LOANS

Major classifications of loans at December 31 were as follows (in thousands):



	2015		2014
Commercial and industrial	$	45,275	35,424
Commercial, secured by real estate	419,633		379,141
Residential real estate	273,139		254,087
Consumer	18,510		18,006
Agricultural	13,479		11,472
Other loans, including deposit overdrafts	665		680
	770,701		698,810
Deferred origination costs (fees), net	237		146
	770,938		698,956
Less allowance for loan losses	3,129		3,121
Loans-net	$	767,809	695,835

Loans acquired from the mergers with First Capital, Eaton National, and BNB were recorded at fair value with no carryover of the acquired entity's previously established allowance for loan losses. The excess of expected cash flows over the estimated fair value of acquired loans is recognized as interest income over the remaining contractual lives of the loans using the level yield method. Subsequent decreases in expected cash flows will require additions to the allowance for loan losses. Subsequent improvements in expected cash flows result in the recognition of additional interest income over the then-remaining contractual lives of the loans. Management estimated the cash flows expected to be collected at acquisition using a third-party risk model, which incorporated the estimate of current key assumptions, such as default rates, severity, and prepayment speeds.

Impaired loans acquired are accounted for under FASB ASC 310-30. Factors considered in evaluating whether an acquired loan was impaired include delinquency status and history, updated borrower credit status, collateral information, and updated loan-to-value information. The difference between contractually required payments at the time of acquisition and the cash flows expected to be collected is referred to as the nonaccretable difference. The interest component of the cash flows expected to be collected is referred to as the accretable yield and is recognized as interest income over the remaining contractual life of the loan using the level yield method. Subsequent decreases in expected cash flows will require additions to the allowance for loan losses. Subsequent improvements in expected cash flows will result in a reclassification from the nonaccretable difference to the accretable yield.

The following table provides certain information at the acquisition date on loans acquired from BNB on April 30, 2015 and from Eaton National on January 24, 2014, not including loans considered to be impaired (in thousands):



	BNB		Eaton National
Contractually required principal at acquisition	$	32,174	102,483
Less fair value adjustment	199		1,347
Fair value of acquired loans	$	31,975	101,136

Contractual cash flows not expected to be collected	$	195	1,702

The following table provides details on acquired impaired loans obtained through the mergers with BNB and Eaton National that are accounted for in accordance with FASB ASC 310-30 (in thousands):



	BNB			Eaton National
Contractually required principal at acquisition	$	3,511		23,414
Contractual cash flows not expected to be collected (nonaccretable difference)	(404		)	(6,088	)
Expected cash flows at acquisition	3,107			17,326
Interest component of expected cash flows (accretable discount)	(413		)	(2,163	)
Fair value of acquired impaired loans	$	2,694		15,163

Non-accrual, past-due, and accruing restructured loans at December 31 were as follows (in thousands):



	2015			2014
Non-accrual loans:
Commercial and industrial	$	—		—
Commercial, secured by real estate	876			4,277
Agricultural	48			70
Residential real estate	799			1,252
Total non-accrual loans	1,723			5,599
Past-due 90 days or more and still accruing	559			203
Total non-accrual and past-due 90 days or more and still accruing	2,282			5,802
Accruing restructured loans	13,723			14,269
Total	$	16,005		20,071

Percentage of total non-accrual and past-due 90 days or more and still accruing to total loans	0.30		%	0.83	%

Percentage of total non-accrual, past-due 90 days or more and still accruing, and accruing restructured loans to total loans	2.08		%	2.87	%

LCNB sold impaired loans with a carrying value of approximately $4.5 million during the second quarter 2015. The decrease in non-accrual loans at December 31, 2015 as compared to December 31, 2014 is primarily due to this sale.

Interest income that would have been recorded during 2015 and 2014 if loans on non-accrual status at December 31, 2015 and 2014 had been current and in accordance with their original terms was approximately $137,000 and $665,000, respectively.

The Company is not committed to lend additional funds to debtors whose loans have been modified to provide a reduction or deferral of principal or interest because of deterioration in the financial position of the borrower.

The allowance for loan losses and recorded investment in loans for the years ended December 31 were as follows (in thousands):



	Commercial & Industrial			Commercial, Secured by Real Estate		Residential Real Estate		Consumer		Agricultural		Other		Total
December 31, 2015
Allowance for loan losses:
Balance, beginning of year	$	129		1,990		926		63		11		2		3,121
Provision charged to expenses	208			955		125		(17	)	55		40		1,366
Losses charged off	(100		)	(1,133	)	(304	)	(52	)	(67	)	(74	)	(1,730	)
Recoveries	7			96		107		60		67		35		372
Balance, end of year	$	244		1,908		854		54		66		3		3,129

Individually evaluated for impairment	$	9		306		48		—		—		—		363
Collectively evaluated for impairment	235			1,602		806		54		66		3		2,766
Acquired credit impaired loans	—			—		—		—		—		—		—
Balance, end of year	$	244		1,908		854		54		66		3		3,129

Loans:
Individually evaluated for impairment	$	370		12,351		1,541		56		—		—		14,318
Collectively evaluated for impairment	43,726			399,092		269,001		18,516		13,438		179		743,952
Acquired credit impaired loans	1,191			7,877		3,039		27		48		486		12,668
Balance, end of year	$	45,287		419,320		273,581		18,599		13,486		665		770,938

December 31, 2014
Allowance for loan losses:
Balance, beginning of year	$	175		2,520		826		66		—		1		3,588
Provision charged to expenses	173			(20	)	712		18		11		36		930
Losses charged off	(261		)	(573	)	(652	)	(129	)	—		(79	)	(1,694	)
Recoveries	42			63		40		108		—		44		297
Balance, end of year	$	129		1,990		926		63		11		2		3,121

Individually evaluated for impairment	$	10		415		89		—		—		—		514
Collectively evaluated for impairment	119			1,273		836		63		11		2		2,304
Acquired credit impaired loans	—			302		1		—		—		—		303
Balance, end of year	$	129		1,990		926		63		11		2		3,121

Loans:
Individually evaluated for impairment	$	401		13,022		1,701		55		—		—		15,179
Collectively evaluated for impairment	33,941			352,774		249,374		17,954		11,371		167		665,581
Acquired credit impaired loans	1,092			12,984		3,425		81		101		513		18,196
Balance, end of year	$	35,434		378,780		254,500		18,090		11,472		680		698,956



	Commercial & Industrial			Commercial, Secured by Real Estate		Residential Real Estate		Consumer		Agricultural	Other		Total
December 31, 2013
Allowance for loan losses:
Balance, beginning of year	$	320		2,296		712		108		—	1		3,437
Provision charged to expenses	(30		)	256		327		12		—	23		588
Losses charged off	(119		)	(58	)	(244	)	(181	)	—	(67	)	(669	)
Recoveries	4			26		31		127		—	44		232
Balance, end of year	$	175		2,520		826		66		—	1		3,588

Individually evaluated for impairment	$	2		760		270		—		—	—		1,032
Collectively evaluated for impairment	173			1,760		556		66		—	1		2,556
Balance, end of year	$	175		2,520		826		66		—	1		3,588

The risk characteristics of LCNB's material loan portfolio segments were as follows:

Commercial and Industrial Loans. LCNB’s commercial and industrial loan portfolio consists of loans for various purposes, including loans to fund working capital requirements (such as inventory and receivables financing) and purchases of machinery and equipment. LCNB offers a variety of commercial and industrial loan arrangements, including term loans, balloon loans, and lines of credit. Most commercial and industrial loans have a variable rate, with adjustment periods ranging from one month to five years. Adjustments are generally based on a publicly available index rate plus a margin. The margin varies based on the terms and collateral securing the loan. Commercial and industrial loans are offered to businesses and professionals for short and medium terms on both a collateralized and uncollateralized basis. Commercial and industrial loans typically are underwritten on the basis of the borrower’s ability to make repayment from the cash flow of the business. Collateral, when obtained, may include liens on furniture, fixtures, equipment, inventory, receivables, or other assets. As a result, such loans involve complexities, variables, and risks that require thorough underwriting and more robust servicing than other types of loans.

Commercial, Secured by Real Estate Loans. Commercial real estate loans include loans secured by a variety of commercial, retail, and office buildings, religious facilities, multifamily (more than two-family) residential properties, construction and land development loans, and other land loans. Commercial real estate loan products generally amortize over five to twenty-five years and are payable in monthly principal and interest installments. Some have balloon payments due within one to ten years after the origination date. Many have adjustable interest rates with adjustment periods ranging from one to ten years, some of which are subject to established “floor” interest rates.

Commercial real estate loans are underwritten based on the ability of the property, in the case of income producing property, or the borrower’s business to generate sufficient cash flow to amortize the debt. Secondary emphasis is placed upon global debt service, collateral value, financial strength of any guarantors, and other factors. Commercial real estate loans are generally originated with a 75% maximum loan to appraised value ratio.

Residential Real Estate Loans. Residential real estate loans include loans secured by first or second mortgage liens on one to two-family residential property. Home equity lines of credit and mortgage loans secured by owner-occupied agricultural property are included in this category. First and second mortgage loans are generally amortized over five to thirty years with monthly principal and interest payments. Home equity lines of credit generally have a five year draw period with interest only payments followed by a repayment period with monthly payments based on the amount outstanding. LCNB offers both fixed and adjustable rate mortgage loans. Adjustable rate loans are available with adjustment periods ranging between one to ten years and adjust according to an established index plus a margin, subject to certain floor and ceiling rates. Home equity lines of credit have a variable rate based on the Wall Street Journal prime rate plus a margin.

LCNB does not originate reverse mortgage loans or residential real estate loans generally considered to be “subprime.”

Residential real estate loans are underwritten primarily based on the borrower’s ability to repay, prior credit history, and the value of the collateral. LCNB requires private mortgage insurance for first mortgage loans that have a loan to appraised value ratio of greater than 80%.

Consumer Loans. LCNB’s portfolio of consumer loans generally includes secured and unsecured loans to individuals for household, family and other personal expenditures. Secured loans include loans to fund the purchase of automobiles, recreational vehicles, boats, and similar acquisitions. Consumer loans made by LCNB generally have fixed rates and terms ranging up to 72 months, depending upon the nature of the collateral, size of the loan, and other relevant factors.

Consumer loans generally have higher interest rates, but pose additional risks of collectibility and loss when compared to certain other types of loans. Collateral, if present, is generally subject to damage, wear, and depreciation. The borrower’s ability to repay is of primary importance in the underwriting of consumer loans.

Agricultural Loans. LCNB’s portfolio of agricultural loans includes loans for financing agricultural production or for financing the purchase of equipment used in the production of agricultural products. LCNB’s agricultural loans are generally secured by farm machinery, livestock, crops, vehicles, or other agri-related collateral.

The Company uses a risk-rating system to quantify loan quality. A loan is assigned to a risk category based on relevant information about the ability of the borrower to service the debt including, but not limited to, current financial information, historical payment experience, credit documentation, public information, and current economic trends. The categories used are:


•	Pass – loans categorized in this category are higher quality loans that do not fit any of the other categories described below.


•	Other Assets Especially Mentioned (OAEM) - loans in this category are currently protected but are potentially weak. These loans constitute a risk but not to the point of justifying a classification of substandard. The credit risk may be relatively minor yet constitute an undue risk in light of the circumstances surrounding a specific asset.

•

Substandard – loans in this category are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the possibility that the Company will sustain some loss if the deficiencies are not corrected.


•	Doubtful – loans classified in this category have all the weaknesses inherent in loans classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

An analysis of the Company’s loan portfolio by credit quality indicators at December 31 is as follows (in thousands):



	Pass		OAEM	Substandard	Doubtful	Total
December 31, 2015
Commercial & industrial	$	44,596	—	691	—	45,287
Commercial, secured by real estate	397,938		9,316	12,066	—	419,320
Residential real estate	267,567		1,935	4,079	—	273,581
Consumer	18,528		—	71	—	18,599
Agricultural	12,246		850	390	—	13,486
Other	665		—	—	—	665
Total	$	741,540	12,101	17,297	—	770,938

December 31, 2014
Commercial & industrial	$	34,322	—	1,112	—	35,434
Commercial, secured by real estate	353,957		6,421	18,402	—	378,780
Residential real estate	246,335		920	7,245	—	254,500
Consumer	17,979		—	111	—	18,090
Agricultural	11,273		—	199	—	11,472
Other	680		—	—	—	680
Total	$	664,546	7,341	27,069	—	698,956

The Company evaluates the loan risk grading system definitions and allowance for loan loss methodology on an ongoing basis. No significant changes were made to either during the past year.

A loan portfolio aging analysis at December 31 is as follows (in thousands):



	30-59 Days Past Due		60-89 Days Past Due	Greater Than 90 Days	Total Past Due	Current	Total Loans Receivable	Total Loans Greater Than 90 Days and Accruing
December 31, 2015
Commercial & industrial	$	—	—	—	—	45,287	45,287	—
Commercial, secured by real estate	73		81	876	1,030	418,290	419,320	—
Residential real estate	777		198	1,124	2,099	271,482	273,581	516
Consumer	62		7	43	112	18,487	18,599	43
Agricultural	—		—	—	—	13,486	13,486	—
Other	109		—	—	109	556	665	—
Total	$	1,021	286	2,043	3,350	767,588	770,938	559

December 31, 2014
Commercial & industrial	$	4	—	—	4	35,430	35,434	—
Commercial, secured by real estate	1,000		83	3,179	4,262	374,518	378,780	9
Residential real estate	648		297	1,289	2,234	252,266	254,500	177
Consumer	59		28	17	104	17,986	18,090	17
Agricultural	73		70	—	143	11,329	11,472	—
Other	106		—	—	106	574	680	—
Total	$	1,890	478	4,485	6,853	692,103	698,956	203

Impaired loans for the years ended December 31 were as follows (in thousands):



	Recorded Investment		Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
December 31, 2015
With no related allowance recorded:
Commercial & industrial	$	1,205	1,500	—	1,467	206
Commercial, secured by real estate	16,345		18,335	—	18,575	2,229
Residential real estate	3,734		5,055	—	4,092	453
Consumer	81		109	—	106	25
Agricultural	48		151	—	81	487
Other	486		701	—	510	82
Total	$	21,899	25,851	—	24,831	3,482

With an allowance recorded:
Commercial & industrial	$	356	356	9	370	21
Commercial, secured by real estate	3,883		4,014	306	4,007	114
Residential real estate	846		958	48	864	37
Consumer	2		1	—	—	—
Agricultural	—		—	—	—	—
Other	—		—	—	—	—
Total	$	5,087	5,329	363	5,241	172

Total:
Commercial & industrial	$	1,561	1,856	9	1,837	227
Commercial, secured by real estate	20,228		22,349	306	22,582	2,343
Residential real estate	4,580		6,013	48	4,956	490
Consumer	83		110	—	106	25
Agricultural	48		151	—	81	487
Other	486		701	—	510	82
Total	$	26,986	31,180	363	30,072	3,654



	Recorded Investment		Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
December 31, 2014
With no related allowance recorded:
Commercial & industrial	$	1,092	2,077	—	1,823	161
Commercial, secured by real estate	21,822		26,715	—	23,360	1,373
Residential real estate	4,057		5,549	—	4,645	379
Consumer	117		178	—	179	14
Agricultural	101		619	—	121	20
Other	513		744	—	550	43
Total	$	27,702	35,882	—	30,678	1,990

With an allowance recorded:
Commercial & industrial	$	401	406	10	319	19
Commercial, secured by real estate	4,184		4,538	717	4,108	117
Residential real estate	1,069		1,265	90	1,026	44
Consumer	19		20	—	18	2
Agricultural	—		—	—	—	—
Other	—		—	—	—	—
Total	$	5,673	6,229	817	5,471	182

Total:
Commercial & industrial	$	1,493	2,483	10	2,142	180
Commercial, secured by real estate	26,006		31,253	717	27,468	1,490
Residential real estate	5,126		6,814	90	5,671	423
Consumer	136		198	—	197	16
Agricultural	101		619	—	121	20
Other	513		744	—	550	43
Total	$	33,375	42,111	817	36,149	2,172



	Recorded Investment		Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
December 31, 2013
With no related allowance recorded:
Commercial & industrial	$	332	531	—	700	35
Commercial, secured by real estate	10,883		12,317	—	11,612	748
Residential real estate	2,096		2,967	—	2,345	182
Consumer	—		—	—	7	—
Agricultural	—		—	—	13	6
Total	$	13,311	15,815	—	14,677	971

With an allowance recorded:
Commercial & industrial	$	165	270	2	186	2
Commercial, secured by real estate	7,725		7,725	760	7,368	252
Residential real estate	1,645		1,663	270	1,123	44
Consumer	27		27	—	17	2
Agricultural	—		—	—	—	—
Total	$	9,562	9,685	1,032	8,694	300

Total:
Commercial & industrial	$	497	801	2	886	37
Commercial, secured by real estate	18,608		20,042	760	18,980	1,000
Residential real estate	3,741		4,630	270	3,468	226
Consumer	27		27	—	24	2
Agricultural	—		—	—	13	6
Total	$	22,873	25,500	1,032	23,371	1,271

Of the interest income recognized on impaired loans during 2015, 2014, and 2013, approximately $96,000, $8,000, and $0, respectively, were recognized on a cash basis. The Company continued to accrue interest on certain loans classified as impaired during 2015, 2014, and 2013 because they were restructured or considered well secured and in the process of collection.

Loan modifications that were classified as troubled debt restructurings during the years ended December 31 were as follows (dollars in thousands):



	2015					2014					2013
	Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance		Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance		Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance
Commercial and industrial	—	$	—	$	—	8	$	658	$	340	1	$	22	$	22
Commercial, secured by real estate	1	75		74		2	896		1,214		3	1,594		1,594
Residential real estate	7	217		221		2	82		82		6	508		508
Consumer	2	9		9		3	40		40		2	27		27
	10	$	301	$	304	15	$	1,676	$	1,676	12	$	2,151	$	2,151

The pre-modification and post-modification recorded balances for the commercial and industrial and commercial, secured by real estate categories in 2014 changed because a borrower had multiple loans classified as commercial and industrial and a loan classified as commercial, secured by real estate, which were all modified into a loan classified as commercial, secured by real estate.

Each restructured loan is separately negotiated with the borrower and includes terms and conditions that reflect the borrower’s ability to pay the debt as modified. Modifications may include interest only payments for a period of time, temporary or permanent reduction of the loan’s interest rate, capitalization of delinquent interest, or extensions of the maturity date.

LCNB is not committed to lend additional funds to borrowers whose loan terms were modified in a troubled debt restructuring.

There were no troubled debt restructurings that subsequently defaulted within twelve months of the restructuring date for the years ended December 31, 2015 and 2014. A restructured automobile loan with a balance of $13,000 was charged off during the first quarter 2013, which was within twelve months of the loan's modification date.

All troubled debt restructurings are considered impaired loans. The allowance for loan loss on such restructured loans is based on the present value of future expected cash flows.

Approximately $147,000 of impaired loans without a valuation allowance and $125,000 of impaired loans with a valuation allowance at December 31, 2015 consisted of loans that were modified during 2015 and were determined to be troubled debt restructurings. Approximately $1,329,000 of impaired loans without a valuation allowance and $299,000 of impaired loans with a valuation allowance at December 31, 2014 consisted of loans that were modified during 2014 and were determined to be troubled debt restructurings.

Mortgage loans sold to and serviced for the Federal Home Loan Mortgage Corporation and other investors are not included in the accompanying consolidated balance sheets. The unpaid principal balances of those loans at December 31, 2015, 2014 and 2013 were approximately $111,837,000, $120,433,000, and $90,343,000 respectively.

Mortgage servicing right assets are included in core deposit and other intangibles in the consolidated balance sheets. Amortization of mortgage servicing rights is an adjustment to loan servicing income, which is included with other operating income in the consolidated statements of income. Activity in the mortgage servicing rights portfolio during the years ended December 31 was as follows (in thousands):



	2015			2014		2013
Balance, beginning of year	$	591		498		475
Amount capitalized to mortgage servicing rights	78			292		191
Amortization of mortgage servicing rights	(181		)	(199	)	(168	)
Balance, end of year	$	488		591		498