Note 4. Allowance for Loan Losses

The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb probable credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s quarterly evaluation of the collectability of the loan portfolio, credit concentrations, historical loss experience, specific impaired loans, and economic conditions. To determine the total allowance for loan losses, the Company estimates the reserves needed for each segment of the portfolio, including loans analyzed individually and loans analyzed on a pooled basis. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows.

For purposes of determining the allowance for loan losses, the Company has segmented certain loans in the portfolio by product type. Within these segments, the Company has sub-segmented its portfolio by classes within the segments, based on the associated risks within these classes.

Loan Classes by Segments

Commercial loan segment:

Commercial and industrial - organic

Commercial and industrial - government guaranteed

Commercial and industrial - syndicated

Real estate construction and land loan segment:

Residential construction

Commercial construction

Land and land development

Real estate mortgage loan segment:

1-4 family residential, first lien, investment

1-4 family residential, first lien, owner occupied

1-4 family residential, junior lien

Home equity lines of credit, first lien

Home equity lines of credit, junior lien

Farm

Multifamily

Commercial owner occupied

Commercial non-owner occupied

Consumer loan segment:

Consumer revolving credit

Consumer all other credit

Student loans purchased

Management utilizes a loss migration model for determining the quantitative risk assigned to unimpaired loans in order to capture historical loss information at the loan level, track loss migration through risk grade deterioration, and increase efficiencies related to performing the calculations. The quantitative risk factor for each loan class primarily utilizes a migration analysis loss method based on loss history for the prior twelve quarters.

The migration analysis loss method is used for all loan classes except for the following:

●

Student loans purchased - On June 27, 2018, the Company was notified that ReliaMax Surety Company (“ReliaMax Surety”), the South Dakota insurance company which issued surety bonds for the student loan pools, was placed into liquidation due to insolvency. As such, a reserve was calculated beginning in the second quarter of 2018 using the insurance claim history on the portfolio to establish a historical charge-off rate. In addition qualitative factors were applied to the student loan pools and the calculated reserve is net of any deposit reserve accounts held at the Bank. For reporting periods prior to June 30, 2018, the Company did not charge off student loans as the insurance covered the past due loans, but the Company did apply qualitative factors to calculate a reserve on these loans, net of the deposit reserve accounts held by the Company for this group of loans.

●

Commercial and industrial syndicated loans - Prior to the quarter ended September 30, 2016, there was not an established loss history in the commercial and industrial syndicated loans. The S&P credit and recovery ratings on the credit facilities were utilized to calculate a three-year weighted average historical default rate. During the third quarter of 2016, there was a small loss in the commercial and industrial syndicated loans; therefore, the Company utilized a combination of the migration analysis loss method and the S&P credit and recovery ratings.

●

Commercial and industrial government guaranteed loans – These loans require no reserve as these are 100% guaranteed by either the Small Business Administration (“SBA”) or the United States Department of Agriculture (“USDA”).

Furthermore, a nominal loss reserve is applied to loans rated “Good,” as described below, in an abundance of caution.

Under the migration analysis method, average loss rates are calculated at the risk grade and class levels by dividing the twelve-quarter average net charge-off amount by the twelve-quarter average loan balances. Qualitative factors are combined with these quantitative factors to arrive at the overall general allowances.

The Company’s internal creditworthiness grading system is based on experiences with similarly graded loans. The Company performs regular credit reviews of the loan portfolio to review the credit quality and adherence to its underwriting standards. Additionally, external reviews of a portion of the credits are conducted on a semi-annual basis.

Loans that trend upward on the risk ratings scale, toward more positive risk ratings, generally exhibit lower risk factor characteristics. Conversely, loans that migrate toward more negative ratings generally will result in a higher risk factor being applied to those related loan balances.

Risk Ratings and Historical Loss Factor Assigned

Excellent

A 0% historical loss factor applied, as these loans are secured by cash or fully guaranteed by a U.S. government agency and represent a minimal risk. The Company has never experienced a loss within this category.

Good

A 0% historical loss factor applied, as these loans represent a low risk and are secured by marketable collateral within margin. The Company has never experienced a loss within this category.

Pass

A historical loss factor for loans rated “Pass” is applied to current balances of like-rated loans, pooled by class. Loans with the following risk ratings are pooled by class and considered together as “Pass”:

Satisfactory – modest risk loans where the borrower has strong and liquid financial statements and more than adequate cash flow
Average – average risk loans where the borrower has reasonable debt service capacity
Marginal – acceptable risk loans where the borrower has acceptable financial statements but is leveraged

Watch

These loans have an acceptable risk but require more attention than normal servicing. A historical loss factor for loans rated “Watch” is applied to current balances of like-rated loans pooled by class.

Special Mention

These potential problem loans are currently protected but are potentially weak. A historical loss factor for loans rated “Special Mention” is applied to current balances of like-rated loans pooled by class.

Substandard

These problem loans are inadequately protected by the sound worth and paying capacity of the borrower and/or the value of any collateral pledged. These loans may be considered impaired and evaluated on an individual basis. Otherwise, a historical loss factor for loans rated “Substandard” is applied to current balances of all other “Substandard” loans pooled by class.

Doubtful

Loans with this rating have significant deterioration in the sound worth and paying capacity of the borrower and/or the value of any collateral pledged, making collection or liquidation of the loan in full highly questionable. These loans would be considered impaired and evaluated on an individual basis.

The following represents the loan portfolio designated by the internal risk ratings assigned to each credit as of June 30, 2019 and December 31, 2018 (dollars in thousands). There were no loans rated “Doubtful” as of either period.

									Special		Sub-
June 30, 2019	Excellent		Good		Pass		Watch		Mention		standard		TOTAL
Commercial
Commercial and industrial - organic	$	2,457	$	20,638	$	15,672	$	176	$	-	$	433	$	39,376
Commercial and industrial - government guaranteed		35,143		-		-		-		-		-		35,143
Commercial and industrial - syndicated		-		-		9,560		-		-		2,531		12,091
Real estate construction
Residential construction		-		-		1,021		-		-		-		1,021
Commercial construction		-		-		3,663		-		-		-		3,663
Land and land development		-		-		8,675		484		-		477		9,636
Real estate mortgages
1-4 family residential, first lien, investment		-		-		36,600		3,827		114		266		40,807
1-4 family residential, first lien, owner occupied		-		-		15,181		1,060		9		54		16,304
1-4 family residential, junior lien		-		-		2,357		39		20		478		2,894
1-4 family residential, first lien - purchased		-		-		18,451		-		-		-		18,451
Home equity lines of credit, first lien		-		-		7,866		338		-		340		8,544
Home equity lines of credit, junior lien		-		-		9,291		99		-		82		9,472
Farm		-		-		7,652		328		-		1,318		9,298
Multifamily		-		-		24,432		-		-		-		24,432
Commercial owner occupied		-		-		86,398		6,828		-		2,060		95,286
Commercial non-owner occupied		-		-		113,143		2,684		-		1,063		116,890
Consumer
Consumer revolving credit		75		23,786		469		11		-		-		24,341
Consumer all other credit		245		3,430		492		2		-		27		4,196
Student loans purchased		-		-		47,392		2,109		347		70		49,918
Total Loans	$	37,920	$	47,854	$	408,315	$	17,985	$	490	$	9,199	$	521,763

									Special		Sub-
December 31, 2018	Excellent		Good		Pass		Watch		Mention		standard		TOTAL
Commercial
Commercial and industrial - organic	$	3,692	$	23,381	$	13,993	$	264	$	28	$	168	$	41,526
Commercial and industrial - government guaranteed		31,367		-		-		-		-		-		31,367
Commercial and industrial - syndicated		-		-		9,588		-		-		2,546		12,134
Real estate construction
Residential construction		-		-		1,552		-		-		-		1,552
Commercial construction		-		-		5,078		-		-		-		5,078
Land and land development		-		-		9,888		501		-		505		10,894
Real estate mortgages
1-4 family residential, first lien, investment		-		-		36,314		3,607		117		273		40,311
1-4 family residential, first lien, owner occupied		-		-		15,540		1,087		11		137		16,775
1-4 family residential, junior lien		-		-		2,573		58		22		516		3,169
1-4 family residential, first lien - purchased		-		-		18,647		-		-		-		18,647
Home equity lines of credit, first lien		-		-		7,911		414		-		-		8,325
Home equity lines of credit, junior lien		-		-		10,704		97		-		111		10,912
Farm		-		-		8,719		339		-		1,339		10,397
Multifamily		-		-		27,328		-		-		-		27,328
Commercial owner occupied		-		-		86,868		6,932		-		-		93,800
Commercial non-owner occupied		-		-		120,720		1,519		-		975		123,214
Consumer
Consumer revolving credit		44		20,852		644		-		-		-		21,540
Consumer all other credit		263		4,699		535		4		-		29		5,530
Student loans purchased		-		-		51,494		2,401		431		365		54,691
Total Loans	$	35,366	$	48,932	$	428,096	$	17,223	$	609	$	6,964	$	537,190

In addition, the adequacy of the Company’s allowance for loan losses is evaluated through reference to eight qualitative factors, listed below and ranked in order of importance:

1)	Changes in national and local economic conditions, including the condition of various market segments;
2)	Changes in the value of underlying collateral;
3)	Changes in volume of classified assets, measured as a percentage of capital;
4)	Changes in volume of delinquent loans;
5)	The existence and effect of any concentrations of credit and changes in the level of such concentrations;
6)	Changes in lending policies and procedures, including underwriting standards;
7)	Changes in the experience, ability and depth of lending management and staff; and
8)	Changes in the level of policy exceptions.

It has been the Company’s experience that the first five factors drive losses to a much greater extent than the last three factors; therefore, the first five factors are weighted more heavily. Qualitative factors are not assessed against loans rated “Excellent” or “Good,” as the Company has never experienced a loss within these categories.

For each segment and class of loans, management must exercise significant judgment to determine the estimation method that fits the credit risk characteristics of its various segments. Although this evaluation is inherently subjective, qualified management utilizes its significant knowledge and experience related to both the Company’s market and the history of the Company’s loan losses.

Impaired loans are individually evaluated and, if deemed appropriate, a specific allocation is made for these loans. In reviewing the loans classified as impaired loans totaling $2.6 million at June 30, 2019, specific valuation allowance was recognized after consideration was given for each borrowing as to the fair value of the collateral on the loan or the present value of expected future cash flows from the borrower. The $51 thousand in the allowance total shown below as individually evaluated for impairment was attributed to the impaired student loans, that required an allowance as of June 30, 2019 due to the loss of the insurance on this portfolio as discussed previously.

A summary of the transactions in the Allowance for Loan Losses by loan portfolio segment for the six months ended June 30, 2019 and the year ended December 31, 2018 appears below (dollars in thousands):

Allowance for Loan Losses Rollforward by Portfolio Segment
As of and for the period ended June 30, 2019
				Real Estate
	Commercial			Construction			Real Estate			Consumer
	Loans			and Land			Mortgages			Loans			Total
Allowance for Loan Losses:
Balance as of January 1, 2019	$	811		$	119		$	2,611		$	1,350		$	4,891
Charge-offs		-			-			-			(823	)		(823	)
Recoveries		35			-			15			79			129
Provision for (recovery of) loan losses		2			(18	)		16			620			620
Ending Balance	$	848		$	101		$	2,642		$	1,226		$	4,817

Ending Balance:
Individually evaluated for impairment	$	-		$	-		$	-		$	51		$	51
Collectively evaluated for impairment		848			101			2,642			1,175			4,766

Loans:
Individually evaluated for impairment	$	-		$	28		$	1,025		$	1,591		$	2,644
Collectively evaluated for impairment		86,610			14,292			341,353			76,864			519,119
Ending Balance	$	86,610		$	14,320		$	342,378		$	78,455		$	521,763

As of and for the year ended December 31, 2018
				Real Estate
	Commercial			Construction			Real Estate			Consumer
	Loans			and Land			Mortgages			Loans			Total
Allowance for Loan Losses:
Balance as of January 1, 2018	$	885		$	206		$	2,730		$	222		$	4,043
Charge-offs		(75	)		-			-			(1,022	)		(1,097	)
Recoveries		54			-			2			16			72
Provision for (recovery of) loan losses		(53	)		(87	)		(121	)		2,134			1,873
Ending Balance	$	811		$	119		$	2,611		$	1,350		$	4,891

Ending Balance:
Individually evaluated for impairment	$	-		$	-		$	-		$	90		$	90
Collectively evaluated for impairment		811			119			2,611			1,260			4,801

Loans:
Individually evaluated for impairment	$	-		$	32		$	1,132		$	1,602		$	2,766
Collectively evaluated for impairment		85,027			17,492			351,746			80,159			534,424
Ending Balance	$	85,027		$	17,524		$	352,878		$	81,761		$	537,190

As previously mentioned, one of the major factors that the Company uses in evaluating the adequacy of its allowance for loan losses is changes in the volume of delinquent loans. Management monitors payment activity on a regular basis. For all classes of loans, the Company considers the entire balance of the loan to be contractually delinquent if the minimum payment is not received by the due date. Interest and fees continue to accrue on past due loans until they are changed to non-accrual status.

The following tables show the aging of past due loans as of June 30, 2019 and December 31, 2018. (Dollars below reported in thousands.)

Past Due Aging as of													90 Days
June 30, 2019	30-59		60-89		90 Days or								Past Due
	Days Past		Days Past		More Past		Total Past				Total		and Still
	Due		Due		Due		Due		Current		Loans		Accruing
Commercial loans
Commercial and industrial - organic	$	172	$	-	$	-	$	172	$	39,204	$	39,376	$	-
Commercial and industrial - government guaranteed		-		-		548		548		34,595		35,143		548
Commercial and industrial - syndicated		-		-		-		-		12,091		12,091		-
Real estate construction and land
Residential construction		-		-		-		-		1,021		1,021		-
Commercial construction		-		-		-		-		3,663		3,663		-
Land and land development		-		15		-		15		9,621		9,636		-
Real estate mortgages
1-4 family residential, first lien, investment		-		-		-		-		40,807		40,807		-
1-4 family residential, first lien, owner occupied		-		-		-		-		16,304		16,304		-
1-4 family residential, junior lien		-		-		-		-		2,894		2,894		-
1-4 family residential - purchased	.			-		-		-		18,451		18,451		-
Home equity lines of credit, first lien		-		-		-		-		8,544		8,544		-
Home equity lines of credit, junior lien		-		-		-		-		9,472		9,472		-
Farm		-		-		-		-		9,298		9,298		-
Multifamily		-		-		-		-		24,432		24,432		-
Commercial owner occupied		-		-		-		-		95,286		95,286		-
Commercial non-owner occupied		3,750		-		-		3,750		113,140		116,890		-
Consumer loans
Consumer revolving credit		-		-		-		-		24,341		24,341		-
Consumer all other credit		-		24		-		24		4,172		4,196		-
Student loans purchased		538		407		432		1,377		48,541		49,918		69
Total Loans	$	4,460	$	446	$	980	$	5,886	$	515,877	$	521,763	$	617

Past Due Aging as of													90 Days
December 31, 2018	30-59		60-89		90 Days or								Past Due
	Days Past		Days Past		More Past		Total Past				Total		and Still
	Due		Due		Due		Due		Current		Loans		Accruing
Commercial loans
Commercial and industrial - organic	$	50	$	172	$	-	$	222	$	41,304	$	41,526	$	-
Commercial and industrial - government guaranteed		-		-		548		548		30,819		31,367		548
Commercial and industrial - syndicated		-		-		-		-		12,134		12,134		-
Real estate construction and land
Residential construction		-		-		-		-		1,552		1,552		-
Commercial construction		-		-		-		-		5,078		5,078		-
Land and land development		1		-		15		16		10,878		10,894		15
Real estate mortgages
1-4 family residential, first lien, investment		-		-		-		-		40,311		40,311		-
1-4 family residential, first lien, owner occupied		-		-		-		-		16,775		16,775		-
1-4 family residential, junior lien		-		-		-		-		3,169		3,169		-
1-4 family residential - purchased		954		-		-		954		17,693		18,647		-
Home equity lines of credit, first lien		-		-		-		-		8,325		8,325		-
Home equity lines of credit, junior lien		-		-		-		-		10,912		10,912		-
Farm		-		-		-		-		10,397		10,397		-
Multifamily		-		-		-		-		27,328		27,328		-
Commercial owner occupied		-		-		-		-		93,800		93,800		-
Commercial non-owner occupied		75		-		-		75		123,139		123,214		-
Consumer loans
Consumer revolving credit		-		-		-		-		21,540		21,540		-
Consumer all other credit		4		599		-		603		4,927		5,530		-
Student loans purchased		850		463		754		2,067		52,624		54,691		332
Total Loans	$	1,934	$	1,234	$	1,317	$	4,485	$	532,705	$	537,190	$	895