NOTE 4. LOANS AND ALLOWANCE FOR CREDIT LOSSES

The Company makes residential mortgage, commercial and consumer loans to customers primarily in Baltimore City, Baltimore County, Howard County, Kent County, Queen Anne’s County, Caroline County, Talbot County and Dorchester County in Maryland, Kent County, Delaware and in Accomack County, Virginia. The following table provides information about the principal classes of the loan portfolio at December 31, 2017 and 2016.


(Dollars in thousands)	2017		2016
Construction	$	125,746	$	84,002
Residential real estate		399,190		325,768
Commercial real estate		464,887		382,681
Commercial		97,284		72,435
Consumer		6,407		6,639
Total loans		1,093,514		871,525
Allowance for credit losses		(9,781)		(8,726)
Total loans, net	$	1,083,733	$	862,799

In the normal course of banking business, loans are made to officers and directors and their affiliated interests. These loans are made on substantially the same terms and conditions as those prevailing at the time for comparable transactions with persons who are not related to the Company and are not considered to involve more than the normal risk of collectibility. As of December 31, 2017 and 2016, such loans outstanding, both direct and indirect (including guarantees), to directors, their associates and policy-making officers, totaled approximately $13.8 million and $13.3 million, respectively. During 2017 and 2016, loan additions were approximately $2.3 million and $3.3 million, respectively, and loan repayments were approximately $1.8 million and $1.1 million, respectively. Due to the consolidation of the former Bank subsidiaries and their Board of Directors during 2016, many directors who served on those boards no longer serve as members of the new consolidated Bank as of December 31, 2016. This resulted in approximately $10.8 million in outstanding loans being excluded for reporting loans made to inside directors of the Company and its subsidiaries as of December 31, 2016. Net loan origination costs, included in balances above, totaled $609 thousand and $509 thousand as of December 31, 2017 and 2016, respectively. Also included in total loans at December 31, 2017 were $108.1 million in loans, acquired in the current year as part of the NWBI branch acquisition. These balances are presented net of the related discount which totaled $1.8 million at December 31, 2017.

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 December 31, 2017 and 2016.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
December 31, 2017
Loans individually
evaluated for impairment	$	6,975	$	6,018	$	4,967	$	337	$	-	$	18,297
Loans collectively
evaluated for impairment		118,771		393,172		459,920		96,947		6,407		1,075,217
Total loans	$	125,746	$	399,190	$	464,887	$	97,284	$	6,407	$	1,093,514

Allowance for credit
losses allocated to:
Loans individually
evaluated for impairment	$	500	$	239	$	33	$	33	$	-	$	805
Loans collectively
evaluated for impairment		1,960		2,045		2,561		2,208		202		8,976
Total loans	$	2,460	$	2,284	$	2,594	$	2,241	$	202	$	9,781


			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 loans	$	2,787	$	1,953	$	2,610	$	1,145	$	231	$	8,726

In the fourth quarter of 2017, management made a change to its method for calculating the allowance. This change and the effect on the allowance for loan losses at December 31, 2017 was as follows:

The Company added pass/watch credits to an existing pool that included loans that are risk rated as special mention and substandard to be collectively evaluated for impairment for both quantitative and qualitative factors. The Company believes that attributing additional reserves to this pool of loans better reflects the perceived risk for the total loan portfolio going forward, due to the significant organic loan growth over the past 24 months, the increase in pass/watch rated credits, and increasing balances/concentrations in certain segments of the loan portfolio. Creating this new pool, increased the provision for loan losses by $1.4 million compared to the prior methodology.

The following table represents the effect on the loan loss provision as a result of these changes in methodology. It compares the methodology actually used for the year ended December 31, 2017to that used in prior periods.


	Calculated Provision		Calculated Provision
	Based on Current		Based on Prior
(Dollars in thousands)	Methodology		Methodology		Difference
Construction	$	(303)	$	(653)	$	350
Residential real estate		736		753		(17)
Commercial real estate		53		(439)		492
Commercial		1,827		1,217		610
Consumer		(22)		(9)		(13)
Total	$	2,291	$	869	$	1,422

The allowance for loan losses was 0.89% of total loans at December 31, 2017, compared to 1.00% at December 31, 2016.

The following tables provide information on impaired loans and any related allowance by loan class as of December 31, 2017 and 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
	Unpaid			investment		investment			Average		Interest
	principal			with no		with an	Related		recorded		income
(Dollars in thousands)	balance			allowance		allowance	allowance		investment		recognized
December 31, 2017
Impaired nonaccrual loans:
Construction	$	3,100	$	182	$	2,821	$	459	$	3,181	$	-
Residential real estate		1,620		1,482		-		-		3,191		-
Commercial real estate		795		149		-		-		542		-
Commercial		425		-		337		33		200		-
Consumer		-		-		-		-		41		-
Total	$	5,940	$	1,813	$	3,158	$	492	$	7,155	$	-

Impaired accruing TDRs:
Construction	$	3,972	$	3,038	$	934	$	41	$	4,067	$	101
Residential real estate		4,536		2,042		2,494		239		3,831		161
Commercial real estate		4,818		4,084		734		33		4,860		185
Commercial		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total	$	13,326	$	9,164	$	4,162	$	313	$	12,758	$	447

Total impaired loans:
Construction	$	7,072	$	3,220	$	3,755	$	500	$	7,248	$	101
Residential real estate		6,156		3,524		2,494		239		7,022		161
Commercial real estate		5,613		4,233		734		33		5,402		185
Commercial		425		-		337		33		200		-
Consumer		-		-		-		-		41		-
Total	$	19,266	$	10,977	$	7,320	$	805	$	19,913	$	447



				Recorded		Recorded
	Unpaid			investment		investment			Average		Interest
	principal			with no		with an	Related		recorded		income
(Dollars in thousands)	balance			allowance		allowance	allowance		investment		recognized
December 31, 2016
Impaired nonaccrual loans:
Construction	$	7,247	$	-	$	3,818	$	1,621	$	5,707	$	-
Residential real estate		4,013		1,957		1,946		166		3,500		-
Commercial real estate		1,801		959		193		117		2,144		-
Commercial		-		-		-		-		108		-
Consumer		99		99		-		-		106		-
Total	$	13,160	$	3,015	$	5,957	$	1,904	$	11,565	$	-

Impaired accruing TDRs:
Construction	$	4,189	$	3,479	$	710	$	18	$	4,172	$	96
Residential real estate		3,875		2,829		1,046		151		4,663		195
Commercial real estate		4,936		1,573		3,363		68		5,090		174
Commercial		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total	$	13,000	$	7,881	$	5,119	$	237	$	13,925	$	465

Total impaired loans:
Construction	$	11,436	$	3,479	$	4,528	$	1,639	$	9,879	$	96
Residential real estate		7,888		4,786		2,992		317		8,163		195
Commercial real estate		6,737		2,532		3,556		185		7,234		174
Commercial		-		-		-		-		108		-
Consumer		99		99		-		-		106		-
Total	$	26,160	$	10,896	$	11,076	$	2,141	$	25,490	$	465

The following tables provide a roll-forward for troubled debt restructurings as of December 31, 2017 and December 31, 2016.


	1/1/2017												12/31/2017
	TDR		New		Disbursements		Charge		Reclassifications/				TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)		Payoffs		Balance		Allowance
For the year ended
December 31, 2017
Accruing TDRs
Construction	$	4,189	$	-	$	(25)	$	-	$	(58)	$	(134)	$	3,972	$	41
Residential real estate		3,875		-		(333)		(89)		1,535		(452)		4,536		239
Commercial real estate		4,936		-		(118)		-		-		-		4,818		33
Commercial		-		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-		-
Total	$	13,000	$	-	$	(476)	$	(89)	$	1,477	$	(586)	$	13,326	$	313

Nonaccrual TDRs
Construction	$	3,818	$	-	$	(890)	$	-	$	(50)	$	-	$	2,878	$	459
Residential real estate		1,603		-		(68)		-		(1,535)		-		-		-
Commercial real estate		83		-		-		-		-		-		83		-
Commercial		-		345		(8)		-		-		-		337		33
Consumer		-		-		-		-		-		-		-		-
Total	$	5,504	$	345	$	(966)	$	-	$	(1,585)	$	-	$	3,298	$	492

Total	$	18,504	$	345	$	(1,442)	$	(89)	$	(108)	$	(586)	$	16,624	$	805


	1/1/2016												12/31/16
	TDR		New		Disbursements		Charge		Reclassifications/				TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)		Payoffs		Balance		Allowance
For the year ended
December 31, 2016
Accruing TDRs
Construction	$	4,069	$	-	$	120	$	-	$	-	$	-	$	4,189	$	18
Residential real estate		5,686		565		(405)		-		(1,595)		(376)		3,875		151
Commercial real estate		5,740		495		(724)		(117)		(458)		-		4,936		68
Commercial		-		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-		-
Total	$	15,495	$	1,060	$	(1,009)	$	(117)	$	(2,053)	$	(376)	$	13,000	$	237

Nonaccrual TDRs
Construction	$	4,960	$	2,570	$	(2,022)	$	(590)	$	(1,100)	$	-	$	3,818	$	1,621
Residential real estate		445		117		(531)		(23)		1,595		-		1,603		156
Commercial real estate		-		-		(117)		(258)		458		-		83		-
Commercial		-		-		-		-		-		-		-		-
Consumer		23		-		(23)		-		-		-		-		-
Total	$	5,428	$	2,687	$	(2,693)	$	(871)	$	953	$	-	$	5,504	$	1,777

Total	$	20,923	$	3,747	$	(3,702)	$	(988)	$	(1,100)	$	(376)	$	18,504	$	2,014

The following tables provide information on loans that were modified and considered TDRs during 2017 and 2016.


		Premodification		Postmodification
		outstanding		outstanding
	Number of	recorded		recorded		Related
(Dollars in thousands)	contracts	investment		investment		allowance
TDRs:
For the year ended
December 31, 2017
Construction	-	$	-	$	-	$	-
Residential real estate	-		-		-		-
Commercial real estate	1		760		755		-
Commercial	1		462		345		-
Consumer	-		-		-		-
Total	2	$	1,222	$	1,100	$	-

For the year ended
December 31, 2016
Construction	-	$	-	$	-	$	-
Residential real estate	3		667		688		-
Commercial real estate	2		695		572		-
Commercial	-		-		-		-
Consumer	-		-		-		-
Total	5	$	1,362	$	1,260	$	-

During the year ended December 31, 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 2017 and 2016. Generally, a loan is considered in default when principal or interest is past due 90 days or more, the loan is placed on nonaccrual, charged-off, or foreclosure proceedings have commenced.


	Number of	Recorded		Related
(Dollars in thousands)	contracts	investment		allowance
TDRs that subsequently defaulted:
For the year ended
December 31, 2017
Construction	-	$	-	$	-
Residential real estate	1		89		-
Commercial real estate	-		-		-
Commercial	-		-		-
Consumer	-		-		-
Total	1	$	89	$	-

For the year ended
December 31, 2016
Construction	2	$	590	$	-
Residential real estate	1		23		-
Commercial real estate	2		375		-
Commercial	-		-		-
Consumer	-		-		-
Total	5	$	988	$	-

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 along with loans rated pass/watch which are deemed to have higher credit risk than the remainder of the pass categories. At December 31, 2017, there were no nonaccrual loans classified as special mention or doubtful and $5.0 million of nonaccrual loans were identified as substandard. The comparable amounts at December 31, 2016 were special mention $0, substandard $9.0 million and doubtful $0, respectively.

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


					Special
(Dollars in thousands)	Pass/Performing		Pass/Watch		Mention		Substandard		Doubtful		Total
December 31, 2017
Construction	$	88,836	$	30,674	$	-	$	6,236	$	-	$	125,746
Residential real estate		355,575		34,973		4,456		4,186		-		399,190
Commercial real estate		342,051		109,041		7,420		6,375		-		464,887
Commercial		72,440		24,102		308		434		-		97,284
Consumer		5,260		1,147		-		-		-		6,407
Total	$	864,162	$	199,937	$	12,184	$	17,231	$	-	$	1,093,514


					Special
(Dollars in thousands)	Pass/Performing		Pass/Watch		Mention		Substandard		Doubtful		Total
December 31, 2016
Construction	$	45,126	$	27,515	$	4,195	$	7,166	$	-	$	84,002
Residential real estate		280,215		32,027		6,646		6,880		-		325,768
Commercial real estate		260,935		102,526		10,939		8,281		-		382,681
Commercial		49,697		21,616		857		265		-		72,435
Consumer		6,406		134		-		99		-		6,639
Total	$	642,379	$	183,818	$	22,637	$	22,691	$	-	$	871,525

The following tables provide information on the aging of the loan portfolio as of December 31, 2017 and 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
December 31, 2017
Construction	$	122,475		$	268		$	-		$	-		$	268		$	3,003		$	125,746
Residential real estate		394,653			1,589			1,045			421			3,055			1,482			399,190
Commercial real estate		460,998			1,061			2,461			218			3,740			149			464,887
Commercial		96,774			173			-			-			173			337			97,284
Consumer		6,395			6			6			-			12			-			6,407
Total	$	1,081,295		$	3,097		$	3,512		$	639		$	7,248		$	4,971		$	1,093,514
Percent of total loans		98.8	%		0.3	%		0.3	%		0.1	%		0.7	%		0.5	%		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	%

The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for 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.


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

Charge-offs		(54)		(445)		(100)		(946)		(32)		-		(1,577)
Recoveries		30		40		31		215		25		-		341
Net charge-offs		(24)		(405)		(69)		(731)		(7)		-		(1,236)

Provision		(303)		736		53		1,827		(22)		-		2,291
Ending Balance	$	2,460	$	2,284	$	2,594	$	2,241	$	202	$	-	$	9,781


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

Charge-offs		(615)		(580)		(503)		(497)		(45)		-		(2,240)
Recoveries		35		298		25		428		16		-		802
Net charge-offs		(580)		(282)		(478)		(69)		(29)		-		(1,438)

Provision		1,721		54		89		656		104		(776)		1,848
Ending Balance	$	2,787	$	1,953	$	2,610	$	1,145	$	231	$	-	$	8,726

Foreclosure Proceedings

Consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure totaled $530 thousand and $687 thousand as of December 31, 2017 and 2016. There were no residential real estate included in the balance of Other real estate owned at December 31, 2017 and $18 thousand included in the balance for two residential properties at December 31, 2016.

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