LOANS

The portfolio of loans outstanding consists of the following:



	March 31, 2016				December 31, 2015
	Amount		Percentage of Total Loans		Amount		Percentage of Total Loans
	(amounts in thousands)
Commercial and Industrial	$	23,050	2.9	%	$	27,140	3.6	%
Real Estate Construction:
Residential	5,555		0.7		7,750		1.0
Commercial	56,025		7.0		45,245		6.0
Real Estate Mortgage:
Commercial – Owner Occupied	158,839		19.8		172,040		22.7
Commercial – Non-owner Occupied	263,278		32.8		256,471		33.8
Residential – 1 to 4 Family	239,346		29.8		213,266		28.1
Residential – Multifamily	38,002		4.7		18,113		2.4
Consumer	18,457		2.3		18,476		2.4
Total Loans	$	802,552	100.0	%	$	758,501	100.0	%

Loan Origination/Risk Management: In the normal course of business the Company is exposed to a variety of operational, reputational, legal, regulatory, and credit risks that could adversely affect our financial performance. Most of our asset risk is primarily tied to credit (lending) risk. The Company has lending policies, guidelines and procedures in place that are designed to maximize loan income within an acceptable level of risk. The Board of Directors reviews and approves these policies, guidelines and procedures. When we originate a loan we make certain subjective judgments about the borrower’s ability to meet the loan’s terms and conditions. We also make objective and subjective value assessments on the assets we finance. The borrower’s ability to repay can be adversely affected by economic changes. Likewise, changes in market conditions and other external factors can affect asset valuations. The Company actively monitors the quality of its loan portfolio. A reporting system supplements the credit review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit risk, loan delinquencies, troubled debt restructures, nonperforming and potential problem loans. Diversification in the loan portfolio is another means of managing risk associated with fluctuations in economic conditions.

Commercial and Industrial Loans: The Company originates secured loans for business purposes. Loans are made to provide working capital to businesses in the form of lines of credit, which may be secured by accounts receivable, inventory, equipment or other assets. The financial condition and cash flow of commercial borrowers are closely monitored by means of corporate financial statements, personal financial statements and income tax returns. The frequency of submissions of required financial information depends on the size and complexity of the credit and the collateral that secures the loan. The Company’s general policy is to obtain personal guarantees from the principals of the commercial loan borrowers. Such loans are made to businesses located in the Company’s market area.

Construction Loans: With respect to construction loans to developers and builders that are secured by non-owner occupied properties, loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analyses of the developers and property owners. Construction loans are also generally underwritten based upon estimates of costs and value associated with the completed project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risk than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

Commercial Real Estate: Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans, in addition to those of real estate loans. Commercial real estate loans may be riskier than loans for one-to-four family residences and are typically larger in dollar size. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. The repayment of these loans is generally largely dependent on the successful operation and management of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s commercial real estate portfolio are diverse in terms of type and geographic location within our market area. This diversity helps reduce the Company's exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. The Company also monitors economic conditions and trends affecting the market areas it serves. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.

Residential Mortgage: The Company originates adjustable and fixed-rate residential mortgage loans. Such mortgage loans are generally originated under terms, conditions and documentation acceptable to the secondary mortgage market. Although the Company has placed all of these loans into its portfolio, a substantial majority of such loans can be sold in the secondary market or pledged for potential borrowings.

Consumer Loans: Consumer loans may carry a higher degree of repayment risk than residential mortgage loans. Repayment is typically dependent upon the borrower’s financial stability which is more likely to be adversely affected by job loss, illness, or personal bankruptcy. To monitor and manage consumer loan risk, policies and procedures have been developed and modified as needed. This activity, coupled with the relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements. Historically the Company’s losses on consumer loans have been negligible.

The Company maintains an outsourced independent loan review program that reviews and validates the credit risk assessment program on a periodic basis. Results of these external independent reviews are presented to management. The external independent loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit risk management personnel.

Non-accrual and Past Due Loans: Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management's opinion, the borrower may be unable to meet payment obligations as they become due, as well as when a loan is 90 days past due, unless the loan is well secured and in the process of collection, as required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

An age analysis of past due loans by class at March 31, 2016 and December 31, 2015 follows:



March 31, 2016	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days and Not Accruing		Total Past Due		Current		Total Loans
	(amounts in thousands)
Commercial and Industrial	$	—	$	—	$	553	$	553	$	22,497	$	23,050
Real Estate Construction:
Residential	—		—		—		—		5,555		5,555
Commercial	—		—		5,203		5,203		50,822		56,025
Real Estate Mortgage:
Commercial – Owner Occupied	622		—		1,265		1,887		156,952		158,839
Commercial – Non-owner Occupied	—		—		4,032		4,032		259,246		263,278
Residential – 1 to 4 Family	227		—		2,928		3,155		236,191		239,346
Residential – Multifamily	—		355		—		355		37,647		38,002
Consumer	—		32		—		32		18,425		18,457
Total Loans	$	849	$	387	$	13,981	$	15,217	$	787,335	$	802,552



December 31, 2015	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days and Not Accruing		Total Past Due		Current		Total Loans
	(amounts in thousands)
Commercial and Industrial	$	—	$	—	$	740	$	740	$	26,400	$	27,140
Real Estate Construction:
Residential	—		—		—		—		7,750		7,750
Commercial	—		—		5,204		5,204		40,041		45,245
Real Estate Mortgage:
Commercial – Owner Occupied	812		—		358		1,170		170,870		172,040
Commercial – Non-owner Occupied	—		—		4,002		4,002		252,469		256,471
Residential – 1 to 4 Family	—		—		3,255		3,255		210,011		213,266
Residential – Multifamily	357		—		—		357		17,756		18,113
Consumer	31		32		—		63		18,413		18,476
Total Loans	$	1,200	$	32	$	13,559	$	14,791	$	743,710	$	758,501

Impaired Loans: Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments.

All impaired loans have are assessed for recoverability based on an independent third-party full appraisal to determine the net realizable value (“NRV”) based on the fair value of the underlying collateral, less cost to sell and other costs, such as unpaid real estate taxes, that have been identified, or the present value of discounted cash flows in the case of certain impaired loans that are not collateral dependent. The appraisal will be based on an "as-is" valuation and will follow a reasonable valuation method that addresses the direct sales comparison, income, and cost approaches to market value, reconciles those approaches, and explains the elimination of each approach not used. Appraisals are generally updated every 12 months or sooner if we have identified possible further deterioration in value. Prior to receiving the updated appraisal, we will establish a specific reserve for any estimated deterioration, based upon our assessment of market conditions, adjusted for estimated costs to sell and other identified costs. If the NRV is greater than the loan amount, then no impairment loss exists. If the NRV is less than the loan amount, the shortfall is recognized by a specific reserve. If the borrower fails to pledge additional collateral in the ninety day period, a charge-off equal to the difference between the loan’s carrying value and NRV will occur. In certain circumstances, however, a direct charge-off may be taken at the time that the NRV calculation reveals a shortfall. All impaired loans are evaluated based on the criteria stated above on a quarterly basis and any change in the reserve requirements are recorded in the period identified. All partially charged-off loans remain on nonaccrual status until they are brought current as to both principal and interest and have at least nine months of payment history and future collectability of principal and interest is assured.

Impaired loans at March 31, 2016 and December 31, 2015 are set forth in the following tables:



March 31, 2016	Recorded Investment		Unpaid Principal Balance		Related Allowance
	(amounts in thousands)
With no related allowance recorded:
Commercial and Industrial	$	530	$	1,783	$	—
Real Estate Construction:
Residential	—		—		—
Commercial	1,420		1,517		—
Real Estate Mortgage:
Commercial – Owner Occupied	1,031		1,031		—
Commercial – Non-owner Occupied	3,413		3,658		—
Residential – 1 to 4 Family	1,536		1,592		—
Residential – Multifamily	—		—		—
Consumer	—		—		—
	7,930		9,581		—
With an allowance recorded:
Commercial and Industrial	458		460		38
Real Estate Construction:
Residential	—		—		—
Commercial	5,684		8,407		1,149
Real Estate Mortgage:
Commercial – Owner Occupied	3,942		3,971		290
Commercial – Non-owner Occupied	21,551		22,991		464
Residential – 1 to 4 Family	2,406		3,180		686
Residential – Multifamily	355		355		5
Consumer	—		—		—
	34,396		39,364		2,632
Total:
Commercial and Industrial	988		2,243		38
Real Estate Construction:
Residential	—		—		—
Commercial	7,104		9,924		1,149
Real Estate Mortgage:
Commercial – Owner Occupied	4,973		5,002		290
Commercial – Non-owner Occupied	24,964		26,649		464
Residential – 1 to 4 Family	3,942		4,772		686
Residential – Multifamily	355		355		5
Consumer	—		—		—
	$	42,326	$	48,945	$	2,632



December 31, 2015	Recorded Investment		Unpaid Principal Balance		Related Allowance
	(amounts in thousands)
With no related allowance recorded:
Commercial and Industrial	$	680	$	1,934	$	—
Real Estate Construction:
Residential	—		—		—
Commercial	1,420		1,517		—
Real Estate Mortgage:
Commercial – Owner Occupied	358		358		—
Commercial – Non-owner Occupied	1,281		1,281		—
Residential – 1 to 4 Family	1,858		1,910		—
Residential – Multifamily	—		—		—
Consumer	—		—		—
	5,597		7,000		—
With an allowance recorded:
Commercial and Industrial	503		504		67
Real Estate Construction:
Residential	—		—		—
Commercial	5,696		8,420		1,149
Real Estate Mortgage:
Commercial – Owner Occupied	4,341		4,370		73
Commercial – Non-owner Occupied	23,303		24,988		486
Residential – 1 to 4 Family	2,426		3,200		709
Residential – Multifamily	356		356		5
Consumer	—		—		—
	36,625		41,838		2,489
Total:
Commercial and Industrial	1,183		2,438		67
Real Estate Construction:
Residential	—		—		—
Commercial	7,116		9,937		1,149
Real Estate Mortgage:
Commercial – Owner Occupied	4,699		4,728		73
Commercial – Non-owner Occupied	24,584		26,269		486
Residential – 1 to 4 Family	4,284		5,110		709
Residential – Multifamily	356		356		5
Consumer	—		—		—
	$	42,222	$	48,838	$	2,489

The following table presents by loan portfolio class, the average recorded investment and interest income recognized on impaired loans for the three months ended March 31, 2016 and 2015:



	Three Months Ended March 31,
	2016				2015
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(amounts in thousands)
Commercial and Industrial	$	1,086	$	12	$	4,187	$	26
Real Estate Construction:
Residential	—		—		—		—
Commercial	7,111		22		13,175		72
Real Estate Mortgage:
Commercial – Owner Occupied	4,836		57		6,268		55
Commercial – Non-owner Occupied	24,774		243		28,162		229
Residential – 1 to 4 Family	4,113		28		8,918		54
Residential – Multifamily	356		4		363		6
Consumer	—		—		93		—
Total	$	42,276	$	366	$	61,166	$	442

Troubled debt restructurings: Periodically management evaluates our loans in order to determine the appropriate risk rating, interest accrual status and potential classification as a troubled debt restructuring (TDR), some of which are performing and accruing interest. A TDR is a loan on which we have granted a concession due to a borrower’s financial difficulty. These are concessions that would not otherwise be considered. The terms of these modified loans may include extension of maturity, renewals, changes in interest rate, additional collateral requirements or infusion of additional capital into the project by the borrower to reduce debt or to support future debt service. On construction and land development loans we may modify the loan as a result of delays or other project issues such as slower than anticipated sell-outs, insufficient leasing activity and/or a decline in the value of the underlying collateral securing the loan. Management believes that working with a borrower to restructure a loan provides us with a better likelihood of collecting our loan. It is our policy not to renegotiate the terms of a commercial loan simply because of a delinquency status. However, we will use our Troubled Debt Restructuring Program to work with delinquent borrowers when the delinquency is temporary. The Bank considers all TDRs to be impaired.

At the time a loan is modified in a TDR, we consider the following factors to determine whether the loan should accrue interest:


•	Whether there is a period of current payment history under the current terms, typically 6 months;


•	Whether the loan is current at the time of restructuring; and


•	Whether we expect the loan to continue to perform under the restructured terms with a debt coverage ratio that complies with the Bank’s credit underwriting policy of 1.25 times debt service.

We also review the financial performance of the borrower over the past year to be reasonably assured of repayment and performance according to the modified terms. This review consists of an analysis of the borrower’s historical results; the borrower’s projected results over the next four quarters; current financial information of the borrower and any guarantors. The projected repayment source needs to be reliable, verifiable, quantifiable and sustainable. In addition, all TDRs are reviewed quarterly to determine the amount of any impairment. At the time of restructuring, the amount of the loan principal for which we are not reasonably assured of repayment is charged-off, but not forgiven.

A borrower with a restructured loan must make a minimum of six consecutive monthly payments at the restructured level and be current as to both interest and principal to be returned to accrual status.

Performing TDRs (not reported as non-accrual loans) totaled $28.3 million and $28.7 million with related allowances of $474,000 and $530,000 as of March 31, 2016 and December 31, 2015, respectively. Nonperforming TDRs remained the same at $3.5 million with related allowances of $603,000 as of March 31, 2016 and December 31, 2015, respectively. All TDRs are classified as impaired loans and are included in the impaired loan disclosures above. There were no new loans modified as a TDR during the three month periods ended March 31, 2016 and 2015. Also, there were no loans that were modified and deemed a TDR that subsequently defaulted during the three month period ended March 31, 2016 and 2015.

Some loans classified as TDRs may not ultimately result in the full collection of principal and interest, as modified, and result in potential incremental losses. These potential incremental losses have been factored into our overall allowance for loan losses estimate. The level of any re-defaults will likely be affected by future economic conditions. Once a loan becomes a TDR, it will continue to be reported as a TDR until it is repaid in full, foreclosed, sold or it meets the criteria to be removed from TDR status.

Credit Quality Indicators: As part of the on-going monitoring of the credit quality of the Company's loan portfolio, management tracks certain credit quality indicators including trends related to the risk grades of loans, the level of classified loans, net charge-offs, nonperforming loans (see details above) and the general economic conditions in the region.

The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 7. Grades 1 through 4 are considered “Pass”. A description of the general characteristics of the seven risk grades is as follows:


1.	Good: Borrower exhibits the strongest overall financial condition and represents the most creditworthy profile.


2.	Satisfactory (A): Borrower reflects a well-balanced financial condition, demonstrates a high level of creditworthiness and typically will have a strong banking relationship with the Bank.


3.	Satisfactory (B): Borrower exhibits a balanced financial condition and does not expose the Bank to more than a normal or average overall amount of risk. Loans are considered fully collectable.


4.	Watch List: Borrower reflects a fair financial condition, but there exists an overall greater than average risk. Risk is deemed acceptable by virtue of increased monitoring and control over borrowings. Probability of timely repayment is present.

Other Assets Especially Mentioned (OAEM): Financial condition is such that assets in this category have a potential weakness or pose unwarranted financial risk to the Bank even though the asset value is not currently impaired. The asset does not currently warrant adverse classification but if not corrected could weaken and could create future increased risk exposure. Includes loans which require an increased degree of monitoring or servicing as a result of internal or external changes.

Substandard: This classification represents more severe cases of #5 (OAEM) characteristics that require increased monitoring. Assets are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Assets are inadequately protected by the current net worth and paying capacity of the borrower or of the collateral. Asset has a well-defined weakness or weaknesses that impairs the ability to repay debt and jeopardizes the timely liquidation or realization of the collateral at the asset’s net book value.

Doubtful: Assets which have all the weaknesses inherent in those assets classified #6 (Substandard) but the risks are more severe relative to financial deterioration in capital and/or asset value; accounting/evaluation techniques may be questionable and the overall possibility for collection in full is highly improbable. Borrowers in this category require constant monitoring, are considered work-out loans and present the potential for future loss to the Bank.

An analysis of the credit risk profile by internally assigned grades as of March 31, 2016 and December 31, 2015 is as follows:



At March 31, 2016	Pass		OAEM		Substandard		Doubtful		Total
	(amounts in thousands)
Commercial and Industrial	$	21,622	$	822	$	606	$	—	$	23,050
Real Estate Construction:
Residential	5,555		—		—		—		5,555
Commercial	34,176		16,645		5,204		—		56,025
Real Estate Mortgage:
Commercial – Owner Occupied	152,739		4,147		1,953		—		158,839
Commercial – Non-owner Occupied	250,029		6,412		6,837		—		263,278
Residential – 1 to 4 Family	234,341		504		4,501		—		239,346
Residential – Multifamily	37,647		—		355		—		38,002
Consumer	18,456		—		1		—		18,457
Total	$	754,565	$	28,530	$	19,457	$	—	$	802,552



At December 31, 2015	Pass		OAEM		Substandard		Doubtful		Total
	(amounts in thousands)
Commercial and Industrial	$	25,658	$	688	$	794	$	—	$	27,140
Real Estate Construction:
Residential	7,750		—		—		—		7,750
Commercial	24,210		15,831		5,204		—		45,245
Real Estate Mortgage:
Commercial – Owner Occupied	163,765		7,225		1,050		—		172,040
Commercial – Non-owner Occupied	242,607		7,044		6,820		—		256,471
Residential – 1 to 4 Family	207,911		515		4,840		—		213,266
Residential – Multifamily	17,757		—		356		—		18,113
Consumer	18,475		—		1		—		18,476
Total	$	708,133	$	31,303	$	19,065	$	—	$	758,501