Allowance for Loan Losses and Credit Quality

The ALL is established for estimated losses in the loan portfolio through a provision for loan losses charged to earnings. For all loan classes, loan losses are charged against the ALL when management believes the loan balance is uncollectible or in accordance with federal guidelines. Subsequent recoveries, if any, are credited to the ALL.

The ALL is maintained at a level believed by management to be appropriate to absorb probable credit losses inherent in the loan portfolio as of the balance sheet date. The amount of the ALL is based on management's periodic evaluation of the collectability of the loan portfolio, including the nature, volume and risk characteristics of the portfolio, credit concentrations, trends in historical loss experience, estimated value of any underlying collateral, specific impaired loans and economic conditions. There was no change to the methodology used to estimate the ALL during the first quarter of 2020. While management uses available information to recognize losses on loans, future additions to the ALL may be necessary based on changes in economic conditions or other relevant factors.

In addition, various regulatory agencies, as an integral part of their examination process, regularly review the Company's ALL. Such agencies may require the Company to recognize additions to the ALL, with a corresponding charge to earnings, based on their judgments about information available to them at the time of their examination, which may not be currently available to management.

The ALL consists of specific, general and unallocated components. The specific component relates to the loans that are classified as impaired. Loans are evaluated for impairment and may be classified as impaired when management believes it is probable that the Company will not collect all the contractual interest and principal payments as scheduled in the loan agreement. Impaired loans may also include troubled loans that are restructured. A TDR occurs when the Company, for economic or legal reasons related to the borrower's financial difficulties, grants a concession to the borrower that would otherwise not be granted. A TDR classification may result from the transfer of assets to the Company in partial satisfaction of a troubled loan, a modification of a loan's terms (such as reduction of stated interest rates below market rates, extension of maturity that does not conform to the Company's policies, reduction of the face amount of the loan, reduction of accrued interest, or reduction or deferment of loan payments), or a combination. A specific reserve amount is allocated to the ALL for individual loans that have been classified as impaired based on management's estimate of the fair value of the collateral for collateral dependent loans, an observable market price, or the present value of anticipated future cash flows. The Company accounts for the change in present value attributable to the passage of time in the loan loss reserve. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer, real estate or small balance commercial loans for impairment evaluation, unless such loans are subject to a restructuring agreement or have been identified as impaired as part of a larger customer relationship. Based on an evaluation of the Company's historical loss experience on substandard commercial loans, management has established the commercial loan threshold for individual impairment evaluation as commercial loan relationships with aggregate balances greater than $500 thousand.

The general component represents the level of ALL allocable to each loan portfolio segment with similar risk characteristics and is determined based on historical loss experience, adjusted for qualitative factors, for each class of loan. Management deems a five year average to be an appropriate time frame on which to base historical losses for each portfolio segment. Qualitative factors considered include underwriting, economic and market conditions, portfolio composition, collateral values, delinquencies, lender experience and legal issues. The qualitative factors are determined based on the various risk characteristics of each portfolio segment. Risk characteristics relevant to each portfolio segment are as follows:

•

Residential real estate - Loans in this segment are collateralized by owner-occupied 1-4 family residential real estate, second and vacation homes, 1-4 family investment properties, home equity and second mortgage loans. Repayment is dependent on the credit quality of the individual borrower. The overall health of the economy, including unemployment rates and housing prices, could have an effect on the credit quality of this segment.

•

Construction real estate - Loans in this segment include residential and commercial construction properties, commercial real estate development loans (while in the construction phase of the projects), land and land development loans. Repayment is dependent on the credit quality of the individual borrower and/or the underlying cash flows generated by the properties being constructed. The overall health of the economy, including unemployment rates, housing prices, vacancy rates and material costs, could have an effect on the credit quality of this segment.

•

Commercial real estate - Loans in this segment are primarily properties occupied by businesses or income-producing properties. The underlying cash flows generated by the properties may be adversely impacted by a downturn in the economy as evidenced by a general slowdown in business or increased vacancy rates which, in turn, could have an effect on the credit quality of this segment. Management requests business financial statements at least annually and monitors the cash flows of these loans.


•	Commercial - Loans in this segment are made to businesses and are generally secured by non-real estate assets of the business. Repayment is expected from the cash flows of the business. A weakened economy, and resultant decreased consumer or business spending, could have an effect on the credit quality of this segment.


•	Consumer - Loans in this segment are made to individuals for personal expenditures, such as an automobile purchase, and include unsecured loans. Repayment is primarily dependent on the credit quality of the individual borrower. The overall health of the economy, including unemployment, could have an effect on the credit quality of this segment.


•	Municipal - Loans in this segment are made to municipalities located within the Company's service area. Repayment is primarily dependent on taxes or other funds collected by the municipalities. Management considers there to be minimal risk surrounding the credit quality of this segment.

An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the ALL reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

All evaluations are inherently subjective as they require estimates that are susceptible to significant revision as more information becomes available or as changes occur in economic conditions or other relevant factors. Despite the allocation shown in the tables below, the ALL is general in nature and is available to absorb losses from any class of loan.

Changes in the ALL, by class of loans, for the three months ended March 31, 2020 and 2019 were as follows:



For The Three Months Ended March 31, 2020	Residential Real Estate		Construction Real Estate			Commercial Real Estate			Commercial		Consumer		Municipal		Unallocated			Total
	(Dollars in thousands)
Balance, December 31, 2019	$	1,392	$	774		$	3,178		$	394	$	23	$	76	$	285		$	6,122
Provision (credit) for loan losses	98		(152		)	335			13		—		9		(3		)	300
Recoveries of amounts charged off	23		—			—			—		—		—		—			23
	1,513		622			3,513			407		23		85		282			6,445
Amounts charged off	—		—			(54		)	—		—		—		—			(54		)
Balance, March 31, 2020	$	1,513	$	622		$	3,459		$	407	$	23	$	85	$	282		$	6,391



For The Three Months Ended March 31, 2019	Residential Real Estate			Construction Real Estate		Commercial Real Estate			Commercial			Consumer			Municipal		Unallocated			Total
	(Dollars in thousands)
Balance, December 31, 2018	$	1,368		$	617	$	2,933		$	354		$	23		$	82	$	362		$	5,739
Provision (credit) for loan losses	37			26		(70		)	177			2			10		(132		)	50
Recoveries of amounts charged off	—			—		—			1			3			—		—			4
	1,405			643		2,863			532			28			92		230			5,793
Amounts charged off	(16		)	—		—			(200		)	(5		)	—		—			(221		)
Balance, March 31, 2019	$	1,389		$	643	$	2,863		$	332		$	23		$	92	$	230		$	5,572

The allocation of the ALL, summarized on the basis of the Company's impairment methodology by class of loan, as of the balance sheet dates, was as follows:



March 31, 2020	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Unallocated		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	68	$	—	$	133	$	7	$	—	$	—	$	—	$	208
Collectively evaluated for impairment	1,445		622		3,326		400		23		85		282		6,183
Total allocated	$	1,513	$	622	$	3,459	$	407	$	23	$	85	$	282	$	6,391



December 31, 2019	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Unallocated		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	39	$	—	$	149	$	8	$	—	$	—	$	—	$	196
Collectively evaluated for impairment	1,353		774		3,029		386		23		76		285		5,926
Total allocated	$	1,392	$	774	$	3,178	$	394	$	23	$	76	$	285	$	6,122

The recorded investment in loans, summarized on the basis of the Company's impairment methodology by class of loan, as of the balance sheet dates, was as follows:



March 31, 2020	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	1,488	$	218	$	3,158	$	280	$	—	$	—	$	5,144
Collectively evaluated for impairment	188,932		53,989		301,046		47,353		3,460		76,607		671,387
Total	$	190,420	$	54,207	$	304,204	$	47,633	$	3,460	$	76,607	$	676,531



December 31, 2019	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	1,515	$	223	$	3,204	$	299	$	—	$	—	$	5,241
Collectively evaluated for impairment	190,610		69,394		286,679		47,400		3,562		67,358		665,003
Total	$	192,125	$	69,617	$	289,883	$	47,699	$	3,562	$	67,358	$	670,244

Risk and collateral ratings are assigned to loans and are subject to ongoing monitoring by lending and credit personnel with such ratings updated annually or more frequently if warranted. The following is an overview of the Company's loan rating system:

1-3 Rating - Pass

Risk-rating grades "1" through "3" comprise those loans ranging from those with lower than average credit risk, defined as borrowers with high liquidity, excellent financial condition, strong management, favorable industry trends or loans secured by highly liquid assets, through those with marginal credit risk, defined as borrowers that, while creditworthy, exhibit some characteristics requiring special attention by the account officer.

4/M Rating - Satisfactory/Monitor

Borrowers exhibit potential credit weaknesses or downward trends warranting management's attention. While potentially weak, these borrowers are currently marginally acceptable; no loss of principal or interest is envisioned. When warranted, these credits may be monitored on the watch list.

5-7 Rating - Substandard

Borrowers exhibit well defined weaknesses that jeopardize the orderly liquidation of debt. The loan may be inadequately protected by the net worth and paying capacity of the obligor and/or the underlying collateral is inadequate.

The following tables summarize the loan ratings applied by management to the Company's loans by class as of the balance sheet dates:



March 31, 2020	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Total
	(Dollars in thousands)
Pass	$	172,425	$	33,632	$	174,365	$	35,464	$	3,364	$	76,607	$	495,857
Satisfactory/Monitor	15,078		20,091		125,767		11,595		91		—		172,622
Substandard	2,917		484		4,072		574		5		—		8,052
Total	$	190,420	$	54,207	$	304,204	$	47,633	$	3,460	$	76,607	$	676,531



December 31, 2019	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Municipal		Total
	(Dollars in thousands)
Pass	$	174,798	$	47,326	$	168,654	$	35,625	$	3,499	$	67,358	$	497,260
Satisfactory/Monitor	14,520		21,819		117,004		10,974		57		—		164,374
Substandard	2,807		472		4,225		1,100		6		—		8,610
Total	$	192,125	$	69,617	$	289,883	$	47,699	$	3,562	$	67,358	$	670,244

The following tables provide information with respect to impaired loans by class of loan as of and for the three months ended March 31, 2020 and March 31, 2019:



	As of March 31, 2020						For The Three Months Ended March 31, 2020
	Recorded Investment (1)		Principal Balance (1)		Related Allowance		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
Residential real estate	$	216	$	226	$	68
Commercial real estate	1,746		1,781		133
Commercial	25		27		7
With an allowance recorded	1,987		2,034		208

Residential real estate	1,272		1,818		—
Construction real estate	218		237		—
Commercial real estate	1,412		1,509		—
Commercial	255		257		—
With no allowance recorded	3,157		3,821		—

Residential real estate	1,488		2,044		68		$	1,502	$	19
Construction real estate	218		237		—		220		1
Commercial real estate	3,158		3,290		133		3,181		22
Commercial	280		284		7		290		7
Total	$	5,144	$	5,855	$	208	$	5,193	$	49

____________________


(1)	Does not reflect government guaranties on impaired loans as of March 31, 2020 totaling $570 thousand.



	As of March 31, 2019						For The Three Months Ended March 31, 2019
	Recorded Investment (1)		Principal Balance (1)		Related Allowance		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
Residential real estate	$	1,720	$	2,344	$	46	$	1,699	$	19
Construction real estate	114		131		—		116		1
Commercial real estate	1,669		1,761		11		1,973		40
Commercial	340		342		10		346		5
Total	$	3,843	$	4,578	$	67	$	4,134	$	65

____________________


(1)	Does not reflect government guaranties on impaired loans as of March 31, 2019 totaling $630 thousand.

The following table provides information with respect to impaired loans by class of loan as of December 31, 2019:



	December 31, 2019
	Recorded Investment (1)		Principal Balance (1)		Related Allowance
	(Dollars in thousands)
Residential real estate	$	218	$	228	$	39
Commercial real estate	1,762		1,783		149
Commercial	11		12		8
With an allowance recorded	1,991		2,023		196

Residential real estate	1,297		1,832		—
Construction real estate	223		241		—
Commercial real estate	1,442		1,539		—
Commercial	288		290		—
With no allowance recorded	3,250		3,902		—

Residential real estate	1,515		2,060		39
Construction real estate	223		241		—
Commercial real estate	3,204		3,322		149
Commercial	299		302		8
Total	$	5,241	$	5,925	$	196

____________________


(1)	Does not reflect government guaranties on impaired loans as of December 31, 2019 totaling $587 thousand.

The following is a summary of TDR loans by class of loan as of the balance sheet dates:



	March 31, 2020			December 31, 2019
	Number of Loans	Principal Balance		Number of Loans	Principal Balance
	(Dollars in thousands)
Residential real estate	25	$	1,488	25	$	1,515
Construction real estate	2	96		2	100
Commercial real estate	8	950		8	966
Commercial	5	271		5	290
Total	40	$	2,805	40	$	2,871

The TDR loans above represent loan modifications in which a concession was provided to the borrower, including due date extensions, maturity date extensions, interest rate reductions or the forgiveness of accrued interest. Troubled loans that are restructured and meet established thresholds are classified as impaired and a specific reserve amount is allocated to the ALL on the basis of the fair value of the collateral for collateral dependent loans, an observable market price, or the present value of anticipated future cash flows.

The following tables provide new TDR activity for the three months ended March 31, 2020 and 2019:



	New TDRs During the					New TDRs During the
	Three Months Ended March 31, 2020					Three Months Ended March 31, 2019
	Number of Loans	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
	(Dollars in thousands)
Residential real estate	—	$	—	$	—	1	$	77	$	79

There were no TDR loans modified within the previous twelve months that subsequently defaulted during the three months ended March 31, 2020 or 2019. TDR loans are considered defaulted at 90 days past due.

In March 2020, the federal banking agencies issued guidance, confirmed by the FASB, that certain modifications made in loans to a borrower affected by the COVID-19 pandemic and government shutdown orders would not be considered a TDR under specified circumstances (See Note 2). As of April 30, 2020, the Company has executed 335 of these modifications on outstanding loan balances of $160.5 million. The Company intends to continue to follow the guidance of the banking regulators in making TDR determinations.

At March 31, 2020 and December 31, 2019, the Company was not committed to lend any additional funds to borrowers whose loans were nonperforming, impaired or restructured.