8.	Loans and Allowance for Loan Losses

The following table sets forth the composition of the Company’s loan portfolio in dollar amounts and as a percentage of the respective portfolio.

	March 31, 2012						December 31, 2011
				Percent						Percent
	Amount			of Total			Amount			of Total
	(Dollars In Thousands)

Real estate loans:
Residential1	$	122,409			27.0	%	$	123,294			27.6	%
Home equity		29,983			6.6	%		29,790			6.7	%
Commercial		177,813			39.2	%		174,761			39.0	%
Total		330,205			72.8	%		327,845			73.3	%
Construction-residential		5,839			1.3	%		5,597			1.3	%
Construction-commercial		35,970			7.9	%		31,706			7.0	%
Total construction		41,809			9.2	%		37,303			8.3	%
Total real estate loans		372,014			82.0	%		365,148			81.6	%
Consumer loans		2,507			0.6	%		2,566			0.6	%
Commercial loans		78,562			17.4	%		79,412			17.8	%
Total loans		453,083			100.0	%		447,126			100.0	%
Deferred loan origination costs, net		915						921
Allowance for loan losses		(4,448	)					(4,576	)

Loans, net	$	449,550					$	443,471

1 Excludes loans held for sale of $1.6 million at March 31, 2012 and December 31, 2011, respectively.

The Company has transferred a portion of its originated commercial real estate and commercial loans to participating lenders. The amounts transferred have been accounted for as sales and therefore not included in the Company’s consolidated statements of financial condition. The Company and participating lenders share proportionally, based on participating agreements, any gains or losses the may result from the borrowers lack of compliance with the terms of the loan. The Company continues to service the loans on behalf of the participating lenders. At March 31, 2012 and December 31, 2011, the Company was servicing loans for participating lenders totaling $10.2 million and $8.8 million, respectively.

In accordance with the Company’s asset/liability management strategy and in an effort to reduce interest rate risk, the Company continues to sell fixed rate, low coupon residential real estate loans to the secondary market. The unpaid principal balance of mortgages that are serviced for others was $83.0 million and $80.7 million at March 31, 2012 and December 31, 2011, respectively. Servicing rights will continue to be retained on all loans written and sold in the secondary market.

Credit Quality

To evaluate the risk in the loan portfolio, internal credit risk ratings are used for the following loan segments: commercial real estate, commercial construction and commercial. The risks evaluated in determining an adequate credit risk rating, include the financial strength of the borrower and the collateral securing the loan. All commercial loans are rated from one through nine. Credit risk ratings one through five are considered pass ratings. Classified assets include credit risk ratings of special mention through loss. At least quarterly, classified assets are reviewed by management and by an independent third party. Credit risk ratings are updated as soon as information is obtained that indicates a change in the credit risk rating may be warranted.

The following describes the credit risk ratings:

Special mention. Assets that do not currently expose the Company to sufficient risk to warrant classification in one of the following categories but possess potential weaknesses.

Substandard. Assets that have one or more defined weaknesses and are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Non-accruing loans are typically classified as substandard.

Doubtful. Assets that have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss.

Loss. Assets rated in this category are considered uncollectible and are charged off against the allowance for loan losses.

Residential real estate and residential construction loans are categorized into pass and substandard risk ratings. Substandard residential loans are loans that are on nonaccrual status and are individually evaluated for impairment.

Consumer loans are considered nonperforming when they are 90 days past due or have not returned to accrual status. Consumer loans are not individually evaluated for impairment.

Home equity loans are considered nonperforming whey they are 90 days past due or have not returned to accrual status. Each nonperforming home equity loan is individually evaluated for impairment.

The following table presents an analysis of total loans segregated by risk rating and segment as of March 31, 2012:

	Commercial Credit Risk Exposure
	Commercial		Commercial Construction		Commercial Real Estate		Total
	(In Thousands)
Pass	$	74,586	$	23,906	$	168,811	$	267,303
Special mention		2,435		11,851		4,358		18,644
Substandard		1,541		213		4,644		6,398
Doubtful		-		-		-		-
Loss		-		-		-		-
Total commercial loans	$	78,562	$	35,970	$	177,813	$	292,345

	Residential Credit Risk Exposure
	Residential Real Estate		Residential Construction		Total
	(In Thousands)
Pass	$	120,829	$	5,508	$	126,337
Substandard (nonaccrual)		1,580		331		1,911
Total residential loans	$	122,409	$	5,839	$	128,248

	Consumer Credit Risk Exposure
	Consumer		Home Equity		Total
	(In Thousands)
Performing	$	2,473	$	29,639	$	32,112
Nonperforming (nonaccrual)		34		344		378
Total consumer loans	$	2,507	$	29,983	$	32,490

The following table presents an analysis of total loans segregated by risk rating and segment as of December 31, 2011:

	Commercial Credit Risk Exposure
	Commercial		Commercial Construction		Commercial Real Estate		Total
	(In Thousands)
Pass	$	74,699	$	19,904	$	165,168	$	259,771
Special mention		2,855		11,586		5,622		20,063
Substandard		1,858		216		3,971		6,045
Doubtful		-		-		-		-
Loss		-		-		-		-
Total commercial loans	$	79,412	$	31,706	$	174,761	$	285,879

	Residential Credit Risk Exposure
	Residential Real Estate		Residential Construction		Total
	(In Thousands)
Pass	$	121,072	$	5,597	$	126,669
Substandard (nonaccrual)		2,222		-		2,222
Total residential loans	$	123,294	$	5,597	$	128,891

	Consumer Credit Risk Exposure
	Consumer		Home Equity		Total
	(In Thousands)
Performing	$	2,487	$	29,484	$	31,971
Nonperforming (nonaccrual)		79		306		385
Total consumer loans	$	2,566	$	29,790	$	32,356

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance consists of general, allocated and unallocated components, as further described below.

General Component

The general component of the allowance for loan losses is based on historical loss experience adjusted for qualitative factors stratified by the following portfolio segments: residential real estate, commercial real estate, commercial, consumer and home equity.

Management uses an average of historical losses based on a time frame appropriate to capture relevant loss data for each portfolio segment. Management deems 36 months to be an appropriate time frame on which to base historical losses for each portfolio segment. This historical loss factor is adjusted for the following qualitative factors for each portfolio segment: levels/trends in delinquencies; trends in volume and terms of loans; effects of changes in risk selection and changes in lending policies, experience, ability, depth of lending management and staff; and national and local economic conditions. Management follows a similar process to estimate its liability for off-balance-sheet commitments to extend credit.

The qualitative factors are determined based on the various risk characteristics of each portfolio segment. Risk characteristics relevant to each portfolio segment are as follows:

Risk Characteristics

Residential real estate loans enable the borrower to purchase or refinance existing homes, most of which serve as the primary residence of the owner. Repayment is dependent on the credit quality of the borrower. Factors attributable to failure of repayment may include a weakened economy and/or unemployment, as well as possible personal considerations. While we anticipate adjustable-rate mortgages will better offset the potential adverse effects of an increase in interest rates as compared to fixed-rate mortgages, the increased mortgage payments required of adjustable-rate loan borrowers in a rising interest rate environment could cause an increase in delinquencies and defaults. The marketability of the underlying property also may be adversely affected in a high interest rate environment.

Commercial real estate loans are secured by commercial real estate and residential investment real estate and generally have larger balances and involve a greater degree of risk than one- to four-family residential mortgage loans. Risk in commercial real estate and residential investment lending are borrower’s creditworthiness and the feasibility and cash flow potential of the project. Payments on loans secured by income properties often depend on successful operation and management of the properties. As a result, repayment of such loans may be subject to a greater extent than residential real estate loans to adverse conditions in the real estate market or the economy.

Commercial and residential construction loans are generally considered to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the property’s value at completion of construction and the estimated cost (including interest) of construction.

Commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value.

Consumer and home equity loans may entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections depend on the borrower’s continuing financial stability, and therefore are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans.

The Company does not disaggregate its portfolio segments into loan classes.

Allocated Component

The allocated component relates to loans that are classified as impaired. Impairment is measured on a loan by loan basis for residential real estate, commercial real estate and commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent. An allowance is established when the discounted cash flows or collateral value of the impaired loan is lower than the carrying value of that loan. The Company recognizes the change in present value attributable to the passage of time as provision for loan losses. Large groups of smaller balance homogenous loans are collectively evaluated for impairment, and the allowance resulting therefrom is reported as the general component, as described above.

Loans considered for impairment include all loan segments of commercial and residential, as well as home equity loans. The segments are considered 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 determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. 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.

Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

The Company may periodically agree to modify the contractual terms of loans. When a loan is modified and a concession is made to a borrower experiencing financial difficulty, the modification is considered a TDR. All TDR’s are classified as impaired.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer loans for impairment evaluation, except for home equity loans.

Unallocated Component

An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general reserves in the portfolio.

There were no changes in the Company’s accounting policies or methodology pertaining to the allowance for loan losses during the current period.

The following table presents the allowance for loan losses and select loan information as of March 31, 2012:

	Residential Real Estate			Residential Construction		Commercial Real Estate		Commercial Construction		Commercial			Consumer Loans			Home Equity		Total
Allowance for loan losses	(In Thousands)
Balance as of December 31, 2011	$	549		$	89	$	1,891	$	526	$	1,343		$	47		$	131	$	4,576
Provision (reduction) for loan losses		(104	)		14		26		46		6			15			4		7
Recoveries		-			-		-		-		-			6			-		6
Loans charged off		(69	)		-		-		-		(48	)		(24	)		-		(141	)
Balance as of March 31, 2012	$	376		$	103	$	1,917	$	572	$	1,301		$	44		$	135	$	4,448

Allowance for loan losses ending balance
Collectively evaluated for impairment	$	337		$	88	$	1,856	$	572	$	1,026		$	44		$	122	$	4,045
Individually evaluated for impairment		39			15		61		-		275			-			13		403
	$	376		$	103	$	1,917	$	572	$	1,301		$	44		$	135	$	4,448

Total loans ending balance
Collectively evaluated for impairment	$	120,475		$	5,508	$	173,478	$	35,757	$	77,104		$	2,507		$	29,640	$	444,469
Individually evaluated for impairment		1,934			331		4,335		213		1,458			-			343		8,614
	$	122,409		$	5,839	$	177,813	$	35,970	$	78,562		$	2,507		$	29,983	$	453,083

The following table presents the allowance for loan losses and select loan information as of March 31, 2011:

	Residential Real Estate			Residential Construction			Commercial Real Estate			Commercial Construction		Commercial		Consumer Loans			Home Equity			Total
	(In Thousands)
Allowance for loan losses
Balance as of December 31, 2010	$	513		$	148		$	1,783		$	402	$	1,429	$	28		$	128			4,431
Provision (reduction) for loan losses		(42	)		(6	)		238			14		10		31			(12	)		233
Recoveries		-			-			-			-		-		6			-			6
Loans charged off		(34	)		(13	)		(164	)		-		-		(17	)		-			(228	)
Balance as of March 31, 2011	$	437		$	129		$	1,857		$	416	$	1,439	$	48		$	116		$	4,442


Allowance for loan losses ending balance
Collectively evaluated for impairment	$	356		$	67		$	1,772		$	388	$	1,025	$	48		$	116		$	3,772
Individually evaluated for impairment		81			62			85			28		414		-			-			670
	$	437		$	129		$	1,857		$	416	$	1,439	$	48		$	116		$	4,442

Total loans ending balance
Collectively evaluated for impairment	$	127,207		$	5,107		$	170,397		$	24,126	$	75,918	$	2,860		$	28,979		$	434,594
Individually evaluated for impairment		2,793			219			3,181			1,725		3,510		-			113			11,541
	$	130,000		$	5,326		$	173,578		$	25,851	$	79,428	$	2,860		$	29,092		$	446,135

Impairment

The following table presents a summary of information pertaining to impaired loans by segment as of and for the three months ended March 31, 2012:

	Recorded Investment		Unpaid Balance		Average Recorded Investment		Related Allowance		Interest Income Recognized
	(In Thousands)
Impaired loans without a valuation allowance:
Residential real estate	$	1,564	$	1,564	$	1,674	$	-	$	10
Residential construction		-		-		-		-		-
Commercial real estate		3,990		4,315		3,039		-		58
Commercial construction		213		213		343		-		3
Commercial		589		589		832		-		11
Consumer		-		-		-		-		-
Home equity		308		308		160		-		1
Total	$	6,664	$	6,989	$	6,048	$	-	$	83

Impaired loans with a valuation allowance:
Residential real estate	$	370	$	370	$	551	$	39	$	5
Residential construction		331		331		119		15		-
Commercial real estate		345		345		596		61		8
Commercial construction		-		-		176		-		-
Commercial		869		869		1,686		275		1
Consumer		-		-		-		-		-
Home equity		35		35		21		13		-
Total	$	1,950	$	1,950	$	3,149	$	403	$	14

Total impaired loans:
Residential real estate	$	1,934	$	1,934	$	2,225	$	39	$	15
Residential construction		331		331		119		15		-
Commercial real estate		4,335		4,660		3,635		61		66
Commercial construction		213		213		519		-		3
Commercial		1,458		1,458		2,518		275		12
Consumer		-		-		-		-		-
Home equity		343		343		181		13		1
Total	$	8,614	$	8,939	$	9,197	$	403	$	97

The following table presents a summary of information pertaining to impaired loans by segment as of and for the year ended December 31, 2011:

	Recorded Investment		Unpaid Balance		Average Recorded Investment		Related Allowance		Interest Income Recognized
	(In Thousands)
Impaired loans without a valuation allowance:
Residential real estate	$	1,127	$	1,127	$	1,816	$	-	$	32
Residential construction		-		-		19		-		-
Commercial real estate		3,424		3,749		2,710		-		191
Commercial construction		-		-		600		-		-
Commercial		580		580		791		-		21
Consumer		-		-		-		-		-
Home equity		271		271		139		-		15
Total	$	5,402	$	5,727	$	6,075	$	-	$	259

Impaired loans with a valuation allowance:
Residential real estate	$	1,095	$	1,095	$	688	$	183	$	39
Residential construction		-		-		97		-		-
Commercial real estate		482		482		792		80		25
Commercial construction		216		216		222		22		14
Commercial		1,083		1,083		2,085		317		52
Consumer		-		-		-		-		-
Home equity		35		35		14		13		2
Total	$	2,911	$	2,911	$	3,898	$	615	$	132

Total impaired loans:
Residential real estate	$	2,222	$	2,222	$	2,504	$	183	$	71
Residential construction		-		-		116		-		-
Commercial real estate		3,906		4,231		3,502		80		216
Commercial construction		216		216		822		22		14
Commercial		1,663		1,663		2,876		317		73
Consumer		-		-		-		-		-
Home equity		306		306		153		13		17
Total	$	8,313	$	8,638	$	9,973	$	615	$	391

As of March 31, 2011, the total average recorded investment of impaired loans was $11.7 million. Interest income recognized on impaired loans was $140,000 for the three months ended March 31, 2012.

Delinquency and Nonaccrual

All loan segments past due greater than 30 days are considered delinquent. The Company calculates the number of days past due based on a 30 day month. Management continuously monitors delinquency and nonaccrual levels and trends.

It is the policy of the Company to discontinue the accrual of interest on all loan classes when principal or interest payments are delinquent 90 days or more. The accrual of interest is also discontinued for impaired loans that are delinquent 90 days or more or at management’s discretion.

All interest accrued, but not collected, for all loan classes, including impaired loans that are placed on nonaccrual or charged off, is reversed against interest income. Interest recognized on these loans is limited to interest payments received until qualifying for return to accrual. All loan classes are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The following table presents an aging analysis of past due loans as of March 31, 2012:

	31-59 Days Past Due		60-89 Days Past Due		Greater than 90 days		Total Past Due		Current		Total Loans		Nonaccrual Loans
	(In Thousands)
Residential real estate	$	1,302	$	314	$	657	$	2,273	$	120,136	$	122,409	$	1,580
Residential construction		-		-		331		331		5,508		5,839		331
Commercial real estate		981		183		481		1,645		176,168		177,813		481
Commercial construction		-		-		-		-		35,970		35,970		-
Commercial		229		609		737		1,575		76,987		78,562		972
Consumer		63		-		4		67		2,440		2,507		344
Home equity		147		40		306		493		29,490		29,983		34
Total	$	2,722	$	1,146	$	2,516	$	6,384	$	446,699	$	453,083	$	3,742

The following table presents an aging analysis of past due loans as of December 31, 2011:

	31-59 Days Past Due		60-89 Days Past Due		Greater than 90 days		Total Past Due		Current		Total Loans		Nonaccrual Loans
	(In Thousands)
Residential real estate	$	1,693	$	179	$	1,379	$	3,251	$	120,043	$	123,294	$	2,222
Residential construction		-		331		-		331		5,266		5,597		-
Commercial real estate		738		565		672		1,975		172,786		174,761		798
Commercial construction		-		-		-		-		31,706		31,706		-
Commercial		79		298		849		1,226		78,186		79,412		1,306
Consumer		83		27		74		184		2,382		2,566		79
Home equity		189		-		306		495		29,295		29,790		306
Total	$	2,782	$	1,400	$	3,280	$	7,462	$	439,664	$	447,126	$	4,711

Any loan with a payment more than 30 days past due will be considered delinquent.

Troubled Debt Restructurings

The following is a summary of accruing and non-accruing TDR loans modified as TDRs by segment during the three months ended March 31, 2012:

	Number of Modifications		Recorded Investment Pre- Modification		Recorded Investment Post- Modification		Current Balance
			(In Thousands)
Residential real estate		1	$	118	$	127	$	127
Residential construction		-		-		-		-
Commercial real estate		-		-		-		-
Commercial construction		-		-		-		-
Commercial		1		67		67		67
Consumer		1		27		27		27
Home equity		1		38		38		38
Total		4	$	250	$	259	$	259

TDR loans consist of loans where the Company, for economic or legal reasons related to the borrower’s financial difficulties, granted a concession to the borrower that the Company would not otherwise consider. TDRs can take the form of a reduction in the stated interest rate, receipts of assets from a debtor in partial or full satisfaction of a loan, the extension of the maturity date, or the reduction of either the interest or principal. Once a loan has been identified as a TDR, it will continue to be reported as a TDR until the loan is paid in full.

During the three months ending March 31, 2012 there were four TDRs totaling $259,000 entered into with borrowers who were experiencing financial difficulty. The Company reviews TDRs on a loan by loan basis and applies specific reserves to loan balances in excess of collateral values if sufficient borrower cash flow cannot be identified. At March 31, 2012, the specific reserves related to TDRs were $15,000. The modifications granted did not result in a reduction of the recorded investment. TDRs granted in 2012 were primarily the result of concessions to reduce the interest rate or extension of the maturity date. At March 31, 2012, the Company had two troubled debt restructurings totaling $64,000 included in nonperforming loans. The two restructured loans continue to be reported on nonaccrual but have been performing as modified. For the three months ended March 31, 2012, the interest income recorded from the restructured loans amounted to approximately $4,000.

In the normal course of business, the Company may modify a loan for a credit worthy borrower where the modified loan is not considered a TDR. In these cases, the modified terms are consistent with loan terms available to credit worthy borrowers and within normal loan pricing. The modifications to such loans are done according to existing underwriting standards which include review of historical financial statements, including current interim information if available, an analysis of the causes of the borrower’s decline in performance and projections to assess repayment ability going forward.