NOTE 7: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

Loans

The composition of our loan portfolio at September 30, 2016 and December 31, 2015 was as follows:


(In thousands)	September 30, 2016		December 31, 2015
Commercial, financial and agricultural	$	268,530	$	237,451
Municipal loans		112,007		105,421
Real estate loans – residential		450,584		468,443
Real estate loans – commercial		584,392		558,004
Real estate loans – construction		55,210		34,802
Installment loans		6,547		10,115
All other loans		15		44
Total loans	$	1,477,285	$	1,414,280

We primarily originate commercial, commercial real estate, municipal, and residential real estate loans to customers throughout the states of Vermont and Massachusetts. There are no significant industry concentrations in the loan portfolio. Total loans included $1.14 million and $1.20 million of net deferred loan origination costs at September 30, 2016 and December 31, 2015, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $267 thousand and $308 thousand at September 30, 2016 and December 31, 2015, respectively.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the three months ended September 30, 2016:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	3,198	$	352	$	2,809	$	5,423	$	549	$	89	$	—	$	12,420
Charge-offs		(115)		—		(82)		—		—		(50)		—		(247)
Recoveries		1		—		6		—		—		14		—		21
Provision (credit)		22		251		(70)		84		25		34		—		346
Ending balance	$	3,106	$	603	$	2,663	$	5,507	$	574	$	87	$	—	$	12,540

In addition to the provision for loan losses included above, there was a provision for the reserve for undisbursed lines of $154 thousand included in the provision for credit losses in the consolidated statement of income.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the three months ended September 30, 2015:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	2,925	$	359	$	3,043	$	5,299	$	477	$	59	$	—	$	12,162
Charge-offs		(11)		—		(29)		—		—		(22)		—		(62)
Recoveries		3		—		7		1		—		8		—		19
Provision (credit)		(84)		272		(62)		(62)		16		11		—		91
Ending balance	$	2,833	$	631	$	2,959	$	5,238	$	493	$	56	$	—	$	12,210

In addition to the provision for loan losses included above, there was a provision for the reserve for undisbursed lines of $59 thousand included in the provision for credit losses in the consolidated statement of income.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the nine months ended September 30, 2016:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	2,696	$	590	$	2,882	$	5,386	$	420	$	66	$	—	$	12,040
Charge-offs		(122)		—		(155)		—		—		(128)		—		(405)
Recoveries		5		—		28		4		—		53		—		90
Provision (credit)		527		13		(92)		117		154		96		—		815
Ending balance	$	3,106	$	603	$	2,663	$	5,507	$	574	$	87	$	—	$	12,540

In addition to the provision for loan losses included above, there was a provision for the reserve for undisbursed lines of $90 thousand included in the provision for credit losses in the consolidated statement of income.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the nine months ended September 30, 2015:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All Other		Total
Allowance for loan losses:
Beginning balance	$	2,583	$	623	$	3,038	$	5,209	$	325	$	13	$	42	$	11,833
Charge-offs		(28)		—		(84)		—		—		(65)		—		(177)
Recoveries		31		—		36		2		—		41		—		110
Provision (credit)		247		8		(31)		27		168		67		(42)		444
Ending balance	$	2,833	$	631	$	2,959	$	5,238	$	493	$	56	$	—	$	12,210

The $250 thousand provision for credit losses in the consolidated statement of income consisted of a $444 thousand provision for loan losses included above plus $194 thousand credit for excess reserves from the reserve for undisbursed lines and letters.

The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon the impairment method at September 30, 2016:


	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	40	$	—	$	178	$	—	$	—	$	—	$	—	$	218
Ending balance collectively evaluated for impairment		3,066		603		2,485		5,507		574		87		—		12,322
Ending balance acquired with deteriorated credit quality		—		—		—		—		—		—		—		—
Totals	$	3,106	$	603	$	2,663	$	5,507	$	574	$	87	$	—	$	12,540
Financing receivables:
Ending balance individually evaluated for impairment	$	465	$	—	$	927	$	973	$	—	$	—	$	—	$	2,365
Ending balance collectively evaluated for impairment		267,271		112,007		449,657		581,480		55,210		6,547		15		1,472,187
Ending balance acquired with deteriorated credit quality		794		—		—		1,939		—		—		—		2,733
Totals	$	268,530	$	112,007	$	450,584	$	584,392	$	55,210	$	6,547	$	15	$	1,477,285

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, 2015:


	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	—	$	—	$	137	$	—	$	—	$	—	$	—	$	137
Ending balance collectively evaluated for impairment		2,696		590		2,745		5,386		420		66		—		11,903
Ending balance acquired with deteriorated credit quality		—		—		—		—		—		—		—		—
Totals	$	2,696	$	590	$	2,882	$	5,386	$	420	$	66	$	—	$	12,040
Financing receivables:
Ending balance individually evaluated for impairment	$	595	$	—	$	706	$	647	$	—	$	22	$	—	$	1,970
Ending balance collectively evaluated for impairment		235,652		105,421		467,737		555,323		34,802		10,093		44		1,409,072
Ending balance acquired with deteriorated credit quality		1,204		—		—		2,034		—		—		—		3,238
Totals	$	237,451	$	105,421	$	468,443	$	558,004	$	34,802	$	10,115	$	44	$	1,414,280

The table below presents the recorded investment of loans segregated by class, with delinquency aging as of September 30, 2016:


	31-60		61-90		91 Days		Total
	Days		Days		or More		Past
(In thousands)	Past Due		Past Due		Past Due		Due		Current			Nonperforming	Total
Commercial, financial and agricultural	$	—	$	562	$	—	$	562	$	266,883	$	1,085	$	268,530
Municipal		—		—		—		—		112,007		—		112,007
Real estate-residential:
First mortgage		171		—		—		171		409,996		813		410,980
Second mortgage		—		—		—		—		39,604		—		39,604
Real estate-commercial:
Owner occupied		—		—		—		—		224,276		1,829		226,105
Non-owner occupied		—		—		—		—		357,778		509		358,287
Real estate-construction:
Residential		—		—		—		—		2,881		—		2,881
Commercial		—		—		—		—		52,329		—		52,329
Installment		92		—		—		92		6,455		—		6,547
Other		—		—		—		—		15		—		15
Total	$	263	$	562	$	—	$	825	$	1,472,224	$	4,236	$	1,477,285

Of the total nonperforming loans in the aging table above, $2.08 million were past due of which $316 thousand were restructured loans, $839 thousand were purchase credit impaired, and $0 were 91 days or more past due and accruing. In the third quarter of 2016, the Company’s policy was updated to classify accruing troubled debt restructurings (“TDRs”) as performing loans to more accurately represent the characteristics of the loans. Prior period amounts have been reclassified to be consistent with the current period presentation. Nonperforming loans, as of December 31, 2015, were reduced $210 thousand for accruing TDRs.

The table below presents the recorded investment of loans segregated by class, with delinquency aging as of December 31, 2015:


	31-60		61-90			91 Days		Total
	Days		Days			or More		Past
(In thousands)	Past Due		Past Due			Past Due		Due		Current			Nonperforming	Total
Commercial, financial and agricultural	$	—		$	251	$	—	$	251	$	235,905	$	1,295	$	237,451
Municipal		—			—		—		—		105,421		—		105,421
Real estate-residential:
First mortgage		50			—		—		50		425,645		581		426,276
Second mortgage		—			8		—		8		42,159		—		42,167
Real estate-commercial:
Owner occupied		323			—		—		323		219,080		1,605		221,008
Non-owner occupied		—			—		—		—		336,514		482		336,996
Real estate-construction:
Residential		—			—		—		—		2,422		—		2,422
Commercial		—			—		—		—		32,380		—		32,380
Installment		61			9		—		70		10,023		22		10,115
Other		—			—		—		—		44		—		44
Total	$	434		$	268	$	—	$	702	$	1,409,593	$	3,985	$	1,414,280

Of the total nonperforming loans in the aging table above, $2.65 million were past due of which $472 thousand were restructured loans, $1.05 million were purchase credit impaired and $0 were 91 days or more past due and accruing.

Impaired loans by class at September 30, 2016 and for the three and nine months ended September 30, 2016 are as follows:


	Period Ended						Three Months Ended				Nine Months Ended
	September 30, 2016						September 30, 2016				September 30, 2016
			Unpaid					Average	Interest			Average	Interest
	Recorded		Principal		Related			Recorded	Income			Recorded	Income
(In thousands)	Investment		Balance		Allowance			Investment	Recognized			Investment	Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	397	$	401	$	—	$	187	$	1	$	225	$	3
Residential:
First mortgage		372		517		—		286		1		246		4
Second mortgage		—		—		—		—		—		1		—
Commercial Real Estate:
Owner occupied		464		468		—		469		—		497		—
Non-owner occupied		509		530		—		513		—		524		—
Construction:
Residential		—		—		—		—		—		—		—
Commercial		—		—		—		—		—		—		—
Installment		—		—		—		5		—		8		—
With related allowance recorded
Commercial, financial and agricultural		68		70		40		400		—		387		—
Residential:
First mortgage		555		565		178		505		—		451		—
Second mortgage		—		—		—		—		—		—		—
Commercial Real Estate:
Owner occupied		—		—		—		—		—		13		—
Total
Commercial, financial and agricultural		465		471		40		587		1		612		3
Residential		927		1,082		178		791		1		698		4
Commercial Real Estate		973		998		—		982		—		1,034		—
Construction		—		—		—		—		—		—		—
Installment		—		—		—		5		—		8		—
Total	$	2,365	$	2,551	$	218	$	2,365	$	2	$	2,352	$	7

Impaired loans by class at December 31, 2015 and for the three and nine months ended September 30, 2015 are as follows:


	Period Ended						Three Months Ended				Nine Months Ended
	December 31, 2015						September 30, 2015				September 30, 2015
			Unpaid				Average		Interest		Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Income
(In thousands)	Investment		Balance		Allowance		Investment		Recognized		Investment		Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	595	$	599	$	—	$	571	$	5	$	303	$	7
Residential:
First mortgage		264		322		—		293		2		200		4
Second mortgage		—		—		—		52		—		70		—
Commercial Real Estate:
Owner occupied		165		165		—		—		—		—		—
Non-owner occupied		482		482		—		—		—		3		—
Installment		22		22		—		—		—		—		—
With related allowance recorded
Commercial, financial and agricultural		—		—		—		—		—		166		—
Residential:
First mortgage		442		442		137		541		—		497		—
Second mortgage		—		—		—		—		—		6		—
Commercial Real Estate:
Owner occupied		—		—		—		—		—		—		—
Installment		—		—		—		—		—		—		—
Total
Commercial, financial and agricultural		595		599		—		571		5		469		7
Residential		706		764		137		886		2		773		4
Commercial Real Estate		647		647		—		—		—		3		—
Installment		22		22		—		—		—		—		—
Total	$	1,970	$	2,032	$	137	$	1,457	$	7	$	1,245	$	11

Residential and commercial loans serviced for others at September 30, 2016 and December 31, 2015 amounted to approximately $23.70 million and $27.87 million, respectively.

Nonperforming loans at September 30, 2016 and December 31, 2015 are as follows:


(In thousands)	September 30, 2016		December 31, 2015
Nonaccrual loans	$	3,488	$	3,513
Loans greater than 90 days and accruing		—		—
Troubled debt restructurings ("TDRs")		748		472
Total nonperforming loans	$	4,236	$	3,985

There were no loans restructured in the three months ended September 30, 2016. One loan was restructured during the nine months ended September 30, 2016 with a balance of $432 thousand and is considered to be a TDR. This loan was individually evaluated for impairment and it was determined that no reserve was required. One loan with a balance of $88 thousand was restructured during the three months ended September 30, 2015 and was considered to be a TDR. Loans with a total balance of $559 thousand were restructured during the nine months ended September 30, 2015 and were considered to be TDRs.

TDRs represent balances where the existing loan was modified involving a concession in rate, term or payment amount due to the distressed financial condition of the borrower. There were three restructured residential mortgages at September 30, 2016 with balances totaling $113 thousand. There were two restructured commercial loans at September 30, 2016 with a balance of $397 thousand. One commercial real estate loan at September 30, 2016 with a balance of $432 thousand was restructured. Five of the six TDRs at September 30, 2016 continue to pay as agreed according to the modified terms. The one TDR that was delinquent at September 30, 2016 totaled $316 thousand. Four of the six TDRs totaling $194 thousand are accruing and are considered performing loans. At September 30, 2016, 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 91 days past due and still accruing at September 30, 2016. Interest income on restructured loans during the three and nine months ended September 30, 2016 and 2015 was insignificant.

Nonaccrual loans by class as of September 30, 2016 and December 31, 2015 are as follows:


(In thousands)	September 30, 2016		December 31, 2015
Commercial, financial and agricultural	$	769	$	823
Real estate - residential:
First mortgage		813		581
Second mortgage		—		—
Real estate - commercial:
Owner occupied		1,829		1,605
Non owner occupied		77		482
Installment		—		22
Total nonaccruing non-TDR loans	$	3,488	$	3,513
Nonaccruing TDR’s
Commercial, financial and agricultural		316		472
Real estate – residential:
First mortgage		—		—
Real estate - commercial:
Non owner occupied		432		—
Total nonaccrual loans including TDRs	$	4,236	$	3,985

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, 2016:


					Pass-		Special		Sub-
(In thousands)	Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	499	$	221,528	$	29,333	$	590	$	16,580	$	268,530
Municipal		79		101,956		9,128		844		—		112,007
Real estate – residential:
First mortgage		402,284		6,311		1,573		—		812		410,980
Second mortgage		39,377		—		227		—		—		39,604
Real estate – commercial:
Owner occupied		228		182,831		27,354		1,845		13,847		226,105
Non-owner occupied		474		314,391		39,898		186		3,338		358,287
Real estate – construction:
Residential		263		2,618		—		—		—		2,881
Commercial		222		46,004		4,412		—		1,691		52,329
Installment		6,547		—		—		—		—		6,547
All other loans		15		—		—		—		—		15
Total	$	449,988	$	875,639	$	111,925	$	3,465	$	36,268	$	1,477,285

Below is a summary of loans by credit quality indicator as of December 31, 2015:


					Pass-		Special		Sub-
(In thousands)	Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	597	$	179,451	$	45,977	$	4,177	$	7,249	$	237,451
Municipal		58		92,011		13,352		—		—		105,421
Real estate – residential:
First mortgage		420,798		4,733		164		—		581		426,276
Second mortgage		42,167		—		—		—		—		42,167
Real estate – commercial:
Owner occupied		296		161,810		41,477		5,959		11,466		221,008
Non-owner occupied		166		290,337		44,485		444		1,564		336,996
Real estate – construction:
Residential		478		1,944		—		—		—		2,422
Commercial		145		27,299		3,136		—		1,800		32,380
Installment		10,093		—		—		—		22		10,115
All other loans		44		—		—		—		—		44
Total	$	474,842	$	757,585	$	148,591	$	10,580	$	22,682	$	1,414,280

The carrying amount of loans purchased with evidence of credit deterioration accounted for under FASB Accounting Standards Codification (“ASC”) 310-30 acquired in the NUVO acquisition totaled $2.73 million and $3.24 million at September 30, 2016 and December 31, 2015, respectively.