5.LOANS

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


	September 30,		December 31,
	2018		2017

Commercial real estate	$	475,978	$	406,742
Commercial, financial, and agricultural		180,661		156,951
Commercial construction		23,812		9,243
One to four family residential real estate		277,508		209,890
Consumer		18,347		17,434
Consumer construction		17,502		10,818

Total loans	$	993,808	$	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, Niagara Bancorporation (“Niagara”) on August 31, 2016 and First Federal of Northern Michigan Bancorp (“FFNM”) on May 18, 2018. The PFC acquired impaired loans totaled $13.290 million, the Eagle River acquired impaired loans totaled $3.401 million, the Niagara acquired impaired loans totaled $2.105 million, and the FFNM acquired impaired loans totaled $5.440 million. In the first nine months of 2018, the Corporation had positive resolution of acquired impaired loans, which resulted in the recognition of approximately $.281 million of accretable interest. In the first nine months of 2017, the Corporation had positive resolution of one PFC acquired impaired loan which resulted in the recognition of approximately $.370 million 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 details the outstanding balances of the FFNM acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	5,440	$	187,302	$	192,742
Nonaccretable difference		(2,100)		—		(2,100)
Expected cash flows		3,340		187,302		190,642
Accretable yield		(700)		(4,498)		(5,198)
Carrying balance at acquisition date	$	2,640	$	182,804	$	185,444

The table below presents a rollforward of the accretable yield on acquired loans for the nine months ended September 30, 2018 (dollars in thousands):


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

Balance, December 31, 2017	$	149	$	—	$	149	$	218	$	603	$	821
Accretion		(86)		—		(86)		(22)		(443)		(465)
Reclassification from nonaccretable difference		65		—		65		17		—		17
Balance, September 30, 2018	$	128	$	—	$	128	$	213	$	160	$	373

	Niagara						First Federal Northern Michigan
	Acquired		Acquired		Acquired		Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total		Impaired		Non-impaired		Total

Balance, December 31, 2017	$	38	$	281	$	319	$	—	$	—	$	—
Acquisition activity		—		—		—		700		4,498		5,198
Accretion		(22)		(160)		(182)		(151)		(617)		(768)
Reclassification from nonaccretable difference		10		—		10		88		—		88
Balance, September 30, 2018	$	26	$	121	$	147	$	637	$	3,881	$	4,518

The table below presents a rollforward of the accretable yield on acquired loans for the nine months ended September 30, 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		(310)		(525)		(835)		(50)		(466)		(516)		(10)		(169)		(179)
Reclassification from nonaccretable difference		215		—		215		37		—		37		(1)		—		(1)
Balance, September 30, 2017	$	187	$	117	$	304	$	223	$	755	$	978	$	41	$	336	$	377

Allowance for Loan Losses

An analysis of the allowance for loan losses for the nine months ended September 30, 2018 and September 30, 2017 is as follows (dollars in thousands):


	September 30,		September 30,
	2018		2017

Balance, January 1	$	5,079	$	5,020
Recoveries on loans previously charged off		290		215
Loans charged off		(383)		(505)
Provision		200		400

Balance at end of period	$	5,186	$	5,130

In the first nine months of 2018, net charge-offs were $93,000, compared to net charge-offs of $290,000 in the same period in 2017. In the first nine months of 2018, the Corporation recorded a provision for loan loss of $.200 million compared to a $.400 million provision for loan losses in the first nine 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 September 30, 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
Three Months Ended September 30, 2018
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,468	$	495	$	53	$	280	$	7	$	9	$	2,829	$	5,141
Charge-offs		—		—		—		(6)		—		(25)		—		(31)
Recoveries		11		3		1		8		—		3		—		26
Provision		196		6		51		(87)		—		21		(137)		50
Ending balance ALLR	$	1,675	$	504	$	105	$	195	$	7	$	8	$	2,692	$	5,186

Nine Months Ended September 30, 2018
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,650	$	576	$	54	$	160	$	6	$	10	$	2,623	$	5,079
Charge-offs		(1)		(128)		—		(153)		—		(101)		—		(383)
Recoveries		41		162		2		60		—		25		—		290
Provision		(15)		(106)		49		128		1		74		69		200
Ending balance ALLR	$	1,675	$	504	$	105	$	195	$	7	$	8	$	2,692	$	5,186

At September 30, 2018
Loans:
Ending balance	$	475,978	$	180,661	$	23,812	$	277,508	$	17,502	$	18,347	$	—	$	993,808
Ending balance ALLR		(1,675)		(504)		(105)		(195)		(7)		(8)		(2,692)		(5,186)
Net loans	$	474,303	$	180,157	$	23,707	$	277,313	$	17,495	$	18,339	$	(2,692)	$	988,622

Ending balance ALLR:
Individually evaluated	$	618	$	259	$	—	$	—	$	—	$	—	$	—	$	877
Collectively evaluated		1,057		245		105		195		7		8		2,692		4,309
Total	$	1,675	$	504	$	105	$	195	$	7	$	8	$	2,692	$	5,186

Ending balance Loans:
Individually evaluated	$	2,148	$	212	$	—	$	—	$	—	$	—	$	—	$	2,360
Collectively evaluated		468,132		179,292		23,443		276,132		17,502		18,292		—		982,793
Acquired with deteriorated credit quality		5,698		1,157		369		1,376		—		55		—		8,655
Total	$	475,978	$	180,661	$	23,812	$	277,508	$	17,502	$	18,347	$	—	$	993,808

Impaired loans, by definition, are individually evaluated.

A breakdown of the allowance for loan losses and recorded balances in loans at September 30, 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
Three Months Ended September 30, 2017
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,463	$	695	$	95	$	259	$	6	$	15	$	2,600	$	5,133
Charge-offs		—		(171)		—		(27)		—		(52)		—		(250)
Recoveries		10		31		1		1		—		4		—		47
Provision		25		187		3		4		—		59		(78)		200
Ending balance ALLR	$	1,498	$	742	$	99	$	237	$	6	$	26	$	2,522	$	5,130

Nine Months Ended September 30, 2017
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,345	$	614	$	57	$	296	$	6	$	90	$	2,612	$	5,020
Charge-offs		—		(264)		—		(76)		—		(165)		—		(505)
Recoveries		72		35		2		63		—		43		—		215
Provision		81		357		40		(46)		—		58		(90)		400
Ending balance ALLR	$	1,498	$	742	$	99	$	237	$	6	$	26	$	2,522	$	5,130

At September 30, 2017
Loans:
Ending balance	$	409,269	$	154,638	$	8,892	$	204,419	$	12,684	$	18,247	$	—	$	808,149
Ending balance ALLR		(1,498)		(742)		(99)		(237)		(6)		(26)		(2,522)		(5,130)
Net loans	$	407,771	$	153,896	$	8,793	$	204,182	$	12,678	$	18,221	$	(2,522)	$	803,019

Ending balance ALLR:
Individually evaluated	$	571	$	331	$	38	$	19	$	—	$	17	$	—	$	976
Collectively evaluated		927		411		61		218		6		9		2,522		4,154
Total	$	1,498	$	742	$	99	$	237	$	6	$	26	$	2,522	$	5,130

Ending balance Loans:
Individually evaluated	$	1,801	$	1,283	$	377	$	525	$	—	$	46	$	—	$	4,032
Collectively evaluated		405,610		153,355		8,515		202,281		12,633		18,201		—		800,595
Acquired with deteriorated credit quality		1,858		—		—		1,613		51		—		—		3,522
Total	$	409,269	$	154,638	$	8,892	$	204,419	$	12,684	$	18,247	$	—	$	808,149

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 September 30, 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	$	11,708	$	21,277	$	189,357	$	236,783	$	7,988	$	8,865	$	—	$	—	$	475,978
Commercial, financial and agricultural		9,085		7,504		65,964		94,178		2,221		1,709		—		—		180,661
Commercial construction		669		265		5,116		8,750		960		833		—		7,219		23,812
One-to-four family residential real estate		—		1,489		3,842		9,507		1,317		4,343		—		257,010		277,508
Consumer construction		—		—		—		—		—		11		—		17,491		17,502
Consumer		—		—		—		72		3		17		—		18,255		18,347

Total loans	$	21,462	$	30,535	$	264,279	$	349,290	$	12,489	$	15,778	$	—	$	299,975	$	993,808

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
September 30, 2018

Commercial real estate	$	5,698	$	2,148	$	7,846	$	9,568	$	618
Commercial, financial and agricultural		1,157		212		1,369		1,790		259
Commercial construction		369		—		369		473		—
One to four family residential real estate		1,376		—		1,376		1,966		—
Consumer construction		—		—		—		—		—
Consumer		55		—		55		56		—
Total	$	8,655	$	2,360	$	11,015	$	13,853	$	877

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
	September 30, 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	$	4,937	$	265	$	2,784	$	141
Commercial, financial and agricultural		768		2		246		1
Commercial construction		185		—		—		3
One to four family residential real estate		1,499		100		2,057		134
Consumer construction		9		3		37		—
Consumer		38		1		13		2
Total	$	7,436	$	371	$	5,137	$	281

A summary of past due loans at September 30, 2018 and December 31, 2017 is as follows (dollars in thousands):


	September 30,								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	$	688	$	—	$	1,623	$	2,311	$	460	$	—	$	866	$	1,326
Commercial, financial and agricultural		492		—		333		825		16		—		338		354
Commercial construction		48		—		269		317		73		—		14		87
One to four family residential real estate		4,448		—		2,282		6,730		3,424		—		1,350		4,774
Consumer construction		—		—		—		—		—		—		—		—
Consumer		147		—		19		166		72		—		—		72

Total past due loans	$	5,823	$	—	$	4,526	$	10,349	$	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 was one troubled debt restructuring that occurred during the nine months ended September 30, 2018 and no troubled debt restructurings during the nine months ended September 30, 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):


	Nine Months Ended		Nine Months Ended
	September 30,		September 30,
	2018		2017
Loans outstanding, January 1	$	10,037	$	9,195
New loans		669		—
Net activity on revolving lines of credit		(375)		554
Repayment		(153)		(476)

Loans outstanding at end of period	$	10,178	$	9,273

There were no loans to related parties classified substandard as of September 30, 2018 or September 30, 2017. In addition to the outstanding balances above, there were unfunded commitments of $.866 million to related parties at September 30, 2018.