Credit Quality of Loans and the Allowance for Loan Losses

6 Months Ended

Jun. 30, 2012

Credit Quality Of Loans And Allowance For Loan Losses

Credit Quality of Loans and the Allowance for Loan Losses

Note 4: Credit Quality of Loans and the Allowance for Loan Losses

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoffs are reported at their outstanding principal balances adjusted for unearned income, charge-offs, the allowance for loan losses, any unamortized deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans.

For loans amortized at cost, interest income is accrued based on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, as well as premiums and discounts, are deferred and amortized as a level yield adjustment over the respective term of the loan.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection. Past due status is determined based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current for a period of six months and future payments are reasonably assured.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to income. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of allocated and general components. The allocated component relates to loans that are classified as impaired. For those loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers nonclassified loans and is based on historical charge-off experience and expected loss given default derived from the Company’s internal risk rating process. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogenous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment measurements, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.

The risk characteristics of each portfolio segment are as follows:

Residential Real Estate Loans

For residential mortgage loans that are secured by one-to-four family residences and are generally owner-occupied, the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in 1-4 family residences. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

All Other Mortgage Loans

All other mortgage loans consist of residential construction loans, non-residential real estate loans, land loans and multifamily real estate loans.

Residential construction loan proceeds are disbursed in increments as construction progresses and as inspections warrant. Construction loans are typically structured as permanent one-to-four family loans originated by the Company with a 12-month construction phase. Accordingly, upon completion of the construction phase, there is no change in interest rate or term to maturity of the original construction loan, nor is a new permanent loan originated. These loans are generally owner-occupied and the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded.

Non-residential real estate loans are negotiated on a case by case basis. Loans secured by non-residential real estate generally involve a greater degree of risk than one-to- four family residential mortgage loans and carry larger loan balances. This increased credit risk is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties, and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by non-residential real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired.

The Company also originates a limited number of land loans secured by individual improved and unimproved lots for future residential construction. In addition, the Company originated loans to commercial customers with land held as the collateral.

Multi-family real estate loans generally involve a greater degree of credit risk than one-to-four family residential mortgage loans and carry larger loan balances. This increased credit risk is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties, and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multi-family real estate is typically dependent upon the successful operation of the related real estate property. If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired.

Commercial Business Loans

Commercial business loans carry a higher degree of risk than one-to-four family residential loans. Such lending typically involves large loan balances concentrated in a single borrower or groups of related borrowers for rental or business properties. In addition, the payment experience on loans secured by income-producing properties is typically dependent on the success of the operation of the related project and thus is typically affected by adverse conditions in the real estate market and in the economy. The Company originates commercial loans generally in the $50,000 to $1,000,000 range with the majority of these loans being under $500,000. Commercial loans are generally underwritten based on the borrower’s ability to pay and assets such as buildings, land and equipment are taken as additional loan collateral. Each loan is evaluated for a level of risk and assigned a rating from “1” (the highest rating) to “7” (the lowest rating).

Consumer Loans

Consumer loans entail greater credit risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly, such as automobiles, mobile homes, boats, and recreational vehicles. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In particular, amounts realizable on the sale of repossessed automobiles may be significantly reduced based upon the condition of the automobiles and the lack of demand for used automobiles.

The following presents by portfolio segment, the activity in the allowance for loan losses for the three and six months ended June 30, 2012 and June 30, 2011:

Three months ended June 30, 2012	One-to-four family residential			All other mortgage loans			Commercial business loans			Consumer loans			Unallocated		Total
	(In thousands)
Beginning balance	$	1,251		$	3,140		$	174		$	9		$	—	$	4,574
Provision charged to expense		(182	)		(181	)		(31	)		—			—		(394	)
Losses charged off		(23	)		(597	)		—			(4	)		—		(624	)
Recoveries		36			—			—			—			—		36
Ending balance	$	1,082		$	2,362		$	143		$	5		$	—	$	3,592

Three months ended June 30, 2011	One-to-four family residential			All other mortgage loans			Commercial business loans		Consumer loans		Unallocated		Total
	(In thousands)
Beginning balance	$	1,073		$	1,967		$	158	$	5	$	—	$	3,203
Provision charged to expense		55			(127	)		137		5		—		70
Losses charged off		(53	)		—			—		—		—		(53	)
Recoveries		1			—			—		—		—		1
Ending balance	$	1,076		$	1,840		$	295	$	10	$	—	$	3,221

Six months ended June 30, 2012	One-to-four family residential			All other mortgage loans			Commercial  business loans			Consumer loans			Unallocated		Total
	(In thousands)
Beginning balance	$	1,128		$	2,547		$	169		$	10		$	—	$	3,854
Provision charged to expense		3			417			(26	)		(1	)		—		393
Losses charged off		(88	)		(602	)		—			(4	)		—		(694	)
Recoveries		39			—			—			—			—		39
Ending balance	$	1,082		$	2,362		$	143		$	5		$	—	$	3,592

Six months ended June 30, 2011	One-to-four family residential			All other mortgage loans		Commercial business loans		Consumer loans		Unallocated			Total
	(In thousands)
Beginning balance	$	1,199		$	1,603	$	253	$	8	$	2		$	3,065
Provision charged to expense		(72	)		222		42		2		(2	)		192
Losses charged off		(53	)		—		—		—		—			(53	)
Recoveries		2			15		—		—		—			17
Ending balance	$	1,076		$	1,840	$	295	$	10	$	—		$	3,221

The following tables present the balance in the allowance for loan losses and the recorded investment in loans based on the portfolio segment and impairment method as of June 30, 2012 and December 31, 2011:

June 30, 2012	One-to-four family residential		All other  mortgage loans		Commercial business loans		Consumer loans		Unallocated		Total
Allowance Balances:
		(in thousands)
Ending balance:  individually evaluated for impairment	$	291	$	1,834	$	43	$	—	$	—	$	2,168
Ending balance:  collectively evaluated for impairment		791		528		100		5		—		1,424
Total allowance for loan losses	$	1,082	$	2,362	$	143	$	5	$	—	$	3,592
Loan Balances:
Ending balance:  individually evaluated for impairment	$	4,147	$	6,694	$	47	$	—			$	10,888
Ending balance:  collectively evaluated for impairment		150,685		67,980		11,167		2,095				231,927
Ending balance	$	154,832	$	74,674	$	11,214	$	2,095			$	242,815

December 31, 2011	One-to-four family residential		All other mortgage loans		Commercial business loans		Consumer loans		Unallocated		Total
Allowance Balances:
		(in thousands)
Ending balance:  individually evaluated for impairment	$	320	$	1,941	$	53	$	—	$	—	$	2,314
Ending balance:  collectively evaluated for impairment		808		606		116		10		—		1,540
Total allowance for loan losses	$	1,128	$	2,547	$	169	$	10	$	—	$	3,854
Loan Balances:
Ending balance:  individually evaluated for impairment	$	3,744	$	6,955	$	92	$	—			$	10,791
Ending balance:  collectively evaluated for impairment		149,320		65,251		10,434		2,257				227,262
Ending balance	$	153,064	$	72,206	$	10,526	$	2,257			$	238,053

Total loans in the above tables do not include deferred loan origination fees of $463,000 and $409,000 or loans in process of $3.3 million and $1.7 million for June 30, 2012 and December 31, 2011, respectively.

The following tables present the credit risk profile of the Bank’s loan portfolio based on rating category and payment activity as of June 30, 2012 and December 31, 2011:

June 30, 2012	One-to-four family residential		All other mortgage loans		Commercial business loans		Consumer loans
			(In thousands)
Rating *
Pass (Risk 1-4)	$	147,697	$	64,073	$	11,022	$	2,095
Special Mention (Risk 5)		2,988		3,907		145		—
Substandard (Risk 6)		4,147		6,694		47		—
Total	$	154,832	$	74,674	$	11,214	$	2,095

December 31, 2011	One-to-four family residential		All other mortgage loans		Commercial business loans		Consumer loans
			(In thousands)
Rating *
Pass (Risk 1-4)	$	145,061	$	61,970	$	10,268	$	2,257
Special Mention (Risk 5)		2,979		3,281		166		—
Substandard (Risk 6)		5,024		6,955		92		—
Total	$	153,064	$	72,206	$	10,526	$	2,257

* Ratings are generally assigned to consumer and residential mortgage loans on a “pass” or “fail” basis, where “fail” results in a substandard classification. Commercial loans, both secured by real estate or other assets or unsecured are analyzed in accordance with an analytical matrix codified in the Bank’s loan policy that produces a risk rating as described below.

Risk 1 is unquestioned credit quality for any credit product. Loans are secured by cash and near cash collateral with immediate access to proceeds.

Risk 2 is very low risk with strong credit and repayment sources. Borrower is well capitalized in a stable industry, financial ratios exceed peers and financial trends are positive.

Risk 3 is very favorable risk with highly adequate credit strength and repayment sources. Borrower has good overall financial condition and adequate capitalization.

Risk 4 is acceptable, average risk with adequate credit strength and repayment sources. Collateral positions must be within Bank policies.

Risk 5 or “Special Mention,” also known as “watch,” has potential weakness that deserves Management’s close attention. This risk includes loans where the borrower has developed financial uncertainties or are resolving them. Bank credits have been secured or negotiations will be ongoing to secure further collateral.

Risk 6 or “Substandard” loans are inadequately protected by the current net worth and paying capacity of the borrower or of the collateral pledged. This risk category contains loans that exhibit a weakening of the borrower’s credit strength with limited credit access and all non-performing loans.

Risk 7 or “Doubtful” loans are significantly under protected by the current net worth and paying capacity of the borrower or of the collateral pledged. This risk category contains loans that are likely to experience a loss of some magnitude, but where the amount of the expected loss is not known with enough certainty to allow for an accurate calculation of a loss amount for charge off. This category is considered to be temporary until a charge off amount can be reasonably determined.

The following tables present the Bank’s loan portfolio aging analysis for June 30, 2012 and December 31, 2011:

June 30, 2012	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90  Days		Total Past Due		Current		Total Loans Receivable		Total Loans > 90 Days & Accruing
					(In thousands)
One-to-four family residential loans	$	183	$	503	$	344	$	1,030	$	153,802	$	154,832	$	—
All other mortgage loans		967		—		1,775		2,742		71,932		74,674		—
Commercial business loans		—		—		2		2		11,212		11,214		—
Consumer loans		2		3		6		11		2,084		2,095		—
Total	$	1,152	$	506	$	2,127	$	3,785	$	239,030	$	242,815	$	—

December 31, 2011	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Total Loans > 90 Days & Accruing
					(In thousands)
One-to-four family residential loans	$	1,513	$	280	$	844	$	2,637	$	150,427	$	153,064	$	—
All other mortgage loans		903		—		1,905		2,808		69,398		72,206		—
Commercial business loans		17		—		35		52		10,474		10,526		—
Consumer loans		17		9		—		26		2,231		2,257		—
Total	$	2,450	$	289	$	2,784	$	5,523	$	232,530	$	238,053	$	—

Non-accrual loans were comprised of the following at:

	June 30, 2012		December 31, 2011
	Nonaccrual		Nonaccrual
	(In thousands)
One-to-four family residential loans	$	2,202	$	2,433
All other mortgage loans		3,102		3,271
Commercial business loans		47		92
Consumer loans		8		12
Total	$	5,359	$	5,808

A loan is considered impaired, in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events, it is probable the Bank will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming commercial loans but also include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. Information with respect to the Company’s impaired loans at June 30, 2012 and December 31, 2011 in combination with activity for the three and six month periods ended June 30, 2012 and June 30, 2011 is presented below:

	As of June 30, 2012						3 months ended June 30, 2012				6 months ended June 30, 2012
	Recorded Balance		Unpaid Principal Balance		Specific Allowance		Average Investment in Impaired Loans		Interest Income Recognized		Average Investment in Impaired Loans		Interest Income Recognized
	(in thousands)
Loans without a specific valuation allowance
One-to-four family residential loans	$	2,998	$	2,998	$	—	$	3,148	$	30	$	3,118	$	69
All other mortgage loans		2,060		2,060		—		2,067		28		1,916		55
Loans with a specific valuation allowance
One-to-four family residential loans		1,149		1,149		291		1,224		8		828		33
All other mortgage loans		4,634		4,634		1,834		4,973		19		4,909		39
Commercial business loans		47		47		43		49		—		70		—
Total:
One-to-four family residential loans	$	4,147	$	4,147	$	291	$	4,372	$	38	$	3,946	$	102
All other mortgage loans		6,694		6,694		1,834		7,040		47		6,825		94
Commercial business loans		47		47		43		49		—		70		—
	$	10,888	$	10,888	$	2,168	$	11,461	$	85	$	10,841	$	196

	As of December 31, 2011						3 months ended June 30, 2011				6 months ended June 30, 2011
	Recorded Balance		Unpaid Principal  Balance		Specific Allowance		Average Investment in Impaired Loans		Interest Income Recognized		Average Investment in Impaired Loans		Interest Income Recognized
	(in thousands)
Loans without a specific valuation allowance
One-to-four family residential loans	$	3,238	$	3,238	$	—	$	2,603	$	32	$	3,003	$	55
All other mortgage loans		1,771		1,771		—		1,493		—		1,985		10
Commercial business loans		—		—		—		—		—		26		—
Loans with a specific valuation allowance
One-to-four family residential loans		506		506		320		567		8		198		10
All other mortgage loans		5,184		5,184		1,941		5,055		65		4,070		97
Commercial business loans		92		92		53		163		—		149		2
Total:
One-to-four family residential loans	$	3,744	$	3,744	$	320	$	3,170	$	40	$	3,201	$	65
All other mortgage loans		6,955		6,955		1,941		6,548		65		6,055		107
Commercial business loans		92		92		53		163		—		175		2
	$	10,791	$	10,791	$	2,314	$	9,881	$	105	$	9,431	$	174

The interest income recognized in the above tables reflects interest income recognized and is not materially different from the cash basis method.

June 30, 2012	Quarter-to-Date						Year-to-Date
	Number  of loans		Pre- modification Unpaid Principal Balance		Post- modification Unpaid Principal Balance		Number of loans		Pre- modification Unpaid Principal Balance		Post- modification Unpaid Principal Balance
Troubled Debt Restructurings	(dollars in thousands)
One-to-four family residential loans		—	$	—	$	—		2	$	538	$	538

The TDR classifications which occurred in the year-to-date June 30, 2012 period were due to an effective interest rate below the market interest rate of similar debt. Each TDR has been individually evaluated for impairment with the appropriate specific valuation allowance included in the allowance for loan losses calculation. There were no TDR classifications which defaulted during the six month period ended June 30, 2012.