LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSS

The following table provides a breakdown, by class of our loans held for investment at June 30, 2015 and December 31, 2014.

Loans held for Investment



	June 30, 2015			December 31, 2014
Commercial	$	141,487,772		$	138,430,999
Real estate
Construction	175,253,142			172,502,330
Residential (1-4 family)	115,106,251			109,404,283
Home equity lines	63,241,585			67,487,000
Multifamily	17,011,090			21,809,189
Commercial	273,184,540			256,966,820
Real estate subtotal	643,796,608			628,169,622
Consumers
Consumer and installment loans	7,807,746			5,968,990
Overdraft protection loans	77,049			96,736
Loans to individuals subtotal	7,884,795			6,065,726
Total gross loans	793,169,175			772,666,347
Unamortized loan fees net of deferred costs	(207,533		)	(76,812		)
Loans held for investment, net of unearned income	792,961,642			772,589,535
Allowance for loan losses	(8,676,361		)	(8,948,837		)
Total net loans	$	784,285,281		$	763,640,698

We have certain lending policies and procedures in place designed to balance loan growth and income with an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, credit concentrations, policy exceptions, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

Our loan portfolio is divided into three loan types; commercial, real estate and consumer. Some of these loan types are further broken down into segments. The commercial loan portfolio, which is not broken down further, includes commercial and industrial loans which are usually secured by the assets being financed or other business assets. The real estate portfolio is broken down into construction, residential 1-4 family, home equity lines, multifamily, and commercial real estate loan segments. The consumer loan portfolio is segmented into consumer and installment loans and overdraft protection loans.

Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand their business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined the borrower’s management possesses sound ethics and solid business acumen, we examine current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and normally incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation or sale of the income producing property securing the loan, or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing our commercial real estate portfolio are diverse in terms of type. This diversity helps reduce our exposure to adverse economic events that could affect any single market or industry. Management monitors and evaluates commercial real estate loans based on purpose, collateral, geography, cash flow, loan to value, and risk grade criteria. As a general rule, we avoid financing special purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. At June 30, 2015 approximately 40% and at December 31, 2014, approximately 44% of the outstanding principal balance of our commercial real estate loans portfolio was secured by owner-occupied properties.

With respect to loans to developers and builders, secured by non-owner occupied properties we may originate from time to time, we generally require the borrower to have an existing relationship with the Company and a record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of considerable funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, supply and demand, government regulation of real property, general economic conditions and the availability of long-term financing.

We generally require multifamily real estate loan borrowers to have an existing relationship with the Company, a record of success and guarantor financial strength, commensurate with the project size. The underlying feasibility of a multifamily project is stress tested for sensitivity to both capitalization and interest rate changes. Each project is underwritten separately and additional underwriting standards are required for the guarantors, which include, but are not limited to, a maximum loan-to-value percentage, global cash flow analysis and contingent liability analysis. Sources of repayment for these types of loans may be rent rolls or sales of the developed property, either by unit or as a whole.

Consumer and residential loan originations utilize analytics to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed. This monitoring, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend, sensitivity analysis, shock analysis and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage, collection remedies, the number of such loans a borrower can have at one time and documentation requirements.

We perform periodic reviews on various segments of our loan portfolio in addition to presenting our larger loan relationships for loan committee review. We utilize an independent company to perform a periodic review to evaluate and validate our credit risk program. Results of these reviews are presented to management and our board. Additionally, we are subject to annual examination by our regulators. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as our policies and procedures.

We have an established methodology to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. This methodology begins with a look at the three loan types; commercial, real estate, and consumer. Loans within the commercial and real estate categories are evaluated on an individual or relationship basis and assigned a risk grade based on the characteristics of the loan or relationship. Loans within the consumer type are assigned risk grades and evaluated as a pool, unless specifically identified through delinquency or other signs of credit deterioration, at which time the identified loan would be individually evaluated.

We designate loans within our loans held for investment portfolio as either “pass” or “watch list” based on nine numerical risk grades which are assigned to the loans. A loan classified as "pass" is fundamentally sound with risk factors that are considered reasonable and acceptable. Loans classified as "watch list" fall into two categories; special mention and substandard. Special mention loans are the highest level of "watch list". These loans have the capacity to perform but contain certain characteristics that require continual supervision and attention from the lender. Loans classified as substandard typically have a well-defined weakness or weaknesses that could jeopardize the orderly liquidation of the debt, leaving the Bank with potential exposure to loss. The numeric designations in the "pass" category, from highest to lowest are: minimal, modest, average, acceptable, and acceptable with care. The "watch list" category from highest to lowest are: special mention, substandard, doubtful and loss.



“Pass”	“Watch List”
1 Minimal	6 Special mention
2 Modest	7 Substandard
3 Average	8 Doubtful
4 Acceptable	9 Loss
5 Acceptable with care

Special mention loans and substandard loans may or may not be classified as nonaccrual, based on current performance. A loan risk graded as doubtful is classified as nonaccrual. A loan risk graded as loss is generally charged-off when identified. There were no loans classified as doubtful or loss at June 30, 2015 or December 31, 2014. Watch list graded loans or relationships are evaluated individually to determine if all, or a portion, of our investment in the borrower is at risk. If a risk is quantified, a specific loss allowance is assigned to the identified loan or relationship. We evaluate our investment in the borrower using either the present value of expected future cash flows, discounted at the historical effective interest rate of the loan, or for a collateral-dependent loan, the fair value of the underlying collateral.

We evaluate additional risk inherent in our satisfactory risk grade groups through a methodology that looks at these loans on a pool basis by loan segment which is further delineated by purpose. Each segment is assigned an expected loss factor based on a moving average “look-back” at our historical losses for that particular segment. In 2014, we reexamined our loss history and determined a five year "look back" or twenty quarter history would be a more prudent approach to modeling historical losses than our previous sixteen quarter "look-back". At September 30, 2014 we began extending our "look-back" period by one quarter to reach our target of twenty quarters or five years at June 30, 2015. At June 30, 2015, having reached our twenty quarter target, this adjustment to our "look-back" period resulted in a $321,325 decrease in the unallocated component of the allowance for loan losses. We believe this methodology provides an accurate evaluation of the potential risk in our portfolio because delineation by purpose establishes a direct correlation to areas of weakness and strength within the portfolio.

Additional metrics, in the form of environmental risk factors, may be applied to a specific class or risk grade of loans within the portfolio based on local or national trends, identifiable events or other economic factors. For the periods presented, five internal and four external environmental factors were applied to the general risk grade groups. The five internal factors are specific to Monarch with regard to lending policies and practices, nature, volume and term of various portfolios, experience level and depth of management, changes in loan quality and concentrations of credits. The four external environmental factors focus on legal and regulatory impacts, changes in economic conditions, competitive pressures and uncertainties surrounding pending governmental actions and their impact on areas within our footprint. The assumptions used to determine the allowance are reviewed to ensure their theoretical foundation, data integrity, computational processes, and reporting practices are appropriate and properly documented.

We utilize various sources in assessing the economic conditions in our target markets and areas of concentration. We track unemployment trends in both Hampton Roads and Virginia compared to the national average. We monitor trends in our industry and among our peers through reports such as the Uniform Bank Performance Report which are made available to us through the Federal Financial Institutions Examination Council. Additionally, we utilize various industry sources that include information published by CB Richard Ellis, an international firm specializing in commercial real estate reporting and Costar, a provider of commercial real estate information and analytics to monitor local, state and national trends.

We evaluate the adequacy of our allowance for loan losses monthly. A degree of imprecision or uncertainty is inherent in our allowance estimates because it requires that we incorporate a range of probable outcomes which may change from period to period. It requires that we exercise judgment as to the risks inherent in our portfolios, economic uncertainties, historical loss and other subjective factors, including industry trends. No single statistic or measurement determines the adequacy of the allowance for loan loss. Changes in the allowance for loan loss and the related provision expense can materially affect net income.

The following table segregates our portfolio between pass and watch list loans, delineated by segments, within loan type for June 30, 2015 and December 31, 2014. The "Weighted Average Risk Grade" looks at the dollar value per risk grade within a segment compared to the total value of that segment. All segments fall within the average to acceptable range.



	June 30, 2015
			Watch List						Weighted Average Risk Grade
	Pass		Special Mention		Substandard		Total		Weighted Average Risk Grade
Commercial	$	139,826,706	$	1,030,495	$	630,571	$	141,487,772	3.35
Real estate
Construction	173,982,189		696,510		574,443		175,253,142		3.22
Residential (1-4 family)	110,045,957		1,076,204		3,984,090		115,106,251		3.82
Home equity lines	61,888,353		—		1,353,232		63,241,585		4.14
Multifamily	17,011,090		—		—		17,011,090		3.59
Commercial	271,946,819		843,806		393,915		273,184,540		3.49
Real estate subtotal	634,874,408		2,616,520		6,305,680		643,796,608		3.56
Consumers
Consumer and installment loans	7,737,896		—		69,850		7,807,746		4.03
Overdraft protection loans	74,283		—		2,766		77,049		4.58
Loans to individuals subtotal	7,812,179		—		72,616		7,884,795		4.03
Total gross loans	$	782,513,293	$	3,647,015	$	7,008,867	$	793,169,175	3.51

	December 31, 2014
			Watch List						Weighted Average Risk Grade
	Pass		Special Mention		Substandard		Total		Weighted Average Risk Grade
Commercial	$	135,292,747	$	1,588,289	$	1,549,963	$	138,430,999	3.31
Real estate
Construction	171,136,553		93,397		1,272,380		172,502,330		3.26
Residential (1-4 family)	101,860,683		177,735		7,365,865		109,404,283		3.93
Home equity lines	66,282,828		102,575		1,101,597		67,487,000		4.12
Multifamily	19,616,130		2,193,059		—		21,809,189		3.53
Commercial	253,525,106		2,029,203		1,412,511		256,966,820		3.54
Real estate subtotal	612,421,300		4,595,969		11,152,353		628,169,622		3.59
Consumers
Consumer and installment loans	5,893,286		—		75,704		5,968,990		4.04
Overdraft protection loans	96,736		—		—		96,736		4.64
Loans to individuals subtotal	5,990,022		—		75,704		6,065,726		4.05
Total gross loans	$	753,704,069	$	6,184,258	$	12,778,020	$	772,666,347	3.55

An aging of our loan portfolio by class as of June 30, 2015 and December 31, 2014 is as follows:



Age Analysis of Past Due Loans
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Recorded Investment > 90 days and Accruing		Recorded Investment Nonaccrual Loans
June 30, 2015
Commercial	$	127,483	$	509,334	$	—	$	636,817	$	140,850,955	$	—	$	628,580
Real estate
Construction	109,063		—		—		109,063		175,144,079		—		109,063
Residential (1-4 family)	—		—		753,467		753,467		114,352,784		—		1,053,472
Home equity lines	280,419		—		244,190		524,609		62,716,976		—		244,190
Multifamily	—		—		—		—		17,011,090		—		—
Commercial	—		—		230,994		230,994		272,953,546		—		230,994
Real estate subtotal	389,482		—		1,228,651		1,618,133		642,178,475		—		1,637,719
Consumers
Consumer and installment loans	126,701		—		—		126,701		7,681,045		—		—
Overdraft protection loans	—		—		—		—		77,049		—		—
Loans to individuals subtotal	126,701		—		—		126,701		7,758,094		—		—
Total gross loans	$	643,666	$	509,334	$	1,228,651	$	2,381,651	$	790,787,524	$	—	$	2,266,299

December 31, 2014
Commercial	$	—	$	—	$	582,059	$	582,059	$	137,848,940	$	—	$	582,059
Real estate
Construction	248,420		—		100,000		348,420		172,153,910		—		212,552
Residential (1-4 family)	761,696		2,412,128		1,252,644		4,426,468		104,977,815		174,976		1,427,931
Home equity lines	109,456		—		249,915		359,371		67,127,629		—		249,915
Multifamily	—		—		—		—		21,809,189		—		—
Commercial	—		166,618		230,994		397,612		256,569,208		—		230,994
Real estate subtotal	1,119,572		2,578,746		1,833,553		5,531,871		622,637,751		174,976		2,121,392
Consumers
Consumer and installment loans	139,446		—		—		139,446		5,829,544		—		1,121
Overdraft protection loans	—		—		—		—		96,736		—		—
Loans to individuals subtotal	139,446		—		—		139,446		5,926,280		—		1,121
Total gross loans	$	1,259,018	$	2,578,746	$	2,415,612	$	6,253,376	$	766,412,971	$	174,976	$	2,704,572

We currently have seven loans totaling $2,591,472 that are classified as restructured loans: one commercial real estate loan totaling $1,329,584, five residential 1-4 family loans totaling $1,192,038, and one consumer loan for $69,850. At June 30, 2015, two of the residential 1-4 family loans totaling $362,735 included in our restructured loans are classified as nonaccrual. The remaining five loans are performing. We restructured one loan during the second quarter of 2015, and restructured three loans during the same period of 2014. We did not have any defaults on restructured loans within twelve months of restructuring during the quarter ended June 30, 2015 or 2014.

Additional information on restructured loans in our portfolio as of June 30, 2015 is as follows:

Troubled Debt Restructurings



	Number of Contracts	Pre-Modification Outstanding Recorded Investment	Post-Modification Outstanding Recorded Investment
Quarter Ended June 30, 2015	One	$237,782	$237,782
Six Months Ended June 30, 2015	One	$237,782	$237,782

Troubled Debt Restructurings That Subsequently Defaulted



	Number of Contracts	Recorded Investment
Quarter Ended June 30, 2015	None	—
Six Months Ended June 30, 2015	None	—

A summary of the activity in the allowance for loan losses account is as follows:



Allocation of the Allowance for Loan Losses
				Real Estate
June 30, 2015	Commercial			Construction			Residential			Home Equity			Multifamily			Commercial
Allowance for loan losses:
Beginning balance	$	1,157,867		$	1,678,022		$	2,456,418		$	1,911,634		$	85,056		$	1,458,664
Charge-offs	(207,059		)	(17,500		)	(658,953		)	—			—			—
Recoveries	3,600			36,561			19,719			53,025			—			—
Provision	707,959			(41,341		)	21,232			(296,862		)	(18,713		)	166,921
Ending balance	$	1,662,367		$	1,655,742		$	1,838,416		$	1,667,797		$	66,343		$	1,625,585

Individually evaluated for impairment	$	939,399		$	77,298		$	537,578		$	475,740		$	—		$	330,057
Collectively evaluated for impairment	722,968			1,578,444			1,300,838			1,192,057			66,343			1,295,528
Loans:
Ending balance	$	141,487,772		$	175,253,142		$	115,106,251		$	63,241,585		$	17,011,090		$	273,184,540
Ending balance: individually evaluated for impairment	1,110,092			1,270,953			4,365,870			1,353,232			—			2,099,953
Ending balance: collectively evaluated for impairment	$	140,377,680		$	173,982,189		$	110,740,381		$	61,888,353		$	17,011,090		$	271,084,587



	Consumers
	Consumer and Installment loans			Overdraft Protection		Unallocated			Total
Allowance for loan losses:
Beginning balance	$	104,661		$	260	$	96,255		$	8,948,837
Charge-offs	(1,869		)	—		—			(885,381		)
Recoveries	—			—		—			112,905
Provision	3,323			23		(42,542		)	500,000
Ending balance	$	106,115		$	283	$	53,713		$	8,676,361

Individually evaluated for impairment	$	69,850		$	—	$	—		$	2,429,922
Collectively evaluated for impairment	36,265			283		53,713			6,246,439
Loans:
Ending balance	$	7,807,746		$	77,049	$	—		$	793,169,175
Ending balance: individually evaluated for impairment	69,850			2,766		—			10,272,716
Ending balance: collectively evaluated for impairment	$	7,737,896		$	74,283	$	—		$	782,896,459



				Real Estate
December 31, 2014	Commercial			Construction			Residential			Home Equity			Multifamily		Commercial
Allowance for loan losses:
Beginning balance	$	1,219,255		$	1,978,320		$	1,685,502		$	2,132,916		$	59,586	$	1,305,131
Charge-offs	(21,789		)	(190,812		)	(163,048		)	(174,319		)	—		—
Recoveries	205,200			79,922			31,505			122,809			—		—
Provision	(244,799		)	(189,408		)	902,459			(169,772		)	25,470		153,533
Ending balance	$	1,157,867		$	1,678,022		$	2,456,418		$	1,911,634		$	85,056	$	1,458,664

Individually evaluated for impairment	$	441,265		$	100,159		$	1,261,490		$	547,172		$	—	$	335,033
Collectively evaluated for impairment	716,602			1,577,863			1,194,928			1,364,462			85,056		1,123,631
Loans:
Ending balance	$	138,430,999		$	172,502,330		$	109,404,283		$	67,487,000		$	21,809,189	$	256,966,820
Ending balance: individually evaluated for impairment	1,549,963			1,272,380			7,198,325			1,101,597			—		3,130,893
Ending balance: collectively evaluated for impairment	$	136,881,036		171,229,950			$	102,205,958		$	66,385,403		$	21,809,189	$	253,835,927



	Consumers
	Consumer and Installment loans		Overdraft Protection			Unallocated			Total
Allowance for loan losses:
Beginning balance	$	99,271	$	688		$	580,700		$	9,061,369
Charge-offs	—		(2,000		)	—			(551,968		)
Recoveries	—		—			—			439,436
Provision	5,390		1,572			(484,445		)	—
Ending balance	$	104,661	$	260		$	96,255		$	8,948,837

Individually evaluated for impairment	$	74,582	$	—		—			$	2,759,701
Collectively evaluated for impairment	30,079		260			96,255			6,189,136
Loans:
Ending balance	$	5,968,990	$	96,736		$	—		$	772,666,347
Ending balance: individually evaluated for impairment	75,704		—			—			14,328,862
Ending balance: collectively evaluated for impairment	$	5,893,286	$	96,736		$	—		$	758,337,485

A loan is considered impaired when, based on current information and events; it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. All amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement. In addition to loans 90 days past due and still accruing, nonaccrual loans and restructured loans, all loans risk graded doubtful or substandard qualify, by definition, as impaired.

There were three residential real estate properties totaling $665,190 in the process of foreclosure at June 30, 2015 and one residential real estate property totaling $182,256 in process of foreclosure at December 31, 2014.

The following table sets forth our impaired loans at June 30, 2015 and December 31, 2014.



Impaired Loans
	With No Related Allowance
	Recorded Investment		Unpaid Principal Balance		Average Recorded Investment		Interest Income Recognized
June 30, 2015
Commercial	$	25,978	$	25,978	$	33,228	$	852
Real estate
Construction	1,040,390		1,040,390		966,577		30,607
Residential (1-4 family)	2,622,287		2,782,112		2,673,004		47,644
Home equity lines	444,716		444,716		445,194		7,381
Multifamily	—		—		—		—
Commercial	539,375		539,375		545,281		17,868
Consumers
Consumer and installment loans	—		715		199		—
Overdraft protection loans	2,766		2,766		2,916		360
Total	$	4,675,512	$	4,836,052	$	4,666,399	$	104,712
December 31, 2014
Commercial	$	—	$	—	$	—	$	—
Real estate
Construction	935,467		935,467		954,181		56,004
Residential (1-4 family)	2,704,883		2,880,739		3,067,193		119,011
Home equity lines	115,925		115,925		115,324		3,962
Multifamily	—		—		—		—
Commercial	1,430,533		1,430,533		1,317,972		79,891
Consumers
Consumer and installment loans	1,122		2,729		3,088		—
Overdraft protection loans	—		—		—		—
Total	$	5,187,930	$	5,365,393	$	5,457,758	$	258,868



	With Related Allowance
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
June 30, 2015
Commercial	$	1,084,114	$	1,084,114	$	939,399	$	1,309,774	$	26,100
Real estate
Construction	230,563		254,598		77,298		231,899		5,183
Residential (1-4 family)	1,743,583		1,746,842		537,578		1,742,161		35,470
Home equity lines	908,516		914,240		475,740		902,466		14,150
Multifamily	—		—		—		—		—
Commercial	1,560,578		1,560,578		330,057		1,560,678		26,901
Consumers
Consumer and installment loans	69,850		69,850		69,850		72,550		1,268
Overdraft protection loans	—		—		—		—		—
Total	$	5,597,204	$	5,630,222	$	2,429,922	$	5,819,528	$	109,072
December 31, 2014
Commercial	$	1,549,963	$	1,549,963	$	441,265	$	1,618,461	$	93,073
Real estate
Construction	336,913		441,459		100,159		408,460		12,358
Residential (1-4 family)	4,493,442		4,535,549		1,261,490		4,564,008		232,522
Home equity lines	985,672		985,672		547,172		988,494		46,161
Multifamily	—		—		—		—		—
Commercial	1,700,360		1,700,360		335,033		1,721,563		79,323
Consumers
Consumer and installment loans	74,582		74,582		74,582		79,632		2,792
Overdraft protection loans	—		—		—		—		—
Total	$	9,140,932	$	9,287,585	$	2,759,701	$	9,380,618	$	466,229