NOTE 4 — LOANS

The composition of loans at December 31 is as follows (dollars in thousands):



	2016		2015

Commercial real estate	$	389,420	$	312,805
Commercial, financial, and agricultural		142,648		122,140
Commercial construction		11,505		15,330
One to four family residential real estate		205,945		140,502
Consumer		20,113		15,847
Consumer construction		12,226		11,770

Total loans	$	781,857	$	618,394

The Corporation completed the acquisition of Peninsula Financial Corporation, (“PFC”), on December 5, 2014, The First National Bank of Eagle River (“Eagle River”) on April 29, 2016 and Niagara Bancorporation (“Niagara”) on August 31, 2016. The PFC acquired impaired loans totaled $13.290 million, the Eagle River acquired impaired loans totaled $3.401 million, and the Niagara acquired impaired loans totaled $2.105 million. In 2016, the Corporation had positive resolution of acquired nonperforming loans, which resulted in the recognition of approximately $96,000 of accretable interest. In 2015, the Corporation had positive resolution of acquired nonperforming loans, which resulted in the recognition of approximately $.578 million of the accretable interest.

The table below details the outstanding balances of the PFC acquired portfolio and the acquisition fair value adjustments at acquisition date (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	13,290	$	53,849	$	67,139
Nonaccretable difference		(2,234)		—		(2,234)
Expected cash flows		11,056		53,849		64,905
Accretable yield		(744)		(2,100)		(2,844)
Carrying balance at acquisition date	$	10,312	$	51,749	$	62,061

The table below details the outstanding balances of the Eagle River acquired portfolio and the acquisition fair value adjustments at acquisition date (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	3,401	$	80,737	$	84,138
Nonaccretable difference		(1,172)		—		(1,172)
Expected cash flows		2,229		80,737		82,966
Accretable yield		(391)		(1,700)		(2,091)
Carrying balance at acquisition date	$	1,838	$	79,037	$	80,875

The table below details the outstanding balances of the Niagara acquired portfolio and the acquisition fair value adjustments at acquisition date (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	2,105	$	30,555	$	32,660
Nonaccretable difference		(265)		—		(265)
Expected cash flows		1,840		30,555		32,395
Accretable yield		(88)		(600)		(688)
Carrying balance at acquisition date	$	1,752	$	29,955	$	31,707

The table below presents a rollforward of the accretable yield on acquired loans for year ended December 31, 2016 (dollars in thousands):


	PFC						Eagle River						Niagara
	Acquired		Acquired		Acquired		Acquired		Acquired		Acquired		Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total		Impaired		Non-impaired		Total		Impaired		Non-impaired		Total

Balance, December 31, 2015	$	426	$	1,342	$	1,768	$	—	$	—	$	—	$	—	$	—	$	—
Acquisitions		—		—		—		391		1,700		2,091		88		600		688
Accretion		(50)		(700)		(750)		(46)		(479)		(525)		—		(95)		(95)
Reclassification from nonaccretable difference		94		—		94		109		—		109		36		—		36
Balance, December 31, 2016	$	282	$	642	$	924	$	236	$	1,221	$	1,457	$	52	$	505	$	557

The table below presents a rollforward of the accretable yield on acquired loans for year ended December 31, 2015 (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total

Balance, December 31, 2014	$	744	$	2,042	$	2,786
Accretion		(578)		(700)		(1,278)
Reclassification from nonaccretable difference		260		—		260
Balance, December 31, 2015	$	426	$	1,342	$	1,768

A breakdown of the allowance for loan losses and recorded balances in loans at December 31, 2016 is as follows (dollars in thousands):


			Commercial,				One to four
	Commercial		financial and		Commercial		family residential		Consumer
	real estate		agricultural		construction		real estate		construction		Consumer		Unallocated		Total
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,611	$	645	$	79	$	274	$	7	$	64	$	2,324	$	5,004
Charge-offs		(245)		(232)		—		(133)		—		(113)		—		(723)
Recoveries		54		41		7		5		—		32		—		139
Provision		(75)		160		(29)		150		(1)		107		288		600
Ending balance ALLR	$	1,345	$	614	$	57	$	296	$	6	$	90	$	2,612	$	5,020

Loans:
Ending balance	$	389,420	$	142,648	$	11,505	$	205,945	$	12,226	$	20,113	$	—	$	781,857
Ending balance ALLR		(1,345)		(614)		(57)		(296)		(6)		(90)		(2,612)		(5,020)
Net loans	$	388,075	$	142,034	$	11,448	$	205,649	$	12,220	$	20,023	$	(2,612)	$	776,837

Ending balance ALLR:
Individually evaluated	$	470	$	365	$	—	$	43	$	—	$	80	$	—	$	958
Collectively evaluated		875		249		57		253		6		10		2,612		4,062
Total	$	1,345	$	614	$	57	$	296	$	6	$	90	$	2,612	$	5,020

Ending balance Loans:
Individually evaluated	$	1,304	$	1,461	$	—	$	1,125	$	—	$	181	$	—	$	4,071
Collectively evaluated		384,882		141,187		11,505		202,028		12,169		19,928		—		771,699
Acquired with deteriorated credit quality		3,234		—		—		2,792		57		4		—		6,087
Total	$	389,420	$	142,648	$	11,505	$	205,945	$	12,226	$	20,113	$	—	$	781,857

Impaired loans, by definition, are individually evaluated.

A breakdown of the allowance for loan losses and recorded balances in loans at December 31, 2015 is as follows (dollars in thousands):


			Commercial,				One to four
	Commercial		financial and		Commercial		family residential		Consumer
	real estate		agricultural		construction		real estate		construction		Consumer		Unallocated		Total
Allowance for loan loss reserve:
Beginning balance ALLR	$	2,813	$	1,539	$	142	$	285	$	6	$	13	$	342	$	5,140
Charge-offs		(52)		(1,749)		—		(142)		—		(87)		—		(2,030)
Recoveries		588		22		52		2		—		26		—		690
Provision		(1,738)		833		(115)		129		1		112		1,982		1,204
Ending balance ALLR	$	1,611	$	645	$	79	$	274	$	7	$	64	$	2,324	$	5,004

Loans:
Ending balance	$	312,805	$	122,140	$	15,330	$	140,502	$	11,770	$	15,847	$	—	$	618,394
Ending balance ALLR		(1,611)		(645)		(79)		(274)		(7)		(64)		(2,324)		(5,004)
Net loans	$	311,194	$	121,495	$	15,251	$	140,228	$	11,763	$	15,783	$	(2,324)	$	613,390

Ending balance ALLR:
Individually evaluated	$	420	$	192	$	—	$	60	$	—	$	55	$	—	$	727
Collectively evaluated		1,191		453		79		214		7		9		2,324		4,277
Total	$	1,611	$	645	$	79	$	274	$	7	$	64	$	2,324	$	5,004

Ending balance Loans:
Individually evaluated	$	1,086	$	617	$	—	$	325	$	83	$	—	$	—	$	2,111
Collectively evaluated		307,336		121,345		15,330		136,940		11,686		15,845		—		608,482
Acquired with deteriorated credit quality		4,383		178		—		3,237		1		2		—		7,801
Total	$	312,805	$	122,140	$	15,330	$	140,502	$	11,770	$	15,847	$	—	$	618,394

Impaired loans, by definition, are individually evaluated.

As part of the management of the loan portfolio, risk ratings are assigned to all commercial loans. Through the loan review process, ratings are modified as believed to be appropriate to reflect changes in the credit. Our ability to manage credit risk depends in large part on our ability to properly identify and manage problem loans.

To do so, we operate a credit risk rating system under which our credit management personnel assign a credit risk rating to each loan at the time of origination and review loans on a regular basis to determine each loan’s credit risk rating on a scale of 1 through 8, with higher scores indicating higher risk. The credit risk rating structure used is shown below.

In the context of the credit risk rating structure, the term Classified is defined as a problem loan which may or may not be in a nonaccrual status, dependent upon current payment status and collectability.

Strong (1)

Borrower is not vulnerable to sudden economic or technological changes. They have “strong” balance sheets and are within an industry that is very typical for our markets or type of lending culture. Borrowers also have “strong” financial and cash flow performance and excellent collateral (low loan to value or readily available to liquidate collateral) in conjunction with an impeccable repayment history.

Good (2)

Borrower shows limited vulnerability to sudden economic change. These borrowers have “above average” financial and cash flow performance and a very good repayment history. The balance sheet of the company is also very good as compared to peer and the company is in an industry that is familiar to our markets or our type of lending. The collateral securing the deal is also very good in terms of its type, loan to value, etc.

Average (3)

Borrower is typically a well-seasoned business, however may be susceptible to unfavorable changes in the economy, and could be somewhat affected by seasonal factors. The borrowers within this category exhibit financial and cash flow performance that appear “average” to “slightly above average” when compared to peer standards and they show an adequate payment history. Collateral securing this type of credit is good, exhibiting above average loan to values, etc.

Acceptable (4)

A borrower within this category exhibits financial and cash flow performance that appear adequate and satisfactory when compared to peer standards and they show a satisfactory payment history. The collateral securing the request is within supervisory limits and overall is acceptable. Borrowers rated acceptable could also be newer businesses that are typically susceptible to unfavorable changes in the economy, and more than likely could be affected by seasonal factors.

Special Mention (5)

The borrower may have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. Examples of this type of credit include a start-up company fully based on projections, a documentation issue that needs to be corrected or a general market condition that the borrower is working through to get corrected.

Substandard (6)

Substandard loans are classified assets exhibiting a number of well-defined weaknesses that jeopardize normal repayment. The assets are no longer adequately protected due to declining net worth, lack of earning capacity, or insufficient collateral offering the distinct possibility of the loss of a portion of the loan principal. Loans classified as substandard clearly represent troubled and deteriorating credit situations requiring constant supervision.

Doubtful (7)

Loans in this category exhibit the same, if not more pronounced weaknesses used to describe the substandard credit. Loans are frozen with collection improbable. Such loans are not yet rated as Charge-off because certain actions may yet occur which would salvage the loan.

Charge-off/Loss (8)

Loans in this category are largely uncollectible and should be charged against the loan loss reserve immediately.

General Reserves:

For loans with a credit risk rating of 5 or better and any loans with a risk rating of 6 or 7 with no specific reserve, reserves are established based on the type of loan collateral, if any, and the assigned credit risk rating. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience, and consideration of current environmental factors and economic trends, all of which may be susceptible to significant change.

Using a historical average loss by loan type as a base, each loan graded as higher risk is assigned a specific percentage. The residential real estate and consumer loan portfolios are assigned a loss percentage as a homogenous group. If, however, on an individual loan the projected loss based on collateral value and payment histories are in excess of the computed allowance, the allocation is increased for the higher anticipated loss. These computations provide the basis for the allowance for loan losses as recorded by the Corporation.

Commercial construction loans in the amount of $4.414 million and $2.409 million at December 31, 2016, and 2015, respectively did not receive a specific risk rating. These amounts represent loans made for land development and unimproved land purchases.

Below is a breakdown of loans by risk category as of December 31, 2016 (dollars in thousands):


							(4)
	(1)		(2)		(3)		Acceptable/		(5)		(6)		(7)		Rating
	Strong		Good		Average		Acceptable Watch		Sp. Mention		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	3,021	$	23,940	$	140,618	$	205,710	$	10,808	$	5,323	$	—	$	—	$	389,420
Commercial, financial and agricultural		10,421		13,434		49,434		65,097		2,485		1,777		—		—		142,648
Commercial construction		—		900		3,146		1,877		783		385		—		4,414		11,505
One-to-four family residential real estate		740		1,373		3,412		6,927		2,658		5,493		—		185,342		205,945
Consumer construction		28		—		—		—		—		17		—		12,181		12,226
Consumer		20		—		15		42		13		103		—		19,920		20,113

Total loans	$	14,230	$	39,647	$	196,625	$	279,653	$	16,747	$	13,098	$	—	$	221,857	$	781,857

Below is a breakdown of loans by risk category as of December 31, 2015 (dollars in thousands)


							(4)
	(1)		(2)		(3)		Acceptable/		(5)		(6)		(7)		Rating
	Strong		Good		Average		Acceptable Watch		Sp. Mention		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	2,072	$	26,197	$	113,868	$	164,954	$	—	$	5,714	$	—	$	—	$	312,805
Commercial, financial and agricultural		13,067		5,954		47,194		53,791		—		2,134		—		—		122,140
Commercial construction		—		400		3,869		8,257		—		395		—		2,409		15,330
One-to-four family residential real estate		591		1,222		3,172		4,078		—		4,093		—		127,346		140,502
Consumer construction		—		—		—		—		—		—		—		11,770		11,770
Consumer		24		—		19		—		—		61		—		15,743		15,847

Total loans	$	15,754	$	33,773	$	168,122	$	231,080	$	—	$	12,397	$	—	$	157,268	$	618,394

Impaired Loans

Nonperforming loans are those which are contractually past due 90 days or more as to interest or principal payments, on nonaccrual status, or loans, the terms of which have been renegotiated to provide a reduction or deferral on interest or principal.

Loans are considered impaired when, based on current information and events, it is probable the Corporation will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loans basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

The following is a summary of impaired loans and their effect on interest income (dollars in thousands):


											Interest Income
	Nonaccrual			Nonaccrual	Accrual		Average		Related		on
	Recorded Balance			Unpaid Balance	Basis		Investment		Valuation Reserve		Accrual Basis
December 31, 2016

With no valuation reserve:
Commercial real estate	$	1,426	$	1,891	$	3,234	$	5,318	$	—	$	232
Commercial, financial and agricultural		11		11		—		116		—		3
Commercial construction		—		—		—		—		—		—
One to four family residential real estate		1,623		2,198		2,792		4,500		—		196
Consumer construction		17		22		57		36		—		4
Consumer		82		86		4		127		—		2

With a valuation reserve:
Commercial real estate	$	306	$	328	$	—	$	103	$	50	$	—
Commercial, financial and agricultural		326		357		—		109		231		—
Commercial construction		—		—		—		—		—		—
One to four family residential real estate		333		333		—		171		94		—
Consumer construction		—		—		—		—		—		—
Consumer		—		—		—		5		5		—

Total:
Commercial real estate	$	1,732	$	2,219	$	3,234	$	5,421	$	50	$	232
Commercial, financial and agricultural		337		368		—		225		231		3
Commercial construction		—		—		—		—		—		—
One to four family residential real estate		1,956		2,531		2,792		4,671		94		196
Consumer construction		17		22		57		36		—		4
Consumer		82		86		4		132		5		2
Total	$	4,124	$	5,226	$	6,087	$	10,485	$	380	$	437

December 31, 2015

With no valuation reserve:
Commercial real estate	$	471	$	803	$	4,051	$	7,205	$	—	$	224
Commercial, financial and agricultural		—		—		1,778		4,849		—		9
Commercial construction		—		—		—		260		—		—
One to four family residential real estate		1,267		1,598		2,385		5,413		—		128
Consumer construction		20		22		2		99		—		—
Consumer		50		51		1		102		—		0

With a valuation reserve:
Commercial real estate	$	—	$	—	$	—	$	—	$	—	$	—
Commercial, financial and agricultural		460		1,139		—		699		192		—
Commercial construction		—		—		—		—		—		—
One to four family residential real estate		229		244		—		232		58		—
Consumer construction		—		—		—		—		—		—
Consumer		10		9		—		10		1		—

Total:
Commercial real estate	$	471	$	803	$	4,051	$	7,205	$	—	$	224
Commercial, financial and agricultural		460		1,139		1,778		5,548		192		9
Commercial construction		—		—		—		260		—		—
One to four family residential real estate		1,496		1,842		2,385		5,645		58		128
Consumer construction		20		22		2		99		—		—
Consumer		60		60		1		112		1		—
Total	$	2,507	$	3,866	$	8,217	$	18,869	$	251	$	361

A summary of past due loans at December 31, is as follows (dollars in thousands):


	2016						2015

	30-89 days		90+ days				30-89 days		90+ days
	Past Due		Past Due/				Past Due		Past Due/
	(accruing)		Nonaccrual		Total		(accruing)		Nonaccrual		Total

Commercial real estate	$	942	$	1,732	$	2,674	$	521	$	471	$	992
Commercial, financial and agricultural		186		337		523		222		460		682
Commercial construction		—		—		—		270		—		270
One to four family residential real estate		2,113		1,956		4,069		807		1,528		2,335
Consumer construction		—		17		17		—		20		20
Consumer		133		82		215		130		60		190

Total past due loans	$	3,374	$	4,124	$	7,498	$	1,950	$	2,539	$	4,489

Troubled Debt Restructuring

Troubled debt restructurings (“TDR”) are determined on a loan-by-loan basis. Generally, restructurings are related to interest rate reductions, loan term extensions and short term payment forbearance as means to maximize collectability of troubled credits. If a portion of the TDR loan is uncollectible (including forgiveness of principal), the uncollectible amount will be charged off against the allowance at the time of the restructuring. In general, a borrower must make at least six consecutive timely payments before the Corporation would consider a return of a restructured loan to accruing status in accordance with FDIC guidelines regarding restoration of credits to accrual status.

The Corporation has, in accordance with generally accepted accounting principles and per recently enacted accounting standard updates, evaluated all loan modifications to determine the fair value impact of the underlying asset. The carrying amount of the loan is compared to the expected payments to be received, discounted at the loan’s original rate, or for collateral dependent loans, to the fair value of the collateral.

There were no troubled debt restructurings that occurred during the years ended December 31 2016, and December 31, 2015.

Insider Loans

The Bank, in the ordinary course of business, grants loans to the Corporation’s executive officers and directors, including their families and firms in which they are principal owners. Activity in such loans is summarized below (dollars in thousands):




	2016		2015
Loans outstanding, January 1	$	6,887	$	8,789
New loans		2,510		0
Net activity on revolving lines of credit		2,119		778
Repayment		(2,321)		(2,680)

Loans outstanding at end of period	$	9,195	$	6,887

There were no loans to related-parties classified substandard as of December 31, 2016 and 2015. In addition to the outstanding balances above, there were unfunded commitments of $.592 million to related parties at December 31, 2016.