NOTE 8. Loans

The following table sets forth the classification of loans by class, including unearned fees, deferred costs and excluding the allowance for loan losses as of March 31, 2016 and December 31, 2015:


(In thousands)	March 31, 2016		December 31, 2015
SBA loans held for investment	$	38,863	$	39,393
SBA 504 loans		27,482		29,353
Commercial loans
Commercial other		50,276		49,332
Commercial real estate		390,345		391,071
Commercial real estate construction		26,645		25,115
Residential mortgage loans		260,957		264,523
Consumer loans
Home equity		44,573		45,042
Consumer other		34,625		32,015
Total loans held for investment	$	873,766	$	875,844
SBA loans held for sale		13,224		13,114
Total loans	$	886,990	$	888,958

Loans are made to individuals as well as commercial entities. Specific loan terms vary as to interest rate, repayment, and collateral requirements based on the type of loan requested and the credit worthiness of the prospective borrower. Credit risk tends to be geographically concentrated in that a majority of the loan customers are located in the markets serviced by the Bank. As a preferred SBA lender, a portion of the SBA portfolio is to borrowers outside the Company’s market area. However, during late 2008, the Company withdrew from SBA lending outside of its primary trade area, but continues to offer SBA loan products as an additional credit product within its primary trade area. Loan performance may be adversely affected by factors impacting the general economy or conditions specific to the real estate market such as geographic location and/or property type. A description of the Company's different loan segments follows:

SBA Loans: SBA 7(a) loans, on which the SBA has historically provided guarantees of up to 90 percent of the principal balance, are considered a higher risk loan product for the Company than its other loan products. The guaranteed portion of the Company’s SBA loans is generally sold in the secondary market with the nonguaranteed portion held in the portfolio as a loan held for investment. SBA loans are for the purpose of providing working capital, financing the purchase of equipment, inventory or commercial real estate and for other business purposes. Loans are guaranteed by the businesses' major owners. SBA loans are made based primarily on the historical and projected cash flow of the business and secondarily on the underlying collateral provided.

SBA 504 Loans: The SBA 504 program consists of real estate backed commercial mortgages where the Company has the first mortgage and the SBA has the second mortgage on the property. SBA 504 loans are made based primarily on the historical and projected cash flow of the business and secondarily on the underlying collateral provided. Generally, the Company has a 50 percent loan to value ratio on SBA 504 program loans at origination.

Commercial Loans: Commercial credit is extended primarily to middle market and small business customers. Commercial loans are generally made in the Company’s market place for the purpose of providing working capital, financing the purchase of equipment, inventory or commercial real estate and for other business purposes. Loans will generally be guaranteed in full or for a meaningful amount by the businesses' major owners. Commercial loans are made based primarily on the historical and projected cash flow of the business and secondarily on the underlying collateral provided.

Residential Mortgage and Consumer Loans: The Company originates mortgage and consumer loans including principally residential real estate and home equity lines and loans and consumer construction lines. Each loan type is evaluated on debt to income, type of collateral and loan to collateral value, credit history and Company’s relationship with the borrower.

Inherent in the lending function is credit risk, which is the possibility a borrower may not perform in accordance with the contractual terms of their loan. A borrower’s inability to pay their obligations according to the contractual terms can create the risk of past due loans and, ultimately, credit losses, especially on collateral deficient loans. The Company minimizes its credit risk by loan diversification and adhering to credit administration policies and procedures. Due diligence on loans begins when we initiate contact regarding a loan with a borrower. Documentation, including a borrower’s credit history, materials establishing the value and liquidity of potential collateral, the purpose of the loan, the source of funds for repayment of the loan, and other factors, are analyzed before a loan is submitted for approval. The loan portfolio is then subject to on-going internal reviews for credit quality which in part is derived from ongoing collection and review of borrowers’ financial information, as well as independent credit reviews by an outside firm.

The Company's extension of credit is governed by the Credit Risk Policy which was established to control the quality of the Company's loans. These policies and procedures are reviewed and approved by the Board of Directors on a regular basis.

Credit Ratings

For SBA 7(a), SBA 504 and commercial loans, management uses internally assigned risk ratings as the best indicator of credit quality. A loan’s internal risk rating is updated at least annually and more frequently if circumstances warrant a change in risk rating. The Company uses a 1 through 10 loan grading system that follows regulatorily accepted definitions.

Pass: Risk ratings of 1 through 6 are used for loans that are performing, as they meet, and are expected to continue to meet, all of the terms and conditions set forth in the original loan documentation, and are generally current on principal and interest payments. These performing loans are termed “Pass”.

Special Mention: Criticized loans are assigned a risk rating of 7 and termed “Special Mention”, as the borrowers exhibit potential credit weaknesses or downward trends deserving management’s close attention. If not checked or corrected, these trends will weaken the Bank’s collateral and position. While potentially weak, these borrowers are currently marginally acceptable and no loss of interest or principal is anticipated. As a result, special mention assets do not expose an institution to sufficient risk to warrant adverse classification. Included in “Special Mention” could be turnaround situations, such as borrowers with deteriorating trends beyond one year, borrowers in startup or deteriorating industries, or borrowers with a poor market share in an average industry. "Special Mention" loans may include an element of asset quality, financial flexibility, or below average management. Management and ownership may have limited depth or experience. Regulatory agencies have agreed on a consistent definition of “Special Mention” as an asset with potential weaknesses which, if left uncorrected, may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. This definition is intended to ensure that the “Special Mention” category is not used to identify assets that have as their sole weakness credit data exceptions or collateral documentation exceptions that are not material to the repayment of the asset.

Substandard: Classified loans are assigned a risk rating of an 8 or 9, depending upon the prospect for collection, and deemed “Substandard”. A risk rating of 8 is used for borrowers with well-defined weaknesses that jeopardize the orderly liquidation of debt. The loan is inadequately protected by the current paying capacity of the obligor or by the collateral pledged, if any. Normal repayment from the borrower is in jeopardy, although no loss of principal is envisioned. There is a distinct possibility that a partial loss of interest and/or principal will occur 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”.

A risk rating of 9 is used for borrowers that have all the weaknesses inherent in a loan with a risk rating of 8, with the added characteristic that the weaknesses make collection of debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Serious problems exist to the point where partial loss of principal is likely. The possibility of loss is extremely high, but because of certain important, reasonably specific pending factors that may work to strengthen the assets, the loans’ classification as estimated losses is deferred until a more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures; capital injection; perfecting liens on additional collateral; and refinancing plans. Partial charge-offs are likely.

Loss: Once a borrower is deemed incapable of repayment of unsecured debt, the risk rating becomes a 10, the loan is termed a “Loss”, and charged-off immediately. Loans to such borrowers are considered uncollectible and of such little value that continuance as active assets of the Bank is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off these basically worthless assets even though partial recovery may be affected in the future.

For residential mortgage and consumer loans, management uses performing versus nonperforming as the best indicator of credit quality. Nonperforming loans consist of loans that are not accruing interest (nonaccrual loans) as a result of principal or interest being in default for a period of 90 days or more or when the ability to collect principal and interest according to the contractual terms is in doubt. These credit quality indicators are updated on an ongoing basis, as a loan is placed on nonaccrual status as soon as management believes there is sufficient doubt as to the ultimate ability to collect interest on a loan.

At March 31, 2016, the Company owned $78 thousand of residential consumer properties that were included in OREO in the Consolidated Balance Sheets, compared to $76 thousand at December 31, 2015. Additionally, there were $3.2 million of residential consumer loans in the process of foreclosure at March 31, 2016, compared to $4.5 million at December 31, 2015.

The tables below detail the Company’s loan portfolio by class according to their credit quality indicators discussed in the paragraphs above as of March 31, 2016:


	March 31, 2016
	SBA, SBA 504 & Commercial loans - Internal risk ratings
(In thousands)	Pass		Special mention		Substandard		Total
SBA loans held for investment	$	35,008	$	2,199	$	1,656	$	38,863
SBA 504 loans		23,883		2,935		664		27,482
Commercial loans
Commercial other		46,719		2,493		1,064		50,276
Commercial real estate		371,371		18,063		911		390,345
Commercial real estate construction		25,591		698		356		26,645
Total commercial loans		443,681		21,254		2,331		467,266
Total SBA, SBA 504 and commercial loans	$	502,572	$	26,388	$	4,651	$	533,611

	Residential mortgage & Consumer loans - Performing/Nonperforming
(In thousands)			Performing		Nonperforming		Total
Residential mortgage loans			$	257,808	$	3,149	$	260,957
Consumer loans
Home equity				44,145		428		44,573
Consumer other				34,625		-		34,625
Total consumer loans				78,770		428		79,198
Total residential mortgage and consumer loans			$	336,578	$	3,577	$	340,155

The tables below detail the Company’s loan portfolio by class according to their credit quality indicators discussed in the paragraphs above as of December 31, 2015:


	December 31, 2015
	SBA, SBA 504 & Commercial loans - Internal risk ratings
(In thousands)	Pass		Special mention		Substandard		Total
SBA loans held for investment	$	35,032	$	2,647	$	1,714	$	39,393
SBA 504 loans		24,003		4,917		433		29,353
Commercial loans
Commercial other		45,870		2,373		1,089		49,332
Commercial real estate		369,510		18,978		2,583		391,071
Commercial real estate construction		24,061		1,054		-		25,115
Total commercial loans		439,441		22,405		3,672		465,518
Total SBA, SBA 504 and commercial loans	$	498,476	$	29,969	$	5,819	$	534,264

	Residential mortgage & Consumer loans - Performing/Nonperforming
(In thousands)			Performing		Nonperforming		Total
Residential mortgage loans			$	262,299	$	2,224	$	264,523
Consumer loans
Home equity				44,452		590		45,042
Consumer other				32,015		-		32,015
Total consumer loans				76,467		590		77,057
Total residential mortgage and consumer loans			$	338,766	$	2,814	$	341,580

Nonperforming and Past Due Loans

Nonperforming loans consist of loans that are not accruing interest (nonaccrual loans) as a result of principal or interest being in default for a period of 90 days or more or when the ability to collect principal and interest according to the contractual terms is in doubt. Loans past due 90 days or more and still accruing interest are not included in nonperforming loans and generally represent loans that are well collateralized and in a continuing process expected to result in repayment or restoration to current status. The risk of loss is difficult to quantify and is subject to fluctuations in collateral values, general economic conditions and other factors. The improved state of the economy has resulted in a substantial reduction in nonperforming loans and loan delinquencies. The Company values its collateral through the use of appraisals, broker price opinions, and knowledge of its local market.

The following tables set forth an aging analysis of past due and nonaccrual loans as of March 31, 2016 and December 31, 2015:


	March 31, 2016
(In thousands)	30-59 days past due		60-89 days past due		90+ days and still accruing		Nonaccrual (1)		Total past due		Current		Total loans
SBA loans held for investment	$	1,048	$	1,181	$	-	$	1,861	$	4,090	$	34,773	$	38,863
SBA 504 loans		-		-		-		513		513		26,969		27,482
Commercial loans
Commercial other		25		548		-		91		664		49,612		50,276
Commercial real estate		570		-		-		489		1,059		389,286		390,345
Commercial real estate construction		-		-		-		356		356		26,289		26,645
Residential mortgage loans		1,426		1,113		-		3,149		5,688		255,269		260,957
Consumer loans
Home equity		141		80		-		428		649		43,924		44,573
Consumer other		-		-		-		-		-		34,625		34,625
Total loans held for investment	$	3,210	$	2,922	$	-	$	6,887	$	13,019	$	860,747	$	873,766
SBA loans held for sale		-		-		-		-		-		13,224		13,224
Total loans	$	3,210	$	2,922	$	-	$	6,887	$	13,019	$	873,971	$	886,990

(1)

At March 31, 2016, nonaccrual loans included $293 thousand of TDRs and $243 thousand of loans guaranteed by the SBA. The remaining $844 thousand of TDRs are in accrual status because they are performing in accordance with their restructured terms.


	December 31, 2015
(In thousands)	30-59 days past due		60-89 days past due		90+ days and still accruing		Nonaccrual (1)		Total past due		Current		Total loans
SBA loans held for investment	$	1,153	$	456	$	-	$	1,764	$	3,373	$	36,020	$	39,393
SBA 504 loans		-		-		-		518		518		28,835		29,353
Commercial loans
Commercial other		157		-		-		10		167		49,165		49,332
Commercial real estate		444		283		-		2,154		2,881		388,190		391,071
Commercial real estate construction		356		-		-		-		356		24,759		25,115
Residential mortgage loans		2,307		1,078		-		2,224		5,609		258,914		264,523
Consumer loans
Home equity		130		3		-		590		723		44,319		45,042
Consumer other		1		-		-		-		1		32,014		32,015
Total loans held for investment	$	4,548	$	1,820	$	-	$	7,260	$	13,628	$	862,216	$	875,844
SBA loans held for sale		-		-		-		-		-		13,114		13,114
Total loans	$	4,548	$	1,820	$	-	$	7,260	$	13,628	$	875,330	$	888,958

(1)

At December 31, 2015, nonaccrual loans included $293 thousand of TDRs and $288 thousand of loans guaranteed by the SBA. The remaining $3.0 million of TDRs are in accrual status because they are performing in accordance with their restructured terms.

Impaired Loans

The Company has defined impaired loans to be all nonperforming loans individually evaluated for impairment and TDRs. Management considers a loan impaired when, based on current information and events, it is determined that the Company will not be able to collect all amounts due according to the loan contract. Impairment is evaluated on an individual basis for SBA, SBA 504, and commercial loans.

The following table provides detail on the Company’s impaired loans that are individually evaluated for impairment with the associated allowance amount, if applicable, as of March 31, 2016:


	March 31, 2016
(In thousands)	Unpaid principal balance		Recorded investment		Specific reserves
With no related allowance:
SBA loans held for investment (1)	$	1,127	$	685	$	-
SBA 504 loans		513		513		-
Commercial loans
Commercial real estate		1,297		1,296		-
Total commercial loans		1,297		1,296		-
Total impaired loans with no related allowance		2,937		2,494		-

With an allowance:
SBA loans held for investment (1)		1,784		970		567
Commercial loans
Commercial other		114		91		91
Commercial real estate		-		-		1
Commercial real estate construction		356		356		59
Total commercial loans		470		447		151
Total impaired loans with a related allowance		2,254		1,417		718

Total individually evaluated impaired loans:
SBA loans held for investment (1)		2,911		1,655		567
SBA 504 loans		513		513		-
Commercial loans
Commercial other		114		91		91
Commercial real estate		1,297		1,296		1
Commercial real estate construction		356		356		59
Total commercial loans		1,767		1,743		151
Total individually evaluated impaired loans	$	5,191	$	3,911	$	718

(1)

Balances are reduced by amount guaranteed by the SBA of $243 thousand at March 31, 2016.

The following table provides detail on the Company’s impaired loans that are individually evaluated for impairment with the associated allowance amount, if applicable, as of December 31, 2015:


	December 31, 2015
(In thousands)	Unpaid principal balance		Recorded investment		Specific reserves
With no related allowance:
SBA loans held for investment (1)	$	961	$	518	$	-
SBA 504 loans		2,226		2,226		-
Commercial loans
Commercial real estate		1,365		1,366		-
Total commercial loans		1,365		1,366		-
Total impaired loans with no related allowance		4,552		4,110		-

With an allowance:
SBA loans held for investment (1)		2,203		1,389		705
Commercial loans
Commercial other		33		10		10
Commercial real estate		1,664		1,664		127
Total commercial loans		1,697		1,674		137
Total impaired loans with a related allowance		3,900		3,063		842

Total individually evaluated impaired loans:
SBA loans held for investment (1)		3,164		1,907		705
SBA 504 loans		2,226		2,226		-
Commercial loans
Commercial other		33		10		10
Commercial real estate		3,029		3,030		127
Total commercial loans		3,062		3,040		137
Total individually evaluated impaired loans	$	8,452	$	7,173	$	842

(1)

Balances are reduced by amount guaranteed by the SBA of $288 thousand at December 31, 2015.

The following tables present the average recorded investments in impaired loans and the related amount of interest recognized during the time period in which the loans were impaired for the three months ended March 31, 2016 and 2015. The average balances are calculated based on the month-end balances of impaired loans. When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is on nonaccrual status, all payments are applied to principal under the cost recovery method, and therefore no interest income is recognized. The interest income recognized on impaired loans noted below represents primarily accruing TDRs and nominal amounts of income recognized on a cash basis for well-collateralized impaired loans.


	For the three months ended March 31,
	2016				2015
(In thousands)	Average recorded investment		Interest income recognized on impaired loans		Average recorded investment		Interest income recognized on impaired loans
SBA loans held for investment (1)	$	2,004	$	2	$	1,997	$	133
SBA 504 loans		1,652		-		3,871		26
Commercial loans
Commercial other		62		25		1,117		18
Commercial real estate		2,052		13		5,036		62
Commercial real estate construction		238		-		-		-
Total	$	6,008	$	40	$	12,021	$	239

(1)

Balances are reduced by the average amount guaranteed by the SBA of $265 thousand and $800 thousand for the three months ended March 31, 2016 and 2015, respectively.

TDRs

The Company's loan portfolio also includes certain loans that have been modified as TDRs. TDRs occur when a creditor, for economic or legal reasons related to a debtor’s financial condition, grants a concession to the debtor that it would not otherwise consider, unless it results in a delay in payment that is insignificant. These concessions typically include reductions in interest rate, extending the maturity of a loan, or a combination of both. When the Company modifies a loan, management evaluates for any possible impairment using either the discounted cash flows method, where the value of the modified loan is based on the present value of expected cash flows, discounted at the contractual interest rate of the original loan agreement, or by using the fair value of the collateral less selling costs if the loan is collateral-dependent. If management determines that the value of the modified loan is less than the recorded investment in the loan, impairment is recognized by segment or class of loan, as applicable, through an allowance estimate or charge-off to the allowance. This process is used, regardless of loan type, and for loans modified as TDRs that subsequently default on their modified terms.

TDRs of $1.1 million and $3.3 million are included in the impaired loan numbers as of March 31, 2016 and December 31, 2015, respectively. The decrease was due to the payoff of two loans and principal pay downs. At March 31, 2016, there were specific reserves of $78 thousand on TDRs, $38 thousand on performing TDRs and $40 thousand on nonperforming TDRs. At December 31, 2015, there were specific reserves of $208 thousand on TDRs, $167 thousand on performing TDRs and $41 thousand on nonperforming TDRs. At March 31, 2016 and December 31, 2015, $293 thousand of TDRs were in nonaccrual status. The remaining TDRs are in accrual status since they continue to perform in accordance with their restructured terms.

To date, the Company’s TDRs consisted of interest rate reductions and maturity extensions. There has been no principal forgiveness. There were no loans modified during the three months ended March 31, 2016 and 2015 that were deemed to be TDRs.

There were no loans modified as a TDR within the previous 12 months that subsequently defaulted at some point during the three months ended March 31, 2016. In this case, the subsequent default is defined as 90 days past due or transferred to nonaccrual status.