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, 2019 and December 31, 2018.


(Dollars in thousands)	September 30, 2019		December 31, 2018
Construction	$	116,368	$	127,572
Residential real estate		442,324		429,560
Commercial real estate		558,741		523,427
Commercial		105,583		107,522
Consumer		12,019		7,274
Total loans		1,235,035		1,195,355
Allowance for credit losses		(10,438)		(10,343)
Total loans, net	$	1,224,597	$	1,185,012

Loans are stated at their principal amount outstanding net of any purchase premiums/discounts, deferred fees and costs. Loans included deferred costs, net of deferred fees, of $1.5 million and discounts on acquired loans of $1.1 million at September 30, 2019. Loans included deferred costs, net of deferred fees, of $789 thousand and discounts on acquired loans of $1.4 million at December 31, 2018. At September 30, 2019 and December 31, 2018, included in total loans were $83.1. million and $92.8 million in loans, respectively, acquired as part of the NWBI branch acquisition. 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 when due. 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. Loan payments received on nonaccrual impaired loans are generally applied to the outstanding principal balance. In certain circumstances, income may be recognized on a cash basis. 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 nonowner 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. Nonowner 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, 2019 and December 31, 2018.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Total
September 30, 2019
Loans individually evaluated for impairment	$	43	$	6,712	$	13,639	$	436	$	—	$	20,830
Loans collectively evaluated for impairment		116,325		435,612		545,102		105,147		12,019		1,214,205
Total loans	$	116,368	$	442,324	$	558,741	$	105,583	$	12,019	$	1,235,035

Allowance for credit losses allocated to:
Loans individually evaluated for impairment	$	—	$	441	$	452	$	62	$	—	$	955
Loans collectively evaluated for impairment		1,541		2,240		3,396		1,954		352		9,483
Total allowance	$	1,541	$	2,681	$	3,848	$	2,016	$	352	$	10,438


			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 allowance	$	2,662	$	2,353	$	3,077	$	1,949	$	302	$	10,343

The following tables provide information on impaired loans and any related allowance by loan class as of September 30, 2019 and December 31, 2018. 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				September 30, 2019
	Unpaid		investment		investment				Quarter-to-date		Average		Interest
	principal		with no		with an		Related		average recorded		recorded		recorded
(Dollars in thousands)	balance		allowance		allowance		allowance		investment		investment		investment
September 30, 2019
Impaired nonaccrual loans:
Construction	$	—		—		—		—		—		1,435		—
Residential real estate		2,366		489		1,570		256		2,642		2,904		—
Commercial real estate		10,834		8,901		1,262		430		10,221		9,717		—
Commercial		425		—		308		4		310		316		—
Consumer		—		—		—		—		—		—		—
Total	$	13,625	$	9,390	$	3,140	$	690	$	13,173	$	14,372	$	—

Impaired accruing TDRs:
Construction	$	43	$	43	$	—	$	—	$	44	$	47	$	9
Residential real estate		4,069		1,260		2,809		185		4,052		4,193		130
Commercial real estate		3,476		2,795		681		22		3,479		3,515		93
Commercial		—		—		—		—		—		—		—
Consumer		—		—		—		—		—		—		—
Total	$	7,588	$	4,098	$	3,490	$	207	$	7,575	$	7,755	$	232

Other Impaired accruing loans:
Construction	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Residential real estate		584		584		—		—		—		—		—
Commercial real estate		—		—		—		—		—		—		—
Commercial		128		—		128		58		—		—		—
Consumer		—		—		—		—		—		—		—
Total	$	712	$	584	$	128	$	58	$	—	$	—	$	—

Total impaired loans:
Construction	$	43	$	43	$	—	$	—	$	44	$	1,482	$	9
Residential real estate		6,435		1,749		4,379		441		6,694		7,097		130
Commercial real estate		14,310		11,696		1,943		452		13,700		13,232		93
Commercial		425		—		308		4		310		316		—
Consumer		—		—		—		—		—		—		—
Total	$	21,213	$	13,488	$	6,630	$	897	$	20,748	$	22,127	$	232



			Recorded		Recorded				September 30, 2018
	Unpaid		investment		investment				Quarter-to-date		Average		Interest
	principal		with no		with an		Related		average recorded		recorded		income
(Dollars in thousands)	balance		allowance		allowance		allowance		investment		investment		recognized
December 31, 2018
Impaired nonaccrual loans:
Construction	$	3,219	$	127	$	2,715	$	320	$	3,043	$	3,006	$	—
Residential real estate		4,281		2,605		1,494		118		1,710		1,573		—
Commercial real estate		10,029		9,307		67		67		1,742		1,438		—
Commercial		445		—		340		36		327		338		—
Consumer		—		—		—		—		—		—		—
Total	$	17,974	$	12,039	$	4,616	$	541	$	6,822	$	6,355	$	—

Impaired accruing TDRs:
Construction	$	51	$	51	$	—	$	—	$	145	$	1,138	$	13
Residential real estate		4,454		1,440		3,014		183		4,709		4,613		46
Commercial real estate		4,158		1,286		2,872		37		4,307		4,499		41
Commercial		—		—		—		—		—		—		—
Consumer		—		—		—		—		—		—		—
Total	$	8,663	$	2,777	$	5,886	$	220	$	9,161	$	10,250	$	100

Total impaired loans:
Construction	$	3,270	$	178	$	2,715	$	320	$	3,188	$	4,144	$	13
Residential real estate		8,735		4,045		4,508		301		6,419		6,186		46
Commercial real estate		14,187		10,593		2,939		104		6,049		5,937		41
Commercial		445		—		340		36		327		338		—
Consumer		—		—		—		—		—		—		—
Total	$	26,637	$	14,816	$	10,502	$	761	$	15,983	$	16,605	$	100

The following tables provide a roll-forward for TDRs as of September 30, 2019 and September 30, 2018.


	1/1/2019												9/30/2019
	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, 2019
Accruing TDRs
Construction	$	51	$	—	$	(8)	$	—	$	—	$	—	$	43	$	—
Residential real estate		4,454		41		(73)		—		—		(353)		4,069		185
Commercial real estate		4,158		—		(682)		—		—		—		3,476		22
Commercial		—		—		—		—		—		—		—		—
Consumer		—		—		—		—		—		—		—		—
Total	$	8,663	$	41	$	(763)	$	—	$	—	$	(353)	$	7,588	$	207

Nonaccrual TDRs
Construction	$	2,798	$	—	$	(1,379)	$	(3)	$	—	$	—	$	1,416	$	133
Residential real estate		—		—		—		—		—		—		—		—
Commercial real estate		—		—		—		—		—		—		—		—
Commercial		320		—		(12)		—		—		—		308		4
Consumer		—		—		—		—		—		—		—		—
Total	$	3,118	$	—	$	(1,391)	$	(3)	$	—	$	—	$	1,724	$	137

Total	$	11,781	$	41	$	(2,154)	$	(3)	$	—	$	(353)	$	9,312	$	344


	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

The following tables provide information on loans that were modified and considered TDRs during the nine months ended September 30, 2019 and September 30, 2018.


		Premodification		Postmodification
		outstanding		outstanding
	Number of	recorded		recorded		Related
(Dollars in thousands)	contracts	investment		investment		allowance
TDRs:
For nine months ended
September 30, 2019
Construction	—	$	—	$	—	$	—
Residential real estate	1		75		41		—
Commercial real estate	—		—		—		—
Commercial	—		—		—		—
Consumer	—		—		—		—
Total	1	$	75	$	41	$	—

For nine months ended
September 30, 2018
Construction	—	$	—	$	—	$	—
Residential real estate	—		—		—		—
Commercial real estate	—		—		—		—
Commercial	—		—		—		—
Consumer	—		—		—		—
Total	—	$	—	$	—	$	—

The following tables provide information on TDRs that defaulted within twelve months of restructuring during the nine months ended September 30, 2019 and September 30, 2018. There were no defaults during the nine months ended September 30, 2019 and two defaults totaling $533 for the nine months ended September 30, 2018. 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, 2019
Construction	—	$	—	$	—
Residential real estate	—		—		—
Commercial real estate	—		—		—
Commercial	—		—		—
Consumer	—		—		—
Total	—	$	—	$	—

For nine months ended
September 30, 2018
Construction	1	$	379	$	—
Residential real estate	1		154		—
Commercial real estate	—		—		—
Commercial	—		—		—
Consumer	—		—		—
Total	2	$	533	$	—

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. 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, 2019, there were no nonaccrual loans classified as special mention or doubtful and $12.5 million of nonaccrual loans were classified as substandard. Similarly, at December 31, 2018, there were no nonaccrual loans classified as special mention or doubtful and $16.7 million of nonaccrual loans were classified as substandard.

The following tables provide information on loan risk ratings as of September 30, 2019 and December 31, 2018.


					Special
(Dollars in thousands)	Pass/Performing		Pass/Watch		Mention		Substandard		Doubtful		Total
September 30, 2019
Construction	$	100,669	$	13,560	$	2,139	$	—	$	—	$	116,368
Residential real estate		405,154		28,927		5,408		2,835		—		442,324
Commercial real estate		427,825		110,846		4,999		15,071		—		558,741
Commercial		85,507		19,725		10		341		—		105,583
Consumer		11,619		397		—		3		—		12,019
Total	$	1,030,774	$	173,455	$	12,556	$	18,250	$	—	$	1,235,035


					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

The following tables provide information on the aging of the loan portfolio as of September 30, 2019 and December 31, 2018.


	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, 2019
Construction	$	116,111		$	—		$	257		$	—		$	257		$	—		$	116,368
Residential real estate		433,458			5,195			1,028			584			6,807			2,059			442,324
Commercial real estate		546,492			1,894			192			—			2,086			10,163			558,741
Commercial		104,809			337			1			128			466			308			105,583
Consumer		11,985			18			16			—			34			—			12,019
Total	$	1,212,855		$	7,444		$	1,494		$	712		$	9,650		$	12,530		$	1,235,035
Percent of total loans		98.2	%		0.6	%		0.1	%		0.1	%		0.8	%		1.0	%		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, 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	%

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, 2019 and September 30, 2018. 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
For three months ended
September 30, 2019
Allowance for credit losses:
Beginning Balance	$	2,443	$	2,155	$	3,367	$	2,057	$	283	$	10,305

Charge-offs		—		(86)		—		(98)		—		(184)
Recoveries		1		12		7		96		1		117
Net charge-offs		1		(74)		7		(2)		1		(67)

Provision		(903)		600		474		(39)		68		200
Ending Balance	$	1,541	$	2,681	$	3,848	$	2,016	$	352	$	10,438


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		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		Total
For nine months ended
September 30, 2019
Allowance for credit losses:
Beginning Balance	$	2,662	$	2,353	$	3,077	$	1,949	$	302	$	10,343

Charge-offs		(3)		(509)		—		(260)		(29)		(801)
Recoveries		8		23		114		248		3		396
Net charge-offs		5		(486)		114		(12)		(26)		(405)

Provision		(1,126)		814		657		79		76		500
Ending Balance	$	1,541	$	2,681	$	3,848	$	2,016	$	352	$	10,438


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

Foreclosure Proceedings

Consumer mortgage loans collateralized by residential real estate property that were in the process of foreclosure totaled $66 thousand as of September 30, 2019 and $949 thousand as of December 31, 2018, respectively. There were no residential real estate properties included in the balance of other real estate owned at September 30, 2019 and December 31, 2018.

All accruing TDRs were in compliance with their modified terms. Both performing and non-performing TDRs had no further commitments associated with them as of September 30, 2019 and December 31, 2018.