4. LOANS AND RELATED ALLOWANCE FOR LOAN LOSSES

The Company grants commercial, industrial, agricultural, residential, and consumer loans primarily to customers throughout North central Pennsylvania and Southern New York. Although the Company has a diversified loan portfolio at December 31, 2013 and 2012, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within these regions. The following table summarizes the primary segments of the loan portfolio, as well as how those segments are analyzed within the allowance for loan losses as of December 31, 2013 and 2012 (in thousands):

2013	Total Loans		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	187,101	$	342	$	186,759
Commercial and agricultural		215,088		8,310		206,778
Construction		8,937		-		8,937
Consumer		9,563		15		9,548
Other commercial and agricultural loans		54,029		1,733		52,296
State and political subdivision loans		65,894		-		65,894
Total		540,612	$	10,400	$	530,212
Allowance for loan losses		7,098
Net loans	$	533,514
2012	Total Loans		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	178,080	$	424	$	177,656
Commercial and agricultural		194,725		9,093		185,632
Construction		12,011		-		12,011
Consumer		10,559		-		10,559
Other commercial and agricultural loans		47,880		901		46,979
State and political subdivision loans		59,208		-		59,208
Total		502,463	$	10,418	$	492,045
Allowance for loan losses		6,784
Net loans	$	495,679

Real estate loans serviced for Freddie Mac and Fannie Mae, which are not included in the consolidated balance sheet, totaled $82,618,000 and $73,813,000 at December 31, 2013 and 2012, respectively.

As of December 31, 2013 and 2012, net unamortized loan fees and costs of $1,187,000 and $1,354,000, respectively, were included in the carrying value of loans.

The segments of the Bank’s loan portfolio are disaggregated into classes to a level that allows management to monitor risk and performance. Residential real estate mortgages consists of 15 to 30 year first mortgages on residential real estate, while residential real estate home equities are consumer purpose installment loans or lines of credit secured by a mortgage which is often a second lien on residential real estate with terms of 15 years or less. Commercial real estate are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate are loans secured by a mortgage on real estate used in agriculture production. Construction real estate are loans secured by residential or commercial real estate used during the construction phase of residential and commercial projects. Consumer loans are typically unsecured or primarily secured by something other than real estate and overdraft lines of credit connected with customer deposit accounts. Other commercial loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non real estate collateral. State and political subdivisions are loans for state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development

Management considers commercial and other loans, commercial and agricultural real estate loans and state and political subdivision loans which are 90 days or more past due to be impaired. Certain residential mortgages, home equity and consumer loans that are cross collateralized with commercial relationships determined to be impaired maybe classified as impaired as well. These loans are analyzed to determine if it is probable that all amounts will not be collected according to the contractual terms of the loan agreement. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance.

The following table includes the recorded investment and unpaid principal balances for impaired loans by class, with the associated allowance amount as of December 31, 2013 and 2012, if applicable (in thousands):

			Recorded		Recorded
	Unpaid		Investment		Investment		Total
	Principal		With No		With		Recorded		Related
	Balance		Allowance		Allowance		Investment		Allowance
2013
Real estate loans:
Mortgages	$	232	$	138	$	70	$	208	$	14
Home Equity		134		65		69		134		13
Commercial		9,901		6,335		1,975		8,310		305
Agricultural		-		-		-		-		-
Construction		-		-		-		-		-
Consumer		15		15		-		15		-
Other commercial loans		1,794		1,679		54		1,733		1
Other agricultural loans		-		-		-		-		-
State and political subdivision loans		-		-		-		-		-
Total	$	12,076	$	8,232	$	2,168	$	10,400	$	333

2012
Real estate loans:
Mortgages	$	309	$	150	$	136	$	286	$	8
Home Equity		138		-		138		138		14
Commercial		10,669		6,476		2,617		9,093		559
Agricultural		-		-		-		-		-
Construction		-		-		-		-		-
Consumer		-		-		-		-		-
Other commercial loans		950		592		309		901		1
Other agricultural loans		-		-		-		-		-
State and political subdivision loans		-		-		-		-		-
Total	$	12,066	$	7,218	$	3,200	$	10,418	$	582

The following table includes the average investment in impaired loans and the income recognized on impaired loans for 2013, 2012 and 2011 (in thousands):

					Interest
	Average		Interest		Income
	Recorded		Income		Recognized
2013	Investment		Recognized		Cash Basis
Real estate loans:
Mortgages	$	327	$	7	$	-
Home Equity		136		4		-
Commercial		8,499		457		377
Agricultural		-		-		-
Construction		-		-		-
Consumer		5		-		-
Other commercial loans		1,761		79		-
Other agricultural loans		-		-		-
State and political subdivision loans		-		-		-
Total	$	10,728	$	547	$	377

2012
Real estate loans:
Mortgages	$	170	$	2	$	2
Home Equity		112		4		4
Commercial		7,882		117		117
Agricultural		-		-		-
Construction		-		-		-
Consumer		-		-		-
Other commercial loans		461		-		-
Other agricultural loans		-		-		-
State and political subdivision loans		-		-		-
Total	$	8,625	$	123	$	123

2011
Real estate loans:
Mortgages	$	-	$	-	$	-
Home Equity		39		1		1
Commercial		8,584		65		65
Agricultural		370		37		37
Construction		-		-		-
Consumer		-		-		-
Other commercial loans		501		-		-
Other agricultural loans		159		20		20
State and political subdivision loans		-		-		-
Total	$	9,653	$	123	$	123

Credit Quality Information

For commercial real estate, agricultural real estate, construction, other commercial, other agricultural loans and state and political subdivision loans, management uses a nine point internal risk rating system to monitor the credit quality. The first five categories are considered not criticized and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The definitions of each rating are defined below:

Pass (Grades 1-5) – These loans are to customers with credit quality ranging from an acceptable to very high quality and are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.

Special Mention (Grade 6) – This loan grade is in accordance with regulatory guidance and includes loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.

Substandard (Grade 7) – This loan grade is in accordance with regulatory guidance and includes loans that have a well-defined weakness based on objective evidence and be characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful (Grade 8) – This loan grade is in accordance with regulatory guidance and includes loans that have all the weaknesses inherent in a substandard asset. In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.

Loss (Grade 9) – This loan grade is in accordance with regulatory guidance and includes loans that are considered uncollectible, or of such value that continuance as an asset is not warranted.

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay loan as agreed, the Bank’s loan rating process includes several layers of internal and external oversight. The Company’s loan officers are responsible for the timely and accurate risk rating of the loans in each of their portfolios at origination and on an ongoing basis under the supervision of management. All commercial and agricultural loans are reviewed annually to ensure the appropriateness of the loan grade. In addition, the Bank engages an external consultant on at least an annual basis. The external consultant is engaged to 1) review a minimum of 55% (60% during 2012) of the dollar volume of the commercial loan portfolio on an annual basis, 2) review a sample of new commercial/agricultural loans originated in the last year, 3) review all relationships in aggregate over $500,000, 4) review all aggregate loan relationships over $100,000 which are over 90 days past due, classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.

The following tables represent credit exposures by internally assigned grades as of December 31, 2013 and 2012 (in thousands):

2013	Pass		Special Mention		Substandard		Doubtful		Loss		Ending Balance
Real estate loans:
Commercial	$	166,956	$	4,645	$	21,284	$	202	$	-	$	193,087
Agricultural		15,923		1,910		4,168		-		-		22,001
Construction		8,937		-		-		-		-		8,937
Other commercial loans		40,798		1,747		1,938		5		-		44,488
Other agricultural loans		7,431		153		1,957		-		-		9,541
State and political subdivision loans		65,894		-		-		-		-		65,894
Total	$	305,939	$	8,455	$	29,347	$	207	$	-	$	343,948

2012	Pass		Special Mention		Substandard		Doubtful		Loss		Ending Balance
Real estate loans:
Commercial	$	149,892	$	7,616	$	19,127	$	75	$	-	$	176,710
Agricultural		13,690		2,386		1,939		-		-		18,015
Construction		12,011		-		-		-		-		12,011
Other commercial loans		39,239		826		1,555		-		-		41,620
Other agricultural loans		4,833		589		838		-		-		6,260
State and political subdivision loans		58,120		-		1,088		-		-		59,208
Total	$	277,785	$	11,417	$	24,547	$	75	$	-	$	313,824

For residential real estate mortgages, home equities and consumer loans, credit quality is monitored based on whether the loan is performing or non-performing, which is typically based on the aging status of the loan and payment activity, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. Non-performing loans include those loans that are considered nonaccrual, described in more detail below and all loans past due 90 or more days. The following table presents the recorded investment in those loan classes based on payment activity as of December 31, 2013 and 2012 (in thousands):

2013	Performing		Non-performing		Total
Real estate loans:
Mortgages	$	119,075	$	809	$	119,884
Home Equity		66,989		228		67,217
Consumer		9,547		16		9,563
Total	$	195,611	$	1,053	$	196,664

2012	Performing		Non-performing		Total
Real estate loans:
Mortgages	$	105,822	$	726	$	106,548
Home Equity		71,263		269		71,532
Consumer		10,555		4		10,559
Total	$	187,640	$	999	$	188,639

Age Analysis of Past Due Loans by Class

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following table includes an aging analysis of the recorded investment of past due loans as of December 31, 2013 and 2012, (in thousands):

	30-59 Days		60-89 Days		90 Days		Total Past				Total Financing		90 Days and
2013	Past Due		Past Due		Or Greater		Due		Current		Receivables		Accruing
Real estate loans:
Mortgages	$	362	$	40	$	739	$	1,141	$	118,743	$	119,884	$	301
Home Equity		632		2		229		863		66,354		67,217		51
Commercial		88		319		3,091		3,498		189,589		193,087		344
Agricultural		-		-		-		-		22,001		22,001		-
Construction		-		-		-		-		8,937		8,937		-
Consumer		96		36		16		148		9,415		9,563		1
Other commercial loans		29		28		49		106		44,382		44,488		-
Other agricultural loans		-		-		-		-		9,541		9,541		-
State and political subdivision loans		-		-		-		-		65,894		65,894		-
Total	$	1,207	$	425	$	4,124	$	5,756	$	534,856	$	540,612	$	697

Loans considered non-accrual	$	98	$	164	$	3,427	$	3,689	$	4,408	$	8,097
Loans still accruing		1,109		261		697		2,067		530,448		532,515
Total	$	1,207	$	425	$	4,124	$	5,756	$	534,856	$	540,612

	30-59 Days		60-89 Days		90 Days		Total Past				Total Financing		90 Days and
2012	Past Due		Past Due		Or Greater		Due		Current		Receivables		Accruing
Real estate loans:
Mortgages	$	636	$	294	$	493	$	1,423	$	105,125	$	106,548	$	244
Home Equity		267		17		222		506		71,026		71,532		88
Commercial		602		-		2,149		2,751		173,959		176,710		152
Agricultural		54		-		-		54		17,961		18,015		-
Construction		-		-		-		-		12,011		12,011		-
Consumer		45		43		4		92		10,467		10,559		4
Other commercial loans		962		-		317		1,279		40,341		41,620		18
Other agricultural loans		-		-		-		-		6,260		6,260		-
State and political subdivision loans		-		-		-		-		59,208		59,208		-
Total	$	2,566	$	354	$	3,185	$	6,105	$	496,358	$	502,463	$	506
Loans considered non-accrual	$	73	$	69	$	2,679	$	2,821	$	5,246	$	8,067
Loans still accruing		2,493		285		506		3,284		491,112		494,396
Total	$	2,566	$	354	$	3,185	$	6,105	$	496,358	$	502,463

Nonaccrual Loans

Loans are considered for nonaccrual status upon reaching 90 days delinquency, unless the loan is well secured and in the process of collection, although the Company may be receiving partial payments of interest and partial repayments of principal on such loans or if full payment of principal and interest is not expected.

The following table reflects the loans on nonaccrual status as of December 31, 2013 and 2012, respectively. The balances are presented by class of loan (in thousands):

	2013		2012
Real estate loans:
Mortgages	$	508	$	482
Home Equity		177		181
Commercial		7,247		7,042
Agricultural		-		-
Construction		-		-
Consumer		15		-
Other commercial loans		150		362
Other agricultural loans		-		-
State and political subdivision		-		-

	$	8,097	$	8,067

Interest income on loans would have increased by approximately $632,000, $531,000, and $625,000 and during 2013, 2012 and 2011, respectively, if these loans had performed in accordance with their terms.

Troubled Debt Restructurings

In situations where, for economic or legal reasons related to a borrower's financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a Troubled Debt Restructuring (TDR). Management strives to identify borrowers in financial difficulty early and work with them to modify more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal, management measures any impairment on the restructuring by calculating the present value of the revised loan terms and comparing this balance to the Company’s investment in the loan prior to the restructuring. As these loans are individually evaluated, they are excluded from pooled portfolios when calculating the allowance for loan and lease losses and a separate allocation within the allowance for loan and lease losses is provided. Management continually evaluates loans that are considered TDRs, including payment history under the modified loan terms, the borrower’s ability to continue to repay the loan based on continued evaluation of their operating results and cash flows from operations. Based on this evaluation management would no longer consider a loan to be a TDR when the relevant facts support such a conclusion. As of December 31, 2013, 2012 and 2011, included within the allowance for loan losses are reserves of $28,000, $14,000 and $14,000, respectively, that are associated with loans modified as TDRs.

Loan modifications that are considered TDR’s completed during the years ended December 31, 2013 and 2012 were as follows (dollars in thousands):

	Number of contracts				Pre-modification Outstanding Recorded Investment				Post-Modification Outstanding Recorded Investment
	Interest Modification		Term Modification		Interest Modification		Term Modification		Interest Modification		Term Modification
2013
Real estate loans:
Mortgages		1		-	$	72	$	-	$	72	$	-
Commercial		-		2		-		1,365		-		1,365
Other commercial loans		-		2		-		1,530		-		1,530
Total		1		4	$	72	$	2,895	$	72	$	2,895

2012
Real estate loans:
Mortgages		1		1	$	48	$	71	$	48	$	71
Commercial		-		3		-		160		-		160
Other commercial loans		-		1		-		25		-		25
Total		1		5	$	48	$	256	$	48	$	256

2011
Real estate loans:
Residential		2		-	$	76	$	-	$	76	$	-
Commercial		5		1		5,912		47		5,912		47
Other commercial loans		1		-		15		-		15		-
Total		8		1	$	6,003	$	47	$	6,003	$	47

Recidivism, or the borrower defaulting on its obligation pursuant to a modified loan, results in the loan once again becoming a non-accrual loan. Recidivism occurs at a notably higher rate than do defaults on new origination loans, so modified loans present a higher risk of loss than do new origination loans. The following table presents the recorded investment in loans that were modified as TDRs during each 12-month period prior to the current reporting periods, which begin January 1, 2013 and 2012, respectively, and that subsequently defaulted during these reporting periods (dollars in thousands):

	2013				2012				2011
	Number of contracts		Recorded investment		Number of contracts		Recorded investment		Number of contracts		Recorded investment
Real estate loans:
Commercial		1	$	55		1	$	50		3	$	150
Other commercial loans		1		6		-		-		-		-
Total recidivism		2	$	61		1	$	50		3	$	150

Allowance for Loan Losses

The following tables roll forward the balance of the allowance for loan and lease losses for the years ended December 31, 2013, 2012 and 2011 and is segregated into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of December 31, 2013, 2012 and 2011 (in thousands):

	Balance at December 31, 2012		Charge-offs			Recoveries		Provision			Balance at December 31, 2013		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	875	$	(17	)	$	5	$	83		$	946	$	27	$	919
Commercial and agricultural		4,437		(62	)		5		178			4,558		305		4,253
Construction		38		-			-		12			50		-		50
Consumer		119		(54	)		33		7			105		-		105
Other commercial and agricultural loans		728		(1	)		-		215			942		1		941
State and political subdivision loans		271		-			-		59			330		-		330
Unallocated		316		-			-		(149	)		167		-		167
Total	$	6,784	$	(134	)	$	43	$	405		$	7,098	$	333	$	6,765

	Balance at December 31, 2011		Charge-offs			Recoveries		Provision			Balance at December 31, 2012		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	805	$	(95	)	$	-	$	165		$	875	$	22	$	853
Commercial and agricultural		4,132		(2	)		9		298			4,437		559		3,878
Construction		15		-			-		23			38		-		38
Consumer		111		(54	)		33		29			119		-		119
Other commercial and agricultural loans		674		(21	)		7		68			728		1		727
State and political subdivision loans		235		-			-		36			271		-		271
Unallocated		515		-			-		(199	)		316		-		316
Total	$	6,487	$	(172	)	$	49	$	420		$	6,784	$	582	$	6,202

	Balance at December 31, 2010		Charge-offs			Recoveries		Provision			Balance at December 31, 2011		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	969	$	(101	)	$	-	$	(63	)	$	805	$	13	$	792
Commercial and agricultural		3,380		(29	)		15		766			4,132		433		3,699
Construction		22		-			-		(7	)		15		-		15
Consumer		108		(71	)		57		17			111		-		111
Other commercial and agricultural loans		983		(6	)		32		(335	)		674		48		626
State and political subdivision loans		137		-			-		98			235		-		235
Unallocated		316		-			-		199			515		-		515
Total	$	5,915	$	(207	)	$	104	$	675		$	6,487	$	494	$	5,993

As discussed in Footnote 1, management evaluates various qualitative factors on a quarterly basis. The following are factors that experienced changes:

2013

The qualitative factor for national, state, regional and local economic trends and business conditions was increased for all loan categories due to rising unemployment rates in the local economy as a result of the slowdown in Marcellus shale natural gas exploration activities.

The qualitative factor for trends in volume, terms and nature of the loan portfolio was increased for commercial and agricultural real estate, other commercial and agricultural loans and state and political subdivision loan categories due to the increase of the number of loans that are participations that were purchased from other banks and therefore subject to different underwriting standards.

2012

The qualitative factors for changes in levels of and trends in delinquencies and impaired/classified loans were increased for residential real estate loans and other commercial loans due to increases in the amount of loans past due.

The qualitative factor for changes in the quality of the loan review system was increased for all portfolio types due to personnel changes.

The qualitative factor for changes in values of underlying collateral was decreased for residential and commercial real estate loans as flooding experienced in our primary market area of north central Pennsylvania at the end of 2011 was not as severe as estimated for the year ended December 31, 2011.

The qualitative factor for changes in unemployment rates was increased for all loan types due to rising unemployment rates in the Bank’s primary market during 2012.

The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for commercial real estate loans and other commercial loans due to the increased size of these loans in regards to the Company’s loan portfolio.

2011:

Separate factors were created for special mention, substandard and doubtful loans for each qualitative factor reviewed to more accurately reflect the risks inherent in the Bank’s loan portfolio.

The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were decreased for all loans portfolio types due to the decreases in nonaccrual loans and total past due loans.

The qualitative factors for changes in the trends of charge-offs and recoveries were decreased for residential, consumer loans, commercial and agricultural loans due to reduced net charge-offs in 2011.

The qualitative factors for changes in portfolio volumes were reduced for agricultural loans due to the decreased size of the portfolio in relation to the total portfolio.

The qualitative factor for changes in values of underlying collateral was increased for residential and commercial real estate loans due to flooding that occurred in our primary market area of north central Pennsylvania. The Company is continuing to monitor the impact, if any, this will have on the loan portfolio.

The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for municipal loans and commercial loans due to the increased size of these loans in regards to the Company’s loan portfolio, while this factor was reduced for agricultural loans.

The negative provision associated with commercial and other loans of $335,000 for 2011 was primarily driven by the $2,857,000 or 6.1% decrease in the loan portfolio balance from December 31, 2010 and the $1,164,000 decrease in commercial and other loans, including other agricultural loans classified as special mention or substandard. These items resulted in certain qualitative factors being reduced, which resulted the negative provision for 2011.