Note 4 – Loans and allowance for credit losses

The Company makes residential mortgage, commercial and consumer loans to customers primarily in Talbot County, Queen Anne’s County, Kent County, Caroline County and Dorchester County in Maryland and in Kent County, Delaware. The following table provides information about the principal classes of the loan portfolio at June 30, 2013 and December 31, 2012.

(Dollars in thousands)	June 30, 2013		December 31, 2012
Construction	$	104,516	$	108,051
Residential real estate		288,494		288,011
Commercial real estate		321,191		314,941
Commercial		56,448		60,786
Consumer		11,539		13,293
Total loans		782,188		785,082
Allowance for credit losses		(15,723)		(15,991)
Total loans, net	$	766,465	$	769,091

Loans are stated at their principal amount outstanding net of any deferred fees and costs. Interest income on loans is accrued at the contractual rate based on the principal amount outstanding. Fees charged and costs capitalized for originating loans are being amortized substantially on the interest method over the term of the loan. A loan is placed on nonaccrual (i.e., interest income is no longer accrued) when it is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more, unless the loan is well secured and in the process of collection. Any unpaid interest previously accrued on those loans is reversed from income. Interest payments received on nonaccrual loans are applied as a reduction of the loan principal balance unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

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. Once the amount of impairment has been determined, the uncollectible portion is charged off. 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). Generally, interest income is not recognized on impaired loans unless the likelihood of further loss is remote. The allowance for credit losses may include specific reserves related to impaired loans. Specific reserves remain until charge offs are made. 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 formula portion of the allowance for credit losses. See additional discussion under the caption “Critical Accounting Policies” in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

A loan is considered a troubled debt restructuring if a borrower is experiencing financial difficulties and a creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. All loans designated as troubled debt restructurings are considered impaired loans and may be on either accrual or nonaccrual status.

The following tables include impairment information relating to loans and the allowance for credit losses as of June 30, 2013 and December 31, 2012.

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
June 30, 2013
Loans individually evaluated for impairment	$	34,638	$	22,438	$	27,258	$	711	$	51	$	-	$	85,096
Loans collectively evaluated for impairment		69,878		266,056		293,933		55,737		11,488		-		697,092
Total loans	$	104,516	$	288,494	$	321,191	$	56,448	$	11,539	$	-	$	782,188

Allowance for credit losses allocated to:
Loans individually evaluated for impairment	$	717	$	377	$	2,189	$	29	$	-	$	-	$	3,312
Loans collectively evaluated for impairment		3,629		3,882		3,325		1,187		301		87		12,411
Total allowance for credit losses	$	4,346	$	4,259	$	5,514	$	1,216	$	301	$	87	$	15,723

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
December 31, 2012
Loans individually evaluated for impairment	$	37,029	$	18,549	$	32,447	$	715	$	87	$	-	$	88,827
Loans collectively evaluated for impairment		71,022		269,462		282,494		60,071		13,206		-		696,255
Total loans	$	108,051	$	288,011	$	314,941	$	60,786	$	13,293	$	-	$	785,082

Allowance for credit losses allocated to:
Loans individually evaluated for impairment	$	941	$	598	$	614	$	-	$	48	$	-	$	2,201
Loans collectively evaluated for impairment		3,446		4,596		3,520		1,682		359		187		13,790
Total allowance for credit losses	$	4,387	$	5,194	$	4,134	$	1,682	$	407	$	187	$	15,991

The following tables provide information on impaired loans and any related allowance by loan class as of June 30, 2013 and December 31, 2012. The difference between the unpaid principal balance and the recorded investment is the amount of partial charge-offs that have been taken.

(Dollars in thousands)	Unpaid principal balance		Recorded investment with no allowance		Recorded investment with an allowance		Related allowance		Quarter-to- date average recorded investment		Year-to-date average recorded investment
June 30, 2013
Impaired nonaccrual loans:
Construction	$	10,961	$	3,751	$	3,744	$	600	$	7,080	$	7,401
Residential real estate		22,890		14,948		1,085		301		12,883		11,920
Commercial real estate		13,876		8,135		2,502		650		9,784		10,824
Commercial		1,611		573		29		29		531		537
Consumer		58		51		-		-		51		49
Total		49,396		27,458		7,360		1,580		30,329		30,731

Impaired accruing restructured loans:
Construction		27,143		23,091		4,052		117		27,052		27,146
Residential real estate		6,405		4,554		1,851		76		6,814		6,882
Commercial real estate		16,621		10,503		6,118		1,539		16,414		16,903
Commercial		109		109		-		-		112		115
Consumer		-		-		-		-		-		-
Total		50,278		38,257		12,021		1,732		50,392		51,046

Total impaired loans:
Construction		38,104		26,842		7,796		717		34,132		34,547
Residential real estate		29,295		19,502		2,936		377		19,697		18,802
Commercial real estate		30,497		18,638		8,620		2,189		26,198		27,727
Commercial		1,720		682		29		29		643		652
Consumer		58		51		-		-		51		49
Total	$	99,674	$	65,715	$	19,381	$	3,312	$	80,721	$	81,777

(Dollars in thousands)	Unpaid principal balance		Recorded investment with no allowance		Recorded investment with an allowance		Related allowance		Quarter-to- date average recorded investment		Year-to-date average recorded investment
December 31, 2012
Impaired nonaccrual loans:
Construction	$	14,288	$	3,371	$	6,323	$	941	$	10,600	$	12,428
Residential real estate		17,975		9,469		2,063		598		13,294		17,472
Commercial real estate		19,515		11,838		2,729		614		13,554		12,975
Commercial		1,556		594		-		-		1,126		1,538
Consumer		92		39		48		48		50		55
Total		53,426		25,311		11,163		2,201		38,624		44,468

Impaired accruing restructured loans:
Construction		27,335		27,335		-		-		27,907		21,193
Residential real estate		7,017		7,017		-		-		6,124		5,064
Commercial real estate		17,880		17,880		-		-		17,433		16,252
Commercial		121		121		-		-		105		87
Consumer		-		-		-		-		-		-
Total		52,353		52,353		-		-		51,569		42,596

Total impaired loans:
Construction		41,623		30,706		6,323		941		38,507		33,621
Residential real estate		24,992		16,486		2,063		598		19,418		22,536
Commercial real estate		37,395		29,718		2,729		614		30,987		29,227
Commercial		1,677		715		-		-		1,231		1,625
Consumer		92		39		48		48		50		55
Total	$	105,779	$	77,664	$	11,163	$	2,201	$	90,193	$	87,064

The following tables provide information on loans that were modified and considered troubled debt restructurings during the six months ended June 30, 2013 and June 30, 2012.

(Dollars in thousands)	Number of contracts		Premodification outstanding recorded investment		Postmodification outstanding recorded investment		Related allowance
Troubled debt restructurings:
For the six months ended June 30, 2013
Construction		2	$	123	$	123	$	-
Residential real estate		3		783		798		37
Commercial real estate		1		474		474		-
Commercial		-		-		-		-
Consumer		-		-		-		-
Total		6	$	1,380	$	1,395	$	37

For the six months ended June 30, 2012
Construction		7	$	5,943	$	5,963	$	-
Residential real estate		8		2,613		2,276		-
Commercial real estate		3		5,351		5,514		-
Commercial		-		-		-		-
Consumer		-		-		-		-
Total		18	$	13,907	$	13,753	$	-

The following tables provide information on troubled debt restructurings that defaulted during the six months ended June 30, 2013 and June 30, 2012. Generally, a loan is considered in default when principal or interest is past due 30 days or more.

(Dollars in thousands)	Number of contracts		Recorded investment		Related allowance
Troubled debt restructurings that subsequently defaulted (1):
For the six months ended June 30, 2013
Construction		-	$	-	$	-
Residential real estate		4		1,563		-
Commercial real estate		1		1,741		74
Commercial		-		-		-
Consumer		-		-		-
Total		5	$	3,304	$	74

Troubled debt restructurings that subsequently defaulted (2):
For the six months ended June 30, 2012
Construction		1	$	666	$	-
Residential real estate		3		913		-
Commercial real estate		-		-		-
Commercial		-		-		-
Consumer		-		-		-
Total		4	$	1,579	$	-

(1) These loans were classified as troubled debt restructurings during 2012.

(2) These loans were classified as troubled debt restructurings during 2011.

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 or doubtful are adversely rated. They are assigned higher risk ratings than favorably rated loans in the calculation of the formula portion of the allowance for credit losses.

The following tables provide information on loan risk ratings as of June 30, 2013 and December 31, 2012.

(Dollars in thousands)	Pass/Performing		Special mention		Substandard		Doubtful		Nonaccrual		Total
June 30, 2013
Construction	$	48,038	$	23,989	$	24,994	$	-	$	7,495	$	104,516
Residential real estate		235,008		24,055		13,398		-		16,033		288,494
Commercial real estate		268,053		23,752		18,749		-		10,637		321,191
Commercial		50,938		4,097		811		-		602		56,448
Consumer		11,433		52		3		-		51		11,539
Total	$	613,470	$	75,945	$	57,955	$	-	$	34,818	$	782,188

(Dollars in thousands)	Pass/Performing		Special mention		Substandard		Doubtful		Nonaccrual		Total
December 31, 2012
Construction	$	45,385	$	30,817	$	22,155	$	-	$	9,694	$	108,051
Residential real estate		237,299		23,657		15,090		433		11,532		288,011
Commercial real estate		257,418		21,554		21,402		-		14,567		314,941
Commercial		55,432		3,062		1,639		59		594		60,786
Consumer		13,147		-		59		-		87		13,293
Total	$	608,681	$	79,090	$	60,345	$	492	$	36,474	$	785,082

The following tables provide information on the aging of the loan portfolio as of June 30, 2013 and December 31, 2012.

	Accruing
(Dollars in thousands)	Current				30-59 days past due			60-89 days past due			90 days or more past due		Total past due			Nonaccrual			Total
June 30, 2013
Construction		$	97,021		$	-		$	-		$	-	$	-		$	7,495		$	104,516
Residential real estate			270,575			1,644			242			-		1,886			16,033			288,494
Commercial real estate			309,318			769			467			-		1,236			10,637			321,191
Commercial			55,720			112			14			-		126			602			56,448
Consumer			11,414			60			11			3		74			51			11,539
Total		$	744,048		$	2,585		$	734		$	3	$	3,322		$	34,818		$	782,188
Percent of total loans			95.1	%		0.3	%		0.1	%		-		0.4	%		4.5	%

	Accruing
(Dollars in thousands)	Current			30-59 days past due			60-89 days past due			90 days or more past due			Total past due			Nonaccrual			Total
December 31, 2012
Construction	$	98,221		$	136		$	-		$	-		$	136		$	9,694		$	108,051
Residential real estate		272,311			3,116			762			290			4,168			11,532			288,011
Commercial real estate		298,522			887			800			165			1,852			14,567			314,941
Commercial		59,746			380			66			-			446			594			60,786
Consumer		13,125			57			19			5			81			87			13,293
Total	$	741,925		$	4,576		$	1,647		$	460		$	6,683		$	36,474		$	785,082
Percent of total loans		94.5	%		0.6	%		0.2	%		0.1	%		0.9	%		4.6	%

Management evaluates the adequacy of the allowance for credit losses at least quarterly and adjusts the provision for credit losses based on this analysis. 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, 2013 and 2012. Allocation of a portion of the allowance to one loan class does not preclude its availability to absorb losses in other loan classes.

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
For the three months ended June 30, 2013
Allowance for credit losses:
Beginning balance	$	4,116	$	4,864	$	4,374	$	1,760	$	330	$	291	$	15,735

Charge-offs		(802)		(1,096)		(872)		(136)		(13)		-		(2,919)
Recoveries		1		59		90		50		7		-		207
Net charge-offs		(801)		(1,037)		(782)		(86)		(6)		-		(2,712)

Provision		1,031		432		1,922		(458)		(23)		(204)		2,700
Ending balance	$	4,346	$	4,259	$	5,514	$	1,216	$	301	$	87	$	15,723

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
For the three months ended June 30, 2012
Allowance for credit losses:
Beginning balance	$	3,344	$	4,448	$	3,549	$	1,539	$	581	$	83	$	13,544

Charge-offs		(714)		(1,554)		(745)		(1,085)		(162)		-		(4,260)
Recoveries		-		43		-		133		5		-		181
Net charge-offs		(714)		(1,511)		(745)		(952)		(157)		-		(4,079)

Provision		215		1,300		1,148		476		61		325		3,525
Ending balance	$	2,845	$	4,237	$	3,952	$	1,063	$	485	$	408	$	12,990

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, 2013 and 2012.

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
For the six months ended June 30, 2013
Allowance for credit losses:
Beginning balance	$	4,387	$	5,194	$	4,134	$	1,682	$	407	$	187	$	15,991

Charge-offs		(1,509)		(1,889)		(1,947)		(223)		(62)		-		(5,630)
Recoveries		2		298		93		102		17		-		512
Net charge-offs		(1,507)		(1,591)		(1,854)		(121)		(45)		-		(5,118)

Provision		1,466		656		3,234		(345)		(61)		(100)		4,850
Ending balance	$	4,346	$	4,259	$	5,514	$	1,216	$	301	$	87	$	15,723

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
For the six months ended June 30, 2012
Allowance for credit losses:
Beginning balance	$	3,745	$	5,014	$	3,415	$	1,498	$	594	$	22	$	14,288

Charge-offs		(1,786)		(5,673)		(1,435)		(4,440)		(177)		-		(13,511)
Recoveries		-		94		7		208		9		-		318
Net charge-offs		(1,786)		(5,579)		(1,428)		(4,232)		(168)		-		(13,193)

Provision		886		4,802		1,965		3,797		59		386		11,895
Ending balance	$	2,845	$	4,237	$	3,952	$	1,063	$	485	$	408	$	12,990