Note 3. Loans and the Allowance for Loan Losses

The following is a summary of the balances in each class of the Company’s loan portfolio as of the dates indicated:

	June 30, 2013			December 31, 2012
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	80,553		$	77,267
Commercial		273,498			274,613
Construction		13,493			12,005
Second mortgages		12,242			14,315
Equity lines of credit		31,201			32,327
Total mortgage loans on real estate		410,987			410,527
Commercial loans		28,687			25,341
Consumer loans		10,985			13,146
Other		18,849			22,119
Total loans		469,508			471,133
Less: Allowance for loan losses		(7,296	)		(7,324	)
Loans, net of allowance and deferred fees	$	462,212		$	463,809

Overdrawn deposit accounts are reclassified as loans and included in the Other category in the table above. Overdrawn deposit accounts totaled $587 thousand and $1.6 million at June 30, 2013 and December 31, 2012, respectively.

CREDIT QUALITY INFORMATION

The Company uses internally-assigned risk grades to estimate the capability of borrowers to repay the contractual obligations of their loan agreements as scheduled or at all. The Company’s internal risk grade system is based on experiences with similarly graded loans. Credit risk grades are updated at least quarterly as additional information becomes available, at which time management analyzes the resulting scores to track loan performance.

The Company’s internally assigned risk grades are as follows:

Pass: Loans are of acceptable risk.

Other Assets Especially Mentioned (OAEM): Loans have potential weaknesses that deserve management’s close attention.

Substandard: Loans reflect significant deficiencies due to several adverse trends of a financial, economic or managerial nature.

Doubtful: Loans have all the weaknesses inherent in a substandard loan with added characteristics that make collection or liquidation in full based on currently existing facts, conditions and values highly questionable or improbable.

Loss: Loans have been charged off because they are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.

The following table presents credit quality exposures by internally assigned risk ratings as of the dates indicated:

Credit Quality Information As of June 30, 2013
(in thousands)
	Pass		OAEM		Substandard		Total
Mortgage loans on real estate:
Residential 1-4 family	$	73,496	$	1,746	$	5,311	$	80,553
Commercial		256,142		7,708		9,648		273,498
Construction		10,374		239		2,880		13,493
Second mortgages		11,895		238		109		12,242
Equity lines of credit		30,598		0		603		31,201
Total mortgage loans on real estate		382,505		9,931		18,551		410,987
Commercial loans		27,533		112		1,042		28,687
Consumer loans		10,956		0		29		10,985
Other		18,849		0		0		18,849
Total	$	439,843	$	10,043	$	19,622	$	469,508

Credit Quality Information As of December 31, 2012
(in thousands)
	Pass		OAEM		Substandard		Total
Mortgage loans on real estate:
Residential 1-4 family	$	70,961	$	1,711	$	4,595	$	77,267
Commercial		258,195		6,781		9,637		274,613
Construction		8,651		254		3,100		12,005
Second mortgages		13,488		242		585		14,315
Equity lines of credit		31,704		239		384		32,327
Total mortgage loans on real estate		382,999		9,227		18,301		410,527
Commercial loans		23,997		209		1,135		25,341
Consumer loans		13,042		0		104		13,146
Other		22,119		0		0		22,119
Total	$	442,157	$	9,436	$	19,540	$	471,133

As of June 30, 2013 and December 31, 2012 the Company did not have any loans internally classified as Loss or Doubtful.

AGE ANALYSIS OF PAST DUE LOANS BY CLASS

All classes of loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Interest and fees continue to accrue on past due loans until the date the loan is placed in nonaccrual status, if applicable. The following table includes an aging analysis of the recorded investment in past due loans as of the dates indicated. Also included in the table below are loans that are 90 days or more past due as to interest and principal and still accruing interest, because they are well-secured and in the process of collection. Loans in nonaccrual status that are also past due are included in the aging categories in the table below.

Age Analysis of Past Due Loans as of June 30, 2013
	30 - 59 Days Past Due		60 - 89 Days Past Due		90 or More Days Past Due		Total Past Due		Total Current Loans (1)		Total Loans		Recorded Investment > 90 Days Past Due and Accruing
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	1,752	$	38	$	3,306	$	5,096	$	75,457	$	80,553	$	258
Commercial		0		200		716		916		272,582		273,498		0
Construction		404		0		2,880		3,284		10,209		13,493		0
Second mortgages		46		35		20		101		12,141		12,242		20
Equity lines of credit		175		75		0		250		30,951		31,201		0
Total mortgage loans on real estate		2,377		348		6,922		9,647		401,340		410,987		278
Commercial loans		54		49		0		103		28,584		28,687		0
Consumer loans		80		40		13		133		10,852		10,985		13
Other		65		9		5		79		18,770		18,849		5
Total	$	2,576	$	446	$	6,940	$	9,962	$	459,546	$	469,508	$	296

(1)

For purposes of this table, Total Current Loans includes loans that are 1 - 29 days past due.

Age Analysis of Past Due Loans as of December 31, 2012
	30 - 59 Days Past Due		60 - 89 Days Past Due		90 or More Days Past Due		Total Past Due		Total Current Loans (1)		Total Loans		Recorded Investment > 90 Days Past Due and Accruing
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	1,115	$	0	$	3,783	$	4,898	$	72,369	$	77,267	$	348
Commercial		207		0		724		931		273,682		274,613		0
Construction		140		0		2,925		3,065		8,940		12,005		0
Second mortgages		113		0		544		657		13,658		14,315		60
Equity lines of credit		90		0		287		377		31,950		32,327		0
Total mortgage loans on real estate		1,665		0		8,263		9,928		400,599		410,527		408
Commercial loans		275		13		122		410		24,931		25,341		25
Consumer loans		85		22		11		118		13,028		13,146		11
Other		54		7		3		64		22,055		22,119		3
Total	$	2,079	$	42	$	8,399	$	10,520	$	460,613	$	471,133	$	447

(1)

For purposes of this table, Total Current Loans includes loans that are 1 - 29 days past due.

NONACCRUAL LOANS

The Company generally places non-consumer loans in nonaccrual status when the full and timely collection of interest or principal becomes uncertain, part of the principal balance has been charged off and no restructuring has occurred or the loan reaches 90 days past due, unless the credit is well-secured and in the process of collection. Under regulatory rules, consumer loans, which are loans to individuals for household, family and other personal expenditures, and loans secured by 1-4 family residential properties are not required to be placed in nonaccrual status. Although consumer loans and loans secured by 1-4 family residential property are not required to be placed in nonaccrual status, the Company may place a consumer loan or loan secured by 1-4 family residential property in nonaccrual status, if necessary to avoid a material overstatement of interest income.

Generally, consumer loans not secured by real estate are placed in nonaccrual status only when part of the principal has been charged off. These loans are charged off or written down to the net realizable value of the collateral when deemed uncollectible, due to bankruptcy or other factors, or when they are past due based on loan product, industry practice, terms and other factors.

When management places a loan in nonaccrual status, the accrued unpaid interest receivable is reversed against interest income and the loan is accounted for by the cash or cost recovery method, until it qualifies for return to accrual status or is charged off. Generally, management returns a loan to accrual status if (a) all delinquent interest and principal payments become current under the terms of the loan agreement or (b) the loan is both well-secured and in the process of collection and collectability is no longer doubtful.

The following table presents loans in nonaccrual status by class of loan as of the dates indicated:

Nonaccrual Loans by Class

	June 30, 2013		December 31, 2012
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	3,363	$	3,663
Commercial		2,965		3,037
Construction		2,880		3,065
Second mortgages		35		484
Equity lines of credit		0		286
Total mortgage loans on real estate		9,243		10,535
Commercial loans		0		97
Consumer loans		0		0
Total	$	9,243	$	10,632

The following table presents the interest income that the Company would have earned under the original terms of its nonaccrual loans and the actual interest recorded by the Company on nonaccrual loans for the periods presented:

	Six Months Ended June 30,
	2013		2012
	(in thousands)
Interest income that would have been recorded under original loan terms	$	275	$	275
Actual interest income recorded for the period		51		32
Reduction in interest income on nonaccrual loans	$	224	$	243

TROUBLED DEBT RESTRUCTURINGS

The Company’s loan portfolio includes certain loans that have been modified in a troubled debt restructuring (TDR), where economic concessions have been granted to borrowers who are experiencing financial difficulties. These concessions typically result from the Company’s loss mitigation activities and could include reduction in the interest rate below current market rates for borrowers with similar risk profiles, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. The Company defines a TDR as nonperforming if the TDR is in nonaccrual status or 90 days or more past due and still accruing interest at the report date.

When the Company modifies a loan, management evaluates any possible impairment as stated in the impaired loan section below.

The following table presents TDRs during the period indicated, by class of loan:

Troubled Debt Restructurings by Class For the Six Months Ended June 30, 2013
(dollars in thousands)
	Number of Modifications		Recorded Investment Prior to Modification		Recorded Investment After Modification		Current Investment on June 30, 2013
Mortgage loans on real estate:
Residential 1-4 family		3	$	676	$	676	$	673
Commercial		1		207		207		203
Total		4	$	883	$	883	$	876

Troubled Debt Restructurings by Class For the Six Months Ended June 30, 2012
(dollars in thousands)
	Number of Modifications		Recorded Investment Prior to Modification		Recorded Investment After Modification		Current Investment on June 30, 2012
Mortgage loans on real estate:
Commercial		2	$	3,019	$	2,461	$	2,373
Second mortgages		1		111		145		140
Total		3	$	3,130	$	2,606	$	2,513

The four loans restructured in the first six months of 2013 were all given below-market rates for debt with similar risk characteristics. The restructurings during the first six months of 2012 were given principal reductions, with the principal forgiveness on all loans in the table totaling $525 thousand. One loan restructured during the first six months of 2012 was also given a below-market rate for debt with similar risk characteristics.

As of June 30, 2013 and June 30, 2012, there were no TDRs for which there was a payment default where the default occurred within twelve months of restructuring. A TDR is considered in default when it is 90 days or more past due or has been charged off.

The TDRs in the tables above are factored into the determination of the allowance for loan losses as of the periods indicated. These loans are included in the impaired loan analysis, as discussed below.

IMPAIRED LOANS

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming commercial loans and loans modified in a TDR. When management identifies a loan as impaired, the impairment is measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, except when the sole or remaining source of repayment for the loan is the operation or liquidation of the collateral. In these cases, management uses the current fair value of the collateral, less selling costs, when foreclosure is probable, instead of the discounted cash flows. 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.

When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is in nonaccrual status, all payments are applied to principal under the cost-recovery method. For financial statement purposes, the recorded investment in the loan is the actual principal balance reduced by payments that would otherwise have been applied to interest. When reporting information on these loans to the applicable customers, the unpaid principal balance is reported as if payments were applied to principal and interest under the original terms of the loan agreements. Therefore, the unpaid principal balance reported to the customer would be higher than the recorded investment in the loan for financial statement purposes. When the ultimate collectability of the total principal of the impaired loan is not in doubt and the loan is in nonaccrual status, contractual interest is credited to interest income when received under the cash-basis method.

The following table includes the recorded investment and unpaid principal balances (a portion of which may have been charged off) for impaired loans with the associated allowance amount, if applicable, as of the dates presented. Also presented are the average recorded investments in the impaired loans and the related amount of interest recognized for the periods presented. The average balances are calculated based on daily average balances.

Impaired Loans by Class (in thousands)
	As of June 30, 2013								For the six months ended June 30, 2013
			Recorded Investment
	Unpaid Principal Balance		Without Valuation Allowance		With Valuation Allowance		Associated Allowance		Average Recorded Investment		Interest Income Recognized
Mortgage loans on real estate:
Residential 1-4 family	$	4,546	$	872	$	3,415	$	237	$	4,738	$	16
Commercial		13,702		3,683		7,082		1,261		10,910		269
Construction		3,639		0		2,880		360		2,891		0
Second mortgages		183		43		136		47		745		4
Equity lines of credit		50		50		0		0		193		1
Total mortgage loans on real estate	$	22,120	$	4,648	$	13,513	$	1,905	$	19,477	$	290
Commercial loans		0		0		0		0		12		0
Consumer loans		16		16		0		0		18		1
Total	$	22,136	$	4,664	$	13,513	$	1,905	$	19,507	$	291

Impaired Loans by Class (in thousands)
	As of December 31, 2012								For the year ended December 31, 2012
			Recorded Investment
	Unpaid Principal Balance		Without Valuation Allowance		With Valuation Allowance		Associated Allowance		Average Recorded Investment		Interest Income Recognized
Mortgage loans on real estate:
Residential 1-4 family	$	4,100	$	681	$	3,235	$	226	$	2,354	$	136
Commercial		12,459		3,741		5,817		180		10,151		242
Construction		3,782		3,064		0		0		3,320		(9	)
Second mortgages		695		583		47		5		542		12
Equity lines of credit		370		286		0		0		391		(2	)
Total mortgage loans on real estate	$	21,406	$	8,355	$	9,099	$	411	$	16,758	$	379
Commercial loans		117		0		97		33		104		(14	)
Consumer loans		17		17		0		0		26		1
Total	$	21,540	$	8,372	$	9,196	$	444	$	16,888	$	366

MONITORING OF LOANS AND EFFECT OF MONITORING FOR THE ALLOWANCE FOR LOAN LOSSES

Loan officers are responsible for continual portfolio analysis and prompt identification and reporting of problem loans, which includes assigning a risk grade to each applicable loan at its origination and revising such grade as the situation dictates. Loan officers maintain frequent contact with borrowers, which should enable the loan officer to identify potential problems before other personnel. In addition, meetings with loan officers and upper management are held to discuss problem loans and review risk grades. Nonetheless, in order to avoid over-reliance upon loan officers for problem loan identification, the Company’s loan review system provides for review of loans and risk grades by individuals who are independent of the loan approval process. Risk grades and historical loss rates by risk grades are used as a component of the calculation of the allowance for loan losses.

ALLOWANCE FOR LOAN LOSSES

Management has an established methodology to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. For purposes of determining the allowance for loan losses, the Company has segmented certain loans in the portfolio by product type. Loans are segmented into the following pools: commercial, real estate-construction, real estate-mortgage, consumer and other loans. The Company also sub-segments the real estate-mortgage segment into four classes: residential 1-4 family, commercial real estate, second mortgages and equity lines of credit. The Company uses an internally developed risk evaluation model in the estimation of the credit risk process. The model and assumptions used to determine the allowance are independently validated and reviewed to ensure that the theoretical foundation, assumptions, data integrity, computational processes and reporting practices are appropriate and properly documented.

Each portfolio segment has risk characteristics as follows:

Commercial: Commercial loans carry risks associated with the successful operation of a business or project, in addition to other risks associated with the ownership of a business. The repayment of these loans may be dependent upon the profitability and cash flows of the business. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much precision.

Real estate-construction: Construction loans carry risks that the project will not be finished according to schedule, the project will not be finished according to budget and the value of the collateral may at any point in time be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be the loan customer, may be unable to finish the construction project as planned because of financial pressure unrelated to the project.

Real estate-mortgage: Residential mortgage loans and equity lines of credit carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral. Commercial real estate loans carry risks associated with the successful operation of a business if owner occupied. If non-owner occupied, the repayment of these loans may be dependent upon the profitability and cash flow from rent receipts.

Consumer loans: Consumer loans carry risks associated with the continued credit-worthiness of the borrowers and the value of the collateral. Consumer loans are more likely than real estate loans to be immediately adversely affected by job loss, divorce, illness or personal bankruptcy.

Other loans: Other loans are loans to mortgage companies, loans for purchasing or carrying securities, and loans to insurance, investment and finance companies. These loans carry risks associated with the successful operation of a business. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time, depend on interest rates or fluctuate in active trading markets.

To determine the balance of the allowance account for each segment of the loan portfolio, management pools each segment by risk grade individually and applies a historical loss percentage. At June 30, 2013 and December 31, 2012, the historical loss percentage was based on losses sustained in each segment of the portfolio over the previous eight quarters.

Management also provides an allocated component of the allowance for loans that are classified as impaired. An allocated allowance is established when the discounted value of future cash flows from the impaired loan (or the collateral value or observable market price of the impaired loan) is lower than the carrying value of that loan.

Based on credit risk assessments and management’s analysis of qualitative factors, additional loss factors are applied to loan balances. These additional qualitative factors include: economic conditions, trends in growth, loan concentrations, changes in certain loans, changes in underwriting, changes in management and changes in the legal and regulatory environment.

THE COMPANY’S ESTIMATION PROCESS

The allowance for loan losses is the accumulation of various components that are calculated based on independent methodologies. Management’s estimate is based on certain observable, historical data that management believes are most reflective of the underlying credit losses being estimated. In addition, impaired loans are separately identified for evaluation and are measured based on the present value of expected future cash flows, the observable market price of the loans or the fair value of the collateral. Also, various qualitative factors are applied to each segment of the loan portfolio.

ALLOWANCE FOR LOAN LOSSES BY SEGMENT

The total allowance reflects management’s estimate of loan losses inherent in the loan portfolio at the balance sheet date. The Company considers the allowance for loan losses of $7.3 million adequate to cover loan losses inherent in the loan portfolio at June 30, 2013.

The following table presents, by portfolio segment, the changes in the allowance for loan losses and the recorded investment in loans for the periods presented. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

ALLOWANCE FOR LOAN LOSSES AND RECORDED INVESTMENT IN LOANS
	(in thousands)
For the Six Months Ended June 30, 2013	Commercial			Real Estate - Construction			Real Estate - Mortgage			Consumer			Other			Total
Allowance for Loan Losses:
Balance at the beginning of period	$	677		$	187		$	6,179		$	204		$	77		$	7,324
Charge-offs		(106	)		(100	)		(413	)		(66	)		(79	)		(764	)
Recoveries		43			3			121			34			35			236
Provision for loan losses		(339	)		429			421			(22	)		11			500
Ending balance	$	275		$	519		$	6,308		$	150		$	44		$	7,296
Ending balance individually evaluated for impairment	$	0		$	360		$	1,545		$	0		$	0		$	1,905
Ending balance collectively evaluated for impairment		275			159			4,763			150			44			5,391
Ending balance	$	275		$	519		$	6,308		$	150		$	44		$	7,296
Loan Balances:
Ending balance individually evaluated for impairment	$	0		$	2,880		$	15,281		$	16		$	0		$	18,177
Ending balance collectively evaluated for impairment		28,687			10,613			382,213			10,969			18,849			451,331
Ending balance	$	28,687		$	13,493		$	397,494		$	10,985		$	18,849		$	469,508

For the Year Ended December 31, 2012	Commercial			Real Estate - Construction			Real Estate - Mortgage			Consumer			Other			Total
Allowance for Loan Losses:
Balance at the beginning of period	$	1,011		$	323		$	6,735		$	300		$	129		$	8,498
Charge-offs		(138	)		(831	)		(2,554	)		(259	)		(187	)		(3,969	)
Recoveries		67			30			162			70			66			395
Provision for loan losses		(263	)		665			1,836			93			69			2,400
Ending balance	$	677		$	187		$	6,179		$	204		$	77		$	7,324
Ending balance individually evaluated for impairment	$	33		$	0		$	411		$	0		$	0		$	444
Ending balance collectively evaluated for impairment		644			187			5,768			204			77			6,880
Ending balance	$	677		$	187		$	6,179		$	204		$	77		$	7,324
Loan Balances:
Ending balance individually evaluated for impairment	$	97		$	3,064		$	14,390		$	17		$	0		$	17,568
Ending balance collectively evaluated for impairment		25,244			8,941			384,132			13,129			22,119			453,565
Ending balance	$	25,341		$	12,005		$	398,522		$	13,146		$	22,119		$	471,133

CHANGES IN ACCOUNTING METHODOLOGY

There were no changes in the Company’s accounting methodology for the allowance for loan losses in the first six months of 2013.