Note 5 – 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, Dorchester County, Baltimore County and Howard County in Maryland and in Kent County, Delaware. The following table provides information about the principal classes of the loan portfolio at June 30, 2017 and December 31, 2016.


(Dollars in thousands)	June 30, 2017		December 31, 2016
Construction	$	100,095	$	84,002
Residential real estate		384,777		325,768
Commercial real estate		452,132		382,681
Commercial		90,650		72,435
Consumer		6,951		6,639
Total loans		1,034,605		871,525
Allowance for credit losses		(9,132)		(8,726)
Total loans, net	$	1,025,473	$	862,799

Loans are stated at their principal amount outstanding net of any purchase premiums, 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 (“TDR”) 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. Loans are identified to be restructured when signs of impairment arise such as borrower interest rate reduction request, slowness to pay, or when an inability to repay becomes evident. The terms being offered are evaluated to determine if they are more liberal than those that would be indicated by policy or industry standards for similar, untroubled credits. In those situations where the terms or the interest rates are considered to be more favorable than industry standards or the current underwriting guidelines of the Company’s banking subsidiary, Shore United Bank (the “Bank”), the loan is classified as a TDR. All loans designated as TDRs are considered impaired loans and may be on either accrual or nonaccrual status. In instances where the loan has been placed on nonaccrual status, six consecutive months of timely payments are required prior to returning the loan to accrual status.

All loans classified as TDRs which are restructured and accrue interest under revised terms require a full and comprehensive review of the borrower’s financial condition, capacity for repayment, realistic assessment of collateral values, and the assessment of risk entered into any workout agreement. Current financial information on the borrower, guarantor, and underlying collateral is analyzed to determine if it supports the ultimate collection of principal and interest. For commercial loans, the cash flows are analyzed, both for the underlying project and globally. For consumer loans, updated salary, credit history and cash flow information is obtained. Current market conditions are also considered. Following a full analysis, the determination of the appropriate loan structure is made.

In the normal course of banking business, risks related to specific loan categories are as follows:

Construction loans – Construction loans generally finance the construction of residential real estate for builders and individuals for single family dwellings. In addition, the Bank periodically finances the construction of commercial projects. Credit risk factors include the borrower’s ability to successfully complete the construction on time and within budget, changing market conditions which could affect the value and marketability of projects, changes in the borrower’s ability or willingness to repay the loan and potentially rising interest rates which can impact both the borrower’s ability to repay and the collateral value.

Residential real estate – Residential real estate loans are typically made to consumers and are secured by residential real estate. Credit risk arises from the borrower’s continuing financial stability, which can be adversely impacted by job loss, divorce, illness, or personal bankruptcy, among other factors. Also impacting credit risk would be a shortfall in the value of the residential real estate in relation to the outstanding loan balance in the event of a default or subsequent liquidation of the real estate collateral.

Commercial real estate – Commercial real estate loans consist of both loans secured by owner occupied properties and non-owner occupied where an established banking relationship exists and involves investment properties for warehouse, retail, and office space with a history of occupancy and cash flow. These loans are subject to adverse changes in the local economy and commercial real estate markets. Credit risk associated with owner occupied properties arises from the borrower’s financial stability and the ability of the borrower and the business to repay the loan. Non-owner occupied properties carry the risk of a tenant’s deteriorating credit strength, lease expirations in soft markets and sustained vacancies which can adversely impact cash flow.

Commercial – Commercial loans are secured or unsecured loans for business purposes. Loans are typically secured by accounts receivable, inventory, equipment and/or other assets of the business. Credit risk arises from the successful operation of the business which may be affected by competition, rising interest rates, regulatory changes and adverse conditions in the local and regional economy.

Consumer – Consumer loans include home equity loans and lines, installment loans and personal lines of credit. Credit risk is similar to residential real estate loans above as it is subject to the borrower’s continuing financial stability and the value of the collateral securing the loan.

The following tables include impairment information relating to loans and the allowance for credit losses as of June 30, 2017 and December 31, 2016.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
June 30, 2017
Loans individually
evaluated for impairment	$	6,926	$	6,443	$	5,567	$	345	$	-	$	19,281
Loans collectively
evaluated for impairment		93,169		378,334		446,565		90,305		6,951		1,015,324
Total loans	$	100,095	$	384,777	$	452,132	$	90,650	$	6,951	$	1,034,605

Allowance for credit
losses allocated to:
Loans individually
evaluated for impairment	$	593	$	259	$	165	$	-	$	-	$	1,017
Loans collectively
evaluated for impairment		1,756		1,837		2,637		1,652		233		8,115
Total allowance	$	2,349	$	2,096	$	2,802	$	1,652	$	233	$	9,132


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
December 31, 2016
Loans individually
evaluated for impairment	$	8,007	$	7,778	$	6,088	$	-	$	99	$	21,972
Loans collectively
evaluated for impairment		75,995		317,990		376,593		72,435		6,540		849,553
Total loans	$	84,002	$	325,768	$	382,681	$	72,435	$	6,639	$	871,525

Allowance for credit
losses allocated to:
Loans individually
evaluated for impairment	$	1,639	$	317	$	185	$	-	$	-	$	2,141
Loans collectively
evaluated for impairment		1,148		1,636		2,425		1,145		231		6,585
Total allowance	$	2,787	$	1,953	$	2,610	$	1,145	$	231	$	8,726

The following tables provide information on impaired loans and any related allowance by loan class as of June 30, 2017 and December 31, 2016. The difference between the unpaid principal balance and the recorded investment is the amount of partial charge-offs that have been taken.


				Recorded		Recorded			Quarter-to-		Year-to-date
	Unpaid			investment		investment			date average		average		Interest
	principal			with no		with an	Related		recorded		recorded		income
(Dollars in thousands)	balance			allowance		allowance	allowance		investment		investment		recognized
June 30, 2017
Impaired nonaccrual loans:
Construction	$	3,017	$	51	$	2,838	$	580	$	3,153	$	3,435	$	-
Residential real estate		3,352		1,066		2,143		114		3,870		3,940		-
Commercial real estate		1,271		547		167		90		670		696		-
Commercial		425		345		-		-		115		57		-
Consumer		-		-		-		-		66		82		-
Total	$	8,065	$	2,009	$	5,148	$	784	$	7,874	$	8,210	$	-

Impaired accruing TDRs:
Construction	$	4,037	$	3,336	$	701	$	13	$	4,040	$	4,111	$	55
Residential real estate		3,234		2,204		1,030		145		3,409		3,585		87
Commercial real estate		4,853		1,866		2,987		75		4,869		4,888		100
Commercial		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-
Total	$	12,124	$	7,406	$	4,718	$	233	$	12,318	$	12,584	$	242

Total impaired loans:
Construction	$	7,054	$	3,387	$	3,539	$	593	$	7,193	$	7,546	$	55
Residential real estate		6,586		3,270		3,173		259		7,279		7,525		87
Commercial real estate		6,124		2,413		3,154		165		5,539		5,584		100
Commercial		425		345		-		-		115		57		-
Consumer		-		-		-		-		66		82		-
Total	$	20,189	$	9,415	$	9,866	$	1,017	$	20,192	$	20,794	$	242


									June 30, 2016
				Recorded		Recorded			Quarter-to-		Year-to-date
	Unpaid			investment		investment			date average		average		Interest
	principal			with no		with an	Related		recorded		recorded		income
(Dollars in thousands)	balance			allowance		allowance	allowance		investment		investment		recognized
December 31, 2016
Impaired nonaccrual loans:
Construction	$	7,247	$	-	$	3,818	$	1,621	$	5,489	$	6,353	$	-
Residential real estate		4,013		1,957		1,946		166		3,914		3,103		-
Commercial real estate		1,801		959		193		117		2,058		2,308		-
Commercial		-		-		-		-		164		161		-
Consumer		99		99		-		-		106		114		-
Total	$	13,160	$	3,015	$	5,957	$	1,904	$	11,731	$	12,039	$	-

Impaired accruing TDRs:
Construction	$	4,189	$	3,479	$	710	$	18	$	4,244	$	4,142	$	43
Residential real estate		3,875		2,829		1,046		151		4,931		5,300		102
Commercial real estate		4,936		1,573		3,363		68		5,066		5,215		85
Commercial		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-
Total	$	13,000	$	7,881	$	5,119	$	237	$	14,241	$	14,657	$	230

Total impaired loans:
Construction	$	11,436	$	3,479	$	4,528	$	1,639	$	9,733	$	10,495	$	43
Residential real estate		7,888		4,786		2,992		317		8,845		8,403		102
Commercial real estate		6,737		2,532		3,556		185		7,124		7,523		85
Commercial		-		-		-		-		164		161		-
Consumer		99		99		-		-		106		114		-
Total	$	26,160	$	10,896	$	11,076	$	2,141	$	25,972	$	26,696	$	230

The following tables provide a roll-forward for troubled debt restructurings as of June 30, 2017 and June 30, 2016.


	1/1/2017												6/30/2017
	TDR		New		Disbursements		Charge		Reclassifications/				TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)		Payoffs		Balance		Allowance
For six months ended
June 30, 2017
Accruing TDRs
Construction	$	4,189	$	-	$	(18)	$	-	$	-	$	(134)	$	4,037	$	13
Residential real estate		3,875		-		(102)		(89)		-		(450)		3,234		145
Commercial real estate		4,936		-		(83)		-		-		-		4,853		75
Commercial		-		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-		-
Total	$	13,000	$	-	$	(203)	$	(89)	$	-	$	(584)	$	12,124	$	233

Nonaccrual TDRs
Construction	$	3,818	$	-	$	(872)	$	-	$	(108)	$	-	$	2,838	$	580
Residential real estate		1,603		-		(44)		-		-		-		1,559		110
Commercial real estate		83		-		-		-		-		-		83		-
Commercial		-		345		-		-		-		-		345		-
Consumer		-		-		-		-		-		-		-		-
Total	$	5,504	$	345	$	(916)	$	-	$	(108)	$	-	$	4,825	$	690

Total	$	18,504	$	345	$	(1,119)	$	(89)	$	(108)	$	(584)	$	16,949	$	923


	1/1/2016												6/30/2016
	TDR		New		Disbursements		Charge		Reclassifications/				TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)		Payoffs		Balance		Allowance
For six months ended
June 30, 2016
Accruing TDRs
Construction	$	4,069	$	-	$	172	$	-	$	-	$	-	$	4,241	$	25
Residential real estate		5,686		533		(350)		-		(1,595)		(179)		4,095		73
Commercial real estate		5,740		495		(659)		(117)		(458)		-		5,001		155
Commercial		-		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-		-
Total	$	15,495	$	1,028	$	(837)	$	(117)	$	(2,053)	$	(179)	$	13,337	$	253

Nonaccrual TDRs
Construction	$	4,960	$	2,570	$	(1,847)	$	(254)	$	-	$	-	$	5,429	$	739
Residential real estate		445		-		(293)		-		1,595		-		1,747		72
Commercial real estate		-		-		-		(258)		458		-		200		112
Commercial		-		-		-		-		-		-		-		-
Consumer		23		-		(23)		-		-		-		-		-
Total	$	5,428	$	2,570	$	(2,163)	$	(512)	$	2,053	$	-	$	7,376	$	923

Total	$	20,923	$	3,598	$	(3,000)	$	(629)	$	-	$	(179)	$	20,713	$	1,176

The following tables provide information on loans that were modified and considered TDRs during the six months ended June 30, 2017 and June 30, 2016.


		Premodification		Postmodification
		outstanding		outstanding
	Number of	recorded		recorded		Related
(Dollars in thousands)	contracts	investment		investment		allowance
TDRs:
For six months ended
June 30, 2017
Construction	-	$	-	$	-	$	-
Residential real estate	-		-		-		-
Commercial real estate	1		760		755		-
Commercial	1		462		345		-
Consumer	-		-		-		-
Total	2	$	1,222	$	1,100	$	-

For six months ended
June 30, 2016
Construction	-	$	-	$	-	$	-
Residential real estate	3		668		668		-
Commercial real estate	1		495		495		-
Commercial	-		-		-		-
Consumer	-		-		-		-
Total	4	$	1,163	$	1,163	$	-

During the six months ended June 30, 2017, there was one new TDR and one previously recorded TDR which was modified. The new TDR consisted of a reduction in principal, whereas, the previously recorded TDR consisted of a change in maturity date.

The following tables provide information on TDRs that defaulted during the six months ended June 30, 2017 and June 30, 2016. Generally, a loan is considered in default when principal or interest is past due 90 days or more.


	Number of	Recorded		Related
(Dollars in thousands)	contracts	investment		allowance
TDRs that subsequently defaulted:
For six months ended
June 30, 2017
Construction	-	$	-	$	-
Residential real estate	1		89		-
Commercial real estate	-		-		-
Commercial	-		-		-
Consumer	-		-		-
Total	1	$	89	$	-

For six months ended
June 30, 2016
Construction	1	$	241	$	-
Residential real estate	-		-		-
Commercial real estate	2		375		-
Commercial	-		-		-
Consumer	-		-		-
Total	3	$	616	$	-

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. At June 30, 2017, there were no nonaccrual loans classified as special mention or doubtful and $7.2 million of nonaccrual loans were identified as substandard. Similarly, at December 31, 2016, there were no nonaccrual loans classified as special mention or doubtful and $9.0 million of nonaccrual loans were identified as substandard.

The following tables provide information on loan risk ratings as of June 30, 2017 and December 31, 2016.


			Special
(Dollars in thousands)	Pass/Performing		Mention		Substandard		Doubtful		Total
June 30, 2017
Construction	$	89,918	$	4,055	$	6,122	$	-	$	100,095
Residential real estate		372,148		6,725		5,904		-		384,777
Commercial real estate		428,971		15,495		7,666		-		452,132
Commercial		89,451		799		400		-		90,650
Consumer		6,951		-		-		-		6,951
Total	$	987,439	$	27,074	$	20,092	$	-	$	1,034,605


			Special
(Dollars in thousands)	Pass/Performing		Mention		Substandard		Doubtful		Total
December 31, 2016
Construction	$	72,641	$	4,195	$	7,166	$	-	$	84,002
Residential real estate		312,242		6,646		6,880		-		325,768
Commercial real estate		363,461		10,939		8,281		-		382,681
Commercial		71,313		857		265		-		72,435
Consumer		6,540		-		99		-		6,639
Total	$	826,197	$	22,637	$	22,691	$	-	$	871,525

The following tables provide information on the aging of the loan portfolio as of June 30, 2017 and December 31, 2016.


		Accruing
				30-59 days			60-89 days			Greater than			Total
(Dollars in thousands)	Current			past due			past due			90 days			past due			Nonaccrual			Total
June 30, 2017
Construction	$	97,045		$	-		$	50		$	111		$	161		$	2,889		$	100,095
Residential real estate		379,217			310			1,838			203			2,351			3,209			384,777
Commercial real estate		450,740			219			459			-			678			714			452,132
Commercial		90,272			33			-			-			33			345			90,650
Consumer		6,944			5			2			-			7			-			6,951
Total	$	1,024,218		$	567		$	2,349		$	314		$	3,230		$	7,157		$	1,034,605
Percent of total loans		99.0	%		0.1	%		0.2	%		-	%		0.3	%		0.7	%		100.0	%


		Accruing
				30-59 days			60-89 days			Greater than			Total
(Dollars in thousands)	Current			past due			past due			90 days			past due			Nonaccrual			Total
December 31, 2016
Construction	$	80,079		$	-		$	105		$	-		$	105		$	3,818		$	84,002
Residential real estate		317,992			1,778			2,095			-			3,873			3,903			325,768
Commercial real estate		375,552			3,219			2,758			-			5,977			1,152			382,681
Commercial		72,272			19			134			10			163			-			72,435
Consumer		6,515			13			2			10			25			99			6,639
Total	$	852,410		$	5,029		$	5,094		$	20		$	10,143		$	8,972		$	871,525
Percent of total loans		97.8	%		0.6	%		0.6	%		-	%		1.2	%		1.0	%		100.0	%

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 and six months ended June 30, 2017 and 2016. Allocation of a portion of the allowance to one loan class does not preclude its availability to absorb losses in other loan classes.

Management re-evaluated the allowance methodology during the third quarter of 2016, in connection with the consolidation of the two former bank subsidiaries. Prior to consolidation, each bank subsidiary applied a separate allowance methodology based on their respective loan portfolios. The revised methodology incorporates both previous methodologies to align with a consolidated loan portfolio. In addition, beginning in January of 2017, the allowance methodology was expanded to require the allocation of general reserves to pass/watch loans. This change resulted in an increase in allowance for the first quarter of 2017 when compared to the fourth quarter of 2016 of $1.1 million, which was partially offset by a reduction in specific reserves of $850 thousand.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Unallocated		Total
For three months ended
June 30, 2017
Allowance for credit losses:
Beginning Balance	$	2,290	$	2,131	$	2,912	$	1,338	$	256	$	-	$	8,927

Charge-offs		(25)		(100)		-		(706)		(15)		-		(846)
Recoveries		9		10		8		42		8		-		77
Net charge-offs		(16)		(90)		8		(664)		(7)		-		(769)

Provision		75		55		(118)		978		(16)		-		974
Ending Balance	$	2,349	$	2,096	$	2,802	$	1,652	$	233	$	-	$	9,132


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Unallocated		Total
For three months ended
June 30, 2016
Allowance for credit losses:
Beginning Balance	$	1,753	$	2,014	$	3,257	$	585	$	177	$	523	$	8,309

Charge-offs		(13)		(102)		(265)		(58)		(2)		-		(440)
Recoveries		10		33		10		57		4		-		114
Net charge-offs		(3)		(69)		(255)		(1)		2		-		(326)

Provision		(6)		90		(131)		93		27		302		375
Ending Balance	$	1,744	$	2,035	$	2,871	$	677	$	206	$	825	$	8,358



			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Unallocated		Total
For six months ended
June 30, 2017
Allowance for credit losses:
Beginning Balance	$	2,787	$	1,953	$	2,610	$	1,145	$	231	$	-	$	8,726

Charge-offs		(54)		(323)		-		(771)		(15)		-		(1,163)
Recoveries		16		21		19		100		12		-		168
Net charge-offs		(38)		(302)		19		(671)		(3)		-		(995)

Provision		(400)		445		173		1,178		5		-		1,401
Ending Balance	$	2,349	$	2,096	$	2,802	$	1,652	$	233	$	-	$	9,132



			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Unallocated		Total
For six months ended
June 30, 2016
Allowance for credit losses:
Beginning Balance	$	1,646	$	2,181	$	2,999	$	558	$	156	$	776	$	8,316

Charge-offs		(254)		(118)		(503)		(125)		(10)		-		(1,010)
Recoveries		16		67		10		122		12		-		227
Net charge-offs		(238)		(51)		(493)		(3)		2		-		(783)

Provision		336		(95)		365		122		48		49		825
Ending Balance	$	1,744	$	2,035	$	2,871	$	677	$	206	$	825	$	8,358

Foreclosure Proceedings

Consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure totaled $105 thousand and $ 687 thousand as of June 30, 2017 and December 31, 2016, respectively. At June 30, 2017, there was 1 residential property held in other real estate owned totaling $15 thousand, compared to 3 residential properties totaling $92 thousand at December 31, 2016.

Performing TDRs were in compliance with their modified terms and there are no further commitments associated with these loans.