Note 4, 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:

	December 31, 2014			December 31, 2013
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	91,318		$	84,500
Commercial		287,531			287,071
Construction		9,082			14,505
Second mortgages		13,403			13,232
Equity lines of credit		43,662			32,163
Total mortgage loans on real estate		444,996			431,471
Commercial loans		37,698			30,702
Consumer loans		30,493			19,791
Other		22,807			18,735
Total loans		535,994			500,699
Less: Allowance for loan losses		(7,075	)		(6,831	)
Loans, net of allowance and deferred fees	$	528,919		$	493,868

Overdrawn deposit accounts are reclassified as loans and included in the Other category in the table above. Overdrawn deposit accounts totaled $541 thousand and $641 thousand at December 31, 2014 and December 31, 2013, 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 December 31, 2014

(in thousands)

	Pass		OAEM		Substandard		Total
Mortgage loans on real estate:
Residential 1-4 family	$	89,480	$	0	$	1,838	$	91,318
Commercial		272,654		10,602		4,275		287,531
Construction		8,026		0		1,056		9,082
Second mortgages		13,306		0		97		13,403
Equity lines of credit		42,976		0		686		43,662
Total mortgage loans on real estate		426,442		10,602		7,952		444,996
Commercial loans		36,007		1,669		22		37,698
Consumer loans		30,463		0		30		30,493
Other		22,807		0		0		22,807
Total	$	515,719	$	12,271	$	8,004	$	535,994

Credit Quality Information

As of December 31, 2013

(in thousands)

	Pass		OAEM		Substandard		Total
Mortgage loans on real estate:
Residential 1-4 family	$	78,612	$	1,167	$	4,721	$	84,500
Commercial		274,749		5,693		6,629		287,071
Construction		10,319		640		3,546		14,505
Second mortgages		12,994		0		238		13,232
Equity lines of credit		31,690		0		473		32,163
Total mortgage loans on real estate		408,364		7,500		15,607		431,471
Commercial loans		30,164		319		219		30,702
Consumer loans		19,723		0		68		19,791
Other		18,735		0		0		18,735
Total	$	476,986	$	7,819	$	15,894	$	500,699

As of December 31, 2014 and 2013 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 December 31, 2014

	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	$	1,043	$	55	$	792	$	1,890	$	89,428	$	91,318	$	0
Commercial		31		0		432		463		287,068		287,531		0
Construction		0		0		499		499		8,583		9,082		0
Second mortgages		81		32		168		281		13,122		13,403		107
Equity lines of credit		49		0		0		49		43,613		43,662		0
Total mortgage loans on real estate		1,204		87		1,891		3,182		441,814		444,996		107
Commercial loans		195		0		10		205		37,493		37,698		10
Consumer loans		1,099		323		1,019		2,441		28,052		30,493		1,019
Other		51		3		5		59		22,748		22,807		5
Total	$	2,549	$	413	$	2,925	$	5,887	$	530,107	$	535,994	$	1,141

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

In the table above, the consumer category includes student loans with principal amounts that are 97 - 98% guaranteed by the government. The past due portion of these guaranteed loans totaled $2.4 million at December 31, 2014.

Age Analysis of Past Due Loans as of December 31, 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	$	324	$	82	$	4,304	$	4,710	$	79,790	$	84,500	$	493
Commercial		120		704		53		877		286,194		287,071		0
Construction		0		0		2,545		2,545		11,960		14,505		0
Second mortgages		0		10		34		44		13,188		13,232		34
Equity lines of credit		139		0		0		139		32,024		32,163		0
Total mortgage loans on real estate		583		796		6,936		8,315		423,156		431,471		527
Commercial loans		15		80		0		95		30,607		30,702		0
Consumer loans		929		5		5		939		18,852		19,791		5
Other		51		15		14		80		18,655		18,735		14
Total	$	1,578	$	896	$	6,955	$	9,429	$	491,270	$	500,699	$	546

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

NONACCRUAL LOANS

The Company generally places commercial loans (including construction loans and commercial loans secured and not secured by real estate) 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 consumer loans secured by real estate (including residential 1 - 4 family mortgages, second mortgages, and equity lines of credit) are not required to be placed in nonaccrual status. Although consumer loans and consumer loans secured by real estate are not required to be placed in nonaccrual status, the Company may elect to place these loans in nonaccrual status, if necessary to avoid a material overstatement of interest income. Generally, consumer loans secured by real estate are placed in nonaccrual status only when payments are 120 days past due.

Generally, consumer loans not secured by real estate are placed in nonaccrual status only when part of the principal has been charged off. If a charge-off has not occurred sooner for other reasons, a consumer loan not secured by real estate will generally be placed in nonaccrual status when payments are 120 days past due. 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 as discussed in the Loan Charge-Off Policies section of Note 1, 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, loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, or when the borrower has resumed paying the full amount of the scheduled contractual interest and principal payments for at least six months.

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

Nonaccrual Loans by Class

	December 31, 2014		December 31, 2013
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	924	$	4,024
Commercial		4,086		4,606
Construction		499		2,545
Second mortgages		61		0
Total mortgage loans on real estate		5,570		11,175
Commercial loans		0		149
Total	$	5,570	$	11,324

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:

	Years Ended December 31,
	2014			2013
	(in thousands)
Interest income that would have been recorded under original loan terms		$	301	$	762
Actual interest income recorded for the period			265		251
Reduction in interest income on nonaccrual loans		$	36	$	511

TROUBLED DEBT RESTRUCTURINGS

The Company's loan portfolio includes certain loans classified as TDRs, 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 is 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 discussed further under Impaired Loans below.

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

Troubled Debt Restructurings by Class

For the Year Ended December 31, 2014

(dollars in thousands)

	Number of Modifications		Recorded Investment Prior to Modification		Recorded Investment After Modification		Current Investment on December 31, 2014
Mortgage loans on real estate:
Residential 1-4 family		2	$	375	$	375	$	366
Construction		1		103		103		102
Second mortgages		1		89		89		86
Total		4	$	567	$	567	$	554

Troubled Debt Restructurings by Class

For the Year Ended December 31, 2013

(dollars in thousands)

	Number of Modifications		Recorded Investment Prior to Modification		Recorded Investment After Modification		Current Investment on December 31, 2013
Mortgage loans on real estate:
Residential 1-4 family		8	$	1,633	$	1,633	$	1,620
Commercial		3		3,665		3,665		3,657
Second mortgages		2		231		231		203
Total		13	$	5,529	$	5,529	$	5,480

The loans restructured in 2013 and 2014 were all given below-market rates for debt with similar risk characteristics.

At December 31, 2014 and 2013, the Company had no outstanding commitments to disburse additional funds on any TDR.

The following table presents TDRs for the years indicated for which there was a payment default where the default occurred within twelve months of restructuring. The Company considers a TDR in default when any of the following occurs: the loan, as restructured, becomes 90 days or more past due; the loan is returned to nonaccrual status following the restructure; the loan is restructured again under terms that would qualify it as a TDR if it were not already so classified; or any portion of the loan is charged off.

Restructurings that Subsequently Defaulted
(dollars in thousands)
	For the Years Ended December 31,
	2014				2013
Mortgage loans on real estate:	Number of Defaults		Amount of Default		Number of Defaults		Amount of Default
Residential 1-4 family		2	$	389		2	$	181
Commercial		0		0		1		2,062
Total		2	$	389		3	$	2,243

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 when 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 December 31, 2014								For the year ended December 31, 2014
			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	$	2,898	$	2,083	$	646	$	91	$	4,099	$	126
Commercial		11,766		4,729		5,322		163		10,669		449
Construction		1,157		623		534		270		2,431		55
Second mortgages		506		195		282		178		470		25
Total mortgage loans on real estate	$	16,327	$	7,630	$	6,784	$	702	$	17,669	$	655
Commercial loans		0		0		0		0		37		0
Consumer loans		14		14		0		0		26		1
Total	$	16,341	$	7,644	$	6,784	$	702	$	17,732	$	656

Impaired Loans by Class

(in thousands)

	As of December 31, 2013												For the year ended December 31, 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		$	5,713		$	1,542		$	4,009		$	1,383		$	5,152		$	102
Commercial			12,905			6,882			4,300			307			10,631			591
Construction			3,309			2,545			0			0			2,798			0
Second mortgages			374			296			47			3			462			(19	)
Total mortgage loans on real estate		$	22,301		$	11,265		$	8,356		$	$ 1,693		$	19,140		$	674
Commercial loans			150			149			0			0			44			6
Consumer loans			15			0			15			0			17			1
Total		$	22,466		$	11,414		$	8,371		$	1,693		$	$ 19,201		$	681

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 migration analysis 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. The Company segments the loans in the portfolio by the categories defined by Schedule RC-C of the Federal Financial Institutions Examination Council Consolidated Reports of Condition and Income Form 041 (Call Report). 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.

Each segment of the portfolio is pooled by risk grade or by days past due. Loans not secured by real estate and made to individuals for household, family and other personal expenditures are segmented into pools based on days past due, while all other loans, including loans to consumers that are secured by real estate, are segmented by risk grades. A historical loss percentage is then calculated by migration analysis and applied to each pool. The migration analysis applied to all pools is able to track the risk grading and historical performance of individual loans throughout a number of periods set by management, which provides management with information regarding trends (or migrations) in a particular loan segment. At December 31, 2013 and December 31, 2014, management used eight-quarter and twelve-quarter migration periods, respectively. Management believes the additional information provided by the extended migration analysis results in more accurate historical loss information.

THE COMPANY'S ESTIMATION PROCESS

Loans are either individually evaluated for impairment or pooled with like loans and collectively evaluated for impairment. Also, various qualitative factors are applied to each segment of the loan portfolio. The allowance for loan losses is the accumulation of these components. Management's estimate is based on certain observable, historical data that management believes are most reflective of the underlying credit losses being estimated.

Management provides an allocated component of the allowance for loans that are individually evaluated for impairment. An allocated allowance is established when the discounted value of expected 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. This allocation represents the sum of management's estimated losses on each loan.

Loans collectively evaluated for impairment are pooled, with a historical loss rate, based on migration analysis, applied to each pool. 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.

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 $7.1 million adequate to cover loan losses inherent in the loan portfolio at December 31, 2014.

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 Year Ended December 31, 2014	Commercial				Real Estate - Construction				Real Estate - Mortgage				Consumer				Other				Total
Allowance for Loan Losses:
Balance at the beginning of period		$	350			$	662			$	5,357			$	294			$	168			$	6,831
Charge-offs			(286	)			(51	)			(563	)			(163	)			(175	)			(1,238	)
Recoveries			55				173				524				64				66				882
Provision for loan losses			476				(81	)			29				24				152				600
Ending balance		$	595			$	703			$	5,347			$	219			$	211			$	7,075
Ending balance individually evaluated for impairment		$	0			$	270			$	432			$	0			$	0			$	702
Ending balance collectively evaluated for impairment			595				433				4,915				219				211				6,373
Ending balance		$	595			$	703			$	5,347			$	219			$	211			$	7,075
Loan Balances:
Ending balance individually evaluated for impairment		$	0			$	1,157			$	13,257			$	14			$	0			$	14,428
Ending balance collectively evaluated for impairment			37,698				7,925				422,657				30,479				22,807				521,566
Ending balance		$	37,698			$	9,082			$	435,914			$	30,493			$	22,807			$	535,994

For the Year Ended December 31, 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			(200	)			(501	)			(1,548	)			(141	)			(316	)			(2,706	)
Recoveries			76				6				513				111				207				913
Provision for loan losses			(203	)			970				213				120				200				1,300
Ending balance		$	350			$	662			$	5,357			$	294			$	168			$	6,831
Ending balance individually evaluated for impairment		$	0			$	0			$	1,693			$	0			$	0			$	1,693
Ending balance collectively evaluated for impairment			350				662				3,664				294				168				5,138
Ending balance		$	350			$	662			$	5,357			$	294			$	168			$	6,831
Loan Balances:
Ending balance individually evaluated for impairment		$	149			$	2,545			$	17,076			$	15			$	0			$	19,785
Ending balance collectively evaluated for impairment			30,553				11,960				399,890				19,776				18,735				480,914
Ending balance		$	30,702			$	14,505			$	416,966			$	19,791			$	18,735			$	500,699

CHANGES IN ACCOUNTING METHODOLOGY

Historical loss rates calculated by migration analysis are determined by the performance of a loan over a period of time (the migration period). Adding additional quarters to the migration analysis extends the period over which the loan could cease to perform, increasing the number of loans that default and thus also increasing the historical loss rates. While a longer migration period provides a more conservative estimate of expected future losses, extending the migration period too far can provide less accurate estimates if there have been changes in the economy or the Company's loan management processes. Management reviews the migration period as part of each quarterly calculation of the allowance.

To better reflect the risks inherent in the loan portfolio, the Company extended the migration period used to calculate the historical loss portion of the allowance from eight quarters at December 31, 2013 to twelve quarters at December 31, 2014.

The following table represents the effect on the loan loss provision for the year ended December 31, 2014 as a result of the changes to the methodology from that used in prior periods.

	Calculated Provision Based on Current Methodology			Calculated Provision Based on Prior Methodology			Difference
	(in thousands)
Portfolio Segment:
Commercial	$	476		$	320		$	156
Real estate - construction		(81	)		(143	)		62
Real estate - mortgage		29			(520	)		549
Consumer loans		24			(69	)		93
Other		152			157			(5	)
Total	$	600		$	(255	)	$	855