Note 7. Credit Quality and Related Allowance for Loan Losses

Management segments the Bank’s 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 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 June 30, 2013 and December 31, 2012:

	June 30, 2013
				Past Due		Past Due 90
				30 To 89		Days Or More		Non-
(In Thousands)	Current			Days		& Still Accruing		Accrual		Total
Commercial and agricultural	$	118,303		$	78	$	—	$	572	$	118,953
Real estate mortgage:
Residential	338,083			1,779		8		1,106		340,976
Commercial	292,728			137		—		3,664		296,529
Construction	15,193			1		—		1,165		16,359
Installment loans to individuals	14,753			352		—		—		15,105
	779,060			$	2,347	$	8	$	6,507	787,922
Net deferred loan fees and discounts	(961		)							(961		)
Allowance for loan losses	(9,404		)							(9,404		)
Loans, net	$	768,695								$	777,557

	December 31, 2012
				Past Due		Past Due 90
				30 To 89		Days Or More		Non-
(In Thousands)	Current			Days		& Still Accruing		Accrual		Total
Commercial and agricultural	$	48,322		$	133	$	—	$	—	$	48,455
Real estate mortgage:
Residential	245,674			4,888		351		1,229		252,142
Commercial	177,539			443		—		4,049		182,031
Construction	13,813			177		—		6,077		20,067
Installment loans to individuals	10,550			109		—		—		10,659
	495,898			$	5,750	$	351	$	11,355	513,354
Net deferred loan fees and discounts	(1,122		)							(1,122		)
Allowance for loan losses	(7,617		)							(7,617		)
Loans, net	$	487,159								$	504,615

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

Upon acquisition, 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 June 30, 2013. The fair value of purchased credit-impaired loans, on the acquisition date, was determined, primarily based on the fair value of loan collateral. The carrying value of purchased loans acquired with deteriorated credit quality was $882,000 at June 30, 2013.

On the acquisition date, the preliminary estimate of the unpaid principal balance for all loans evidencing credit impairment acquired in the Luzerne 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 the customer nor 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 carrying value of the loans acquired and accounted for in accordance with ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, was determined by projecting discounted contractual cash flows. The table below presents the components of the purchase accounting adjustments related to the purchased impaired loans acquired in the Luzerne acquisition as of June 1, 2013:

(In Thousands)
Unpaid principal balance	$	1,211
Interest	572
Contractual cash flows	1,783
Non-accretable discount	(842		)
Expected cash flows	941
Accretable discount	(63		)
Estimated fair value	$	878

Changes in the amortizable yield for purchased credit-impaired loans were as follows for the month ended June 30, 2013:

(In Thousands)
Balance at beginning of period	$	63
Accretion	(4		)
Balance at end of period	$	59

The following table presents additional information regarding loans acquired and accounted for in accordance with ASC 310-30:

	June 1, 2013		June 30, 2013
(In Thousands)	Acquired Loans with Specific Evidence of Deterioration in Credit Quality (ASC 310-30)		Acquired Loans with Specific Evidence of Deterioration in Credit Quality (ASC 310-30)
Outstanding balance	$	1,211	$	1,211
Carrying amount	878		882

The following table presents the interest income 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 and six months ended June 30, 2013 and 2012:

	Three Months Ended June 30,
	2013				2012
(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 and agricultural	$	4	$	—	$	—	$	—
Real estate mortgage:
Residential	22		3		4		7
Commercial	31		34		22		5
Construction	40		14		105		25
	$	97	$	51	$	131	$	37

	Six Months Ended June 30,
	2013				2012
(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 and agricultural	$	4	$	—	$	—	$	—
Real estate mortgage:
Residential	54		12		12		13
Commercial	116		84		43		8
Construction	81		25		221		56
	$	255	$	121	$	276	$	77

Impaired Loans

Impaired loans are loans for which it is probable the Bank will not be able to collect all amounts due according to the contractual terms of the loan agreement. The Bank evaluates 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 Bank may choose to place a loan on non-accrual status due to payment delinquency or uncertain collectability, while not classifying the loan as impaired. A loan evaluated for impairment is considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. 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 Bank’s policy on nonaccrual loans.

The following table presents the recorded investment, unpaid principal balance, and related allowance of impaired loans by segment as of June 30, 2013 and December 31, 2012:

	June 30, 2013
	Recorded		Unpaid Principal		Related
(In Thousands)	Investment		Balance		Allowance
With no related allowance recorded:
Commercial and agricultural	$	303	$	439	$	—
Real estate mortgage:
Residential	986		1,151		—
Commercial	1,436		1,436		—
Construction	539		539		—
	3,264		3,565		—
With an allowance recorded:
Commercial and agricultural	556		556		319
Real estate mortgage:
Residential	892		1,021		302
Commercial	7,155		7,174		2,139
Construction	638		2,993		267
	9,241		11,744		3,027
Total:
Commercial and agricultural	859		995		319
Real estate mortgage:
Residential	1,878		2,172		302
Commercial	8,591		8,610		2,139
Construction	1,177		3,532		267
	$	12,505	$	15,309	$	3,027

	December 31, 2012
	Recorded		Unpaid Principal		Related
(In Thousands)	Investment		Balance		Allowance
With no related allowance recorded:
Commercial and agricultural	$	—	$	—	$	—
Real estate mortgage:
Residential	410		487		—
Commercial	324		324		—
Construction	2,894		4,599		—
	3,628		5,410		—
With an allowance recorded:
Commercial and agricultural	485		485		46
Real estate mortgage:
Residential	1,146		1,255		237
Commercial	8,515		8,611		2,018
Construction	3,196		4,696		234
	13,342		15,047		2,535
Total:
Commercial and agricultural	485		485		46
Real estate mortgage:
Residential	1,556		1,742		237
Commercial	8,839		8,935		2,018
Construction	6,090		9,295		234
	$	16,970	$	20,457	$	2,535

The following table presents the average recorded investment in impaired loans and related interest income recognized for the three and six months ended for June 30, 2013 and 2012:

	Three Months Ended June 30,
	2013						2012
(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 and agricultural	$	718	$	7	$	—	$	—	$	—	$	—
Real estate mortgage:
Residential	1,679		9		6		1,277		12		6
Commercial	8,491		46		38		6,488		93		5
Construction	2,532		—		14		8,419		—		26
	$	13,420	$	62	$	58	$	16,184	$	105	$	37

	Six Months Ended June 30,
	2013						2012
(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 and agricultural	$	615	$	13	$	—	$	—	$	—	$	—
Real estate mortgage:
Residential	1,618		17		11		1,386		25		29
Commercial	8,598		93		84		6,502		161		8
Construction	3,718		553		553		8,861		—		56
	$	14,549	$	676	$	648	$	16,749	$	186	$	93

There is approximately $126,000 committed to be advanced in connection with impaired loans.

Modifications

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.

Loan modifications that are considered TDRs completed during the three and six months ended June 30, 2013 and 2012 were as follows:

	Three Months Ended June 30,
	2013					2012
(In Thousands, Except Number of Contracts)	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Real estate mortgage:
Residential	2	$	61	$	61	1	$	49	$	49
Commercial	—	—		—		—	—		—
Construction	—	—		—		—	—		—
	2	$	61	$	61	1	$	49	$	49

	Six Months Ended June 30,
	2013					2012
(In Thousands, Except Number of Contracts)	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Real estate mortgage:
Residential	2	$	61	$	61	2	$	154	$	154
Commercial	2	264		264		1	37		37
Construction	—	—		—		2	26		26
	4	$	325	$	325	5	$	217	$	217

There were two loan modifications considered troubled debt restructurings made during the twelve months previous to June 30, 2013 that defaulted during the six months ended June 30, 2013. The loans that defaulted are commercial real estate loans that are currently in litigation with a recorded investment of $259,000 at June 30, 2013.

Troubled debt restructurings amounted to $10,961,000 and $16,217,000 as of June 30, 2013 and December 31, 2012.

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 considered Substandard. 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 Bank has 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 all commercial relationships $800,000 or greater 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 June 30, 2013 and December 31, 2012:

	June 30, 2013
	Commercial and		Real Estate Mortgages						Installment Loans
(In Thousands)	Agricultural		Residential		Commercial		Construction		to Individuals		Totals
Pass	$	111,182	$	339,476	$	278,576	$	12,790	$	15,105	$	757,129
Special Mention	7,390		—		5,349		—		—		12,739
Substandard	381		1,500		12,604		3,569		—		18,054
	$	118,953	$	340,976	$	296,529	$	16,359	$	15,105	$	787,922

	December 31, 2012
	Commercial and		Real Estate Mortgages						Installment Loans
(In Thousands)	Agricultural		Residential		Commercial		Construction		to Individuals		Totals
Pass	$	46,805	$	250,161	$	167,463	$	13,944	$	10,659	$	489,032
Special Mention	1,480		—		1,630		—		—		3,110
Substandard	170		1,981		12,938		6,123		—		21,212
	$	48,455	$	252,142	$	182,031	$	20,067	$	10,659	$	513,354

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 Bank’s 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 Bank’s 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. 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.

There has been no allowance for loan losses recorded for acquired loans with or without specific evidence of deterioration in credit quality as of June 1, 2013 as well as those acquired without specific evidence of deterioration in credit quality as of June 30, 2013.

Activity in the allowance is presented for the three and six months ended June 30, 2013 and 2012:

	Three Months Ended June 30, 2013
	Commercial and			Real Estate Mortgages							Installment Loans
(In Thousands)	Agricultural			Residential		Commercial			Construction		to Individuals			Unallocated		Totals
Beginning Balance	$	568		$	2,772	$	3,759		$	814	$	144		$	773	$	8,830
Charge-offs	—			—		(6		)	—		(25		)	—		(31		)
Recoveries	11			4		5			—		10			—		30
Provision	(39		)	269		230			29		12			74		575
Ending Balance	$	540		$	3,045	$	3,988		$	843	$	141		$	847	$	9,404

	Three Months Ended June 30, 2012
	Commercial and			Real Estate Mortgages									Installment Loans
(In Thousands)	Agricultural			Residential			Commercial			Construction			to Individuals			Unallocated		Totals
Beginning Balance	$	396		$	882		$	3,276		$	2,719		$	175		$	297	$	7,745
Charge-offs	—			(11		)	(18		)	(877		)	(19		)	—		(925		)
Recoveries	5			1			1			1			10			—		18
Provision	(46		)	88			(95		)	296			3			354		600
Ending Balance	$	355		$	960		$	3,164		$	2,139		$	169		$	651	$	7,438

	Six Months Ended June 30, 2013
	Commercial and		Real Estate Mortgages									Installment Loans
(In Thousands)	Agricultural		Residential			Commercial			Construction			to Individuals			Unallocated		Totals
Beginning Balance	$	361	$	1,954		$	3,831		$	950		$	144		$	377	$	7,617
Charge-offs	—		(134		)	(6		)	—			(50		)	—		(190		)
Recoveries	13		5			6			850			28			—		902
Provision	166		1,220			157			(957		)	19			470		1,075
Ending Balance	$	540	$	3,045		$	3,988		$	843		$	141		$	847	$	9,404

	Six Months Ended June 30, 2012
	Commercial and			Real Estate Mortgages									Installment Loans
(In Thousands)	Agricultural			Residential			Commercial			Construction			to Individuals			Unallocated		Totals
Beginning Balance	$	418		$	939		$	2,651		$	2,775		$	190		$	181	$	7,154
Charge-offs	—			(11		)	(18		)	(877		)	(51		)	—		(957		)
Recoveries	6			3			2			4			26			—		41
Provision	(69		)	29			529			237			4			470		1,200
Ending Balance	$	355		$	960		$	3,164		$	2,139		$	169		$	651	$	7,438

The Company grants commercial, industrial, residential, and installment loans to customers throughout north-east and central Pennsylvania. Although the Company has a diversified loan portfolio at June 30, 2013, 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 loans at June 30, 2013 and 2012 as follows:

	June 30,
	2013		2012
Owners of residential rental properties	14.71	%	13.52	%
Owners of commercial rental properties	14.15	%	15.25	%

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 June 30, 2013 and December 31, 2012:

	June 30, 2013
	Commercial and		Real Estate Mortgages						Installment Loans
(In Thousands)	Agricultural		Residential		Commercial		Construction		to Individuals		Unallocated		Totals
Allowance for Loan Losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	319	$	302	$	2,139	$	267	$	—	$	—	$	3,027
Collectively evaluated for impairment	221		2,743		1,849		576		141		847		6,377
Total ending allowance balance	$	540	$	3,045	$	3,988	$	843	$	141	$	847	$	9,404
Loans:
Individually evaluated for impairment	$	556	$	1,558	$	8,332	$	1,177	$	—			$	11,623
Loans acquired with deteriorated credit quality	303		320		259		—		—				882
Collectively evaluated for impairment	118,094		339,098		287,938		15,182		15,105				775,417
Total ending loans balance	$	118,953	$	340,976	$	296,529	$	16,359	$	15,105			$	787,922

	December 31, 2012
	Commercial and		Real Estate Mortgages						Installment Loans
(In Thousands)	Agricultural		Residential		Commercial		Construction		to Individuals		Unallocated		Totals
Allowance for Loan Losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	46	$	237	$	2,018	$	234	$	—	$	—	$	2,535
Collectively evaluated for impairment	315		1,717		1,813		716		144		377		5,082
Total ending allowance balance	$	361	$	1,954	$	3,831	$	950	$	144	$	377	$	7,617
Loans:
Individually evaluated for impairment	$	485	$	1,556	$	8,839	$	6,090	$	—			$	16,970
Collectively evaluated for impairment	47,970		250,586		173,192		13,977		10,659				496,384
Total ending loans balance	$	48,455	$	252,142	$	182,031	$	20,067	$	10,659			$	513,354