NOTE 4: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

Loans

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


(In thousands)	2011		2010
Commercial, financial and agricultural	$	146,990	$	112,514
Municipal loans		101,705		67,861
Real estate loans – residential		439,818		422,981
Real estate loans – commercial		313,915		284,296
Real estate loans – construction		18,993		16,420
Installment loans		5,806		6,284
All other loans		399		438
Total loans	$	1,027,626	$	910,794

At December 31, 2011 and 2010, total loans included $11 thousand and $(80) thousand of net deferred loan origination fees. The aggregate amount of overdrawn deposit balances classified as loan balances was $399 thousand and $437 thousand at December 31, 2011 and 2010, respectively.

Residential and commercial loans serviced for others at December 31, 2011 and 2010 amounted to approximately $18.02 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. There has been continued volatility in financial and capital markets during 2011. 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 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 make longer term loans 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. 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 and leases, 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.

A summary of changes in the allowance for credit losses for the years ended December 31, 2011, 2010 and 2009 is as follows:


(In thousands)	2011			2010			2009
Balance, beginning of year	$	10,754		$	11,702		$	9,311
Charge-offs		(329	)		(1,977	)		(1,876	)
Recoveries		178			2,779			167
(Credit) provision		750			(1,750	)		4,100
Balance, end of year	$	11,353		$	10,754		$	11,702
Components:
Allowance for loan losses	$	10,619		$	10,135		$	10,976
Reserve for undisbursed lines of credit		734			619			726
Allowance for credit losses	$	11,353		$	10,754		$	11,702

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


	Commercial, financial and agricultural			Municipal		Real estate- residential			Real estate- commercial			Real estate- construction			Installment			All other			Totals

(In thousands)
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 following table reflects our loan loss experience and activity in the allowance for credit losses for the twelve months ended December 31, 2010:


	Commercial, financial and agricultural			Municipal		Real estate- residential			Real estate- commercial			Real estate- construction			Installment			All other			Totals

(In thousands)
Allowance for credit losses:
Beginning balance	$	3,697		$	134	$	2,289		$	5,000		$	360		$	39		$	183		$	11,702
Charge-offs		(1,691	)		0		(25	)		(259	)		0			(2	)		0			(1,977	)
Recoveries		2,128			0		20			30			593			8			0			2,779
Provision (credit)		(1,517	)		102		144			372			(670	)		(21	)		(160	)		(1,750	)
Ending balance	$	2,617		$	236	$	2,428		$	5,143		$	283		$	24		$	23		$	10,754

Ending balance individually
evaluated for impairment	$	275		$	0	$	58		$	0		$	0		$	0		$	0		$	333
Ending balance collectively
evaluated for impairment		2,342			236		2,370			5,143			283			24			23			10,421
Totals	$	2,617		$	236	$	2,428		$	5,143		$	283		$	24		$	23		$	10,754

Financing receivables:
Ending balance individually
evaluated for impairment	$	595		$	0	$	2,626		$	883		$	0		$	0		$	0		$	4,104
Ending balance collectively
evaluated for impairment		111,919			67,861		420,355			283,413			16,420			6,284			438			906,690
Totals	$	112,514		$	67,861	$	422,981		$	284,296		$	16,420		$	6,284		$	438		$	910,794

Components:
Allowance for loan losses	$	2,113		$	236	$	2,366		$	5,096		$	277		$	24		$	23		$	10,135
Reserve for undisbursed
lines of credit		504			0		62			47			6			0			0			619
Total allowance for credit
losses	$	2,617		$	236	$	2,428		$	5,143		$	283		$	24		$	23		$	10,754

Presented below is an aging of past due loans, including nonaccrual loans, by class as of December 31, 2011:


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


(In thousands)

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

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


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


(In thousands)

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 December 31, 2011 are as follows:


	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized

(In thousands)
With no related allowance recorded:
Commercial, financial and agricultural	$	77	$	1,099	$	0	$	154	$	0
Real estate loans – residential:
First mortgage		914		1,162		0		1,201		44
Second mortgage		222		224		0		325		43
Real estate loans – commercial:
Owner occupied		412		548		0		495		11
Non-owner occupied		0		70		0		64		4
Real estate – construction:
Residential		0		0		0		0		0
Commercial		0		94		0		107		0
Installment		0		43		0		3		1
With an allowance recorded:
Commercial, financial and agricultural		37		43		17		240		18
Real estate loans – 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 loans – residential		1,985		2,276		210		2,321		87
Real estate loans – commercial		412		618		0		605		24
Real estate – construction		0		94		0		107		0
Installment		0		43		0		3		1
Total	$	2,511	$	4,173	$	227	$	3,430	$	130

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


	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized

(In thousands)
With no related allowance recorded:
Commercial, financial and agricultural	$	112	$	1,077	$	0	$	2,767	$	248
Real estate – residential:
First mortgage		1,318		1,636		0		293		83
Second mortgage		644		644		0		444		17
Real estate – commercial:
Owner occupied		483		490		0		656		49
Non-owner occupied		400		640		0		439		22
Real estate – construction:
Residential		0		0		0		213		41
Commercial		0		0		0		141		0
Installment		0		17		0		0		0
With related allowance recorded:
Commercial, financial and agricultural		483		483		275		2,070		100
Real estate – residential:
First mortgage		664		664		58		1,156		14
Total:
Commercial, financial and agricultural		595		1,560		275		4,837		348
Real estate – residential		2,626		2,944		58		1,893		114
Real estate – commercial		883		1,130		0		1,095		71
Real estate – construction		0		0		0		354		41
Installment		0		17		0		0		0
Total	$	4,104	$	5,651	$	333	$	8,179	$	574

Impaired loans at December 31, 2011 consist predominantly of residential real estate loans. Total impaired loans totaled $2.51 million and $4.10 million at December 31, 2011 and 2010, respectively. At December 31, 2011, $885 thousand of the impaired loans had a specific reserve allocation of $227 thousand, and $1.63 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 $130 thousand during 2011. No interest was recorded on a cash basis during the period the loan was impaired. We recorded interest income on impaired loans of approximately $574 thousand during 2010 which included $288 thousand in interest recorded on a cash basis during the period the loan was impaired. We recorded interest income on impaired loans of $38 thousand during 2009. The average balance of impaired loans was $3.43 million, $8.18 million and $12.56 million during 2011, 2010 and 2009, respectively.

Nonperforming loans at December 31, 2011 and 2010 are as follows:


(In thousands)	2011		2010
Nonaccrual loans	$	1,953	$	3,171
Loans greater than 90 days and accruing		0		384
TDRs		558		549
Total nonperforming loans	$	2,511	$	4,104

Of the total TDRs in the table above, $224 thousand at December 31, 2011 and $146 thousand at December 31, 2010, are nonaccruing.

As a result of adopting the amendments in ASU 2011-02, we have reassessed all restructurings that occurred on or after January 1, 2011 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 $558 thousand at December 31, 2011 are $347 thousand which were restructured prior to January 1, 2011.

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


	Number of loans	Pre- modification Outstanding Recorded Investment		Post- modification Outstanding Recorded Investment



(Dollars in thousands)
Real estate – residential:
First mortgage	3	$	262	$	211

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. All three of the loans that were restructured during 2011 were in non-accruing status at the time of the modification. One of the loans was returned to accruing status at the end of the year because there was a sustained period of repayment performance by the borrower, in accordance with the modified term of the loan, 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.

TDRs consist of seven residential real estate loans at December 31, 2011. All seven borrowers experienced financial difficulties that led to the restructure. At the time of restructure five were in payment default and all seven demonstrated cash flow insufficient to service their debt as well and an inability to obtain funds at market rates from other sources. At December 31, 2011, five of the restructured loans were performing in accordance with modified agreements, while two loans totaling $63 thousand, that were restructured in a prior year, were in default with foreclosure proceedings in process. At December 31, 2011, three of the loans totaling $334 thousand were accruing and four of the loans totaling $224 thousand were in nonaccrual. At December 31, 2011, there were no commitments to lend additional funds to borrower 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. Merchants recorded interest income on restructured loans of approximately $13 thousand for 2011. Merchants had no commitments to lend additional funds to borrowers whose loans were in nonaccrual or TDR status at the end of 2011.

We had $358 thousand in OREO at December 31, 2011, compared with $191 thousand at December 31, 2010.

Nonaccrual loans by class as of December 31, 2011 and 2010 are as follows:


(In thousands)	2011		2010
Commercial, financial and agricultural	$	114	$	595
Real estate loans – residential:
First mortgage		1,146		1,340
Second mortgage		281		391
Real estate loans – commercial:
Owner occupied		412		445
Non owner occupied		0		400
Installment
Total nonaccrual non-TDR loans	$	1,953	$	3,171

Nonaccruing TDRs
Real estate – residential:
First Mortgage		224		146
Total nonaccrual loans	$	2,177	$	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, though 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 December 31, 2011:


	Unrated Residential and Consumer		Pass		Pass- Watch		Special Mention		Sub- standard		Total


(In thousands)
Commercial, financial and agricultural	$	2	$	117,772	$	28,326	$	170	$	720	$	146,990
Municipal loans		0		101,705		0		0		0		101,705
Real estate loans – 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 loans – 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 loans – construction:
Residential		99		0		1,699		0		0		1,798
Commercial		81		15,925		573		0		616		17,195
Installment loans		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

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


	Unrated Residential and Consumer		Pass		Pass- Watch		Special Mention		Sub- Standard		Total


(In thousands)
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 $193 thousand, $425 thousand and $638 thousand in 2011, 2010 and 2009, 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.