Loans and Allowance for Loan Losses

The composition of the Company’s loan portfolio, excluding residential loans held for sale, at December 31, 2013 and 2012 was as follows:



	December 31,
	2013			2012
Residential real estate loans	$	570,391		$	572,768
Commercial real estate loans	541,099			506,231
Commercial loans	179,203			190,454
Home equity loans	272,630			278,375
Consumer loans	17,651			16,633
Deferred loan fees net of costs	(572		)	(595		)
Total loans	$	1,580,402		$	1,563,866

The Company’s lending activities are primarily conducted in Maine. The Company originates single family and multi-family residential loans, commercial real estate loans, business loans, municipal loans and a variety of consumer loans. In addition, the Company makes loans for the construction of residential homes, multi-family properties and commercial real estate properties. The ability and willingness of borrowers to honor their repayment commitments is generally dependent on the level of overall economic activity within the geographic area and the general economy. For the years ended December 31, 2013, 2012, and 2011, the Company sold $33.3 million, $16.9 million, and $28.6 million of fixed rate residential mortgage loans on the secondary market, which resulted in a net gain on sale of loans of $728,000, $268,000, and $292,000, respectively.

In 2012, the Company acquired $6.0 million in performing commercial loans in connection with the Branch Acquisition. The loans were recorded at fair value, which was determined by estimating the amount and timing of principal and interest cash flows expected to be collected on the loans and discounting those cash flows at a market rate of interest. As a result of this analysis, the Company recorded a fair value mark of $317,000, which will amortize over the estimated life of the loan. Additionally, the acquired loans did not have any related ALL as they were recorded at fair value; however, an ALL will be established should the credit quality of these loans deteriorate subsequent to the acquisition. As the acquired loans and fair value mark are immaterial to the Company's financial position, additional disclosures related to the acquired loans are not required.

The Company, in the normal course of business, has made loans to its subsidiaries, and certain officers, directors, and their associated companies, under terms that are consistent with the Company’s lending policies and regulatory requirements. Loans, including any unused lines of credit, to related parties were as follows:



	December 31,
	2013			2012
Balance at beginning of year	$	14,590		$	15,361
Loans made/advanced and additions	4,317			350
Repayments and reductions	(1,479		)	(1,121		)
Balance at end of year	$	17,428		$	14,590

The ALL is management’s best estimate of the inherent risk of loss in the Company’s loan portfolio as of the consolidated statement of condition date. Management makes various assumptions and judgments about the collectability of the loan portfolio and provides an allowance for potential losses based on a number of factors including historical losses. If those assumptions are incorrect, the ALL may not be sufficient to cover losses and may cause an increase in the allowance in the future. Among the factors that could affect the Company’s ability to collect loans and require an increase to the allowance in the future are: (i) general real estate and economic conditions; (ii) regional credit concentration; (iii) industry concentration, for example in the hospitality, tourism and recreation industries; and (iv) a requirement by federal and state regulators to increase the provision for loan losses or recognize additional charge-offs.

Prior to 2013, the Company performed its annual assessment of the loss allocation factors for its various loan portfolios and pools during the first calendar quarter of the year. In 2013, the Company performed this assessment in the first quarter and, again, in the fourth quarter. The Company believes performing this assessment in advance of its calendar year end and financial reporting is a best practice and, going forward, will continue to perform annually in the fourth quarter of the calendar year. In conjunction with the fourth quarter assessment of the loss allocation factors, the Company eliminated a pool of smaller-balanced non-performing residential loans and released the related allowance. The net effect to the ALL was a $945,000 release of the allocated allowance. This pool was created prior to 2013 when the Company was experiencing significant increases in non-performing residential real estate secured loans as a result of post-recession consumer strain. The associated reserve was based on estimated fair value of the loans if sold as a group. While the loans in the pool shared certain characteristics, the qualifying pool composition varied. The Company determined the sale of loans as a group was less likely and discontinued the use of a separate pool. Loans that were formerly part of this pooling methodology are now being evaluated for an allowance as part of the loss allocation factor analysis.

During 2012, the Company modified its process to base historical loss factors on the net rather than gross charge-offs. The effect of the change was to reduce the historical loss factor component of the ALL by $325,000.

The board of directors monitors credit risk through the Directors’ Loan Review Committee, which reviews large credit exposures, monitors the external loan review reports, reviews the lending authority for individual loan officers when required, and has approval authority and responsibility for all matters regarding the loan policy and other credit-related policies, including reviewing and monitoring asset quality trends, concentration levels, and the ALL methodology. The Corporate Risk Management Group and the Credit Risk Policy Committee oversee the Company's systems and procedures to monitor the credit quality of its loan portfolio, conduct a loan review program, maintain the integrity of the loan rating system, determine the adequacy of the ALL, and support the oversight efforts of the Directors' Loan Review Committee and the board of directors. The Company's practice is to proactively manage the portfolio such that management can identify problem credits early, assess and implement effective work-out strategies, and take charge-offs as promptly as practical. In addition, the Company continuously reassesses its underwriting standards in response to credit risk posed by changes in economic conditions. For purposes of determining the ALL, the Company disaggregates its loans into portfolio segments, which include residential real estate, commercial real estate, commercial, home equity, and consumer.

The following table presents the activity in the ALL and select loan information by portfolio segment for the year ended December 31, 2013:



	Residential Real Estate			Commercial Real Estate			Commercial			Home Equity			Consumer			Unallocated			Total
ALL:
Beginning balance	$	6,996		$	4,549		$	5,933		$	2,520		$	184		$	2,862		$	23,044
Loans charged off	(1,059		)	(952		)	(1,426		)	(647		)	(190		)	—			(4,274		)
Recoveries	35			121			495			56			61			—			768
Provision (reduction)	(369		)	656			1,218			474			264			(191		)	2,052
Ending balance	$	5,603		$	4,374		$	6,220		$	2,403		$	319		$	2,671		$	21,590
ALL balance attributable loans:
Individually evaluated for impairment	$	1,750		$	526		$	132		$	433		$	140		$	—		$	2,981
Collectively evaluated for impairment	3,853			3,848			6,088			1,970			179			2,671			18,609
Total ending ALL	$	5,603		$	4,374		$	6,220		$	2,403		$	319		$	2,671		$	21,590
Loans:
Individually evaluated for impairment	$	14,435		$	8,864		$	2,635		$	1,571		$	442		$	—		$	27,947
Collectively evaluated for impairment	555,384			532,235			176,568			271,059			17,209			—			1,552,455
Total ending loans balance	$	569,819		$	541,099		$	179,203		$	272,630		$	17,651		$	—		$	1,580,402

The following table presents activity in the ALL and select loan information by portfolio segment for the year ended December 31, 2012:



	Residential Real Estate			Commercial Real Estate			Commercial			Home Equity			Consumer			Unallocated			Total
ALL:
Beginning balance	$	6,398		$	5,702		$	4,846		$	2,704		$	420		$	2,941		$	23,011
Loans charged off	(1,197		)	(593		)	(1,393		)	(1,234		)	(85		)	—			(4,502		)
Recoveries	73			222			406			23			20			—			744
Provision (reduction)	1,722			(782		)	2,074			1,027			(171		)	(79		)	3,791
Ending balance	$	6,996		$	4,549		$	5,933		$	2,520		$	184		$	2,862		$	23,044
ALL balance attributable loans:
Individually evaluated for impairment	$	2,255		$	265		$	286		$	261		$	39		$	—		$	3,106
Collectively evaluated for impairment	4,741			4,284			5,647			2,259			145			2,862			19,938
Total ending ALL	$	6,996		$	4,549		$	5,933		$	2,520		$	184		$	2,862		$	23,044
Loans:
Individually evaluated for impairment	$	13,805		$	7,968		$	3,610		$	1,515		$	259		$	—		$	27,157
Collectively evaluated for impairment	558,368			498,263			186,844			276,860			16,374			—			1,536,709
Total ending loans balance	$	572,173		$	506,231		$	190,454		$	278,375		$	16,633		$	—		$	1,563,866

The ALL for the Company's portfolio segments is determined based on loan balances and the historical performance factor of each portfolio segment. The significant change in the ALL at December 31, 2013 compared to December 31, 2012 was within the residential real estate portfolio segment. As previously discussed, the decrease in the ALL for the residential real estate portfolio segment is primarily the result of a change in the allowance related to the pool of residential real estate loans for which a separate reserve was previously established.

The Company focuses on maintaining a well-balanced and diversified loan portfolio. Despite such efforts, it is recognized that credit concentrations may occasionally emerge as a result of economic conditions, changes in local demand, natural loan growth and runoff. To ensure that credit concentrations can be effectively identified, all commercial and commercial real estate loans are assigned Standard Industrial Classification codes, North American Industry Classification System codes, and state and county codes. Shifts in portfolio concentrations are monitored by the Corporate Risk Management Group. As of December 31, 2013, the two most significant industry exposures within the commercial real estate loan portfolio were non-residential building operators (operators of commercial and industrial buildings, retail establishments, theaters, banks and insurance buildings) and lodging (inns, bed & breakfasts, ski lodges, tourist cabins, hotels, and motels). At December 31, 2013, exposure to these two industries, as a percentage of total commercial real estate loans was 28% and 25%, respectively.

To further identify loans with similar risk profiles, the Company categorizes each portfolio segment into classes by credit risk characteristic and applies a credit quality indicator to each portfolio segment. The indicators for commercial, commercial real estate and residential real estate loans are represented by Grades 1 through 10 as outlined below. In general, risk ratings are adjusted periodically throughout the year as updated analysis and review warrants. This process may include, but is not limited to annual credit and loan reviews, periodic reviews of loan performance metrics such as delinquency rates, and quarterly reviews of adversely risk rated loans. The Company uses the following definitions when assessing grades for the purpose of evaluating the risk and adequacy of the ALL:

•

Grade 1 through 6 — Grades 1 through 6 represent loans that are not subject to adverse criticism as defined in regulatory guidance. Loans in these groups exhibit characteristics that represent low to moderate risks, which is measured using a variety of credit risk criteria, such as cash flow coverage, debt service coverage, balance sheet leverage, liquidity, management experience, industry position, prevailing economic conditions, support from secondary sources of repayment and other credit factors that may be relevant to a specific loan. In general, these loans are support by properly margined collateral and guarantees of principal parties.

•

Grade 7 — Loans with potential weakness (Special Mention). Loans in this category are currently protected based on collateral and repayment capacity and do not constitute undesirable credit risk, but have potential weakness that may result in deterioration of the repayment process at some future date. This classification is used if a negative trend is evident in the obligor’s financial situation. Special mention loans do not sufficiently expose the Company to warrant adverse classification.


•	Grade 8 — Loans with definite weakness (Substandard). Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or by collateral pledged. Borrowers experience difficulty in meeting debt repayment requirements. Deterioration is sufficient to cause the Company to look to the sale of collateral.

•

Grade 9 — Loans with potential loss (Doubtful). Loans classified as doubtful have all the weaknesses inherent in the substandard grade with the added characteristic that the weaknesses make collection or liquidation of the loan in full highly questionable and improbable. The possibility of some loss is extremely high, but because of specific pending factors that may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined.


•	Grade 10 — Loans with definite loss (Loss). Loans classified as loss are considered uncollectible. The loss classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off the asset because recovery and collection time may be protracted.

Asset quality indicators are periodically reassessed to appropriately reflect the risk composition of the Company’s loan portfolio. Home equity and consumer loans are not individually risk rated, but rather analyzed as groups taking into account delinquency rates and other economic conditions which may affect the ability of borrowers to meet debt service requirements, including interest rates and energy costs. Performing loans include loans that are current and loans that are past due less than 90 days. Loans that are past due over 90 days and non-accrual loans are considered non-performing loans.

The following table summarizes credit risk exposure indicators by portfolio segment as of the following dates:



	Residential Real Estate		Commercial Real Estate		Commercial		Home Equity		Consumer		Total
December 31, 2013:
Pass (Grades 1 – 6)	$	551,035	$	496,257	$	155,851	$	—	$	—	$	1,203,143
Performing	—		—		—		271,059		17,210		288,269
Special Mention (Grade 7)	3,196		7,749		11,315		—		—		22,260
Substandard (Grade 8)	15,588		37,093		12,037		—		—		64,718
Non-performing	—		—		—		1,571		441		2,012
Total	$	569,819	$	541,099	$	179,203	$	272,630	$	17,651	$	1,580,402
December 31, 2012:
Pass (Grades 1 – 6)	$	555,444	$	440,610	$	165,460	$	—	$	—	$	1,161,514
Performing	—		—		—		276,742		16,376		293,118
Special Mention (Grade 7)	1,291		17,069		7,449		—		—		25,809
Substandard (Grade 8)	15,438		48,552		17,545		—		—		81,535
Non-performing	—		—		—		1,633		257		1,890
Total	$	572,173	$	506,231	$	190,454	$	278,375	$	16,633	$	1,563,866

The Company closely monitors the performance of its loan portfolio. A loan is placed on non-accrual status when the financial condition of the borrower is deteriorating, payment in full of both principal and interest is not expected as scheduled or principal or interest has been in default for 90 days or more. Exceptions may be made if the asset is well-secured by collateral sufficient to satisfy both the principal and accrued interest in full and collection is assured by a specific event such as the closing of a pending sale contract. When one loan to a borrower is placed on non-accrual status, all other loans to the borrower are re-evaluated to determine if they should also be placed on non-accrual status. All previously accrued and unpaid interest is reversed at this time. A loan may be returned to accrual status when collection of principal and interest is assured and the borrower has demonstrated timely payments of principal and interest for a reasonable period. Unsecured loans, however, are not normally placed on non-accrual status because they are charged-off once their collectability is in doubt.

The following is a loan aging analysis by portfolio segment (including loans past due over 90 days and non-accrual loans) and a summary of non-accrual loans, which include TDRs, and loans past due over 90 days and accruing as of the following dates:



	30 – 59 Days Past Due		60 – 89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Outstanding		Loans > 90 Days Past Due and Accruing		Non-Accrual Loans
December 31, 2013:
Residential real estate	$	3,218	$	684	$	7,269	$	11,171	$	558,648	569,819		$	—	$	10,520
Commercial real estate	926		2,036		3,301		6,263		534,836		541,099		257		7,799
Commercial	159		237		1,980		2,376		176,827		179,203		198		2,146
Home equity	1,395		388		1,007		2,790		269,840		272,630		—		1,571
Consumer	63		21		418		502		17,149		17,651		—		441
Total	$	5,761	$	3,366	$	13,975	$	23,102	$	1,557,300	$	1,580,402	$	455	$	22,477
December 31, 2012:
Residential real estate	$	1,459	$	850	$	8,410	$	10,719	$	561,454	$	572,173	$	193	$	10,584
Commercial real estate	896		2,227		5,380		8,503		497,728		506,231		138		6,719
Commercial	1,079		68		2,969		4,116		186,338		190,454		160		3,409
Home equity	2,230		355		1,105		3,690		274,685		278,375		118		1,514
Consumer	342		199		259		800		15,833		16,633		2		257
Total	$	6,006	$	3,699	$	18,123	$	27,828	$	1,536,038	$	1,563,866	$	611	$	22,483

Interest income that would have been recognized if loans on non-accrual status had been current in accordance with their original terms was approximately $990,000 for 2013 and $1.1 million for both 2012 and 2011.

The Company takes a conservative approach in credit risk management and remains focused on community lending and reinvesting. The Company works closely with borrowers experiencing credit problems to assist in loan repayment or term modifications. TDR loans consist of loans where the Company, for economic or legal reasons related to the borrower’s financial difficulties, granted a concession to the borrower that it would not otherwise consider. TDRs involve term modifications or a reduction of either interest or principal. Once such an obligation has been restructured, it will continue to remain in a restructured status until paid in full.

At December 31, 2013 and 2012, the allowance related to TDRs was $656,000 and $494,000, respectively. The specific reserve component was determined by discounting the total expected future cash flows from the borrower, or if the loan is currently collateral-dependent, using the fair value of the underlying collateral, which was obtained through independent appraisals and internal evaluations. At December 31, 2013, the Company did not have any commitments to lend additional funds to borrowers with loans classified as TDRs.

For 2013, the Company modified fourteen loans as TDRs, which had current balances of $1.7 million at December 31, 2013. For 2012, the Company modified nine loans with current balances of $1.9 million at December 31, 2012. The modification of these loans as TDRs did not have a material financial effect on the Company. Loans restructured due to credit difficulties that are now performing were $5.5 million at December 31, 2013 and $4.7 million at December 31, 2012. The Company had three TDRs that subsequently defaulted during 2013, which had current balances of $765,000 at December 31, 2013. The Company had one TDR that subsequently defaulted during 2012, which had a current balance of $65,000 at December 31, 2012.

The following is a summary of accruing and non-accruing TDR loans by portfolio segment as of December 31, 2013 and 2012:



	Number of Contracts		Pre-Modification Outstanding Recorded Investment				Post-Modification Outstanding Recorded Investment				Current Balance
	2013	2012	2013		2012		2013		2012		2013		2012
Residential real estate	26	20	$	4,140	$	3,305	$	4,311	$	3,434	$	4,089	$	3,286
Commercial real estate	10	6	3,031		2,602		3,074		2,649		2,558		2,344
Commercial	7	3	504		303		504		303		488		236
Consumer and home equity	1	1	3		3		3		3		1		2
Total	44	30	$	7,678	$	6,213	$	7,892	$	6,389	$	7,136	$	5,868

The following is a summary of TDR loans that subsequently defaulted by portfolio segment as of December 31, 2013 and 2012:



	2013			2012
	Number of Contracts	Recorded Investment		Number of Contracts	Recorded Investment
Residential real estate	1	$	109	1	$	65
Commercial real estate	2	656		—	—
Total	3	$	765	1	$	65

Impaired loans consist of non-accrual and TDR loans. All impaired loans are allocated a portion of the allowance to cover potential losses.

The following is a summary of impaired loan balances and the associated allowance by portfolio segment as of December 31, 2013:



	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With related allowance recorded:
Residential real estate	$	11,902	$	11,902	$	1,750	$	10,411	$	118
Commercial real estate	6,805		6,805		526		5,517		20
Commercial	1,876		1,876		132		2,543		10
Home equity	1,228		1,228		433		1,291		—
Consumer	425		425		140		460		—
Ending Balance	$	22,236	$	22,236	$	2,981	$	20,222	$	148
Without related allowance recorded:
Residential real estate	$	2,533	$	3,846	$	—	$	2,925	$	28
Commercial real estate	2,059		2,782		—		3,362		55
Commercial	759		871		—		765		8
Home equity	343		479		—		334		—
Consumer	17		37		—		11		—
Ending Balance	$	5,711	$	8,015	$	—	$	7,397	$	91
Total impaired loans	$	27,947	$	30,251	$	2,981	$	27,619	$	239

The following is a summary of impaired loan balances and the associated allowance by portfolio segment as of December 31, 2012:



	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With related allowance recorded:
Residential real estate	$	11,021	$	11,021	$	2,255	$	10,585	$	114
Commercial real estate	4,296		4,296		265		5,551		—
Commercial	2,971		2,971		286		3,927		—
Home equity	1,236		1,236		261		1,289		—
Consumer	257		257		39		239		—
Ending Balance	$	19,781	$	19,781	$	3,106	$	21,591	$	114
Without related allowance recorded:
Residential real estate	$	2,784	$	3,841	$	—	$	2,548	$	26
Commercial real estate	3,672		4,127		—		2,056		33
Commercial	639		956		—		389		13
Home equity	279		550		—		617		—
Consumer	2		2		—		6		—
Ending Balance	$	7,376	$	9,476	$	—	$	5,616	$	72
Total impaired loans	$	27,157	$	29,257	$	3,106	$	27,207	$	186