Loans and Allowance for Loan and Lease Losses

The major components of loans in the consolidated balance sheets at March 31, 2014 and December 31, 2013 are as follows:



In thousands	3/31/2014			12/31/2013
Commercial	$	93,791		$	88,119
Real estate:
Commercial real estate	282,734			278,215
Construction real estate	44,787			44,368
Residential real estate	159,390			155,280
Consumer	4,062			4,336
Deferred loan fees, net	(7		)	42
Gross loans	584,757			570,360
Allowance for loan losses	(6,425		)	(7,200		)
Net loans	$	578,332		$	563,160

Substantially all one-four family residential and commercial real estate loans collateralize the line of credit available from the Federal Home Loan Bank and substantially all commercial and construction loans collateralize the line of credit with the Federal Reserve Bank of Richmond Discount Window. The aggregate amount of deposit overdrafts that have been reclassified as loans and included in the consumer category in the above table as of March 31, 2014 and December 31, 2013 was $76 and $82, respectively.

Loan Origination. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management and the Board of Directors review and approve these policies and procedures on a periodic basis. A reporting system supplements the review process by providing management and the Board of Directors with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower’s management possesses sound ethics and solid business acumen, the Company’s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate market or in the general economy. Management monitors and evaluates commercial real estate loans based on collateral and risk grade criteria. In addition, management tracks the level of owner-occupied commercial real estate loans versus income producing loans. At March 31, 2014, approximately 41% of the outstanding principal balance of the Company’s commercial real estate loans was secured by owner-occupied properties and 50% was secured by income-producing properties.

With respect to construction and development loans that the Company may originate from time to time, the Company generally requires the borrower to have had an existing relationship with the Company and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by recurring on-site inspections during the construction phase and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

Residential real estate loans are secured by deeds of trust on 1-4 family residential properties. The Bank also serves as a broker for residential real estate loans placed in the secondary market. There are occasions when a borrower or the real estate does not qualify under secondary market criteria, but the loan request represents a reasonable credit risk. On these occasions, if the loan meets the Bank’s internal underwriting criteria, the loan will be closed and placed in the Company’s portfolio. Residential real estate loans carry risk associated with the continued credit-worthiness of the borrower and changes in the value of collateral.

The Company routinely makes consumer loans, both secured and unsecured, for financing automobiles, home improvements, education, and personal investments. The credit history, cash flow and character of individual borrowers is evaluated as a part of the credit decision. Loans used to purchase vehicles or other specific personal property and loans associated with real estate are usually secured with a lien on the subject vehicle or property. Negative changes in a customer’s financial circumstances due to a large number of factors, such as illness or loss of employment, can place the repayment of a consumer loan at risk. In addition, deterioration in collateral value can add risk to consumer loans.

Risk Management. It is the Company’s policy that loan portfolio credit risk shall be continually evaluated and categorized on a consistent basis. The Board of Directors recognizes that commercial, commercial real estate and construction lending involve varying degrees of risk, which must be identified, managed, and monitored through established risk rating procedures. Management’s ability to accurately segment the loan portfolio by the various degrees of risk enables the Bank to achieve the following objectives:


1.	Assess the adequacy of the Allowance for Loan and Lease Losses;


2.	Identify and track high risk situations and ensure appropriate risk management;


3.	Conduct portfolio risk analysis and make informed portfolio planning and strategic decisions; and


4.	Provide risk profile information to management, regulators and independent accountants as requested in a timely manner.

There are three levels of accountability in the risk rating process:

Risk Identification - The primary responsibility for risk identification lies with the account officer. It is the account officer's responsibility for the initial and ongoing risk rating of all notes and commitments in his or her portfolio. The account officer is the one individual who is closest to the credit relationship and is in the best position to identify changing risks. Account officers are required to continually review the risk ratings for their credit relationships and make timely adjustments, up or down, at the time the circumstances warrant a change. Account officers are responsible for ensuring that accurate and timely risk ratings are maintained at all times. Account officers are allowed a maximum 30-day period to assess current financial information (e.g. prepare credit analysis) which may influence the current risk rating. Account officers are required to review the risk ratings of loans assigned to their portfolios on a monthly basis and to certify to the accuracy of the ratings. Certifications are submitted to the Chief Credit Officer and Chief Lending Officer for review. All risk rating changes (upgrades and downgrades) must be approved by the Chief Credit Officer prior to submission for input into the Commercial Loan System.

Risk Supervision - In addition to the account officer’s process of assigning and managing risk ratings, the Chief Credit Officer is responsible for periodically reviewing the risk rating process employed by the account officers. Through credit administration, the Chief Credit Officer manages the credit process which, among other things, includes maintaining and managing the risk identification process. The Chief Credit Officer is responsible for the accuracy and timeliness of account officer risk ratings and has the authority to override account officer risk ratings and initiate rating changes, if warranted. Upgrades from a criticized or classified category to a pass category or upgrades within the criticized/classified categories require the approval of the Senior Loan Committee or Directors’ Loan Committee based upon aggregate exposure. Upgrades must be reported to the Directors' Loan Committee and Board of Directors at their next scheduled meetings.

Risk Monitoring - Valley Bank has a loan review program to provide an independent validation of portfolio quality. This independent review is intended to assess adherence to underwriting guidelines, proper credit analysis and documentation. In addition, the loan review process is required to test the integrity, accuracy, and timeliness of account officer risk ratings and to test the effectiveness of the credit administration function's controls over the risk identification process. Portfolio quality and risk rating accuracy are evaluated during regularly scheduled portfolio reviews. Risk Management is required to report all loan review findings to the quarterly joint meeting of the Audit Committee and Directors’ Loan Committee.

Related party loans. In the ordinary course of business, the Company has granted loans to certain directors, executive officers, significant shareholders and their affiliates (collectively referred to as “related parties”). These loans were made on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other unaffiliated persons, and do not involve more than normal credit risk or present other unfavorable features.

Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. The following schedule is an aging of past due loans receivable by portfolio segment as of March 31, 2014 and December 31, 2013:



In thousands	30 - 59 Days Past Due		60 - 89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current			Total Loans			Recorded Investment > 90 Days, Accruing
March 31, 2014
Commercial	$	40	$	0	$	201	$	241	$	93,550		$	93,791		$	0
Commercial real estate
Owner occupied	468		0		0		468		115,041			115,509			0
Income producing	0		0		0		0		142,378			142,378			0
Multifamily	0		0		0		0		24,847			24,847			0
Construction real estate
1 - 4 Family	79		0		0		79		17,278			17,357			0
Other	0		0		2,030		2,030		24,032			26,062			0
Farmland	0		0		0		0		1,368			1,368			0
Residential real estate
Equity Lines	113		0		403		516		26,068			26,584			349
1 - 4 Family	0		1		35		36		124,914			124,950			0
Junior Liens	35		0		0		35		7,821			7,856			0
Consumer
Credit Cards	7		0		0		7		1,272			1,279			0
Other	20		0		5		25		2,758			2,783			0
Deferred loan fees, net	0		0		0		0		(7		)	(7		)	0
Total	$	762	$	1	$	2,674	$	3,437	$	581,320		$	584,757		$	349



In thousands	30 - 59 Days Past Due		60 - 89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 Days, Accruing
December 31, 2013
Commercial	$	186	$	0	$	384	$	570	$	87,549	$	88,119	$	0
Commercial real estate
Owner occupied	0		0		0		0		116,137		116,137		0
Income producing	0		20		0		20		137,319		137,339		0
Multifamily	0		0		0		0		24,739		24,739		0
Construction real estate
1 - 4 Family	5		0		0		5		17,434		17,439		0
Other	0		0		3,161		3,161		22,285		25,446		0
Farmland	0		0		0		0		1,483		1,483		0
Residential real estate
Equity Lines	449		0		54		503		26,731		27,234		0
1 - 4 Family	174		156		0		330		119,736		120,066		0
Junior Liens	44		0		0		44		7,936		7,980		0
Consumer
Credit Cards	13		0		0		13		1,316		1,329		0
Other	10		0		5		15		2,992		3,007		0
Deferred loan fees, net	0		0		0		0		42		42		0
Total	$	881	$	176	$	3,604	$	4,661	$	565,699	$	570,360	$	0

As noted in the chart above, the Company reduced total past due loans from December 31, 2013 to March 31, 2014 by $1,224 or 26% from $4,661 to $3,437.

Nonaccrual Loans. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. Loans will be placed on nonaccrual status automatically when principal or interest is past due 90 days or more, unless the loan is both well secured and in the process of collection. In this case, the loan will continue to accrue interest despite its past due status. When interest accrual is discontinued, all unpaid accrued interest is reversed and any subsequent payments received are applied to the outstanding principal balance. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. The following is a schedule of loans receivable, by portfolio segment, on nonaccrual status as of March 31, 2014 and December 31, 2013:



In thousands	March 31, 2014		December 31, 2013
Commercial	$	201	$	383
Construction real estate
Other	2,029		3,161
Residential real estate
Equity Lines	54		54
1 - 4 Family	35		62
Consumer
Other	5		5
Total	$	2,324	$	3,665

Had nonaccrual loans performed in accordance with their original contract terms, the Company would have recognized additional interest income in the amount of $42 during the three months ended March 31, 2014; $222 during the year ended December 31, 2013, and $106 during the three months ended March 31, 2013. There were four restructured loans totaling $2,885 at March 31, 2014 and there were four restructured loans totaling $2,922 at December 31, 2013.

Impaired Loans. Impaired loans are identified by the Company as loans in which it is determined to be probable that the borrower will not make interest and principal payments according to the contract terms of the loan. In determining impaired loans, our credit administration department reviews past-due loans, examiner classifications, Bank classifications, and a selection of other loans to provide evidence as to whether the loan is impaired. All loans rated as substandard are evaluated for impairment by the Bank’s Allowances for Loan and Lease Losses (“ALLL”) Committee. Once classified as impaired, the ALLL Committee individually evaluates the total loan relationship, including a detailed collateral analysis, to determine the reserve appropriate for each one. Any potential loss exposure identified in the collateral analysis is set aside as a specific reserve (valuation allowance) in the allowance for loan and lease losses. If the impaired loan is subsequently resolved and it is determined the reserve is no longer required, the specific reserve will be taken back into income during the period the determination is made. Impaired loans, or portions thereof, are charged off when deemed uncollectible. Impaired loans as of March 31, 2014 and December 31, 2013 are set forth in the following table:



In thousands	Recorded Investment		Unpaid Principal Balance (1)		Related Allowance		Average Recorded Investment		Interest Income Recognized
March 31, 2014
With no related allowance:
Commercial	$	1,637	$	1,925	$	0	$	1,729	$	17
Commercial real estate
Owner occupied	5,152		5,152		0		5,172		82
Income producing	4,508		4,508		0		4,523		70
Construction real estate
1 - 4 Family	580		580		0		580		7
Other	5,591		8,708		0		6,500		48
Farmland	169		169		0		170		2
Residential real estate
Equity Lines	493		500		0		493		5
1 - 4 Family	467		549		0		553		6
Consumer
Other	11		16		0		17		0
Total loans with no allowance	$	18,608	$	22,107	$	0	$	19,737	$	237

Total loans with an allowance	$	0	$	0	$	0	$	0	$	0
Total:
Commercial	$	1,637	$	1,925	$	0	$	1,729	$	17
Commercial real estate	9,660		9,660		0		9,695		152
Construction real estate	6,340		9,457		0		7,250		57
Residential real estate	960		1,049		0		1,046		11
Consumer	11		16		0		17		0
Totals	$	18,608	$	22,107	$	0	$	19,737	$	237



In thousands	Recorded Investment		Unpaid Principal Balance (1)		Related Allowance		Average Recorded Investment		Interest Income Recognized
December 31, 2013
With no related allowance:
Commercial	$	1,570	$	1,706	$	0	$	1,433	$	50
Commercial real estate
Owner occupied	5,182		5,182		0		5,249		340
Income producing	4,538		4,538		0		4,577		287
Construction real estate
1 - 4 Family	580		580		0		489		23
Other	4,294		6,279		0		4,457		206
Farmland	171		171		0		175		10
Residential real estate
Equity Lines	493		500		0		499		21
1 - 4 Family	473		530		0		543		26
Consumer
Other	13		18		0		21		2
Total loans with no allowance	$	17,314	$	19,504	$	0	$	17,443	$	965
With an allowance recorded:
Construction real estate
Other	$	2,566	$	2,566	$	1,337	$	2,566	$	0
Residential real estate
1 - 4 Family	26		26		20		26		1
Total loans with an allowance	$	2,592	$	2,592	$	1,357	$	2,592	$	1
Total:
Commercial	$	1,570	$	1,706	$	0	$	1,433	$	50
Commercial real estate	9,720		9,720		0		9,826		627
Construction real estate	7,611		9,596		1,337		7,687		239
Residential real estate	992		1,056		20		1,068		48
Consumer	13		18		0		21		2
Totals	$	19,906	$	22,096	$	1,357	$	20,035	$	966

⁽¹⁾ Balances transferred to foreclosed assets are not included as unpaid principal balance.

Cash basis interest income on impaired loans was $247 for the three months ended March 31, 2014 and $1,011 for the year ended December 31, 2013.

Credit Quality Indicators. The Company categorizes loans and leases into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. This categorization is made on all commercial, commercial real estate and construction and development loans. The Company analyzes loans and leases individually by classifying the loans and leases as to credit risk. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings:

Risk rated 1

Highest Caliber Credit – to qualify as a “1”, a credit must be either fully secured by cash or secured by a portfolio of marketable securities within margin.

Risk rated 2

Very High Caliber Credit – to qualify as a “2”, a credit must be a borrower within an industry exhibiting strong trends. The borrower must be a highly-rated individual or company whose management, profitability, liquidity, and leverage are very strong and above industry averages. Borrower should show substantial liquidation net worth and income or alternative fund sources to retire the debt as agreed.

Risk rated 3

High Caliber Credit - to qualify as a “3”, the criteria of management, industry, profitability, liquidity, and leverage must be generally strong and comparable to industry averages. Borrower should show above average liquidation net worth and sufficient income or alternative fund sources to retire the debt as agreed.

Risk rated 4

Satisfactory Credit – to qualify as a “4”, a credit should be performing relatively close to expectations, with adequate evidence that the borrower is continuing to generate adequate cash flow to service debt. There should be no significant departure from the intended source and timing of repayment, and there should be no undue reliance on secondary sources of repayment. To the extent that some variance exists in one or more criteria being measured, it may be offset by the relative strength of other factors and/or collateral pledged to secure the transaction. A credit secured by a portfolio of marketable securities in an out-of-margin condition would qualify as a “4”. Borrower should show average liquidation net worth and income sufficient to retire the debt on an amortizing basis.

Risk rated 5

Monitored Satisfactory Credit – there are certain satisfactory credits, which have elements of risk that the Bank chooses to monitor formally. The objective of the monitoring process is to assure that no weaknesses develop in credits with certain financial or operating leverage, or credits, which are subject to cyclical economic or variable industry conditions. Also included in this category are credits with positive operating trends and satisfactory financial conditions, which are achieving performance expectations at a slower pace than anticipated. This rating may also include loans which exhibit satisfactory credit quality but which are improperly structured as evidenced by excessive renewals, unusually long repayment schedules, the lack of a specific repayment plan, or which exhibit loan policy exceptions or documentation deficiencies.

Risk rated 6

Special Mention – assets in this category are still adequately protected by the borrower’s capital adequacy and payment capability, but exhibit distinct weakening trends and/or elevated levels of exposure to external conditions. If left unchecked or uncorrected, these potential weaknesses may result in deteriorated prospects of repayment. These exposures require management’s close attention so as to avoid becoming undue or unwarranted credit exposures.

Risk rated 7

Substandard - substandard loans are inadequately protected by the borrower’s current financial condition and payment capability or of the collateral pledged, if any. Loans and leases so classified have a well-defined weakness or weaknesses that jeopardize the orderly repayment of debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

Risk rated 8

Doubtful – an asset classified as doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Possibility of loss is extremely high, but because of certain important and reasonably specific factors that may work to the advantage and strengthening of the exposure, its classification as an estimate loss is deferred until its more exact status may be determined.

Risk rated 9

Loss – assets classified as loss are considered to be non-collectible and of such little value that their continuance as bankable assets is not warranted. This does not mean the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future. Losses are taken in the period in which they surface as uncollectible.

As of March 31, 2014 and December 31, 2013, and based on the most recent analysis performed at those dates, the risk category of loans and leases is as follows:



Internal Risk Rating Grades
In thousands	1-4		5		6		7		8
March 31, 2014
Commercial	$	28,004	$	63,142	$	1,008	$	1,436	$	201
Commercial real estate
Owner occupied	35,889		69,748		2,931		6,941		0
Income producing	19,585		110,230		3,098		9,465		0
Multifamily	13,615		11,232		0		0		0
Construction real estate
1 - 4 Family	3,841		10,858		1,072		1,586		0
Other	124		17,414		565		6,524		1,435
Farmland	217		982		0		169		0
Totals	$	101,275	$	283,606	$	8,674	$	26,121	$	1,636
Total:
Commercial	$	28,004	$	63,142	$	1,008	$	1,436	$	201
Commercial real estate	69,089		191,210		6,029		16,406		0
Construction real estate	4,182		29,254		1,637		8,279		1,435
Totals	$	101,275	$	283,606	$	8,674	$	26,121	$	1,636



December 31, 2013
Commercial	$	22,054	$	63,329	$	765	$	1,971	$	0
Commercial real estate
Owner occupied	36,025		70,048		2,694		7,370		0
Income producing	14,921		110,200		3,155		9,063		0
Multifamily	13,690		11,049		0		0		0
Construction real estate
1 - 4 Family	3,921		10,809		1,129		1,580		0
Other	874		14,943		441		9,188		0
Farmland	220		1,092		0		171		0
Totals	$	91,705	$	281,470	$	8,184	$	29,343	$	0
Total:
Commercial	$	22,054	$	63,329	$	765	$	1,971	$	0
Commercial real estate	64,636		191,297		5,849		16,433		0
Construction real estate	5,015		26,844		1,570		10,939		0
Totals	$	91,705	$	281,470	$	8,184	$	29,343	$	0

The loan classified as doubtful (risk rated 8) at March 31, 2014 is secured by land that is currently involved in litigation between the land owner and the Virginia Department of Transportation ("VDOT") regarding an imminent domain action brought by VDOT. The current appraisal supports the carrying value at March 31, 2014. There are no loans classified as 9 as of March 31, 2014 or December 31, 2013.

All consumer-related loans, including residential real estate are evaluated and monitored based upon payment activity. Once a consumer-related loan becomes past due on a recurring basis, the Company will pull that loan out of the homogenized pool and evaluate it individually for impairment. At this time, the consumer-related loan may be placed on the Company’s internal watch list and risk rated either special mention or substandard, depending upon the individual circumstances.



Risk Based on Payment Activity	Performing				Non-Performing
In thousands	3/31/2014		12/31/2013		3/31/2014		12/31/2013
Residential real estate
Equity Lines	$	26,181	$	27,180	$	403	$	54
1 - 4 Family	124,915		120,004		35		62
Junior Liens	7,856		7,980		0		0
Consumer
Credit Cards	1,279		1,329		0		0
Other	2,778		3,002		5		5
Totals	$	163,009	$	159,495	$	443	$	121
Total:
Residential real estate	$	158,952	$	155,164	$	438	$	116
Consumer	4,057		4,331		5		5
Totals	$	163,009	$	159,495	$	443	$	121

Allowance for Loan Losses

The allowance for possible loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans.

The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including, among other things, the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.

The Company’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with accounting principles regarding receivables based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with accounting principles regarding contingencies based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with accounting principles regarding contingencies based on general economic conditions and other qualitative risk factors both internal and external to the Company.

Specific Valuation

The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. When a loan is added to the internal watch list, the ALLL Committee analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, and economic conditions affecting the borrower’s industry, among other things.

Historical Valuation

Historical valuation allowances are calculated based on the historical loss experience of specific types of loans at the time they were charged-off. The Company uses a rolling 8-quarter analysis to determine its historical loss ratio for the specific pool. The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the average balance of loans in the pool for the respective quarter. The loss factors used at March 31, 2014 and December 31, 2013 are as follows:



	3/31/2014	12/31/2013
Commercial	0.30%	0.21%
Commercial real estate - Owner occupied	0.00%	0.00%
Commercial real estate - Income producing	0.00%	0.00%
Commercial real estate - Multifamily	0.00%	0.00%
Construction real estate - 1-4 Family	0.39%	0.42%
Construction real estate - Other	4.43%	2.23%
Construction real estate - Farmland	0.00%	0.00%
Residential real estate - Equity lines	0.26%	0.26%
Residential real estate - 1-4 Family	0.17%	0.36%
Residential real estate - Junior Liens	0.00%	0.00%
Consumer & credit cards	0.73%	0.59%
Loans held for sale	0.00%	0.00%

The Company applies the historical loss ratios to balances of all loans within each category to establish the reserve needed for this section of the allowance calculation. All impaired loans are excluded from this calculation as they are individually evaluated in the specific valuation section as described above.

As can be seen from the above table, the loss factors changed in several categories at March 31, 2014 as compared to December 31, 2013 based upon historical charge-offs experienced during the respective 8-quarter look-back periods. The most significant change is in the construction real estate - other category as $1.1 million of the $1.3 million net charge-offs for the first quarter of 2014 were in this category. The net effect of these changes is an approximate $343 increase in the reserve requirement for the historical valuation section of the allowance calculation at March 31, 2014.

General Valuation

General valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) levels and trends in credit quality; (ii) trends in the volume of loans; (iii) the experience, ability and effectiveness of the bank’s lending management and staff; (iv) local economic trends and conditions; (v) credit concentration risk; (vi) current industry conditions; (vii) real estate market conditions; (viii) and large relationship credit risk. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Each component is determined to have either a high, moderate or low degree of risk. The results are then input into a general allocation matrix to determine an appropriate general valuation allowance, based on the risk assessment performed by management and the loss factors established. Loans identified as losses by management, internal loan review and/or regulatory examiners are charged-off.

During the first quarter of 2014, the Company increased the risk assessment from medium to high for its credit quality environmental factor listed below to correspond with the Federal Reserve Board's risk assessment which was based primarily upon the high inherent risk associated with credit risk in conjunction with the Bank's elevated level of nonperforming assets, despite the fact that the majority of the Company's nonperforming assets are concentrated in the foreclosed asset portfolio. Management believes a nonperforming asset to total assets ratio of below 2% will warrant a reduction to medium risk. Additionally, in comparison to December 31, 2013, the Company increased the loss factor for its trend in volume of loans due to the 7.1% growth rate during the past 12-month period. Finally, the Company reduced the loss factor on local economic trends and conditions due to continued improvement in employment numbers as well as the improving housing market in the Roanoke MSA. The net effect of these changes is an approximate $183 increase in the environmental factor section of the allowance calculation at both the high and low ends of the range.



Environmental Factors	3/31/2014	12/31/2013
Levels and trends in credit quality	0.20%	0.15%
Trends in volume of loans	1.25%	1.00%
Experience, ability, and depth of lending management and staff	0.00%	0.00%
Local economic trends and conditions	0.20%	0.25%
Credit concentration risk	0.05%	0.05%
Current industry conditions/general economic conditions	0.10%	0.10%
Commercial Real Estate Devaluation	0.25%	0.25%
Residential Real Estate Devaluation	0.15%	0.15%
Credit concentration risk - large relationships > $8 Million	0.30%	0.30%

All impaired loans are excluded from this calculation as they are individually evaluated in the specific valuation section as described above. The loss factors are multiplied by the loan balances related to each environmental factor at quarter-end. Therefore for example, only commercial real estate balances are used in the determination for the estimated loss for the commercial real estate devaluation factor.

As a result of the Company's analysis, changes in the allowance for loan losses for the three months ended March 31, 2014 by segment are as follows:



In thousands	Beginning										Ending
March 31, 2014	Balance		Charge-offs			Recoveries		Provision			Balance
Commercial	$	544	$	(157	)	$	2	$	226		$	615
Commercial real estate	2,587		0			0		200			2,787
Construction real estate	2,894		(1,132		)	12		259			2,033
Residential real estate	1,081		(25		)	8		(235		)	829
Consumer	50		(2		)	1		13			62
Unallocated	44		0			0		55			99
Total	$	7,200	$	(1,316	)	$	23	$	518		$	6,425

The reduction in the residential real estate category is driven by the reduction in the historical loss ratio for the 1-4 Family category which decreased from 0.36% at December 31, 2013 to 0.17% at March 31, 2014.

As of March 31, 2014 and December 31, 2013, loans individually and collectively evaluated for impairment, by loan portfolio segment, and the corresponding allowance are as follows:



	Individually Evaluated for Impairment
	3/31/2014				12/31/2013
In thousands	Allowance		Total Loans		Allowance		Total Loans
Commercial	$	0	$	1,637	$	0	$	1,570
Commercial real estate	0		9,660		0		9,720
Construction real estate	0		6,340		1,337		7,611
Residential real estate	0		960		20		992
Consumer	0		11		0		13
Total	$	0	$	18,608	$	1,357	$	19,906



	Collectively Evaluated for Impairment
	3/31/2014					12/31/2013
In thousands	Allowance		Total Loans			Allowance		Total Loans
Commercial	$	615	$	92,154		$	544	$	86,549
Commercial real estate	2,787		273,074			2,587		268,495
Construction real estate	2,033		38,447			1,557		36,757
Residential real estate	829		158,430			1,061		154,288
Consumer	62		4,051			50		4,323
Unallocated	99		(7		)	44		42
Total	$	6,425	$	566,149		$	5,843	$	550,454

Troubled Debt Restructurings ("TDRs”)

Modifications of terms for loans and their inclusion as TDRs are based on individual facts and circumstances. Loan modifications that are included as TDRs may involve either an increase or reduction of the interest rate, extension of the term of the loan, or deferral of principal payments, regardless of the period of the modification. The loans included in all loan classes as TDRs at March 31, 2014 had either an interest rate modification or a deferral of principal payments, which we consider to be a concession. All loans designated as TDRs were modified due to financial difficulties experienced by the borrower.

There were no TDRs identified during the three months ending March 31, 2014 and 2013.

TDR Defaults are those TDRs that were greater than 90 days past due, and aligns with our internal definition of default for those loans not identified as TDRs. The Company did not experience any TDR defaults during the three month periods ended March 31, 2014 or 2013.