NOTE 5 – LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES

The fundamental lending business of the Company is based on understanding, measuring, and controlling the credit risk inherent in the loan portfolio. The Company's loan portfolio is subject to varying degrees of credit risk. These risks entail both general risks, which are inherent in the lending process, and risks specific to individual borrowers. The Company's credit risk is mitigated through portfolio diversification, which limits exposure to any single customer, industry or collateral type.

The Company currently manages its credit products and the respective exposure to loan losses by the following specific portfolio segments, which are levels at which the Company develops and documents its systematic methodology to determine the allowance for loan losses. The Company considers each loan type to be a portfolio segment having unique risk characteristics.


	March 31,			December 31,
	2018			2017
(dollars in thousands)	$		%	$		%
Consumer	$	15,730	5	$	16,112	6
Residential real estate		82,151	30		81,926	30
Indirect		90,278	33		85,186	32
Commercial		11,176	4		11,257	4
Construction		4,385	2		3,536	1
Commercial real estate		71,996	26		73,595	27
Total Loans		275,716	100		271,612	100
Allowance for credit losses		(2,899)			(2,589)
Net Loans	$	272,817		$	269,023

The Bank’s net loans totaled $272.8 million at March 31, 2018, compared to $269.0 million at December 31, 2017, an increase of $3.8 million (1.41%). Indirect loans increased from $85.2 million to $90.3 million ($5.1 million or 5.98%). Construction loans increased from $3.5 million to $4.4 million ($0.9 million or 24.03%). Commercial real estate loans decreased from $73.6 million to $72.0 million ($1.6 or 2.17%) as loan payoffs outpaced loan originations.

Credit Risk and Allowance for Credit Losses. Credit risk is the risk of loss arising from the inability of a borrower to meet his or her obligations and entails both general risks, which are inherent in the process of lending, and risks specific to individual borrowers. Credit risk is mitigated through portfolio diversification, which limits exposure to any single customer, industry, or collateral type. Residential mortgage and home equity loans and lines generally have the lowest credit loss experience. Loans secured by personal property, such as auto loans, generally experience medium credit losses. Unsecured loan products, such as personal revolving credit, have the highest credit loss experience and for that reason, the Bank has chosen not to engage in a significant amount of this type of lending. Credit risk in commercial lending can vary significantly, as losses as a percentage of outstanding loans can shift widely during economic cycles and are particularly sensitive to changing economic conditions. Generally, improving economic conditions result in improved operating results on the part of commercial customers, enhancing their ability to meet their particular debt service requirements. Improvements, if any, in operating cash flows can be offset by the impact of rising interest rates that may occur during improved economic times. Inconsistent economic conditions may have an adverse effect on the operating results of commercial customers, reducing their ability to meet debt service obligations.

The allowance for credit losses is established through a provision for credit losses charged to expense. Loans are charged against the allowance for credit losses when management believes that the collectability of the principal is unlikely. The allowance, based on evaluations of the collectability of loans and prior loan loss experience, is an amount that management believes will be adequate to absorb possible losses on existing loans that may become uncollectible. The evaluations are performed for each class of loans and take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, value of collateral securing the loans and current economic conditions and trends that may affect the borrowers’ ability to pay. For example, delinquencies in unsecured loans and indirect automobile installment loans will be reserved for at significantly higher ratios than loans secured by real estate. Based on that analysis, the Bank deems its allowance for credit losses in proportion to the total non-accrual loans and past due loans to be sufficient.

For purposes of determining the allowance for credit losses, the Bank has segmented the loan portfolio into the following classifications:

Consumer

Residential Real Estate

Indirect

Commercial

Construction

Commercial Real Estate

Each of these segments are reviewed and analyzed quarterly using the average historical charge-offs over a four year period for their respective segments as well as the following qualitative factors:

Changes in asset quality metrics including past due (30-89 days) loans, nonaccrual loans, classified assets, watch list loans all in relation to total loans. Also policy exceptions in relationship to loan volume.

Changes in the rate and direction of the loan volume by portfolio segment.

Concentration of credit including the concentration percentages, changes in concentration and concentrations relative to goals.

Changes in macro-economic factors including the rates and direction of unemployment, median income and population.

Changes in internal factors including external loan review required reserve changes, internal review penetration, internal required reserve changes, and weighted required reserve trends.

Changes in rate and direction of charge offs and recoveries.

Transactions in the allowance for credit losses for the three months ended March 31, 2018 and the year ended December 31, 2017 were as follows:



March 31, 2018			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Unallocated		Total

Balance, beginning of year	$	214	$	1,061	$	774	$	237	$	12	$	291	$	—	$	2,589
Charge-offs		(62)		—		(39)		—		—		—		—		(101)
Recoveries		5		2		44		—		—		—		—		51
Provision for loan losses		56		(3)		14		8		(8)		293		—		360

Balance, end of year	$	213	$	1,060	$	793	$	245	$	4	$	584	$	—	$	2,899

Individually evaluated for impairment:
Balance in allowance	$	29	$	513	$	—	$	214	$	—	$	305	$	—	$	1,061
Related loan balance		99		2,323		—		214		—		3,146		—		5,782

Collectively evaluated for impairment:
Balance in allowance	$	184	$	547	$	793	$	31	$	4	$	279	$	—	$	1,838
Related loan balance		15,631		79,828		90,278		10,962		4,385		68,850		—		269,934



December 31, 2017			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Unallocated		Total

Balance, beginning of year	$	182	$	1,042	$	693	$	284	$	10	$	259	$	14	$	2,484
Charge-offs		(96)		(3)		(458)		(9)		—		—		—		(566)
Recoveries		8		27		286		—		—		14		—		335
Provision for loan losses		120		(5)		253		(38)		2		18		(14)		336

Balance, end of year	$	214	$	1,061	$	774	$	237	$	12	$	291	$	—	$	2,589

Individually evaluated for impairment:
Balance in allowance	$	52	$	513	$	—	$	217	$	—	$	—	$	—	$	782
Related loan balance		160		2,345		—		217		—		1,176		—		3,898

Collectively evaluated for impairment:
Balance in allowance	$	162	$	548	$	774	$	20	$	12	$	291	$	—	$	1,807
Related loan balance		15,952		79,580		85,186		11,040		3,536		72,420		—		267,714

Management believes the allowance for credit losses is at an appropriate level to absorb inherent probable losses in the portfolio.


	March 31,			March 31,
(dollars in thousands)	2018			2017
Average loans	$	273,964		$	267,494
Net charge offs to average loans (annualized)		0.07	%		0.12	%

During the first quarter of 2018, loans to 7 borrowers and related entities totaling approximately $101,000 were determined to be uncollectible and were charged off. During the first quarter of 2017, loans to 11 borrowers and related entities totaling approximately $170,000 were determined to be uncollectible and were charged off.

Reserve for Unfunded Commitments. Loan commitments and unused lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. The Bank generally requires collateral to support financial instruments with credit risk on the same basis as it does for on-balance sheet instruments. The collateral requirement is based on management's credit evaluation of the counter party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. Each customer's creditworthiness is evaluated on a case-by-case basis.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

As of March 31, 2018 and 2017, the Bank had outstanding commitments totaling $24.7 million and $26.5 million, respectively. These outstanding commitments consisted of letters of credit, undrawn lines of credit, and other loan commitments. The following table shows the Bank’s reserve for unfunded commitments arising from these transactions:


	Three Months
	Ended March 31,
(dollars in thousands)	2018		2017
Beginning balance	$	24	$	25
Reduction of unfunded reserve		(18)		—
Provisions charged to operations		6		17

Ending balance	$	12	$	42

Contractual Obligations and Commitments. No material changes, outside the normal course of business, have been made during the first quarter of 2018.

Asset Quality. The following tables set forth the amount of the Bank’s current, past due, and non-accrual loans by categories of loans and restructured loans, at the dates indicated.


At March 31, 2018					90 Days or
(dollars in thousands)			30-89 Days		More and
	Current		Past Due		Still Accruing		Nonaccrual		Total

Consumer	$	15,469	$	110	$	—	$	151	$	15,730
Residential Real Estate		79,767		94		—		2,290		82,151
Indirect		89,557		577		—		144		90,278
Commercial		11,122		—		6		48		11,176
Construction		4,014		—		53		318		4,385
Commercial Real Estate		67,506		2,000		—		2,490		71,996

	$	267,435	$	2,781	$	59	$	5,441	$	275,716


At December 31, 2017					90 Days or
(dollars in thousands)			30-89 Days		More and
	Current		Past Due		Still Accruing		Nonaccrual		Total

Consumer	$	15,823	$	80	$	24	$	185	$	16,112
Residential Real Estate		79,205		597		—		2,124		81,926
Indirect		83,932		1,166		—		88		85,186
Commercial		11,203		—		6		48		11,257
Construction		3,188		—		30		318		3,536
Commercial Real Estate		73,088		—		—		507		73,595

	$	266,439	$	1,843	$	60	$	3,270	$	271,612

The balances in the above charts have not been reduced by the allowance for loan loss. For the period ending March 31, 2018, the allowance for loan loss is $2.9 million. For the period ending December 31, 2017, the allowance for loan loss is $2.6 million.

At March 31, 2018, there was $1.0 million in loans outstanding, that were in an accrual status, but known information about possible credit problems of borrowers caused management to have doubts as to the ability of such borrowers to comply with present loan repayment terms. Such loans consist of loans which were not 90 days or more past due but where the borrower is in bankruptcy or has a history of delinquency, or the loan to value ratio is considered excessive due to deterioration of the collateral or other factors. The three loans outstanding, totaling $1.0 million are as follows: $667,000 Residential Real Estate loan where the guarantor is in bankruptcy and the loan has an accelerated payoff since we have an assignment of rents from the property which has a very long-term national tenant; $160,000 Home Equity Line of Credit which is paying as agreed, however the borrower has defaulted on other commercial loans which have been satisfied; and a $214,000 Commercial Real Estate loan with a loan to value ratio which has deteriorated, which has a complete specific reserve of $214,000. All three of these loans are classified with a risk rating of Substandard.

Non-accrual loans with specific reserves at March 31, 2018 are comprised of:

Consumer loans – Two loans to two borrowers in the amount of $99,500 with specific reserves of $29,278 established for the loans.

Residential Real Estate – One loan to one borrower in the amount of $1.3 million, secured by residential property with a specific reserve of $513,000 established for the loan.

Commercial loans – One loan to one borrower in the amount of $214,000 with specific reserves of $214,000 established for the loan.

Commercial Real Estate – One loan to one borrower in the amount of $2.0 million with specific reserves of $305,000 established for the loan.

Below is a summary of the recorded investment amount and related allowance for losses of the Bank’s impaired loans at March 31, 2018 and December 31, 2017.


March 31, 2018			Unpaid		Interest				Average
(dollars in thousands)	Recorded		Principal		Income		Specific		Recorded
	Investment		Balance		Recognized		Reserve		Investment
Impaired loans with specific reserves:
Consumer	$	100	$	100	$	—	$	29	$	137
Residential Real Estate		1,294		1,294		—		513		1,306
Commercial		214		214		3		214		215
Commercial Real Estate		2,000		2,000		14		305		3,103
Total impaired loans with specific reserves		3,608		3,608		17		1,061		4,761


Impaired loans with no specific reserve:
Residential Real Estate	$	977	$	1,403	$	2	$	—	$	1,566
Indirect		144		144		—		—		—
Construction		236		236		—		—		236
Commercial Real Estate		1,238		1,548		9		—		1,666
Total impaired loans with no specific reserve	$	2,595	$	3,331	$	11		—	$	3,468


December 31, 2017			Unpaid		Interest				Average
(dollars in thousands)	Recorded		Principal		Income		Specific		Recorded
	Investment		Balance		Recognized		Reserve		Investment
Impaired loans with specific reserves:
Consumer	$	160	$	160	$	5	$	52	$	205
Residential Real Estate		1,294		1,322		—		513		1,312
Commercial		217		217		—		217		223
Total impaired loans with specific reserves		1,671		1,699		5		782		1,740

Impaired loans with no specific reserve:
Consumer	$	49	$	49	$	—		—	$	—
Residential Real Estate		992		1,760		11		—		1,572
Indirect		88		88		—		—		—
Commercial		2		2		—		—		2
Construction		318		318		—		—		322
Commercial Real Estate		1,194		1,194		39		—		1,632
Total impaired loans with no specific reserve	$	2,643	$	3,411	$	50		—	$	3,528


	March 31,			December 31,
(dollars in thousands)	2018			2017

Troubled debt restructured loans	$	260		$	263
Non-accrual and 90+ days past due and still accruing loans to gross loans		2.09	%		1.32	%
Allowance for loan losses to nonaccrual & 90+ days past due and still accruing loans		52.70	%		77.70	%

At March 31, 2018, there were two troubled debt restructured loans consisting of a commercial loan of $214,000 and a consumer loan of $46,000. The consumer loan is in a nonaccrual status.

Following is a table showing activity for non-accrual loans for the quarters ended March 31, 2017 and 2018.



		Residential				Commercial
(dollars in thousands)	Consumer	Real Estate	Indirect	Commercial	Construction	Real Estate	Totals

December 31, 2016	403	2,508	193	—	—	647	3,751
Transfers into nonaccrual	4	—	229	—	170	48	451
Loans paid down/payoffs	(12)	(31)	(42)	—	—	(10)	(95)
Loans returned to accrual status	—	(132)	(33)	—	—	—	(165)
Loans charged off	—	(3)	(167)	—	—	—	(170)

March 31, 2017	395	2,342	180	—	170	685	3,772


December 31, 2017	185	2,124	88	48	318	507	3,270
Transfers into nonaccrual	38	183	160	—	—	2,000	2,381
Loans paid down/payoffs	(9)	(17)	(33)	—	—	(17)	(76)
Loans returned to accrual status	—	—	(37)	—	—	—	(37)
Loans charged off	(63)	—	(34)	—	—	—	(97)

March 31, 2018	151	2,290	144	48	318	2,490	5,441

Other Real Estate Owned. At March 31, 2018, the Company had $114,000 in real estate acquired in partial or total satisfaction of debt, unchanged from $114,000 at December 31, 2017. All such properties are initially recorded at the lower of cost or fair value (net realizable value) at the date acquired and carried on the balance sheet as other real estate owned. Losses arising at the date of acquisition are charged against the allowance for credit losses. Subsequent write-downs that may be required and expense of operation are included in noninterest expense. Gains and losses realized from the sale of other real estate owned are included in noninterest expense.

Credit Quality Information

In addition to monitoring the performance status of the loan portfolio, the Company utilizes a risk rating scale (1-8) to evaluate loan asset quality for all loans. Loans that are rated 1-4 are classified as pass credits. For the pass rated loans, management believes there is a low risk of loss related to these loans and, as necessary, credit may be strengthened through improved borrower performance and/or additional collateral.

The Bank’s internal risk ratings are as follows:

Superior – minimal risk. (normally supported by pledged deposits, United States government securities, etc.)

Above Average - low risk. (all of the risks associated with this credit based on each of the bank’s creditworthiness criteria are minimal)

Average – moderately low risk. (most of the risks associated with this credit based on each of the bank’s creditworthiness criteria are minimal)

Acceptable – moderate risk. (the weighted overall risk associated with this credit based on each of the bank’s creditworthiness criteria is acceptable)

Other Assets Especially Mentioned – moderately high risk. (possesses deficiencies which corrective action by the bank would remedy; potential watch list)

Substandard – (the bank is inadequately protected and there exists the distinct possibility of sustaining some loss if not corrected)

Doubtful – (weaknesses make collection or liquidation in full, based on currently existing facts, improbable)

Loss – (of little value; not warranted as a bankable asset)

The following table provides information with respect to the Company's credit quality indicators by class of the loan portfolio at March 31, 2018:



March 31, 2018			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Total

Pass	$	15,574	$	81,612	$	89,345	$	11,175	$	4,385	$	71,672	$	273,763
Special mention		97		217		561		1		—		324		1,200
Substandard		14		322		321		—		—		—		657
Doubtful		45		—		51		—		—		—		96
Loss		—		—		—		—		—		—		—

	$	15,730	$	82,151	$	90,278	$	11,176	$	4,385	$	71,996	$	275,716

Nonaccrual		151		2,290		144		48		318		2,490		5,441
Troubled debt restructures		46		—		—		214		—		—		260
Number of TDRs accounts		1		—		—		1		—		—		2
Non-performing TDRs		46		—		—		—		—		—		46
Number of non-performing TDR accounts		1		—		—		—		—		—		1



December 31, 2017			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Total

Pass	$	16,008	$	81,346	$	83,803	$	11,256	$	3,536	$	73,268	$	269,217
Special mention		77		344		1,027		1		—		327		1,776
Substandard		3		236		315		—		—		—		554
Doubtful		24		—		41		—		—		—		65
Loss		—		—		—		—		—		—		—

	$	16,112	$	81,926	$	85,186	$	11,257	$	3,536	$	73,595	$	271,612

Nonaccrual		185		2,124		88		48		318		507		3,270
Troubled debt restructures		46		—		—		217		—		—		263
Number of TDRs accounts		1		—		—		1		—		—		2
Non-performing TDRs		46		—		—		—		—		—		46
Number of non-performing TDR accounts		1		—		—		—		—		—		1