5.LOANS

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


	March 31,		December 31,
	2017		2016

Commercial real estate	$	397,192	$	389,420
Commercial, financial, and agricultural		144,673		142,648
Commercial construction		10,618		11,505
One to four family residential real estate		202,654		205,945
Consumer		19,021		20,113
Consumer construction		12,388		12,226

Total loans	$	786,546	$	781,857

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 the first three months of 2017, the Corporation had positive resolution of acquired nonperforming loans, which resulted in the recognition of $100,000 of accretable interest. In the first three months of 2016, the Corporation had positive resolution of one PFC acquired nonperforming loan which resulted in the recognition of approximately $96,000 of accretable interest.

The table below details the outstanding balances of the PFC acquired portfolio and the 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 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 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 the three months ended March 31, 2017 (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, 2016	$	282	$	642	$	924	$	236	$	1,221	$	1,457	$	52	$	505	$	557
Accretion		(100)		(175)		(275)		—		(179)		(179)		—		(72)		(72)
Reclassification from nonaccretable difference		57		—		57		—		—		—		(8)		—		(8)
Balance, March 31, 2017	$	239	$	467	$	706	$	236	$	1,042	$	1,278	$	44	$	433	$	477

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


	PFC
	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total

Balance, December 31, 2015	$	426	$	1,342	$	1,768
Accretion		—		(175)		(175)
Reclassification from nonaccretable difference		(17)		—		(17)
Balance, March 31, 2016	$	409	$	1,167	$	1,576

Allowance for Loan Losses

An analysis of the allowance for loan losses for the three months ended March 31, 2017 and the year ended December 31, 2016 is as follows (dollars in thousands):


	March 31,		March 31,
	2017		2016

Balance, January 1	$	5,020	$	5,004
Recoveries on loans previously charged off		102		56
Loans charged off		(126)		(236)
Provision		150		0

Balance at end of period	$	5,146	$	4,824

In the first three months of 2017, net charge-offs were $24,000, compared to net charge-offs of $.180 million in the same period in 2016. In the first three months of 2017, the Corporation recorded a provision for loan loss of $.150 million compared to no provision in the first three months of 2016. The Corporation’s allowance for loan loss reserve policy calls for a measurement of the adequacy of the reserve at each quarter end. This process includes an analysis of the loan portfolio to take into account increases in loans outstanding and portfolio composition, historical loss rates, and specific reserve requirements of nonperforming loans.

A breakdown of the allowance for loan losses and recorded balances in loans at March 31, 2017 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	$	1,345	$	614	$	57	$	296	$	6	$	90	$	2,612	$	5,020
Charge-offs		—		—		—		(49)		—		(77)		—		(126)
Recoveries		34		1		—		61		—		6		—		102
Provision		(19)		35		38		(43)		1		(4)		142		150
Ending balance ALLR	$	1,360	$	650	$	95	$	265	$	7	$	15	$	2,754	$	5,146

Loans:
Ending balance	$	397,192	$	144,673	$	10,618	$	202,654	$	12,388	$	19,021	$	—	$	786,546
Ending balance ALLR		(1,360)		(650)		(95)		(265)		(7)		(15)		(2,754)		(5,146)
Net loans	$	395,832	$	144,023	$	10,523	$	202,389	$	12,381	$	19,006	$	(2,754)	$	781,400

Ending balance ALLR:
Individually evaluated	$	525	$	394	$	38	$	3	$	—	$	5	$	—	$	965
Collectively evaluated		835		256		57		262		7		10		2,754		4,181
Total	$	1,360	$	650	$	95	$	265	$	7	$	15	$	2,754	$	5,146

Ending balance Loans:
Individually evaluated	$	1,564	$	1,464	$	382	$	403	$	—	$	22	$	—	$	3,835
Collectively evaluated		392,409		143,209		8,228		202,196		12,388		18,996		—		777,426
Acquired with deteriorated credit quality		3,219		—		2,008		55		—		3		—		5,285
Total	$	397,192	$	144,673	$	10,618	$	202,654	$	12,388	$	19,021	$	—	$	786,546

Impaired loans, by definition, are individually evaluated.

A breakdown of the allowance for loan losses and recorded balances in loans at March 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		—		(185)		—		(39)		—		(12)		—		(236)
Recoveries		7		31		7		1		—		10		—		56
Provision		(3)		89		(12)		21		—		(22)		(73)		—
Ending balance ALLR	$	1,615	$	580	$	74	$	257	$	7	$	40	$	2,251	$	4,824

Loans:
Ending balance	$	317,081	$	124,005	$	14,489	$	135,641	$	11,959	$	15,450	$	—	$	618,625
Ending balance ALLR		(1,615)		(580)		(74)		(257)		(7)		(40)		(2,251)		(4,824)
Net loans	$	315,466	$	123,425	$	14,415	$	135,384	$	11,952	$	15,410	$	(2,251)	$	613,801

Ending balance ALLR:
Individually evaluated	$	533	$	185	$	—	$	45	$	—	$	31	$	—	$	794
Collectively evaluated		1,082		395		74		212		7		9		2,251		4,030
Total	$	1,615	$	580	$	74	$	257	$	7	$	40	$	2,251	$	4,824

Ending balance Loans:
Individually evaluated	$	2,001	$	392	$	—	$	750	$	—	$	36	$	—	$	3,179
Collectively evaluated		310,709		123,436		14,489		132,242		11,957		15,413		—		608,246
Acquired with deteriorated credit quality		4,371		177		—		2,649		2		1		—		7,200
Total	$	317,081	$	124,005	$	14,489	$	135,641	$	11,959	$	15,450	$	—	$	618,625

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, and other relevant characteristics.

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, and other relevant characteristics.

Acceptable/Acceptable Watch (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 not considered impaired, 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.

Below is a breakdown of loans by risk category as of March 31, 2017 (dollars in thousands):


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

Commercial real estate	$	3,309	$	24,533	$	149,448	$	204,557	$	10,582	$	4,763	$	—	$	—	$	397,192
Commercial, financial and agricultural		10,616		13,463		48,226		68,018		2,463		1,887		—		—		144,673
Commercial construction		—		875		3,163		1,961		756		382		—		3,481		10,618
One-to-four family residential real estate		825		1,367		3,190		7,128		2,798		4,165		—		183,181		202,654
Consumer construction		28		—		—		—		—		16		—		12,344		12,388
Consumer		15		—		14		39		12		59		—		18,882		19,021

Total loans	$	14,793	$	40,238	$	204,041	$	281,703	$	16,611	$	11,272	$	—	$	217,888	$	786,546

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		Special Mention		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	3,021	$	23,940	$	140,618	$	216,518	$		$	5,323	$	—	$	—	$	389,420
Commercial, financial and agricultural		10,421		13,434		49,434		67,582				1,777		—		—		142,648
Commercial construction		—		900		3,146		2,660				385		—		4,414		11,505
One-to-four family residential real estate		740		1,373		3,412		9,585				5,493		—		185,342		205,945
Consumer construction		28		—		—		—		—		17		—		12,181		12,226
Consumer		20		—		15		55				103		—		19,920		20,113

Total loans	$	14,230	$	39,647	$	196,625	$	296,400	$	—	$	13,098	$	—	$	221,857	$	781,857

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):


							QTD				Interest Income
	Nonaccrual			Nonaccrual	Accrual		Average		Related		on
	Recorded Balance			Unpaid Balance	Basis		Investment		Valuation Reserve		Accrual Basis
March 31, 2017

With no valuation reserve:
Commercial real estate	$	1,391	$	1,834	$	2,097	$	4,086	$	—	$	121
Commercial, financial and agricultural		9		9		—		9		—		—
Commercial construction		—		—		—		—		—		—
One to four family residential real estate		1,253		1,607		1,903		3,981		—		104
Consumer construction		16		21		55		73		—		1
Consumer		15		19		3		52		—		—

With a valuation reserve:
Commercial real estate	$	301	$	310	$	—	$	302	$	50	$	—
Commercial, financial and agricultural		335		335		—		327		261		—
Commercial construction		—		—		—		—		—		—
One to four family residential real estate		386		387		—		235		27		—
Consumer construction		—		—		—		—		—		—
Consumer		24		24		—		12		11		—

Total:
Commercial real estate	$	1,692	$	2,144	$	2,097	$	4,388	$	50	$	121
Commercial, financial and agricultural		344		344		—		336		261		—
Commercial construction		—		—		—		—		—		—
One to four family residential real estate		1,639		1,994		1,903		4,216		27		104
Consumer construction		16		21		55		73		—		1
Consumer		39		43		3		64		11		—
Total	$	3,730	$	4,546	$	4,058	$	9,077	$	349	$	226

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		0		0		—		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

A summary of past due loans at March 31, 2017 and December 31, 2016 is as follows (dollars in thousands):


	March 31,						December 31,
	2017						2016
	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	$	822	$	1,692	$	2,514	$	942	$	1,732	$	2,674
Commercial, financial and agricultural		150		344		494		186		337		523
Commercial construction		—		—		—		—		—		—
One to four family residential real estate		2,206		1,639		3,845		2,113		1,956		4,069
Consumer construction		52		16		68		—		17		17
Consumer		71		39		110		133		82		215

Total past due loans	$	3,301	$	3,730	$	7,031	$	3,374	$	4,124	$	7,498

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 three months ended March 31, 2017 or March 31, 2016.

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):


	Three Months Ended		Three Months Ended
	March 31,		March 31,
	2017		2016
Loans outstanding, January 1	$	9,195	$	6,887
New loans		—		—
Net activity on revolving lines of credit		500		510
Repayment		(313)		(2,034)

Loans outstanding at end of period	$	9,382	$	5,363

There were no loans to related parties classified substandard as of March 31 2017 or March 31, 2016. In addition to the outstanding balances above, there were unfunded commitments of $91,000 to related parties at March 31, 2017.