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,
	2019			2018
(dollars in thousands)	Amount		%	Amount		%
Consumer	$	12,369	4	$	13,071	4
Residential real estate		80,211	28		82,637	28
Indirect		106,088	38		116,698	39
Commercial		11,350	4		14,284	5
Construction		3,161	1		2,317	1
Commercial real estate		70,710	25		70,113	23
Loans, net of deferred fees and costs		283,889	100		299,120	100
Less: Allowance for loan losses		(2,307)			(2,541)
Loans, net	$	281,582		$	296,579

The Bank’s net loans totaled $281.6 million at September 30, 2019, compared to $296.6 million at December 31, 2018, a decrease of $15.0 million, or 5.06%. Consumer loans decreased from $13.1 million at December 31, 2018 to $12.4 million at September 30, 2019, a decrease of $0.7 million, or 5.37%. Residential real estate loans decreased by $2.4 million, or 2.94%, from $82.6 million at December 31, 2018 to $80.2 million at September 30, 2019. Indirect loans decreased from $116.7 million at December 31, 2018 to $106.1 million at September 30, 2019, a decrease of $10.6 million, or 9.09%. Commercial loans decreased $2.9 million, or 20.54%, to $11.4 million at September 30, 2019, compared to $14.3 million at December 31, 2018. Construction loans increased by $0.8 million, or 36.40% to $3.2 million at September 30, 2019, compared to $2.3 million at December 31, 2018. Commercial real estate loans increased from $70.1 million at December 31, 2018 to $70.7 million at September 30, 2019, an increase of $0.6 million or 0.85%.

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, 2019 and the year ended December 31, 2018 were as follows:



September 30, 2019			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Total

Balance, beginning of year	$	161	$	864	$	988	$	241	$	4	$	283	$	2,541
Charge-offs		(69)		(16)		(407)		(27)		—		—		(519)
Recoveries		15		1		194		10		—		—		220
Provision for loan losses		46		(210)		164		2		3		60		65

Balance, end of quarter	$	153	$	639	$	939	$	226	$	7	$	343	$	2,307

Individually evaluated for impairment:
Balance in allowance	$	15	$	—	$	—	$	195	$	—	$	—	$	210
Related loan balance		88		659		—		195		—		3,854		4,796

Collectively evaluated for impairment:
Balance in allowance	$	138	$	639	$	939	$	31	$	7	$	343	$	2,097
Related loan balance		12,281		79,552		106,088		11,155		3,161		66,856		279,093



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

Balance, beginning of year	$	214	$	1,061	$	774	$	237	$	12	$	291	$	2,589
Charge-offs		(208)		(589)		(341)		—		—		(13)		(1,151)
Recoveries		48		2		183		14		—		—		247
Provision for loan losses		107		390		372		(10)		(8)		5		856

Balance, end of year	$	161	$	864	$	988	$	241	$	4	$	283	$	2,541

Individually evaluated for impairment:
Balance in allowance	$	22	$	—	$	—	$	204	$	—	$	—	$	226
Related loan balance		138		854		—		204		—		1,054		2,250

Collectively evaluated for impairment:
Balance in allowance	$	139	$	864	$	988	$	37	$	4	$	283	$	2,315
Related loan balance		12,933		81,783		116,698		14,080		2,317		69,059		296,870

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)	2019			2018
Average loans	$	293,958		$	283,006
Net charge offs to average loans (annualized)		0.14	%		0.35	%

During the nine-month period ended September 30, 2019, loans to 47 borrowers and related entities totaling approximately $519,000 were determined to be uncollectible and were charged off. 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.

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, 2019 and 2018, the Bank had outstanding commitments totaling $35.5 million and $31.4 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
	Ended September 30,
(dollars in thousands)	2019		2018
Beginning balance	$	35	$	24
Reduction of unfunded reserve		(23)		(45)
Provisions charged to operations		25		46

Ending balance	$	37	$	25

Contractual Obligations and Commitments. No material changes, outside the normal course of business, have been made during the third quarter 2019.

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, 2019					90 Days or
(dollars in thousands)			30-89 Days		More and
	Current		Past Due		Still Accruing		Nonaccrual		Total

Consumer	$	12,171	$	54	$	—	$	144	$	12,369
Residential Real Estate		79,370		63		22		756		80,211
Indirect		105,517		535		—		36		106,088
Commercial		11,350		—		—		—		11,350
Construction		3,161		—		—		—		3,161
Commercial Real Estate		67,417		—		—		3,293		70,710

	$	278,986	$	652	$	22	$	4,229	$	283,889


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

Consumer	$	12,669	$	216	$	—	$	186	$	13,071
Residential Real Estate		80,923		732		26		956		82,637
Indirect		115,890		692		—		116		116,698
Commercial		14,171		86		—		27		14,284
Construction		2,317		—		—		—		2,317
Commercial Real Estate		69,451		—		—		662		70,113

	$	295,421	$	1,726	$	26	$	1,947	$	299,120

The balances in the above charts have not been reduced by the allowance for loan loss. For the period ending September 30, 2019, the allowance for loan loss is $2.3 million. For the period ending December 31, 2018, the allowance for loan loss is $2.5 million.

At September 30, 2019, there was $0.7 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 two loans outstanding, totaling $0.7 million are as follows: $546,000 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; and a $195,000 Commercial loan with a loan to value ratio which has deteriorated, which has a complete specific reserve of $195,000. Both of these loans are classified with a risk rating of Substandard.

Non-accrual loans with specific reserves at September 30, 2019 are comprised of:

Consumer loans –One loan to one borrowers that totaled $41,641 with specific reserves of $15,260 established for the loan, which 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, 2019 and December 31, 2018.


September 30, 2019			Unpaid		Interest				Average
(dollars in thousands)	Recorded		Principal		Income		Specific		Recorded
	Investment		Balance		Recognized		Reserve		Investment
Impaired loans with specific reserves:
Consumer	$	42	$	42	$	2	$	15	$	50
Commercial		195		195		11		195		200
Total impaired loans with specific reserves		237		237		13		210		250


Impaired loans with no specific reserve:
Consumer	$	102	$	102	$	—	$	n/a	$	50
Residential Real Estate		757		1,526		8		n/a		1,829
Indirect		35		35		—		n/a		—
Commercial Real Estate		3,854		3,854		67		n/a		4,006
Total impaired loans with no specific reserve	$	4,748	$	5,517	$	75		—	$	5,885


December 31, 2018			Unpaid		Interest				Average
(dollars in thousands)	Recorded		Principal		Income		Specific		Recorded
	Investment		Balance		Recognized		Reserve		Investment
Impaired loans with specific reserves:
Consumer	$	89	$	89	$	3	$	22	$	136
Commercial		204		204		12		204		211
Total impaired loans with specific reserves		294		294		15		226		347

Impaired loans with no specific reserve:
Consumer	$	96	$	300	$	2		n/a	$	50
Residential Real Estate		956		1,545		4		n/a		1,981
Indirect		116		457		—		n/a		—
Commercial Real Estate		1,267		1,267		39		n/a		1,148
Total impaired loans with no specific reserve	$	2,435	$	3,569	$	45		—	$	3,179


	September 30,			December 31,
(dollars in thousands)	2019			2018

Troubled debt restructured loans	$	237		$	248
Non-accrual and 90+ days past due and still accruing loans to average loans		1.51	%		0.76	%
Allowance for loan losses to nonaccrual & 90+ days past due and still accruing loans		54.3	%		128.7	%

At September 30, 2019, there were two troubled debt restructured loans consisting of a commercial loan of $195,000 and a consumer loan of $42,000. The consumer loan is in a nonaccrual status.

The following table shows the activity for non-accrual loans at September 30, 2018 and 2019.



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

December 31, 2017	185	2,124	88	48	318	507	3,270
Transfers into nonaccrual	44	183	305	—	—	2,000	2,532
Loans paid down/payoffs	(15)	(41)	(51)	(48)	(8)	(136)	(299)
Loans returned to accrual status	—	—	(50)	—	—	—	(50)
Loans charged off	(92)	(513)	(163)	—	—	—	(768)

September 30, 2018	122	1,753	129	—	310	2,371	4,685


December 31, 2018	186	956	116	27	—	662	1,947
Transfers into nonaccrual	135	572	467	86	—	2,746	4,006
Loans paid down/payoffs	(48)	(755)	(52)	(86)	—	(115)	(1,056)
Loans returned to accrual status	(88)	—	(105)	—	—	—	(193)
Loans charged off	(41)	(17)	(390)	(27)	—	—	(475)

September 30, 2019	144	756	36	—	—	3,293	4,229

Other Real Estate Owned. At September 30, 2019 and December 31, 2018, the Company had $705,000 in real estate acquired in partial or total satisfaction of debt. 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, 2019 and December 31, 2018:



September 30, 2019			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Total

Pass	$	12,225	$	79,453	$	106,053	$	11,155	$	3,161	$	66,856	$	278,903
Special mention		—		—		—		—		—		—		—
Substandard		144		758		4		195		—		3,854		4,955
Doubtful		—		—		31		—		—		—		31
Loss		—		—		—		—		—		—		—

	$	12,369	$	80,211	$	106,088	$	11,350	$	3,161	$	70,710	$	283,889

Nonaccrual	$	144	$	756	$	36	$	—	$	—	$	3,293	$	4,229
Troubled debt restructures	$	42	$	—	$	—	$	195	$	—	$	—	$	237
Number of TDRs accounts		1		—		—		1		—		—		2
Non-performing TDRs	$	42	$	—	$	—	$	—	$	—	$	—	$	42
Number of non-performing TDR accounts		1		—		—		—		—		—		1



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

Pass	$	12,888	$	82,111	$	115,724	$	14,284	$	2,317	$	69,900	$	297,224
Special mention		—		424		645		—		—		—		1,069
Substandard		183		102		244		—		—		213		742
Doubtful		—		—		85		—		—		—		85
Loss		—		—		—		—		—		—		—

	$	13,071	$	82,637	$	116,698	$	14,284	$	2,317	$	70,113	$	299,120

Nonaccrual	$	186	$	956	$	116	$	27	$	—	$	662	$	1,947
Troubled debt restructures	$	44	$	—	$	—	$	204	$	—	$	—	$	248
Number of TDRs accounts		1		—		—		1		—		—		2
Non-performing TDRs	$	44	$	—	$	—	$	—	$	—	$	—	$	44
Number of non-performing TDR accounts		1		—		—		—		—		—		1