Loans

Management segments the Banks' loan portfolio to a level that enables risk and performance monitoring according to similar risk characteristics. Loans are segmented based on the underlying collateral characteristics. Categories include commercial, financial, and agricultural, real estate, and installment loans to individuals. Real estate loans are further segmented into three categories: residential, commercial, and construction.

The following table presents the related aging categories of loans, by segment, as of March 31, 2017 and December 31, 2016:



	March 31, 2017
				Past Due		Past Due 90
				30 To 89		Days Or More		Non-
(In Thousands)	Current			Days		& Still Accruing		Accrual		Total
Commercial, financial, and agricultural	$	141,648		$	277	$	9	$	128	$	142,062
Real estate mortgage:
Residential	558,068			5,244		—		1,899		565,211
Commercial	302,700			671		132		8,682		312,185
Construction	37,289			101		—		—		37,390
Installment loans to individuals	54,950			605		—		21		55,576
	1,094,655			$	6,898	$	141	$	10,730	1,112,424
Net deferred loan fees and discounts	(1,324		)							(1,324		)
Allowance for loan losses	(12,905		)							(12,905		)
Loans, net	$	1,080,426								$	1,098,195



	December 31, 2016
				Past Due		Past Due 90
				30 To 89		Days Or More		Non-
(In Thousands)	Current			Days		& Still Accruing		Accrual		Total
Commercial, financial, and agricultural	$	145,179		$	785	$	14	$	132	$	146,110
Real estate mortgage:
Residential	553,053			9,112		587		1,988		564,740
Commercial	296,537			786		268		8,591		306,182
Construction	33,879			771		—		—		34,650
Installment loans to individuals	43,008			202		1		45		43,256
	1,071,656			$	11,656	$	870	$	10,756	1,094,938
Net deferred loan fees and discounts	(1,257		)							(1,257		)
Allowance for loan losses	(12,896		)							(12,896		)
Loans, net	$	1,057,503								$	1,080,785

Purchased loans acquired are recorded at fair value on their purchase date without a carryover of the related allowance for loan losses.

Upon the acquisition of Luzerne Bank on June 1, 2013, the Company evaluated whether each acquired loan (regardless of size) was within the scope of ASC 310-30, Receivables-Loans and Debt Securities Acquired with Deteriorated Credit Quality. Purchased credit-impaired loans are loans that have evidence of credit deterioration since origination and it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. There were no material increases or decreases in the expected cash flows of these loans between June 1, 2013 (the “acquisition date”) and March 31, 2017. The fair value of purchased credit-impaired loans, on the acquisition date, was determined, primarily based on the fair value of loan collateral.

On the acquisition date, the preliminary estimate of the unpaid principal balance for all loans evidencing credit impairment acquired in the Luzerne Bank acquisition was $1,211,000 and the estimated fair value of the loans was $878,000. Total contractually required payments on these loans, including interest, at the acquisition date was $1,783,000. However, the Company’s preliminary estimate of expected cash flows was $941,000. At such date, the Company established a credit risk related non-accretable discount (a discount representing amounts which are not expected to be collected from either the customer or liquidation of collateral) of $842,000 relating to these impaired loans, reflected in the recorded net fair value. Such amount is reflected as a non-accretable fair value adjustment to loans. The Company further estimated the timing and amount of expected cash flows in excess of the estimated fair value and established an accretable discount of $63,000 on the acquisition date relating to these impaired loans.

The following table presents interest income the Banks would have recorded if interest had been recorded based on the original loan agreement terms and rate of interest for non-accrual loans and interest income recognized on a cash basis for non-accrual loans for the three months ended March 31, 2017 and 2016:



	Three Months Ended March 31,
	2017				2016
(In Thousands)	Interest Income That Would Have Been Recorded Based on Original Term and Rate		Interest Income Recorded on a Cash Basis		Interest Income That Would Have Been Recorded Based on Original Term and Rate		Interest Income Recorded on a Cash Basis
Commercial, financial, and agricultural	$	6	$	—	$	4	$	1
Real estate mortgage:
Residential	151		101		32		14
Commercial	496		105		169		64
Construction	—		—		6		—
	$	653	$	206	$	211	$	79

Impaired Loans

Impaired loans are loans for which it is probable the Banks will not be able to collect all amounts due according to the contractual terms of the loan agreement. The Banks evaluate such loans for impairment individually and does not aggregate loans by major risk classifications. The definition of “impaired loans” is not the same as the definition of “non-accrual loans,” although the two categories overlap. The Banks may choose to place a loan on non-accrual status due to payment delinquency or uncertain collectability, while not classifying the loan as impaired. Factors considered by management in determining impairment include payment status and collateral value. The amount of impairment for these types of loans is determined by the difference between the present value of the expected cash flows related to the loan, using the original interest rate, and its recorded value, or as a practical expedient in the case of collateralized loans, the difference between the fair value of the collateral and the recorded amount of the loan. When foreclosure is probable, impairment is measured based on the fair value of the collateral.

Management evaluates individual loans in all of the commercial segments for possible impairment if the loan is greater than $100,000 and if the loan is either on non-accrual status or has a risk rating of substandard. Management may also elect to measure an individual loan for impairment if less than $100,000 on a case-by-case basis.

Mortgage loans on one-to-four family properties and all consumer loans are large groups of smaller-balance homogeneous loans and are measured for impairment collectively. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. Management determines the significance of payment delays on a case-by-case basis taking into consideration all circumstances surrounding the loan and the borrower including the length of the delay, the borrower’s prior payment record, and the amount of shortfall in relation to the principal and interest owed. Interest income for impaired loans is recorded consistent with the Banks' policy on non-accrual loans.

The following table presents the recorded investment, unpaid principal balance, and related allowance of impaired loans by segment as of March 31, 2017 and December 31, 2016:



	March 31, 2017
	Recorded		Unpaid Principal		Related
(In Thousands)	Investment		Balance		Allowance
With no related allowance recorded:
Commercial, financial, and agricultural	$	55	$	55	$	—
Real estate mortgage:
Residential	1,563		1,563		—
Commercial	1,564		1,564		—
Installment loans to individuals	—		—		—
	3,182		3,182		—
With an allowance recorded:
Commercial, financial, and agricultural	129		129		74
Real estate mortgage:
Residential	1,674		1,674		567
Commercial	10,571		10,666		1,723
Installment loans to individuals	4		4		4
	12,378		12,473		2,368
Total:
Commercial, financial, and agricultural	184		184		74
Real estate mortgage:
Residential	3,237		3,237		567
Commercial	12,135		12,230		1,723
Installment loans to individuals	4		4		4
	$	15,560	$	15,655	$	2,368



	December 31, 2016
	Recorded		Unpaid Principal		Related
(In Thousands)	Investment		Balance		Allowance
With no related allowance recorded:
Commercial, financial, and agricultural	$	109	$	109	$	—
Real estate mortgage:
Residential	1,584		1,584		—
Commercial	1,833		1,833		—
Installment loans to individuals	—		—		—
	3,526		3,526		—
With an allowance recorded:
Commercial, financial, and agricultural	132		132		74
Real estate mortgage:
Residential	1,893		1,893		437
Commercial	10,425		10,520		1,668
Installment loans to individuals	—		—		—
	12,450		12,545		2,179
Total:
Commercial, financial, and agricultural	241		241		74
Real estate mortgage:
Residential	3,477		3,477		437
Commercial	12,258		12,353		1,668
Installment loans to individuals	—		—		—
	$	15,976	$	16,071	$	2,179

The following table presents the average recorded investment in impaired loans and related interest income recognized for the three months ended for March 31, 2017 and 2016:



	Three Months Ended March 31,
	2017						2016
(In Thousands)	Average Investment in Impaired Loans		Interest Income Recognized on an Accrual Basis on Impaired Loans		Interest Income Recognized on a Cash Basis on Impaired Loans		Average Investment in Impaired Loans		Interest Income Recognized on an Accrual Basis on Impaired Loans		Interest Income Recognized on a Cash Basis on Impaired Loans
Commercial, financial, and agricultural	$	212	$	4	$	—	$	533	$	4	$	1
Real estate mortgage:
Residential	3,258		22		16		2,899		22		14
Commercial	11,946		33		10		12,829		82		63
Construction	—		—		—		245		—		1
Installment loans to individuals	2		—		—		—		—		—
	$	15,418	$	59	$	26	$	16,506	$	108	$	79

Currently, there is $26,000 committed to be advanced in connection with impaired loans.

Troubled Debt Restructurings

The loan portfolio also includes certain loans that have been modified in a Troubled Debt Restructuring (“TDR”), where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance, or other actions. Certain TDRs are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months.

There were no loan modifications that were considered TDRs completed during the three months ended March 31 for both 2017 and 2016.

There were no loan modifications considered to be TDRs made during the twelve months previous to March 31, 2017 that defaulted during the three months ended March 31, 2017. There were five loan modifications considered TDRs made during the twelve months previous to March 31, 2016 that defaulted during the three months ended March 31, 2016. The defaulted loan types and recorded investments at March 31, 2016 are as follows: one commercial loan with a recorded investment of $103,000, one commercial real estate loan with a recorded investment of $239,000, and three residential real estate loan with a recorded investment of $173,000.

Troubled debt restructurings amounted to $8,998,000 and $9,180,000 as of March 31, 2017 and December 31, 2016.

The amount of foreclosed residential real estate held at March 31, 2017 and December 31, 2016, totaled $547,000 and 839,000, respectively. Consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process at March 31, 2017 and December 31, 2016, totaled $78,000 and 167,000, respectively.

Internal Risk Ratings

Management uses a ten point internal risk rating system to monitor the credit quality of the overall loan portfolio. The first six categories are considered not criticized, and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The special mention category includes assets that are currently protected but are potentially weak, resulting in an undue and unwarranted credit risk, but not to the point of justifying a substandard classification. Loans in the substandard category have well-defined weaknesses that jeopardize the liquidation of the debt, and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected. All loans greater than 90 days past due are evaluated for substandard classification. Loans in the doubtful category exhibit the same weaknesses found in the substandard loans, however, the weaknesses are more pronounced. Such loans are static and collection in full is improbable. However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Loans classified loss are considered uncollectible and charge-off is imminent.

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay a loan as agreed, the Banks have a structured loan rating process with several layers of internal and external oversight. Generally, consumer and residential mortgage loans are included in the pass category unless a specific action, such as bankruptcy, repossession, or death occurs to raise awareness of a possible credit event. An external annual loan review of large commercial relationships is performed, as well as a sample of smaller transactions. Confirmation of the appropriate risk category is included in the review. Detailed reviews, including plans for resolution, are performed on loans classified as substandard, doubtful, or loss on a quarterly basis.

The following table presents the credit quality categories identified above as of March 31, 2017 and December 31, 2016:



	March 31, 2017
	Commercial, Financial, and Agricultural		Real Estate Mortgages						Installment Loans to Individuals
(In Thousands)	Commercial, Financial, and Agricultural		Residential		Commercial		Construction		Installment Loans to Individuals		Totals
Pass	$	136,886	$	561,995	$	283,564	$	37,236	$	55,576	$	1,075,257
Special Mention	2,852		850		9,907		—		—		13,609
Substandard	2,324		2,366		18,714		154		—		23,558
	$	142,062	$	565,211	$	312,185	$	37,390	$	55,576	$	1,112,424



	December 31, 2016
	Commercial, Financial, and Agricultural		Real Estate Mortgages						Installment Loans to Individuals
(In Thousands)	Commercial, Financial, and Agricultural		Residential		Commercial		Construction		Installment Loans to Individuals		Totals
Pass	$	140,497	$	561,440	$	277,916	$	34,493	$	43,256	$	1,057,602
Special Mention	2,943		740		11,143		—		—		14,826
Substandard	2,670		2,560		17,123		157		—		22,510
	$	146,110	$	564,740	$	306,182	$	34,650	$	43,256	$	1,094,938

Allowance for Loan Losses

An allowance for loan losses (“ALL”) is maintained to absorb losses from the loan portfolio. The ALL is based on management’s continuing evaluation of the risk characteristics and credit quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated future loss experience, and the amount of non-performing loans.

The Banks' methodology for determining the ALL is based on the requirements of ASC Section 310-10-35 for loans individually evaluated for impairment (previously discussed) and ASC Subtopic 450-20 for loans collectively evaluated for impairment, as well as the Interagency Policy Statements on the Allowance for Loan and Lease Losses and other bank regulatory guidance. The total of the two components represents the Banks' ALL.

Loans that are collectively evaluated for impairment are analyzed with general allowances being made as appropriate. Allowances are segmented based on collateral characteristics previously disclosed, and consistent with credit quality monitoring. Loans that are collectively evaluated for impairment are grouped into two classes for evaluation. A general allowance is determined for “Pass” rated credits, while a separate pool allowance is provided for “Criticized” rated credits that are not individually evaluated for impairment.

For the general allowances, historical loss trends are used in the estimation of losses in the current portfolio. These historical loss amounts are modified by other qualitative factors. A historical charge-off factor is calculated utilizing a twelve quarter moving average. However, management may adjust the moving average time frame by up to four quarters to adjust for variances in the economic cycle. Management has identified a number of additional qualitative factors which it uses to supplement the historical charge-off factor because these factors are likely to cause estimated credit losses associated with the existing loan pools to differ from historical loss experience. The additional factors that are evaluated quarterly and updated using information obtained from internal, regulatory, and governmental sources are: national and local economic trends and conditions; levels of and trends in delinquency rates and non-accrual loans; trends in volumes and terms of loans; effects of changes in lending policies; experience, ability, and depth of lending staff; value of underlying collateral; and concentrations of credit from a loan type, industry and/or geographic standpoint.

Loans in the criticized pools, which possess certain qualities or characteristics that may lead to collection and loss issues, are closely monitored by management and subject to additional qualitative factors. Management also monitors industry loss factors by loan segment for applicable adjustments to actual loss experience.

Management reviews the loan portfolio on a quarterly basis in order to make appropriate and timely adjustments to the ALL. When information confirms all or part of specific loans to be uncollectible, these amounts are promptly charged off against the ALL.

Activity in the allowance is presented for the three months ended March 31, 2017 and 2016:



	Three Months Ended March 31, 2017
	Commercial, Financial, and Agricultural			Real Estate Mortgages								Installment Loans to Individuals
(In Thousands)	Commercial, Financial, and Agricultural			Residential			Commercial			Construction		Installment Loans to Individuals			Unallocated		Totals
Beginning Balance	$	1,554		$	5,383		$	4,975		$	178	$	416		$	390	$	12,896
Charge-offs	(213		)	(98		)	—			—		(77		)	—		(388		)
Recoveries	6			30			—			3		28			—		67
Provision	94			256			(509		)	6		181			302		330
Ending Balance	$	1,441		$	5,571		$	4,466		$	187	$	548		$	692	$	12,905



	Three Months Ended March 31, 2016
	Commercial, Financial, and Agricultural			Real Estate Mortgages							Installment Loans to Individuals
(In Thousands)	Commercial, Financial, and Agricultural			Residential		Commercial		Construction			Installment Loans to Individuals			Unallocated		Totals
Beginning Balance	$	1,532		$	5,116	$	4,217	$	160		$	243		$	776	$	12,044
Charge-offs	—			—		—		—			(51		)	—		(51		)
Recoveries	—			3		5		3			28			—		39
Provision	(278		)	4		250		(16		)	44			346		350
Ending Balance	$	1,254		$	5,123	$	4,472	$	147		$	264		$	1,122	$	12,382

The shifts in allocation of the loan provision is due to an increase in residential originations along with a tapering of commercial originations.

The Company grants commercial, industrial, residential, and installment loans to customers primarily throughout north-east and central Pennsylvania. Although the Company has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within this region.

The Company has a concentration of the following to gross loans at March 31, 2017 and 2016:



	March 31,
	2017		2016
Owners of residential rental properties	16.29	%	16.27	%
Owners of commercial rental properties	14.66	%	14.27	%

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based on impairment method as of March 31, 2017 and December 31, 2016:



	March 31, 2017
	Commercial, Financial, and Agricultural		Real Estate Mortgages						Installment Loans to Individuals		Unallocated
(In Thousands)	Commercial, Financial, and Agricultural		Residential		Commercial		Construction		Installment Loans to Individuals		Unallocated		Totals
Allowance for Loan Losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	74	$	567	$	1,723	$	—	$	4	$	—	$	2,368
Collectively evaluated for impairment	1,367		5,004		2,743		187		544		692		10,537
Total ending allowance balance	$	1,441	$	5,571	$	4,466	$	187	$	548	$	692	$	12,905

Loans:
Individually evaluated for impairment	$	184	$	3,237	$	12,135	$	—	$	4			$	15,560
Collectively evaluated for impairment	141,878		561,974		300,050		37,390		55,572				1,096,864
Total ending loans balance	$	142,062	$	565,211	$	312,185	$	37,390	$	55,576			$	1,112,424



	December 31, 2016
	Commercial, Financial, and Agricultural		Real Estate Mortgages						Installment Loans to Individuals		Unallocated
(In Thousands)	Commercial, Financial, and Agricultural		Residential		Commercial		Construction		Installment Loans to Individuals		Unallocated		Totals
Allowance for Loan Losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	74	$	437	$	1,668	$	—	$	—	$	—	$	2,179
Collectively evaluated for impairment	1,480		4,946		3,307		178		416		390		10,717
Total ending allowance balance	$	1,554	$	5,383	$	4,975	$	178	$	416	$	390	$	12,896

Loans:
Individually evaluated for impairment	$	241	$	3,477	$	12,258	$	—	$	—			$	15,976
Collectively evaluated for impairment	145,869		561,263		293,924		34,650		43,256				1,078,962
Total ending loans balance	$	146,110	$	564,740	$	306,182	$	34,650	$	43,256			$	1,094,938