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 June 30, 2016 and December 31, 2015:



(In thousands)	June 30, 2016		December 31, 2015
SBA loans held for investment	$	40,006	$	39,393
SBA 504 loans	27,038		29,353
Commercial loans
Commercial other	51,981		49,332
Commercial real estate	396,480		391,071
Commercial real estate construction	33,252		25,115
Residential mortgage loans	268,774		264,523
Consumer loans
Home equity	44,518		45,042
Consumer other	39,749		32,015
Total loans held for investment	$	901,798	$	875,844
SBA loans held for sale	13,245		13,114
Total loans	$	915,043	$	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. 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 June 30, 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 $4.5 million of residential consumer loans in the process of foreclosure at June 30, 2016 and 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 June 30, 2016:



	June 30, 2016
	SBA, SBA 504 & Commercial loans - Internal risk ratings
(In thousands)	Pass		Special mention		Substandard		Total
SBA loans held for investment	$	36,748	$	1,435	$	1,823	$	40,006
SBA 504 loans	23,555		2,829		654		27,038
Commercial loans
Commercial other	48,721		1,731		1,529		51,981
Commercial real estate	380,332		15,659		489		396,480
Commercial real estate construction	32,225		721		306		33,252
Total commercial loans	461,278		18,111		2,324		481,713
Total SBA, SBA 504 and commercial loans	$	521,581	$	22,375	$	4,801	$	548,757

	Residential mortgage & Consumer loans - Performing/Nonperforming
(In thousands)			Performing		Nonperforming		Total
Residential mortgage loans			$	267,185	$	1,589	$	268,774
Consumer loans
Home equity			44,019		499		44,518
Consumer other			39,749		—		39,749
Total consumer loans			83,768		499		84,267
Total residential mortgage and consumer loans			$	350,953	$	2,088	$	353,041

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 June 30, 2016 and December 31, 2015:



	June 30, 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	$	763	$	315	$	—	$	1,616	$	2,694	$	37,312	$	40,006
SBA 504 loans	—		—		—		513		513		26,525		27,038
Commercial loans
Commercial other	2		—		—		1,529		1,531		50,450		51,981
Commercial real estate	2,065		11		—		489		2,565		393,915		396,480
Commercial real estate construction	—		—		—		306		306		32,946		33,252
Residential mortgage loans	1,989		1,061		485		1,589		5,124		263,650		268,774
Consumer loans
Home equity	280		—		—		499		779		43,739		44,518
Consumer other	—		—		—		—		—		39,749		39,749
Total loans held for investment	$	5,099	$	1,387	$	485	$	6,541	$	13,512	$	888,286	$	901,798
SBA loans held for sale	—		—		—		—		—		13,245		13,245
Total loans	$	5,099	$	1,387	$	485	$	6,541	$	13,512	$	901,531	$	915,043


(1)	At June 30, 2016, nonaccrual loans included $161 thousand of TDRs and $134 thousand of loans guaranteed by the SBA. The remaining $772 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 June 30, 2016:



	June 30, 2016
(In thousands)	Unpaid principal balance		Recorded investment		Specific reserves
With no related allowance:
SBA loans held for investment (1)	$	1,097	$	719	$	—
SBA 504 loans	513		513		—
Commercial loans
Commercial other	922		922		—
Commercial real estate	1,226		1,226		—
Commercial real estate construction	356		306		—
Total commercial loans	2,504		2,454		—
Total impaired loans with no related allowance	4,114		3,686		—

With an allowance:
SBA loans held for investment (1)	1,457		798		415
Commercial loans
Commercial other	620		607		274
Commercial real estate	—		—		—
Commercial real estate construction	—		—		—
Total commercial loans	620		607		274
Total impaired loans with a related allowance	2,077		1,405		689

Total individually evaluated impaired loans:
SBA loans held for investment (1)	2,554		1,517		415
SBA 504 loans	513		513		—
Commercial loans
Commercial other	1,542		1,529		274
Commercial real estate	1,226		1,226		—
Commercial real estate construction	356		306		—
Total commercial loans	3,124		3,061		274
Total individually evaluated impaired loans	$	6,191	$	5,091	$	689


(1)	Balances are reduced by amount guaranteed by the SBA of $134 thousand at June 30, 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 and six months ended June 30, 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 June 30,
	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)	$	1,640	$	1	$	1,873	$	2
SBA 504 loans	513		—		1,996		26
Commercial loans
Commercial other	929		14		1,073		38
Commercial real estate	1,273		19		4,521		9
Commercial real estate construction	339		—		—		—
Total	$	4,694	$	34	$	9,463	$	75


(1)	Balances are reduced by the average amount guaranteed by the SBA of $218 thousand and $269 thousand for the three months ended June 30, 2016 and 2015, respectively.



	For the six months ended June 30,
	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)	$	1,822	$	3	$	1,935	$	39
SBA 504 loans	1,082		—		2,933		53
Commercial loans
Commercial other	496		38		1,095		56
Commercial real estate	1,662		31		4,778		71
Commercial real estate construction	288		—		—		—
Total	$	5,350	$	72	$	10,741	$	219


(1)	Balances are reduced by the average amount guaranteed by the SBA of $241 thousand and $534 thousand for the six months ended June 30, 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 $933 thousand and $3.3 million are included in the impaired loan numbers as of June 30, 2016 and December 31, 2015, respectively. The decrease was due to the payoff of three loans and principal pay downs. At June 30, 2016, there were specific reserves of $70 thousand on TDRs, $35 thousand on performing TDRs and $35 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 June 30, 2016, $161 thousand of TDRs were in nonaccrual status, compared to $293 thousand at December 31, 2015. 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 or six months ended June 30, 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 or six months ended June 30, 2016. In this case, the subsequent default is defined as 90 days past due or transferred to nonaccrual status.