NOTE

LOANS

Outstanding loan balances consist of the following at

December 31, 2019,

and

December 31, 2018.

(Amounts in thousands)	As of December 31
Loan Portfolio	2019			2018
Commercial	$	141,197		$	135,543
Commercial real estate:
Real estate – construction and land development		26,830			22,563
Real estate – commercial non-owner occupied		493,920			433,708
Real estate – commercial owner occupied		218,833			204,622
Residential real estate:
Real estate – residential - Individual Tax Identification Number ("ITIN")		33,039			37,446
Real estate – residential - 1-4 family mortgage		63,661			34,366
Real estate – residential - equity lines		22,099			26,958
Consumer and other		33,324			51,045
Gross loans		1,032,903			946,251
Deferred fees and costs		2,162			1,927
Loans, net of deferred fees and costs		1,035,065			948,178
Allowance for loan and lease losses		(12,231	)		(12,292	)
Net loans	$	1,022,834		$	935,886

Certain loans are pledged as collateral with the Federal Home Loan Bank of San Francisco and the Federal Reserve Bank. Pledged loans totaled

$542.1

million and

$490.2

million at

December 31, 2019

and

December 31, 2018,

respectively.

When we purchase loans they are typically purchased at a discount to enhance yield and compensate for credit risk. We have

purchased credit impaired loans as of

December 31, 2019,

and

December 31, 2018.

Gross loan balances in the table above include net purchase discounts of

$1.5

million and

$2.5

million as of

December 31, 2019,

and

December 31, 2018,

respectively.

Gross loan balances in the table above at

December 31, 2019

include a fair value discount of

$1.7

million for loans acquired from Merchants during the

first

quarter of

2019.

We recorded

$620

thousand in accretion of the discount for these loans during the year ended

December 31, 2019.

Past Due Loans

Past due loans (gross), segregated by loan portfolio were as follows, as of

December 31, 2019,

and

December 31, 2018.

													Recorded
(Amounts in thousands)	30-59		60-89		90 or Greater								Investment >
Past Due Loans at	Days Past		Days Past		Days Past		Total Past						90 Days and
December 31, 2019	Due		Due		Due		Due		Current		Total		Accruing
Commercial	$	71	$	—	$	—	$	71	$	141,126	$	141,197	$	—
Commercial real estate:
Real estate - construction and land development		—		—		—		—		26,830		26,830		—
Real estate - commercial non-owner occupied		—		—		—		—		493,920		493,920		—
Real estate - commercial owner occupied		655		—		3,103		3,758		215,075		218,833		—
Residential real estate:
Real estate - residential - ITIN		371		323		43		737		32,302		33,039		—
Real estate - residential - 1-4 family mortgage		—		—		—		—		63,661		63,661		—
Real estate - residential - equity lines		100		—		—		100		21,999		22,099		—
Consumer and other		200		50				250		33,074		33,324		—
Total	$	1,397	$	373	$	3,146	$	4,916	$	1,027,987	$	1,032,903	$	—

													Recorded
(Amounts in thousands)	30-59		60-89		90 or Greater								Investment >
Past Due Loans at	Days Past		Days Past		Days Past		Total Past						90 Days and
December 31, 2018	Due		Due		Due		Due		Current		Total		Accruing
Commercial	$	—	$	—	$	—	$	—	$	135,543	$	135,543	$	—
Commercial real estate:
Real estate - construction and land development		—		—		—		—		22,563		22,563		—
Real estate - commercial non-owner occupied		10,878		—		548		11,426		422,282		433,708		—
Real estate - commercial owner occupied		688		—		—		688		203,934		204,622		—
Residential real estate:
Real estate - residential - ITIN		184		279		259		722		36,724		37,446		—
Real estate - residential - 1-4 family mortgage		—		—		185		185		34,181		34,366		—
Real estate - residential - equity lines		90		—		—		90		26,868		26,958		—
Consumer and other		534		263		—		797		50,248		51,045		—
Total	$	12,374	$	542	$	992	$	13,908	$	932,343	$	946,251	$	—

Nonaccrual Loans

Nonaccrual loans, segregated by loan portfolio, were as follows as of

December 31, 2019,

and

December 31, 2018.

(Amounts in thousands)	As of December 31
Nonaccrual Loans	2019		2018
Commercial	$	61	$	959
Commercial real estate:
Real estate - commercial non-owner occupied		—		548
Real estate - commercial owner occupied		3,103		—
Residential real estate:
Real estate - residential - ITIN		2,221		2,388
Real estate - residential - 1-4 family mortgage		191		185
Real estate - residential - equity lines		—		43
Consumer and other		40		23
Total	$	5,616	$	4,146

Had nonaccrual loans performed in accordance with their contractual terms, we would have recognized additional interest income, net of tax, of approximately

$254

thousand and

$166

thousand for the years ended

December 31, 2019

and

2018,

respectively.

Impaired Loans

A loan is considered impaired when, based on current information and events, we determine it is probable that we will

not

be able to collect all amounts due according to the loan contract, including scheduled interest payments. The following tables summarize impaired loans by loan portfolio as of

December 31, 2019,

and

December 31, 2018.

	As of December 31, 2019
			Unpaid
(Amounts in thousands)	Recorded		Principal		Related
Impaired Loans	Investment		Balance		Allowance
With no related allowance recorded:
Commercial	$	94	$	251	$	—
Commercial real estate:
Real estate - commercial owner-occupied		3,103		3,103		—
Residential real estate:
Real estate - residential - ITIN		5,723		7,386		—
Real estate - residential - 1-4 family mortgage		191		313		—
Total with no related allowance recorded	$	9,111	$	11,053	$	—

With an allowance recorded:
Commercial	$	562	$	563	$	159
Residential real estate:
Real estate - residential - ITIN		455		455		38
Real estate - residential - equity lines		231		231		116
Consumer and other		40		40		11
Total with an allowance recorded	$	1,288	$	1,289	$	324

By loan portfolio:
Commercial	$	656	$	814	$	159
Commercial real estate		3,103		3,103		—
Residential real estate		6,600		8,385		154
Consumer and other		40		40		11
Total impaired loans	$	10,399	$	12,342	$	324

	As of December 31, 2018
			Unpaid
(Amounts in thousands)	Recorded		Principal		Related
Impaired Loans	Investment		Balance		Allowance
With no related allowance recorded:
Commercial	$	51	$	69	$	—
Commercial real estate:
Real estate - commercial owner-occupied		548	$	548		—
Residential real estate:
Real estate - residential - ITIN		6,138		7,676		—
Real estate - residential - 1-4 family mortgage		185		223		—
Real estate - residential - equity lines		43		48		—
Total with no related allowance recorded	$	6,965	$	8,564	$	—

With an allowance recorded:
Commercial	$	2,132	$	2,256	$	748
Commercial real estate:
Real estate - commercial non-owner occupied		795		795		209
Residential real estate:
Real estate - residential - ITIN		734		772		91
Real estate - residential - equity lines		363		363		182
Consumer and other		23		23		7
Total with an allowance recorded	$	4,047	$	4,209	$	1,237

By loan portfolio:
Commercial	$	2,183	$	2,325	$	748
Commercial real estate		1,343		1,343		209
Residential real estate		7,463		9,082		273
Consumer and other		23		23		7
Total impaired loans	$	11,012	$	12,773	$	1,237

The following table summarizes average recorded investment and interest income recognized on impaired loans by loan portfolio for the years ended

December 31, 2019

and

2018.

	2019				2018
	Average		Interest		Average		Interest
(Amounts in thousands)	Recorded		Income		Recorded		Income
Average Recorded Investment and Interest Income	Investment		Recognized		Investment		Recognized
Commercial	$	1,201	$	51	$	2,455	$	78
Commercial real estate:
Real estate - commercial non-owner occupied		9,400		30		890		46
Real estate - commercial owner- occupied		259		—		—		—
Residential real estate:
Real estate - residential - ITIN		6,574		161		7,198		170
Real estate - residential - 1-4 family mortgage		193		—		218		—
Real estate - residential - equity lines		288		18		415		20
Consumer and other		25		—		31		—
Total	$	17,940	$	260	$	11,207	$	314

The increase in the average recorded investment in impaired loans for

2019

compared to

2018

was due to a

$9.9

million commercial real estate loan which was placed in nonaccrual status in the

first

quarter and sold in the

fourth

quarter of

2019.

The impaired loans on which these interest income amounts were recognized are primarily accruing troubled debt restructured loans. Loans are reported as troubled debt restructurings when we grant a concession(s) to a borrower experiencing financial difficulties that we would

not

otherwise consider. Examples of such concessions include a reduction in the loan rate, forgiveness of principal or accrued interest, extending the maturity date(s) significantly, or providing a lower interest rate than would be normally available for a transaction of similar risk. As a result of these concessions, troubled debt restructured loans are impaired as we will

not

collect all amounts due, either principal or interest, in accordance with the terms of the original loan agreement.

Troubled Debt Restructurings

December 31, 2019

and

December 31, 2018,

impaired loans of

$4.8

million and

$6.9

million, respectively, were classified as performing restructured loans.

For a restructured loan to be on accrual status, the loan’s collateral coverage must generally be greater than or equal to

100%

of the loan balance, the loan payments must be current, and the borrower must demonstrate the ability to make payments from a verified source of cash flow. As of

December 31, 2019,

we had

obligations to lend additional funds on any restructured loans. As of

December 31, 2018,

we had only

one

restructured commercial line of credit in nonaccrual status that had

$313

thousand in available credit.

As of

December 31, 2019,

we had

$6.5

million in troubled debt restructurings compared to

$9.6

million as of

December 31, 2018.

As of

December 31, 2019,

we had

loans that qualified as troubled debt restructurings, of which

loans were performing according to their restructured terms. Troubled debt restructurings represented

0.63%

of gross loans as of

December 31, 2019,

compared with

1.01%

December 31, 2018.

The types of modifications offered can generally be described in the following categories:

Rate

– A modification in which the interest rate is changed.

Maturity

– A modification in which the maturity date is changed.

Payment deferral

– A modification in which a portion of the principal is deferred.

Principal

eduction

– A modification in which a portion of the owing principal is decreased.

The following table presents the period ended balances of newly restructured loans and the types of modifications that occurred during the year ended

December 31, 2019.

We did

not

have any newly restructured loans or modifications for the year ended

December 31, 2018.

	For The Year Ended December 31, 2019
			Rate &
(Amounts in thousands)	Rate &		Payment
Troubled Debt Restructuring Modification Types	Maturity		Deferral		Maturity		Total
Commercial	$	—	$	—	$	47	$	47
Consumer and other		20		—		—		20
Total	$	20	$	—	$	47	$	67

For the year ended

December 31, 2019,

the table below provides information regarding the number of loans where the contractual terms have been restructured.

	2019
			Pre-Modification		Post-Modification
(Amounts in thousands)	Number of		Outstanding Recorded		Outstanding Recorded
Troubled Debt Restructurings	Contracts		Investment		Investment
Commercial		1	$	99	$	99
Consumer and other		1		20		20
Total		2	$	119	$	119

We had

one

$20

thousand consumer loan that was modified as a troubled debt restructuring during the

12 months ended

December 31, 2019,

for which there was a subsequent payment default during the period from date of restructuring to

December 31, 2019.

There were

loans modified as troubled debt restructuring during the

12 months ended

December 31, 2018

for which there was a subsequent payment default during the period from the date of restructuring to

December 31, 2018.

Performing and Nonperforming Loans

We define a performing loan as a loan where any installment of principal or interest is

not

days or more past due, and management believes the ultimate collection of original contractual principal and interest is likely. We define a nonperforming loan as an impaired loan, which

may

be on nonaccrual, or is

days past due and still accruing, or has been restructured and does

not

comply with its modified terms, and our ultimate collection of original contractual principal and interest is uncertain.

Performing and nonperforming loans, segregated by loan portfolio, are as follows at

December 31, 2019

and

2018.

(Amounts in thousands)	December 31, 2019
Performing and Nonperforming Loans	Performing		Nonperforming		Total
Commercial	$	141,136	$	61	$	141,197
Commercial real estate:
Real estate - construction and land development		26,830		—		26,830
Real estate - commercial non-owner occupied		493,920		—		493,920
Real estate - commercial owner occupied		215,730		3,103		218,833
Residential real estate:
Real estate - residential - ITIN		30,818		2,221		33,039
Real estate - residential - 1-4 family mortgage		63,470		191		63,661
Real estate - residential - equity lines		22,099		—		22,099
Consumer and other		33,284		40		33,324
Total	$	1,027,287	$	5,616	$	1,032,903

(Amounts in thousands)	December 31, 2018
Performing and Nonperforming Loans	Performing		Nonperforming		Total
Commercial	$	134,584	$	959	$	135,543
Commercial real estate:
Real estate - construction and land development		22,563		—		22,563
Real estate - commercial non-owner occupied		433,160		548		433,708
Real estate - commercial owner occupied		204,622		—		204,622
Residential real estate:
Real estate - residential - ITIN		35,058		2,388		37,446
Real estate - residential - 1-4 family mortgage		34,181		185		34,366
Real estate - residential - equity lines		26,915		43		26,958
Consumer and other		51,022		23		51,045
Total	$	942,105	$	4,146	$	946,251

Credit Quality Ratings

Management assigns a credit quality rating (risk grade) to each loan. The foundation or primary factor in determining the appropriate credit quality rating is the degree of a debtor’s willingness and ability to perform as agreed. In conjunction with evaluating the performing versus nonperforming nature of our loan portfolio, management evaluates the following credit risk and other relevant factors in determining the appropriate credit quality indicator (rating) for each loan portfolio:

Pass Grade:

A Pass loan is a strong credit with

existing or known weaknesses that

may

require management’s close attention. Some pass loans require short-term enhanced monitoring to determine when the credit relationship would merit either an upgrade or a downgrade. Loans classified as Pass Grade specifically demonstrate:

●

Strong Cash Flows – borrower’s cash flows must meet or exceed our minimum debt service coverage ratio.

●

Collateral Margin – generally, the borrower must have pledged an acceptable collateral class with an adequate collateral margin.

●

Qualitative Factors – in addition to meeting our minimum cash flow and collateral requirements, a number of other qualitative factors are also factored into assigning a Pass Grade including the borrower’s level of leverage (debt to equity), prospects, history and experience in their industry, credit history, and any other relevant factors including a borrower’s character.

Those borrowers who qualify for unsecured loans must fully demonstrate above average cash flows and strong secondary sources of repayment to mitigate the lack of unpledged collateral.

Watch Grade:

The credit is acceptable but the borrower has experienced a temporary setback or adverse information has been received, and

may

exhibit

one

or more of the characteristics shown in the list below. This risk grade could apply to credits on a temporary basis pending a full review. Credits with this risk grade will require more handling time and increased management. The list below contains characteristics of this risk grade, but individually do

not

automatically cause the loan to be assigned a Watch Grade.

●

The primary source of repayment

may

be weakening causing greater reliance on the secondary source of repayment or

●

The primary source of repayment is adequate, but the secondary source of repayment is insufficient

●

In-depth financial analysis would compare to the lower quartile in

two

or more of the major components of the Risk Management Association Annual Statement Studies

●

Volatile or deteriorating collateral

●

Management decisions

may

be called into question

●

Delinquencies in bank credits or other financial/trade creditors

●

Frequent overdrafts

●

Significant change in management/ownership

Special Mention Grade:

Credits in this grade are potentially weak and deserve management's close attention. If left uncorrected, these potential weaknesses

may

result in deterioration of the repayment prospects of the credit. Special Mention credits are

not

adversely classified and do

not

expose the Bank to sufficient risk to warrant adverse classification. The list below exhibits the characteristics of this grade, but individually do

not

automatically cause the borrower to be assigned a grade of Special Mention:

●

Inadequate or incomplete loan documentation or perfection of collateral, or any other deviation from prudent lending practices

●

Credit is structured in a manner in which the timing of the repayment source does

not

match the payment schedule or maturity, materially jeopardizing repayment

●

Current economic or market conditions exist which

may

affect the borrower's ability to perform or affect the Bank's collateral position

●

Adverse trends in the borrower's operations or continued deterioration in the borrower’s financial condition that has

not

yet reached a point where the retirement of debt is jeopardized. A credit in this grade should have favorable prospects of the deteriorating financial trends reversing within a reasonable timeframe.

●

The borrower is less than cooperative or unable to produce current and adequate financial information

Substandard Grade:

A Substandard credit is inadequately protected by the current net worth and paying capacity of the borrower or of the collateral pledged, if any. Substandard credits have a well-defined weakness or weaknesses that jeopardize the liquidation or timely collection of the debt. Substandard credits are characterized by the distinct possibility that we will sustain some loss if the deficiencies are

not

corrected. However, a potential loss does

not

have to be recognizable in an individual credit for it to be considered a substandard credit. As such, substandard credits

may

not

be graded as impaired.

The following represents, but is

not

limited to, the potential characteristics of a Substandard Grade and do

not

necessarily generate automatic reclassification into this loan grade:

●

Sustained or substantial deteriorating financial trends,

●

Unresolved management problems,

●

Collateral is insufficient to repay debt; collateral is

not

sufficiently supported by independent sources, such as asset-based financial audits, appraisals, or equipment evaluations,

●

Improper perfection of lien position, which is

not

readily correctable,

●

Unanticipated and severe decline in market values,

●

High reliance on secondary source of repayment,

●

Legal proceedings, such as bankruptcy or a divorce, which has substantially decreased the borrower’s capacity to repay the debt,

●

Fraud committed by the borrower,

●

IRS liens that take precedence,

●

Forfeiture statutes for assets involved in criminal activities,

●

Protracted repayment terms outside of policy that are for longer than the same type of credit in our portfolio,

●

Any other relevant quantitative or qualitative factor that negatively affects the current net worth and paying capacity of the borrower or of the collateral pledged, if any.

Doubtful Grade:

A Doubtful loan has all the weaknesses inherent in

one

classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain pending factors that

may

work to the advantage and strengthening of the credit, its classification as an estimated loss is deferred until its more exact status

may

be determined. Pending factors

may

include, but are

not

limited to:

●

Proposed merger(s),

●

Acquisition or liquidation procedures,

●

Capital injection,

●

Perfecting liens on additional collateral,

●

Refinancing plans.

Generally, a Doubtful Grade does

not

remain outstanding for a period greater than

six

months. Within

six

months, the pending events should have been resolved. Based on resolution of the pending events, the credit grade should have improved or the principal balance charged against the ALLL.

The following table summarizes loans by internal risk grades and by loan class as of

December 31, 2019,

and

December 31, 2018

	December 31, 2019
					Special
(Amounts in thousands)	Pass		Watch		Mention		Substandard		Doubtful		Total
Commercial	$	125,222	$	14,974	$	833	$	168	$	—	$	141,197
Commercial real estate:
Real estate - construction and land development		26,810		20		—		—		—		26,830
Real estate - commercial non-owner occupied		454,493		32,902		5,424		1,101		—		493,920
Real estate - commercial owner occupied		195,950		7,224		1,220		14,439		—		218,833
Residential real estate:
Real estate - residential - ITIN		28,609		—		—		4,430		—		33,039
Real estate - residential - 1-4 family mortgage		62,485		985		—		191		—		63,661
Real estate - residential - equity lines		22,012		—		—		87		—		22,099
Consumer and other		33,283		—		—		41		—		33,324
Total	$	948,864	$	56,105	$	7,477	$	20,457	$	—	$	1,032,903

	December 31, 2018
					Special
(Amounts in thousands)	Pass		Watch		Mention		Substandard		Doubtful		Total
Commercial	$	118,643	$	15,247	$	—	$	1,653	$	—	$	135,543
Commercial real estate:
Real estate - construction and land development		22,539		24		—		—		—		22,563
Real estate - commercial non-owner occupied		409,157		21,698		—		2,853		—		433,708
Real estate - commercial owner occupied		179,154		14,075		—		11,393		—		204,622
Residential real estate:
Real estate - residential - ITIN		31,805		—		—		5,641		—		37,446
Real estate - residential - 1-4 family mortgage		33,388		793		—		185		—		34,366
Real estate - residential - equity lines		25,336		1,313		—		309		—		26,958
Consumer and other		51,016		—		—		29		—		51,045
Total	$	871,038	$	53,150	$	—	$	22,063	$	—	$	946,251

The recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure was

$100

thousand at

December 31, 2019.

Allowance for Loan and Lease Losses

The following tables below summarize the ALLL by portfolio for the years ended

December 31, 2019

and

2018.

	As of December 31, 2019
(Amounts in thousands)				Commercial			Residential
ALLL by Loan Portfolio	Commercial			Real Estate			Real Estate			Consumer			Unallocated			Total
Beginning balance	$	2,205		$	7,116		$	1,173		$	1,356		$	442		$	12,292
Charge-offs		(238	)		(233	)		(181	)		(848	)		—			(1,500	)
Recoveries		927			—			261			251			—			1,439
Provision		(1,072	)		1,213			(221	)		174			(94	)		—
Ending balance	$	1,822		$	8,096		$	1,032		$	933		$	348		$	12,231

	As of December 31, 2018
(Amounts in thousands)				Commercial		Residential
ALLL by Loan Portfolio	Commercial			Real Estate		Real Estate			Consumer			Unallocated		Total
Beginning balance	$	2,397		$	6,514	$	1,169		$	1,435		$	410	$	11,925
Charge-offs		(132	)		—		(226	)		(890	)		—		(1,248	)
Recoveries		865			—		435			315			—		1,615
Provision		(925	)		602		(205	)		496			32		—
Ending balance	$	2,205		$	7,116	$	1,173		$	1,356		$	442	$	12,292

The following tables summarize the ALLL and the recorded investment in loans and leases as of

December 31, 2019

and

2018.

	As of December 31, 2019
			Commercial		Residential
(Amounts in thousands)	Commercial		Real Estate		Real Estate		Consumer		Unallocated		Total
ALLL:
Individually evaluated for impairment	$	159	$	—	$	154	$	11	$	—	$	324
Collectively evaluated for impairment		1,663		8,096		878		922		348		11,907
Total		1,822		8,096		1,032		933		348		12,231
Gross loans:
Individually evaluated for impairment	$	656	$	3,103	$	6,600	$	40	$	—	$	10,399
Collectively evaluated for impairment		140,541		736,480		112,199		33,284		—		1,022,504
Total gross loans	$	141,197	$	739,583	$	118,799	$	33,324	$	—	$	1,032,903

	As of December 31, 2018
			Commercial		Residential
(Amounts in thousands)	Commercial		Real Estate		Real Estate		Consumer		Unallocated		Total
ALLL:
Individually evaluated for impairment	$	748	$	209	$	273	$	7	$	—	$	1,237
Collectively evaluated for impairment		1,457		6,907		900		1,349		442		11,055
Total		2,205		7,116		1,173		1,356		442		12,292
Gross loans:
Individually evaluated for impairment	$	2,183	$	1,343	$	7,463	$	23	$	—	$	11,012
Collectively evaluated for impairment		133,360		659,550		91,307		51,022		—		935,239
Total gross loans	$	135,543	$	660,893	$	98,770	$	51,045	$	—	$	946,251

The ALLL totaled

$12.2

million at

December 31, 2019

and

$12.3

million at

December 31, 2018.

The loans acquired from Merchants were recorded at fair value, which included a discount for credit risk adjustments, which is

not

a part of the ALLL.

ALLL is required for these acquired loans on the date of acquisition. As a result, our ALLL as a percentage of gross loans declined to

1.18%

as of

December 31, 2019

compared to

1.30%

as of

December 31, 2018.

As of

December 31, 2019

and

December 31, 2018,

we had commitments to extend credit of

$275.1

million and

$235.8

million, respectively. The reserve for unfunded commitments recorded in

Other Liabilities

in the

Consolidated Balance Sheets

December 31, 2019

and

2018

was

$695

thousand.

The ALLL is based upon estimates of future loan and lease losses and is maintained at a level considered adequate to provide for probable losses inherent in the outstanding loan portfolio. Our ALLL methodology incorporates management’s current judgments, and reflects management’s estimate of future loan and lease losses and risks inherent in the loan portfolio in accordance with ASC Topic

450

Contingencies

and ASC Topic

310

Receivables.

The allowance is increased by provisions charged to expense and reduced by net charge-offs. In periodic evaluations of the adequacy of the allowance balance, management considers past loan and lease loss experience by type of credit, known and inherent risks in the portfolio, adverse situations that

may

affect a borrower’s ability to repay, the estimated value of any underlying collateral, current economic conditions and other factors. We formally assess the adequacy of the ALLL on a quarterly basis. These assessments include the periodic re-grading of classified loans based on changes in their individual credit characteristics including delinquency, seasoning, recent financial performance of the borrower, economic factors, changes in the interest rate environment and other factors as warranted. Loans are initially rated when originated. They are reviewed as they are renewed, when there is a new loan to the same borrower and/or when identified facts demonstrate heightened risk of default. Confirmation of the quality of our grading process is obtained by independent reviews conducted by outside consultants specifically hired for this purpose and by periodic examination by various bank regulatory agencies.

Our method for assessing the appropriateness of the allowance includes specific allowances for identified problem loans, an allowance factor for categories of credits and allowances for changing environmental factors (e.g., portfolio trends, concentration of credit, growth, economic factors). Allowances for identified problem loans are based on specific analysis of individual credits. Loss estimation factors for loan categories are based on analysis of local economic factors applicable to each loan category. Allowances for changing environmental factors are management’s best estimate of the probable impact these changes have had on the loan portfolio as a whole.

We believe that the ALLL was adequate as of

December 31, 2019.

There is, however,

assurance that future loan and lease losses will

not

exceed the levels provided for in the ALLL and could possibly result in additional charges to the provision for loan and lease losses. In addition, bank regulatory authorities, as part of their periodic examination of the Company,

may

require additional charges to the provision for loan and lease losses in future periods if warranted as a result of their review.

As of

December 31, 2019,

83%

of our gross loan portfolio is secured by real estate, and a significant decline in real estate market values

may

require an increase in the ALLL. Deterioration in economic conditions particularly in our markets

may

adversely affect our loan portfolio and

may

lead to additional charges to the provision for loan and lease losses.

Management monitors delinquent loans continuously and identifies problem loans to be evaluated individually for impairment testing. For loans that are determined impaired, a formal impairment measurement is performed at least quarterly on a loan-by-loan basis. If the measurement of each impaired loans’ value is less than the recorded investment in the loan, we recognize this impairment and adjust the carrying value of the loan to fair value through the ALLL. For collateral dependent loans, this can be accomplished by charging off the impaired portion of the loan based on the underlying value of the collateral. For non-collateral dependent loans, we establish a specific component within the ALLL based on the present value of the future cash flows. If we determine the sources of repayment will

not

result in a reasonable probability that the carrying value of a loan can be recovered, the amount of a loan’s specific impairment is charged off against the ALLL. Impairment reserves on non-collateral dependent restructured loans are measured by comparing the present value of expected future cash flows on the restructured loans discounted at the interest rate of the original loan agreement to the loan’s carrying value. These impairment reserves are recognized as a specific component to be provided for in the ALLL.

The unallocated portion of the ALLL provides for coverage of credit losses inherent in the loan portfolio but

not

captured in the credit loss factors that are utilized in the risk rating-based component, or in the specific impairment reserve component of the ALLL, and acknowledges the inherent imprecision of all loss prediction models. As of

December 31, 2019,

the unallocated allowance amount represented

of the ALLL, compared to

December 31, 2018.

While the ALLL composition is an indication of specific amounts or loan categories in which future charge-offs

may

occur, actual amounts

may

differ.

We have lending policies and procedures in place with the objective of optimizing loan income within an accepted risk tolerance level. We review and approve these policies and procedures annually. Monitoring and reporting systems supplement the review process with regular frequency as related to loan production, loan quality, concentrations of credit, potential problem loans, loan delinquencies, and nonperforming loans.

The following is a brief summary, by loan type, of management’s evaluation of the general risk characteristics and underwriting standards:

Commercial Loans

– Commercial loans are underwritten after evaluating the borrower’s financial ability to maintain profitability including future expansion objectives. In addition, the borrower’s qualitative qualities are evaluated, such as management skills and experience, ethical traits, and overall business acumen. Commercial loans are primarily extended based on the cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The borrower’s cash flow

may

deviate from initial projections, and the value of collateral securing these loans

may

change.

Most commercial loans are generally secured by the assets being financed and other business assets such as accounts receivable or inventory. Management

may

also incorporate a personal guarantee; however, some short-term loans

may

be extended on an unsecured basis. Repayment of commercial loans secured by accounts receivable

may

be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial Real Estate (“CRE”) Loans

– CRE loans are subject to similar underwriting standards and processes as commercial loans. CRE loans are viewed predominantly as cash flow loans and secondarily as loans collateralized by real estate. Generally, CRE lending involves larger principal amounts with repayment largely dependent on the successful operation of the property securing the loan or the business conducted on the collateralized property. CRE loans tend to be more adversely affected by conditions in the real estate markets or by general economic conditions.

The properties securing the CRE portfolio are diverse in terms of type and primary source of repayment. This diversity helps reduce our exposure to adverse economic events that affect any single industry. We monitor and evaluate CRE loans based on occupancy status (investor versus owner occupied), collateral, geography, and risk grade criteria.

Generally, CRE loans are made to developers and builders that are secured by non-owner occupied properties require the borrower to have had an existing relationship with the Company and a proven record of success. Construction loans are underwritten utilizing feasibility studies, sensitivity analysis of absorption and lease rates, and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of cost and value associated with the complete project (as-is value). These estimates

may

be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment largely dependent on the success of the ultimate project. Sources of repayment for these types of loans

may

be pre-committed permanent loans from approved long-term lenders, sales of developed property, or an interim loan commitment from the Company until permanent financing is secured. These loans are closely monitored by on-site inspections, and are considered to have higher inherent risks than other CRE loans due to their ultimate repayment sensitivity to interest rate changes, governmental regulation of real property, general economic conditions, and the availability of long-term financing.

Residential Real Estate Loans

– We do

not

originate consumer real estate mortgage loans. The majority of our loans secured by non owner occupied residential real estate are made either as part of a commercial relationship and subject to similar underwriting standards and processes as the CRE portfolio, or loans that were purchased in a prior year as part of a pool of loans. Purchased loan pools are evaluated based on risk characteristics established for each segmented group of loans. These characteristics include a significant emphasis on historical losses within each loan group, inherent risks for each, and specific loan class characteristics such as trends related to nonaccrual loans, past due loans, criticized loans, net charge-offs or recoveries, among other relevant credit risk factors. Residential equity lines of credit are included in the discussion of consumer loans below.

We originate some single family residence construction loans. The loan amounts are

greater than

million and are short term real estate secured financing for the construction of a single family residence to be occupied by the owner. The loans have a draw down feature with interest only payments, and a balloon payment at the

-month maturity. All of these loans are refinanced and paid-off by the borrower’s permanent mortgage lender who provided the initial pre-approved mortgage financing. These loans are underwritten utilizing financial analysis of the borrower and are generally based upon estimates of cost and value associated with the complete project (as-is value). These estimates

may

be inaccurate. The loan disbursement and monitoring process is controlled utilizing similar processes as our CRE construction loans.

Consumer Loans –

Our consumer loan originations are generally limited to home equity loans with nominal originations in unsecured personal loans. The portfolio also includes unsecured consumer home improvement loans and residential solar panel loans secured by UCC filings. We are highly dependent on

third

party credit scoring analysis to supplement the internal underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed, jointly by management and staff personnel. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are

not

limited to, a maximum loan-to-value percentage of

80%,

collection remedies, the number of such loans a borrower can have at

one

time, and documentation requirements.

We maintain an independent loan review program that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to the Board of Directors, Loan Committee and Audit Committee. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as our policies and procedures.

Management’s continuing evaluation of all known relevant quantitative and qualitative internal and external risk factors provides the foundation for the

three

major components of the ALLL: (

) historical valuation allowances established in accordance with ASC

450,

Contingencies (“ASC

450”

) for groups of similarly situated loan pools; (

) general valuation allowances established in accordance with ASC

450

that are based on qualitative credit risk factors; and (

) specific valuation allowances established in accordance with ASC

310,

Receivables (“ASC

310”

) that are based on estimated probable losses on specific impaired loans. All

three

components are aggregated and constitute the ALLL; while portions of the allowance

may

be allocated to specific credits, the allowance net of specific reserves is available for the remaining credits that management deems as “loss.” It is our policy to classify a credit as loss with a concurrent charge-off when management considers the credit uncollectible and of such little value that its continuance as a bankable asset is

not

warranted. A loss classification does

not

mean that the loan has absolutely

recovery or salvage value, but rather it is

not

practical or desirable to defer recognizing the likely credit loss of a valueless asset even though partial recovery

may

occur in the future.

Our loan portfolio is evaluated by general loan class including commercial, commercial real estate (which includes construction and other real estate), residential real estate (which includes

family and home equity loans), consumer and other loans. In accordance with ASC

450,

historical valuation allowances are established for loan pools with similar risk characteristics common to each loan grouping. These loan pools are similarly risk-graded and each portfolio is evaluated by identifying all relevant risk characteristics that are common to these segmented groups of loans. These characteristics include a significant emphasis on historical losses within each loan group, inherent risks for each, and specific loan class characteristics such as trends related to nonaccrual loans, past due loans, criticized loans, net charge-offs or recoveries, among other relevant credit risk factors. We periodically review and update our historical loss ratios based on net charge-off experience for each loan and lease class. Other credit risk factors are also reviewed periodically and adjusted as necessary to account for any changes in potential loss exposure.

General valuation allowances, as prescribed by ASC

450,

are based on qualitative factors such as changes in asset quality trends, concentrations of credit or changes in concentrations of credit, changes in underwriting standards, changes in experience or depth of lending staff or management, the effectiveness of loan grading and the internal loan review function, and any other relevant factors. Management evaluates each qualitative component quarterly to determine the associated risks to the quality of our loan portfolio.