
	NOTE 11 – LOANS

Loans consist of the following:


(dollars in thousands)	June 30, 2014	December 31, 2013

Commercial real estate	$ 531,919	$ 476,648
Residential first mortgages	156,833	159,147
Construction and land development	32,086	32,001
Home equity and second mortgages	21,225	21,692
Commercial loans	77,583	94,176
Consumer loans	736	838
Commercial equipment	25,876	23,738
	846,258	808,240
Less:
Deferred loan fees	1,081	972
Allowance for loan loss	8,050	8,138
	9,131	9,110

	$ 837,127	$ 799,130

At June 30, 2014, the Bank’s allowance for loan losses totaled $8.1 million, or 0.95% of loan balances, as compared to $8.1 million, or 1.01% of loan balances, at December 31, 2013. Management’s determination of the adequacy of the allowance is based on a periodic evaluation of the portfolio with consideration given to the overall loss experience, current economic conditions, size, growth and composition of the loan portfolio, financial condition of the borrowers and other relevant factors that, in management’s judgment, warrant recognition in providing an adequate allowance.

Risk Characteristics of Portfolio Segments

The Company manages its credit products and exposure to credit losses (credit risk) by the following specific portfolio segments (classes), which are levels at which the Company develops and documents its allowance for loan loss methodology. These segments are:

Commercial Real Estate (“CRE”)

Commercial and other real estate projects include office buildings, retail locations, churches, other special purpose buildings and commercial construction. Commercial construction balances were below 5% of the CRE portfolio at June 30, 2014 and December 31, 2013. The Bank offers both fixed-rate and adjustable-rate loans under these product lines. The primary security on a commercial real estate loan is the real property and the leases that produce income for the real property. Loans secured by commercial real estate are generally limited to 80% of the lower of the appraised value or sales price at origination and have an initial contractual loan payment period ranging from three to 20 years.

Loans secured by commercial real estate are larger and involve greater risks than one-to four-family residential mortgage loans. Because payments on loans secured by such properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to a greater extent to adverse conditions in the real estate market or the economy.

Residential First Mortgages

Residential first mortgage loans made by the Bank are generally long-term loans, amortized on a monthly basis, with principal and interest due each month. The contractual loan payment period for residential loans typically ranges from ten to 30 years. The Bank’s experience indicates that real estate loans remain outstanding for significantly shorter time periods than their contractual terms. Borrowers may refinance or prepay loans at their option, without penalty. The Bank originates both fixed-rate and adjustable-rate residential first mortgages.

The annual and lifetime limitations on interest rate adjustments may limit the increases in interest rates on these loans. There are also credit risks resulting from potential increased costs to the borrower as a result of the repricing of adjustable-rate mortgage loans. During periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase due to the upward adjustment of interest cost to the borrower. The Bank’s adjustable rate residential first mortgage portfolio was $27.4 million or 3.2% of total gross loans of $846.3 million at June 30, 2014.

Construction and Land Development

The Bank offers loans for the construction of one-to four-family dwellings. Generally, these loans are secured by the real estate under construction as well as by guarantees of the principals involved. In addition, the Bank offers loans to acquire and develop land, as well as loans on undeveloped, subdivided lots for home building by individuals.

A decline in demand for new housing might adversely affect the ability of borrowers to repay these loans. Construction and land development loans are inherently riskier than providing financing on owner-occupied real estate. The Bank’s risk of loss is affected by the accuracy of the initial estimate of the market value of the completed project as well as the accuracy of the cost estimates made to complete the project. In addition, the volatility of the real estate market has made it increasingly difficult to ensure that the valuation of land associated with these loans is accurate. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the development. If the estimate of value proves to be inaccurate, a project’s value might be insufficient to assure full repayment. As a result of these factors, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the project rather than the ability of the borrower or guarantor to repay principal and interest. If the Bank forecloses on a project, there can be no assurance that the Bank will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.

Home Equity and Second Mortgage Loans

The Bank maintains a portfolio of home equity and second mortgage loans. These products contain a higher risk of default than residential first mortgages as in the event of foreclosure, the first mortgage would need to be paid off prior to collection of the second mortgage. This risk has been heightened as the market value of residential property has declined.

Commercial Loans

The Bank offers commercial loans to its business customers. The Bank offers a variety of commercial loan products including term loans and lines of credit. Such loans are generally made for terms of five years or less. The Bank offers both fixed-rate and adjustable-rate loans under these product lines. When making commercial business loans, the Bank considers the financial condition of the borrower, the borrower’s payment history of both corporate and personal debt, the projected cash flows of the business, the viability of the industry in which the consumer operates, the value of the collateral, and the borrower’s ability to service the debt from income. These loans are primarily secured by equipment, real property, accounts receivable, or other security as determined by the Bank.

Commercial loans are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself.

Consumer Loans

Consumer loans consist of loans secured by automobiles, boats, recreational vehicles and trucks. The Bank also makes home improvement loans and offers both secured and unsecured personal lines of credit. Consumer loans entail greater risk from other loan types due to being secured by rapidly depreciating assets or the reliance on the borrower’s continuing financial stability.

Commercial Equipment Loans

These loans consist primarily of fixed-rate, short-term loans collateralized by a commercial customer’s equipment. When making commercial equipment loans, the Bank considers the same factors it considers when underwriting a commercial business loan. Commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. In the case of business failure, collateral would need to be liquidated to provide repayment for the loan. In many cases, the highly specialized nature of collateral equipment would make full recovery from the sale of collateral problematic.

Non-accrual and Past Due Loans

Non-accrual loans as of June 30, 2014 and December 31, 2013 were as follows:



	June 30, 2014
(dollars in thousands)	90 or Greater Days Delinquent	Number of Loans	Non-accrual Only Loans	Number of Loans	Total Non-accrual Loans	Total Number of Loans

Commercial real estate	$ 5,113	11	$ -	-	$ 5,113	11
Residential first mortgages	540	2	-	-	540	2
Construction and land development	3,811	2	-	-	3,811	2
Home equity and second mortgages	166	2	-	-	166	2
Commercial loans	2,035	8	-	-	2,035	8
Consumer loans	-	-	-	-	-	-
Commercial equipment	221	4	-	-	221	4
	$ 11,886	29	$ -	-	$ 11,886	29



	December 31, 2013
(dollars in thousands)	90 or Greater Days Delinquent	Number of Loans	Non-accrual Only Loans	Number of Loans	Total Non-accrual Loans	Total Number of Loans

Commercial real estate	$ 4,235	10	$ 3,695	2	$ 7,930	12
Residential first mortgages	1,683	6	562	3	2,245	9
Construction and land development	2,968	1	-	-	2,968	1
Home equity and second mortgages	115	3	-	-	115	3
Commercial loans	1,935	6	-	-	1,935	6
Consumer loans	-	-	24	1	24	1
Commercial equipment	234	2	-	-	234	2
	$ 11,170	28	$ 4,281	6	$ 15,451	34

Non-accrual loans (90 days or greater delinquent and non-accrual only loans) decreased $3.6 million from $15.5 million or 1.91% of total loans at December 31, 2013 to $11.9 million or 1.40% of total loans at June 30, 2014. Non-accrual only loans are loans classified as non-accrual due to customer operating results or payment history. In accordance with the Company’s policy, interest income is recognized on a cash-basis for these loans if the loans are not impaired or there is no impairment. There were no non-accrual only loans at June 30, 2014. At December 31, 2013 non-accrual only loans were $4.3 million, representing one well-secured commercial relationship with no specific reserves due to the Bank's superior credit position with underlying collateral, which consisted primarily of commercial real estate. As of December 31, 2013, the Bank had received all scheduled interest and principal payments on this relationship.

Non-accrual loans at June 30, 2014 included $4.0 million for a stalled residential development project. The Bank has deferred the collection of principal and interest for one year to enable the project to use available funds to build units and complete the project. At June 30, 2014, the stalled development project loans are considered both troubled debt restructured (“TDRs”) loans and non-accrual loans and are reported solely as non-accrual loans for financial reporting purposes. If the loans return to performing status after the forbearance period, they will be reported as TDR loans.

Non-accrual loans on which the recognition of interest has been discontinued, which did not have a specific allowance for impairment, amounted to $6.0 million and $9.1 million at June 30, 2014 and December 31, 2013, respectively. Interest due but not recognized on these balances at June 30, 2014 and December 31, 2013 was $427,000 and $304,000, respectively. Non-accrual loans with a specific allowance for impairment on which the recognition of interest has been discontinued amounted to $5.9 million and $6.4 million at June 30, 2014 and December 31, 2013, respectively. Interest due but not recognized on these balances at June 30, 2014 and December 31, 2013 was $331,000 and $295,000, respectively.

An analysis of past due loans as of June 30, 2014 and December 31, 2013 was as follows:


	June 30, 2014
(dollars in thousands)	Current	31-60 Days	61-89 Days	90 or Greater Days	Total Past Due	Total Loan Receivables
Commercial real estate	$ 522,327	$ -	$ 4,479	$ 5,113	$ 9,592	$ 531,919
Residential first mortgages	155,674	6	613	540	1,159	156,833
Construction and land dev.	28,275	-	-	3,811	3,811	32,086
Home equity and second mtg.	20,418	360	281	166	807	21,225
Commercial loans	75,548	-	-	2,035	2,035	77,583
Consumer loans	733	-	3	-	3	736
Commercial equipment	25,505	111	39	221	371	25,876
Total	$ 828,480	$ 477	$ 5,415	$ 11,886	$ 17,778	$ 846,258


	December 31, 2013
(dollars in thousands)	Current	31-60 Days	61-89 Days	90 or Greater Days	Total Past Due	Total Loan Receivables
Commercial real estate	$ 469,182	$ 58	$ 3,173	$ 4,235	$ 7,466	$ 476,648
Residential first mortgages	157,043	8	413	1,683	2,104	159,147
Construction and land dev.	28,525	-	508	2,968	3,476	32,001
Home equity and second mtg.	21,183	121	273	115	509	21,692
Commercial loans	88,812	3,111	318	1,935	5,364	94,176
Consumer loans	830	8	-	-	8	838
Commercial equipment	23,435	26	43	234	303	23,738
Total	$ 789,010	$ 3,332	$ 4,728	$ 11,170	$ 19,230	$ 808,240

There were no loans greater than 90 days still accruing interest at June 30, 2014 and at December 31, 2013.

Impaired Loans and Troubled Debt Restructures (“TDRs”)

Impaired loans, including TDRs, at June 30, 2014 and 2013 and at December 31, 2013 were as follows:


	June 30, 2014
(dollars in thousands)	Unpaid Contractual Principal Balance	Recorded Investment With No Allowance	Recorded Investment With Allowance	Total Recorded Investment	Related Allowance	Three Month Average Recorded Investment	Three Month Interest Income Recognized	Year to Date Average Recorded Investment	Year to Date Interest Income Recognized

Commercial real estate	$ 17,500	$ 13,143	$ 4,328	$ 17,471	$ 311	$ 17,473	$ 172	$ 17,446	$ 332
Residential first mortgages	3,078	2,559	519	3,078	75	3,103	35	3,113	70
Construction and land dev.	6,049	1,799	4,250	6,049	81	6,015	28	5,916	56
Home equity and second mtg.	403	330	73	403	33	378	2	335	2
Commercial loans	5,380	4,800	580	5,380	269	5,585	46	5,672	93
Consumer loans	5	5	-	5	-	8	-	12	1
Commercial equipment	399	212	168	380	90	381	4	392	8
Total	$ 32,814	$ 22,848	$ 9,918	$ 32,766	$ 859	$ 32,943	$ 287	$ 32,886	$ 562


	December 31, 2013
(dollars in thousands)	Unpaid Contractual Principal Balance	Recorded Investment With No Allowance	Recorded Investment With Allowance	Total Recorded Investment	Related Allowance	Average Recorded Investment	Interest Income Recognized

Commercial real estate	$ 18,342	$ 14,274	$ 3,899	$ 18,173	$ 372	$ 18,473	$ 770
Residential first mortgages	3,401	2,695	706	3,401	171	3,392	125
Construction and land dev.	5,666	1,489	4,177	5,666	55	5,386	252
Home equity and second mtg.	207	207	-	207	-	297	12
Commercial loans	10,218	9,297	921	10,218	304	10,600	432
Consumer loans	24	24	-	24	-	39	3
Commercial equipment	335	234	83	317	83	367	13
Total	$ 38,193	$ 28,220	$ 9,786	$ 38,006	$ 985	$ 38,554	$ 1,607


	June 30, 2013
(dollars in thousands)	Unpaid Contractual Principal Balance	Recorded Investment With No Allowance	Recorded Investment With Allowance	Total Recorded Investment	Related Allowance	Three Month Average Recorded Investment	Three Month Interest Income Recognized	Year to Date Average Recorded Investment	Year to Date Interest Income Recognized

Commercial real estate	$ 20,474	$ 16,090	$ 4,384	$ 20,474	$ 614	$ 20,560	$ 236	$ 20,625	$ 435
Residential first mortgages	5,236	4,328	908	5,236	407	5,278	46	5,283	94
Construction and land dev.	5,705	4,497	1,208	5,705	170	5,574	71	5,295	147
Home equity and second mtg.	214	214	-	214	-	233	2	265	5
Commercial loans	11,388	11,231	157	11,388	40	11,379	149	11,321	227
Consumer loans	41	41	-	41	-	44	1	47	2
Commercial equipment	174	152	3	155	3	174	-	174	-
Total	$ 43,232	$ 36,553	$ 6,660	$ 43,213	$ 1,234	$ 43,242	$ 505	$ 43,010	$ 910

TDRs, included in the impaired loan schedules above, as of June 30, 2014 and December 31, 2013 were as follows:


	June 30, 2014		December 31, 2013
(dollars in thousands)	Dollars	Number of Loans	Dollars	Number of Loans

Commercial real estate	$ 2,101	3	$ 3,141	8
Residential first mortgages	916	3	1,485	4
Construction and land development	3,811	2	-	-
Home equity and second mortgage	-	-	-	-
Commercial loans	227	2	-	-
Consumer loans	-	-	-	-
Commercial equipment	157	2	67	1
Total TDRs	$ 7,212	12	$ 4,693	13
Less: TDRs included in non-accrual loans	(4,037)	(4)	-	-
Total accrual TDR loans	$ 3,175	8	$ 4,693	13

At June 30, 2014, non-accrual loans included $4.0 million for a stalled residential development project. The Bank has deferred the collection of principal and interest for one year to enable the project to use available funds to build units and complete the project. At June 30, 2014, the stalled development project loans are considered both TDR loans and non-accrual loans and are reported solely as non-accrual loans for financial reporting purposes. If the loans return to performing status after the forbearance period, they will be reported as TDR loans.

At June 30, 2014, the Bank had eight accruing TDRs totaling $3.2 million compared to 13 TDRs totaling $4.7 million as of December 31, 2013. At June 30, 2014, all TDRs were performing according to the terms of their restructured agreements. At December 31, 2013, one TDR of $329,000 was over 90 days past due. The Bank had specific reserves of $197,000 on four TDRs totaling $2.4 million at June 30, 2014 and $79,000 on two TDRs totaling $1.8 million at December 31, 2013. The Bank added three TDRs totaling $968,000 during the six months ended June 30, 2014. During the same period, there were eight TDRs totaling $2.4 million that were no longer reported as TDRs due to the payment of principal and interest at market rates for greater than six consecutive months. TDR activity for the year ended December 31, 2013 included three additions to the number of TDRs totaling $204,000. There were no other TDR transactions for the year ended December 31, 2013. Interest income in the amount of $124,000 and $214,000 was recognized on TDR loans for the six months ended June 30, 2014 and the year ended December 31, 2013, respectively.

Allowance for Loan Losses

The following tables detail activity in the allowance for loan losses at and for the three and six months ended June 30, 2014 and 2013, respectively, and for the year ended December 31, 2013 and loan receivable balances at June 30, 2014 and 2013, respectively, and at December 31, 2013. An allocation of the allowance to one category of loans does not prevent the Company’s ability to utilize the allowance to absorb losses in a different category. The loan receivables are disaggregated on the basis of the Company’s impairment methodology.



(dollars in thousands)	Commercial Real Estate	Residential First Mortgage	Construction and Land Development	Home Equity and Second Mtg.	Commercial Loans	Consumer Loans	Commercial Equipment	Total
At and For the Three Months Ended June 30, 2014
Allowance for loan losses:
Balance at April 1,	$ 3,610	$ 1,272	$ 561	$ 340	$ 2,115	$ 6	$ 293	$ 8,197
Charge-offs	(28)	-	-	-	(720)	-	-	(748)
Recoveries	2	-	-	-	2	10	24	38
Provisions	393	(182)	12	(57)	338	(12)	71	563
Balance at June 30,	$ 3,977	$ 1,090	$ 573	$ 283	$ 1,735	$ 4	$ 388	$ 8,050

At and For the Six Months Ended June 30, 2014
Allowance for loan losses:
Balance at January 1,	$ 3,525	$ 1,401	$ 584	$ 249	$ 1,916	$ 10	$ 453	$ 8,138
Charge-offs	(49)	(94)	-	-	(755)	-	-	(898)
Recoveries	7	-	-	-	3	10	24	44
Provisions	494	(217)	(11)	34	571	(16)	(89)	766
Balance at June 30,	$ 3,977	$ 1,090	$ 573	$ 283	$ 1,735	$ 4	$ 388	$ 8,050
Ending balance: individually evaluated for impairment	$ 311	$ 75	$ 81	$ 33	$ 269	$ -	$ 90	$ 859
Ending balance: collectively evaluated for impairment	$ 3,666	$ 1,015	$ 492	$ 250	$ 1,466	$ 4	$ 298	$ 7,191
Loan receivables:
Ending balance	$ 531,919	$ 156,833	$ 32,086	$ 21,225	$ 77,583	$ 736	$ 25,876	$ 846,258
Ending balance: individually evaluated for impairment	$ 17,471	$ 3,078	$ 6,049	$ 403	$ 5,380	$ 5	$ 380	$ 32,766
Ending balance: collectively evaluated for impairment	$ 514,448	$ 153,755	$ 26,037	$ 20,822	$ 72,203	$ 731	$ 25,496	$ 813,492



(dollars in thousands)	Commercial Real Estate	Residential First Mortgage	Construction and Land Development	Home Equity and Second Mtg.	Commercial Loans	Consumer Loans	Commercial Equipment	Total

At and For the Year Ended December 31, 2013
Allowance for loan losses:
Balance at January 1,	$ 4,092	$ 1,083	$ 533	$ 280	$ 1,948	$ 19	$ 292	$ 8,247
Charge-offs	(140)	(348)	(36)	(111)	(480)	(12)	(35)	(1,162)
Recoveries	-	11	1	17	23	3	58	113
Provisions	(427)	655	86	63	425	-	138	940
Balance at December 31,	$ 3,525	$ 1,401	$ 584	$ 249	$ 1,916	$ 10	$ 453	$ 8,138
Ending balance: individually evaluated for impairment	$ 372	$ 171	$ 55	$ -	$ 304	$ -	$ 83	$ 985
Ending balance: collectively evaluated for impairment	$ 3,153	$ 1,230	$ 529	$ 249	$ 1,612	$ 10	$ 370	$ 7,153
Loan receivables:
Ending balance	$ 476,648	$ 159,147	$ 32,001	$ 21,692	$ 94,176	$ 838	$ 23,738	$ 808,240
Ending balance: individually evaluated for impairment	$ 18,173	$ 3,401	$ 5,666	$ 207	$ 10,218	$ 24	$ 317	$ 38,006
Ending balance: collectively evaluated for impairment	$ 458,475	$ 155,746	$ 26,335	$ 21,485	$ 83,958	$ 814	$ 23,421	$ 770,234


(dollars in thousands)	Commercial Real Estate	Residential First Mortgage	Construction and Land Development	Home Equity and Second Mtg.	Commercial Loans	Consumer Loans	Commercial Equipment	Total
At and For the Three Months Ended June 30, 2013
Allowance for loan losses:
Balance at April 1,	$ 3,540	$ 1,985	$ 497	$ 318	$ 1,824	$ 17	$ 169	$ 8,350
Charge-offs	-	-	-	(111)	(406)	-	(21)	(538)
Recoveries	-	10	-	-	11	1	-	22
Provisions	(182)	(34)	104	157	90	(4)	69	200
Balance at June 30,	$ 3,358	$ 1,961	$ 601	$ 364	$ 1,519	$ 14	$ 217	$ 8,034
At and For the Six Months Ended June 30, 2013
Allowance for loan losses:
Balance at January 1,	$ 4,092	$ 1,083	$ 533	$ 280	$ 1,948	$ 19	$ 292	$ 8,247
Charge-offs	-	(59)	(36)	(111)	(406)	(9)	(21)	(642)
Recoveries	-	11	-	-	12	2	49	74
Provisions	(734)	926	104	195	(35)	2	(103)	355
Balance at June 30,	$ 3,358	$ 1,961	$ 601	$ 364	$ 1,519	$ 14	$ 217	$ 8,034
Ending balance: individually evaluated for impairment	$ 614	$ 407	$ 170	$ -	$ 40	$ -	$ 3	$ 1,234
Ending balance: collectively evaluated for impairment	$ 2,744	$ 1,554	$ 431	$ 364	$ 1,479	$ 14	$ 214	$ 6,800
Loan receivables:
Ending balance	$ 434,616	$ 165,434	$ 29,120	$ 21,769	$ 84,993	$ 937	$ 17,347	$ 754,216
Ending balance: individually evaluated for impairment	$ 20,474	$ 5,236	$ 5,705	$ 214	$ 11,388	$ 41	$ 155	$ 43,213
Ending balance: collectively evaluated for impairment	$ 414,142	$ 160,198	$ 23,415	$ 21,555	$ 73,605	$ 896	$ 17,192	$ 711,003

Credit Quality Indicators

Credit quality indicators as of June 30, 2014 and December 31, 2013 were as follows:


Credit Risk Profile by Internally Assigned Grade

	Commercial Real Estate		Construction and Land Dev.
(dollars in thousands)	6/30/2014	12/31/2013	6/30/2014	12/31/2013

Unrated	$ 69,610	$ 66,481	$ 4,482	$ 5,782
Pass	430,956	380,124	18,785	17,628
Special mention	6,772	7,084	-	-
Substandard	24,581	22,959	8,819	8,591
Doubtful	-	-	-	-
Loss	-	-	-	-
Total	$ 531,919	$ 476,648	$ 32,086	$ 32,001

	Commercial Loans		Commercial Equipment
(dollars in thousands)	6/30/2014	12/31/2013	6/30/2014	12/31/2013

Unrated	$ 13,467	$ 12,873	$ 7,014	$ 6,137
Pass	56,638	67,354	18,694	17,516
Special mention	-	402	-	2
Substandard	7,304	13,547	168	83
Doubtful	174	-	-	-
Loss	-	-	-	-
Total	$ 77,583	$ 94,176	$ 25,876	$ 23,738


Credit Risk Profile Based on Payment Activity

	Residential First Mortgages		Home Equity and Second Mtg.		Consumer Loans
(dollars in thousands)	6/30/2014	12/31/2013	6/30/2014	12/31/2013	6/30/2014	12/31/2013

Performing	$ 156,293	$ 157,464	$ 21,059	$ 21,577	$ 736	$ 838
Nonperforming	540	1,683	166	115	-	-
Total	$ 156,833	$ 159,147	$ 21,225	$ 21,692	$ 736	$ 838

Summary of Total Classified Loans

(dollars in thousands)		6/30/2014	12/31/2013
By Internally Assigned Grade		$ 41,046	$ 45,181
By Payment Activity		2,495	2,464
Total Classified		$ 43,541	$ 47,645

A risk grading scale is used to assign grades to commercial real estate, construction and land development, commercial loans and commercial equipment loans. Loans are graded at inception, annually thereafter when financial statements are received and at other times when there is an indication that a credit may have weakened or improved. Only commercial loan relationships with an aggregate exposure to the Bank of $750,000 or greater are subject to being risk rated.

Residential first mortgages, home equity and second mortgages and consumer loans are evaluated for creditworthiness in underwriting and are monitored based on borrower payment history. These loans are classified as unrated unless they are part of a larger commercial relationship that requires grading or are troubled debt restructures or nonperforming loans with an Other Assets Especially Mentioned (“OAEM”) or higher risk rating due to a delinquent payment history.

Management regularly reviews credit quality indicators as part of its individual loan reviews and on a monthly and quarterly basis. The overall quality of the Bank’s loan portfolio is assessed using the Bank’s risk grading scale, the level and trends of net charge-offs, nonperforming loans and delinquencies, the performance of troubled debt restructured loans and the general economic conditions in the Company’s geographical market. This review process is assisted by frequent internal reporting of loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potential problem loans. Credit quality indicators and allowance factors are adjusted based on management’s judgment during the monthly and quarterly review process.

Loans subject to risk ratings are graded on a scale of one to ten. The Company considers loans classified substandard, doubtful and loss as classified assets for regulatory and financial reporting.

Ratings 1 thru 6 - Pass

Ratings 1 thru 6 have asset risks ranging from excellent low risk to adequate. The specific rating assigned considers customer history of earnings, cash flows, liquidity, leverage, capitalization, consistency of debt service coverage, the nature and extent of customer relationship and other relevant specific business factors such as the stability of the industry or market area, changes to management, litigation or unexpected events that could have an impact on risks.

Rating 7 - OAEM (Other Assets Especially Mentioned) – Special Mention

These credits, while protected by the financial strength of the borrowers, guarantors or collateral, have reduced quality due to economic conditions, less than adequate earnings performance or other factors which require the lending officer to direct more than normal attention to the credit. Financing alternatives may be limited and/or command higher risk interest rates. OAEM loans are the first adversely classified assets on our watch list. These relationships will be reviewed at least quarterly.

Rating 8 - Substandard

Substandard assets are assets that are inadequately protected by the sound worth or paying capacity of the borrower or of the collateral pledged. These assets have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard. The loans may have a delinquent history or combination of weak collateral, weak guarantor strength or operating losses. When a loan is assigned to this category the Bank may estimate a specific reserve in the loan loss allowance analysis. These assets listed may include assets with histories of repossessions or some that are non-performing bankruptcies. These relationships will be reviewed at least quarterly.

Rating 9 - Doubtful

Doubtful assets have many of the same characteristics of Substandard with the exception that the Bank has determined that loss is not only possible but is probable and the risk is close to certain that loss will occur. When a loan is assigned to this category the Bank will identify the probable loss and the loan will receive a specific reserve in the loan loss allowance analysis. These relationships will be reviewed at least quarterly.

Rating 10 - Loss

Once an asset is identified as a definite loss to the Bank, it will receive the classification of “loss”. There may be some future potential recovery; however it is more practical to write off the loan at the time of classification. Losses will be taken in the period in which they are determined to be uncollectable.