Note 7 – Loans and Related Allowance for Loan Losses

The following table summarizes the primary segments of the loan portfolio as of March 31, 2015 and December 31, 2014:



(in thousands)	Commercial Real Estate		Acquisition and Development		Commercial and Industrial		Residential Mortgage		Consumer		Total
March 31, 2015

Individually evaluated for impairment	$	10,726	$	6,088	$	1,516	$	4,516	$	13	$	22,859
Collectively evaluated for impairment	$	241,546	$	93,325	$	92,700	$	362,221	$	23,799	$	813,591
Total loans	$	252,272	$	99,413	$	94,216	$	366,737	$	23,812	$	836,450

December 31, 2014

Individually evaluated for impairment	$	11,949	$	6,553	$	1,861	$	4,418	$	0	$	24,781
Collectively evaluated for impairment	$	244,115	$	92,748	$	91,394	$	363,223	$	23,730	$	815,210
Total loans	$	256,064	$	99,301	$	93,255	$	367,641	$	23,730	$	839,991

The segments of the Bank’s loan portfolio are disaggregated to a level that allows management to monitor risk and performance. The commercial real estate (“CRE”) loan segment is then segregated into two classes. Non-owner occupied CRE loans, which include loans secured by non-owner occupied, non-farm, and nonresidential properties, generally have a greater risk profile than all other CRE loans, which include loans secured by farmland, multifamily structures and owner-occupied commercial structures. The acquisition and development (“A&D”) loan segment is segregated into two classes. One-to-four family residential construction loans are generally made to individuals for the acquisition of and/or construction on a lot or lots on which a residential dwelling is to be built. All other A&D loans are generally made to developers or investors for the purpose of acquiring, developing and constructing residential or commercial structures. A&D loans have a higher risk profile because the ultimate buyer, once development is completed, is generally not known at the time of the loan is made. The commercial and industrial (“C&I”) loan segment consists of loans made for the purpose of financing the activities of commercial customers. The residential mortgage loan segment is segregated into two classes. Amortizing term loans are primarily first lien loans. Home equity lines of credit are generally second lien loans. The consumer loan segment consists primarily of installment loans (direct and indirect) and overdraft lines of credit connected with customer deposit accounts.

Management uses a 10-point internal risk rating system to monitor the credit quality of the overall loan portfolio. The first six categories are considered not criticized, and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The Special Mention category includes assets that are currently protected but are potentially weak, resulting in an undue and unwarranted credit risk, but not to the point of justifying a Substandard classification. Loans in the Substandard category have well-defined weaknesses that jeopardize the liquidation of the debt, and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected. All loans greater than 90 days past due are considered Substandard. The portion of a specific allocation of the allowance for loan losses that management believes is associated with a pending event that could trigger loss in the short-term will be classified in the Doubtful category. Any portion of a loan that has been charged off is placed in the Loss category.

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay a loan as agreed, the Bank has a structured loan rating process with several layers of internal and external oversight. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as bankruptcy, repossession, or death occurs to raise awareness of a possible credit event. The Bank’s Commercial Loan Officers are responsible for the timely and accurate risk rating of the loans in the commercial segments at origination and on an ongoing basis. The Bank’s experienced Credit Quality and Loan Review Department performs an annual review of all commercial relationships of $500,000 or greater. Confirmation of the appropriate risk grade is included as part of the review process on an ongoing basis. The Credit Quality and Loan Review Department continually reviews and assesses loans within the portfolio. In addition, the Bank engages an external consultant to conduct loan reviews on at least an annual basis. Generally, the external consultant reviews commercial relationships greater than $1,000,000 and/or criticized non-consumer loans greater than $500,000. Detailed reviews, including plans for resolution, are performed on loans classified as Substandard on a quarterly basis. Loans in the Special Mention and Substandard categories that are collectively evaluated for impairment are given separate consideration in the determination of the allowance.

The following table presents the classes of the loan portfolio summarized by the aggregate Pass and the criticized categories of Special Mention and Substandard within the internal risk rating system as of March 31, 2015 and December 31, 2014:




(in thousands)	Pass		Special Mention		Substandard		Total
March 31, 2015
Commercial real estate
Non owner-occupied	$	110,491	$	13,118	$	10,050	$	133,659
All other CRE		89,339		9,486		19,788		118,613
Acquisition and development
1-4 family residential construction		14,664		0		790		15,454
All other A&D		69,225		3,241		11,493		83,959
Commercial and industrial		89,494		620		4,102		94,216
Residential mortgage
Residential mortgage - term		279,724		323		10,888		290,935
Residential mortgage - home equity		74,206		50		1,546		75,802
Consumer		23,741		0		71		23,812
Total	$	750,884	$	26,838	$	58,728	$	836,450

December 31, 2014
Commercial real estate
Non owner-occupied	$	115,276	$	10,884	$	11,273	$	137,433
All other CRE		90,740		8,618		19,273		118,631
Acquisition and development
1-4 family residential construction		12,920		0		790		13,710
All other A&D		72,323		1,356		11,912		85,591
Commercial and industrial		88,579		884		3,792		93,255
Residential mortgage
Residential mortgage - term		280,113		379		10,934		291,426
Residential mortgage - home equity		74,698		90		1,427		76,215
Consumer		23,658		0		72		23,730
Total	$	758,307	$	22,211	$	59,473	$	839,991

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. A loan is considered to be past due when a payment remains unpaid 30 days past its contractual due date. For all loan segments, the accrual of interest is discontinued when principal or interest is delinquent for 90 days or more unless the loan is well-secured and in the process of collection. All non-accrual loans are considered to be impaired. Interest payments received on non-accrual loans are applied as a reduction of the loan principal balance. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. The Corporation’s policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition.

The following table presents the classes of the loan portfolio summarized by the aging categories of performing loans and non-accrual loans as of March 31, 2015 and December 31, 2014:



(in thousands)	Current		30-59 Days Past Due		60-89 Days Past Due		90 Days+ Past Due		Total Past Due and Accruing		Non-Accrual		Total Loans
March 31, 2015
Commercial real estate
Non owner-occupied	$	131,635	$	1,472	$	64	$	0	$	1,536	$	488	$	133,659
All other CRE		109,328		4,855		66		0		4,921		4,364		118,613
Acquisition and development
1-4 family residential construction		15,454		0		0		0		0		0		15,454
All other A&D		80,256		609		0		1		610		3,093		83,959
Commercial and industrial		94,027		0		0		19		19		170		94,216
Residential mortgage
Residential mortgage - term		281,928		7,211		217		87		7,515		1,492		290,935
Residential mortgage - home equity		74,270		986		74		61		1,121		411		75,802
Consumer		23,594		139		45		21		205		13		23,812
Total	$	810,492	$	15,272	$	466	$	189	$	15,927	$	10,031	$	836,450

December 31, 2014
Commercial real estate
Non owner-occupied	$	135,994	$	104	$	183	$	0	$	287	$	1,152	$	137,433
All other CRE		112,825		1,196		0		0		1,196		4,610		118,631
Acquisition and development
1-4 family residential construction		13,710		0		0		0		0		0		13,710
All other A&D		81,702		239		40		1		280		3,609		85,591
Commercial and industrial		93,060		0		20		4		24		171		93,255
Residential mortgage
Residential mortgage - term		279,340		8,654		1,350		416		10,420		1,666		291,426
Residential mortgage - home equity		74,913		577		313		69		959		343		76,215
Consumer		23,316		287		88		39		414		0		23,730
Total	$	814,860	$	11,057	$	1,994	$	529	$	13,580	$	11,551	$	839,991

Non-accrual loans which have been subject to a partial charge-off totaled $5.4 million as of March 31, 2015, compared to $4.6 million as of December 31, 2014. Loans secured by 1-4 family residential real estate properties in the process of foreclosure were $1.6 million at March 31, 2015 and $1.9 million at December 31, 2014.

An allowance for loan losses (“ALL”) is maintained to absorb losses from the loan portfolio. The ALL is based on management’s continuing evaluation of the risk characteristics and credit quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.

The Bank’s methodology for determining the ALL is based on the requirements of ASC Section 310-10-35, Receivables-Overall-Subsequent Measurement, for loans individually evaluated for impairment and ASC Subtopic 450-20, Contingencies-Loss Contingencies, for loans collectively evaluated for impairment, as well as the Interagency Policy Statement on the Allowance for Loan and Lease Losses and other bank regulatory guidance. The total of the two components represents the Bank’s ALL.

The following table summarizes the primary segments of the ALL, segregated by the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of March 31, 2015 and December 31, 2014:


(in thousands)	Commercial Real Estate		Acquisition and Development		Commercial and Industrial		Residential Mortgage		Consumer		Total
March 31, 2015

Individually evaluated for impairment	$	33	$	730	$	0	$	62	$	0	$	825
Collectively evaluated for impairment	$	2,543	$	2,962	$	1,477	$	3,728	$	216	$	10,926
Total ALL	$	2,576	$	3,692	$	1,477	$	3,790	$	216	$	11,751

December 31, 2014

Individually evaluated for impairment	$	36	$	1,141	$	0	$	59	$	0	$	1,236
Collectively evaluated for impairment	$	2,388	$	2,771	$	1,680	$	3,803	$	187	$	10,829
Total ALL	$	2,424	$	3,912	$	1,680	$	3,862	$	187	$	12,065

Management evaluates individual loans in all of the commercial segments for possible impairment if the loan (a) is greater than $500,000 or (b) is part of a relationship that is greater than $750,000 and is either (i) in nonaccrual status or (ii) risk-rated Substandard and greater than 60 days past due. Loans are considered to be impaired when, based on current information and events, it is probable that the Bank 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 evaluating impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. 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. The Bank does not separately evaluate individual consumer and residential mortgage loans for impairment, unless such loans are part of a larger relationship that is impaired; otherwise, loans in these segments are considered impaired when they are classified as non-accrual.

Once the determination has been made that a loan is impaired, the determination of whether a specific allocation of the allowance is necessary is measured by comparing the recorded investment in the loan to the fair value of the loan using one of three methods: (a) the present value of expected future cash flows discounted at the loan’s effective interest rate; (b) the loan’s observable market price; or (c) the fair value of the collateral less selling costs. The method is selected on a loan-by-loan basis, with management primarily utilizing the fair value of collateral method. If the fair value of the collateral less selling costs method is utilized for collateral securing loans in the commercial segments, then an updated external appraisal is ordered on the collateral supporting the loan if the loan balance is greater than $500,000 and the existing appraisal is greater than 18 months old. If an updated appraisal has not been received and reviewed in time for the determination of estimated fair value at quarter (or year) end, or if the appraisal is found to be deficient in our internal appraisal review process and re-ordered, then the estimated fair value of the collateral is determined by adjusting the existing appraisal by the appropriate percentage from an internally prepared appraisal discount grid. This grid considers the age of a third party appraisal and the geographic region where the collateral is located. The discount rates in the appraisal discount grid are updated periodically to reflect the most current knowledge that management has available, including the results of current appraisals. A specific allocation of the ALL is recorded if there is any deficiency in collateral value determined by comparing the estimated fair value to the recorded investment of the loan. When updated appraisals are received and reviewed, adjustments are made to the specific allocation as needed.

The evaluation of the need and amount of a specific allocation of the ALL and whether a loan can be removed from impairment status is made on a quarterly basis.

The following table presents impaired loans by class, segregated by those for which a specific allowance was required and those for which a specific allowance was not necessary as of March 31, 2015 and December 31, 2014:



		Impaired Loans with Specific Allowance				Impaired Loans with No Specific Allowance		Total Impaired Loans
(in thousands)		Recorded Investment		Related Allowances		Recorded Investment		Recorded Investment		Unpaid Principal Balance
March 31, 2015
Commercial real estate
Non owner-occupied	$	141	$	33	$	3,406	$	3,547	$	3,844
All other CRE		0		0		7,179		7,179		7,670
Acquisition and development
1-4 family residential construction		790		130		0		790		836
All other A&D		2,069		600		3,229		5,298		9,240
Commercial and industrial		0		0		1,516		1,516		2,378
Residential mortgage
Residential mortgage - term		290		62		3,815		4,105		4,471
Residential mortgage – home equity		0		0		411		411		432
Consumer		0		0		13		13		13
Total impaired loans	$	3,290	$	825	$	19,569	$	22,859	$	28,884

December 31, 2014
Commercial real estate
Non owner-occupied	$	143	$	35	$	4,353	$	4,496	$	4,543
All other CRE		0		0		7,453		7,453		7,944
Acquisition and development
1-4 family residential construction		790		105		0		790		836
All other A&D		3,615		1,037		2,148		5,763		9,590
Commercial and industrial		0		0		1,861		1,861		2,723
Residential mortgage
Residential mortgage - term		296		59		3,779		4,075		4,485
Residential mortgage – home equity		0		0		343		343		363
Consumer		0		0		0		0		0
Total impaired loans	$	4,844	$	1,236	$	19,937	$	24,781	$	30,484

Loans that are collectively evaluated for impairment are analyzed with general allowances being made as appropriate. For general allowances, historical loss trends are used in the estimation of losses in the current portfolio. These historical loss amounts are modified by other qualitative factors.

The classes described above, which are based on the Federal call code assigned to each loan, provide the starting point for the ALL analysis. Management tracks the historical net charge-off activity (full and partial charge-offs, net of full and partial recoveries) at the call code level. A historical charge-off factor is calculated utilizing a defined number of consecutive historical quarters. Consumer pools currently utilize a rolling 12 quarters, while Commercial pools currently utilize a rolling eight quarters.

“Pass” rated credits are segregated from “Criticized” credits for the application of qualitative factors. “Pass” pools for commercial and residential real estate are further segmented based upon the geographic location of the underlying collateral. There are seven geographic regions utilized – six that represent the Bank’s lending footprint and a seventh for all out-of-market credits. Different economic environments and resultant credit risks exist in each region that are acknowledged in the assignment of qualitative factors. Loans in the criticized pools, which possess certain qualities or characteristics that may lead to collection and loss issues, are closely monitored by management and subject to additional qualitative factors.

Management supplements the historical charge-off factor with a number of additional qualitative factors that are likely to cause estimated credit losses associated with the existing loan pools to differ from historical loss experience. The additional factors, which are evaluated quarterly and updated using information obtained from internal, regulatory, and governmental sources, are: (a) national and local economic trends and conditions; (b) levels of and trends in delinquency rates and non-accrual loans; (c) trends in volumes and terms of loans; (d) effects of changes in lending policies; (e) experience, ability, and depth of lending staff; (f) value of underlying collateral; and (g) concentrations of credit from a loan type, industry and/or geographic standpoint.

Management reviews the loan portfolio on a quarterly basis using a defined, consistently applied process in order to make appropriate and timely adjustments to the ALL. When information confirms all or part of specific loans to be uncollectible, these amounts are promptly charged off against the ALL. Residential mortgage and consumer loans are charged off after they are 120 days contractually past due. All other loans are charged off based on an evaluation of the facts and circumstances of each individual loan. When the Bank believes that its ability to collect is solely dependent on the liquidation of the collateral, a full or partial charge-off is recorded promptly to bring the recorded investment to an amount that the Bank believes is supported by an ability to collect on the collateral. The circumstances that may impact the Bank’s decision to charge-off all or a portion of a loan include default or non-payment by the borrower, scheduled foreclosure actions, and/or prioritization of the Bank’s claim in bankruptcy. There may be circumstances where, due to pending events, the Bank will place a specific allocation of the ALL on a loan for which a partial charge-off has been previously recognized. This specific allocation may be either charged off or removed depending upon the outcome of the pending event. Full or partial charge-offs are not recovered until full principal and interest on the loan have been collected, even if a subsequent appraisal supports a higher value. Loans with partial charge-offs generally remain in non-accrual status. Both full and partial charge-offs reduce the recorded investment of the loan and the ALL and are considered to be charge-offs for purposes of all credit loss metrics and trends, including the historical rolling charge-off rates used in the determination of the ALL.

Activity in the ALL is presented for the three-month periods ended March 31, 2015 and March 31, 2014:


(in thousands)	Commercial Real Estate		Acquisition and Development		Commercial and Industrial		Residential Mortgage		Consumer		Total
ALL balance at January 1, 2015	$	2,424	$	3,912	$	1,680	$	3,862	$	187	$	12,065
Charge-offs		(287)		(231)		0		37		(96)		(577)
Recoveries		3		15		7		105		59		189
Provision		436		(4)		(210)		(214)		66		74
ALL balance at March 31, 2015	$	2,576	$	3,692	$	1,477	$	3,790	$	216	$	11,751

ALL balance at January 1, 2014	$	4,052	$	4,172	$	766	$	4,320	$	284	$	13,594
Charge-offs		(21)		(819)		(152)		(468)		(179)		(1,639)
Recoveries		10		12		3		49		179		253
Provision		(642)		531		453		61		(39)		364
ALL balance at March 31, 2014	$	3,399	$	3,896	$	1,070	$	3,962	$	245	$	12,572

The ALL is based on estimates, and actual losses may vary from current estimates. Management believes that the granularity of the homogeneous pools and the related historical loss ratios and other qualitative factors, as well as the consistency in the application of assumptions, result in an ALL that is representative of the risk found in the components of the portfolio at any given date.

The following table presents the average recorded investment in impaired loans by class and related interest income recognized for the periods indicated:



	Three Months Ended						Three Months Ended
	March 31, 2015						March 31, 2014
(in thousands)	Average investment		Interest income recognized on an accrual basis		Interest income recognized on a cash basis		Average investment		Interest income recognized on an accrual basis		Interest income recognized on a cash basis
Commercial real estate
Non owner-occupied	$	4,022	$	40	$	0	$	1,189	$	7	$	0
All other CRE		7,316		27		1		10,489		41		1
Acquisition and development
1-4 family residential construction		790		9		0		2,365		14		0
All other A&D		5,530		32		0		8,677		61		0
Commercial and industrial		1,689		23		0		2,226		26		2
Residential mortgage
Residential mortgage - term		4,091		40		0		6,879		54		9
Residential mortgage – home equity		377		0		0		683		3		1
Consumer		13		0		0		11		0		0
Total	$	23,828	$	171	$	1	$	32,519	$	206	$	13

In the normal course of business, the Bank modifies loan terms for various reasons. These reasons may include as a retention strategy, remaining competitive in the current interest rate environment, and re-amortizing or extending a loan term to better match the loan’s payment stream with the borrower’s cash flows. A modified loan is considered to be a troubled debt restructuring (“TDR”) when the Bank has determined that the borrower is troubled (i.e., experiencing financial difficulties). The Bank evaluates the probability that the borrower will be in payment default on any of its debt obligations in the foreseeable future without modification. To make this determination, the Bank performs a global financial review of the borrower and loan guarantors to assess their current ability to meet their financial obligations.

When the Bank restructures a loan to a troubled borrower, the loan terms (i.e., interest rate, payment amount, amortization period, and/or maturity date) are modified in such a way as to enable the borrower to cover the modified debt service payments based on current financials and cash flow adequacy. If a borrower’s hardship is thought to be temporary, then modified terms are only offered for that time period. Where possible, the Bank obtains additional collateral and/or secondary payment sources at the time of the restructure in order to put the Bank in the best possible position if the borrower is not able to meet the modified terms. To date, the Bank has not forgiven any principal as a restructuring concession. The Bank will not offer modified terms if it believes that modifying the loan terms will only delay an inevitable permanent default.

All loans designated as TDRs are considered impaired loans and may be in either accruing or non-accruing status. The Corporation’s policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition. Accordingly, the accrual of interest is discontinued when principal or interest is delinquent for 90 days or more unless the loan is well-secured and in the process of collection. If the loan was accruing at the time of the modification, then it continues to be in accruing status subsequent to the modification. Non-accrual TDRs may return to accruing status when there has been sufficient payment performance for a period of at least six months. TDRs are considered to be in payment default if, subsequent to modification, the loans are transferred to non-accrual status or to foreclosure. Loans may be removed from being reported as a TDR in the calendar year following the modification if the interest rate at the time of modification was consistent with the interest rate for a loan with comparable credit risk and the loan has performed according to its modified terms for at least six months.

The volume and type of TDR activity is considered in the assessment of the local economic trends’ qualitative factor used in the determination of the ALL for loans that are evaluated collectively for impairment.

The following tables present the volume and recorded investment at the time of modification of TDRs by class and type of modification that occurred during the periods indicated:


	Temporary Rate Modification			Extension of Maturity			Modification of Payment and Other Terms
(in thousands)	Number of Contracts	Recorded Investment		Number of Contracts	Recorded Investment		Number of Contracts	Recorded Investment
Three Months Ended March 31, 2015
Commercial real estate
Non owner-occupied	0	$	0	1	$	3,097	1	$	136
All other CRE	0		0	0		0	5		3,847
Acquisition and development
1-4 family residential construction	0		0	0		0	0		0
All other A&D	0		0	3		372	0		0
Commercial and industrial	0		0	0		0	0		0
Residential mortgage
Residential mortgage – term	0		0	2		599	1		116
Residential mortgage – home equity	0		0	0		0	0		0
Consumer	0		0	0		0	0		0
Total	0	$	0	6	$	4,068	7	$	4,099


	Temporary Rate						Modification of Payment
	Modification			Extension of Maturity			and Other Terms
	Number of	Recorded		Number of	Recorded		Number of	Recorded
(in thousands)	Contracts	Investment		Contracts	Investment		Contracts	Investment
Three Months Ended March 31, 2014
Commercial real estate
Non owner-occupied	0	$	0	2	$	277	0	$	0
All other CRE	0		0	0		0	1		454
Acquisition and development
1-4 family residential construction	0		0	0		0	0		0
All other A&D	0		0	0		0	0		0
Commercial and industrial	0		0	0		0	0		0
Residential mortgage
Residential mortgage – term	1		90	0		0	0		0
Residential mortgage – home equity	0		0	0		0	0		0
Consumer	0		0	0		0	0		0
Total	1	$	90	2	$	277	1	$	454

During the three months ended March 31, 2015, there were five new TDRs. In addition, eight existing TDRs which had reached their original modification maturity were re-modified. The new TDRs were impaired at the time of modification, resulting in no impact to the ALL as a result of the modifications and there was no impact to the recorded investment relating to the transfer of these loans.

During the three months ended March 31, 2015, there were no payment defaults.

During the three months ended March 31, 2014, there were two new TDRs. In addition, two existing TDRs which had reached their original modification maturity were re-modified. A $1,055 reduction of the ALL resulted from a change to the impairment evaluation of one loan, from evaluated collectively to being evaluated individually. The remaining new TDR was impaired at the time of modification, resulting in no impact to the ALL as a result of the modification. There was no impact to the recorded investment relating to the transfer of these loans.

During the three months ended March 31, 2014, one A&D loan totaling $1.4 million that was modified as TDR within the previous 12 months was transferred to non-accrual, and is considered a payment default.