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Note 4 - Loans

3 Months Ended

Mar. 31, 2021

Loans, Notes, Trade and Other Receivables Disclosure [Text Block]

NOTE 4. LOANS

Outstanding loan balances consisted of the following at March 31, 2021, and December 31, 2020.

	March 31,			December 31,
(Amounts in thousands)	2021			2020
Loan Portfolio:
Commercial	$	117,597		$	115,559
Paycheck Protection Program ("PPP")		117,991			130,814
Commercial real estate:
Construction and land development		32,145			44,549
Non-owner occupied		592,157			550,020
Owner occupied		165,367			172,967
Residential real estate:
Individual Tax Identification Number (“ITIN”)		27,839			29,035
1-4 family mortgage		54,562			55,925
Equity lines		18,600			18,894
Consumer and other		19,685			21,969
Gross loans		1,145,943			1,139,732
Deferred fees and costs		143			229
Loans, net of deferred fees and costs		1,146,086			1,139,961
Allowance for loan and lease losses		(17,027	)		(16,910	)
Net loans	$	1,129,059		$	1,123,051

Gross loan balances in the table above include discounts on purchased loans and fair value adjustments made to acquired loans using the acquisition method of accounting.

Discounts on purchased loans - Gross loan balances include net purchase discounts of $761 thousand and $879 thousand as of March 31, 2021, and December 31, 2020, respectively. When we purchase loans, they are typically purchased at a discount to enhance yield and compensate for credit risk. We have no purchased credit impaired loans as of March 31, 2021, and December 31, 2020.

Fair value adjustment - Gross loan balances include a net fair value discount of $810 thousand and $920 thousand at March 31, 2021 and December 31, 2020, respectively, for loans acquired in conjunction with our acquisition of Merchants National Bank of Sacramento during the first quarter of 2019. We recorded $110 thousand and $163 thousand in accretion of the discount for these loans during the three months ended March 31, 2021 and 2020, respectively.

Pledged Loans

Certain loans are pledged as collateral for lines of credit with the FHLB and the Federal Reserve Bank. Pledged loans totaled $557.3 million and $523.5 million at March 31, 2021 and December 31, 2020, respectively.

Short-Term Loan Modifications

At March 31, 2021, there were 26 loans totaling $4.1 million with a COVID-19 related loan payment deferral compared to 82 loans totaling $9.5 million at December 31, 2020. In accordance with the CARES Act and regulatory guidance, these modified loans are not troubled debt restructurings and are not considered to be past due or non-performing. We have granted payment deferrals ranging from one to six months determined on a case-by-case basis considering the nature of the business and the impact of COVID-19. For some borrowers who were initially granted a payment deferral of less than six months, we have granted an additional payment deferral period on a case-by-case basis. Without these deferrals, past due loan totals might have been higher at March 31, 2021. We cannot predict the impact to past due loan totals once the deferral periods end.

Past Due Loans

Past due loans (gross), segregated by loan portfolio were as follows, as of March 31, 2021, and December 31, 2020.

													Recorded
	30-59		60-89		*90 or Greater*								*Investment >*
	*Days Past*		*Days Past*		*Days Past*		*Total Past*						*90 Days and*
(Amounts in thousands)	*Due*		*Due*		*Due*		*Due*		*Current*		*Total*		*Accruing*
Past Due Loans at March 31, 2021
Commercial	$	101	$	—	$	1,413	$	1,514	$	116,083	$	117,597	$	—
PPP		—		—		—		—		117,991		117,991		—
Commercial real estate:
Construction and land development		—		—		—		—		32,145		32,145		—
Non-owner occupied		1,693		—		—		1,693		590,464		592,157		—
Owner occupied		—		—		—		—		165,367		165,367		—
Residential real estate:
ITIN		274		50		123		447		27,392		27,839		—
1-4 family mortgage		—		—		—		—		54,562		54,562		—
Equity lines		19		—		—		19		18,581		18,600		—
Consumer and other		80		10		—		90		19,595		19,685		—
Total	$	2,167	$	60	$	1,536	$	3,763	$	1,142,180	$	1,145,943	$	—

Recorded

30-59

60-89

90 or Greater

Investment >

Days Past

Days Past

Days Past

Total Past

90 Days and

(Amounts in thousands)

Due

Due

Due

Due

Current

Total

Accruing

Past Due Loans at December 31, 2020

Commercial
$ — $ — $ 1,413 $ 1,413 $ 114,146 $ 115,559 $ —

PPP
— — — — 130,814 130,814

Commercial real estate:

Construction and land development
— — — — 44,549 44,549 —

Non-owner occupied
640 — — 640 549,380 550,020 —

Owner occupied
— — 2,993 2,993 169,974 172,967 —

Residential real estate:

ITIN
40 — 169 209 28,826 29,035 —

1-4 family mortgage
— — — — 55,925 55,925 —

Equity lines
60 — — 60 18,834 18,894 —

Consumer and other
82 17 — 99 21,870 21,969 —

Total
$ 822 $ 17 $ 4,575 $ 5,414 $ 1,134,318 $ 1,139,732 $ —

Nonaccrual Loans

Nonaccrual loans, segregated by loan portfolio, were as follows as of March 31, 2021 and December 31, 2020.

March 31,

December 31,

(Amounts in thousands)

2021

2020

Nonaccrual Loans:

Commercial
$ 1,520 $ 1,535

Commercial real estate:

Non-owner occupied
626 640

Owner occupied
95 3,094

Residential real estate:

ITIN
1,529 1,585

1-4 family mortgage
137 141

Consumer and other
17 18

Total
$ 3,924 $ 7,013

Had nonaccrual loans performed in accordance with their contractual terms, we would have recognized additional interest income, net of tax, of approximately $44 thousand and $58 thousand for the three months ended March 31, 2021 and 2020, 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, 2021 and December 31, 2020.

As of March 31, 2021

Unpaid

Recorded

Principal

Related

(Amounts in thousands)

Investment

Balance

Allowance

Impaired Loans:

With no related allowance recorded:

Commercial
$ 1,558 $ 1,915 $ —

Commercial real estate:

Non-owner occupied
626 654 —

Owner occupied
95 98 —

Residential real estate:

ITIN
4,775 6,309 —

1-4 family mortgage
137 200 —

Total with no related allowance recorded
$ 7,191 $ 9,176 $ —

With an allowance recorded:

Commercial
$ 456 $ 456 $ 114

Residential real estate:

ITIN
174 174 9

Equity lines
121 121 61

Consumer and other
17 17 4

Total with an allowance recorded
$ 768 $ 768 $ 188

By loan portfolio:

Commercial
$ 2,014 $ 2,371 $ 114

Commercial real estate
721 752 —

Residential real estate
5,207 6,804 70

Consumer and other
17 17 4

Total impaired loans
$ 7,959 $ 9,944 $ 188

As of December 31, 2020

Unpaid

Recorded

Principal

Related

(Amounts in thousands)

Investment

Balance

Allowance

Impaired Loans:

With no related allowance recorded:

Commercial
$ 1,577 $ 1,932 $ —

Commercial real estate:

Non-owner occupied
640 654 —

Owner occupied
3,094 3,206 —

Residential real estate:

ITIN
4,876 6,500 —

1-4 family mortgage
141 202 —

Total with no related allowance recorded
$ 10,328 $ 12,494 $ —

With an allowance recorded:

Commercial
$ 456 $ 456 $ 114

Residential real estate:

ITIN
175 175 11

Equity lines
126 126 63

Consumer and other
18 18 4

Total with an allowance recorded
$ 775 $ 775 $ 192

By loan portfolio:

Commercial
$ 2,033 $ 2,388 $ 114

Commercial real estate
3,734 3,860 —

Residential real estate
5,318 7,003 74

Consumer and other
18 18 4

Total impaired loans
$ 11,103 $ 13,269 $ 192

The following table summarizes average recorded investment and interest income recognized on impaired loans by loan portfolio for the three months ended March 31, 2021 and 2020.

Three Months Ended

Three Months Ended

March 31, 2021

March 31, 2020

Average

Interest

Average

Interest

Recorded

Income

Recorded

Income

(Amounts in thousands)

Investment

Recognized

Investment

Recognized

Average Recorded Investment and Interest Income:

Commercial
$ 2,020 $ 7 $ 640 $ 9

Commercial real estate:

Non-owner occupied
632 — — —

Owner occupied
2,092 — 3,103 —

Residential real estate:

ITIN
4,983 32 5,957 37

1-4 family mortgage
139 — 186 —

Equity lines
123 2 228 4

Consumer and other
17 — 39 —

Total
$ 10,006 $ 41 $ 10,153 $ 50

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), 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.

The recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure was $109 thousand and $80 thousand at March 31, 2021 and December 31, 2020, respectively.

Troubled Debt Restructurings

As of March 31, 2021, we had $6.0 million in troubled debt restructurings compared to $6.1 million as of December 31, 2020. As of March 31, 2021, we had 90 loans that were classified as troubled debt restructurings, of which 88 were performing according to their restructured terms. Of the 90 troubled debt restructurings, 82 were ITIN loans totaling $4.7 million which are serviced by a third party. Troubled debt restructurings represented 0.52% of gross loans as of March 31, 2021, compared to 0.53% of gross loans at December 31, 2020.

At March 31, 2021 and December 31, 2020, impaired loans of $4.0 million and $4.1 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, 2021 and December 31, 2020, we had no obligations to lend additional funds on any troubled debt restructured loans. We do not have any new troubled debt restructurings for the three months ended March 31, 2021 and 2020. There was one $626 thousand commercial real estate loan modified as troubled debt restructuring within the previous twelve months for which there were a payment default (after restructuring) during the three months ended March 31, 2021.

Performing and Nonperforming Loans

We define a performing loan as a loan where any installment of principal or interest is not 90 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 90 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, 2021 and December 31, 2020.

March 31, 2021

(Amounts in thousands)

Performing

Nonperforming

Total

Performing and Nonperforming Loans:

Commercial
$ 116,077 $ 1,520 $ 117,597

PPP
117,991 — 117,991

Commercial real estate:

Construction and land development
32,145 — 32,145

Non-owner occupied
591,531 626 592,157

Owner occupied
165,272 95 165,367

Residential real estate:

ITIN
26,310 1,529 27,839

1-4 family mortgage
54,425 137 54,562

Equity lines
18,600 — 18,600

Consumer and other
19,668 17 19,685

Total
$ 1,142,019 $ 3,924 $ 1,145,943

December 31, 2020

(Amounts in thousands)

Performing

Nonperforming

Total

Performing and Nonperforming Loans:

Commercial
$ 114,024 $ 1,535 $ 115,559

PPP
130,814 — 130,814

Commercial real estate:

Construction and land development
44,549 — 44,549

Non-owner occupied
549,380 640 550,020

Owner occupied
169,873 3,094 172,967

Residential real estate:

ITIN
27,450 1,585 29,035

1-4 family mortgage
55,784 141 55,925

Equity lines
18,894 — 18,894

Consumer and other
21,951 18 21,969

Total
$ 1,132,719 $ 7,013 $ 1,139,732

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 no 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 or 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, 2021 and December 31, 2020.

As of March 31, 2021

Special

(Amounts in thousands)

Pass

Watch

Mention

Substandard

Doubtful

Total

Loan Portfolio:

Commercial
$ 103,683 $ 8,555 $ 381 $ 4,978 $ — $ 117,597

PPP
117,991 — — — — 117,991

Commercial real estate:

Construction and land development
31,831 117 — 197 — 32,145

Non-owner occupied
490,585 62,451 33,455 5,666 — 592,157

Owner occupied
145,573 12,366 — 7,428 — 165,367

Residential real estate:

ITIN
24,441 — — 3,398 — 27,839

1-4 family mortgage
52,655 — — 1,907 — 54,562

Equity lines
18,600 — — — — 18,600

Consumer and other
19,666 2 — 17 — 19,685

Total
$ 1,005,025 $ 83,491 $ 33,836 $ 23,591 $ — $ 1,145,943

As of December 31, 2020

Special

(Amounts in thousands)

Pass

Watch

Mention

Substandard

Doubtful

Total

Loan Portfolio:

Commercial
$ 102,067 $ 8,549 $ 540 $ 4,403 $ — $ 115,559

PPP
130,814 — — — — 130,814

Commercial real estate:

Construction and land development
41,767 2,782 — — — 44,549

Non-owner occupied
456,725 79,845 12,810 640 — 550,020

Owner occupied
152,623 13,945 414 5,985 — 172,967

Residential real estate:

ITIN
25,558 — — 3,477 — 29,035

1-4 family mortgage
54,288 195 — 1,442 — 55,925

Equity lines
18,894 — — — — 18,894

Consumer and other
21,952 — — 17 — 21,969

Total
$ 1,004,688 $ 105,316 $ 13,764 $ 15,964 $ — $ 1,139,732

Allowance for Loan and Lease Losses

The following tables summarize the ALLL by portfolio for the three months ended March 31, 2021 and 2020.

For the Three Months Ended March 31, 2021

Paycheck

Protection

Commercial

Residential

(Amounts in thousands)

Commercial

Program ⁽¹⁾

Real Estate

Real Estate

Consumer

Unallocated

Total

ALLL by Loan Portfolio:

Beginning balance
$ 2,402 $ — $ 11,895 $ 1,324 $ 683 $ 606 $ 16,910

Charge-offs
— — — (22 ) (68 ) — (90 )

Recoveries
10 — 110 25 62 — 207

Provision
(46 ) — 248 (106 ) (120 ) 24 —

Ending balance
$ 2,366 $ — $ 12,253 $ 1,221 $ 557 $ 630 $ 17,027

⁽¹⁾ PPP loans are fully guaranteed by SBA and no allowance is provided for them.

For the Three Months Ended March 31, 2020

Paycheck

Protection

Commercial

Residential

(Amounts in thousands)

Commercial

Program

Real Estate

Real Estate

Consumer

Unallocated

Total

ALLL by Loan Portfolio:

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

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, 2021 and December 31, 2020, the unallocated allowance amount represented 4% of the ALLL. The following tables summarize the ALLL and the recorded investment in loans and leases as of March 31, 2021 and December 31, 2020.

As of March 31, 2021

Paycheck

Protection

Commercial

Residential

(Amounts in thousands)

Commercial

Program⁽¹⁾

Real Estate

Real Estate

Consumer

Unallocated

Total

ALLL:

Individually evaluated for impairment
$ 114 $ — $ — $ 70 $ 4 $ — $ 188

Collectively evaluated for impairment
2,252 — 12,253 1,151 553 630 16,839

Total
$ 2,366 $ — $ 12,253 $ 1,221 $ 557 $ 630 $ 17,027

Gross loans:

Individually evaluated for impairment
$ 2,014 $ — $ 721 $ 5,207 $ 17 $ — $ 7,959

Collectively evaluated for impairment
115,583 117,991 788,948 95,794 19,668 — 1,137,984

Total gross loans
$ 117,597 $ 117,991 $ 789,669 $ 101,001 $ 19,685 $ — $ 1,145,943

⁽¹⁾ PPP loans are fully guaranteed by SBA and no allowance is provided for them.

As of December 31, 2020

Paycheck

Protection

Commercial

Residential

(Amounts in thousands)

Commercial

Program⁽¹⁾

Real Estate

Real Estate

Consumer

Unallocated

Total

ALLL:

Individually evaluated for impairment
$ 114 $ — $ — $ 74 $ 4 $ — $ 192

Collectively evaluated for impairment
2,288 — 11,895 1,250 679 606 16,718

Total
$ 2,402 $ — $ 11,895 $ 1,324 $ 683 $ 606 $ 16,910

Gross loans:

Individually evaluated for impairment
$ 2,033 $ — $ 3,734 $ 5,318 $ 18 $ — $ 11,103

Collectively evaluated for impairment
113,526 130,814 763,802 98,536 21,951 — 1,128,629

Total gross loans
$ 115,559 $ 130,814 $ 767,536 $ 103,854 $ 21,969 $ — $ 1,139,732

⁽¹⁾ PPP loans are fully guaranteed by SBA and no allowance is provided for them.

The ALLL totaled $17.0 million or 1.49% of total gross loans at March 31, 2021 and $16.9 million or 1.48% of total gross loans at December 31, 2020. As of March 31, 2021 and December 31, 2020, we had commitments to extend credit of $281.4 million and $267.8 million, respectively. The reserve for unfunded commitments recorded in Other Liabilities in the Consolidated Balance Sheets at March 31, 2021 and December 31, 2020 was $800 thousand.

We believe that the ALLL was adequate as of March 31, 2021. There is, however, no 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.

COVID-19

During 2020 based on our anticipation that the COVID‐19 pandemic would result in economic recession and increased loan losses, particularly in certain hard hit industries, we significantly increased our qualitative credit risk factors for “changes in international, national, regional and local conditions” and “changes in the volume and severity of past due loans and other similar conditions”.

During the current quarter, we decreased our qualitative credit risk factor for “changes in international, national, regional and local conditions” to reflect our more positive outlook on the economy.

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.

We formally assess the adequacy of the ALLL on a quarterly basis. 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 (“ASC 450”) and ASC Topic 310 Receivables (“ASC 310”).

Management’s assessment of the ALLL is based on our continuing evaluation of all known relevant quantitative and qualitative internal and external risk factors provides the foundation for the four major components of the ALLL:

(1)

Historical valuation allowances established in accordance with ASC 450, for groups of similarly situated loan pools.

(2)

General valuation allowances established in accordance with ASC 450, that are based on qualitative credit risk factors (e.g., portfolio trends, concentration of credit, growth, economic factors). Loss estimation factors are based on analysis of local economic factors. 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.

(3)

Specific valuation allowances established in accordance with ASC 310, that are based on estimated probable losses on specific impaired loans.

(4)

Unallocated valuation allowances established in accordance with ASC 310 and ASC 450, that are based on credit losses inherent in the loan portfolio but not contemplated in the credit loss factors.

All four 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 no 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.

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.

Our assessment of the adequacy of the ALLL includes 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.

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 1-4 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, changes in economic conditions, and any other relevant factors. Management evaluates each qualitative component quarterly to determine the associated risks to the quality of our loan portfolio.

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.

PPP Loans - The Paycheck Protection Program (“PPP”) was launched in April of 2020 to provide small businesses assistance in the form of forgivable 100% guaranteed U.S. SBA loans. We have actively participated in the PPP and at March 31, 2021, we have 424 loans totaling $118.0 million. This financial support of our customers’ businesses may help moderate other Commercial and Commercial Real Estate loan losses. The loans are underwritten following the guidelines and approval process from the SBA and pose essentially no credit risk to the loan portfolio.

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 no greater than $1 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 12-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, 2021, approximately 78% of our gross loan portfolio (87% excluding PPP loans) 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 loan 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.

Reserve For Unfunded Commitments

The reserve for unfunded commitments, which is included in Other Liabilities in the Consolidated Balance Sheets, was $800 thousand at March 31, 2021 and December 31, 2020. The adequacy of the reserve for unfunded commitments is reviewed on a quarterly basis, based upon changes in the amount of commitments, loss experience, and economic conditions. When necessary, the provision expense is recorded in other noninterest expense in the Consolidated Statements of Income.