NOTE 4: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

Loans

The composition of our loan portfolio at December 31, 2012 and 2011 was as follows:



(In thousands)	December 31, 2012		December 31, 2011
Commercial, financial and agricultural	$	165,023	$	146,990
Municipal loans		84,689		101,705
Real estate loans – residential		489,951		439,818
Real estate loans – commercial		327,622		313,915
Real estate loans – construction		10,561		18,993
Installment loans		4,701		5,806
All other loans		376		399
Total loans	$	1,082,923	$	1,027,626

We primarily originate residential real estate, commercial, commercial real estate, municipal obligations and installment loans to customers throughout the state of Vermont. There are no significant industry concentrations in the loan portfolio. Loans totaled $1.08 billion and $1.03 billion at December 31, 2012 and 2011, respectively. Total loans included $(250) thousand and $11 thousand of net deferred loan origination fees at December 31, 2012 and December 31, 2011, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $376 thousand and $399 thousand at December 31, 2012 and 2011, respectively.

Allowance for Credit Losses

We have divided the loan portfolio into portfolio segments, each with different risk characteristics and methodologies for assessing risk. Each portfolio segment is broken down into class segments where appropriate. Class segments contain unique measurement attributes, risk characteristics and methods for monitoring and assessing risk that are necessary to develop the allowance for loan and lease losses. Unique characteristics such as borrower type, loan type, collateral type, and risk characteristics define each class segment. A description of the segments follows:

Commercial, financial and agricultural: We offer a variety of loan options to meet the specific needs of commercial customers including term loans and lines of credit. Such loans are made available to businesses for working capital such as inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment, receivables, inventory or other assets owned by the borrower. These loans carry a higher risk than commercial real estate loans by the nature of the underlying collateral, and the collateral value may change daily. To reduce the risk, management generally employs enhanced monitoring requirements, obtains personal guarantees and, where appropriate, may also attempt to secure real estate as collateral.

Municipal: Municipal loans primarily consist of shorter term loans issued on a tax-exempt basis which are considered general obligations of the municipality. These loans are generally viewed as lower risk and self-liquidating as Vermont statutes mandate that a municipality utilize its taxing power to meet its financial obligations. To a lesser extent, we also made longer term loans under the federal Qualified School Construction Bond program. Proceeds were used for the construction, rehabilitation or repair of public school properties and we receive a federal tax credit in lieu of interest income on these loans.

Real Estate – Residential: Residential real estate loans consist primarily of loans secured by first or second mortgages on primary residences. We originate adjustable-rate and fixed-rate, one-to-four family residential real estate loans for the construction, purchase or refinancing of a mortgage. These loans are collateralized by owner-occupied properties located in our market area. Loans on one-to-four family residential real estate are generally originated in amounts of no more than 80% of the purchase price or appraised value (whichever is lower). Mortgage title insurance and hazard insurance are required.

Real Estate – Commercial: We offer commercial real estate loans to finance real estate purchases and refinancing of existing commercial properties. These commercial real estate loans are secured by first liens on the real estate, which may include both owner occupied and non owner occupied facilities. The types of facilities financed include apartments, hotels, warehouses, retail facilities, manufacturing facilities and office buildings. Our underwriting analysis includes credit verification, independent appraisals, a review of the borrower's financial condition, and a detailed analysis of the borrower’s underlying cash flows.

Real Estate – Construction: We offer construction loans for the construction, expansion and improvement of residential and commercial properties which are secured by the real estate being developed. A review of all plans and budgets is performed prior to approval, third party progress documents are required during construction, and an independent approval process for all draw and release requests is maintained to ensure that funding is prudently administered and that funds are sufficient to complete the project.

Installment: We offer traditional direct consumer installment loans for various personal needs, including vehicle and boat financing. The vast majority of these loans are secured by a lien on the purchased vehicle and are underwritten using credit scores and income verification. We do not provide any indirect consumer lending activities.

For purposes of evaluating the adequacy of the allowance for credit losses, we consider a number of significant factors that affect the collectability of the portfolio. For individually evaluated loans, these include estimates of loss exposure, which reflect the facts and circumstances that affect the likelihood of repayment of such loans as of the evaluation date. For homogeneous pools of loans, estimates of our exposure to credit loss reflect a current assessment of a number of factors, which could affect collectability. These factors include: past loss experience; size, trend, composition, and nature of loans; changes in lending policies and procedures, including underwriting standards and collection, charge-offs and recoveries; trends experienced in nonperforming and delinquent loans; current economic conditions in our market; the effect of external factors such as competition, legal and regulatory requirements; and the experience, ability, and depth of lending management and staff. Past loss experience is based on net loan losses as a percentage of portfolio balances, using a five year weighted average. An external loan review firm and various regulatory agencies periodically review our allowance for credit losses.

After a thorough consideration of the factors discussed above, any required additions to the allowance for credit losses are made periodically by charges to the provision for credit losses. These charges are necessary to maintain the allowance for credit losses at a level which Management believes is reasonably reflective of overall inherent risk of probable loss in the portfolio. While Management uses available information to recognize losses on loans, additions may fluctuate from one reporting period to another. These fluctuations are reflective of changes in risk associated with portfolio content and/or changes in management’s assessment of any or all of the determining factors discussed above.

The following table reflects our loan loss experience and activity in the allowance for credit losses for the twelve months ended December 31, 2012:



(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Beginning balance	$	2,905	$	309	$	3,138	$	4,484	$	477	$	23	$	17	$	11,353
Charge-offs		(9)		0		(20)		(32)		0		0		0		(61)
Recoveries		30		0		14		1		25		0		0		70
Provision (credit)		521		213		450		46		(268)		(6)		(6)		950
Ending balance	$	3,447	$	522	$	3,582	$	4,499	$	234	$	17	$	11	$	12,312
Ending balance individually
evaluated for impairment	$	149	$	0	$	361	$	59	$	0	$	0	$	0	$	569
Ending balance collectively
evaluated for impairment		3,298		522		3,221		4,440		234		17		11		11,743
Totals	$	3,447	$	522	$	3,582	$	4,499	$	234	$	17	$	11	$	12,312
Financing receivables:
Ending balance individually
evaluated for impairment	$	233	$	0	$	2,317	$	472	$	0	$	0	$	0	$	3,022
Ending balance collectively
evaluated for impairment		164,790		84,689		487,634		327,150		10,561		4,701		376		1,079,901
Totals	$	165,023	$	84,689	$	489,951	$	327,622	$	10,561	$	4,701	$	376	$	1,082,923
Components:
Allowance for loan losses	$	2,915	$	494	$	3,494	$	4,444	$	187	$	17	$	11	$	11,562
Reserve for undisbursed
lines of credit		532		28		88		55		47		0		0		750
Total allowance for credit
losses	$	3,447	$	522	$	3,582	$	4,499	$	234	$	17	$	11	$	12,312

The following table reflects our loan loss experience and activity in the allowance for credit losses for the twelve months ended December 31, 2011:



(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Beginning balance	$	2,617	$	236	$	2,428	$	5,143	$	283	$	24	$	23	$	10,754
Charge-offs		(80)		0		(83)		(60)		(96)		(10)		0		(329)
Recoveries		101		0		4		44		25		4		0		178
Provision (credit)		267		73		789		(643)		265		5		(6)		750
Ending balance	$	2,905	$	309	$	3,138	$	4,484	$	477	$	23	$	17	$	11,353
Ending balance individually
evaluated for impairment	$	17	$	0	$	210	$	0	$	0	$	0	$	0	$	227
Ending balance collectively
evaluated for impairment		2,888		309		2,928		4,484		477		23		17		11,126
Totals	$	2,905	$	309	$	3,138	$	4,484	$	477	$	23	$	17	$	11,353
Financing receivables:
Ending balance individually
evaluated for impairment	$	114	$	0	$	1,985	$	412	$	0	$	0	$	0	$	2,511
Ending balance collectively
evaluated for impairment		146,876		101,705		437,833		313,503		18,993		5,806		399		1,025,115
Totals	$	146,990	$	101,705	$	439,818	$	313,915	$	18,993	$	5,806	$	399	$	1,027,626
Components:
Allowance for loan losses	$	2,412	$	307	$	3,025	$	4,442	$	393	$	23	$	17	$	10,619
Reserve for undisbursed
lines of credit		493		2		113		42		84		0		0		734
Total allowance for credit
losses	$	2,905	$	309	$	3,138	$	4,484	$	477	$	23	$	17	$	11,353

The table below presents the recorded investment of loans, including nonaccrual and restructured loans, segregated by class, with delinquency aging as of December 31, 2012:



	30-59 Days		60-89 Days		90 Days or More		Total Past						Greater Than 90 Days and
(In thousands)	Past Due		Past Due		Past Due		Due		Current		Total		Accruing
Commercial, financial and agricultural	$	0	$	0	$	0	$	0	$	165,023	$	165,023	$	0
Municipal		0		0		0		0		84,689		84,689		0
Real estate-residential:
First mortgage		92		43		950		1,085		449,956		451,041		0
Second mortgage		0		0		716		716		38,194		38,910		0
Real estate-commercial:
Owner occupied		0		0		295		295		222,013		222,308		0
Non-owner occupied		0		0		0		0		105,314		105,314		0
Real estate-construction:
Residential		0		0		0		0		1,559		1,559		0
Commercial		0		0		0		0		9,002		9,002		0
Installment		0		0		0		0		4,701		4,701		0
Other		0		0		0		0		376		376		0
Total	$	92	$	43	$	1,961	$	2,096	$	1,080,827	$	1,082,923	$	0

All of the total past due loans in the aging table above consist of non-accruing and restructured loans. There were no past due performing loans at December 31, 2012.

The table below presents the recorded investment of loans, including nonaccrual and restructured loans, segregated by class, with delinquency aging as of December 31, 2011:



	30-59 Days		60-89 Days		90 Days or More		Total Past						Greater Than 90 Days and
(In thousands)	Past Due		Past Due		Past Due		Due		Current		Total		Accruing
Commercial, financial and agricultural	$	0	$	40	$	8	$	48	$	146,942	$	146,990	$	0
Municipal		0		0		0		0		101,705		101,705		0
Real estate-residential:
First mortgage		39		305		731		1,075		400,256		401,331		0
Second mortgage		0		0		281		281		38,206		38,487		0
Real estate-commercial:
Owner occupied		0		325		87		412		205,844		206,256		0
Non-owner occupied		0		0		0		0		107,659		107,659		0
Real estate-construction:
Residential		0		0		0		0		1,798		1,798		0
Commercial		0		0		0		0		17,195		17,195		0
Installment		0		0		0		0		5,806		5,806		0
Other		0		0		0		0		399		399		0
Total	$	39	$	670	$	1,107	$	1,816	$	1,025,810	$	1,027,626	$	0

Non-accruing and restructured loans make up $1.60 million of the total past due loans in the aging table above.

Impaired loans by class at December 31, 2012 are as follows:



(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	7	$	970	$	0	$	39	$	1
Real estate – residential:
First mortgage		853		1,174		0		807		51
Second mortgage		16		52		0		247		34
Real estate – commercial:
Owner occupied		295		487		0		380		3
Non-owner occupied		0		70		0		0		0
Installment		0		45		0		1		0
With related allowance recorded
Commercial, financial and agricultural		226		228		149		37		2
Real estate – residential:
First mortgage		748		766		173		662		1
Second mortgage		700		700		188		320		0
Real estate – commercial:
Owner occupied		177		179		59		136		2
Total
Commercial, financial and agricultural		233		1,198		149		76		3
Real estate – residential		2,317		2,692		361		2,036		86
Real estate – commercial		472		736		59		516		5
Installment and other		0		45		0		1		0
Total	$	3,022	$	4,671	$	569	$	2,629	$	94

Impaired loans by class at December 31, 2011 are as follows:



(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	77	$	1,099	$	0	$	154	$	0
Real estate – residential:
First mortgage		914		1,162		0		1,201		44
Second mortgage		222		224		0		325		43
Real estate – commercial:
Owner occupied		412		548		0		495		11
Non-owner occupied		0		70		0		64		4
Real estate – construction:
Commercial		0		94		0		107		0
Installment		0		43		0		3		1
With related allowance recorded
Commercial, financial and agricultural		37		43		17		240		18
Real estate – residential:
First mortgage		790		830		207		761		0
Second mortgage		59		60		3		34		0
Real estate – commercial:
Non-owner occupied		0		0		0		46		9
Total
Commercial, financial and agricultural		114		1,142		17		394		18
Real estate – residential		1,985		2,276		210		2,321		87
Real estate – commercial		412		618		0		605		24
Real estate – construction		0		94		0		107		0
Installment and other		0		43		0		3		1
Total	$	2,511	$	4,173	$	227	$	3,430	$	130

Impaired loans by class at December 31, 2010 are as follows:



(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	112	$	1,077	$	0	$	2,536	$	248
Real estate – residential:
First mortgage		1,318		1,636		0		269		83
Second mortgage		644		644		0		407		17
Real estate – commercial:
Owner occupied		483		490		0		601		49
Non-owner occupied		400		640		0		402		22
Real estate – construction:
Residential		0		0		0		195		41
Commercial		0		0		0		130		0
Installment		0		17		0		0		0
With related allowance recorded
Commercial, financial and agricultural		483		483		275		1,898		100
Real estate – residential:
First mortgage		664		664		58		1,059		14
Total
Commercial, financial and agricultural		595		1,560		275		4,434		348
Real estate – residential		2,626		2,944		58		1,735		114
Real estate – commercial		883		1,130		0		1,003		71
Real estate – construction		0		0		0		325		41
Installment and other		0		17		0		0		0
Total	$	4,104	$	5,651	$	333	$	7,497	$	574

Interest income recorded on impaired loans is reflected below:



(In thousands)	2012		2011		2010
Interest income - accrual basis	$	94	$	130	$	286
Interest income - cash basis		0		0		288

Residential and commercial loans serviced for others at December 31, 2012 and 2011 amounted to approximately $22.30 million and $18.02 million, respectively.

Nonperforming loans at December 31, 2012 and 2011 are as follows:



(In thousands)	December 31, 2012		December 31, 2011
Nonaccrual loans	$	2,355	$	1,953
Loans past due greater than 90 days and accruing		0		0
TDRs		557		558
Total nonperforming loans	$	2,912	$	2,511

Of the total TDRs in the table above, $374 thousand at December 31, 2012 and $224 thousand at December 31, 2011, are nonaccruing.

We have reviewed all restructurings that occurred on or after January 1, 2012 for identification as troubled debt restructurings. We did not identify as TDR any loans for which the allowance for credit losses had been measured under a general allowance for credit losses methodology. The loans in the table below are considered impaired under the guidance in Section 310-10-35. Included in the total TDRs of $557 thousand at December 31, 2012 are $336 thousand which were restructured prior to January 1, 2012.

Presented below is a summary of our restructurings during the year ended December 31, 2012 and December 31, 2011:



	2012					2011
	Number	Pre-Modification Recorded		Post-Modification Recorded		Number	Pre-Modification Recorded		Post-modification Recorded
(Dollars in thousands)	of Loans	Investment		Investment		of Loans	Investment		Investment
Commercial, financial and agricultural	1	$	9	$	8	0	$	0	$	0
Real estate – residential:
First mortgage	1		18		14	3		262		211
Second mortgage	1		25		22	0		0		0
Real estate - commercial:
Owner occupied	1		182		177	0		0		0

The loans in the table above were classified as TDRs because the borrowers demonstrated cash flow insufficient to service their debt, as well as an inability to obtain funds at market rates from other sources. Three of the loans that were restructured during 2012 were in non-accruing status at the time of the modification. The loan in accruing status at the end of the year demonstrated a sustained period of repayment performance, in accordance with the modified terms of the loan, the loan is considered adequately secured and all principal and interest amounts contractually due are reasonably assured of repayment within an acceptable period of time.

Modifications were granted which consisted of lower interest rates and more favorable payment terms to the borrower. There were no TDRs restructured within the past twelve months that have defaulted.

There were ten TDRs at at December 31, 2012, all of which demonstrated cash flow insufficient to service their debt, as well as an inability to obtain funds at market rates from other sources. At December 31, 2012, two restructured loans totaling $69 thousand that were restructured in a prior year, were in default with foreclosure proceedings in process. The other loans were performing in accordance with their modified agreements. At December 31, 2012, four of the loans totaling $183 thousand were accruing and six of the loans totaling $374 thousand were in nonaccrual. At December 31, 2012, there were no commitments to lend additional funds to borrower whose loans have been modified in a troubled debt restructuring. We had $332 thousand in commitments to lend additional funds to borrowers whose loans were in nonaccrual status or to borrowers whose loans were 90 days past due and still accruing. Merchants recorded interest income on restructured loans of approximately $28 thousand for 2012.

We had no OREO at December 31, 2012, compared with $358 thousand at December 31, 2011.

Nonaccrual loans by class as of December 31, 2012 and 2011 are as follows:



(In thousands)	December 31, 2012		December 31, 2011
Commercial, financial and agricultural	$	225	$	114
Real estate - residential:
First mortgage		1,119		1,146
Second mortgage		716		281
Real estate - commercial:
Owner occupied		295		412
Total nonaccruing non-TDR loans	$	2,355	$	1,953
Nonaccruing TDR’s
Commercial, financial and agricultural		8		0
Real estate – residential:
First mortgage		189		224
Real estate - commercial:
Owner occupied		177		0
Total nonaccrual loans including TDRs	$	2,729	$	2,177

Commercial Grading System

We use risk rating definitions for our commercial loan portfolios and certain residential loans which are generally consistent with regulatory and banking industry norms. Loans are assigned a credit quality grade which is based upon management’s on-going assessment of risk based upon an evaluation of the quantitative and qualitative aspects of each credit. This assessment is a dynamic process and risk ratings are adjusted as each borrower’s financial situation changes. This process is designed to provide timely recognition of a borrower’s financial condition and appropriately focus management resources.

Pass rated loans exhibit acceptable risk to the bank in terms of financial capacity to repay their loans as well as possessing acceptable fallback repayment sources, typically collateral and personal guarantees. These loans are subject to a formal annual review process; additionally, management reviews the risk rating at the time of any late payments, overdrafts or other sign of deterioration in the interim.

Loans rated Pass-Watch require more than usual attention and monitoring by the account officer, though not to the extent that a formal remediation plan is warranted. Borrowers can be rated Pass-Watch based upon a weakened capital structure, marginally adequate cash flow and/or collateral coverage or early-stage declining trends in operations or financial condition.

Loans rated Special Mention possess potential weakness that may expose the bank to some risk of loss in the future. These loans require more frequent monitoring and formal reporting to Management.

Substandard loans reflect well-defined weaknesses in the current repayment capacity, collateral or net worth of the borrower with the possibility of some loss to the bank if these weaknesses are not corrected. Action plans are required for these loans to address the inherent weakness in the credit and are formally reviewed.

Below is a summary of loans by credit quality indicator as of December 31, 2012:




	Unrated Residential and				Pass-		Special		Sub-
(In thousands)	Consumer		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	85	$	138,307	$	18,738	$	5,704	$	2,189	$	165,023
Municipal		5		77,242		7,442		0		0		84,689
Real estate – residential:
First mortgage		418,802		29,237		1,275		194		1,533		451,041
Second mortgage		37,200		1,000		0		0		710		38,910
Real estate – commercial:
Owner occupied		86		188,330		16,718		3,546		13,628		222,308
Non-owner occupied		40		93,002		10,211		613		1,448		105,314
Real estate – construction:
Residential		41		0		1,518		0		0		1,559
Commercial		598		7,882		522		0		0		9,002
Installment		4,701		0		0		0		0		4,701
All other loans		376		0		0		0		0		376
Total	$	461,934	$	535,000	$	56,424	$	10,057	$	19,508	$	1,082,923

Below is a summary of loans by credit quality indicator as of December 31, 2011:




	Unrated Residential and				Pass-		Special		Sub-
(In thousands)	Consumer		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	2	$	117,772	$	28,326	$	170	$	720	$	146,990
Municipal		0		101,705		0		0		0		101,705
Real estate – residential:
First mortgage		379,512		18,647		1,569		641		962		401,331
Second mortgage		38,020		146		0		0		321		38,487
Real estate – commercial:
Owner occupied		0		175,878		14,001		7,355		9,022		206,256
Non-owner occupied		0		95,239		8,891		1,195		2,334		107,659
Real estate – construction:
Residential		99		0		1,699		0		0		1,798
Commercial		81		15,925		573		0		616		17,195
Installment		5,806		0		0		0		0		5,806
All other loans		399		0		0		0		0		399
Total	$	423,919	$	525,312	$	55,059	$	9,361	$	13,975	$	1,027,626

The amount of interest which was not earned, but which would have been earned had our nonaccrual and restructured loans performed in accordance with their original terms and conditions, was approximately $142 thousand, $193 thousand and $425 thousand in 2012, 2011 and 2010, respectively.

It is our policy to make loans to directors, executive officers, and associates of such persons on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons.