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,			December 31,
	2012			2011
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	77,533		$	77,588
Commercial		272,968			288,108
Construction		13,957			19,981
Second mortgages		15,571			16,044
Equity lines of credit		33,520			34,220
Total mortgage loans on real estate		413,549			435,941
Commercial loans		29,665			35,015
Consumer loans		14,878			17,041
Other		18,398			32,330
Total loans		476,490			520,327
Less: Allowance for loan losses		(7,671	)		(8,498	)
Loans, net of allowance and deferred fees	$	468,819		$	511,829

Overdrawn deposit accounts are reclassified as loans and included in the Other category in the table above. Overdrawn deposit accounts totaled $751 thousand and $583 thousand at June 30, 2012 and December 31, 2011, 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, 2012
(in thousands)
	Pass		OAEM		Substandard		Doubtful		Total
Mortgage loans on real estate:
Residential 1-4 family	$	74,284	$	1,110	$	2,139	$	0	$	77,533
Commercial		244,896		15,630		12,442		0		272,968
Construction		10,369		389		3,199		0		13,957
Second mortgages		15,141		0		430		0		15,571
Equity lines of credit		32,718		234		568		0		33,520
Total mortgage loans on real estate		377,408		17,363		18,778		0		413,549
Commercial loans		26,498		2,149		1,018		0		29,665
Consumer loans		14,761		0		117		0		14,878
Other		18,398		0		0		0		18,398
Total	$	437,065	$	19,512	$	19,913	$	0	$	476,490

Credit Quality Information
As of December 31, 2011
(in thousands)
	Pass		OAEM		Substandard		Doubtful		Total
Mortgage loans on real estate:
Residential 1-4 family	$	74,839	$	677	$	2,072	$	0	$	77,588
Commercial		258,610		11,803		17,695		0		288,108
Construction		19,548		396		37		0		19,981
Second mortgages		15,212		0		832		0		16,044
Equity lines of credit		33,390		182		648		0		34,220
Total mortgage loans on real estate		401,599		13,058		21,284		0		435,941
Commercial loans		29,455		4,295		1,265		0		35,015
Consumer loans		16,955		0		86		0		17,041
Other		32,330		0		0		0		32,330
Total	$	480,339	$	17,353	$	22,635	$	0	$	520,327

As of June 30, 2012 and December 31, 2011 the Company did not have any loans internally classified as Loss.

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 at June 30, 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	$	519	$	381	$	284	$	1,184	$	76,349	$	77,533	$	130
Commercial		1,710		2,979		0		4,689		268,279		272,968		0
Construction		36		0		3,021		3,057		10,900		13,957		0
Second mortgages		71		0		201		272		15,299		15,571		0
Equity lines of credit		267		0		368		635		32,885		33,520		0
Total mortgage loans on real estate		2,603		3,360		3,874		9,837		403,712		413,549		130
Commercial loans		196		29		0		225		29,440		29,665		0
Consumer loans		161		91		1		253		14,625		14,878		1
Other		68		9		4		81		18,317		18,398		4
Total	$	3,028	$	3,489	$	3,879	$	10,396	$	466,094	$	476,490	$	135

(1)

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

Age Analysis of Past Due Loans at December 31, 2011
	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	$	75	$	0	$	627	$	702	$	76,886	$	77,588	$	0
Commercial		0		0		1,123		1,123		286,985		288,108		510
Construction		148		0		0		148		19,833		19,981		0
Second mortgages		104		0		469		573		15,471		16,044		0
Equity lines of credit		159		0		369		528		33,692		34,220		0
Total mortgage loans on real estate		486		0		2,588		3,074		432,867		435,941		510
Commercial loans		101		0		0		101		34,914		35,015		0
Consumer loans		58		89		2		149		16,892		17,041		2
Other		44		0		5		49		32,281		32,330		5
Total	$	689	$	89	$	2,595	$	3,373	$	516,954	$	520,327	$	517

(1)

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

Past due loans increased $7.0 million between December 31, 2011 and June 30, 2012. Of this increase, $4.7 million was due to increases in nonaccrual loans that were also past due. Of the $6.8 million in past due nonaccrual loans at June 30, 2012, all but $964 thousand have been written down to their net realizable value. At December 31, 2011, loans past due, excluding loans on nonaccrual status, were at $1.3 million or 0.25% of total loans, the lowest level of the previous four year-ends. The historically low levels seen at December 31, 2011 are difficult to maintain, and at June 30, 2012 past dues not including nonaccrual loans were still within acceptable levels at $3.6 million or 0.76% of total loans.

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 reach 90 days 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. 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
(in thousands)
	June 30, 2012		December 31, 2011

Mortgage loans on real estate:
Residential 1-4 family	$	496	$	748
Commercial		4,509		6,719
Construction		3,163		0
Second mortgages		201		499
Equity lines of credit		368		368
Total mortgage loans on real estate		8,737		8,334
Commercial loans		103		129
Consumer loans		8		12
Total	$	8,848	$	8,475

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,
	2012		2011
	(in thousands)
Interest income that would have been recorded under original loan terms	$	499	$	723
Actual interest income recorded for the period		87		194
Reduction in interest income on nonaccrual loans	$	412	$	529

TROUBLED DEBT RESTRUCTURINGS

The Company's loan portfolio also 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, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. A TDR that is on nonaccrual status or is 30 days or more past due is considered to be nonperforming. Beginning with the second quarter of 2012, the Company changed its method for determining when a TDR is considered to be nonperforming. Prior to the second quarter of 2012, the Company classified TDRs as nonperforming at the time of restructure and a TDR could only be returned to performing status after considering the borrower's sustained repayment performance in accordance with the restructured terms for a reasonable period, generally six months. Beginning with the second quarter of 2012, the Company defines a TDR as nonperforming only if the TDR is in nonaccrual status or 30 days or more past due at the report date. The reason for this change is that the Company found that some new TDRs were being classified as nonperforming solely because six months had not yet passed since the restructuring. As a result, under the previous system, even loans which had favorable repayment performance in accordance with the restructured terms for a reasonable period prior to the restructuring were being classified as nonperforming TDRs because there was no opportunity to measure their performance after the restructuring.

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

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-02 "A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring" (ASU 2011-02). 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, 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 mortgage loans on real estate		3		3,130		2,606		2,513
Total		3	$	3,130	$	2,606	$	2,513

The loans in the table above were given principal reductions, with the principal forgiveness on all loans in the table totaling $525 thousand. One loan was also given a below-market rate for debt with similar risk characteristics.

In the first six months of 2012 there were no TDRs for which there was a payment default where the default occured within twelve months of restructuring.

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 certain loans modified in a troubled debt restructuring. 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 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 period presented. The average balances are calculated based on daily average balances.

Impaired Loans by Class
(in thousands)
	As of June 30, 2012								Six Months Ended June 30, 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	$	686	$	670	$	0	$	0	$	705	$	30
Commercial		9,968		5,196		4,509		947		10,864		355
Construction		3,166		3,163		0		0		3,539		109
Second mortgages		360		350		0		0		551		26
Equity lines of credit		371		368		0		0		367		17
Total mortgage loans on real estate	$	14,551	$	9,747	$	4,509	$	947	$	16,026	$	537
Commercial loans		120		103		0		0		108		4
Consumer loans		25		8		17		17		27		1
Total	$	14,696	$	9,858	$	4,526	$	964	$	16,161	$	542

Impaired Loans by Class
(in thousands)
	As of December 31, 2011								For the Year Ended December 31, 2011
			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	$	486	$	391	$	91	$	6	$	3,753	$	554
Commercial		8,263		4,734		3,371		968		8,911		456
Construction		0		0		0		0		0		0
Second mortgages		520		250		258		31		603		24
Equity lines of credit		371		369		0		0		392		21
Total mortgage loans on real estate	$	9,640	$	5,744	$	3,720	$	1,005	$	13,659	$	1,055
Commercial loans		142		19		110		23		130		2
Total	$	9,782	$	5,763	$	3,830	$	1,028	$	13,789	$	1,057

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, may depend on interest rates or may 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, 2012 and December 31, 2011, the historical loss percent 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, concentrations, changes in collateral-dependent student loans, changes in underwriting, changes in management and changes in the legal and regulatory environment.

The Company implemented two changes to the qualitative factors component of its allowance for loan loss in the second quarter of 2012. These changes were made to the allocations for the qualitative factors for economic conditions and for collateral-dependent loans.

The allocation for the qualitative factor for economic conditions for June 30, 2012 was decreased as compared to the same allocation at March 31, 2012 and December 31, 2011. This decrease is due to a decrease in the allocation for pass rated loans. Management does not believe that losses in the near future will be equal to or greater than the losses in the current eight-quarter historical loss average, and accordingly believes the majority of the risk within the loan portfolio has been properly reflected in the quantitative historical loss component. In the historical loss component of the allowance, the actual loan loss experience for pass-rated loans is overridden by using the loss experience for the entire loan portfolio. This method includes the OAEM and substandard rated credits which are already accounted for in their own respective allocations, which results in pass rated loans being associated with a greater loss experience than management believes is likely to occur. Because management believes the consequences of recent negative economic conditions have already been accounted for in the historical loss component and believes the historical loss component already includes a conservative allocation with respect to pass-rated loans, management has determined that a decrease in the adjustment for economic conditions appropriately reflects the risk in the loan portfolio. In management's opinion, to increase the loss allocation for pass-rated loans in the qualitative factors component in addition to the conservation allocation in the history loss component is excessive. Since the purpose of the qualitative factors is to provide for losses that are not accounted for in the historical loss and impaired loan components of the allowance, the loss allocation for pass-rated loans in the qualitative factor component was reduced.

The allocation for the qualitative factor for collateral dependent loans also decreased as of June 30, 2012 as compared to the same allocation at March 31, 2012 and December 31, 2011. Management implemented a new strategy in the recognition of risk in the collateral-dependent loan component of the qualitative factors. Management believes that risk in the existing collateral-dependent loans is concentrated in the OAEM and substandard risk grades and that the risk of pass rated loans becoming collateral-dependent within the next six to twelve months is extremely low. In addition, the sharp declines in the market value of real estate seen in past years have begun to level off in 2012. The value of collateral-dependent loans is therefore less subject to reductions. The allocation for this qualitative factor was increased in the past due to uncertainty in the market; with the real estate market beginning to stabilize, management believes that a smaller allocation is acceptable.

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 $7.7 million adequate to cover loan losses inherent in the loan portfolio at June 30, 2012.

The following table presents, by portfolio segment, the changes in the allowance for loan losses and the recorded investment in loans for the period 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, 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		(19	)		(780	)		(1,283	)		(75	)		(58	)		(2,215	)
Recoveries		19			0			80			60			29			188
Provision for loan losses		(312	)		682			915			(55	)		(30	)		1,200
Ending balance	$	699		$	225		$	6,447		$	230		$	70		$	7,671
Ending balance individually evaluated for impairment	$	0		$	0		$	947		$	17		$	0		$	964
Ending balance collectively evaluated for impairment		699			225			5,500			213			70			6,707
Ending balance	$	699		$	225		$	6,447		$	230		$	70		$	7,671
Loan Balances:
Ending balance individually evaluated for impairment	$	103		$	3,163		$	11,093		$	25		$	0		$	14,384
Ending balance collectively evaluated for impairment		29,562			10,794			388,499			14,853			18,398			462,106
Ending balance	$	29,665		$	13,957		$	399,592		$	14,878		$	18,398		$	476,490

For the Year Ended December 31, 2011	Commercial			Real Estate - Construction			Real Estate - Mortgage			Consumer			Other			Total
Allowance for Loan Losses:
Balance at the beginning of period	$	799		$	441		$	11,498		$	357		$	133		$	13,228
Charge-offs		(942	)		0			(7,822	)		(333	)		(210	)		(9,307	)
Recoveries		141			0			575			102			59			877
Provision for loan losses		1,013			(118	)		2,484			174			147			3,700
Ending balance	$	1,011		$	323		$	6,735		$	300		$	129		$	8,498
Ending balance individually evaluated for impairment	$	23		$	0		$	1,005		$	0		$	0		$	1,028
Ending balance collectively evaluated for impairment		988			323			5,730			300			129			7,470
Ending balance	$	1,011		$	323		$	6,735		$	300		$	129		$	8,498
Loan Balances:
Ending balance individually evaluated for impairment	$	129		$	0		$	9,464		$	0		$	0		$	9,593
Ending balance collectively evaluated for impairment		34,886			19,981			406,496			17,041			32,330			510,734
Ending balance	$	35,015		$	19,981		$	415,960		$	17,041		$	32,330		$	520,327

CHANGES IN ACCOUNTING METHODOLOGY

There were no changes Company's accounting methodology for the allowance for loan losses in the first six months of 2012.