Note 4 – Loans and allowance for credit losses

The Company makes residential mortgage, commercial and consumer loans to customers primarily in the Maryland counties of Talbot, Queen Anne’s, Kent, Caroline and Dorchester and in Kent County, Delaware. The following table provides information about the principal classes of the loan portfolio at June 30, 2011 and December 31, 2010:

(Dollars in thousands)	June 30, 2011			December 31, 2010
Construction	$	128,140		$	143,952
Residential real estate		332,134			333,738
Commercial real estate		327,307			318,726
Commercial		74,485			82,787
Consumer		15,265			16,201
Total loans		877,331			895,404
Allowance for credit losses		(16,358	)		(14,227	)
Total loans, net	$	860,973		$	881,177

Loans include deferred costs net of deferred fees of $123 thousand at June 30, 2011 and $38 thousand at December 31, 2010.

A loan is considered impaired if it is probable that the Company will not collect all principal and interest payments according to the loan’s contractual terms. An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. The impairment of a loan is measured at the present value of expected future cash flows using the loan’s effective interest rate, or at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Generally, the Company measures impairment on such loans by reference to the fair value of the collateral. Income on impaired loans is recognized on a cash basis, and payments are first applied against the principal balance outstanding (i.e., placing impaired loans on nonaccrual status). Impaired loans do not include groups of smaller balance homogenous loans such as residential mortgage and consumer installment loans that are evaluated collectively for impairment. Reserves for probable credit losses related to these loans are based on historical loss ratios and are included in the allowance for credit losses.

Loans are evaluated on a case-by-case basis for impairment. Once the amount of impairment has been determined, the uncollectible portion is charged off. In some cases, a specific allocation within the allowance for credit losses is made until such time a charge-off is made. At June 30, 2011, impaired loans had been reduced by partial charge-offs totaling $9.2 million, or 15.9%, of the unpaid principal balance. In addition, $1.4 million in specific reserves were established against $6.7 million of impaired loans. At December 31, 2010, impaired loans had been reduced by partial charge-offs totaling $8.3 million, or 18.6%, of the unpaid principal balance. In addition, $203 thousand in specific reserves were established against $837 thousand of impaired loans.

A loan is considered a trouble debt restructuring if a concession is granted due to deterioration in a borrower's financial condition. At June 30, 2011 and December 31, 2010, the Company had troubled debt restructurings of $22.3 million and $21.4 million, respectively. Because these loans were performing in accordance with their modified terms, there were no specific reserves established against them.

Gross interest income of $1.4 million for the first six months of 2011, $2.1 million for fiscal year 2010 and $1.0 million for the first six months of 2010 would have been recorded if impaired loans had been current and performing in accordance with their original terms. No interest was recorded on such loans for the first six months of 2011 or 2010.

The following tables provide information on impaired loans by loan class as of June 30, 2011 and December 31, 2010.

(Dollars in thousands)	Unpaid principal balance		Recorded investment		Related allowance		Average recorded investment
June 30, 2011
Impaired loans with no related allowance recorded:
Construction	$	23,938	$	18,129	$	-	$	16,916
Residential real estate		12,692		11,258		-		9,279
Commercial real estate		10,783		9,901		-		7,772
Commercial		2,768		2,423		-		2,919
Consumer		30		29		-		29
Total		50,211		41,740		-		36,915

Impaired loans with a related allowance recorded:
Construction		-		-		-		-
Residential real estate		956		929		289		2,539
Commercial real estate		5,921		5,240		506		4,408
Commercial		567		567		567		629
Consumer		-		-		-		-
Total		7,444		6,736		1,362		7,576

Total impaired loans:
Construction		23,938		18,129		-		16,916
Residential real estate		13,648		12,187		289		11,818
Commercial real estate		16,704		15,141		506		12,180
Commercial		3,335		2,990		567		3,548
Consumer		30		29		-		29
Total	$	57,655	$	48,476	$	1,362	$	44,491

(Dollars in thousands)	Unpaid principal balance		Recorded investment		Related allowance		Average recorded investment
December 31, 2010
Impaired loans with no related allowance recorded:
Construction	$	22,643	$	17,261	$	-	$	17,784
Residential real estate		11,038		9,132		-		8,368
Commercial real estate		5,558		5,133		-		3,827
Commercial		4,305		3,845		-		2,793
Consumer		30		30		-		56
Total		43,574		35,401		-		32,828

Impaired loans with a related allowance recorded:
Construction		-		-		-		1,596
Residential real estate		945		837		203		420
Commercial real estate		-		-		-		-
Commercial		-		-		-		398
Consumer		-		-		-		-
Total		945		837		203		2,414

Total impaired loans:
Construction		22,643		17,261		-		19,380
Residential real estate		11,983		9,969		203		8,788
Commercial real estate		5,558		5,133		-		3,827
Commercial		4,305		3,845		-		3,191
Consumer		30		30		-		56
Total	$	44,519	$	36,238	$	203	$	35,242

Management uses risk ratings as part of its monitoring of the credit quality in the Company’s loan portfolio. Loans that are identified as special mention, substandard and doubtful are adversely rated and are assigned higher risk ratings than favorably rated loans.

The following tables provide information on loan risk ratings as of June 30, 2011 and December 31, 2010.

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Total
June 30, 2011
Pass/Performing	$	60,273	$	265,824	$	262,221	$	64,992	$	15,139	$	668,449
Special mention		26,799		22,651		15,150		1,731		2		66,333
Substandard		22,939		30,067		34,409		4,686		95		92,196
Doubtful		-		1,405		386		86		-		1,877
Nonaccrual		18,129		12,187		15,141		2,990		29		48,476
Total	$	128,140	$	332,134	$	327,307	$	74,485	$	15,265	$	877,331

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Total
December 31, 2010
Pass/Performing	$	83,344	$	283,895	$	260,040	$	73,502	$	16,043	$	716,824
Special mention		23,090		23,847		17,821		2,249		-		67,007
Substandard		20,257		13,752		35,732		3,088		128		72,957
Doubtful		-		2,275		-		103		-		2,378
Nonaccrual		17,261		9,969		5,133		3,845		30		36,238
Total	$	143,952	$	333,738	$	318,726	$	82,787	$	16,201	$	895,404

The following tables provide information on the aging of the loan portfolio as of June 30, 2011 and December 31, 2010.

	Accruing
(Dollars in thousands)	Current		30-59 days past due		60-89 days past due		90 days or more past due		Total past due		Non- accrual		Total
June 30, 2011
Construction	$	110,011	$	-	$	-	$	-	$	-	$	18,129	$	128,140
Residential real estate		312,795		4,155		2,040		957		7,152		12,187		332,134
Commercial real estate		308,760		2,163		1,243		-		3,406		15,141		327,307
Commercial		70,663		274		532		26		832		2,990		74,485
Consumer		14,819		373		37		7		417		29		15,265
Total	$	817,048	$	6,965	$	3,852	$	990	$	11,807	$	48,476	$	877,331

	Accruing
(Dollars in thousands)	Current		30-59 days past due		60-89 days past due		90 days or more past due		Total past due		Non- accrual		Total
December 31, 2010
Construction	$	124,892	$	1,691	$	108	$	-	$	1,799	$	17,261	$	143,952
Residential real estate		314,914		4,046		1,355		3,454		8,855		9,969		333,738
Commercial real estate		306,497		3,393		2,717		986		7,096		5,133		318,726
Commercial		77,833		470		465		174		1,109		3,845		82,787
Consumer		15,572		486		25		88		599		30		16,201
Total	$	839,708	$	10,086	$	4,670	$	4,702	$	19,458	$	36,238	$	895,404

	Accruing
	Current			30-59 days past due			60-89 days past due			90 days or more past due			Total past due			Non- accrual
June 30, 2011
Construction		85.9	%		-	%		-	%		-	%		-	%		14.1	%
Residential real estate		94.1			1.3			0.6			0.3			2.2			3.7
Commercial real estate		94.3			0.7			0.4			-			1.1			4.6
Commercial		94.9			0.4			0.7			-			1.1			4.0
Consumer		97.1			2.5			0.2			-			2.7			0.2
Total		93.2			0.8			0.4			0.1			1.3			5.5

	Accruing
	Current			30-59 days past due			60-89 days past due			90 days or more past due			Total past due			Non- accrual
December 31, 2010
Construction		86.8	%		1.1	%		0.1	%		-	%		1.2	%		12.0	%
Residential real estate		94.4			1.2			0.4			1.0			2.6			3.0
Commercial real estate		96.2			1.0			0.9			0.3			2.2			1.6
Commercial		94.0			0.6			0.6			0.2			1.4			4.6
Consumer		96.1			3.0			0.2			0.5			3.7			0.2
Total		93.8			1.2			0.5			0.5			2.2			4.0

We have established an allowance for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts and is decreased by current period charge-offs of uncollectible debts. Management evaluates the adequacy of the allowance for credit losses on a quarterly basis and adjusts the provision for credit losses based upon this analysis. Allocation of a portion of the allowance to one loan class does not preclude its availability to absorb losses in other loan classes.

The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for the three months ended June 30, 2011 and 2010.

(Dollars in thousands)	Construction			Residential real estate			Commercial real estate			Commercial			Consumer			Unallocated			Total
For the three months ended June 30, 2011
Allowance for credit losses:
Beginning balance	$	3,324		$	5,420		$	5,280		$	2,776		$	591		$	80		$	17,471

Charge-offs		(728	)		(2,390	)		(2,265	)		(1,525	)		(40	)		-			(6,948	)
Recoveries		-			34			5			380			21			-			440
Net charge-offs		(728	)		(2,356	)		(2,260	)		(1,145	)		(19	)		-			(6,508	)

Provision		937			1,120			2,231			1,079			33			(5	)		5,395
Ending balance	$	3,533		$	4,184		$	5,251		$	2,710		$	605		$	75		$	16,358

(Dollars in thousands)	Construction			Residential real estate			Commercial real estate			Commercial			Consumer			Unallocated		Total
For the three months ended June 30, 2010
Allowance for credit losses:
Beginning balance	$	3,035		$	3,326		$	3,806		$	1,897		$	516		$	211	$	12,791

Charge-offs		(681	)		(2,525	)		(46	)		(1,164	)		(145	)		-		(4,561	)
Recoveries		13			36			1			53			39			-		142
Net charge-offs		(668	)		(2,489	)		(45	)		(1,111	)		(106	)		-		(4,419	)

Provision		1,432			2,744			(531	)		1,003			31			238		4,917
Ending balance	$	3,799		$	3,581		$	3,230		$	1,789		$	441		$	449	$	13,289

The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for the six months ended June 30, 2011 and 2010.

(Dollars in thousands)	Construction			Residential real estate			Commercial real estate			Commercial			Consumer			Unallocated			Total
For the six months ended June 30, 2011
Allowance for credit losses:
Beginning balance	$	3,327		$	4,833		$	3,665		$	1,422		$	637		$	343		$	14,227

Charge-offs		(1,414	)		(4,481	)		(2,493	)		(1,771	)		(115	)		-			(10,274	)
Recoveries		49			68			5			457			41			-			620
Net charge-offs		(1,365	)		(4,413	)		(2,488	)		(1,314	)		(74	)		-			(9,654	)

Provision		1,571			3,764			4,074			2,602			42			(268	)		11,785
Ending balance	$	3,533		$	4,184		$	5,251		$	2,710		$	605		$	75		$	16,358

(Dollars in thousands)	Construction			Residential real estate			Commercial real estate			Commercial			Consumer			Unallocated		Total
For the six months ended June 30, 2010
Allowance for credit losses:
Beginning balance	$	2,630		$	1,528		$	3,947		$	2,132		$	515		$	124	$	10,876

Charge-offs		(4,190	)		(3,516	)		(46	)		(2,388	)		(311	)		-		(10,451	)
Recoveries		13			74			102			56			85			-		330
Net charge-offs		(4,177	)		(3,442	)		56			(2,332	)		(226	)		-		(10,121	)

Provision		5,346			5,495			(773	)		1,989			152			325		12,534
Ending balance	$	3,799		$	3,581		$	3,230		$	1,789		$	441		$	449	$	13,289

The following tables include impairment information relating to loans and the allowance for credit losses as of June 30, 2011 and 2010.

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
June 30, 2011
Loans individually evaluated for impairment	$	18,129	$	12,187	$	15,141	$	2,990	$	29	$	-	$	48,476
Loans collectively evaluated for impairment		110,011		319,947		312,166		71,495		15,236		-		828,855
Total loans	$	128,140	$	332,134	$	327,307	$	74,485	$	15,265	$	-	$	877,331

Allowance for credit losses allocated to:
Loans individually evaluated for impairment	$	-	$	289	$	506	$	567	$	-	$	-	$	1,362
Loans collectively evaluated for impairment		3,533		3,895		4,745		2,143		605		75		14,996
Total allowance for credit losses	$	3,533	$	4,184	$	5,251	$	2,710	$	605	$	75	$	16,358

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
June 30, 2010
Loans individually evaluated for impairment	$	20,449	$	8,783	$	4,224	$	3,968	$	64	$	-	$	37,488
Loans collectively evaluated for impairment		134,730		324,292		312,140		82,091		14,736		-		867,989
Total loans	$	155,179	$	333,075	$	316,364	$	86,059	$	14,800	$	-	$	905,477

Allowance for credit losses allocated to:
Loans individually evaluated for impairment	$	1,162	$	-	$	-	$	200	$	-	$	-	$	1,362
Loans collectively evaluated for impairment		2,637		3,581		3,230		1,589		441		449		11,927
Total allowance for credit losses	$	3,799	$	3,581	$	3,230	$	1,789	$	441	$	449	$	13,289