 31, 2018 and December 31, 2017, were as follows:



(Dollars in thousands)	March 31, 2018		December 31, 2017
Commercial and Non-Residential Real Estate	$	824,625	$	783,909
Residential Real Estate	260,513		246,214
Home Equity	59,526		62,400
Consumer	11,909		12,783
Total Loans	$	1,156,573	$	1,105,306
Deferred loan origination fees and costs, net	600		635
Loans receivable	$	1,157,173	$	1,105,941

All loan origination fees and direct loan origination costs are deferred and recognized over the life of the loan.

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.

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. The Bank's methodology allows 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. Total collectively evaluated impaired loans were $1.4 million and $1.3 million, while the related reserves were $173 thousand and $169 thousand as of March 31, 2018 and December 31, 2017.

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 below in the impaired loans by class table, 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. As of March 31, 2018 and December 31, 2017, the liability for unfunded commitments related to loans held for investment was $284 thousand.

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 ALL 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.

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 March 31, 2018:



(Dollars in thousands)	Commercial			Residential			Home Equity			Consumer			Total
ALL balance at December 31, 2017	$	7,804		$	1,119		$	705		$	250		$	9,878
Charge-offs	(324		)	(11		)	—			(21		)	(356		)
Recoveries	2			9			56			4			71
Provision	516			60			(68		)	(34		)	474
ALL balance at March 31, 2018	$	7,998		$	1,177		$	693		$	199		$	10,067
Individually evaluated for impairment	$	915		$	—		$	—		$	—		$	915
Collectively evaluated for impairment	$	7,083		$	1,177		$	693		$	199		$	9,152

The following table summarizes the primary segments of the Company loan portfolio as of March 31, 2018:



(Dollars in thousands)	Commercial		Residential		Home Equity		Consumer		Total
Individually evaluated for impairment	$	12,957	$	1,707	$	44	$	43	$	14,751
Collectively evaluated for impairment	811,668		258,806		59,482		11,866		1,141,822
Total Loans	$	824,625	$	260,513	$	59,526	$	11,909	$	1,156,573



(Dollars in thousands)	Commercial			Residential			Home Equity			Consumer			Total
ALL balance at December 31, 2016	$	7,181		$	990		$	728		$	202		$	9,101
Charge-offs	(113		)	(141		)	(33		)	(3		)	(290		)
Recoveries	9			32			1			1			43
Provision	208			204			94			12			518
ALL balance at March 31, 2017	$	7,285		$	1,085		$	790		$	212		$	9,372
Individually evaluated for impairment	$	279		$	46		$	36		$	25		$	386
Collectively evaluated for impairment	$	7,006		$	1,039		$	754		$	187		$	8,986

The following table summarizes the primary segments of the Company loan portfolio as of March 31, 2017:



(Dollars in thousands)	Commercial		Residential		Home Equity		Consumer		Total
Individually evaluated for impairment	$	10,300	$	1,356	$	647	$	125	$	12,428
Collectively evaluated for impairment	742,031		243,250		64,523		13,636		1,063,440
Total Loans	$	752,331	$	244,606	$	65,170	$	13,761	$	1,075,868

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 evaluates residential mortgage loans, home equity lines of credit, and consumer loans in homogeneous pools, rather than on an individual basis, when each of those loans are below specific thresholds based on outstanding principal balance. Such loans that individually exceed these thresholds are evaluated individually 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 March 31, 2018 and December 31, 2017:



	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
March 31, 2018
Commercial
Commercial Business	$	139	$	76	$	4,738	$	4,877	$	4,898
Commercial Real Estate	4,026		839		2,762		6,788		7,596
Acquisition & Development	—		—		1,292		1,292		3,572
Total Commercial	4,165		915		8,792		12,957		16,066
Residential	—		—		1,707		1,707		1,755
Home Equity	—		—		44		44		44
Consumer	—		—		43		43		49
Total Impaired Loans	$	4,165	$	915	$	10,586	$	14,751	$	17,914

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

Impaired loans have decreased by $805 thousand, or 5.2%, during the first quarter of 2018. This change is the net effect of multiple factors, including the identification of $1.0 million of impaired loans, principal curtailments of $307 thousand, partial charge-offs of $335 thousand, the foreclosure of a commercial development loan which required the reclassification of $720 thousand to other real estate owned, the classification of $292 thousand to performing loans based on improved repayment performance, and normal loan amortization.

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

	Three Months Ended March 31, 2018						Three Months Ended March 31, 2017
(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
Commercial
Commercial Business	$	4,525	$	38	$	53	$	3,349	$	39	$	13
Commercial Real Estate	7,431		21		23		2,803		25		26
Acquisition & Development	1,837		—		—		3,775		2		3
Total Commercial	13,793		59		76		9,927		66		42
Residential	1,747		5		48		1,417		2		17
Home Equity	65		—		—		653		—		—
Consumer	132		—		—		142		—		—
Total	$	15,737	$	64	$	124	$	12,139	$	68	$	59

As of March 31, 2018, the Bank's other real estate owned balance totaled $1.9 million. The Bank held nine foreclosed residential real estate properties representing $890 thousand, or 47%, 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 three properties for a total of $395 thousand, while the other also included three properties for a total of $178 thousand. The three remaining residential real estate properties, totaling $317 thousand, were result of the foreclosure of three unrelated borrowers. The remaining $1.0 million, or 53%, of other real estate owned is the result of the foreclosure of three unrelated commercial development loans. There are two additional consumer mortgage loans collateralized by residential real estate properties in the process of foreclosure. The total recorded investment in these loans was $329 thousand as of March 31, 2018. These loans are included in the table above and have $0 in specific allowance allocated to them.

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 March 31, 2018 and December 31, 2017:



(Dollars in thousands)	Pass		Special Mention		Substandard		Doubtful		Total
March 31, 2018
Commercial
Commercial Business	$	380,106	$	4,793	$	4,547	$	—	$	389,446
Commercial Real Estate	304,669		14,553		2,394		4,236		325,852
Acquisition & Development	105,111		994		2,230		992		109,327
Total Commercial	789,886		20,340		9,171		5,228		824,625
Residential	257,307		2,879		205		122		260,513
Home Equity	58,413		1,074		39		—		59,526
Consumer	11,695		191		16		7		11,909
Total Loans	$	1,117,301	$	24,484	$	9,431	$	5,357	$	1,156,573

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

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 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.

Management is currently monitoring the payment performance of a $3.2 million commercial loan that has paid slow in recent months. This loan is classified as a troubled debt restructured loan based on multiple interest only periods being provided in the past, however, as of March 31, 2018, this loan was paid current. The borrower has continued to work through ongoing litigation, resolution of which is expected in the near future.

The following table presents the classes of the loan portfolio summarized by aging categories of performing loans and nonaccrual loans as of March 31, 2018 and December 31, 2017:



(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
March 31, 2018
Commercial
Commercial Business	$	387,428	$	473	$	393	$	1,152	$	2,018	$	389,446	$	1,758	$	—
Commercial Real Estate	321,198		1,188		—		3,466		4,654		325,852		4,664		—
Acquisition & Development	108,035		860		—		432		1,292		109,327		1,292		—
Total Commercial	816,661		2,521		393		5,050		7,964		824,625		7,714		—
Residential	255,659		4,417		108		329		4,854		260,513		1,301		—
Home Equity	59,050		194		282		—		476		59,526		44		—
Consumer	11,831		28		19		31		78		11,909		43		—
Total Loans	$	1,143,201	$	7,160	$	802	$	5,410	$	13,372	$	1,156,573	$	9,102	$	—

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	$	—

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 March 31, 2018 and December 31, 2017, the Bank had specific reserve allocations for TDR’s of $443 thousand and $439 thousand, respectively.

Loans considered to be troubled debt restructured loans totaled $6.4 million and $6.4 million as of March 31, 2018 and December 31, 2017, respectively. Of these totals, $5.6 million and $5.9 million, respectively, represent accruing troubled debt restructured loans and represent 38% and 38%, respectively of total impaired loans. Meanwhile, $432 thousand represents 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 March 31, 2018 and December 31, 2017. There were no previously restructured loans that defaulted during the three months ended March 31, 2018.

A commercial loan in the amount of $128 thousand was classified as impaired and as a TDR in the first quarter of 2018. This loan represents the only new TDR for the three months ended March 31, 2018. There were no new TDR's for the three months ended March 31, 2017.



	New TDR's ¹
	Three Months Ended March 31, 2018					Three Months Ended March 31, 2017
(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	$	128	$	128	—	$	—	$	—
Commercial Real Estate	—	—		—		—	—		—
Acquisition & Development	—	—		—		—	—		—
Total Commercial	1	128		128		—	—		—
Residential	—	—		—		—	—		—
Home Equity	—	—		—		—	—		—
Consumer	—	—		—		—	—		—
Total	1	$	128	$	128	—	$	—	$	—

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