Note 5 - Loans Receivable and the Allowance for Loan Losses

Major classes of loans are as follows:

December 31,	2017		2016
Commercial:
Commercial and industrial	$	147,190	$	110,233
Construction		51,157		39,268
Secured by commercial real estate		286,867		255,188
Secured by residential real estate		71,703		68,731
State and political subdivisions		38,087		35,260
Retail:
1-4 family residential mortgages		55,818		47,124
Home equity loans and lines		75,576		71,525
Consumer		6,680		5,670
Total loans		733,078		632,999
Net unearned costs		205		80
Loans receivable	$	733,283	$	633,079

Loans secured by commercial real estate include all loans collateralized at least in part by commercial real estate. These loans may not be for the express purpose of conducting commercial real estate transactions.

Overdrafts are reclassified as loans and are included in consumer loans above and total loans on the balance sheet. At December 31, 2017 and 2016, overdrafts were $126,000 and $171,000, respectively.

QNB generally lends in its trade area which is comprised of Quakertown and the surrounding communities. To a large extent, QNB makes loans collateralized at least in part by real estate. Its lending activities could be affected by changes in the general economy, the regional economy, or real estate values. Other than disclosed in the table above, at December 31, 2017, there were no concentrations of loans exceeding 10% of total loans.

The Company engages in a variety of lending activities, including commercial, residential real estate and consumer transactions. The Company focuses its lending activities on individuals, professionals and small to medium sized businesses. Risks associated with lending activities include economic conditions and changes in interest rates, which can adversely impact both the ability of borrowers to repay their loans and the value of the associated collateral.

Commercial and industrial loans, commercial real estate loans, construction loans and residential real estate loans with a business purpose are generally perceived as having more risk of default than residential real estate loans with a personal purpose and consumer loans. These types of loans involve larger loan balances to a single borrower or groups of related borrowers and are more susceptible to a risk of loss during a downturn in the business cycle. These loans may involve greater risk because the availability of funds to repay these loans depends on the successful operation of the borrower’s business. The assets financed are used within the business for its ongoing operation. Repayment of these kinds of loans generally comes from the cash flow of the business or the ongoing conversions of assets, such as accounts receivable and inventory, to cash. Typical collateral for commercial and industrial loans includes the borrower’s accounts receivable, inventory and machinery and equipment. Commercial real estate and residential real estate loans secured for a business purpose are originated primarily within the eastern Pennsylvania market area at conservative loan-to-value ratios and often backed by the individual guarantees of the borrowers or owners. Repayment of this kind of loan is dependent upon either the ongoing cash flow of the borrowing entity or the resale of or lease of the subject property. Commercial real estate loans may be affected to a greater extent than residential loans by adverse conditions in real estate markets or the economy because commercial real estate borrowers’ ability to repay their loans depends on successful development of their properties, as well as the factors affecting residential real estate borrowers.

Loans to state and political subdivisions are tax-exempt or taxable loans to municipalities, school districts and housing and industrial development authorities. These loans can be general obligations of the municipality or school district repaid through their taxing authority, revenue obligations repaid through the income generated by the operations of the authority, such as a water or sewer authority, or loans issued to a housing and industrial development agency, for which a private corporation is responsible for payments on the loans.

In October 2016, the Company sold its interest in third-party originated lease financing receivables, recording a loss on sale of $223,000, which was essentially offset by a $220,000 reversal of the allowance for loan losses associated with this sold portfolio. The lease financing receivables comprised loans to small businesses collateralized by equipment to borrowers within Pennsylvania and in states contiguous to Pennsylvania. QNB was not the lessor and did not service these loans.

The Company originates fixed-rate and adjustable-rate real estate-residential mortgage loans for personal purposes that are secured by first liens on the underlying 1-4 family residential properties. Credit risk exposure in this area of lending is minimized by the evaluation of the credit worthiness of the borrower, including debt-to-income ratios, credit scores and adherence to underwriting policies that emphasize conservative loan-to-value ratios of generally no more than 80%. Residential mortgage loans granted in excess of the 80% loan-to-value ratio criterion are generally insured by private mortgage insurance.

The real estate-home equity portfolio consists of fixed-rate home equity loans and variable-rate home equity lines of credit. Risks associated with loans secured by residential properties are generally lower than commercial loans and include general economic risks, such as the strength of the job market, employment stability and the strength of the housing market. Since most loans are secured by a primary or secondary residence, the borrower’s continued employment is the greatest risk to repayment.

The Company offers a variety of loans to individuals for personal and household purposes. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and is more likely to decrease in value than real estate. Credit risk in this portfolio is controlled by conservative underwriting standards that consider debt-to-income levels and the creditworthiness of the borrower and, if secured, collateral values.

The Company employs an eight (8) grade risk rating system related to the credit quality of commercial loans, loans to state and political subdivisions and indirect lease financing of which the first four categories are pass categories (credits not adversely rated). The following is a description of the internal risk ratings and the likelihood of loss related to each risk rating.

1 - Excellent - no apparent risk

2 - Good - minimal risk

3 - Acceptable - average risk

4 - Watch List - greater than average risk

5 - Special Mention - potential weaknesses

6 - Substandard - well defined weaknesses

7 - Doubtful - full collection unlikely

8 - Loss - considered uncollectible

The Company maintains a loan review system, which allows for a periodic review of our loan portfolio and the early identification of potential problem loans. Each loan officer assigns a rating to commercial loans, loans to state and political subdivisions and indirect lease financing at the time the loan is originated. Loans with risk ratings of one through three are reviewed annually based on the borrower’s fiscal year. Loans with risk ratings of four are reviewed every six to twelve months based on the dollar amount of the relationship with the borrower. Loans with risk ratings of five through eight are reviewed at least quarterly, and as often as monthly, at management’s discretion. The Company also utilizes an outside loan review firm to review the portfolio on a semi-annual basis to provide the Board of Directors and senior management an independent review of the Bank’s loan portfolio on an ongoing basis. These reviews are designed to recognize deteriorating credits in their earliest stages in an effort to reduce and control risk in the lending function as well as identifying potential shifts in the quality of the loan portfolio. The examinations by the outside loan review firm include the review of lending activities with respect to underwriting and processing new loans, monitoring the risk of existing loans and to provide timely follow-up and corrective action for loans showing signs of deterioration in quality. In addition, the outside firm reviews the methodology for the allowance for loan losses to determine compliance to policy and regulatory guidance.

The following tables present the classes of the loan portfolio summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company’s internal risk rating system as of December 31, 2017 and 2016:

December 31, 2017	Pass		Special mention		Substandard		Doubtful		Total
Commercial:
Commercial and industrial	$	139,820	$	863	$	6,507	$	—	$	147,190
Construction		51,156		—		1		—		51,157
Secured by commercial real estate		268,069		10,569		8,229		—		286,867
Secured by residential real estate		69,571		222		1,910		—		71,703
State and political subdivisions		38,087		—		—		—		38,087
Total	$	566,703	$	11,654	$	16,647	$	—	$	595,004

December 31, 2016	Pass		Special mention		Substandard		Doubtful		Total
Commercial:
Commercial and industrial	$	102,396	$	686	$	7,151	$	—	$	110,233
Construction		39,259		—		9		—		39,268
Secured by commercial real estate		238,290		5,185		11,713		—		255,188
Secured by residential real estate		65,169		231		3,331		—		68,731
State and political subdivisions		35,260		—		—		—		35,260
Total	$	480,374	$	6,102	$	22,204	$	—	$	508,680

For retail loans, the Company evaluates credit quality based on the performance of the individual credits. The following tables present the recorded investment in the retail classes of the loan portfolio based on payment activity as of December 31, 2017 and 2016:

December 31, 2017	Performing		Non-performing		Total
Retail:
1-4 family residential mortgages	$	54,936	$	882	$	55,818
Home equity loans and lines		75,433		143		75,576
Consumer		6,595		85		6,680
Total	$	136,964	$	1,110	$	138,074

December 31, 2016	Performing		Non-performing		Total
Retail:
1-4 family residential mortgages	$	46,858	$	266	$	47,124
Home equity loans and lines		71,436		89		71,525
Consumer		5,577		93		5,670
Total	$	123,871	$	448	$	124,319

The performance and credit quality of the loan portfolio is also monitored by analyzing the age of the loans receivable as determined by the length of time a recorded payment is past due. The following table presents the classes of the loan portfolio (excluding deferred fees and costs) summarized by the past due status, regardless of whether the loan is on non-accrual status, as of December 31, 2017 and 2016:

December 31, 2017	30-59 days past due		60-89 days past due		90 days or more past due		Total past due loans		Current		Total loans receivable
Commercial:
Commercial and industrial	$	25	$	429	$	57	$	511	$	146,679	$	147,190
Construction		—		—		—		—		51,157		51,157
Secured by commercial real estate		899		—		730		1,629		285,238		286,867
Secured by residential real estate		24		—		210		234		71,469		71,703
State and political subdivisions		—		—		—		—		38,087		38,087
Retail:
1-4 family residential mortgages		744		152		504		1,400		54,418		55,818
Home equity loans and lines		251		44		119		414		75,162		75,576
Consumer		23		8		—		31		6,649		6,680
Total	$	1,966	$	633	$	1,620	$	4,219	$	728,859	$	733,078

December 31, 2016	30-59 days past due		60-89 days past due		90 days or more past due		Total past due loans		Current		Total loans receivable
Commercial:
Commercial and industrial	$	463		—		—	$	463	$	109,770	$	110,233
Construction		214		—		—		214		39,054		39,268
Secured by commercial real estate		64	$	395	$	1,596		2,055		253,133		255,188
Secured by residential real estate		—		—		285		285		68,446		68,731
State and political subdivisions		—		—		—		—		35,260		35,260
Retail:
1-4 family residential mortgages		1,459		323		—		1,782		45,342		47,124
Home equity loans and lines		107		15		—		122		71,403		71,525
Consumer		14		2		—		16		5,654		5,670
Total	$	2,321	$	735	$	1,881	$	4,937	$	628,062	$	632,999

The following tables disclose the recorded investment in loans receivable that are either on non-accrual status or past due 90 days or more and still accruing interest as of December 31, 2017 and 2016:

December 31, 2017	90 days or more past due (still accruing)		Non-accrual
Commercial:
Commercial and industrial	$	—	$	3,367
Construction		—		—
Secured by commercial real estate		—		1,987
Secured by residential real estate		—		1,458
State and political subdivisions		—		—
Retail:
1-4 family residential mortgages		—		882
Home equity loans and lines		—		142
Consumer		—		85
Total	$	—	$	7,921

December 31, 2016	90 days or more past due (still accruing)		Non-accrual
Commercial:
Commercial and industrial	$	—	$	4,798
Construction		—		—
Secured by commercial real estate		—		3,007
Secured by residential real estate		—		1,866
State and political subdivisions		—		—
Retail:
1-4 family residential mortgages		—		266
Home equity loans and lines		—		89
Consumer		—		93
Total	$	—	$	10,119

Activity in the allowance for loan losses for the years ended December 31, 2017, 2016 and 2015 are as follows:

Year ended December 31, 2017	Balance, beginning of period		Provision for (credit to) loan losses			Charge-offs			Recoveries		Balance, end of period
Commercial:
Commercial and industrial	$	1,459	$	2,178		$	(960	)	$	34	$	2,711
Construction		449		114			—			—		563
Secured by commercial real estate		2,646		(244	)		—			8		2,410
Secured by residential real estate		1,760		(959	)		(23	)		38		816
State and political subdivisions		123		(9	)		—			—		114
Retail:
1-4 family residential mortgages		366		78			—			—		444
Home equity loans and lines		353		(6	)		—			10		357
Consumer		76		41			(92	)		32		57
Unallocated		162		207		N/A			N/A			369
Total	$	7,394	$	1,400		$	(1,075	)	$	122	$	7,841

Year ended December 31, 2016	Balance, beginning of period		Provision for (credit to) loan losses			Charge-offs			Recoveries		Balance, end of period
Commercial:
Commercial and industrial	$	1,521	$	41		$	(140	)	$	37	$	1,459
Construction		286		163			—			—		449
Secured by commercial real estate		2,411		227			—			8		2,646
Secured by residential real estate		1,812		(44	)		(120	)		112		1,760
State and political subdivisions		222		(99	)		—			—		123
Indirect lease financing		164		(121	)		(52	)		9		—
Retail:
1-4 family residential mortgages		350		16			—			—		366
Home equity loans and lines		428		(91	)		—			16		353
Consumer		76		60			(92	)		32		76
Unallocated		284		(122	)	N/A			N/A			162
Total	$	7,554	$	30		$	(404	)	$	214	$	7,394

Year ended December 31, 2015	Balance, beginning of period		Provision for (credit to) loan losses			Charge-offs			Recoveries		Balance, end of period
Commercial:
Commercial and industrial	$	1,892	$	(353	)	$	(56	)	$	38	$	1,521
Construction		297		(11	)		—			—		286
Secured by commercial real estate		2,700		(214	)		(84	)		9		2,411
Secured by residential real estate		1,630		687			(531	)		26		1,812
State and political subdivisions		221		1			—			—		222
Indirect lease financing		93		76			(21	)		16		164
Retail:
1-4 family residential mortgages		312		38			—			—		350
Home equity loans and lines		453		(47	)		—			22		428
Consumer		85		57			(95	)		29		76
Unallocated		318		(34	)	N/A			N/A			284
Total	$	8,001	$	200		$	(787	)	$	140	$	7,554

As previously discussed, the Company maintains a loan review system, which includes a continuous review of the loan portfolio by internal and external parties to aid in the early identification of potential 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 the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans, loans to state and political subdivisions and indirect lease financing loans by using either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential mortgage loans for impairment disclosures, unless such loans are part of a larger relationship that is impaired, or are classified as a troubled debt restructuring.

An allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of the majority of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral.

For commercial loans secured by real estate, estimated fair values are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.

For commercial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable agings or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.

From time to time, QNB may extend, restructure, or otherwise modify the terms of existing loans, on a case-by-case basis, to remain competitive and retain certain customers, as well as assist other customers that may be experiencing financial difficulties. A loan is considered to be a troubled debt restructuring (“TDR”) loan when the Company grants a concession to the borrower because of the borrower’s financial condition that it would not otherwise consider. Such concessions include the reduction of interest rates, forgiveness of principal or interest, or other modifications of interest rates to less than the current market rate for new obligations with similar risk. Loans classified as TDRs are considered non-performing and are also designated as impaired.

The concessions made for TDRs involve lowering the monthly payments on loans through periods of interest only payments, a reduction in interest rate below a market rate or an extension of the term of the loan without a corresponding adjustment to the risk premium reflected in the interest rate, or a combination of these three methods. The restructurings rarely result in the forgiveness of principal or accrued interest. If the borrower has demonstrated performance under the previous terms and our underwriting process shows the borrower has the capacity to continue to perform under the restructured terms, the loan will continue to accrue interest. Non-accruing restructured loans may be returned to accrual status when there has been a sustained period of repayment performance (generally six consecutive months of payments) and both principal and interest are deemed collectible.

Performing TDRs (not reported as non-accrual or past due 90 days or more and still accruing) totaled $1,321,000 and $1,819,000 as of December 31, 2017 and 2016, respectively. Non-performing TDRs totaled $2,994,000 and $3,555,000 as of December 31, 2017 and 2016, respectively. All TDRs are included in impaired loans.

The following table illustrates the specific reserve for loan losses allocated to loans modified as TDRs. These specific reserves are included in the allowance for loan losses for loans individually evaluated for impairment. There were charge-offs resulting from loans modified as TDRs of $3,000, $0 and $5,000 during the years ended December 31, 2017, 2016 and 2015, respectively.

December 31,	2017				2016
	Unpaid principal balance		Related allowance		Unpaid principal balance		Related allowance
TDRs with no specific allowance recorded	$	3,448		—	$	3,992		—
TDRs with an allowance recorded		867	$	235		1,382	$	761
Total	$	4,315	$	235	$	5,374	$	761

There were no newly identified TDRs during the year ended December 31, 2017. As of December 31, 2017 and 2016, QNB had commitments of $0 and $30,000, respectively, to lend additional funds to customers with loans whose terms have been modified in troubled debt restructurings.

The following table presents loans, by loan class, modified as TDRs during the years ended December 31, 2017 and 2016. The pre-modification outstanding recorded investment disclosed represents the carrying amounts immediately prior to the modification of the loan. The post-modification outstanding recorded investment is net of loan repayments.

Year ended December 31,	2017						2016
	Number of contracts		Pre-modification outstanding recorded investment		Post-modification outstanding recorded investment		Number of contracts		Pre-modification outstanding recorded investment		Post-modification outstanding recorded investment
Commercial:
Commercial and industrial		—	$	—	$	—		7	$	1,099	$	1,020
Secured by commercial real estate		—		—		—		2		1,296		1,251
Secured by residential real estate		—		—		—		5		1,156		1,126
Retail:
1-4 family residential mortgages		—		—		—		1		193		193
Consumer		—		—		—		1		96		93
Total		—	$	—	$	—		16	$	3,840	$	3,683

The following table presents loans modified as TDRs, included above, within the previous 12 months from December 31, 2017 and 2016, for which there was a payment default, past due 60 days or more, during the respective year end.

Year ended December 31,	2017				2016
TDRs Subsequently Defaulted	Number of contracts		Recorded investment		Number of contracts		Recorded investment
Commercial:
Secured by residential real estate		—	$	—		1	$	111

The company had three mortgages secured by residential real estate with a recorded investment of $421,000 for which foreclosure proceedings were in process as of December 31, 2017. There were no mortgage loans secured by residential real estate for which foreclosure proceedings were in process at December 31, 2016.

The following tables present the balance in the allowance of loan losses disaggregated on the basis of the Company’s impairment method by class of loans receivable along with the balance of loans receivable by class, excluding unearned fees and costs, disaggregated on the basis of the Company’s impairment methodology:

	Allowance for Loan Losses						Loans Receivable
December 31, 2017	Balance		Balance related to loans individually evaluated for impairment		Balance related to loans collectively evaluated for impairment		Balance		Balance individually evaluated for impairment		Balance collectively evaluated for impairment
Commercial:
Commercial and industrial	$	2,711	$	1,260	$	1,451	$	147,190	$	6,498	$	140,692
Construction		563		—		563		51,157		1		51,156
Secured by commercial real estate		2,410		—		2,410		286,867		3,874		282,993
Secured by residential real estate		816		84		732		71,703		1,744		69,959
State and political subdivisions		114		—		114		38,087		—		38,087
Retail:
1-4 family residential mortgages		444		8		436		55,818		1,218		54,600
Home equity loans and lines		357		40		317		75,576		164		75,412
Consumer		57		—		57		6,680		85		6,595
Unallocated		369	N/A		N/A		N/A		N/A		N/A
Total	$	7,841	$	1,392	$	6,080	$	733,078	$	13,584	$	719,494

	Allowance for Loan Losses						Loans Receivable
December 31, 2016	Balance		Balance related to loans individually evaluated for impairment		Balance related to loans collectively evaluated for impairment		Balance		Balance individually evaluated for impairment		Balance collectively evaluated for impairment
Commercial:
Commercial and industrial	$	1,459	$	696	$	763	$	110,233	$	5,134	$	105,099
Construction		449		—		449		39,268		224		39,044
Secured by commercial real estate		2,646		—		2,646		255,188		6,383		248,805
Secured by residential real estate		1,760		494		1,266		68,731		2,313		66,418
State and political subdivisions		123		—		123		35,260		—		35,260
Retail:
1-4 family residential mortgages		366		8		358		47,124		748		46,376
Home equity loans and lines		353		—		353		71,525		111		71,414
Consumer		76		—		76		5,670		93		5,577
Unallocated		162	N/A		N/A		N/A		N/A		N/A
Total	$	7,394	$	1,198	$	6,034	$	632,999	$	15,006	$	617,993

The following table summarizes additional information regarding impaired loans by loan portfolio class as of December 31, 2017 and 2016:

	December 31, 2017						December 31, 2016
	Recorded investment (after charge-offs)		Unpaid principal balance		Related allowance		Recorded investment (after charge-offs)		Unpaid principal balance		Related allowance
With no specific allowance recorded:
Commercial:
Commercial and industrial	$	5,070	$	5,461	$	—	$	2,482	$	2,862	$	—
Construction		1		1		—		224		234		—
Secured by commercial real estate		3,874		4,464		—		6,383		6,367		—
Secured by residential real estate		914		1,239		—		1,046		1,438		—
Retail:
1-4 family residential mortgages		1,057		1,108		—		570		589		—
Home equity loans and lines		124		168		—		111		174		—
Consumer		85		90		—		93		95		—
Total	$	11,125	$	12,531	$	—	$	10,909	$	11,759	$	—

With an allowance recorded:
Commercial:
Commercial and industrial	$	1,428	$	2,593	$	1,260	$	2,652	$	2,812	$	696
Construction		—		—		—		—		—		—
Secured by commercial real estate		—		—		—		—		—		—
Secured by residential real estate		830		879		84		1,267		1,435		494
Retail:
1-4 family residential mortgages		161		163		8		178		193		8
Home equity loans and lines		40		41		40		—		—		—
Consumer		—		—		—		—		—		—
Total	$	2,459	$	3,676	$	1,392	$	4,097	$	4,440	$	1,198

Total:
Commercial:
Commercial and industrial	$	6,498	$	8,054	$	1,260	$	5,134	$	5,674	$	696
Construction		1		1		—		224		234		—
Secured by commercial real estate		3,874		4,464		—		6,383		6,367		—
Secured by residential real estate		1,744		2,118		84		2,313		2,873		494
Retail:
1-4 family residential mortgages		1,218		1,271		8		748		782		8
Home equity loans and lines		164		209		40		111		174		—
Consumer		85		90		—		93		95		—
Total	$	13,584	$	16,207	$	1,392	$	15,006	$	16,199	$	1,198

The following table presents additional information regarding the average recorded investment and interest income recognized on impaired loans for the years ended December 31, 2017, 2016 and 2015:

Year Ended December 31,	2017				2016				2015
	Average recorded investment		Interest income recognized		Average recorded investment		Interest income recognized		Average recorded investment		Interest income recognized
Commercial:
Commercial and industrial	$	5,301	$	14	$	4,200	$	58	$	6,108	$	169
Construction		51		2		370		18		396		20
Secured by commercial real estate		5,744		145		6,129		131		7,370		149
Secured by residential real estate		2,252		23		1,960		15		1,544		—
Indirect lease financing		—		—		88		—		43		1
Retail:
1-4 family residential mortgages		1,155		13		583		10		448		6
Home equity loans and lines		138		1		129		1		135		1
Consumer		97		—		29		—		2		—
Total	$	14,738	$	198	$	13,488	$	233	$	16,046	$	346