5.LOANS

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


	September 30,		December 31,
	2019		2018

Commercial real estate	$	508,332	$	496,207
Commercial, financial, and agricultural		209,872		191,060
Commercial construction		34,511		29,765
One to four family residential real estate		268,333		286,908
Consumer		20,214		20,371
Consumer construction		18,680		14,553

Total loans	$	1,059,942	$	1,038,864

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, First Federal of Northern Michigan Bancorp (“FFNM”) on May 18, 2018 and Lincoln Community Bank (“Lincoln”) on October 1, 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, the FFNM acquired impaired loans totaled $5.440 million, and the Lincoln acquired impaired loans totaled $1.901 million.

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


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	1,901	$	37,700	$	39,601
Nonaccretable difference		(546)		—		(546)
Expected cash flows		1,355		37,700		39,055
Accretable yield		(561)		(493)		(1,054)
Carrying balance at acquisition date	$	794	$	37,207	$	38,001

The table below presents a rollforward of the accretable yield on acquired loans for the nine months ended September 30, 2019 (dollars in thousands):


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

Balance, December 31, 2018	$	128	$	—	$	128	$	213	$	16	$	229
Accretion		(81)		—		(81)		(17)		(16)		(33)
Reclassification from nonaccretable difference		60		—		60		13		—		13
Balance, September 30, 2019	$	107	$	—	$	107	$	209	$	—	$	209

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

Balance, December 31, 2018	$	26	$	69	$	95	$	571	$	3,446	$	4,017
Accretion		(14)		(69)		(83)		(145)		(1,157)		(1,302)
Reclassification from nonaccretable difference		11		—		11		109		—		109
Balance, September 30, 2019	$	23	$	—	$	23	$	535	$	2,289	$	2,824

	Lincoln Community Bank						Total
	Acquired		Acquired		Acquired		Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total		Impaired		Non-impaired		Total

Balance, December 31, 2018	$	140	$	442	$	582	$	1,078	$	3,973	$	5,051
Accretion		(109)		(138)		(247)		(366)		(1,380)		(1,746)
Reclassification from nonaccretable difference		82		—		82		275		—		275
Balance, September 30, 2019	$	113	$	304	$	417	$	987	$	2,593	$	3,580

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						Total
	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	$	38	$	281	$	319	$	—	$	—	$	—	$	405	$	884	$	1,289
Acquisition		—		—		—		700		4,498		5,198		700		4,498		5,198
Accretion		(22)		(160)		(182)		(151)		(617)		(768)		(281)		(1,220)		(1,501)
Reclassification from nonaccretable difference		10		—		10		88		—		88		180		—		180
Balance, September 30, 2018	$	26	$	121	$	147	$	637	$	3,881	$	4,518	$	1,004	$	4,162	$	5,166

Allowance for Loan Losses

An analysis of the allowance for loan losses for the nine months ended September 30, 2019 and September 30, 2018 is as follows (dollars in thousands):


	September 30,		September 30,
	2019		2018

Balance, January 1	$	5,183	$	5,079
Recoveries on loans previously charged off		199		290
Loans charged off		(424)		(383)
Provision		350		200

Balance at end of period	$	5,308	$	5,186

In the first nine months of 2019, net charge-offs were $225,000, compared to net charge-offs of $93,000 in the same period in 2018. In the first nine months of 2019, the Corporation recorded a provision for loan loss of $350,000 compared to a $200,000 provision for loan losses in the first nine months of 2018. 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, 2019 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, 2019
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,208	$	861	$	77	$	228	$	5	$	10	$	2,917	$	5,306
Charge-offs		(7)		—		—		(19)		—		(52)		—		(78)
Recoveries		17		—		1		2		—		10		—		30
Provision		(6)		326		—		(29)		6		207		(454)		50
Ending balance ALLR	$	1,212	$	1,187	$	78	$	182	$	11	$	175	$	2,463	$	5,308

Nine Months Ended September 30, 2019
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,682	$	648	$	101	$	199	$	6	$	8	$	2,539	$	5,183
Charge-offs		(27)		(103)		—		(139)		—		(155)		—		(424)
Recoveries		151		4		2		13		—		29		—		199
Provision		(594)		638		(25)		109		5		293		(76)		350
Ending balance ALLR	$	1,212	$	1,187	$	78	$	182	$	11	$	175	$	2,463	$	5,308

At September 30, 2019
Loans:
Ending balance	$	508,332	$	209,872	$	34,511	$	268,333	$	18,680	$	20,214	$	—	$	1,059,942
Ending balance ALLR		(1,212)		(1,187)		(78)		(182)		(11)		(175)		(2,463)		(5,308)
Net loans	$	507,120	$	208,685	$	34,433	$	268,151	$	18,669	$	20,039	$	(2,463)	$	1,054,634

Ending balance ALLR:
Individually evaluated	$	490	$	773	$	—	$	—	$	—	$	—	$	—	$	1,263
Collectively evaluated		722		414		78		182		11		175		2,463		4,045
Total	$	1,212	$	1,187	$	78	$	182	$	11	$	175	$	2,463	$	5,308

Ending balance Loans:
Individually evaluated	$	2,474	$	3,642	$	361	$	—	$	—	$	—	$	—	$	6,477
Collectively evaluated		503,669		204,023		33,773		267,342		18,680		20,185		—		1,047,672
Acquired with deteriorated credit quality		2,189		2,207		377		991		—		29		—		5,793
Total	$	508,332	$	209,872	$	34,511	$	268,333	$	18,680	$	20,214	$	—	$	1,059,942

Impaired loans, by definition, are individually evaluated.

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

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, 2019 (dollars in thousands):


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

Commercial real estate	$	9,143	$	18,231	$	213,506	$	257,222	$	4,728	$	5,502	$	—	$	—	$	508,332
Commercial, financial and agricultural		11,595		9,445		69,891		113,790		696		4,455		—		—		209,872
Commercial construction		—		397		7,792		22,363		402		712		—		2,845		34,511
One-to-four family residential real estate		40		1,822		3,894		13,858		851		2,953		—		244,915		268,333
Consumer construction		—		—		—		—		99		—		—		18,581		18,680
Consumer		1		172		289		715		—		65		—		18,972		20,214

Total loans	$	20,779	$	30,067	$	295,372	$	407,948	$	6,776	$	13,687	$	—	$	285,313	$	1,059,942

Below is a breakdown of loans by risk category as of December 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	$	9,564	$	22,265	$	189,898	$	257,627	$	5,993	$	10,860	$	—	$	—	$	496,207
Commercial, financial and agricultural		8,077		8,678		72,466		97,441		2,269		2,129		—		—		191,060
Commercial construction		734		706		6,844		12,244		829		823		—		7,585		29,765
One-to-four family residential real estate		70		2,873		6,941		15,711		2,095		4,757		—		254,461		286,908
Consumer construction		—		—		—		200		50		11		—		14,292		14,553
Consumer		19		236		625		1,156		42		77		—		18,216		20,371

Total loans	$	18,464	$	34,758	$	276,774	$	384,379	$	11,278	$	18,657	$	—	$	294,554	$	1,038,864

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, 2019

Commercial real estate	$	2,189	$	2,474	$	4,663	$	8,903	$	490
Commercial, financial and agricultural		2,207		3,642		5,849		3,819		773
Commercial construction		377		361		738		374		—
One to four family residential real estate		991		—		991		3,085		—
Consumer construction		—		—		—		—		—
Consumer		29		—		29		40		—
Total	$	5,793	$	6,477	$	12,270	$	16,221	$	1,263

December 31, 2018
Commercial real estate	$	2,777	$	2,148	$	4,925	$	10,740	$	486
Commercial, financial and agricultural		1,460		577		2,037		2,249		340
Commercial construction		366		—		366		1,132		—
One to four family residential real estate		1,231		—		1,231		4,136		—
Consumer construction		217		—		217		—		—
Consumer		42		—		42		55		—
Total	$	6,093	$	2,725	$	8,818	$	18,312	$	826


	Individually Evaluated Impaired Loans
	September 30, 2019				December 31, 2018
	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	$	7,225	$	224	$	5,024	$	410
Commercial, financial and agricultural		379		1		374		26
Commercial construction		390		—		383		13
One to four family residential real estate		3,611		198		2,879		203
Consumer construction		—		—		9		—
Consumer		47		1		38		4
Total	$	11,652	$	424	$	8,707	$	656


	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, 2019 and December 31, 2018 is as follows (dollars in thousands):


	September 30,								December 31,
	2019								2018
	30-89 days		90+ days						30-89 days		90+ days
	Past Due		Past Due						Past Due		Past Due
	(accruing)		(accruing)		Nonaccrual		Total		(accruing)		(accruing)		Nonaccrual		Total

Commercial real estate	$	444	$	—	$	761	$	1,205	$	298	$	—	$	1,700	$	1,998
Commercial, financial and agricultural		273		—		714		987		398		—		320		718
Commercial construction		255		—		205		460		112		—		266		378
One to four family residential real estate		3,338		11		3,090		6,439		5,456		18		2,725		8,199
Consumer construction		—		—		—		—		—		—		—		—
Consumer		73		—		74		147		108		5		43		156

Total past due loans	$	4,383	$	11	$	4,844	$	9,238	$	6,372	$	23	$	5,054	$	11,449

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 a 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 four TDR’s that occurred during the nine months ended September 30, 2019 and 1 TDR during the nine months ended September 30, 2018. The four restructured loans included only modifications to the repayment schedules. The balance of these restructured loans pre-modification was $1.983 million. Post-modification balances as of September 30, 2019 were $1.955 million.

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,
	2019		2018
Loans outstanding, January 1	$	9,817	$	10,037
New loans		1,872		669
Net activity on revolving lines of credit		954		(375)
Change in status of insiders		(285)		—
Repayment		(673)		(153)
Loans outstanding at end of period	$	11,685	$	10,178

There were no loans to related parties classified substandard as of September 30, 2019 or September 30, 2018. In addition to the outstanding balances above, there were unfunded commitments of $.252 million to related parties at September 30, 2019.