NOTE 4 – ALLOWANCE FOR LOAN LOSSES AND CREDIT QUALITY OF FINANCING RECEIVABLES

The following table presents changes in the allowance for loan losses disaggregated by the class of loans receivable for the three and nine months ended September 30, 2012 and 2011:



	Commercial					Commercial		Residential		Consumer
	and					Real		Real		and
(Dollars in thousands)	Industrial			Construction		Estate		Estate		Other		Unallocated		Total

Three Months Ended:
September 30, 2012
Beginning balance	$	430		$	170	$	4,547	$	1,055	$	11	$	47	$	6,260
Charge-offs		-			(122)		(264)		(266)		(8)		-		(660)
Recoveries		-			-		2		-		15		-		17
Provision		183			131		153		393		(10)		254		1,104
Ending balance	$	613			179		4,438		1,182		8		301		6,721

September 30, 2011
Beginning balance	$	428		$	969	$	4,773	$	945	$	45	$	376	$	7,536
Charge-offs		-			-		(868)		-		(10)		-		(878)
Recoveries		1			-		1		-		4		-		6
Provision		58			435		327		58		(1)		(140)		737
Ending balance	$	487		$	1,404	$	4,233	$	1,003	$	38	$	236	$	7,401

	Commercial					Commercial		Residential		Consumer
	and					Real		Real		and
(Dollars in thousands)	Industrial			Construction		Estate		Estate		Other		Unallocated		Total

Nine Months Ended:
September 30, 2012
Beginning balance	$		304		294		4,833		987		9		783	$	7,210
Charge-offs			-		(830)		(2,081)		(546)		(53)		-		(3,510)
Recoveries			2		-		71		-		26		-		99
Provision			307		715		1,615		741		26		(482)		2,922
Ending balance	$		613	$	179	$	4,438	$	1,182	$	8	$	301	$	6,721

September 30, 2011
Beginning balance	$		436	$	1,183	$	3,760	$	798	$	56	$	164	$	6,397
Charge-offs			(13)		(909)		(1,263)		(12)		(33)		-		(2,230)
Recoveries			4		516		9		-		17		-		546
Provision			60		614		1,727		217		(2)		72		2,688
Ending balance	$		487	$	1,404	$	4,233	$	1,003	$	38	$	236	$	7,401

The following table presents the balance in the allowance of loan losses at September 30, 2012, and December 31, 2011 disaggregated on the basis of our impairment method by class of loans receivable along with the balance of loans receivable by class disaggregated on the basis of our impairment methodology.



	Allowance for Loan Losses						Loans Receivable
			Balance		Balance
			Related to		Related to
			Loans		Loans
			Individually		Collectively				Individually		Collectively
			Evaluated for		Evaluated for				Evaluated for		Evaluated for
(Dollars in thousands)	Balance		Impairment		Impairment		Balance		Impairment		Impairment

September 30, 2012
Commercial and industrial	$	613	$	382	$	231	$	13,244	$	396	$	12,848
Construction		179		133		46		6,679		4,507		2,172
Commercial real estate		4,438		1,399		3,039		222,525		17,219		205,306
Residential real estate		1,182		363		819		96,916		2,988		93,928
Consumer and other		8		-		8		1,347		-		1,347
Unallocated		301		-		-		-		-		-
Total	$	6,721	$	2,277	$	4,143	$	340,711	$	25,110	$	315,601

December 31, 2011
Commercial and industrial	$	304	$	16	$	288	$	13,711	$	32	$	13,679
Construction		294		50		244		8,520		2,458		6,062
Commercial real estate		4,833		1,572		3,261		216,191		22,722		193,469
Residential real estate		987		319		668		100,175		2,482		97,693
Consumer and other		9		-		9		1,336		-		1,336
Unallocated		783		-		-		-		-		-
Total	$	7,210	$	1,957	$	4,470	$	339,933	$	27,694	$	312,239

An age analysis of loans receivable which were past due as of September 30, 2012, and December 31, 2011 is as follows:



													Recorded
													Investment
					Greater						Total		> 90 Days
	30-59 Days		60-89 days		Than		Total Past				Financing		and
(Dollars in thousands)	Past Due		Past Due		90 Days (a)		Due		Current		Receivables		Accruing

September 30, 2012
Commercial and industrial	$	-	$	-	$	396	$	396	$	12,848	$	13,244	$	2
Construction		-		-		4,507		4,507		2,172		6,679		-
Commercial real estate		4,617		1,306		16,164		22,087		200,438		222,525		57
Residential real estate		665		445		2,984		4,094		92,822		96,916		-
Consumer and other		5		2		1		8		1,339		1,347		-
Total	$	5,287	$	1,753	$	24,052	$	31,092	$	309,619	$	340,711	$	59

December 31, 2011
Commercial and industrial	$	428	$	-	$	32	$	460	$	13,251	$	13,711	$	-
Construction		558		-		3,243		3,801		4,719		8,520		785
Commercial real estate		5,238		137		19,311		24,686		191,505		216,191		-
Residential real estate		940		-		2,482		3,422		96,753		100,175		-
Consumer and other		17		1		18		36		1,300		1,336		18
Total	$	7,181	$	138	$	25,086	$	32,405	$	307,528	$	339,933	$	803

(a) includes loans greater than 90 days past due and still accruing and non-accrual loans.

Loans for which the accrual of interest has been discontinued at September 30, 2012, and December 31, 2011 were:



(Dollars in thousands)	September 30, 2012		December 31, 2011

Commercial and industrial	$	394	$	32
Construction		4,507		2,458
Commercial real estate		16,107		19,311
Residential real estate		2,984		2,482
Consumer and other		1		-
Total	$	23,993	$	24,283

In determining the adequacy of the allowance for loan losses, we estimate losses based on the identification of specific problem loans through our credit review process and we also estimate losses inherent in other loans on an aggregate basis by loan type. The credit review process includes the independent evaluation of the loan officer assigned risk ratings by the Chief Credit Officer and a third party loan review company. Such risk ratings are assigned loss component factors that reflect our loss estimate for each group of loans. It is management’s and the board of directors’ responsibility to oversee the lending process to ensure that all credit risks are properly identified, monitored, and controlled, and that loan pricing, terms, and other safeguards against non-performance and default are commensurate with the level of risk undertaken and is rated as such based on a risk-rating system. Factors considered in assigning risk ratings and loss component factors include: borrower specific information related to expected future cash flows and operating results, collateral values, financial condition, payment status and other information; levels of and trends in portfolio charge-offs and recoveries; levels in portfolio delinquencies; effects of changes in loan concentrations and observed trends in the economy and other qualitative measurements.

Our risk-rating system as defined below is consistent with the system used by regulatory agencies and consistent with industry practices. Loans rated “Substandard”, “Doubtful” or “Loss” is consistent with the regulatory definitions of classified assets.

Pass: This category represents loans performing to contractual terms and conditions and the primary source of repayment is adequate to meet the obligation. We have five categories within the Pass classification depending on strength of repayment sources, collateral values and financial condition of the borrower.

Special Mention: This category represents loans performing to contractual terms and conditions; however, the primary source of repayment or the borrower is exhibiting some deterioration or weaknesses in financial condition that could potentially threaten the borrowers’ future ability to repay our loan principal and interest or fees due.

Substandard: This category represents loans that the primary source of repayment has significantly deteriorated or weakened which has or could threaten the borrowers’ ability to make scheduled payments. The weaknesses require close supervision by management and there is a distinct possibility that we could sustain a loss if the deficiencies are not corrected. Such weaknesses could jeopardize the timely and ultimate collection of our loan principal and interest or fees due. Loss may not be expected or evident, however, loan repayment is inadequately supported by current financial information or pledged collateral.

Doubtful: Loans so classified have all the inherent weaknesses of a substandard loan with the added provision that collection or liquidation in full is highly questionable and not reasonably assured. The probability of at least partial loss is high, but extraneous factors might strengthen the asset to prevent loss. The validity of the extraneous factors must be continuously monitored. Once these factors are questionable the loan should be considered for full or partial charge-off.

Loss: Loans so classified are considered uncollectible, and of little value that their continuance as active assets is not warranted. Such loans are fully charged off.

The following tables illustrate our corporate credit risk profile by creditworthiness category as of September 30, 2012, and December 31, 2011:



			Special
(Dollars in thousands)	Pass		Mention		Substandard		Doubtful		Total
September 30, 2012
Commercial and industrial	$	12,644	$	204	$	24	$	372	$	13,244
Construction		2,172		-		4,507		-		6,679
Commercial real estate		195,004		5,844		21,104		573		222,525
Residential real estate		92,241		454		3,897		324		96,916
Consumer and other		1,347		-		-		-		1,347
	$	303,408	$	6,502	$	29,532	$	1,269	$	340,711

December 31, 2011
Commercial and industrial	$	13,103	$	398	$	202	$	8	$	13,711
Construction		5,057		-		3,463		-		8,520
Commercial real estate		180,862		6,987		27,769		573		216,191
Residential real estate		95,491		494		4,190		-		100,175
Consumer and other		1,336		-		-		-		1,336
	$	295,849	$	7,879	$	35,624	$	581	$	339,933

In accordance with FASB ASC 310-10-35-16, a loan is considered impaired when based on current information and events, it is probable that we will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, postponement or forgiveness of principal, forbearance or other actions intended to maximize collection. The average recorded investment in impaired loans is calculated using the average of impaired loans over the past five quarter-end periods. We recognize income on impaired loans under the cash basis when the collateral on the loan is sufficient to cover the outstanding obligation to us. If these factors do not exist, we will record all payments as a reduction of principal on such loans.

The following table reflects our impaired loans by class as of September 30, 2012, and December 31, 2011:



		September 30, 2012						December 31, 2011

				Unpaid						Unpaid
		Recorded		Principal				Recorded		Principal
		Investment		Balance		Related		Investment		Balance		Related
(Dollars in thousands)	(1)			(2)		Allowance	(1)			(2)		Allowance
With no related allowance recorded:
Construction	$	2,802	$	3,779	$	-	$	2,062	$	2,331	$	-
Commercial real estate		3,777		4,542		-		10,362		12,932		-
Residential real estate		2,081		2,081		-		1,758		1,757		-
Total impaired loans without a related allowance		8,660		10,402		-		14,182		17,020		-

With an allowance recorded:
Commercial and industrial		396		396		382		32		32		16
Construction		1,705		1,827		133		396		396		50
Commercial real estate		13,442		15,827		1,399		12,404		12,399		1,572
Residential real estate		907		1,058		363		732		724		319
Total impaired loans with an allowance		16,450		19,108		2,277		13,564		13,551		1,957
Total impaired loans	$	25,110	$	29,510	$	2,277	$	27,746	$	30,571	$	1,957

(1) The recorded investment of impaired loans includes the outstanding principal balance and any unpaid interest and escrow balances due.

(2) Unpaid principal balance includes the present recorded principal balance plus any amounts that have been previously charged-off.

The average recorded investment and income recognized is presented for the nine month periods ended September 30, 2012, and 2011:



	For the Nine Months Ended September 30, 2012				For the Nine Months Ended September 30, 2011
	Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income
(Dollars in thousands)	Investment		Recognized		Investment		Recognized
With no related allowance recorded:
Commercial and industrial	$	-	$	-	$	10	$	1
Construction		1,986		-		3,454		-
Commercial real estate		6,505		42		8,608		142
Residential real estate		1,756		41		954		27
Consumer and other		-		-		-		-
Total impaired loans without a related allowance		10,247		83		13,026		170

With an allowance recorded:
Commercial and industrial		189		-		81		-
Construction		1,405		3		1,980		-
Commercial real estate		14,610		59		10,899		144
Residential real estate		786		17		637		1
Consumer and other		-		-		-		-
Total impaired loans with an allowance		16,990		79		13,597		145
Total impaired loans	$	27,237	$	162	$	26,623	$	315

The following table presents the recorded investment in troubled debt restructured loans, based on payment performance status:



(Dollars in thousands)		Commercial Real Estate	Commercial & Industrial		Total

September 30, 2012
Performing	$	603	$	-	$	603
Non-performing		1,847		-		1,847
Total	$	2,450	$		$	2,450

December 31, 2011
Performing	$	5,592	$	8	$	5,600
Non-performing		2,682		-		2,682
Total	$	8,274	$	8	$	8,282

Troubled debt restructured loans are considered impaired and are included in the previous impaired loans disclosures in this footnote. As of September 30, 2012, we have not committed to lend additional amounts to customers with outstanding loans that are classified as troubled debt restructurings.

Troubled debt restructured loans can include one or a combination of the following: an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; temporary reduction in the interest rate; change in scheduled payment amount; or permanent reduction of the principal or interest of the loan.

During the three and nine months ended September 30, 2012, we have not restructured any troubled debt or required an allocation of the allowance for credit losses. During the three and nine months ended September 30, 2011, one commercial real estate loan modification was executed which constituted a troubled debt restructuring. The modification included one or a combination of the following: an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; temporary reduction in the interest rate; change in scheduled payment amount; or permanent reduction of the principal or interest of the loan or an extension of additional credit for payment of delinquent real estate taxes. The modification had a pre- and post-modification outstanding recorded investment of $1.5 million dollars.

There were no payment defaults of loans during the three and nine months ended September 30, 2012 and the three months ended September 30, 2011, which were modified in a troubled debt restructuring within the previous 12 months. There were two commercial real estate loans with a recorded investment of $1.4 million for which there was a payment default during the nine months ended September 30, 2011, which were modified in a troubled debt restructuring within the previous 12 months.

A troubled debt restructured loan is considered to be in payment default once it is greater than 30 days contractually past due under the modified terms. The troubled debt restructurings that subsequently defaulted resulted in a net allocation of the allowance for credit losses of $1 thousand and $3 thousand for the three and nine months ended September 30, 2012, respectively, and $7 thousand for the three and nine months ended September 30, 2011. There were no charge-offs on defaulted troubled debt restructurings during the three and nine months ended September 30, 2012 and 2011.