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:

	September 30,			December 31,
	2012			2011
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	74,965		$	77,588
Commercial		270,772			288,108
Construction		13,789			19,981
Second mortgages		14,758			16,044
Equity lines of credit		32,288			34,220
Total mortgage loans on real estate		406,572			435,941
Commercial loans		25,800			35,015
Consumer loans		13,904			17,041
Other		17,268			32,330
Total loans		463,544			520,327
Less: Allowance for loan losses		(7,301	)		(8,498	)
Loans, net of allowance and deferred fees	$	456,243		$	511,829

Overdrawn deposit accounts are reclassified as loans and included in the Other category in the table above. Overdrawn deposit accounts totaled $937 thousand and $583 thousand at September 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 September 30, 2012

(in thousands)

	Pass		OAEM		Substandard		Doubtful		Total
Mortgage loans on real estate:
Residential 1-4 family	$	68,837	$	913	$	5,215	$	0	$	74,965
Commercial		254,391		4,844		11,537		0		270,772
Construction		10,250		386		3,153		0		13,789
Second mortgages		14,150		244		364		0		14,758
Equity lines of credit		31,492		232		564		0		32,288
Total mortgage loans on real estate		379,120		6,619		20,833		0		406,572
Commercial loans		23,623		1,136		1,041		0		25,800
Consumer loans		13,757		0		147		0		13,904
Other		17,268		0		0		0		17,268
Total	$	433,768	$	7,755	$	22,021	$	0	$	463,544

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 September 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 as of September 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	$	3,396	$	0	$	831	$	4,227	$	70,738	$	74,965	$	224
Commercial		1,179		883		1,918		3,980		266,792		270,772		0
Construction		36		0		2,976		3,012		10,777		13,789		0
Second mortgages		0		0		272		272		14,486		14,758		0
Equity lines of credit		60		0		381		441		31,847		32,288		15
Total mortgage loans on real estate		4,671		883		6,378		11,932		394,640		406,572		239
Commercial loans		100		160		0		260		25,540		25,800		0
Consumer loans		202		47		15		264		13,640		13,904		15
Other		44		9		3		56		17,212		17,268		3
Total	$	5,017	$	1,099	$	6,396	$	12,512	$	451,032	$	463,544	$	257

(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, 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 $9.1 million between December 31, 2011 and September 30, 2012. Of this increase, $6.4 million was due to increases in nonaccrual loans that were also past due. Of the $9.3 million in past due nonaccrual loans at September 30, 2012, all but $502 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 year-end level since December 31, 2008. At September 30, 2012, loans past due, excluding loans on nonaccrual status, were $3.3 milllion or 0.71% 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 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

(in thousands)

	September 30, 2012		December 31, 2011

Mortgage loans on real estate:
Residential 1-4 family	$	3,752	$	748
Commercial		3,190		6,719
Construction		3,116		0
Second mortgages		272		499
Equity lines of credit		466		368
Total mortgage loans on real estate		10,796		8,334
Commercial loans		100		129
Consumer loans		5		12
Total	$	10,901	$	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:

	Nine Months Ended September 30,
	2012		2011
	(in thousands)
Interest income that would have been recorded under original loan terms	$	823	$	1,202
Actual interest income recorded for the period		235		515
Reduction in interest income on nonaccrual loans	$	588	$	687

TROUBLED DEBT RESTRUCTURINGS

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 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, 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, including those with favorable repayment performance for a reasonable period prior to restructuring, were being classified as nonperforming solely because six months had not yet passed since the restructuring.

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 Nine Months Ended September 30, 2012

(dollars in thousands)

	Number of Modifications		Recorded Investment Prior to Modification		Recorded Investment After Modification		Current Investment on September 30, 2012
Mortgage loans on real estate:
Residential 1-4 family		1	$	93	$	87	$	72
Commercial		3		3,486		2,928		2,782
Second mortgages		1		111		145		139
Total		5	$	3,690	$	3,160	$	2,993

Three loans in the table above were given principal reductions, with the principal forgiveness on these loans totaling $530 thousand. Three loans were given below-market rates for debt with similar risk characteristics. One loan was given both a principal reduction and a below-market rate.

The following table presents TDRs for which there was a payment default as of September 30, 2012, where the default occurred within twelve months of restructuring.

Restructurings that Subsequently Defaulted

As of September 30, 2012

(in thousands)

	Recorded Investment in Defaulting Loans
Mortgage loans on real estate:
Commercial	$	253
Total	$	253

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 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 September 30, 2012								Nine Months Ended September 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	$	4,062	$	729	$	3,276	$	334	$	1,809	$	127
Commercial		11,495		5,124		3,488		138		10,313		211
Construction		3,834		3,117		0		0		3,404		(10	)
Second mortgages		483		372		48		6		510		5
Equity lines of credit		470		109		357		145		400		1
Total mortgage loans on real estate	$	20,344	$	9,451	$	7,169	$	623	$	16,436	$	334
Commercial loans		119		0		100		13		106		0
Consumer loans		21		21		0		0		26		2
Total	$	20,484	$	9,472	$	7,269	$	636	$	16,568	$	336

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 September 30, 2012 and December 31, 2011, 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, concentrations, changes in certain 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. See the quarterly report on Form 10-Q for the second quarter of 2012, filed with the Securities and Exchange Commission on August 14, 2012 for details. The Company implemented one change to the qualitative factors component of its allowance for loan loss in the third quarter of 2012. This change was made to the allocations for the qualitative factors for changes in past due loans, nonaccruals loans and loans risk rated substandard or doubtful. The allocation was increased to account for increases in past dues and nonaccruals in the real estate categories, as seen in the tables above under "Age Analysis of Past Due Loans by Class."

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 September 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 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 Nine Months Ended September 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		(86	)		(780	)		(2,232	)		(182	)		(130	)		(3,410	)
Recoveries		54			0			103			55			51			263
Provision for loan losses		(374	)		674			1,585			51			14			1,950
Ending balance	$	605		$	217		$	6,191		$	224		$	64		$	7,301
Ending balance individually evaluated for impairment	$	13		$	0		$	623		$	0		$	0		$	636
Ending balance collectively evaluated for impairment		592			217			5,568			224			64			6,665
Ending balance	$	605		$	217		$	6,191		$	224		$	64		$	7,301
Loan Balances:
Ending balance individually evaluated for impairment	$	100		$	3,117		$	13,503		$	21		$	0		$	16,741
Ending balance collectively evaluated for impairment		25,700			10,672			379,280			13,883			17,268			446,803
Ending balance	$	25,800		$	13,789		$	392,783		$	13,904		$	17,268		$	463,544

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 in the Company's accounting methodology for the allowance for loan losses in the first nine months of 2012.