NOTE

LOANS

Outstanding loan balances consisted of the following at

March 31, 2020,

and

December 31, 2019.

(Amounts in thousands)	March 31,			December 31,
Loan Portfolio	2020			2019
Commercial	$	138,870		$	141,197
Commercial real estate:
Real estate - construction and land development		34,394			26,830
Real estate - commercial non-owner occupied		514,052			493,920
Real estate - commercial owner occupied		217,319			218,833
Residential real estate:
Real estate - residential - Individual Tax Identification Number (“ITIN”)		31,998			33,039
Real estate - residential - 1-4 family mortgage		62,533			63,661
Real estate - residential - equity lines		23,158			22,099
Consumer and other		29,921			33,324
Gross loans		1,052,245			1,032,903
Deferred fees and costs		2,129			2,162
Loans, net of deferred fees and costs		1,054,374			1,035,065
Allowance for loan and lease losses		(15,067	)		(12,231	)
Net loans	$	1,039,307		$	1,022,834

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

$549.0

million and

$542.1

million at

March 31, 2020

and

December 31, 2019,

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

March 31, 2020,

and

December 31, 2019.

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

$1.3

million and

$1.5

million as of

March 31, 2020,

and

December 31, 2019,

respectively.

Gross loan balances in the table above at

March 31, 2020

include a fair value discount of

$1.5

million for loans acquired from Merchants during the

first

quarter of

2019.

We recorded

$163

thousand and

$48

thousand in accretion of the discount for these loans during the

three

months ended

March 31, 2020

and

2019,

respectively.

Past Due Loans

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

March 31, 2020,

and

December 31, 2019.

(Amounts in thousands) Past Due Loans at March 31, 2020	30-59 Days Past Due		60-89 Days Past Due		90 or Greater Days Past Due		Total Past Due		Current		Total		Recorded Investment > 90 Days and Accruing
Commercial	$	710	$	—	$	—	$	710	$	138,160	$	138,870	$	—
Commercial real estate:
Real estate - construction and land development		—		—		—		—		34,394		34,394		—
Real estate - commercial non-owner occupied		1,097		—		—		1,097		512,955		514,052		—
Real estate - commercial owner occupied		654		—		3,103		3,757		213,562		217,319		—
Residential real estate:
Real estate - residential - ITIN		513		57		119		689		31,309		31,998		—
Real estate - residential - 1-4 family mortgage		—		—		—		—		62,533		62,533		—
Real estate - residential - equity lines		61		29		—		90		23,068		23,158		—
Consumer and other		138		66		2		206		29,715		29,921		2
Total	$	3,173	$	152	$	3,224	$	6,549	$	1,045,696	$	1,052,245	$	2

(Amounts in thousands) Past Due Loans at December 31, 2019	30-59 Days Past Due		60-89 Days Past Due		90 or Greater Days Past Due		Total Past Due		Current		Total		Recorded Investment > 90 Days and 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	$	—

Nonaccrual Loans

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

March 31, 2020

and

December 31, 2019.

(Amounts in thousands)	March 31,		December 31,
Nonaccrual Loans	2020		2019
Commercial	$	39	$	61
Commercial real estate:
Real estate - commercial owner occupied		3,103		3,103
Residential real estate:
Real estate - residential - ITIN		1,878		2,221
Real estate - residential - 1-4 family mortgage		184		191
Consumer and other		39		40
Total	$	5,243	$	5,616

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

$58

thousand and

$158

thousand for the

three

months ended

March 31, 2020

and

2019,

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

March 31, 2020

and

December 31, 2019.

	As of March 31, 2020
			Unpaid
(Amounts in thousands)	Recorded		Principal		Related
Impaired Loans	Investment		Balance		Allowance
With no related allowance recorded:
Commercial	$	71	$	231	$	—
Commercial real estate:
Real estate - commercial owner occupied		3,103		3,103		—
Residential real estate:
Real estate - residential - ITIN		5,233		6,899		—
Real estate - residential - 1-4 family mortgage		184		310		—
Total with no related allowance recorded	$	8,591	$	10,543	$	—

With an allowance recorded:
Commercial	$	560	$	561	$	160
Residential real estate:
Real estate - residential - ITIN		536		537		35
Real estate - residential - equity lines		226		226		113
Consumer and other		39		39		10
Total with an allowance recorded	$	1,361	$	1,363	$	318

By loan portfolio:
Commercial	$	631	$	792	$	160
Commercial real estate		3,103		3,103		—
Residential real estate		6,179		7,972		148
Consumer and other		39		39		10
Total impaired loans	$	9,952	$	11,906	$	318

	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

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

three

months ended

March 31, 2020

and

2019.

	Three Months Ended				Three Months Ended
	March 31, 2020				March 31, 2019
	Average		Interest		Average		Interest
(Amounts in thousands)	Recorded		Income		Recorded		Income
Average Recorded Investment and Interest Income	Investment		Recognized		Investment		Recognized
Commercial	$	640	$	9	$	2,021	$	17
Commercial real estate:
Real estate - commercial non-owner occupied		—		—		8,412		11
Real estate - commercial owner occupied		3,103		—		—		—
Residential real estate:
Real estate - residential - ITIN		5,957		37		6,874		42
Real estate - residential - 1-4 family mortgage		186		—		184		—
Real estate - residential - equity lines		228		4		401		5
Consumer and other		39		—		23		—
Total	$	10,153	$	50	$	17,915	$	75

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, 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

March 31, 2020

and

December 31, 2019,

impaired loans of

$4.7

million and

$4.8

million, respectively, were classified as performing troubled debt restructured loans.

For a troubled debt 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

March 31, 2020

and

December 31, 2019,

we had

obligations to lend additional funds on any troubled debt restructured loans.

As of

March 31, 2020,

we had

$6.3

million in troubled debt restructurings compared to

$6.5

million as of

December 31, 2019.

As of

March 31, 2020,

we had

loans that qualified as troubled debt restructurings, of which

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

0.60%

of gross loans as of

March 31, 2020,

compared to

0.63%

December 31, 2019.

We do

not

have any new troubled debt restructurings for the

three

months ended

March 31, 2020

and

2019.

There were

loans modified as a troubled debt restructuring within the previous

twelve

months for which there was a payment default (after restructuring) during the

three

months ended

March 31, 2020.

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, were as follows at

March 31, 2020

and

December 31, 2019.

(Amounts in thousands)	March 31, 2020
Performing and Nonperforming Loans	Performing		Nonperforming		Total
Commercial	$	138,831	$	39	$	138,870
Commercial real estate:
Real estate - construction and land development		34,394		—		34,394
Real estate - commercial non-owner occupied		514,052		—		514,052
Real estate - commercial owner occupied		214,216		3,103		217,319
Residential real estate:
Real estate - residential - ITIN		30,120		1,878		31,998
Real estate - residential - 1-4 family mortgage		62,349		184		62,533
Real estate - residential - equity lines		23,158		—		23,158
Consumer and other		29,880		41		29,921
Total	$	1,047,000	$	5,245	$	1,052,245

(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

Short Term Loan Modifications

We are responding to the needs of our borrowers in accordance with the regulatory guidance to grant short-term COVID-

related loan modifications. These modified loans are

not

troubled debt restructurings and are

not

considered to be past due or non-performing. We have granted deferrals ranging from

months determined on a case-by-case basis considering the nature of the business and the impact of COVID-

19.

As of

April 24, 2020

we have received

124

requests for short term loan modifications totaling

$82.9

million. Of those requests, we have approved

120

requests totaling

$78.0

million.

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 tables summarize loans by internal risk grades and by loan class as of

March 31, 2020

and

December 31, 2019.

	As of March 31, 2020
					Special
(Amounts in thousands)	Pass		Watch		Mention		Substandard		Doubtful		Total
Commercial	$	121,692	$	15,166	$	1,875	$	137	$	—	$	138,870
Commercial real estate:
Real estate - construction and land development		34,376		18		—		—		—		34,394
Real estate - commercial non-owner occupied		481,281		31,265		409		1,097		—		514,052
Real estate - commercial owner occupied		195,457		9,517		—		12,345		—		217,319
Residential real estate:
Real estate - residential - ITIN		27,955		—		—		4,043		—		31,998
Real estate - residential - 1-4 family mortgage		60,724		232		671		906		—		62,533
Real estate - residential - equity lines		23,072		—		—		86		—		23,158
Consumer and other		29,882		—		—		39		—		29,921
Total	$	974,439	$	56,198	$	2,955	$	18,653	$	—	$	1,052,245

	As of 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

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

$141

thousand and

$100

thousand at

March 31, 2020

and

December 31, 2019,

respectively.

Allowance for Loan and Lease Losses

The following tables summarize the ALLL by portfolio for the

three

months ended

March 31, 2020

and

2019.

	For the Three Months Ended March 31, 2020
(Amounts in thousands)			Commercial		Residential
ALLL by Loan Portfolio	Commercial		Real Estate		Real Estate			Consumer			Unallocated		Total
Beginning balance	$	1,822	$	8,096	$	1,032		$	933		$	348	$	12,231
Charge-offs		—		—		(6	)		(163	)		—		(169	)
Recoveries		7		—		44			104			—		155
Provision		654		1,803		211			98			84		2,850
Ending balance	$	2,483	$	9,899	$	1,281		$	972		$	432	$	15,067

	For the Three Months Ended March 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		—		—			(68	)		(280	)		—		(348	)
Recoveries		153		—			82			63			—		298
Provision		121		(160	)		24			(83	)		98		—
Ending balance	$	2,479	$	6,956		$	1,211		$	1,056		$	540	$	12,242

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

may

occur, actual amounts

may

differ. 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

March 31, 2020

and

December 31, 2019,

the unallocated allowance amount represented

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

March 31, 2020

and

December 31, 2019.

	As of March 31, 2020
			Commercial		Residential
(Amounts in thousands)	Commercial		Real Estate		Real Estate		Consumer		Unallocated		Total
ALLL:
Individually evaluated for impairment	$	160	$	—	$	148	$	10	$	—	$	318
Collectively evaluated for impairment		2,323		9,899		1,133		962		432		14,749
Total	$	2,483	$	9,899	$	1,281	$	972	$	432	$	15,067
Gross loans:
Individually evaluated for impairment	$	631	$	3,103	$	6,179	$	39	$	—	$	9,952
Collectively evaluated for impairment		138,239		762,662		111,510		29,882		—		1,042,293
Total gross loans	$	138,870	$	765,765	$	117,689	$	29,921	$	—	$	1,052,245

	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

The ALLL totaled

$15.1

million or

1.43%

of total gross loans at

March 31, 2020

and

$12.2

million or

1.18%

December 31, 2019.

As of

March 31, 2020

and

December 31, 2019,

we had commitments to extend credit of

$276.3

million and

$275.1

million, respectively. The reserve for unfunded commitments recorded in

Other Liabilities

in the

Consolidated Balance Sheets

March 31, 2020

and

December 31, 2019

was

$695

thousand.

We believe that the ALLL was adequate as of

March 31, 2020.

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.

ALLL Methodology

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 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 and lease 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.

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.

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.

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.

COVID‐19

The

COVID‐19

Pandemic which suddenly unfolded in

2020

is having a dramatic worldwide economic effect, with significant drop in GDP’s projected for

2020.

This will inevitably result in economic recession and increased loan losses, particularly in certain hard hit industries such as airlines, travel and hospitality, retail and energy sectors. As a result, we have significantly increased our qualitative credit risk factor for “Changes in international, national, regional and local conditions,”

Impaired loans

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.

Risk Characteristics and Underwriting

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.

Concentrations of Credit Risk

As of

March 31, 2020,

approximately

84%

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.

Credit review

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. 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.