NOTE 5. 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, 2018 and 2017.


(Dollars in thousands)	2018		2017
Construction	$	127,572	$	125,746
Residential real estate		429,560		399,190
Commercial real estate		523,427		464,887
Commercial		107,522		97,284
Consumer		7,274		6,407
Total loans		1,195,355		1,093,514
Allowance for credit losses		(10,343)		(9,781)
Total loans, net	$	1,185,012	$	1,083,733

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 collectability. As of December 31, 2018 and 2017, such loans outstanding, both direct and indirect (including guarantees), to directors, their associates and policy-making officers, totaled approximately $13.2 million and $13.8 million, respectively. During 2018 and 2017, loan additions were approximately $1.9 million and $2.3 million, respectively, and loan repayments were approximately $2.6 million and $1.8 million, respectively. Net loan origination costs, included in balances above, totaled $789 thousand and $609 thousand as of December 31, 2018 and 2017, respectively. At December 31, 2018 and December 31, 2017 included in total loans were $92.8 million and $108.1 million in loans, respectively, acquired as part of the NWBI branch acquisition. These balances are presented net of the related discount which totaled $1.4 million at December 31, 2018 and $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 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 December 31, 2018 and 2017.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
December 31, 2018
Loans individually
evaluated for impairment	$	2,893	$	8,553	$	13,532	$	340	$	-	$	25,318
Loans collectively
evaluated for impairment		124,679		421,007		509,895		107,182		7,274		1,170,037
Total loans	$	127,572	$	429,560	$	523,427	$	107,522	$	7,274	$	1,195,355

Allowance for credit
losses allocated to:
Loans individually
evaluated for impairment	$	320	$	301	$	104	$	36	$	-	$	761
Loans collectively
evaluated for impairment		2,342		2,052		2,973		1,913		302		9,582
Total loans	$	2,662	$	2,353	$	3,077	$	1,949	$	302	$	10,343


			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

The allowance for loan losses was 0.87% of total loans at December 31, 2018, compared to 0.89% at December 31, 2017.

The following tables provide information on impaired loans and any related allowance by loan class as of December 31, 2018 and 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.


				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, 2018
Impaired nonaccrual loans:
Construction	$	3,219	$	127	$	2,715	$	320	$	2,988	$	-
Residential real estate		4,281		2,605		1,494		118		1,884		-
Commercial real estate		10,029		9,307		67		67		2,149		-
Commercial		445		-		340		36		336		-
Consumer		-		-		-		-		-		-
Total	$	17,974	$	12,039	$	4,616	$	541	$	7,357	$	-

Impaired accruing TDRs:
Construction	$	51	$	51	$	-	$	-	$	866	$	35
Residential real estate		4,454		1,440		3,014		183		4,606		125
Commercial real estate		4,158		1,286		2,872		37		4,416		149
Commercial		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total	$	8,663	$	2,777	$	5,886	$	220	$	9,888	$	309

Total impaired loans:
Construction	$	3,270	$	178	$	2,715	$	320	$	3,854	$	35
Residential real estate		8,735		4,045		4,508		301		6,490		125
Commercial real estate		14,187		10,593		2,939		104		6,565		149
Commercial		445		-		340		36		336		-
Consumer		-		-		-		-		-		-
Total	$	26,637	$	14,816	$	10,502	$	761	$	17,245	$	309



				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

The following tables provide a roll-forward for troubled debt restructurings as of December 31, 2018 and December 31, 2017.


	1/1/2018												12/31/2018
	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, 2018
Accruing TDRs
Construction	$	3,972	$	-	$	(229)	$	(397)	$	(695)	$	(2,600)	$	51	$	-
Residential real estate		4,536		-		(85)		-		541		(538)		4,454		183
Commercial real estate		4,818		-		(441)		-		-		(219)		4,158		37
Commercial		-		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-		-
Total	$	13,326	$	-	$	(755)	$	(397)	$	(154)	$	(3,357)	$	8,663	$	220

Nonaccrual TDRs
Construction	$	2,878	$	-	$	(163)	$	-	$	83	$	-	$	2,798	$	320
Residential real estate		-		-		-		(80)		80		-		-		-
Commercial real estate		83		-		-		-		(83)		-		-		-
Commercial		337		-		(17)		-		-		-		320		16
Consumer		-		-		-		-		-		-		-		-
Total	$	3,298	$	-	$	(180)	$	(80)	$	80	$	-	$	3,118	$	336

Total	$	16,624	$	-	$	(935)	$	(477)	$	(74)	$	(3,357)	$	11,781	$	556


	1/1/2017												12/31/17
	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

The following tables provide information on loans that were modified and considered TDRs during 2018 and 2017.


		Premodification		Postmodification
		outstanding		outstanding
	Number of	recorded		recorded		Related
(Dollars in thousands)	contracts	investment		investment		allowance
TDRs:
For the year ended
December 31, 2018
Construction	-	$	-	$	-	$	-
Residential real estate	-		-		-		-
Commercial real estate	-		-		-		-
Commercial	-		-		-		-
Consumer	-		-		-		-
Total	-	$	-	$	-	$	-

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	$	-

During the year ended December 31, 2018, there were no new TDR’s or previously recorded TDR’s which were modified.

The following tables provide information on TDRs that defaulted during 2018 and 2017 within 12 months of their restructuring. 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 there is a transfer to OREO or repossessed assets.


	Number of	Recorded		Related
(Dollars in thousands)	contracts	investment		allowance
TDRs that subsequently defaulted:
For the year ended
December 31, 2018
Construction	-	$	-	$	-
Residential real estate	-		-		-
Commercial real estate	-		-		-
Commercial	-		-		-
Consumer	-		-		-
Total	-	$	-	$	-

For the year ended
December 31, 2017
Construction	-	$	-	$	-
Residential real estate	-		-		-
Commercial real estate	-		-		-
Commercial	-		-		-
Consumer	-		-		-
Total	-	$	-	$	-

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, due to the significant organic loan growth over the past 24 months, the increase in pass/performing 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 December 31, 2018, there were no nonaccrual loans classified as special mention or doubtful and $16.7 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 December 31, 2018 and 2017.


					Special
(Dollars in thousands)	Pass/Performing		Pass/Watch		Mention		Substandard		Doubtful		Total
December 31, 2018
Construction	$	93,977	$	30,735	$	-	$	2,860	$	-	$	127,572
Residential real estate		386,553		33,739		3,769		5,499		-		429,560
Commercial real estate		389,219		113,873		4,515		15,820		-		523,427
Commercial		90,777		15,727		642		376		-		107,522
Consumer		6,805		466		-		3		-		7,274
Total	$	967,331	$	194,540	$	8,926	$	24,558	$	-	$	1,195,355


					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 December 31, 2018 and 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
December 31, 2018
Construction	$	124,535		$	195		$	-		$	-		$	195		$	2,842		$	127,572
Residential real estate		423,732			1,384			206			139			1,729			4,099			429,560
Commercial real estate		512,252			253			1,548			-			1,801			9,374			523,427
Commercial		107,089			83			10			-			93			340			107,522
Consumer		7,238			30			6			-			36			-			7,274
Total	$	1,174,846		$	1,945		$	1,770		$	139		$	3,854		$	16,655		$	1,195,355
Percent of total loans		98.3	%		0.2	%		0.1	%		-	%		0.3	%		1.4	%		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 2018 and 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		Total
2018
Allowance for credit losses:
Beginning Balance	$	2,460	$	2,284	$	2,594	$	2,241	$	202	$	9,781

Charge-offs		(397)		(406)		(240)		(441)		(27)		(1,511)
Recoveries		43		112		29		203		12		399
Net charge-offs		(354)		(294)		(211)		(238)		(15)		(1,112)

Provision		556		363		694		(54)		115		1,674
Ending Balance	$	2,662	$	2,353	$	3,077	$	1,949	$	302	$	10,343


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		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

Foreclosure Proceedings

Consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure totaled $ 949 thousand and $ 530 thousand as of December 31, 2018 and 2017. There were no residential real estate properties included in the balance of other real estate owned at December 31, 2018 and December 31, 2017.

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