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, 2018 and December 31, 2017.


(Dollars in thousands)	September 30, 2018		December 31, 2017
Construction	$	126,313	$	125,746
Residential real estate		425,842		399,190
Commercial real estate		513,169		464,887
Commercial		108,823		97,284
Consumer		6,410		6,407
Total loans		1,180,557		1,093,514
Allowance for credit losses		(10,328)		(9,781)
Total loans, net	$	1,170,229	$	1,083,733

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 $725 thousand and discounts on acquired loans of $1.5 million at September 30, 2018. Loans included deferred costs, net of deferred fees, of $609 thousand and discounts on acquired loans of $1.8 million at December 31, 2017. 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 are offered primarily to builders and individuals to finance the construction of 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, 2018 and December 31, 2017.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
September 30, 2018
Loans individually
evaluated for impairment	$	3,104	$	6,931	$	5,936	$	324	$	-	$	16,295
Loans collectively
evaluated for impairment		123,209		418,911		507,233		108,499		6,410		1,164,262
Total loans	$	126,313	$	425,842	$	513,169	$	108,823	$	6,410	$	1,180,557

Allowance for credit
losses allocated to:
Loans individually
evaluated for impairment	$	375	$	194	$	32	$	20	$	-	$	621
Loans collectively
evaluated for impairment		2,409		1,947		2,905		2,190		256		9,707
Total allowance	$	2,784	$	2,141	$	2,937	$	2,210	$	256	$	10,328


			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 allowance	$	2,460	$	2,284	$	2,594	$	2,241	$	202	$	9,781

The following tables provide information on impaired loans and any related allowance by loan class as of September 30, 2018 and December 31, 2017. The difference between the unpaid principal balance and the recorded investment is the amount of partial charge-offs that have been taken and interest paid on nonaccrual loans that has been applied to principal.


									September 30, 2018
				Recorded		Recorded				Quarter-to-date	Year-to-date
	Unpaid			investment		investment			average		average
	principal			with no		with an	Related		recorded		recorded
(Dollars in thousands)	balance			allowance		allowance	allowance		investment		investment
September 30, 2018
Impaired nonaccrual loans:
Construction	$	3,409	$	284	$	2,748	$	356	$	3,043	$	3,006
Residential real estate		2,399		2,267		-		-		1,710		1,573
Commercial real estate		2,155		1,739		-		-		1,742		1,438
Commercial		425		-		324		20		327		338
Consumer		-		-		-		-		-		-
Total	$	8,388	$	4,290	$	3,072	$	376	$	6,822	$	6,355

Impaired accruing TDRs:
Construction	$	72	$	53	$	19	$	19	$	145	$	1,138
Residential real estate		4,664		1,635		3,029		194		4,709		4,613
Commercial real estate		4,197		3,485		712		32		4,307		4,499
Commercial		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total	$	8,933	$	5,173	$	3,760	$	245	$	9,161	$	10,250

Total impaired loans:
Construction	$	3,481	$	337	$	2,767	$	375	$	3,188	$	4,144
Residential real estate		7,063		3,902		3,029		194		6,419		6,186
Commercial real estate		6,352		5,224		712		32		6,049		5,937
Commercial		425		-		324		20		327		338
Consumer		-		-		-		-		-		-
Total	$	17,321	$	9,463	$	6,832	$	621	$	15,983	$	16,605


									September 30, 2017
				Recorded		Recorded				Quarter-to-date	Year-to-date
	Unpaid			investment		investment			average		average
	principal			with no		with an	Related		recorded		recorded
(Dollars in thousands)	balance			allowance		allowance	allowance		investment		investment
December 31, 2017
Impaired nonaccrual loans:
Construction	$	3,100	$	182	$	2,821	$	459	$	2,890	$	3,253
Residential real estate		1,620		1,482		-		-		2,840		3,573
Commercial real estate		795		149		-		-		489		627
Commercial		425		-		337		33		344		153
Consumer		-		-		-		-		-		55
Total	$	5,940	$	1,813	$	3,158	$	492	$	6,563	$	7,661

Impaired accruing TDRs:
Construction	$	3,972	$	3,038	$	934	$	41	$	4,034	$	4,086
Residential real estate		4,536		2,042		2,494		239		3,691		3,620
Commercial real estate		4,818		4,084		734		33		4,841		4,872
Commercial		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total	$	13,326	$	9,164	$	4,162	$	313	$	12,566	$	12,578

Total impaired loans:
Construction	$	7,072	$	3,220	$	3,755	$	500	$	6,924	$	7,339
Residential real estate		6,156		3,524		2,494		239		6,531		7,193
Commercial real estate		5,613		4,233		734		33		5,330		5,499
Commercial		425		-		337		33		344		153
Consumer		-		-		-		-		-		55
Total	$	19,266	$	10,977	$	7,320	$	805	$	19,129	$	20,239

The following tables provide a roll-forward for troubled debt restructurings as of September 30, 2018 and September 30, 2017.


	1/1/2018												9/30/2018
	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, 2018
Accruing TDRs
Construction	$	3,972	$	-	$	(225)	$	(379)	$	(696)	$	(2,600)	$	72	$	19
Residential real estate		4,536		-		(63)		-		542		(351)		4,664		194
Commercial real estate		4,818		-		(402)		-		-		(219)		4,197		32
Commercial		-		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-		-
Total	$	13,326	$	-	$	(690)	$	(379)	$	(154)	$	(3,170)	$	8,933	$	245

Nonaccrual TDRs
Construction	$	2,878	$	-	$	(73)	$	-	$	83	$	-	$	2,888	$	356
Residential real estate		-		-		-		(80)		80		-		-		-
Commercial real estate		83		-		-		-		(83)		-		-		-
Commercial		337		-		(13)		-		-		-		324		20
Consumer		-		-		-		-		-		-		-		-
Total	$	3,298	$	-	$	(86)	$	(80)	$	80	$	-	$	3,212	$	376

Total	$	16,624	$	-	$	(776)	$	(459)	$	(74)	$	(3,170)	$	12,145	$	621


	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

The following tables provide information on loans that were modified and considered TDRs during the nine months ended September 30, 2018 and September 30, 2017.


		Premodification		Postmodification
		outstanding		outstanding
	Number of	recorded		recorded		Related
(Dollars in thousands)	contracts	investment		investment		allowance
TDRs:
For nine months ended
September 30, 2018
Construction	-	$	-	$	-	$	-
Residential real estate	-		-		-		-
Commercial real estate	-		-		-		-
Commercial	-		-		-		-
Consumer	-		-		-		-
Total	-	$	-	$	-	$	-

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	$	-

During the nine months ended September 30, 2018, there were no new TDR’s or previously recorded TDR’s which were modified.

The following tables provide information on TDRs that defaulted within twelve months of restructuring during the nine months ended September 30, 2018 and September 30, 2017. Generally, a loan is considered in default when principal or interest is past due 90 days or more, the loan is placed on nonaccrual, 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, 2018
Construction	1	$	379	$	-
Residential real estate	1		154		-
Commercial real estate	-		-		-
Commercial	-		-		-
Consumer	-		-		-
Total	2	$	533	$	-

For nine months ended
September 30, 2017
Construction	-	$	-	$	-
Residential real estate	1		89		-
Commercial real estate	-		-		-
Commercial	-		-		-
Consumer	-		-		-
Total	1	$	89	$	-

Management uses risk ratings as part of its monitoring of the credit quality in the Company’s loan portfolio. 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 at December 31, 2017. 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. Loans that are identified as special mention, substandard or doubtful are adversely rated. These loans and the pass/watch loans are assigned higher qualitative factors than favorably rated loans in the calculation of the formula portion of the allowance for credit losses. At September 30, 2018, there were no nonaccrual loans classified as special mention or doubtful and $7.4 million of nonaccrual loans were identified as substandard. Similarly, 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 following tables provide information on loan risk ratings as of September 30, 2018 and December 31, 2017.


					Special
(Dollars in thousands)	Pass/Performing		Pass/Watch		Mention		Substandard		Doubtful		Total
September 30, 2018
Construction	$	92,937	$	30,307	$	-	$	3,069	$	-	$	126,313
Residential real estate		382,280		35,793		3,433		4,336		-		425,842
Commercial real estate		384,759		115,459		5,604		7,347		-		513,169
Commercial		83,245		24,569		645		364		-		108,823
Consumer		5,898		509		-		3		-		6,410
Total	$	949,119	$	206,637	$	9,682	$	15,119	$	-	$	1,180,557


					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

The following tables provide information on the aging of the loan portfolio as of September 30, 2018 and December 31, 2017.


		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, 2018
Construction	$	123,262		$	19		$	-		$	-		$	19		$	3,032		$	126,313
Residential real estate		421,384			1,707			484			-			2,191			2,267			425,842
Commercial real estate		508,781			723			1,926			-			2,649			1,739			513,169
Commercial		107,632			519			348			-			867			324			108,823
Consumer		6,399			4			4			3			11			-			6,410
Total	$	1,167,458		$	2,972		$	2,762		$	3		$	5,737		$	7,362		$	1,180,557
Percent of total loans		98.9	%		0.3	%		0.2	%		-	%		0.5	%		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, 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	%

The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for the three and nine months ended September 30, 2018 and September 30, 2017. 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
For three months ended
September 30, 2018
Allowance for credit losses:
Beginning Balance	$	2,593	$	2,150	$	2,845	$	2,210	$	323	$	-	$	10,121

Charge-offs		-		(109)		-		(137)		-		-		(246)
Recoveries		3		5		5		122		11		-		146
Net charge-offs		3		(104)		5		(15)		11		-		(100)

Provision		188		95		87		15		(78)		-		307
Ending Balance	$	2,784	$	2,141	$	2,937	$	2,210	$	256	$	-	$	10,328


			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 nine months ended
September 30, 2018
Allowance for credit losses:
Beginning Balance	$	2,460	$	2,284	$	2,594	$	2,241	$	202	$	-	$	9,781

Charge-offs		(379)		(288)		-		(263)		(24)		-		(954)
Recoveries		18		91		23		144		11		-		287
Net charge-offs		(361)		(197)		23		(119)		(13)		-		(667)

Provision		685		54		320		88		67		-		1,214
Ending Balance	$	2,784	$	2,141	$	2,937	$	2,210	$	256	$	-	$	10,328



			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

Foreclosure Proceedings

Consumer mortgage loans collateralized by residential real estate property that were in the process of foreclosure totaled $132 thousand and $530 thousand as of September 30, 2018 and December 31, 2017, respectively. There was one residential property included in the balance of other real estate owned of $77 thousand at September 30, 2018 and no residential properties included in the balance of other real estate owned at December 31, 2017.

All accruing TDRs were in compliance with their modified terms. One loan was transferred to nonaccrual as of September 30, 2018. Both performing and non-performing TDRs had no further commitments associated with them as of September 30, 2018 and December 31, 2017.