LOANS AND ALLOWANCE FOR LOAN LOSSES

The Company routinely generates 1-4 family mortgages for sale into the secondary market. During 2018, 2017 and 2016, the Company recognized sales proceeds of $1.2 billion, $1.4 billion and $1.7 billion, resulting in mortgage fee income of $32.3 million, $37.1 million and $35.7 million, respectively.

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



(Dollars in thousands)	2018			2017
Commercial and Non-Residential Real Estate	$	941,033		$	783,909
Residential	294,929			246,214
Home Equity	59,015			62,400
Consumer	9,605			12,783
Total Loans	1,304,582			1,105,306
Deferred loan origination (fees) and costs, net	(216		)	635
Loans receivable	$	1,304,366		$	1,105,941

The following table summarizes the primary segments of the loan portfolio as of December 31, 2018 and 2017:



(Dollars in thousands)	Commercial		Residential		Home Equity		Consumer		Total
December 31, 2018
Individually evaluated for impairment	$	9,734	$	2,831	$	123	$	90	$	12,778
Collectively evaluated for impairment	931,299		292,098		58,892		9,515		1,291,804
Total Loans	$	941,033	$	294,929	$	59,015	$	9,605	$	1,304,582
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

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, 2018 and 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
December 31, 2018
Commercial
Commercial Business	$	4,885	$	668	$	387	$	5,272	$	5,292
Commercial Real Estate	1,842		375		396		2,238		2,300
Acquisition & Development	—		—		2,224		2,224		3,601
Total Commercial	6,727		1,043		3,007		9,734		11,193
Residential	—		—		2,831		2,831		2,882
Home Equity	—		—		123		123		123
Consumer	—		—		90		90		316
Total Impaired Loans	$	6,727	$	1,043	$	6,051	$	12,778	$	14,514

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 $2.8 million, or 17.9%, during 2018, due to multiple factors including increases due to the identification of $5.6 million of recently impaired loans, the sale of three impaired commercial loans totaling $5.4 million, principal curtailments of $738 thousand, partial charge-offs of $708 thousand, foreclosure and reclassification to other real estate owned of $720 thousand, reclassification of $620 thousand of previously reported impaired loans to performing loans, and normal loan amortization of $153 thousand.

The $5.6 million total of recently identified impaired loans includes $3.7 million, or 66.1%, of commercial loans, $1.6 million, or 28.6%, of residential mortgage loans, and $213 thousand, or 5.3%, of consumer loans. The commercial loans are primarily concentrated in two relationships, including a $1.8 million note secured by a stalled real estate development project, and two notes totaling $1.4 million secured by a struggling automotive dealership. These three loans represent 86.5% of the recently impaired commercial loans, while the remaining $500 thousand represent six additional commercial loans ranging from $11 thousand to $152 thousand in outstanding balances.

The $5.4 million total of sold impaired loans includes three loans in two commercial relationships, including a $3.4 million purchased participation note secured by a senior healthcare facility, a $1.1 million commercial real estate loan, net of a $579 thousand sold participation, secured by a retail strip center, and a $874 thousand development loan secured by a developed commercial pad site adjacent to the retail strip center. The healthcare loan was purchased by another investor with significant resources in the healthcare industry, while the retail and development loans were purchased by an investor with personal ties to the project.

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

	December 31, 2018						December 31, 2017						December 31, 2016
(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	$	4,052	$	51	$	106	$	3,718	$	155	$	113	$	4,027	$	155	$	104
Commercial Real Estate	6,416		159		94		3,199		100		98		3,590		100		75
Acquisition & Development	1,367		106		8		3,429		9		13		3,983		9		112
Total Commercial	11,835		316		208		10,346		264		224		11,600		264		291
Residential	2,569		20		14		1,424		13		53		928		20		28
Home Equity	100		2		1		538		1		1		50		1		1
Consumer	149		—		—		187		—		—		245		—		—
Total	$	14,653	$	338	$	223	$	12,495	$	278	$	278	$	12,823	$	285	$	320

As of December 31, 2018, the Bank held thirteen foreclosed residential real estate properties representing $914 thousand, or 43%, 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 four properties for a total of $395 thousand, while the other included seven properties for a total of $174 thousand. The two remaining properties, totaling $345 thousand, were result of the foreclosure of two unrelated borrowers. There are three additional consumer mortgage loans and one installment loan collateralized by residential real estate property in the process of foreclosure. The total recorded investment in these loans was $1.5 million as of December 31, 2018. These loans are included in the table above and have a total of $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 December 31, 2018 and 2017:



(Dollars in thousands)	Pass		Special Mention		Substandard		Doubtful		Total
December 31, 2018
Commercial
Commercial Business	$	432,589	$	5,290	$	5,652	$	—	$	443,531
Commercial Real Estate	371,309		2,071		2,181		—		375,561
Acquisition & Development	118,754		179		2,879		129		121,941
Total Commercial	922,652		7,540		10,712		129		941,033
Residential	290,602		2,608		1,600		119		294,929
Home Equity	58,100		876		39		—		59,015
Consumer	9,359		164		19		63		9,605
Total Loans	$	1,280,713	$	11,188	$	12,370	$	311	$	1,304,582

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 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, 2018 and 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
December 31, 2018
Commercial
Commercial Business	$	432,097	$	6,380	$	1,746	$	3,308	$	11,434	$	443,531	$	3,684	$	—
Commercial Real Estate	374,880		681		—		—		681		375,561		385		—
Acquisition & Development	121,644		—		—		297		297		121,941		426		—
Total Commercial	928,621		7,061		1,746		3,605		12,412		941,033		4,495		—
Residential	291,665		1,000		760		1,504		3,264		294,929		2,442		—
Home Equity	58,575		400		40		—		440		59,015		84		—
Consumer	9,485		28		10		82		120		9,605		82		—
Total Loans	$	1,288,346	$	8,489	$	2,556	$	5,191	$	16,236	$	1,304,582	$	7,103	$	—

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	$	—

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 $771 thousand, $423 thousand, and $396 thousand for 2018, 2017 and 2016, 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 $204 thousand and $169 thousand as of December 31, 2018 and 2017, respectively.

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 track 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, 2018 and 2017.

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, 2018, 2017, and 2016. Activity in the allowance is presented for the periods indicated:



(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	(1,024		)	(166		)	—			(290		)	(1,480		)
Recoveries	15			22			59			5			101
Provision	1,810			430			(80		)	280			2,440
ALL balance at December 31, 2018	$	8,605		$	1,405		$	684		$	245		$	10,939
Individually evaluated for impairment	$	1,043		$	—		$	—		$	—		$	1,043
Collectively evaluated for impairment	$	7,562		$	1,405		$	684		$	245		$	9,896



(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

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, 2018 and 2017, the Bank had specific reserve allocations for TDR’s of $1.0 million and $439 thousand, respectively.

Loans considered to be troubled debt restructured loans totaled $8.0 million and $6.4 million as of December 31, 2018 and December 31, 2017, respectively. Of these totals, $4.2 million and $5.9 million, respectively, represent accruing troubled debt restructured loans and represent 33% and 38%, respectively, of total impaired loans. Meanwhile, as of December 31, 2018, $3.6 million represent three loans to two borrowers that have defaulted under the restructured terms. The largest of these loans, at $3.2 million, is a commercial loan to a company dependent of the coal industry. The other two of these loans, totaling $426 thousand, 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, 2018. These two development loans were also considered non-performing loans as of December 31, 2017.

During the year ended December 31, 2018, a restructured loan with an outstanding balance of $3.2 million defaulted under its modified terms. This loan is to a borrower highly dependent on the coal industry and has experienced continued financial difficulty since the loan was restructured, and as a result has not performed as agreed.

There were no commitments to advance funds to any TDRs as of December 31, 2018.

The following table presents details related to loans identified as Troubled Debt Restructurings during the years ended December 31, 2018 and 2017.



	New TDR’s ¹
	December 31, 2018					December 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	2	$	272	$	210	1	$	147	$	147
Commercial Real Estate	1	11		11		—	—		—
Acquisition & Development	1	1,798		1,798		—	—		—
Total Commercial	4	2,081		2,019		1	147		147
Residential	—	—		—		—	—		—
Home Equity	1	39		39		—	—		—
Consumer	1	10		8		—	—		—
Total	6	$	2,130	$	2,066	1	$	147	$	147

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