4. Loans

The classifications of loans at December 31, 2012 and 2011 are summarized as follows:

As of December 31,

(dollars in thousands)

2012

2011

Commercial and industrial

$ 65,110

$ 68,372

Commercial real estate:

Non-owner occupied

81,998

79,475

Owner occupied

80,509

76,611

Construction

10,679

9,387

Consumer:

Home equity installment

32,828

36,390

Home equity line of credit

34,169

32,486

Auto

17,411

13,539

Other

6,139

5,833

Residential:

Real estate

96,765

80,091

Construction

7,948

4,110

Total

433,556

406,294

Less:

Allowance for loan losses

(8,972)

(8,108)

Loans, net

$ 424,584

$ 398,186

Net deferred loan costs of $1.0 million and $0.8 million have been added to the carrying values of loans at December 31, 2012 and 2011, respectively.

The Company services real estate loans for investors in the secondary mortgage market which are not included in the accompanying consolidated balance sheets. The approximate amount of mortgages serviced amounted to $214.7 million and $193.5 million as of December 31, 2012 and 2011.

The Company utilizes an external independent loan review firm that reviews and validates the credit risk program on at least an annual basis. Results of these reviews are presented to management and the Board of Directors. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Company's policies and procedures.

Non-accrual loans

The decision to place loans on non-accrual status is made on an individual basis after considering factors pertaining to each specific loan. Commercial and industrial and commercial real estate loans are placed on non-accrual status when management has determined that payment of all contractual principal and interest is in doubt or the loan is past due 90 days or more as to principal and interest, unless well-secured and in the process of collection. Consumer loans secured by real estate and residential mortgage loans are placed on non-accrual status at 120 days past due as to principal and interest and unsecured consumer loans are charged off when the loan is 90 days or more past due as to principal and interest.

Non-accrual loans, segregated by class, at December 31, were as follows:

As of December 31,

(dollars in thousands)

2012

2011

Commercial and industrial

$ 18

$ 458

Commercial real estate:

Non-owner occupied

1,884

2,406

Owner occupied

5,031

6,288

Construction

1,123

656

Consumer:

Home equity installment

1,306

1,017

Home equity line of credit

381

730

Other

Residential:

Real estate

2,330

2,329

Construction

Total

$ 12,121

$ 13,962

Troubled Debt Restructuring

A modification of a loan constitutes a troubled debt restructuring (TDR) when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Company offers various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted. Commercial and industrial loans modified in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Additional collateral, a co-borrower, or a guarantor is often requested. Commercial real estate and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period. Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers' financial needs for an extended period of time. After the lowered monthly payment period ends, the borrower would revert back to paying principal and interest per the original terms with the maturity date adjusted accordingly. Home equity and automobile loan modifications are typically not made and therefore standard modification terms do not exist for loans of this type.

Loans modified in a TDR may or may not be placed on non-accrual status. As of December 31, 2012, total TDRs amounted to $2.2 million of which $1.1 million were on non-accrual status. As of December 31, 2011, total TDRs amounted to $6.7 million of which $1.4 million were on non-accrual status. The majority of the $4.5 million reduction in TDRs is the result of a loan of $1.8 million which was repaid upon the sale of the underlying collateral by the borrower. The proceeds of which were used to repay the loan. The sale of the underlying collateral and subsequent repayment of the loan did not result in an adverse impact to the Company. A second loan of $2.4 million to a related borrower which had been a TDR was repaid with the proceeds of a new loan by the Bank on conventional loan terms and conditions. Partial charge-offs may be taken against the outstanding loan balance of TDRs, but only in rare instances. As a result, loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance for loan losses associated with the loan. The Company considers all TDRs to be impaired loans. An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the loan's observable market price. If the loan is collateral dependent, the estimated fair value of the collateral, less any selling costs, is used to establish the allowance. Management exercises significant judgment in developing these estimates. There were no loans modified in a TDR during the three and twelve months ended December 31, 2012.

Loans modified in a TDR are closely monitored for delinquency as an early indicator of possible future default. If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. The allowance may be increased, adjustments may be made in the allocation of the allowance or partial charge offs may be taken to further write-down the carrying value of the loan.

Past due loans

Loans are considered past due when the contractual principal and/or interest is not received by the due date. An aging analysis of past due loans, segregated by class of loans, as of the period indicated is as follows (dollars in thousands):

Recorded

Past due

Total

investment past

30 - 59 Days

60 - 89 Days

90 days

Total

loans

due ≥ 90 days

December 31, 2012

past due

or more *

past due

Current

receivables

and accruing

Commercial and industrial

$ 676

$ 15

$ 254

$ 945

$ 64,165

$ 65,110

$ 236

Commercial real estate:

Non-owner occupied

141

1,884

2,025

79,973

81,998

Owner occupied

208

282

5,439

5,929

74,580

80,509

408

Construction

1,123

9,556

10,679

Consumer:

Home equity installment

216

132

1,325

1,673

31,155

32,828

Home equity line of credit

381

447

33,722

34,169

Auto

459

505

16,906

17,411

Other

117

6,022

6,139

Residential:

Real estate

544

3,357

4,000

92,765

96,765

1,027

Construction

7,948

Total

$ 1,706

$ 1,214

$ 13,844

$ 16,764

$ 416,792

$ 433,556

$ 1,723

*Includes $12.1 million of non-accrual loans.

									Recorded
					Past due			Total	investment past
			30 - 59 Days	60 - 89 Days	90 days	Total		loans	due ≥ 90 days
December 31, 2011			past due	past due	or more *	past due	Current	receivables	and accruing

Commercial and industrial			$ 61	$ 20	$ 458	$ 539	$ 67,833	$ 68,372	$ -
Commercial real estate:
	Non-owner occupied		1,802	386	2,406	4,594	74,881	79,475	-
	Owner occupied		134	71	6,288	6,493	70,118	76,611	-
	Construction		-	-	656	656	8,731	9,387	-
Consumer:
	Home equity installment		450	161	1,017	1,628	34,762	36,390	-
	Home equity line of credit		11	-	730	741	31,745	32,486	-
	Auto		437	181	-	618	12,921	13,539	-
	Other		19	11	-	30	5,803	5,833	-
Residential:
	Real estate		297	317	2,594	3,208	76,883	80,091	265
	Construction		-	-	78	78	4,032	4,110	-
		Total	$ 3,211	$ 1,147	$ 14,227	$ 18,585	$ 387,709	$ 406,294	$ 265

* Includes $14.0 million of non-accrual loans.

Impaired loans

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 in accordance with the contractual terms of the loan. Factors considered in determining impairment include payment status, collateral value and the probability of collecting payments when due. The significance of payment delays and/or shortfalls is determined on a case-by-case basis. All circumstances surrounding the loan are taken into account. Such factors include the length of the delinquency, the underlying reasons and the borrower's prior payment record. Impairment is measured on these loans on a loan-by-loan basis. Impaired loans may include non-accrual loans, TDRs and other loans deemed to be impaired based on the aforementioned factors. As of December 31, 2012 and 2011, impaired loans consisted of non-accrual loans and TDRs.

At December 31, 2012, impaired loans consisted of accruing TDRs totaling $1.1 million and $12.1 million of non-accrual loans. The non-accrual total, as of December 31, 2012, includes $1.1 million of non-accruing TDRs. At December 31, 2011, impaired loans consisted of accruing TDRs totaling $5.3 million in addition to the $14.0 million of non-accrual loans. The non-accrual total, as of December 31, 2011, included $1.4 million of non-accruing TDRs. Payments received on non-accrual loans are recognized on a cash basis. Payments are first applied against the outstanding principal balance, then to the recovery of any charged-off amounts. Any excess is treated as a recovery of interest income.

Impaired loans, segregated by class, as of the period indicated are detailed below:

Recorded

Cash basis

Unpaid

investment

Total

Average

Interest

interest

principal

with

with no

recorded

income

(dollars in thousands)

balance

allowance

investment

allowance

investment

recognized

December 31, 2012

Commercial & industrial

$ 52

$ 8

$ 52

$ 60

$ 4

$ 275

$ 4

$ -

Commercial real estate:

Non-owner occupied

2,431

957

1,420

2,377

233

4,172

152

Owner occupied

5,940

4,500

1,099

5,599

1,230

7,292

121

Construction

1,123

210

913

1,123

194

941

Consumer:

Home equity installment

1,480

524

782

1,306

1,023

Home equity line of credit

435

144

237

381

482

Auto

Other

102

Residential:

Real Estate

2,688

564

1,766

2,330

2,342

Construction

Total

$ 14,251

$ 6,923

$ 6,301

$ 13,224

$ 1,814

$ 16,608

$ 294

$ 20

				Recorded	Recorded					Cash basis
			Unpaid	investment	investment	Total		Average	Interest	interest
			principal	with	with no	recorded	Related	recorded	income	income
(dollars in thousands)			balance	allowance	allowance	investment	allowance	investment	recognized	recognized
December 31, 2011
Commercial & industrial			$ 549	$ 322	$ 179	$ 501	$ 63	$ 355	$ 2	$ -
Commercial real estate:
	Non-owner occupied		5,434	3,144	2,176	5,320	301	3,026	53	-
	Owner occupied		8,538	5,730	2,915	8,645	792	4,953	108	14
	Construction		656	656	-	656	152	375	-	-
Consumer:
	Home equity installment		1,050	395	622	1,017	88	751	6	3
	Home equity line of credit		730	229	501	730	55	488	2	1
	Auto		-	-	-	-	-	3	-	-
	Other		-	-	-	-	-	12	-	-
Residential:
	Real Estate		2,619	1,083	1,246	2,329	84	2,867	155	59
	Construction		94	78	-	78	-	91	-	-
		Total	$ 19,670	$ 11,637	$ 7,639	$ 19,276	$ 1,535	$ 12,921	$ 326	$ 77

Credit Quality Indicators

Commercial and industrial and commercial real estate

The Company utilizes a loan grading system and assigns a credit risk grade to its loans in the commercial and industrial and commercial real estate portfolios. The grading system provides a means to measure portfolio quality and aids in the monitoring of the credit quality of the overall loan portfolio. The credit risk grades are arrived at using a risk rating matrix to assign a grade to each of the loans in the commercial and industrial and commercial real estate portfolios.

The following is a description of each risk rating category the Company uses to classify each of its commercial and industrial and commercial real estate loans:

Pass

Loans in this category have an acceptable level of risk and are graded in a range of one to five. Secured loans generally have good collateral coverage. Current financial statements reflect acceptable balance sheet ratios, sales and earnings trends. Management is considered to be good, and there is some depth existing. Payment experience on the loans has been good with minor or no delinquency experience. Loans with a grade of one are of the highest quality in the range. Those graded five are of marginally acceptable quality.

Special Mention

Loans in this category are graded a six and may be protected but are potentially weak. They constitute a credit risk to the Company, but have not yet reached the point of adverse classification. Some of the following conditions may exist: little or no collateral coverage; lack of current financial information; delinquency problems; highly leveraged; available financial information reflects poor balance sheet ratios and profit and loss statements reflect uncertain trends; and document exceptions. Cash flow may not be sufficient to support total debt service requirements. Loans in this category should not remain on the list for an inordinate period of time (no more than one year) and then the loan should be passed or classified appropriately.

Substandard

Loans in this category are graded a seven and have a well-defined weakness which may jeopardize the ultimate collectability of the debt. The collateral pledged may be lacking in quality or quantity. Financial statements may indicate insufficient cash flow to service the debt; and/or do not reflect a sound net worth. The payment history indicates chronic delinquency problems. Management is considered to be weak. There is a distinct possibility that the Company may sustain a loss. All loans on non-accrual are rated substandard. Loans 90days or more past due unless otherwise fully supported should be classified substandard. Also, borrowers that are bankrupt are substandard.

Doubtful

Loans in this category are graded an eight and have a better than 50% possibility of the Company sustaining a loss, but the loss cannot be determined because of specific reasonable factors which may strengthen credit in the near-term. Many of the weaknesses present in a substandard loan exist. Liquidation of collateral, if any, is likely. Any loan graded lower than an eight is considered to be uncollectible and charged-off.

Consumer and Residential

The consumer and residential loan segments are regarded as homogeneous loan pools and as such are not risk rated. For these portfolios, the Company utilizes payment activity, history and recency of payment. Non-performing loans are considered to be loans past due 90 days or more and accruing and non-accrual loans. All loans not classified as non-performing are considered performing.

The following table presents loans, segregated by class, categorized into the appropriate credit quality indicator category as of the period indicated:

Commercial credit exposure

Credit risk profile by creditworthiness category

Commercial real estate -

Commercial and industrial

non-owner occupied

owner occupied

construction

(dollars in thousands)

12/31/2012

12/31/2011

12/31/2012

12/31/2011

12/31/2012

12/31/2011

12/31/2012

12/31/2011

Pass

$ 61,821

$ 64,064

$ 72,738

$ 65,819

$ 73,922

$ 66,298

$ 8,094

$ 6,911

Special mention

2,221

2,953

3,520

5,681

222

1,627

1,422

1,246

Substandard

1,068

1,355

5,740

7,975

6,365

8,686

1,163

1,230

Doubtful

Total

$ 65,110

$ 68,372

$ 81,998

$ 79,475

$ 80,509

$ 76,611

$ 10,679

$ 9,387

Consumer credit exposure

Credit risk profile based on payment activity

Home equity installment

Home equity line of credit

Auto

Other

(dollars in thousands)

12/31/2012

12/31/2011

12/31/2012

12/31/2011

12/31/2012

12/31/2011

12/31/2012

12/31/2011

Performing

$ 31,503

$ 35,373

$ 33,788

$ 31,756

$ 17,395

$ 13,539

$ 6,074

$ 5,833

Non-performing

1,325

1,017

381

730

Total

$ 32,828

$ 36,390

$ 34,169

$ 32,486

$ 17,411

$ 13,539

$ 6,139

$ 5,833

Mortgage lending credit exposure

Credit risk profile based on payment activity

Residential real estate

Residential construction

(dollars in thousands)

12/31/2012

12/31/2011

12/31/2012

12/31/2011

Performing

$ 93,408

$ 77,497

$ 7,948

$ 4,032

Non-performing

3,357

2,594

Total

$ 96,765

$ 80,091

$ 7,948

$ 4,110

Allowance for loan losses

Management continually evaluates the credit quality of the Company's loan portfolio and performs a formal review of the adequacy of the allowance for loan losses (the allowance) on a quarterly basis. The allowance reflects management's best estimate of the amount of credit losses in the loan portfolio. Management's judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans. Those estimates may be susceptible to significant change. Loan losses are charged directly against the allowance when loans are deemed to be uncollectible. Recoveries from previously charged-off loans are added to the allowance when received.

Management applies two primary components during the loan review process to determine proper allowance levels. The two components are a specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated. The methodology to analyze the adequacy of the allowance for loan losses is as follows:

§ identification of specific impaired loans by loan category;

§ specific loans that are not impaired, but have an identified potential for loss;

§ calculation of specific allowances where required for the impaired loans based on collateral and other objective and quantifiable evidence;

§ determination of loans with similar credit characteristics within each class of the loan portfolio segment and eliminating the impaired loans;

§ application of historical loss percentages (two-year average) to pools to determine the allowance allocation;

§ application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio. Qualitative factor adjustments include:

o levels of and trends in delinquencies and non-accrual loans;

o levels of and trends in charge-offs and recoveries;

o trends in volume and terms of loans;

o changes in risk selection and underwriting standards;

o changes in lending policies, procedures and practices;

o experience, ability and depth of lending management;

o national and local economic trends and conditions; and

o changes in credit concentrations.

Allocation of the allowance for different categories of loans is based on the methodology as explained above. A key element of the methodology to determine the allowance is the Company's credit risk evaluation process, which includes credit risk grading of individual commercial and industrial and commercial real estate loans. Commercial and industrial and commercial real estate loans are assigned credit risk grades based on the Company's assessment of conditions that affect the borrower's ability to meet its contractual obligations under the loan agreement. That process includes reviewing borrowers' current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower. Upon review, the commercial loan credit risk grade is revised or reaffirmed as the case may be. The credit risk grades may be changed at any time management feels an upgrade or downgrade may be warranted. The credit risk grades for the commercial and industrial and commercial real estate loan portfolios are taken into account in the reserve methodology and loss factors are applied based upon the credit risk grades. The loss factors applied are based upon the Company's historical experience as well as what we believe to be best practices and common industry standards. Historical experience reveals there is a direct correlation between the credit risk grades and loan charge-offs. The changes in allocations in the commercial and industrial and commercial real estate loan portfolio from period to period are based upon the credit risk grading system and from periodic reviews of the loan portfolio.

Each quarter, management performs an assessment of the allowance for loan losses. The Company's Special Assets Committee meets quarterly and the applicable lenders discuss each relationship under review and reach a consensus on the appropriate estimated loss amount based on current accounting guidance. The Special Assets Committee's focus is on ensuring the pertinent facts are considered and the reserve amounts pursuant to the accounting principles are reasonable. The assessment process includes the review of all loans on a non-accruing basis as well as a review of certain loans to which the lenders or the Company's Credit Administration function have assigned a criticized or classified risk rating. In 2012, the Company did not change its policy or methodology in calculating the allowance for loan losses from the policy or methodology used in 2011.

The Company's policy is to charge off unsecured consumer loans when they become 90 days or more past due as to principal and interest. In the other portfolio segments, amounts are charged off at the point in time when the Company deems the balance, or a portion thereof, to be uncollectible.

Information related to the change in the allowance for loan losses and the Company's recorded investment in loans by portfolio segment as of the period indicated is as follows:

As of and for the year ended December 31, 2012

Commercial &

Commercial

Residential

(dollars in thousands)

industrial

real estate

Consumer

real estate

Unallocated

Total

Allowance for Loan Losses:

Beginning balance

$ 1,221

$ 3,979

$ 1,435

$ 1,051

$ 422

$ 8,108

Charge-offs

185

1,335

737

231

2,488

Recoveries

102

Provision

(140)

2,218

911

683

(422)

3,250

Ending balance

$ 922

$ 4,908

$ 1,639

$ 1,503

$ -

$ 8,972

Ending balance: individually

evaluated for impairment

$ 4

$ 1,657

$ 77

$ 76

$ 1,814

Ending balance: collectively

evaluated for impairment

$ 918

$ 3,251

$ 1,562

$ 1,427

$ 7,158

Loans Receivables:

Ending balance

$ 65,110

$ 173,186

$ 90,547

$ 104,713

$ 433,556

Ending balance: individually

evaluated for impairment

$ 60

$ 9,099

$ 1,735

$ 2,330

$ 13,224

Ending balance: collectively

evaluated for impairment

$ 65,050

$ 164,087

$ 88,812

$ 102,383

$ 420,332


As of and for the year ended December 31, 2011
			Commercial &	Commercial		Residential
(dollars in thousands)			industrial	real estate	Consumer	real estate	Unallocated	Total

Allowance for Loan Losses:
	Beginning balance		$ 1,368	$ 4,239	$ 1,248	$ 863	$ 180	$ 7,898
		Charge-offs	128	699	654	577	-	2,058
		Recoveries	407	37	17	7	-	468
		Provision	(426)	402	824	758	242	1,800
	Ending balance		$ 1,221	$ 3,979	$ 1,435	$ 1,051	$ 422	$ 8,108
	Ending balance: individually
		evaluated for impairment	$ 63	$ 1,245	$ 143	$ 84		$ 1,535
	Ending balance: collectively
		evaluated for impairment	$ 1,158	$ 2,734	$ 1,292	$ 967		$ 6,151
Loans Receivables:
	Ending balance		$ 68,372	$ 165,473	$ 88,248	$ 84,201		$ 406,294
	Ending balance: individually
		evaluated for impairment	$ 501	$ 14,621	$ 1,747	$ 2,407		$ 19,276
	Ending balance: collectively
		evaluated for impairment	$ 67,871	$ 150,852	$ 86,501	$ 81,794		$ 387,018