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.


	September 30,			December 31,
	2018			2017
(dollars in thousands)	Amount		%	Amount		%
Consumer	$	14,602	5	$	16,112	6
Residential real estate		82,705	28		81,926	30
Indirect		110,192	38		85,186	32
Commercial		13,266	4		11,257	4
Construction		2,677	1		3,536	1
Commercial real estate		71,539	24		73,595	27
Loans, net of deferred fees and costs		294,981	100		271,612	100
Less: Allowance for loan losses		(2,455)			(2,589)
Loans, net	$	292,526		$	269,023

The Bank’s net loans totaled $292.5 million at September 30, 2018, compared to $269.0 million at December 31, 2017, an increase of $23.5 million, or 8.74%. Consumer loans decreased from $16.1 million at December 31, 2017 to $14.6 million at September 30, 2018, a decrease of $1.5 million, or 9.37%. Residential real estate loans increased by $0.8 million, or 0.95%, from $81.9 million at December 31, 2017 to $82.7 million at September 30, 2018. Indirect loans increased from $85.2 million at December 31, 2017 to $110.2 million at September 30, 2018, an increase of $25.0 million, or 29.36%. Commercial loans increased $2.0 million, or 17.85%, to $13.3 million at September 30, 2018 compared to $11.3 million at December 31, 2017. Construction loans decreased by $0.9 million, or 24.27% to $2.7 million at September 30, 2018, compare to $3.5 million at December 31, 2017. Commercial real estate loans decreased from $73.6 million at December 31, 2017 to $71.5 million at September 30, 2018, a decrease of $2.0 million or 2.79%.

Credit Risk and Allowance for Loan 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 loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan 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 loan losses in proportion to the total nonaccrual loans and past due loans to be sufficient.

For purposes of determining the allowance for loan losses, the Bank segments 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 forty-eight to sixty month period for their respective segments as well as the following qualitative factors:

Changes in asset quality metrics including past due loans (30 - 89 days), 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 loan losses for the nine months ended September 30, 2018 and the year ended December 31, 2017 were as follows:



September 30, 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		(96)		(589)		(256)		(13)		—		—		—		(954)
Recoveries		46		2		171		—		—		—		—		219
Provision for loan losses		40		353		234		18		(9)		(35)		—		601

Balance, end of year	$	204	$	827	$	923	$	242	$	3	$	256	$	—	$	2,455

Individually evaluated for impairment:
Balance in allowance	$	74	$	—	$	—	$	208	$	—	$	—	$	—	$	282
Related loan balance		280		1,282		—		208		—		1,085		—		2,855

Collectively evaluated for impairment:
Balance in allowance	$	130	$	827	$	923	$	34	$	3	$	256	$	—	$	2,173
Related loan balance		14,322		81,423		110,192		13,058		2,677		70,454		—		292,126



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.


	September 30,			September 30,
(dollars in thousands)	2018			2017
Average loans	$	283,005		$	269,333
Net charge offs to average loans (annualized)		0.35	%		0.05	%

During the nine-month period ending September 30, 2018, loans to 43 borrowers and related entities totaling approximately $954,000 were determined to be uncollectible and were charged off. During the nine-month period ending September 30, 2017, loans to 48 borrowers and related entities totaling approximately $356,000 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 September 30, 2018 and 2017, the Bank had outstanding commitments totaling $31.4 million and $21.3 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:


	Nine Months
	Ended September 30,
(dollars in thousands)	2018		2017
Beginning balance	$	24	$	25
Reduction of unfunded reserve		(45)		(29)
Provisions charged to operations		46		17

Ending balance	$	25	$	13

Contractual Obligations and Commitments. No material changes, outside the normal course of business, have been made during 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 September 30, 2018					90 Days or
(dollars in thousands)			30-89 Days		More and
	Current		Past Due		Still Accruing		Nonaccrual		Total

Consumer	$	14,187	$	81	$	—	$	334	$	14,602
Residential Real Estate		81,335		409		28		933		82,705
Indirect		109,380		677		—		135		110,192
Commercial		13,266		—		—		—		13,266
Construction		2,449		—		—		228		2,677
Commercial Real Estate		71,007		—		—		532		71,539

	$	291,624	$	1,167	$	28	$	2,162	$	294,981


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 September 30, 2018, the allowance for loan loss is $2.5 million. For the period ending December 31, 2017, the allowance for loan loss is $2.6 million.

At September 30, 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: $626,000 Commercial 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; $158,000 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 $208,000 Commercial loan with a loan to value ratio which has deteriorated, which has a complete specific reserve of $208,000. All three of these loans are classified with a risk rating of Substandard.

Non-accrual loans with specific reserves at September 30, 2018 are comprised of:

Consumer loans – Three loans to three borrowers that totaled $230,677 with specific reserves of $74,149 established for the loans. One of these loans totaling $44,401 with a specific reserve in the amount of $15,953 was also a Troubled Debt Restructured loan.

Below is a summary of the recorded investment amount and related allowance for losses of the Bank’s impaired loans at September 30, 2018 and December 31, 2017.


September 30, 2018			Unpaid		Interest				Average
(dollars in thousands)	Recorded		Principal		Income		Specific		Recorded
	Investment		Balance		Recognized		Reserve		Investment
Impaired loans with specific reserves:
Consumer	$	231	$	231	$	5	$	74	$	274
Commercial		208		208		6		208		212
Total impaired loans with specific reserves		438		438		11		282		486


Impaired loans with no specific reserve:
Consumer	$	104	$	104	$	1	$	—	$	50
Residential Real Estate		1,090		1,516		10		—		1,660
Indirect		108		108		—		—		—
Construction		228		228		—		—		236
Commercial Real Estate		1,158		1,468		27		—		1,643
Total impaired loans with no specific reserve	$	2,688	$	3,424	$	38		—	$	3,589


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


	September 30,			December 31,
(dollars in thousands)	2018			2017

Troubled debt restructured loans	$	252		$	263
Non-accrual and 90+ days past due and still accruing loans to average loans		0.85	%		1.32	%
Allowance for loan losses to nonaccrual & 90+ days past due and still accruing loans		112.1	%		77.7	%

At September 30, 2018, there were two troubled debt restructured loans consisting of a commercial loan of $208,000 and a consumer loan of $44,000. The consumer loan is in a nonaccrual status.

The following table shows the activity for non-accrual loans for the quarters ended September 30, 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	6	524	624	48	84	132	1,418
Loans paid down/payoffs	(77)	(183)	(113)	—	(86)	(147)	(606)
Loans returned to accrual status	(47)	(132)	(162)	—	—	—	(341)
Loans charged off	(4)	(3)	(349)	—	—	—	(356)

September 30, 2017	281	2,714	193	48	(2)	632	3,866


December 31, 2017	185	2,124	88	48	318	507	3,270
Transfers into nonaccrual	261	183	464	—	—	2,082	2,989
Loans paid down/payoffs	(20)	(595)	(90)	(48)	(90)	(2,057)	(2,900)
Loans returned to accrual status	—	(191)	(71)	—	—	—	(262)
Loans charged off	(92)	(588)	(256)	—	—	—	(936)

September 30, 2018	334	933	135	—	228	532	2,162

Other Real Estate Owned. At September 30, 2018, the Company had $705,000 in real estate acquired in partial or total satisfaction of debt, compared to $114,000 at December 31, 2017. The $591,000 increase was due to the sale of one property and the addition of one new property. 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 were included in noninterest income.

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 tables provides information with respect to the Company's credit quality indicators by loan portfolio segment at September 30, 2018 and December 31, 2017:



September 30, 2018			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Total

Pass	$	14,191	$	81,142	$	109,785	$	13,058	$	2,677	$	70,412	$	291,265
Special mention		—		172		47		—		—		—		219
Substandard		411		1,391		340		208		—		1,127		3,477
Doubtful		—		—		20		—		—		—		20
Loss		—		—		—		—		—		—		—

	$	14,602	$	82,705	$	110,192	$	13,266	$	2,677	$	71,539	$	294,981

Nonaccrual		334		933		135		—		228		532		2,162
Troubled debt restructures		44		—		—		208		—		—		252
Number of TDRs accounts		1		—		—		1		—		—		2
Non-performing TDRs		44		—		—		—		—		—		44
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	$	15,952	$	79,126	$	84,574	$	11,040	$	3,536	$	72,092	$	266,320
Special mention		—		218		129		—		—		327		674
Substandard		160		2,582		383		217		—		1,176		4,518
Doubtful		—		—		100		—		—		—		100
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