NOTE 4: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

Loans

The composition of our loan portfolio at September 30, 2013 and December 31, 2012 was as follows:



(In thousands)	September 30, 2013		December 31, 2012
Commercial, financial and agricultural	$	163,138	$	165,023
Municipal loans		96,491		84,689
Real estate loans – residential		493,667		460,395
Real estate loans – commercial		373,085		357,178
Real estate loans – construction		32,768		10,561
Installment loans		5,898		4,701
All other loans		454		376
Total loans	$	1,165,501	$	1,082,923

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. Total loans in the table above included $561 thousand and $250 thousand of net deferred loan origination cost at September 30, 2013 and December 31, 2012, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $454 thousand and $376 thousand at September 30, 2013 and December 31, 2012, respectively. Ending loan balances in the table above at September 30, 2013 and December 31, 2012 reflect the reclassification of $35.07 million and $29.56 million, respectively, in non-owner occupied residential real estate loans from the residential real estate category to the commercial real estate category. This presentation more accurately presents the risk profile of these loans.

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 term and time loans issued on a tax-exempt and taxable basis which are general obligations of the municipality. These loans are viewed as lower risk as municipalities can utilize taxing power to meet financial obligations.

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). Hazard insurance is required. Mortgage title insurance is also required for all first mortgages and for second mortgages in excess of $100,000.

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 generally 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 by portfolio segment for the three months ended September 30, 2013:



(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	$	3,274	$	400	$	3,385	$	5,018	$	551	$	21	$	9	$	12,658
Charge-offs		0		0		(49)		0		0		(9)		(27)		(85)
Recoveries		13		0		0		0		1		0		4		18
Provision (credit)		137		346		(192)		100		(19)		6		22		400
Ending balance	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the nine months ended September 30, 2013:



(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	$	3,447	$	522	$	3,421	$	4,660	$	234	$	17	$	11	$	12,312
Charge-offs		0		0		(152)		(1)		0		(9)		(75)		(237)
Recoveries		62		0		4		40		2		0		8		116
Provision (credit)		(85)		224		(129)		419		297		10		64		800
Ending balance	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the three months ended September 30, 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	$	3,102	$	410	$	3,357	$	4,676	$	233	$	21	$	18	$	11,817
Charge-offs		0		0		0		0		0		0		0		0
Recoveries		3		0		1		1		8		0		0		13
Provision (credit)		136		31		75		13		(10)		(2)		7		250
Ending balance	$	3,241	$	441	$	3,433	$	4,690	$	231	$	19	$	25	$	12,080

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the nine months ended September 30, 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	$	3,017	$	4,605	$	477	$	23	$	17	$	11,353
Charge-offs		(9)		0		(20)		0		0		0		0		(29)
Recoveries		21		0		13		1		21		0		0		56
Provision (credit)		324		132		423		84		(267)		(4)		8		700
Ending balance	$	3,241	$	441	$	3,433	$	4,690	$	231	$	19	$	25	$	12,080

The allowance for credit losses consists of the allowance for loan losses and the reserve for undisbursed lines of credit. The reserve for undisbursed lines of credit is included in other liabilities on the balance sheet. The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at September 30, 2013:



(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Ending balance individually evaluated for impairment	$	253	$	0	$	129	$	56	$	0	$	0	$	0	$	438
Ending balance collectively evaluated for impairment		3,171		746		3,015		5,062		533		18		8		12,553
Totals	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991
Financing receivables:
Ending balance individually evaluated for impairment	$	1,275	$	0	$	1,135	$	274	$	0	$	0	$	0	$	2,684
Ending balance collectively evaluated for impairment		161,863		96,491		492,532		372,811		32,768		5,898		454		1,162,817
Totals	$	163,138	$	96,491	$	493,667	$	373,085	$	32,768	$	5,898	$	454	$	1,165,501
Components:
Allowance for loan losses	$	2,810	$	731	$	3,057	$	5,075	$	500	$	18	$	8	$	12,199
Reserve for undisbursed lines of credit		614		15		87		43		33		0		0		792
Total allowance for credit losses	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991

The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at 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:
Ending balance individually evaluated for impairment	$	149	$	0	$	361	$	59	$	0	$	0	$	0	$	569
Ending balance collectively evaluated for impairment		3,298		522		3,060		4,601		234		17		11		11,743
Totals	$	3,447	$	522	$	3,421	$	4,660	$	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		458,078		356,706		10,561		4,701		376		1,079,901
Totals	$	165,023	$	84,689	$	460,395	$	357,178	$	10,561	$	4,701	$	376	$	1,082,923
Components:
Allowance for loan losses	$	2,915	$	494	$	3,333	$	4,605	$	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	$	3,421	$	4,660	$	234	$	17	$	11	$	12,312

The table below presents the recorded investment of loans, including nonaccrual and restructured loans, segregated by class, with delinquency aging as of September 30, 2013:



	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	$	133	$	65	$	8	$	206	$	162,932	$	163,138	$	0
Municipal		0		0		0		0		96,491		96,491		0
Real estate-residential:
First mortgage		9		436		702		1,147		457,430		458,577		0
Second mortgage		65		0		199		264		34,826		35,090		83
Real estate-commercial:
Owner occupied		158		0		107		265		217,091		217,356		0
Non-owner occupied		0		0		0		0		155,729		155,729		0
Real estate-construction:
Residential		0		0		0		0		2,223		2,223		0
Commercial		0		0		0		0		30,545		30,545		0
Installment		0		0		0		0		5,898		5,898		0
Other		0		0		0		0		454		454		0
Total	$	365	$	501	$	1,016	$	1,882	$	1,163,619	$	1,165,501	$	83

Out of the total past due loans above $1.01 million are non-accruing or restructured.

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		420,400		421,485		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		134,870		134,870		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.

Impaired loans by class at September 30, 2013 are as follows:



(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded
Commercial, financial and agricultural	$	275	$	1,152	$	0
Real estate – residential:
First mortgage		499		920		0
Second mortgage		199		235		0
Real estate – commercial:
Owner occupied		107		242		0
Non-owner occupied		0		70		0
Installment		0		53		0
With related allowance recorded
Commercial, financial and agricultural		1,000		1,000		253
Real estate – residential:
First mortgage		384		393		96
Second mortgage		53		53		33
Real estate – commercial:
Owner occupied		167		176		56
Installment		0		0		0
Total
Commercial, financial and agricultural		1,275		2,152		253
Real estate – residential		1,135		1,601		129
Real estate – commercial		274		488		56
Installment		0		53		0
Total	$	2,684	$	4,294	$	438

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



(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded
Commercial, financial and agricultural	$	7	$	970	$	0
Real estate – residential:
First mortgage		853		1,174		0
Second mortgage		16		52		0
Real estate – commercial:
Owner occupied		295		487		0
Non-owner occupied		0		70		0
Installment		0		45		0
With related allowance recorded
Commercial, financial and agricultural		226		228		149
Real estate – residential:
First mortgage		748		766		173
Second mortgage		700		700		188
Real estate – commercial:
Owner occupied		177		179		59
Total
Commercial, financial and agricultural		233		1,198		149
Real estate – residential		2,317		2,692		361
Real estate – commercial		472		736		59
Installment		0		45		0
Total	$	3,022	$	4,671	$	569

Average recorded investment and interest income recognized on our impaired loans for the three and nine months ended September 30, 2013 are as follows:



	Three Months				Nine Months
(In thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	272	$	15	$	223	$	42
Real estate – residential:
First mortgage		463		24		622		68
Second mortgage		188		1		133		2
Real estate – commercial:
Owner occupied		107		0		83		15
Non-owner occupied		0		0		0		0
Installment		0		0		1		0
With related allowance recorded
Commercial, financial and agricultural		333		0		342		0
Real estate – residential:
First mortgage		399		0		523		0
Second mortgage		18		0		317		0
Real estate – commercial:
Owner occupied		168		0		171		0
Installment		6		0		6		0
Total
Commercial, financial and agricultural		605		15		565		42
Real estate – residential		1,068		25		1,595		70
Real estate – commercial		275		0		254		15
Installment		6		0		7		0
Total	$	1,954	$	40	$	2,421	$	127

There was no interest recognized on a cash basis for the periods in the table above.

Average recorded investment and interest income recognized on our impaired loans for the three and nine months ended September 30, 2012 are as follows:



	Three Months				Nine Months
(In thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	24	$	0	$	49	$	1
Real estate – residential:
First mortgage		888		27		818		47
Second mortgage		331		7		325		34
Real estate – commercial:
Owner occupied		350		2		405		5
Non-owner occupied		0		0		0		0
Installment		2		0		1		0
With related allowance recorded
Commercial, financial and agricultural		13		0		23		0
Real estate – residential:
First mortgage		580		0		662		0
Second mortgage		481		0		194		0
Real estate – commercial:
Owner occupied		231		0		113		0
Total
Commercial, financial and agricultural		37		0		72		1
Real estate – residential		2,280		34		1,999		81
Real estate – commercial		581		2		518		5
Installment		2		0		1		0
Total	$	2,900	$	36	$	2,590	$	87

There was no interest recognized on a cash basis for the periods in the table above.

Nonperforming loans at September 30, 2013 and December 31, 2012 are as follows:



(In thousands)	September 30, 2013		December 31, 2012
Nonaccrual loans	$	2,236	$	2,355
Loans greater than 90 days and accruing		83		0
Troubled debt restructurings ("TDRs")		365		557
Total nonperforming loans	$	2,684	$	2,912

Of the total TDRs in the table above, $242 thousand at September 30, 2013 and $374 thousand at December 31, 2012, are nonaccruing. All TDRs at September 30, 2013 were restructured prior to January 1, 2013. We have reviewed all restructurings that occurred on or after January 1, 2013 for identification as TDRs. We did not identify as a TDR any loan for which the allowance for credit losses had been measured under a general allowance for credit losses methodology. Seven of the TDRs at September 30, 2013 were residential real estate and one was commercial real estate. At September 30, 2013, there were no commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring. We had no 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 at September 30, 2013. Interest income on restructured loans during the three and nine months ended September 30, 2013 and 2012 was insignificant.

Our OREO balance at September 30, 2013 was $23 thousand. We had no OREO at December 31, 2012.

Nonaccrual loans by class as of September 30, 2013 and December 31, 2012 are as follows:



(In thousands)	September 30, 2013		December 31, 2012
Commercial, financial and agricultural	$	1,266	$	225
Real estate - residential:
First mortgage		686		1,119
Second mortgage		177		716
Real estate - commercial:
Owner occupied		107		295
Non owner occupied		0		0
Installment		0		0
Total nonaccruing non-TDR loans	$	2,236	$	2,355
Nonaccruing TDR’s
Commercial, financial and agricultural		1		8
Real estate – residential:
First mortgage		74		189
Real estate - commercial:
Owner occupied		167		177
Total nonaccrual loans including TDRs	$	2,478	$	2,729

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. Pass rated commercial loan relationships with a total exposure of $1 million or greater 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.

Residential real estate and consumer loans

We do not use a grading system for our performing residential real estate and consumer loans. Credit quality for these loans is based on performance and payment status.

Below is a summary of loans by credit quality indicator as of September 30, 2013:



	Unrated Residential and				Pass-		Special		Sub-
(In thousands)	Consumer		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	235	$	143,379	$	10,875	$	1,010	$	7,639	$	163,138
Municipal		37		70,951		23,740		1,763		0		96,491
Real estate – residential:
First mortgage		455,233		2,787		0		66		491		458,577
Second mortgage		35,080		0		0		0		10		35,090
Real estate – commercial:
Owner occupied		144		181,775		20,852		3,833		10,752		217,356
Non-owner occupied		153		134,616		11,817		300		8,843		155,729
Real estate – construction:
Residential		691		103		1,429		0		0		2,223
Commercial		751		29,301		493		0		0		30,545
Installment		5,898		0		0		0		0		5,898
All other loans		454		0		0		0		0		454
Total	$	498,676	$	562,912	$	69,206	$	6,972	$	27,735	$	1,165,501

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		1,718		32		71		862		421,485
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		120,521		11,454		736		2,119		134,870
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

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 $32 thousand and $108 thousand for the three and nine months ended September 30, 2013 and was approximately $38 thousand and $107 thousand for the three and nine months ended September 30, 2012, respectively.