Note 6. Loan Quality

Management utilizes a risk rating scale ranging from 1 (Prime) to 9 (Loss) to evaluate loan quality. This risk rating scale is used primarily for commercial purpose loans. Consumer purpose loans are identified as either a pass or substandard rating. Substandard consumer loans are loans that are 90 days or more past due and still accruing. Loans rated 1 – 4 are considered pass credits. Loans that are rated 5 are pass credits, but have been identified as credits that are likely to warrant additional attention and monitoring. Loans rated 6 (Special Mention) or worse begin to receive enhanced monitoring and reporting by the Bank. Loans rated 7 (Substandard) or 8 (Doubtful) exhibit the greatest financial weakness and present the greatest possible risk of loss to the Bank. Nonaccrual loans are rated no better than 7. The following represents some of the factors used in determining the risk rating of a borrower: cash flow, debt coverage, liquidity, management, and collateral. Risk ratings, for pass credits, are generally reviewed annually for term debt and at renewal for revolving or renewing debt. The Bank monitors loan quality by reviewing four measurements: (1) loans rated 6 or worse (collectively “watch list”), (2) delinquent loans, (3) other real estate owned (OREO), and (4) net-charge-offs. Management compares trends in these measurements with the Bank’s internally established targets, as well as its national peer group.

Watch list loans exhibit financial weaknesses that increase the potential risk of default or loss to the Bank. However, inclusion on the watch list, does not by itself, mean a loss is certain. The watch list includes both performing and nonperforming loans. Watch list loans totaled $40.5 million at year-end, approximately half of the $76.3 million watch list at the prior year-end. The watch list is comprised of $17.9 million rated 6, and $22.5 million rated 7. Loans rated 7 have declined by $34.8 million since year-end 2013. The Bank has no loans rated 8 (Doubtful) or 9 (Loss). Included in the 2014 substandard loan total is $12.3 million of nonaccrual loans compared to $24.6 million one year earlier.

The following table reports on the credit rating for those loans in the portfolio that are assigned an individual credit rating as of December 31, 2014 and 2013




(Dollars in thousands)	Pass		Special Mention		Substandard		Doubtful		Total

December 31, 2014
Residential Real Estate 1-4 Family
First liens	$	155,676	$	1,919	$	3,719	$	-	$	161,314
Junior liens and lines of credit		43,559		29		207		-		43,795
Total		199,235		1,948		3,926		-		205,109
Residential real estate - construction		8,784		-		931		-		9,715
Commercial real estate		301,149		10,578		14,755		-		326,482
Commercial		170,774		5,413		2,884		-		179,071
Consumer		6,137		-		17		-		6,154
Total	$	686,079	$	17,939	$	22,513	$	-	$	726,531



December 31, 2013
Residential Real Estate 1-4 Family
First liens	$	150,762	$	3,653	$	7,624	$	-	$	162,039
Junior liens and lines of credit		40,102		66		407		-		40,575
Total		190,864		3,719		8,031		-		202,614
Residential real estate - construction		10,955		-		1,564		-		12,519
Commercial real estate		281,857		11,861		35,655		-		329,373
Commercial		154,888		3,393		12,046		-		170,327
Consumer		8,570		-		10		-		8,580
Total	$	647,134	$	18,973	$	57,306	$	-	$	723,413

Delinquent loans are a result of borrowers’ cash flow and/or alternative sources of cash being insufficient to repay loans. The Bank’s likelihood of collateral liquidation to repay the loans becomes more probable the further behind a borrower falls, particularly when loans reach 90 days or more past due. Management monitors the performance status of loans by the use of an aging report. The aging report can provide an early indicator of loans that may become severely delinquent and possibly result in a loss to the Bank. The following table presents the aging of payments in the loan portfolio as of December 31, 2014 and 2013.



(Dollars in thousands)			Loans Past Due and Still Accruing										Total
	Current		30-59 Days		60-89 Days		90 Days+		Total		Non-Accrual		Loans
December 31, 2014
Residential Real Estate 1-4 Family
First liens	$	158,197	$	1,531	$	297	$	165	$	1,993	$	1,124	$	161,314
Junior liens and lines of credit		43,424		174		28		-		202		169		43,795
Total		201,621		1,705		325		165		2,195		1,293		205,109
Residential real estate - construction		8,784		-		-		-		-		931		9,715
Commercial real estate		317,576		336		-		140		476		8,430		326,482
Commercial		177,407		12		15		-		27		1,637		179,071
Consumer		6,056		59		22		17		98		-		6,154
Total	$	711,444	$	2,112	$	362	$	322	$	2,796	$	12,291	$	726,531



December 31, 2013
Residential Real Estate 1-4 Family
First liens	$	156,916	$	1,725	$	497	$	302	$	2,524	$	2,599	$	162,039
Junior liens and lines of credit		40,204		204		19		41		264		107		40,575
Total		197,120		1,929		516		343		2,788		2,706		202,614
Residential real estate - construction		11,458		523		-		-		523		538		12,519
Commercial real estate		309,531		634		-		207		841		19,001		329,373
Commercial		167,747		78		60		44		182		2,398		170,327
Consumer		8,430		117		23		10		150		-		8,580
Total	$	694,286	$	3,281	$	599	$	604	$	4,484	$	24,643	$	723,413

Nonaccruing loans generally represent Management’s determination that the borrower will be unable to repay the loan in accordance with its contractual terms and that collateral liquidation may or may not fully repay both interest and principal. It is the Bank’s policy to evaluate the probable collectability of principal and interest due under terms of loan contracts for all loans 90-days or more past due, nonaccrual loans or impaired loans. Further, it is the Bank’s policy to discontinue accruing interest on loans that are not adequately secured and in the process of collection. Upon determination of nonaccrual status, the Bank subtracts any current year accrued and unpaid interest from its income, and any prior year accrued and unpaid interest from the allowance for loan losses. Management continually monitors the status of nonperforming loans, the value of any collateral and potential of risk of loss. Nonaccrual loans are rated no better than 7 (Substandard).

The following table provides additional information on significant nonaccrual loans.

December 31, 2014

(Dollars in thousands)

ALL

Nonaccrual

TDR

Last

Balance

Reserve

Date

Status

Collateral

Location

Appraisal(1)

Credit 1 - Commercial real estate

3,040

Dec-10

1st lien on 90 acres undeveloped commercial real estate

Nov-14

5,855

Credit 2 - Residential real estate and commercial real estate

864

Aug-11

1st lien on commercial and residential properties and 70 acres of farm land

Aug-14

1,290

Credit 3 - Residential real estate

1,985

Mar-12

1st and 2nd liens on commercial real estate, residential real estate and business assets

Oct-14

3,895

Credit 4 - Commercial real estate

1,756

Dec-14

Hotel and entertainment complex

Feb-14

4,007

Credit 5 - Commercial / commercial real estate

1,831

162

Mar-13

Liens on land, commercial and residential real estate and business assets

Sep-14

2,965

Credit 6 - Commercial real estate

729

Mar-14

1st lien on commercial real estate

Jun-13

1,550

10,205

162

(1) Appraisal value, as reported, does not reflect the pay-off of any senior liens or the cost to liquidate the collateral, but does reflect only the Bank’s share of the collateral if it is a participated loan.

Interest not recognized on nonaccrual loans was $752 thousand, $96 thousand and $800 thousand for the years ended December 31, 2014, 2013 and 2012, respectively. In addition to monitoring nonaccrual loans, the Bank also closely monitors impaired loans and troubled debt restructurings. A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Nonaccrual loans, excluding consumer purpose loans, and TDR loans are considered impaired. For impaired loans with balances less than $250 thousand and consumer purpose loans, a specific reserve analysis is not performed and these loans are added to the general allocation pool. Impaired loans totaled $26.6 million at year-end 2014 compared to $30.9 million at December 31, 2013.

The following table for additional information on impaired loans.



	Impaired Loans
	With No Allowance				With Allowance
(Dollars in thousands)			Unpaid						Unpaid
	Recorded		Principal		Recorded		Principal			Related
December 31, 2014	Investment		Balance		Investment		Balance			Allowance
Residential Real Estate 1-4 Family
First liens	$	1,804	$	2,002	$	-	$	-		$	-
Junior liens and lines of credit		169		195		-		-			-
Total		1,973		2,197		-		-			-
Residential real estate - construction		931		977		-		-			-
Commercial real estate		21,487		25,744		862		1,001			60
Commercial		78		80		1,274		1,990			171
Consumer		-		-		-		-			-
Total	$	24,469	$	28,998	$	2,136	$	2,991		$	231



December 31, 2013
Residential Real Estate 1-4 Family
First liens	$	3,030	$	3,500	$	9	$	39	$	9
Junior liens and lines of credit		108		127		-		-		-
Total		3,138		3,627		9		39		9
Residential real estate - construction		537		556		-		-		-
Commercial real estate		24,188		30,334		966		1,043		89
Commercial		88		89		1,970		2,043		1,002
Consumer		-		-		-		-		-
Total	$	27,951	$	34,606	$	2,945	$	3,125	$	1,100



	Twelve Months Ended				Twelve Months Ended
	December 31, 2014				December 31, 2013
	Average		Interest		Average		Interest
(Dollars in thousands)	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
Residential Real Estate 1-4 Family
First liens	$	2,619	$	4	$	3,365	$	4
Junior liens and lines of credit		136		-		417		-
Total		2,755		4		3,782		4
Residential real estate - construction		686		-		544		-
Commercial real estate		23,801		118		31,730		118
Commercial		1,890		-		2,112		-
Consumer		-		-		-		-
Total	$	29,132	$	122	$	38,168	$	122

A loan is considered a troubled debt restructuring (TDR) if the creditor (the Bank), for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. These concessions may include lowering the interest rate, extending the maturity, reamortization of payment, or a combination of multiple concessions. The Bank reviews all loans rated 6 or worse when it is providing a loan restructure, modification or new credit facility to determine if the action is a TDR. If a TDR loan is placed on nonaccrual status, it remains on nonaccrual status for at least six months to ensure performance. However, TDR loans are always considered impaired until paid-off. All TDR loans are in compliance with their modified terms except one, credit 3 on the significant nonaccrual table contained in this note. The following table identifies TDR loans as of December 31, 2014 and 2013:



								Troubled Debt Restructurings
								That Have Defaulted on
(Dollars in thousands)	Troubled Debt Restructurings							Modified Terms YTD
	Number of	Recorded						Number of	Recorded
	Contracts	Investment			Performing*		Nonperforming*	Contracts	Investment
December 31, 2014
Residential real estate - construction	1	$	521	$	-	$	521	-	$	-
Residential real estate	5		699		673		26	-		-
Commercial real estate	12		15,748		14,283		1,465	-		-
Total	18	$	16,968	$	14,956	$	2,012	-	$	-



December 31, 2013
Residential real estate - construction	1	$	537	$	-	$	537	-	$	-
Residential real estate	5		625		625		-	-		-
Commercial	12		15,877		14,318		1,559	-		-
Total	18	$	17,039	$	14,943	$	2,096	-	$	-

*The performing status is determined by the loans compliance with the modified terms.

The following table reports new TDR loans made during 2014, concession granted and the recorded investment at December 31, 2014.



(Dollars in thousands)	New During Period
	Number of	Pre-TDR		After-TDR		Recorded
Twelve Months Ended December 31, 2014	Contracts	Modification		Modification		Investment		Concession
Residential real estate	1	$	168	$	158	$	158	multiple
Total	1	$	168	$	158	$	158

The following table reports new TDR loans made during 2013, concession granted and the recorded investment as of December 31, 2013.



(Dollars in thousands)	New During Period
	Number of	Pre-TDR		After-TDR		Recorded
Twelve Months Ended December 31, 2013	Contracts	Modification		Modification		Investment		Concession
Residential real estate	2	$	286	$	323	$	311	multiple
Commercial real estate	2		10,458		10,745		10,493	multiple
Total	4	$	10,744	$	11,068	$	10,804

The Bank holds $3.7 million of other real estate owned (OREO), comprised of five properties compared to $4.7 million and eight properties one year earlier. During 2014, the Bank recorded net losses on the sales of, or write-downs on OREO of $220 thousand that is recorded in other income. The Bank also incurred $45 thousand in expense to hold and maintain OREO. The following table provides additional information on significant other real estate owned properties.

The following table provides additional information on significant other real estate owned properties.



December 31, 2014

(Dollars in thousands)	Date						Last
	Acquired		Balance	Collateral	Location		Appraisal

Property 1 (2 properties)	2011	$	488	Unimproved and improved real estate for residential development - 1 tract with 23 acres	PA		Jan-14
						$	585

Property 2	2012		2,758	1st, 2nd, and 3rd liens residential development land - 4 tracts with 196 acres	PA		Apr-14
						$	2,950
		$	3,246

At December 31, 2014, the Bank had $763 thousand of residential properties in the process of foreclosure compared to $1.0 million at the end of 2013.

Allowance for Loan Losses:

Management performs a monthly evaluation of the adequacy of the allowance for loan losses (ALL). The ALL is determined by segmenting the loan portfolio based on the loan’s collateral. The Bank further classifies the portfolio based on the primary purpose of the loan, either consumer or commercial. When calculating the ALL, consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, historical charge-offs, the adequacy of the underlying collateral (if collateral dependent) and other relevant factors. The Bank begins enhanced monitoring of all loans rated 6 (OAEM) or worse, and obtains a new appraisal or asset valuation for any placed on nonaccrual and rated 7 (substandard) or worse. Management, at its discretion, may determine that additional adjustments to the appraisal or valuation are required. Valuation adjustments will be made as necessary based on factors, including, but not limited to: the economy, deferred maintenance, industry, type of property/equipment, age of the appraisal, etc. and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. When determining the allowance for loan losses, certain factors involved in the evaluation are inherently subjective and require material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans. Management monitors the adequacy of the allowance for loan losses on an ongoing basis and reports its adequacy quarterly to the Credit Risk Oversight Committee of the Board of Directors. Management believes that the allowance for loan losses at December 31, 2014 is adequate.

The analysis for determining the ALL is consistent with guidance set forth in generally accepted accounting principles (GAAP) and the Interagency Policy Statement on the Allowance for Loan and Lease Losses. The analysis has two components, specific and general allocations. The specific component addresses specific reserves established for impaired loans. A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Collateral values discounted for market conditions and selling costs are used to establish specific allocations for impaired loans. However, it is possible that as a result of the credit analysis, a specific reserve is not required for an impaired loan. The balance of impaired loans and the ALL for these loans declined in 2014. At December 31, 2013, $993 thousand of the ALL for impaired loans was for credit 5 on the table of significant nonaccrual loans contained in this note. Due to a $549 thousand charge-off in 2014 on this credit, the specific ALL decreased significantly and the change in this credit accounts for the majority of the decrease in total ALL for impaired loans.

The general allocation component addresses the reserves established for pools of homogenous loans. The general component includes a quantitative and qualitative analysis. When calculating the general allocation, the Bank segregates its loan portfolio into the following sectors based primarily on the type of supporting collateral: residential real estate, commercial, industrial or agricultural real estate; commercial and industrial (C&I non-real estate), and consumer. The residential real estate sector is further segregated by first lien loans, junior liens and home equity products, and residential real estate construction. The historical loss experience factor for the general allocation was 1.00% of gross loans at December 31, 2014, compared to 0.99% at the prior year-end. The quantitative analysis uses the Bank’s eight quarter rolling historical loan loss experience adjusted for factors derived from current economic and market conditions that have been determined to have an effect on the probability and magnitude of a loss. The qualitative analysis utilizes a risk matrix that incorporates qualitative and environmental factors such as: loan volume, management, loan review process, credit concentrations, competition, and legal and regulatory issues. These factors are each risk rated from minimal to high risk and in total can add up to a qualitative factor of 37.5 basis points. At December 31, 2014, the qualitative factor was 21.5 basis points, a slight increase from the prior year-end. These factors are determined on the basis of Management’s observation, judgment and experience.

Real estate appraisals and collateral valuations are an important part of the Bank’s process for determining potential loss on collateral dependent loans and thereby have a direct effect on the determination of loan reserves, charge-offs and the calculation of the allowance for loan losses. As long as the loan remains a performing loan, no further updates to appraisals are required. If a loan or relationship migrates to nonaccrual and a risk rating of 7 or worse, an evaluation for impairment status is made based on the current information available at the time of downgrade and a new appraisal or collateral valuation is obtained. We believe this practice complies with the regulatory guidance dated December 12, 2010.

In determining the allowance for loan losses, Management, at its discretion, may determine that additional adjustments to the fair value obtained from an appraisal or collateral valuation are required. Adjustments will be made as necessary based on factors, including, but not limited to the economy, deferred maintenance, industry, type of property or equipment etc., and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. If an appraisal is not available, Management may make its best estimate of the real value of the collateral or use last known market value and apply appropriate discounts. If an adjustment is made to the collateral valuation, this will be documented with appropriate support and reported to the Loan Management Committee.

The following table shows, by loan class, the activity in the ALL, for the years ended December 31, 2014, 2013 and 2012.



							Commercial
	Residential Real Estate 1-4 Family						Industrial &		Commercial
			Junior Liens &				Agricultural		Industrial &
(Dollars in thousands)	First Liens		Lines of Credit		Construction		Real Estate		Agricultural		Consumer		Total

Allowance at December 31, 2011	$	1,049	$	308	$	1,222	$	5,257	$	1,651	$	236	$	9,723
Charge-offs		(251)		(71)		-		(3,298)		(861)		(236)		(4,717)
Recoveries		1		25		-		13		21		88		148
Provision		114		44		(323)		4,478		809		103		5,225
Allowance at December 31, 2012	$	913	$	306	$	899	$	6,450	$	1,620	$	191	$	10,379

Allowance at December 31, 2012	$	913	$	306	$	899	$	6,450	$	1,620	$	191	$	10,379
Charge-offs		(547)		(45)		-		(2,855)		(363)		(162)		(3,972)
Recoveries		13		-		-		203		100		59		375
Provision		729		17		(608)		1,773		949		60		2,920
Allowance at December 31, 2013	$	1,108	$	278	$	291	$	5,571	$	2,306	$	148	$	9,702

Allowance at December 31, 2013	$	1,108	$	278	$	291	$	5,571	$	2,306	$	148	$	9,702
Charge-offs		(291)		-		(41)		(408)		(644)		(189)		(1,573)
Recoveries		21		-		-		50		65		82		218
Provision		387		56		(24)		204		46		95		764
Allowance at December 31, 2014	$	1,225	$	334	$	226	$	5,417	$	1,773	$	136	$	9,111

The following table shows, by loan class, the loans that were evaluated for the ALL under a specific reserve (individually) and those that were evaluated under a general reserve (collectively), and the amount of the allowance established in each category as of December 31, 2014 and 2013.



							Commercial
	Residential Real Estate 1-4 Family						Industrial &		Commercial
			Junior Liens &				Agricultural		Industrial &
(Dollars in thousands)	First Liens		Lines of Credit		Construction		Real Estate		Agricultural		Consumer		Total

December 31, 2014
Loans evaluated for allowance:
Individually	$	1,171	$	51	$	931	$	22,307	$	1,298	$	-	$	25,758
Collectively		160,143		43,744		8,784		304,175		177,773		6,154		700,773
Total	$	161,314	$	43,795	$	9,715	$	326,482	$	179,071	$	6,154	$	726,531

Allowance established for loans evaluated:
Individually	$	-	$	-	$	-	$	60	$	171	$	-	$	231
Collectively		1,225		334		226		5,357		1,602		136		8,880
Allowance at December 31, 2014	$	1,225	$	334	$	226	$	5,417	$	1,773	$	136	$	9,111

December 31, 2013
Loans evaluated for allowance:
Individually	$	2,354	$	50	$	537	$	25,107	$	1,996	$	-	$	30,044
Collectively		159,685		40,525		11,982		304,266		168,331		8,580		693,369
Total	$	162,039	$	40,575	$	12,519	$	329,373	$	170,327	$	8,580	$	723,413

Allowance established for loans evaluated:
Individually	$	9	$	-	$	-	$	89	$	1,002	$	-	$	1,100
Collectively		1,099		278		291		5,482		1,304		148		8,602
Allowance at December 31, 2013	$	1,108	$	278	$	291	$	5,571	$	2,306	$	148	$	9,702