Loans Receivable and Related Allowance for Loan Losses

6 Months Ended

Jun. 30, 2020

Loans Receivable and Related Allowance for Loan Losses

Loans Receivable and Related Allowance for Loan Losses

(8)  Loans Receivable and Related Allowance for Loan Losses

The following table summarizes the primary segments of the loan portfolio by the amounts collectively evaluated for impairment and the amounts individually evaluated for impairment, and the related allowance for loan losses, as of June 30, 2020 and December 31, 2019 (dollars in thousands):

	Real Estate Loans
	One-to-four-		Commercial		Home
	family		Real Estate		Equity Loans
	Residential and		and		and Lines		Commercial		Other
	Construction		Construction		of Credit		Business		Loans		Total
June 30, 2020:
Collectively evaluated for impairment	$	212,447	$	340,403	$	103,699	$	88,365	$	541	$	745,455
Individually evaluated for impairment		—		3,082		—		610		—		3,692
Total loans before allowance for loan losses	$	212,447	$	343,485	$	103,699	$	88,975	$	541	$	749,147
December 31, 2019:
Collectively evaluated for impairment	$	234,421	$	323,008	$	111,499	$	46,907	$	570	$	716,405
Individually evaluated for impairment		—		835		—		607		—		1,442
Total loans before allowance for loan losses	$	234,421	$	323,843	$	111,499	$	47,514	$	570	$	717,847

Total loans at June 30, 2020 and December 31, 2019 were net of deferred loan fees of $1.6 million and $233,000, respectively. The increase in net deferred loan fees was primarily the result of fees booked related to Paycheck Protection Program (“PPP”) loans booked during the period which are discussed further below.

The segments of the Bank’s loan portfolio are disaggregated to a level that allows management to monitor risk and performance.  The three segments are:  real estate, commercial business and other.  The real estate loan segment is further disaggregated into three classes.  One-to-four family residential mortgages (including residential construction loans) include loans to individuals secured by residential properties having maturities up to 30 years. Commercial real estate (including commercial construction loans) consists of loans to commercial borrowers secured by commercial or residential real estate. Home equity loans and lines of credit include loans having maturities up to 20 years. The commercial business loan segment consists of loans to finance the activities of commercial business customers and includes PPP loans. The other loan segment consists primarily of consumer loans and overdraft lines of credit. The portfolio segments utilized in the calculation of the allowance for loan losses are disaggregated at the same level that management uses to monitor risk in the portfolio. Therefore the portfolio segments and classes of loans are the same.

There are various risks associated with lending to each portfolio segment. One-to-four family residential mortgage loans are typically longer-term loans which generally entail greater interest rate risk than consumer and commercial loans. Under certain economic conditions, housing values may decline, which may increase the risk that the collateral values are insufficient. Commercial real estate loans generally present a higher level of risk than loans secured by residences. This greater risk is due to several factors including but not limited to concentration of principal in a limited number of loans and borrowers, the effect of general economic conditions on income producing properties and the increased difficulty in monitoring these types of loans. Furthermore, the repayment of commercial real estate loans is typically dependent upon successful operation of the related real estate project. If the cash flow from the project is reduced by such occurrences as leases not being obtained, renewed or not entirely fulfilled, the borrower’s ability to repay the loan may be impaired. Commercial business loans are primarily secured by business assets, inventories and accounts receivable which present collateral risk. The repayment of the commercial business loan is dependent upon the ongoing cash flow of the operating entity and the ability of a guarantor to support the company. The other loan segment generally has higher interest rates and

shorter terms than one-to-four family residential mortgage loans, however, they can have additional credit risk due to the type of collateral securing the loan.

The following table provides additional information with respect to the Company’s commercial real estate and construction and commercial business loans by industry sector at June 30, 2020 (dollars in thousands):

Type of Loan (1)	Number of Loans	Balance
Real Estate Rental and Leasing	1,281	$	273,820
Construction	165		26,908
Accommodation and Food Services	72		23,618
Other Services (except Public Administration)	141		15,868
Health Care and Social Assistance	117		15,645
Retail Trade	88		14,854
Manufacturing	48		12,418
Professional, Scientific, and Technical Services	131		10,622
Wholesale Trade	58		7,743
Finance and Insurance	41		7,391
Other	244		23,573
Total	2,386	$	432,460

(1)   Loan types are based on the North American Industry Classification System (NAICS).

As of June 30, 2020, the real estate rental and leasing sector included the following industry categories:

Detail of Real Estate Rental and Leasing	Number of Loans	Balance
Lessors or Residential Buildings and Dwellings	930	$	142,156
Lessors of Nonresidential Buildings	210		99,033
Other Activities Related to Real Estate	47		8,120
Lessors of Mini warehouses and Self-Storage Units	15		5,860
Other General Government Support	17		6,171
Lessors of Other Real Estate Property	13		4,249
Real Estate Property Managers	11		2,575
All Other Real Estate Rental and Leasing	38		5,656
Total	1,281	$	273,820

The Company’s primary business activity is with customers located within its local market area.  Although the Company has a diversified loan portfolio, loans outstanding to individuals and businesses are dependent upon the local economic conditions in its immediate market area.  At June 30, 2020, the Company’s largest commercial loan concentrations are to the lessors of residential properties and the lessors of nonresidential properties representing 33.0% and 22.9% of the commercial loan portfolio, respectively.  The construction portfolio is very well diversified with no exposure in any NAICS above $5.8 million. Additionally, the Bank had approximately $15.5 million in hotel and motel loans and $7.3 million in restaurant loans at June 30, 2020. Included in the hotel and motel and restaurant loans were $153,000 and $2.8 million of PPP loans, respectively.

The Coronavirus Aid Relief and Economic Security Act, (the ”CARES Act”), was signed into law on March 27, 2020, and provided over $2.0 trillion in emergency economic relief to individuals and businesses impacted by the COVID-19 pandemic. The CARES act authorized the SBA to temporarily guarantee PPP loans under a new 7(a) loan program. As a qualified SBA lender, the Company was automatically authorized to originate PPP loans. As of June 30, 2020, the Company had received approval from the SBA for 399 PPP loans totaling $41.8 million which generated $1.6 million in fees to be recognized over the life of the loans.  The Company continues to make these loans available to customers and noncustomers.

An eligible business can apply for a PPP loan up to the greater of: (1) 2.5 times its average monthly “payroll costs;” or (2) $10.0 million. PPP loans have: (a) an interest rate of 1.0%, (b) a five-year loan term to maturity for loans made on or after

June 5, 2020 (loans made prior to June 5, 2020 have a two-year term, however borrowers and lenders may mutually agree to extend the maturity for such loans to five years); and (c) principal and interest payments deferred for six months from the date of disbursement.  The SBA will guarantee 100% of the PPP loans made to eligible borrowers.  The entire principal amount of the borrower’s PPP loan, including any accrued interest, is eligible to be reduced by the loan forgiveness amount under the PPP so long as employee and compensation levels of the business are maintained and 60% of the loan proceeds are used for payroll expenses, with the remaining 40% of the loan proceeds used for other qualifying expenses.

Management evaluates individual loans in all of the commercial segments for possible impairment if the relationship is greater than $200,000, and  the loan is in nonaccrual status, risk-rated Substandard or Doubtful, 90 days or more past due or represents a troubled debt restructuring ("TDR"). 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. The definition of “impaired loans” is not the same as the definition of “nonaccrual loans,” although the two categories overlap. The Company may choose to place a loan on nonaccrual status due to payment delinquency or uncertain collectability, while not classifying the loan as impaired if the loan is not a commercial business or commercial real estate loan. 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 does not separately evaluate individual consumer and residential mortgage loans for impairment, unless such loan is part of a larger relationship that is impaired, has a classified risk rating, or is a TDR.

Once the decision has been made that a loan is impaired, the determination of whether a specific allocation of the allowance is necessary is calculated 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 appropriate 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 Company’s policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition.

Consistent with accounting and regulatory guidance, the Company recognizes a TDR when a borrower is experiencing financial difficulties and the Bank, for economic or legal reasons related to a borrower's financial difficulties, grants a concession to the borrower that would not normally be considered.  Regardless of the form of concession granted, the Company's objective in offering a TDR is to increase the probability of repayment of the borrower's loan.  The Company did not modify any loans as TDR’s during the three or six month periods ended June 30, 2020 or June 30, 2019.  As of June 30, 2020, all TDR’s were performing in accordance with their modified terms and are included in the impaired loan table below.

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 at June 30, 2020 and December 31, 2019 (dollars in thousands):

					Impaired Loans
	Impaired Loans With				Without
	Allowance				Allowance		Total Impaired Loans
	Recorded		Related		Recorded		Recorded		Unpaid Principal
	Investment		Allowance		Investment		Investment		Balance
June 30, 2020:
Commercial real estate and construction	$	—	$	—	$	3,082	$	3,082	$	3,082
Commercial business		—		—		610		610		610
Total impaired loans	$	—	$	—	$	3,692	$	3,692	$	3,692
December 31, 2019:
Commercial real estate and construction	$	—	$	—	$	835	$	835	$	835
Commercial business		—		—		607		607		607
Total impaired loans	$	—	$	—	$	1,442	$	1,442	$	1,442

The following table presents the average recorded investment in impaired loans and related interest income recognized for the three and six months ended June 30, 2020 and June 30, 2019 (dollars in thousands):

	For the Three Months Ended June 30,				For the Six Months Ended June 30,
	2020		2019		2020		2019
Average investment in impaired loans:
Commercial real estate and construction	$	2,651	$	—	$	2,045	$	—
Commercial business		607		—		607		—
	$	3,258	$	—	$	2,652	$	—
Interest income recognized on impaired loans	$	40	$	—	$	93	$	—

The Company has elected to follow the loan modification guidance under Section 4013 of the CARES Act with regard to COVID-19 modifications made between March 1, 2020 and the earlier of either December 31, 2020 or the 60th day after the end of the COVID-19 national emergency. Under that guidance, any short-term loan modification that is done as a result of COVID-19 for a loan that was current prior to any relief, will not be categorized as a TDR. A modification of six months or less is considered to be a short-term loan modification. The interagency guidance defines current as a loan that is less than 30 days past due on the contractual payments at the time of modification. The Company has developed loan payment deferral programs to provide assistance to both individuals and small business clients directly impacted by the COVID-19 pandemic that will initially defer payments for up to 90 days.  As of June 30, 2020, the Bank had 414 commercial loans totaling $133.3 million and 187 consumer loans totaling $25.3 million that had been modified as a result of COVID-19.  All of these loans were initially provided a deferral period of 90 days. Upon request from the customer, the Bank may approve an additional 90 day deferral period.

The following table provides additional information with respect to the modified loans in the Company’s loan portfolio at June 30, 2020 (dollars in thousands):

				Weighted Average
Type of Loan	Number of Loans	Balance		Interest Rate
One-to-four family and residential and construction	99	$	19,186	4.05	%
Commercial real estate and construction	369		123,674	4.77	%
Home equity loans and lines of credit	87		6,059	3.35	%
Commercial business	45		9,593	4.32	%
Other loans	1		10	2.60	%
Total	601	$	158,522	4.60	%

Management uses a nine-point internal risk rating system to monitor the credit quality of the overall loan portfolio. The first five 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 performing 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 collection of the debt, and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected. All loans 90 days or more past due are considered Substandard. Any loan that has a specific allocation of the allowance for loan losses and is in the process of liquidation of the collateral 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 Company 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 delinquency, bankruptcy, repossession, or death occurs to raise awareness of a possible credit event. The Company’s Commercial Loan Officers are responsible for the timely and accurate risk rating of the loans in their portfolio at origination. Commercial relationships are periodically reviewed internally for credit deterioration or improvement in order to confirm that the relationship is appropriately risk rated. The Audit Committee of the Company also engages an external consultant to conduct loan reviews. The scope of the annual external engagement, which is performed through semi-annual loan reviews, includes reviewing approximately the top 50 to 60 loan relationships, all watchlist loans greater than $100,000, all commercial Reg O loans, and a random sampling of new loan originations between $200,000 and $500,000 during the year. Status reports are provided to management for loans classified as Substandard on a quarterly basis, which results in a proactive approach to resolution. 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 presents the classes of the loan portfolio summarized by the aggregate Pass rating and the criticized categories of Special Mention, Substandard and Doubtful within the Company’s internal risk rating system as of June 30, 2020 and December 31, 2019 (dollars in thousands):

			Special
	Pass		Mention		Substandard		Doubtful		Total
June 30, 2020:
Real estate loans:
One-to-four-family residential and construction	$	210,367	$	—	$	2,080	$	—	$	212,447
Commercial real estate and construction		339,743		1,141		2,601		—		343,485
Home equity loans and lines of credit		103,421		59		219		—		103,699
Commercial business loans		87,852		1,049		74		—		88,975
Other loans		539		—		2		—		541
Total	$	741,922	$	2,249	$	4,976	$	—	$	749,147
December 31, 2019:
Real estate loans:
One-to-four-family residential and construction	$	232,354	$	—	$	2,067	$	—	$	234,421
Commercial real estate and construction		320,988		2,544		311		—		323,843
Home equity loans and lines of credit		111,165		62		272		—		111,499
Commercial business loans		46,636		818		60		—		47,514
Other loans		564		—		6		—		570
Total	$	711,707	$	3,424	$	2,716	$	—	$	717,847

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 based on the loans’ contractual due dates. Management considers nonperforming loans to be those loans that are past due 90 days or more and are still accruing as well as all nonaccrual loans. At June 30, 2020, there were 31 loans on non-accrual status that were less than 90 days past due totaling $1.3 million. There were no loans on non-accrual status that were less than 90 days past due at December 31, 2019.  The following table presents the segments of the loan portfolio summarized by the past due status of the loans still accruing and nonaccrual loans as of June 30, 2020 and December 31, 2019 (dollars in thousands):

			30‑59 Days		60‑89 Days				90 Days Past		Total
	Current		Past Due		Past Due		Non-Accrual		Due & Accruing		Loans
June 30, 2020:
Real estate loans:
One-to-four-family residential and construction	$	210,243	$	10	$	114	$	2,080	$	—	$	212,447
Commercial real estate and construction		342,129		—		125		1,231		—		343,485
Home equity loans and lines of credit		103,398		59		23		219		—		103,699
Commercial business loans		88,901		—		—		74		—		88,975
Other loans		537		—		2		2		—		541
Total	$	745,208	$	69	$	264	$	3,606	$	—	$	749,147
December 31, 2019:
Real estate loans:
One-to-four-family residential and construction	$	230,952	$	1,021	$	381	$	2,067	$	—	$	234,421
Commercial real estate and construction		322,922		610		—		311		—		323,843
Home equity loans and lines of credit		110,634		591		2		272		—		111,499
Commercial business loans		47,420		34		—		60		—		47,514
Other loans		564		—		—		6		—		570
Total	$	712,492	$	2,256	$	383	$	2,716	$	—	$	717,847

An allowance for loan losses (“ALL”) is maintained to absorb losses from the loan portfolio. The loan portfolio for the purposes of the ALL excludes all merger related loans as well as PPP loans which are guaranteed by the SBA. The ALL is based on management’s continuing evaluation of the risk characteristics and credit quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.

The Bank’s methodology for determining the ALL is based on the requirements of ASC Section 310-10-35 for loans individually evaluated for impairment (discussed above) and ASC Subtopic 450-20 for loans collectively evaluated for impairment, as well as the Interagency Policy Statements on the Allowance for Loan and Lease Losses and other bank regulatory guidance. The total of the two components represents the Bank’s ALL.

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 other qualitative factors. Management tracks the historical net charge-off activity for the loan segments which may be adjusted for qualitative factors. 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.

Management has 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 are evaluated using information obtained from internal, regulatory, and governmental sources such as national and local economic trends and conditions; levels of and trends in delinquency rates

and non-accrual loans; trends in volumes and terms of loans; effects of changes in lending policies; experience, depth and ability of management; and concentrations of credit from a loan type, industry and/or geographic standpoint.

During the current quarter, Management added a new qualitative factor to address several risks that could potentially impact customers credit worthiness as we move forward through the COVID-19 pandemic. Additionally, Management identified the hotel sector as an area where additional reserves were needed. Both the addition of the new qualitative factor and the identification of the hotel sector had a significant impact on the provision both the three and six month periods.

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. Management utilizes an internally developed methodology to track and apply the various components of the allowance. During the three months ended June 30, 2020, there was a decrease in the provision for the one-to four family residential and construction loan class primarily due to decreases in qualitiative factors partially offset by an increase due to the addition of the new qualitative factor for the COVID-19 pandemic. During the six months ended June 30, 2020, there was an increase in the provision for the one-to-four family residential and construction loan class primarily due to an increase in several qualitative factors as a result of the COVID-19 pandemic offset by decreases in the qualitative factors related to changes in lending policies and the experience, depth and ability of management. During both the three and six months ended June 30, 2020, there was (1) an increase in the provision for the commercial real estate and construction loan class primarily due to an increase in several qualitative factors as a result of the COVID-19 pandemic as well as additional reserves required for the hotel sector partially offset by decreases in the qualitative factors related to changes in lending policies and the experience, depth and ability of management; (2) a decrease in the provision for home equity loans and lines of credit loan class primarily due to decreases in the qualitative factors related to changes in loan balances, lending policies and the experience, depth and ability of management partially offset by increases in several qualitative factors as a result of the COVID-19 pandemic as well as charge-offs incurred during the six month period; and (3) a decrease in the provision for the commercial business loan class due to decreases in the qualitative factors related to changes in loan balances, lending policies and the experience, depth and ability of management partially offset by increases in several qualitative factors as a result of the COVID-19 pandemic as well as charge-offs incurred during both the three and six month periods.

The following tables summarize the activity in the primary segments of the ALL for the three and six months ended June 30, 2020 and June 30, 2019 as well as the allowance required for loans individually and collectively evaluated for impairment as of June 30, 2020 and December 31, 2019 (dollars in thousands):

	Real Estate Loans
	One-to-four-		Commercial		Home
	family		Real Estate		Equity Loans
	Residential and		and		and Lines		Commercial		Other
	Construction		Construction		of Credit		Business		Loans		Total
Three Months Ended :
Balance March 31, 2020	$	1,369	$	3,109	$	354	$	547	$	4	$	5,383
Charge-offs		(23)		—		—		(13)		—		(36)
Recoveries		1		—		—		—		—		1
Provision		(401)		2,204		(76)		(107)		—		1,620
Balance June 30, 2020	$	946	$	5,313	$	278	$	427	$	4	$	6,968
Balance March 31, 2019	$	860	$	2,754	$	298	$	461	$	2	$	4,375
Charge-offs		—		—		(59)		—		(5)		(64)
Recoveries		—		—		2		—		—		2
Provision		(9)		82		54		49		5		181
Balance at June 30, 2019	$	851	$	2,836	$	295	$	510	$	2	$	4,494
Six Months Ended :
Balance December 31, 2019	$	721	$	3,313	$	310	$	534	$	4	$	4,882
Charge-offs		(23)		—		(13)		(51)		(2)		(89)
Recoveries		3		1		—		1		—		5
Provision		245		1,999		(19)		(57)		2		2,170
Balance June 30, 2020	$	946	$	5,313	$	278	$	427	$	4	$	6,968
Balance at December 31, 2018	$	1,051	$	2,761	$	312	$	286	$	4	$	4,414
Charge-offs		—		(121)		(59)		—		(33)		(213)
Recoveries		—		—		3		—		—		3
Provision		(200)		196		39		224		31		290
Balance at June 30, 2019	$	851	$	2,836	$	295	$	510	$	2	$	4,494

	Real Estate Loans
	One-to-four-		Commercial		Home
	family		Real Estate		Equity Loans
	Residential and		and		and Lines		Commercial		Other
	Construction		Construction		of Credit		Business		Loans		Total
Evaluated for Impairment:
Collectively	$	946	$	5,313	$	278	$	427	$	4	$	6,968
Individually		—		—		—		—		—		—
Balance at June 30, 2020	$	946	$	5,313	$	278	$	427	$	4	$	6,968
Evaluated for Impairment:
Collectively	$	721	$	3,313	$	310	$	534	$	4	$	4,882
Individually		—		—		—		—		—		—
Balance at December 31, 2019	$	721	$	3,313	$	310	$	534	$	4	$	4,882

The ALL is based on estimates and actual losses will vary from current estimates. Management believes that the granularity of the homogeneous pools and the related historical loss ratios and other qualitative factors, as well as the consistency in the application of assumptions, result in an ALL that is representative of the risk found in the components of the loan

portfolio at any given date. In addition, federal regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses and may require the Bank to make changes to the allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to Management. Based on Management’s comprehensive analysis of the loan portfolio, they believe the current level of the allowance for loan losses is adequate.