
	NOTE 11 – LOANS

Loans consist of the following:


(dollars in thousands)	June 30, 2015	December 31, 2014

Commercial real estate	$ 601,270	$ 561,080
Residential first mortgages	143,662	152,837
Construction and land development	39,159	36,370
Home equity and second mortgages	21,068	21,452
Commercial loans	63,480	73,625
Consumer loans	396	613
Commercial equipment	26,804	26,152
	895,839	872,129
Less:
Deferred loan fees	1,168	1,239
Allowance for loan losses	8,757	8,481
	9,925	9,720

	$ 885,914	$ 862,409

At June 30, 2015, the Bank’s allowance for loan losses totaled $8.8 million, or 0.98% of loan balances, as compared to $8.5 million, or 0.97% of loan balances, at December 31, 2014. 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 5.2% and 4.4% of the CRE portfolio at June 30, 2015 and December 31, 2014, respectively. 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 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’s residential portfolio has 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 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 $23.4 million or 2.6% of total gross loans of $895.8 million at June 30, 2015.

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, 2015 and December 31, 2014 were as follows:


	June 30, 2015		December 31, 2014
(dollars in thousands)	Total Non-accrual Loans	Total Number of Loans	Total Non-accrual Loans	Total Number of Loans

Commercial real estate	$ 6,119	13	$ 3,824	11
Residential first mortgages	1,158	5	533	2
Construction and land development	3,554	2	3,634	2
Home equity and second mortgages	366	5	399	6
Commercial loans	1,472	7	1,587	6
Commercial equipment	387	5	286	4
	$ 13,056	37	$ 10,263	31

Non-accrual loans (90 days or greater delinquent and non-accrual only loans) increased $2.8 million from $10.3 million or 1.18% of total loans at December 31, 2014 to $13.1 million or 1.46% of total loans at June 30, 2015. 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. There were no non-accrual only loans at June 30, 2015 or at December 31, 2014.

The Bank had 37 non-accrual loans at June 30, 2015 compared to 31 non-accrual loans at December 31, 2014. Non-accrual loans at June 30, 2015 included $10.4 million, or 80% of non-accrual loans, attributed to 18 loans representing five customer relationships classified as substandard. Non-accrual loans at December 31, 2014 included $8.8 million, or 86% of nonperforming loans, attributed to 16 loans representing six customer relationships classified as substandard. Of these loans at June 30, 2015 and December 31, 2014, four loans totaling $3.8 and $3.9 million, respectively, represented a stalled residential development project. During the second quarter of 2014, the Bank deferred the collection of principal and interest to enable the project to use available funds to build units and complete the project. The stalled development project loans are considered both troubled debt restructures (“TDRs”) and non-accrual loans. Additionally at June 30, 2015 and December 31, 2014, the Bank had one TDR commercial real estate loan of $1.0 million that is greater than 90 days delinquent. These loans are classified solely as non-accrual loans for the calculation of financial ratios.

Non-accrual loans on which the recognition of interest has been discontinued, which did not have a specific allowance for impairment, amounted to $12.3 million and $9.3 million at June 30, 2015 and December 31, 2014, respectively. Interest due but not recognized on these balances at June 30, 2015 and December 31, 2014 was $898,000 and $781,000, respectively. Non-accrual loans with a specific allowance for impairment on which the recognition of interest has been discontinued amounted to $802,000 and $1.0 million at June 30, 2015 and December 31, 2014, respectively. Interest due but not recognized on these balances at June 30, 2015 and December 31, 2014 was $72,000 and $64,000, respectively.

An analysis of past due loans as of June 30, 2015 and December 31, 2014 was as follows:


	June 30, 2015
(dollars in thousands)	Current	31-60 Days	61-89 Days	90 or Greater Days	Total Past Due	Total Loan Receivables
Commercial real estate	$ 593,802	$ -	$ 1,349	$ 6,119	$ 7,468	$ 601,270
Residential first mortgages	141,971	132	401	1,158	1,691	143,662
Construction and land dev.	35,605	-	-	3,554	3,554	39,159
Home equity and second mtg.	20,456	72	174	366	612	21,068
Commercial loans	62,008	-	-	1,472	1,472	63,480
Consumer loans	396	-	-	-	-	396
Commercial equipment	26,400	17	-	387	404	26,804
Total	$ 880,638	$ 221	$ 1,924	$ 13,056	$ 15,201	$ 895,839


	December 31, 2014
(dollars in thousands)	Current	31-60 Days	61-89 Days	90 or Greater Days	Total Past Due	Total Loan Receivables
Commercial real estate	$ 556,584	$ -	$ 672	$ 3,824	$ 4,496	$ 561,080
Residential first mortgages	151,375	133	796	533	1,462	152,837
Construction and land dev.	32,736	-	-	3,634	3,634	36,370
Home equity and second mtg.	20,939	90	24	399	513	21,452
Commercial loans	71,952	86	-	1,587	1,673	73,625
Consumer loans	612	1	-	-	1	613
Commercial equipment	25,848	17	1	286	304	26,152
Total	$ 860,046	$ 327	$ 1,493	$ 10,263	$ 12,083	$ 872,129

There were no loans greater than 90 days still accruing interest at June 30, 2015 and at December 31, 2014.

Impaired Loans and Troubled Debt Restructures (“TDRs”)

Impaired loans, including TDRs, at June 30, 2015 and 2014 and at December 31, 2014 were as follows:



	June 30, 2015
(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	$ 28,010	$ 25,424	$ 2,556	$ 27,980	$ 150	$ 28,090	$ 232	$ 28,155	$ 488
Residential first mortgages	3,996	3,491	505	3,996	75	4,006	34	4,016	74
Construction and land dev.	4,329	4,329	-	4,329	-	4,382	4	4,285	7
Home equity and second mtg.	488	429	-	429	-	434	2	437	6
Commercial loans	5,184	4,499	581	5,080	227	5,041	44	5,034	96
Commercial equipment	1,462	292	1,097	1,389	1,021	1,401	12	1,407	26
Total	$ 43,469	$ 38,464	$ 4,739	$ 43,203	$ 1,473	$ 43,354	$ 328	$ 43,334	$ 697


	December 31, 2014
(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	$ 31,812	$ 28,907	$ 2,622	$ 31,529	$ 97	$ 31,672	$ 1,258
Residential first mortgages	3,407	2,526	881	3,407	76	3,426	155
Construction and land dev.	6,402	6,102	-	6,102	-	6,474	133
Home equity and second mtg.	708	649	-	649	-	630	19
Commercial loans	7,587	7,030	406	7,436	155	7,196	252
Consumer loans	-	-	-	-	-	-	-
Commercial equipment	605	373	213	586	123	623	23
Total	$ 50,521	$ 45,587	$ 4,122	$ 49,709	$ 451	$ 50,021	$ 1,840


	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

TDRs, included in the impaired loan schedules above, as of June 30, 2015 and December 31, 2014 were as follows:


	June 30, 2015		December 31, 2014
(dollars in thousands)	Dollars	Number of Loans	Dollars	Number of Loans

Commercial real estate	$ 12,237	12	$ 10,438	9
Residential first mortgages	895	3	906	3
Construction and land development	4,329	4	4,376	4
Commercial loans	1,084	7	2,262	6
Commercial equipment	140	2	154	2
Total TDRs	$ 18,685	28	$ 18,136	24
Less: TDRs included in non-accrual loans	(4,777)	(5)	(4,887)	(5)
Total accrual TDR loans	$ 13,908	23	$ 13,249	19

The Bank added six and 15 TDRs totaling $2.3 million and $12.0 million during the six months ended June 30, 2015 and the year ended December 31, 2014, respectively. Two TDRs totaling $1.6 million were disposed of during the second quarter of 2015 due to a payoff and refinancing by another lender. The Bank had specific reserves of $447,000 on seven TDRs totaling $3.0 million at June 30, 2015 and $251,000 on five TDRs totaling $2.5 million at December 31, 2014.

At June 30, 2015 and December 31, 2014, four loans totaling $3.8 and $3.9 million, respectively, represented a stalled residential development project. During the second quarter of 2014, the Bank deferred the collection of principal and interest to enable the project to use available funds to build units and complete the project. The stalled development project loans are considered both TDRs and non-accrual loans. Additionally at June 30, 2015 and December 31, 2014, the Bank had one TDR commercial real estate loan of $1.0 million that is greater than 90 days delinquent. These loans are classified solely as non-accrual loans for the calculation of financial ratios.

Interest income in the amount of $249,000 and $563,000 was recognized on TDR loans for the six months ended June 30, 2015 and the year ended December 31, 2014, 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, 2015 and 2014, respectively, and for the year ended December 31, 2014 and loan receivable balances at June 30, 2015 and 2014, respectively, and at December 31, 2014. 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, 2015

Allowance for loan losses:
Balance at April 1,	$ 4,348	$ 904	$ 1,099	$ 208	$ 1,740	$ 2	$ 320	$ 8,621
Charge-offs	-	(30)	-	-	(215)	-	(54)	(299)
Recoveries	4	-	32	-	6	-	1	43
Provisions	(493)	11	74	(2)	(165)	-	967	392
Balance at June 30,	$ 3,859	$ 885	$ 1,205	$ 206	$ 1,366	$ 2	$ 1,234	$ 8,757

At and For the Six Months Ended June 30, 2015

Allowance for loan losses:
Balance at January 1,	$ 4,076	$ 1,092	$ 1,071	$ 173	$ 1,677	$ 3	$ 389	$ 8,481
Charge-offs	(46)	(30)	-	-	(215)	-	(54)	(345)
Recoveries	7	1	32	-	7	-	4	51
Provisions	(178)	(178)	102	33	(103)	(1)	895	570
Balance at June 30,	$ 3,859	$ 885	$ 1,205	$ 206	$ 1,366	$ 2	$ 1,234	$ 8,757
Ending balance: individually evaluated for impairment	$ 150	$ 75	$ -	$ -	$ 227	$ -	$ 1,021	$ 1,473
Ending balance: collectively evaluated for impairment	$ 3,709	$ 810	$ 1,205	$ 206	$ 1,139	$ 2	$ 213	$ 7,284
Loan receivables:
Ending balance	$ 601,270	$ 143,662	$ 39,159	$ 21,068	$ 63,480	$ 396	$ 26,804	$ 895,839
Ending balance: individually evaluated for impairment	$ 27,980	$ 3,996	$ 4,329	$ 429	$ 5,080	$ -	$ 1,389	$ 43,203
Ending balance: collectively evaluated for impairment	$ 573,290	$ 139,666	$ 34,830	$ 20,639	$ 58,400	$ 396	$ 25,415	$ 852,636



(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, 2014
Allowance for loan losses:
Balance at January 1,	$ 3,525	$ 1,401	$ 584	$ 249	$ 1,916	$ 10	$ 453	$ 8,138
Charge-offs	(350)	(94)	(992)	(59)	(1,134)	(3)	(10)	(2,642)
Recoveries	11	186	84	10	5	11	25	332
Provisions	890	(401)	1,395	(27)	890	(15)	(79)	2,653
Balance at December 31,	$ 4,076	$ 1,092	$ 1,071	$ 173	$ 1,677	$ 3	$ 389	$ 8,481
Ending balance: individually evaluated for impairment	$ 97	$ 76	$ -	$ -	$ 155	$ -	$ 123	$ 451
Ending balance: collectively evaluated for impairment	$ 3,979	$ 1,016	$ 1,071	$ 173	$ 1,522	$ 3	$ 266	$ 8,030
Loan receivables:
Ending balance	$ 561,080	$ 152,837	$ 36,370	$ 21,452	$ 73,625	$ 613	$ 26,152	$ 872,129
Ending balance: individually evaluated for impairment	$ 31,529	$ 3,407	$ 6,102	$ 649	$ 7,436	$ -	$ 586	$ 49,709
Ending balance: collectively evaluated for impairment	$ 529,551	$ 149,430	$ 30,268	$ 20,803	$ 66,189	$ 613	$ 25,566	$ 822,420


(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

Credit Quality Indicators

Credit quality indicators as of June 30, 2015 and December 31, 2014 were as follows:


Credit Risk Profile by Internally Assigned Grade

	Commercial Real Estate		Construction and Land Dev.
(dollars in thousands)	6/30/2015	12/31/2014	6/30/2015	12/31/2014

Unrated	$ 69,819	$ 74,955	$ 6,607	$ 3,108
Pass	502,595	451,256	28,223	27,160
Special mention	3,078	4,383	-	-
Substandard	25,778	30,486	4,329	6,102
Doubtful	-	-	-	-
Loss	-	-	-	-
Total	$ 601,270	$ 561,080	$ 39,159	$ 36,370

	Commercial Loans		Commercial Equipment
(dollars in thousands)	6/30/2015	12/31/2014	6/30/2015	12/31/2014

Unrated	$ 10,349	$ 12,296	$ 8,765	$ 7,173
Pass	48,414	53,844	16,840	18,517
Special mention	49	49	-	-
Substandard	4,668	7,436	1,199	462
Doubtful	-	-	-	-
Loss	-	-	-	-
Total	$ 63,480	$ 73,625	$ 26,804	$ 26,152


Credit Risk Profile Based on Payment Activity

	Residential First Mortgages		Home Equity and Second Mtg.		Consumer Loans
(dollars in thousands)	6/30/2015	12/31/2014	6/30/2015	12/31/2014	6/30/2015	12/31/2014

Performing	$ 142,504	$ 152,304	$ 20,702	$ 21,053	$ 396	$ 613
Nonperforming	1,158	533	366	399	-	-
Total	$ 143,662	$ 152,837	$ 21,068	$ 21,452	$ 396	$ 613

Summary of Total Classified Loans

(dollars in thousands)		6/30/2015	12/31/2014
By Internally Assigned Grade		$ 35,974	$ 44,486
By Payment Activity		1,465	2,249
Total Classified		$ 37,439	$ 46,735

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.

Home equity and second mortgages and consumer loans are evaluated for creditworthiness in underwriting and are monitored based on borrower payment history. Residential first mortgages are evaluated for creditworthiness during credit due diligence before being purchased. Residential first mortgages, home equity and second mortgages and consumer 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.