NOTE 3. LOANS AND ALLOWANCE FOR LOAN LOSSES

The Company routinely generates 1-4 family mortgages for sale into the secondary market. During 2014 and 2013, the Company recognized sales proceeds of $882.2 million and $1.0 billion, resulting in gains on loans held for sale of $18.4 million and $21.5 million, respectively.

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


(in thousands)	2014		2013

Commercial and non-residential real estate	$	560,752	$	457,388
Residential real estate		174,507		118,204
Home equity		45,935		27,797
Consumer		17,103		18,916
	$	798,297	$	622,305

All loan origination fees and direct loan origination costs are deferred and recognized over the life of the loan. As of December 31, 2014 and 2013, net deferred (fees) and costs of $1,365 and $1,462, respectively, were included in the carrying value of loans.

The following table summarizes the primary segments of the loan portfolio as of December 31, 2014 and 2013 (in thousands):


					Home
	Commercial		Residential		Equity		Consumer		Total
December 31, 2014
Individually evaluated for impairment	$	13,782	$	969	$	28	$	2	$	14,781
Collectively evaluated for impairment		546,970		173,538		45,907		17,101		783,516
Total Loans	$	560,752	$	174,507	$	45,935	$	17,103	$	798,297
December 31, 2013
Individually evaluated for impairment	$	6,254	$	261	$	28	$	93	$	6,636
Collectively evaluated for impairment		451,134		117,943		27,769		18,823		615,669
Total Loans	$	457,388	$	118,204	$	27,797	$	18,916	$	622,305

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 and residential mortgage 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. A collateral evaluation is completed when it is determined that the loan is impaired.

Once the determination has been made that a loan is impaired, the determination of whether a specific allocation of the allowance is necessary is measured by comparing the recorded investment in the loan to the fair value of the loan using one of three 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, 2014 and 2013 (in thousands):


					Impaired
					Loans with
					No
	Impaired Loans with				Specific
	Specific Allowance				Allowance		Total Impaired Loans
									Unpaid
	Recorded		Related		Recorded		Recorded		Principal
	Investment		Allowance		Investment		Investment		Balance
December 31, 2014

Commercial
Commercial Business	$	—	$	—	$	3,606	$	3,606	$	3,606
Commercial Real Estate		1,527		260		5,021		6,548		6,548
Acquisition & Development		273		102		3,355		3,628		4,703
Total Commercial		1,800		362		11,982		13,782		14,857
Residential		969		298		—		969		969
Home Equity		28		28		—		28		28
Consumer		2		2		—		2		2
Total impaired loans	$	2,799	$	690	$	11,982	$	14,781	$	15,856

December 31, 2013

Commercial
Commercial Real Estate	$	1,801	$	407	$	120	$	1,921	$	2,199
Acquisition & Development		4,333		836		—		4,333		4,055
Total Commercial		6,134		1,243		120		6,254		6,254
Residential		261		175		—		261		261
Home Equity		28		28		—		28		28
Consumer		25		12		68		93		93
Total impaired loans	$	6,448	$	1,458	$	188	$	6,636	$	6,636

Impaired loans have increased during 2014, but remain at a level that is manageable. The increase is primarily attributed to two loans that have experienced financial adversity as a result of the developments in the respective industries within which they operate, neither of which represents a concentration of any kind in the Bank’s commercial loan portfolio. One loan, with an outstanding balance of $3.6 million is dependent upon the condition of the coal industry, while the other loan, with a balance of $5.0 million, is a commercial real estate property in the Northern Virginia market, which had as primary tenants, government contractors that have vacated the premises as a result of losing significant contracts with the United States government. It is important to note that the commercial real estate loan was purchased from another financial institution in late 2013. It is the Bank’s position that the “Loan Sales Agreement” has been breached by the selling institution and legal recourse is being pursued by the Bank.

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



	December 31, 2014						December 31, 2013
	Average		Interest		Interest		Average		Interest		Interest
	Investment		Income		Income		Investment		Income		Income
	in Impaired		Recognized on		Recognized on		in Impaired		Recognized on		Recognized on
	Loans		Accrual Basis		Cash Basis		Loans		Accrual Basis		Cash Basis
Commercial
Commercial Business	$	301	$	14	$	61	$	—	$	—	$	—
Commercial Real Estate		2,213		149		105		1,878		38		58
Acquisition & Development		4,456		112		94		2,360		74		91
Total Commercial		6,970		275		260		4,238		112		149
Residential		804		20		20		356		7		6
Home Equity		28		1		1		2		1		—
Consumer		20		1		1		19		1		2
Total	$	7,822	$	297	$	282	$	4,615	$	121	$	157

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. The portion of any loan that represents a specific allocation of the allowance for loan losses is placed in the Doubtful category. Any portion of a loan that has been 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 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 performs an annual review of all commercial relationships $1,000 or greater. Confirmation of the appropriate risk grade is included in the review on an ongoing basis. The Bank has an experienced Credit Department that continually reviews and assesses loans within the portfolio. The 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, 2014 and 2013 (in thousands):


			Special
	Pass		Mention		Substandard		Doubtful		Total
December 31, 2014

Commercial
Commercial Business	$	234,547	$	618	$	3,713	$	—	$	238,878
Commercial Real Estate		262,215		11,242		7,323		—		280,780
Acquisition & Development		34,391		3,075		1,496		2,132		41,094
Total Commercial		531,153		14,935		12,532		2,132		560,752
Residential		171,395		2,147		965		—		174,507
Home Equity		45,684		223		28		—		45,935
Consumer		16,477		624		2		—		17,103
Total Loans	$	764,709	$	17,929	$	13,527	$	2,132	$	798,297

December 31, 2013

Commercial
Commercial Business	$	196,608	$	5,830	$	26	$	—	$	202,464
Commercial Real Estate		231,083		2,816		3,306		—		237,205
Acquisition & Development		9,783		2,920		5,016		—		17,719
Total Commercial		437,474		11,566		8,348		—		457,388
Residential		115,283		2,660		261		—		118,204
Home Equity		27,662		107		28		—		27,797
Consumer		18,188		635		93		—		18,916
Total Loans	$	598,607	$	14,968	$	8,730	$	—	$	622,305

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 is in a collection process could warrant non-accrual status. A thorough review is to be presented to the Chief Credit Officer and or the Mortgage 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 will be subject to applicable regulatory restrictions and guidelines. Generally, loans should be placed in non-accrual status when the loan approaches 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 should be charged off when a loan is placed in non-accrual status. Any payments subsequently received should be 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, 2014 and 2013 (in thousands):


							90
			30-59		60-89		Days +		Total						90+ Days
			Days		Days		Past		Past		Total		Non-		Still
	Current		Past Due		Past Due		Due		Due		Loans		Accrual		Accruing
December 31, 2014
Commercial
Commercial Business	$	233,464	$	3,738	$	1,500	$	176	$	5,414	$	238,878	$	107	$	69
Commercial Real Estate		270,600		234		4,925		5,021		10,180		280,780		—		5,021
Acquisition & Development		37,739		—		—		3,355		3,355		41,094		3,355		—
Total Commercial		541,803		3,972		6,425		8,552		18,949		560,752		3,462		5,090
Residential		167,392		4,478		2,126		511		7,115		174,507		487		216
Home Equity		45,815		120		—		—		120		45,935		—		—
Consumer		16,692		411		—		—		411		17,103		—		—
Total	$	771,702	$	8,981	$	8,551	$	9,063	$	26,595	$	798,297	$	3,949	$	5,306

December 31, 2013
Commercial
Commercial Business	$	202,275	$	139	$	24	$	26	$	189	$	202,464	$	26	$	—
Commercial Real Estate		236,870		77		—		258		335		237,205		258		—
Acquisition & Development		17,719		—		—		—		—		17,719		—		—
Total Commercial		456,864		216		24		284		524		457,388		284		—
Residential		116,150		1,401		193		460		2,054		118,204		30		430
Home Equity		27,741		28		—		28		56		27,797		—		28
Consumer		18,747		92		—		77		169		18,916		76		1
Total	$	619,502	$	1,737	$	217	$	849	$	2,803	$	622,305	$	390	$	459

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 $221 and $47 for 2014 and 2013, 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.

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: national and local economic trends and conditions; levels of and trends in delinquency rates and non-accrual loans; trends in volume and terms of loans; effects of changes in lending policies; experience, ability, and depth of lending staff; value of underlying collateral; and concentrations of credit from a loan type, industry and/or geographic standpoint. 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.

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 table summarizes 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, 2014 and 2013. Activity in the allowance is presented for the periods indicated (in thousands):


					Home
	Commercial		Residential		Equity		Consumer		Total
ALL balance at December 31, 2013	$	3,609	$	519	$	554	$	253	$	4,935
Charge-offs		(1,110)		(130)		—		(68)		(1,308)
Recoveries		7		—		3		4		14
Provision		1,857		573		134		18		2,582
ALL balance at December 31, 2014	$	4,363	$	962	$	691	$	207	$	6,223
Individually evaluated for impairment	$	362	$	298	$	28	$	2	$	690
Collectively evaluated for impairment	$	4,001	$	664	$	663	$	205	$	5,533


					Home
	Commercial		Residential		Equity		Consumer		Total
ALL balance at December 31, 2012	$	3,107	$	514	$	242	$	213	$	4,076
Charge-offs		(1,458)		(38)		—		(33)		(1,529)
Recoveries		57		60		10		1		128
Provision		1,903		(17)		302		72		2,260
ALL balance at December 31, 2013	$	3,609	$	519	$	554	$	253	$	4,935
Individually evaluated for impairment	$	1,243	$	175	$	28	$	12	$	1,458
Collectively evaluated for impairment	$	2,366	$	344	$	526	$	241	$	3,477

During December 2013 the Bank purchased $74.3 million in performing commercial real estate secured loans in the northern Virginia area. At the time of acquisition, none of these loans were considered impaired. They were acquired at a premium of roughly 1.024 or $1.8 million, which is being amortized in accordance with ASC 310-20. These loans are collectively evaluated for impairment under ASC 450. Loans are monitored individually for payoff activity, and any necessary adjustments to the premium will be made accordingly. At December 31, 2014, these balances totaled $51.3 million. Of the $23 million decrease, MVB refinanced $15.7 million and sold a participation totaling $2.9 million. The weighted average yield on the remaining portfolio is 5.66%.

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. No TDR’s have defaulted for the years ended December 31, 2014 and 2013, respectively.

At December 31, 2014 and 2013, the Bank had specific reserve allocations for TDR’s of $582 and $1.4 million, respectively.

The following table presents details related to loans identified as Troubled Debt Restructurings during the years ended December 31, 2014 and 2013.


	December 31, 2014					December 31, 2013
		Pre-		Post-			Pre-		Post-
		Modification		Modification			Modification		Modification
	Number	Outstanding		Outstanding		Number	Outstanding		Outstanding
	of	Recorded		Recorded		of	Recorded		Recorded
(Dollars in thousands)	Contracts	Investment		Investment		Contracts	Investment		Investment

Commercial
Commercial Business	1	$	3,606	$	3,606	2	$	119	$	119
Commercial Real Estate	1		496		300	1		352		250
Acquisition and Development	—		—		—	3		4,349		4,333
Total Commercial	2		4,102		3,906	6		4,820		4,702
Residential Real Estate	1		389		382	—		—		—
Home Equity	—		—		—	1		28		28
Consumer	—		—		—	3		8		6
Total	3	$	4,491	$	4,288	10	$	4,856	$	4,736

(1)

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