Allowance for Loan Losses and Credit Quality

The allowance for loan losses is established for estimated losses in the loan portfolio through a provision for loan losses charged to earnings. For all loan classes, loan losses are charged against the allowance when management believes the loan balance is uncollectible or in accordance with federal guidelines. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is maintained at a level believed by management to be appropriate to absorb probable credit losses inherent in the loan portfolio as of the balance sheet date. The amount of the allowance is based on management's periodic evaluation of the collectability of the loan portfolio, including the nature, volume and risk characteristics of the portfolio, credit concentrations, trends in historical loss experience, estimated value of any underlying collateral, specific impaired loans and economic conditions. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions or other relevant factors.

In addition, various regulatory agencies, as an integral part of their examination process, regularly review the Company's allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance for loan losses based on their judgments about information available to them at the time of their examination, which may not be currently available to management.

The allowance consists of specific, general and unallocated components. The specific component relates to the loans that are classified as impaired. Loans are also evaluated for impairment and may be classified as impaired when management believes it is probable that the Company will not collect all the contractual interest and principal payments as scheduled in the loan agreement. Impaired loans may also include troubled loans that are restructured. A troubled debt restructuring occurs when the Company, for economic or legal reasons related to the borrower's financial difficulties, grants a concession to the borrower that would otherwise not be granted. Troubled debt restructuring may include the transfer of assets to the Company in partial satisfaction of a troubled loan, a modification of a loan's terms (such as reduction of stated interest rates below market rates, extension of maturity that does not conform to the Company's policies, reduction of face amount of loan, reduction of accrued interest, or reduction or deferment of cash payments in the near future), or a combination. A specific reserve amount is allocated to the allowance for individual loans that have been classified as impaired on the basis of the fair value of the collateral for collateral dependent loans, an observable market price, or the present value of anticipated future cash flows. The Company accounts for the change in present value attributable to the passage of time in the loan loss reserve. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer, real estate or small balance commercial loans for impairment evaluation, unless such loans are subject to a restructuring agreement or have been identified as impaired as part of a larger customer relationship.

The general component represents the level of allowance allocable to each loan portfolio segment with similar risk characteristics and is determined based on historical loss experience, adjusted for qualitative factors, for each class of loan. Management deems a five year average to be an appropriate time frame on which to base historical losses for each portfolio segment. Qualitative factors considered include underwriting, economic and market conditions, portfolio composition, collateral values, delinquencies, lender experience and legal issues. The qualitative factors are determined based on the various risk characteristics of each portfolio segment. Risk characteristics relevant to each portfolio segment are as follows:

•

Residential real estate - Loans in this segment are collateralized by owner-occupied 1-4 family residential real estate, second and vacation homes, 1-4 family investment properties, home equity and second mortgage loans. Repayment is dependent on the credit quality of the individual borrower. The overall health of the economy, including unemployment rates and housing prices, could have an effect on the credit quality of this segment.

•

Construction real estate - Loans in this segment include residential and commercial construction properties, land and land development loans. Repayment is dependent on the credit quality of the individual borrower and/or the underlying cash flows generated by the properties being constructed. The overall health of the economy, including unemployment rates, housing prices, vacancy rates and material costs, could have an effect on the credit quality of this segment.

•

Commercial real estate - Loans in this segment are primarily properties occupied by businesses or income-producing properties. The underlying cash flows generated by the properties may be adversely impacted by a downturn in the economy as evidenced by a general slowdown in business or increased vacancy rates which, in turn, could have an effect on the credit quality of this segment. Management requests business financial statements at least annually and monitors the cash flows of these loans.


•	Commercial - Loans in this segment are made to businesses and are generally secured by nonreal estate assets of the business. Repayment is expected from the cash flows of the business. A weakened economy, and resultant decreased consumer or business spending, could have an effect on credit quality of this segment.


•	Consumer - Loans in this segment are made to individuals for personal expenditures, such as an automobile purchase, and include unsecured loans. Repayment is primarily dependent on the credit quality of the individual borrower. The overall health of the economy, including unemployment, could have an effect on the credit quality of this segment.


•	Municipal - Loans in this segment are made to municipalities located within the Company's service area. Repayment is primarily dependent on taxes or other funds collected annually by the municipalities. Management considers there to be minimal risk surrounding the credit quality of this segment.

An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

All evaluations are inherently subjective as they require estimates that are susceptible to significant revision as more information becomes available or as changes occur in economic conditions or other relevant factors. Despite the allocation shown in the tables below, the Allowance for loan losses is general in nature and is available to absorb losses from any loan type.

Changes in the Allowance for loan losses, by class of loans, for the three and nine months ended September 30, 2012 and 2011 were as follows:



For The Three Months Ended September 30, 2012	Residential Real Estate			Construction Real Estate			Commercial Real Estate			Commercial			Consumer, Municipal and Unallocated			Total
	(Dollars in thousands)
Balance, June 30, 2012	$	1,298		$	419		$	2,451		$	265		$	147		$	4,580
Provision (credit) for loan losses	34			44			119			(92		)	45			150
Recoveries of amounts charged off	1			3			—			2			2			8
	1,333			466			2,570			175			194			4,738
Amounts charged off	(58		)	(25		)	(92		)	—			(7		)	(182		)
Balance, September 30, 2012	$	1,275		$	441		$	2,478		$	175		$	187		$	4,556



For The Three Months Ended September 30, 2011	Residential Real Estate			Construction Real Estate			Commercial Real Estate			Commercial			Consumer, Municipal and Unallocated			Total
	(Dollars in thousands)
Balance, June 30, 2011	$	1,135		$	295		$	2,238		$	289		$	103		$	4,060
Provision (credit) for loan losses	79			116			(66		)	1			20			150
Recoveries of amounts charged off	2			—			—			5			2			9
	1,216			411			2,172			295			125			4,219
Amounts charged off	(7		)	(17		)	—			(2		)	(7		)	(33		)
Balance, September 30, 2011	$	1,209		$	394		$	2,172		$	293		$	118		$	4,186



For The Nine Months Ended September 30, 2012	Residential Real Estate			Construction Real Estate			Commercial Real Estate			Commercial			Consumer, Municipal and Unallocated			Total
	(Dollars in thousands)
Balance, December 31, 2011	$	1,250		$	367		$	2,278		$	232		$	99		$	4,226
Provision (credit) for loan losses	83			98			295			(63		)	97			510
Recoveries of amounts charged off	8			9			—			6			14			37
	1,341			474			2,573			175			210			4,773
Amounts charged off	(66		)	(33		)	(95		)	—			(23		)	(217		)
Balance, September 30, 2012	$	1,275		$	441		$	2,478		$	175		$	187		$	4,556



For The Nine Months Ended September 30, 2011	Residential Real Estate			Construction Real Estate			Commercial Real Estate		Commercial			Consumer, Municipal and Unallocated			Total
	(Dollars in thousands)
Balance, December 31, 2010	$	1,033		$	240		$	2,117	$	250		$	115		$	3,755
Provision for loan losses	189			171			55		35			—			450
Recoveries of amounts charged off	3			—			—		10			24			37
	1,225			411			2,172		295			139			4,242
Amounts charged off	(16		)	(17		)	—		(2		)	(21		)	(56		)
Balance, September 30, 2011	$	1,209		$	394		$	2,172	$	293		$	118		$	4,186

The allocation of the Allowance for loan losses, summarized on the basis of the Company's impairment methodology by class of loan, as of the balance sheet dates was as follows:



September 30, 2012	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer, Municipal and Unallocated		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	46	$	—	$	10	$	—	$	—	$	56
Collectively evaluated for impairment	1,229		441		2,468		175		187		4,500
Total allocated	$	1,275	$	441	$	2,478	$	175	$	187	$	4,556



December 31, 2011	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer, Municipal and Unallocated		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	328	$	12	$	293	$	41	$	11	$	685
Collectively evaluated for impairment	922		355		1,985		191		88		3,541
Total allocated	$	1,250	$	367	$	2,278	$	232	$	99	$	4,226

The recorded investment in loans, summarized on the basis of the Company's impairment methodology by class of loan, as of the balance sheet dates was as follows:



September 30, 2012	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Tax Exempt		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	716	$	42	$	2,066	$	130	$	—	$	—	$	2,954
Collectively evaluated for impairment	138,868		34,430		169,635		21,056		5,974		52,581		422,544
	139,584		34,472		171,701		21,186		5,974		52,581		425,498
Acquired loans	9,954		8		12,403		540		245		529		23,679
Total	$	149,538	$	34,480	$	184,104	$	21,726	$	6,219	$	53,110	$	449,177



December 31, 2011	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Tax Exempt		Total
	(Dollars in thousands)
Individually evaluated for impairment	$	2,810	$	92	$	6,499	$	355	$	33	$	—	$	9,789
Collectively evaluated for impairment	132,115		27,976		169,576		21,861		5,724		29,344		386,596
	134,925		28,068		176,075		22,216		5,757		29,344		396,385
Acquired loans	12,501		9		13,695		802		377		550		27,934
Total	$	147,426	$	28,077	$	189,770	$	23,018	$	6,134	$	29,894	$	424,319

Risk and collateral ratings are assigned to loans and are subject to ongoing monitoring by lending and credit personnel with such ratings updated annually or more frequently if warranted. The following is an overview of the Company's loan rating system:

1-3 Rating - Pass

Risk-rating grades "1" through "3" comprise those loans ranging from lower than average credit risk defined as borrowers with high liquidity, excellent financial condition, strong management, favorable industry trends or loans secured by highly liquid assets through loans with marginal credit risk, defined as borrowers that while creditworthy, exhibit some characteristics which require special attention by the account officer.

4/M Rating - Satisfactory/Monitor

Borrowers exhibit potential credit weaknesses or downward trends warranting management's attention. While potentially weak, these borrowers are currently marginally acceptable; no loss of principal or interest is envisioned. When warranted, these credits may be monitored on the watch list.

5-8 Rating - Substandard

Borrowers exhibit well defined weaknesses that jeopardize the orderly liquidation of debt. The loan may be inadequately protected by the net worth and paying capacity of the obligor and/or the underlying collateral is inadequate.

The following tables summarize the loan ratings applied to the Company's loans by class as of the balance sheet dates:



September 30, 2012	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Tax Exempt		Total
	(Dollars in thousands)
Pass	$	128,929	$	30,136	$	118,646	$	18,840	$	5,887	$	52,581	$	355,019
Satisfactory/Monitor	7,076		4,294		46,074		2,120		70		—		59,634
Substandard	3,579		42		6,981		226		17		—		10,845
	139,584		34,472		171,701		21,186		5,974		52,581		425,498
Acquired loans	9,954		8		12,403		540		245		529		23,679
Total	$	149,538	$	34,480	$	184,104	$	21,726	$	6,219	$	53,110	$	449,177



December 31, 2011	Residential Real Estate		Construction Real Estate		Commercial Real Estate		Commercial		Consumer		Tax Exempt		Total
	(Dollars in thousands)
Pass	$	127,338	$	26,928	$	135,764	$	19,069	$	5,652	$	29,344	$	344,095
Satisfactory/Monitor	4,777		1,048		33,812		2,792		72		—		42,501
Substandard	2,810		92		6,499		355		33		—		9,789
Total	134,925		28,068		176,075		22,216		5,757		29,344		396,385
Acquired loans	12,501		9		13,695		802		377		550		27,934
Total	$	147,426	$	28,077	$	189,770	$	23,018	$	6,134	$	29,894	$	424,319

Acquired loans are risk rated, as appropriate, according to the Company's loan rating system, but such ratings are not a determining factor in the establishment of the allowance for loan losses. Rather, acquired loans are initially recorded at fair value, determined based upon an estimate of the amount and timing of both principal and interest cash flows expected to be collected and discounted using a market interest rate, which includes an estimate of future credit losses expected to be incurred over the life of the portfolio. The primary credit quality indicator for acquired loans is whether there has been a decrease in expected cash flows. Monitoring of this portfolio is ongoing to determine if there is evidence of deterioration in credit quality since acquisition that requires the establishment of an allowance for loan losses. As of September 30, 2012, there was no allowance for loan losses established with respect to the acquired loans.

The following table provides information with respect to impaired loans by class of loan as of and for the three and nine months ended September 30, 2012:



	As of September 30, 2012						For The Three Months Ended September 30, 2012				For The Nine Months Ended September 30, 2012
	Recorded Investment (1)		Principal Balance (1)		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
With an allowance recorded:
Residential real estate	$	357	$	363	$	46
Commercial real estate	1,742		1,742		10
	2,099		2,105		56
With no allowance recorded:
Residential real estate	359		471		—
Construction real estate	42		47		—
Commercial real estate	324		394		—
Commercial	130		130		—
	855		1,042		—
Total:
Residential real estate	716		834		46		$	558	$	3	$	485	$	5
Construction real estate	42		47		—		42		—		21		—
Commercial real estate	2,066		2,136		10		2,414		21		2,286		90
Commercial	130		130		—		65		—		32		—
Total	$	2,954	$	3,147	$	56	$	3,079	$	24	$	2,824	$	95

____________________


(1)	Does not reflect government guaranties on impaired loans as of September 30, 2012 totaling $86 thousand.

The following table provides information with respect to impaired loans by class of loan as of and for the three and nine months ended September 30, 2011:



	As of September 30, 2011						For The Three Months Ended September 30, 2011				For The Nine Months Ended September 30, 2011
	Recorded Investment (1)		Principal Balance (1)		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
Total:
Residential real estate	$	425	$	497	$	65	$	429	$	—	$	364	$	5
Commercial real estate	2,384		2,460		57		2,281		21		2,268		63
Total	$	2,809	$	2,957	$	122	$	2,710	$	21	$	2,632	$	68

____________________


(1)	Does not reflect government guaranties on impaired loans as of September 30, 2011 totaling $110 thousand.

The following table provides information with respect to impaired loans as of December 31, 2011:



	December 31, 2011
	Recorded Investment (1)		Principal Balance (1)		Related Allowance
	(Dollars in thousands)
With an allowance recorded:
Residential real estate	$	241	$	243	$	55
Commercial real estate	1,907		1,930		21
	2,148		2,173		76
With no allowance recorded:
Residential real estate	177		252		—
Commercial real estate	318		374		—
	495		626		—

Total:
Residential real estate	418		495		55
Commercial real estate	2,225		2,304		21
Total	$	2,643	$	2,799	$	76

____________________


(1)	Does not reflect government guaranties on impaired loans as of December 31, 2011 totaling $88 thousand.

Troubled debt restructured loans as of September 30, 2012 by class of loan include one commercial real estate loan that received a concession with the extension of a due date that was not considered a market transaction to the Company, one construction real estate loan that received a concession with the extension of both the maturity and due dates, and three residential real estate loans that represent loan modifications in which a concession was provided to the borrower, such as due date or maturity date extension, interest rate reduction, or the forgiveness of accrued interest. The one commercial real estate loan and three residential real estate loans noted above represented troubled debt restructured loans as of September 30, 2011 as well. Troubled loans, that are restructured and meet established thresholds, are classified as impaired and a specific reserve amount is established in the allowance on the basis of the fair value of the collateral for collateral dependent loans, an observable market price, or the present value of anticipated future cash flows.

The following table provides new troubled debt restructure activity for the nine months ended September 30, 2012 and September 30, 2011:



	New Troubled Debt Restructurings During the					New Troubled Debt Restructurings During the
	Nine Months Ended September 30, 2012					Nine Months Ended September 30, 2011
	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
	(Dollars in thousands)
Construction real estate	1	$	43	$	43	—	$	—	$	—
Residential real estate	—	$	—	$	—	1	$	238	$	246

The construction real estate loan modified during the nine months ended September 30, 2012 consisted of an extension of the maturity and due dates in May 2012. The residential real estate loan modified during the nine months ended September 30, 2011 consisted of an interest rate reduction, forgiveness of accrued interest, protective advance for delinquent taxes, and extension of due date. There was no new troubled debt restructured during the three months ended September 30, 2012 or September 30, 2011.

During the nine month periods ended September 30, 2012 and September 30, 2011, there were no troubled debt restructured loans that had been modified within the previous twelve month periods that had subsequently defaulted. Troubled debt restructured loans are considered defaulted at 90 days past due.

At September 30, 2012 and December 31, 2011, the Company was not committed to lend any additional funds to borrowers whose loans were nonperforming, impaired or restructured.