Note 3: Loans and the allowance for credit losses

Loans

The composition of the loan portfolio at June 30, 2011 and December 31, 2010 is as follows:


(In thousands)	June 30, 2011	December 31, 2010
Commercial, financial and agricultural	$165,665	$112,514
Municipal loans	37,933	67,861
Real estate loans – residential	418,246	422,981
Real estate loans – commercial	304,347	284,296
Real estate loans – construction	10,303	16,420
Installment loans	6,319	6,284
All other loans	537	438
Total loans	$943,350	$910,794

At June 30, 2011 and December 31, 2010, total loans included $28 thousand and $80 thousand of net deferred loan origination fees. The aggregate amount of overdrawn deposit balances classified as loan balances was $537 thousand and $437 thousand at June 30, 2011 and December 31, 2010, respectively.

Residential and commercial loans serviced for others at June 30, 2011 and December 31, 2010 amounted to approximately $21.30 million and $19.41 million, respectively.

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. Economic conditions have continued to improve during 2011, but there are remaining areas of weakness. While continuing to adhere to prudent underwriting standards, we are not immune to some negative consequences arising from overall economic weakness and, in particular, a sharp downturn in the real estate market in Vermont.

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 classes where appropriate. Portfolio classes 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 portfolio class. A description of each portfolio segment 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 make longer term municipal loans, which are also considered general obligations of the municipality. Most of the longer term loans were originated under the federal Qualified School Construction Bond program. Proceeds are 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. These loans may be less risky than commercial loans, since they are secured by real estate and 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. These loans are typically originated in amounts of no more than 75% of the appraised value of the property.

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. The bank does 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. In addition, 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 first six months of 2011:


(In thousands)	Commercial,	Municipal	Real estate -	Real estate -	Real estate -	Installment	All	Totals
	financial and		residential	commercial	construction		other
	agricultural
Allowance for credit
losses:
Beginning balance	$ 2,617	$ 236	$ 2,428	$ 5,143	$ 283	$ 24	$ 23	$ 10,754
Chargeoffs	-77	0	-49	-60	-11	-8	0	-205
Recoveries	44	0	1	43	11	3	0	102
Provision	538	-121	183	-270	-90	6	4	250
Ending balance	$ 3,122	$ 115	$ 2,563	$ 4,856	$ 193	$ 25	$ 27	$ 10,901

Ending balance	$ 130	$ 0	$ 79	$ 0	$ 0	$ 0	$ 0	$ 209
individually evaluated
for impairment
Ending balance	2,992	115	2,484	4,856	193	25	27	10,692
collectively evaluated
for impairment
Totals	$ 3,122	$ 115	$ 2,563	$ 4,856	$ 193	$ 25	$ 27	$ 10,901

Financing receivables:
Ending balance	$ 428	$ 0	$ 2,199	$ 656	$ 158	$ 3	$ 0	$ 3,444
individually evaluated
for impairment
Ending balance	165,237	37,933	416,047	303,691	10,145	6,316	537	939,906
collectively evaluated
for impairment
Totals	$165,665	$37,933	$418,246	$304,347	$10,303	$6,319	$537	$943,350

Components:

Allowance for loan losses	$ 2,806	$ 115	$ 2,492	$ 4,796	$ 177	$ 25	$ 27	$ 10,438
Reserve for undisbursed	316	0	71	60	16	0	0	463
lines of credit	316	0	71	60	16	0	0	463
Total	$ 3,122	$ 115	$ 2,563	$ 4,856	$ 193	$ 25	$ 27	$ 10,901

Presented below is an aging of past due loans, including nonaccrual loans, by class as of June 30, 2011:


(In thousands)	30-59	60-89	Over 90	Total	Current	Total	Greater
	Days	Days	Days	Past Due			Than 90
	Past	Past	Past				Days and
	Due	Due	Due				Accruing

Commercial, financial and agricultural	$ 0	$ 0	$ 45	$ 45	$165,620	$165,665	$0
Municipal	0	0	0	0	37,933	37,933	0
Real estate – residential:
First mortgage	176	918	866	1,960	377,075	379,035	0
Second mortgage	10	0	302	312	38,899	39,211	0
Real estate – commercial:
Owner occupied	0	0	147	147	141,952	142,099	0
Non-owner occupied	0	0	0	0	162,248	162,248	0
Real estate – construction:
Residential	0	0	0	0	2,005	2,005	0
Commercial	0	0	158	158	8,140	8,298	0
Installment	3	1	3	7	6,312	6,319	0
Other	0	0	0	0	537	537	0
Total	$189	$919	$1,521	$2,629	$940,721	$943,350	$0

Presented below is an aging of past due loans, including nonaccrual loans, by class as of December 31, 2010:


(In thousands)	30-59	60-89	Over 90	Total	Current	Total	Greater
	Days	Days	Days	Past Due			Than 90
	Past	Past	Past				Days and
	Due	Due	Due				Accruing

Commercial, financial and agricultural	$ 38	$ 88	$ 169	$ 295	$112,219	$112,514	$ 0
Municipal	0	0	0	0	67,861	67,861	0
Real estate – residential:
First mortgage	0	743	1,461	2,204	378,508	380,712	216
Second mortgage	128	118	491	737	41,532	42,269	168
Real estate – commercial:
Owner occupied	186	0	445	631	125,325	125,956	0
Non-owner occupied	0	21	400	421	157,919	158,340	0
Real estate – construction:
Residential	0	0	0	0	6,287	6,287	0
Commercial	0	167	0	167	9,966	10,133	0
Installment	20	6	0	26	6,258	6,284	0
Other	5	0	0	5	433	438	0
Total	$377	$1,143	$2,966	$4,486	$906,308	$910,794	$384

Impaired loans by class at June 30, 2011 were as follows:


(In thousands)	Recorded	Unpaid	Related	Average	Interest
	Investment	Principal	Allowance	Recorded	Income
		Balance		Investment	Recognized
With no related allowance recorded
Commercial, financial and agricultural	$ 133	$1,196	$ 0	$ 186	$0
Real estate – residential
First mortgage	1,131	1,373	0	1,180	0
Second mortgage	328	328	0	443	0
Real estate – commercial
Owner occupied	475	475	0	474	0
Non-owner occupied	181	251	0	69	0
Real estate – construction
Residential	0	0	0	0	0
Commercial	158	325	0	161	0
Installment	3	27	0	4	0
With related allowance recorded
Commercial, financial and agricultural	295	295	130	390	0
Real estate – residential
First mortgage	681	681	76	628	0
Second mortgage	59	59	3	10	0
Real estate – commercial
Non-owner occupied	0	0	0	92	0
Total
Commercial, financial and agricultural	428	1,491	130	576	0
Real estate – residential	2,199	2,441	79	2,261	0
Real estate – commercial	656	726	0	635	0
Real estate – construction	158	325	0	161	0
Installment and other	3	27	0	4	0
Total	$3,444	$5,010	$209	$3,637	$0

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


(In thousands)	Recorded	Unpaid	Related
	Investment	Principal	Allowance
		Balance
With no related allowance recorded:
Commercial, financial and agricultural	$ 112	$1,077	$ 0
Real estate – residential:
First mortgage	1,318	1,636	0
Second mortgage	644	644	0
Real estate – commercial:
Owner occupied	483	490	0
Non-owner occupied	400	640	0
Installment	0	17	0
With related allowance recorded
Commercial, financial and agricultural	483	483	275
Real estate – residential:
First mortgage	664	664	58
Total:
Commercial, financial and agricultural	595	1,560	275
Real estate – residential	2,626	2,944	58
Real estate – commercial	883	1,130	0
Installment	0	17	0
Total	$4,104	$5,651	$333

Impaired loans at June 30, 2011 consist primarily of residential real estate loans. Total impaired loans totaled $3.44 million and $4.10 million at June 30, 2011 and December 31, 2010, respectively. At June 30, 2011, $1.04 million of the impaired loans had a specific reserve allocation of $209 thousand, and $2.40 million of the impaired loans had no specific reserve allocation. At December 31, 2010, $1.15 million of the impaired loans had a specific reserve allocation of $333 thousand, and $2.96 million of the impaired loans had no specific reserve allocation. We recorded interest income on impaired loans of approximately $7 thousand during the six months ended June 30, 2011. No interest was recorded on a cash basis during the period the loans were impaired. The average balance of impaired loans was $3.64 million during the six months ended June 30, 2011.

Nonperforming loans at June 30, 2011 and December 31, 2010 were as follows:


(In thousands)	June 30,	December 31,
(In thousands)	2011	2010
Nonaccrual loans	$3,071	$3,317
Troubled debt restructured loans ("TDRs")	373	403
Loans greater than 90 days and accruing	0	384
Total nonperforming loans	$3,444	$4,104

TDRs consist of three residential real estate loans; one of the loans was restructured with longer terms at market rates and two were restructured with rate concessions, all are performing in accordance with modified agreements with the borrowers at June 30, 2011. There have been no defaults on TDRs. There were no commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring at June 30, 2011. We had no commitments to lend additional funds to borrowers whose loans were in nonaccrual status and no commitments to lend additional funds to borrowers whose loans were 90 days past due and still accruing. We had no OREO at June 30, 2011 and a balance of $191 thousand at December 31, 2010.

Nonaccrual loans by class as of June 30, 2011 and December 31, 2010 were as follows:


(In thousands)	June 30,	December 31,
(In thousands)	2011	2010
Commercial, financial and agricultural	$ 428	$ 595
Real estate – residential:
First mortgage	1,525	1,486
Second mortgage	301	391
Real estate – commercial:
Owner occupied	475	445
Non owner occupied	181	400
Real estate – construction:
Commercial	158	0
Installment	3	0
Total nonaccrual loans	$3,071	$3,317

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, but not to the extent that a formal remediation plan is warranted. Borrowers can be rated Pass-Watch based upon a weakened capital structure, adequate but low 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 June 30, 2011:


(In thousands)	Unrated	Pass	Pass-	Special	Sub-	Total
	Residential		Watch	Mention	Standard
	and
	Consumer
Commercial, financial and agricultural	$ 0	$139,974	$23,028	$ 910	$ 1,753	$165,665
Municipal	0	37,933	0	0	0	37,933
Real estate – residential
First mortgage	375,031	0	1,871	702	1,431	379,035
Second mortgage	39,022	0	0	0	189	39,211
Real estate – commercial
Owner occupied	0	109,658	15,990	5,016	11,435	142,099
Non-owner occupied	0	132,488	23,548	1,830	4,382	162,248
Real estate – construction
Residential	2,005	0	0	0	0	2,005
Commercial	0	6,809	638	693	158	8,298
Installment	6,319	0	0	0	0	6,319
All other loans	385	0	0	152	0	537
Total	$422,762	$426,862	$65,075	$9,303	$19,348	$943,350

Below is a summary of loans by credit quality indicator as of December 31, 2010:


(In thousands)	Unrated Residential and Consumer	Pass	Pass- Watch	Special Mention	Sub- Standard	Total
Commercial, financial and agricultural	$ 0	$103,384	$ 5,271	$ 2,038	$ 1,821	$112,514
Municipal	0	67,861	0	0	0	67,861
Real estate – residential
First mortgage	380,712	0	0	0	0	380,712
Second mortgage	42,269	0	0	0	0	42,269
Real estate – commercial
Owner occupied	0	95,705	14,732	4,601	10,918	125,956
Non-owner occupied	0	120,491	26,735	4,604	6,510	158,340
Real estate – construction
Residential	0	3,568	1,562	1,157	0	6,287
Commercial	0	9,015	186	629	303	10,133
Installment	6,284	0	0	0	0	6,284
All other loans	270	0	0	168	0	438
Total	$429,535	$400,024	$48,486	$13,197	$19,552	$910,794

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 $108 thousand for the six months ended June 30, 2011.

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.