5.LOANS

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


	March 31,		December 31,
	2018		2017

Commercial real estate	$	411,526	$	406,742
Commercial, financial, and agricultural		160,188		156,951
Commercial construction		8,004		9,243
One to four family residential real estate		204,542		209,890
Consumer		16,919		17,434
Consumer construction		11,262		10,818

Total loans	$	812,441	$	811,078

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 2018, the Corporation had positive resolution of acquired impaired loans, which resulted in the recognition of approximately $50,000 of accretable interest. In the first three months of 2017, the Corporation had positive resolution of one PFC acquired impaired loan which resulted in the recognition of approximately $100,000 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, 2018 (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, 2017	$	149	$	—	$	149	$	218	$	603	$	821	$	38	$	281	$	319
Accretion		(30)		—		(30)		—		(150)		(150)		—		(54)		(54)
Reclassification from nonaccretable difference		23		—		23		—		—		—		—		—		—
Balance, March 31, 2018	$	142	$	—	$	142	$	218	$	453	$	671	$	38	$	227	$	265

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

Allowance for Loan Losses

An analysis of the allowance for loan losses for the three months ended March 31, 2018 and March 31, 2017 is as follows (dollars in thousands):


	March 31,		March 31,
	2018		2017

Balance, January 1	$	5,079	$	5,020
Recoveries on loans previously charged off		25		102
Loans charged off		(53)		(126)
Provision		50		150

Balance at end of period	$	5,101	$	5,146

In the first three months of 2018, net charge-offs were $28,000, compared to net charge-offs of $24,000 in the same period in 2017. In the first three months of 2018, the Corporation recorded a provision for loan loss of $50,000 compared to a $.150 million provision for loan losses in the first three months of 2017. 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, 2018 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	$	1,650	$	576	$	54	$	160	$	6	$	10	$	2,623	$	5,079
Charge-offs		—		—		—		(47)		—		(6)		—		(53)
Recoveries		7		3		1		2		—		12		—		25
Provision		676		965		371		58		—		(7)		(2,013)		50
Ending balance ALLR	$	2,333	$	1,544	$	426	$	173	$	6	$	9	$	610	$	5,101

Loans:
Ending balance	$	411,526	$	160,188	$	8,004	$	204,542	$	11,262	$	16,919	$	—	$	812,441
Ending balance ALLR		(2,333)		(1,544)		(426)		(173)		(6)		(9)		(610)		(5,101)
Net loans	$	409,193	$	158,644	$	7,578	$	204,369	$	11,256	$	16,910	$	(610)	$	807,340

Ending balance ALLR:
Individually evaluated	$	362	$	310	$	—	$	—	$	—	$	—	$	—	$	672
Collectively evaluated		1,971		1,234		426		173		6		9		610		4,429
Total	$	2,333	$	1,544	$	426	$	173	$	6	$	9	$	610	$	5,101

Ending balance Loans:
Individually evaluated	$	1,568	$	1,307	$	372	$	—	$	—	$	—	$	—	$	3,247
Collectively evaluated		408,273		158,881		7,632		203,032		11,215		16,919		—		805,952
Acquired with deteriorated credit quality		1,685		—		—		1,510		47		—		—		3,242
Total	$	411,526	$	160,188	$	8,004	$	204,542	$	11,262	$	16,919	$	—	$	812,441

Impaired loans, by definition, are individually evaluated.

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

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 (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.

Acceptable Watch (44)

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. Acceptable Watch 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 44 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 is 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, 2018 (dollars in thousands):


	(1)		(2)		(3)		(4)		(44)		(6)		(7)		Rating
	Strong		Good		Average		Acceptable		Acceptable Watch		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	4,004	$	23,121	$	160,116	$	211,764	$	8,514	$	4,007	$	—	$	—	$	411,526
Commercial, financial and agricultural		11,622		12,264		52,168		80,536		2,228		1,370		—		—		160,188
Commercial construction		—		289		2,531		1,299		642		372		—		2,871		8,004
One-to-four family residential real estate		—		1,440		2,461		5,874		1,199		2,992		—		190,576		204,542
Consumer construction		—		—		—		—		—		13		—		11,249		11,262
Consumer		—		—		—		26		4		78		—		16,811		16,919

Total loans	$	15,626	$	37,114	$	217,276	$	299,499	$	12,587	$	8,832	$	—	$	221,507	$	812,441

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


	(1)		(2)		(3)		(4)		(44)		(6)		(7)		Rating
	Strong		Good		Average		Acceptable		Acceptable Watch		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	2,775	$	23,929	$	159,385	$	207,921	$	8,700	$	4,032	$	—	$	—	$	406,742
Commercial, financial and agricultural		11,528		8,980		53,448		77,964		3,658		1,373		—		—		156,951
Commercial construction		—		308		2,749		1,310		648		374		—		3,854		9,243
One-to-four family residential real estate		—		1,377		2,575		5,449		1,212		3,515		—		195,762		209,890
Consumer construction		—		—		—		—		—		14		—		10,804		10,818
Consumer		—		—		—		28		5		96		—		17,305		17,434

Total loans	$	14,303	$	34,594	$	218,157	$	292,672	$	14,223	$	9,404	$	—	$	227,725	$	811,078

Impaired Loans

Impaired 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 loan 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):


	Impaired Loans		Impaired Loans		Total		Unpaid		Related
	with No Related		with Related		Impaired		Principal		Allowance for
	Allowance		Allowance		Loans		Balance		Loan Losses
March 31, 2018

Commercial real estate	$	1,685	$	1,568	$	3,253	$	2,512	$	362
Commercial, financial and agricultural		—		1,307		1,307		1,307		310
Commercial construction		—		372		372		372		—
One to four family residential real estate		1,510		—		1,510		2,200		—
Consumer construction		47		—		47		62		—
Consumer		—		—		—		—		—
Total	$	3,242	$	3,247	$	6,489	$	6,453	$	672

December 31, 2017
Commercial real estate	$	1,511	$	516	$	2,027	$	3,326	$	168
Commercial, financial and agricultural		—		166		166		326		166
Commercial construction		—		—		—		—		—
One to four family residential real estate		1,621		—		1,621		2,315		—
Consumer construction		17		—		17		66		—
Consumer		21		—		21		21		—
Total	$	3,170	$	682	$	3,852	$	6,054	$	334

	Individually Evaluated Impaired Loans
	March 31, 2018				December 31, 2017
	Average		Interest Income		Average		Interest Income
	Balance for		Recognized for		Balance for		Recognized for
	the Period		the Period		the Period		the Period
Commercial real estate	$	2,919	$	56	$	2,784	$	141
Commercial, financial and agricultural		817		7		246		1
Commercial construction		186		—		—		3
One to four family residential real estate		2,257		30		2,057		134
Consumer construction		64		1		37		—
Consumer		11		—		13		2
Total	$	6,254	$	94	$	5,137	$	281

A summary of past due loans at March 31, 2018 and December 31, 2017 is as follows (dollars in thousands):


	March 31,								December 31,
	2018								2017

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

Commercial real estate	$	664	$	—	$	1,823	$	2,487	$	460	$	—	$	866	$	1,326
Commercial, financial and agricultural		—		—		247		247		16		—		338		354
Commercial construction		—		—		13		13		73		—		14		87
One to four family residential real estate		2,387		—		2,181		4,568		3,424		—		1,350		4,774
Consumer construction		—		—		—		—		—		—		—		—
Consumer		17		—		78		95		72		—		—		72

Total past due loans	$	3,068	$	—	$	4,342	$	7,410	$	4,045	$	—	$	2,568	$	6,613

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 applicable 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, 2018 or March 31, 2017.

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,
	2018		2017
Loans outstanding, January 1	$	10,037	$	9,195
Net activity on revolving lines of credit		—		500
Repayment		(123)		(313)

Loans outstanding at end of period	$	9,914	$	9,382

There were no loans to related parties classified substandard as of March 31, 2018 or March 31, 2017. In addition to the outstanding balances above, there were unfunded commitments of $.605 million to related parties at March 31, 2018.