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, Kent County, Delaware and Accomack County, Virginia. The following table provides information about the principal classes of the loan portfolio at September 30, 2017 and December 31, 2016.


(Dollars in thousands)	September 30, 2017		December 31, 2016
Construction	$	106,617	$	84,002
Residential real estate		387,722		325,768
Commercial real estate		454,626		382,681
Commercial		91,799		72,435
Consumer		6,483		6,639
Total loans		1,047,247		871,525
Allowance for credit losses		(9,295)		(8,726)
Total loans, net	$	1,037,952	$	862,799

Loans are stated at their principal amount outstanding net of any purchase premiums, deferred fees and costs. Loans included deferred costs, net of deferred fees, of $632 thousand and discounts on acquired loans of $2.0 million at September 30, 2017. Loans included deferred costs, net of deferred fees, of $509 thousand at December 31, 2016. 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 properties 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 September 30, 2017 and December 31, 2016.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
September 30, 2017
Loans individually
evaluated for impairment	$	6,986	$	7,190	$	5,265	$	341	$	-	$	19,782
Loans collectively
evaluated for impairment		99,631		380,532		449,361		91,458		6,483		1,027,465
Total loans	$	106,617	$	387,722	$	454,626	$	91,799	$	6,483	$	1,047,247

Allowance for credit
losses allocated to:
Loans individually
evaluated for impairment	$	589	$	251	$	35	$	-	$	-	$	875
Loans collectively
evaluated for impairment		1,652		1,792		2,849		1,804		323		8,420
Total allowance	$	2,241	$	2,043	$	2,884	$	1,804	$	323	$	9,295


			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 September 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
September 30, 2017
Impaired nonaccrual loans:
Construction	$	3,035	$	125	$	2,828	$	548	$	2,890	$	3,253	$	-
Residential real estate		2,736		2,439		126		23		2,840		3,573		-
Commercial real estate		1,075		430		-		-		489		627		-
Commercial		425		341		-		-		344		153		-
Consumer		-		-		-		-		-		55		-
Total	$	7,271	$	3,335	$	2,954	$	571	$	6,563	$	7,661	$	-

Impaired accruing TDRs:
Construction	$	4,033	$	3,098	$	935	$	41	$	4,034	$	4,086	$	82
Residential real estate		4,625		2,190		2,435		228		3,691		3,620		117
Commercial real estate		4,835		4,094		741		35		4,841		4,872		145
Commercial		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-
Total	$	13,493	$	9,382	$	4,111	$	304	$	12,566	$	12,578	$	344

Total impaired loans:
Construction	$	7,068	$	3,223	$	3,763	$	589	$	6,924	$	7,339	$	82
Residential real estate		7,361		4,629		2,561		251		6,531		7,193		117
Commercial real estate		5,910		4,524		741		35		5,330		5,499		145
Commercial		425		341		-		-		344		153		-
Consumer		-		-		-		-		-		55		-
Total	$	20,764	$	12,717	$	7,065	$	875	$	19,129	$	20,239	$	344


									September 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	$	5,361	$	6,022	$	-
Residential real estate		4,013		1,957		1,946		166		4,012		3,406		-
Commercial real estate		1,801		959		193		117		2,177		2,265		-
Commercial		-		-		-		-		108		143		-
Consumer		99		99		-		-		99		109		-
Total	$	13,160	$	3,015	$	5,957	$	1,904	$	11,757	$	11,945	$	-

Impaired accruing TDRs:
Construction	$	4,189	$	3,479	$	710	$	18	$	4,213	$	4,166	$	74
Residential real estate		3,875		2,829		1,046		151		4,100		4,900		149
Commercial real estate		4,936		1,573		3,363		68		4,982		5,137		127
Commercial		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-
Total	$	13,000	$	7,881	$	5,119	$	237	$	13,295	$	14,203	$	350

Total impaired loans:
Construction	$	11,436	$	3,479	$	4,528	$	1,639	$	9,574	$	10,188	$	74
Residential real estate		7,888		4,786		2,992		317		8,112		8,306		149
Commercial real estate		6,737		2,532		3,556		185		7,159		7,402		127
Commercial		-		-		-		-		108		143		-
Consumer		99		99		-		-		99		109		-
Total	$	26,160	$	10,896	$	11,076	$	2,141	$	25,052	$	26,148	$	350

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


	1/1/2017												9/30/2017
	TDR		New		Disbursements		Charge		Reclassifications/				TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)		Payoffs		Balance		Allowance
For nine months ended
September 30, 2017
Accruing TDRs
Construction	$	4,189	$	-	$	(22)	$	-	$	-	$	(134)	$	4,033	$	41
Residential real estate		3,875		-		(120)		(89)		1,411		(452)		4,625		228
Commercial real estate		4,936		-		(101)		-		-		-		4,835		35
Commercial		-		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-		-
Total	$	13,000	$	-	$	(243)	$	(89)	$	1,411	$	(586)	$	13,493	$	304

Nonaccrual TDRs
Construction	$	3,818	$	-	$	(882)	$	-	$	(108)	$	-	$	2,828	$	548
Residential real estate		1,603		-		(66)		-		(1,411)		-		126		23
Commercial real estate		83		-		-		-		-		-		83		-
Commercial		-		345		(4)		-		-		-		341		-
Consumer		-		-		-		-		-		-		-		-
Total	$	5,504	$	345	$	(952)	$	-	$	(1,519)	$	-	$	3,378	$	571

Total	$	18,504	$	345	$	(1,195)	$	(89)	$	(108)	$	(586)	$	16,871	$	875


	1/1/2016												9/30/2016
	TDR		New		Disbursements		Charge		Reclassifications/				TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)		Payoffs		Balance		Allowance
For nine months ended
September 30, 2016
Accruing TDRs
Construction	$	4,069	$	-	$	130	$	-	$	-	$	-	$	4,199	$	21
Residential real estate		5,686		565		(375)		-		(1,595)		(179)		4,102		154
Commercial real estate		5,740		495		(689)		(117)		(458)		-		4,971		89
Commercial		-		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-		-
Total	$	15,495	$	1,060	$	(934)	$	(117)	$	(2,053)	$	(179)	$	13,272	$	264

Nonaccrual TDRs
Construction	$	4,960	$	2,570	$	(2,012)	$	(263)	$	-	$	-	$	5,255	$	810
Residential real estate		445		-		(294)		-		1,595		-		1,746		25
Commercial real estate		-		-		-		(258)		458		-		200		112
Commercial		-		-		-		-		-		-		-		-
Consumer		23		-		(23)		-		-		-		-		-
Total	$	5,428	$	2,570	$	(2,329)	$	(521)	$	2,053	$	-	$	7,201	$	947

Total	$	20,923	$	3,630	$	(3,263)	$	(638)	$	-	$	(179)	$	20,473	$	1,211

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


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

For nine months ended
September 30, 2016
Construction	-	$	-	$	-	$	-
Residential real estate	3		667		699		-
Commercial real estate	1		495		495		-
Commercial	-		-		-		-
Consumer	-		-		-		-
Total	4	$	1,162	$	1,194	$	-

During the nine months ended September 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 within twelve months of restructuring during the nine months ended September 30, 2017 and September 30, 2016. Generally, a loan is considered in default when principal or interest is past due 90 days or more, the loan is charged off, or there is a transfer to OREO or repossessed assets.


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

For nine months ended
September 30, 2016
Construction	1	$	263	$	-
Residential real estate	-		-		-
Commercial real estate	2		375		-
Commercial	-		-		-
Consumer	-		-		-
Total	3	$	638	$	-

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 September 30, 2017, there were no nonaccrual loans classified as special mention or doubtful and $6.3 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 September 30, 2017 and December 31, 2016.


			Special
(Dollars in thousands)	Pass/Performing		Mention		Substandard		Doubtful		Total
September 30, 2017
Construction	$	97,304	$	3,127	$	6,186	$	-	$	106,617
Residential real estate		376,600		5,509		5,613		-		387,722
Commercial real estate		438,694		6,780		9,152		-		454,626
Commercial		90,680		660		459		-		91,799
Consumer		6,483		-		-		-		6,483
Total	$	1,009,761	$	16,076	$	21,410	$	-	$	1,047,247


			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 September 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
September 30, 2017
Construction	$	103,606		$	58		$	-		$	-		$	58		$	2,953		$	106,617
Residential real estate		383,913			572			667			5			1,244			2,565			387,722
Commercial real estate		451,789			2,407			-			-			2,407			430			454,626
Commercial		91,225			202			31			-			233			341			91,799
Consumer		6,478			-			5			-			5			-			6,483
Total	$	1,037,011		$	3,239		$	703		$	5		$	3,947		$	6,289		$	1,047,247
Percent of total loans		99.0	%		0.3	%		0.1	%		-	%		0.4	%		0.6	%		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 nine months ended September 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
September 30, 2017
Allowance for credit losses:
Beginning Balance	$	2,349	$	2,096	$	2,802	$	1,652	$	233	$	-	$	9,132

Charge-offs		-		(70)		(100)		(99)		(18)		-		(287)
Recoveries		11		11		8		67		8		-		105
Net charge-offs		11		(59)		(92)		(32)		(10)		-		(182)

Provision		(119)		6		174		184		100		-		345
Ending Balance	$	2,241	$	2,043	$	2,884	$	1,804	$	323	$	-	$	9,295


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Unallocated		Total
For three months ended
September 30, 2016
Allowance for credit losses:
Beginning Balance	$	1,744	$	2,035	$	2,871	$	677	$	206	$	825	$	8,358

Charge-offs		(9)		(407)		-		(139)		(13)		-		(568)
Recoveries		8		121		10		79		1		-		219
Net charge-offs		(1)		(286)		10		(60)		(12)		-		(349)

Provision		275		331		306		300		(40)		(567)		605
Ending Balance	$	2,018	$	2,080	$	3,187	$	917	$	154	$	258	$	8,614



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

Charge-offs		(54)		(393)		(100)		(870)		(33)		-		(1,450)
Recoveries		27		32		27		167		20		-		273
Net charge-offs		(27)		(361)		(73)		(703)		(13)		-		(1,177)

Provision		(519)		451		347		1,362		105		-		1,746
Ending Balance	$	2,241	$	2,043	$	2,884	$	1,804	$	323	$	-	$	9,295



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

Charge-offs		(263)		(525)		(503)		(264)		(23)		-		(1,578)
Recoveries		24		188		20		201		13		-		446
Net charge-offs		(239)		(337)		(483)		(63)		(10)		-		(1,132)

Provision		611		236		671		422		8		(518)		1,430
Ending Balance	$	2,018	$	2,080	$	3,187	$	917	$	154	$	258	$	8,614

Foreclosure Proceedings

Consumer mortgage loans collateralized by residential real estate property that were in the process of foreclosure totaled $620 thousand and $687 thousand as of September 30, 2017 and December 31, 2016, respectively. At September 30, 2017, there were 2 residential properties held in other real estate owned totaling $0, compared to 3 residential properties totaling $92 thousand at December 31, 2016.

All TDRs were in compliance with their modified terms and there are no further commitments associated with these loans as of September 30, 2017 and December 31, 2016.