Note 7. Loans and the Allowance for Loan Losses

Loans are stated at their principal amounts inclusive of net deferred loan origination fees. Interest income is credited as earned except when a loan becomes past due 90 days or more and doubt exists as to the ultimate collection of interest or principal; in those cases the recognition of income is discontinued. Loans that are past due 90 days or more that are both well secured and in the process of collection will remain on an accruing basis. When a loan is placed on non-accrual status, interest accruals cease and uncollected accrued interest is reversed and charged against current income.

Portfolio segments are defined as the level at which an entity develops and documents a systematic methodology to determine its allowance. Management has determined that the Corporation has two portfolio segments of loans and leases (commercial and consumer) in determining the allowance. Both quantitative and qualitative factors are used by management at the portfolio segment level in determining the adequacy of the allowance for the Corporation. Classes of loans and leases are a disaggregation of the Corporation's portfolio segments. Classes are defined as a group of loans and leases which share similar initial measurement attributes, risk characteristics, and methods for monitoring and assessing credit risk. Management has determined that the Corporation has five classes of loans and leases: commercial and industrial (including lease financing), commercial – real estate, construction, residential mortgage (including home equity) and installment.

Generally, all classes of commercial and consumer loans and leases are placed on non-accrual status upon becoming contractually past due 90 days or more as to principal or interest (unless loans and leases are adequately secured by collateral, are in the process of collection, and are reasonably expected to result in repayment), when terms are renegotiated below market levels, or where substantial doubt about full repayment of principal or interest is evident. For certain installment loans the entire outstanding balance on the loan is charged-off when the loan becomes 60 days past due.

Payments received on non-accrual loans are applied against principal. A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection or all past due amounts have been collected and six months of payments have been received to demonstrate that the borrower can continue to meet the loan terms. Loan origination fees and certain direct loan origination costs are deferred and recognized over the life of the loan as an adjustment to the loan’s yield using the level yield method.

Impaired Loans

The Corporation accounts for impaired loans in accordance with FASB ASC 310-10-35. The value of impaired loans is based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or at the fair value of the collateral if the loan is collateral dependent.

A loan is considered impaired when, based on current information and events, it is probable that the Corporation will not be able to collect all amounts due from the borrower in accordance with the contractual terms of the loan, including scheduled interest payments. The Corporation has defined its population of impaired loans to include all classes of non-accrual and troubled debt restructuring (“TDR”) loans. As part of the evaluation of impaired loans, the Corporation individually reviews for impairment all non-homogeneous loans (in each instance, above an established dollar threshold of $200,000) internally classified as substandard or below. Generally, smaller impaired non-homogeneous loans and impaired homogeneous loans are collectively evaluated for impairment.

When a loan has been identified as being impaired, the amount of impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral-dependent. If the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest, net of deferred loan fees or costs and unamortized premiums or discounts), an impairment is recognized by creating or adjusting an existing allocation of the allowance, or by recording a partial charge-off of the loan to its fair value. Interest payments made on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest income may be accrued or recognized on a cash basis.

Loans Modified in a Troubled Debt Restructuring

Loans are considered to have been modified in a TDR when due to a borrower's financial difficulties, the Corporation makes certain concessions to the borrower that it would not otherwise consider. Modifications may include interest rate reductions, principal or interest forgiveness, forbearance, and other actions intended to minimize economic loss and to avoid foreclosure or repossession of collateral. Generally, a non-accrual loan that has been modified in a TDR remains on non-accrual status for a period of six months to demonstrate that the borrower is able to meet the terms of the modified loan. However, performance prior to the modification, or significant events that coincide with the modification, are included in assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status at the time of loan modification or after a shorter performance period. If the borrower's ability to meet the revised payment schedule is uncertain, the loan remains on non-accrual status.

Reserve for Credit Losses

The Corporation's reserve for credit losses is comprised of two components, the allowance for loan losses and the reserve for unfunded commitments (the "Unfunded Commitments").

Allowance for Loan Losses

The allowance for loan losses is maintained at a level determined adequate to provide for probable loan losses. The allowance is increased by provisions charged to operations and reduced by loan charge-offs, net of recoveries. The allowance is based on management’s evaluation of the loan portfolio considering economic conditions, the volume and nature of the loan portfolio, historical loan loss experience and individual credit situations.

Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for significant properties.

The ultimate collectability of a substantial portion of the Corporation’s loan portfolio is susceptible to changes in the real estate market and economic conditions in the State of New Jersey and the impact of such conditions on the creditworthiness of the borrowers.

Management believes that the allowance for loan losses is adequate. Management uses available information to recognize loan losses; however, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examinations.

Reserve for Unfunded Commitments

The reserve for unfunded commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities and is included in other liabilities in the consolidated statements of condition. The determination of the adequacy of the reserve is based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, and credit risk. Net adjustments to the reserve for unfunded commitments are included in other expense.

Risk Related to Representation and Warranty Provisions

The Corporation sells residential mortgage loans in the secondary market primarily to Fannie Mae. The Corporation sells residential mortgage loans to Fannie Mae that include various representations and warranties regarding the origination and characteristics of the residential mortgage loans. Although the specific representations and warranties vary, they typically cover ownership of the loan, validity of the lien securing the loan, the absence of delinquent taxes or liens against the property securing the loan, compliance with loan criteria set forth in the applicable agreement, compliance with applicable federal, state, and local laws, and other matters.

As of September 30, 2013, the unpaid principal balance of the Corporation’s portfolio of residential mortgage loans sold to Fannie Mae was $8.5 million. These loans are generally sold on a non-recourse basis. The agreements under which the Corporation sells residential mortgage loans require the Corporation to deliver various documents to the investor or its document custodian. Although these loans are primarily sold on a non-recourse basis, the Corporation may be obligated to repurchase residential mortgage loans where required documents are not delivered or are defective. Investors may require the immediate repurchase of a mortgage loan when an early payment default discovered in an underwriting review reveals significant underwriting deficiencies, even if the mortgage loan has subsequently been brought current. As of September 30, 2013, there were no pending repurchase requests related to representation and warranty provisions.

Composition of Loan Portfolio

The following table sets forth the composition of the Corporation’s loan portfolio, including net deferred fees and costs, at September 30, 2013 and December 31, 2012:

	September 30,		December 31,
	2013		2012
	(in thousands)
Commercial and industrial	$	229,212	$	181,682
Commercial real estate		531,674		497,392
Construction		42,727		40,277
Residential mortgage		152,934		169,094
Installment		789		1,104
Subtotal		957,336		889,549
Net deferred loan costs		156		123
Total loans	$	957,492	$	889,672

At September 30, 2013 and December 31, 2012, loans to executive officers and directors aggregated approximately $22,456,000 and $18,977,000, respectively. During the nine months ended September 30, 2013, the Corporation made new loans and advances to executive officers and directors in the amount of $11,322,000. Payments by such persons during the nine months ended September 30, 2013 aggregated $7,843,000. Management is of the opinion that the above loans were made on the same terms and conditions as those prevailing for comparable transactions with non-related borrowers.

At September 30, 2013 and December 31, 2012, loan balances of approximately $538.1 million and $532.8 million, respectively, were pledged to secure borrowings from the Federal Reserve Bank of New York and the Federal Home Loan Bank of New York.

The following table presents information about loan receivables on non-accrual status at September 30, 2013 and December 31, 2012:

Loans Receivable on Non-Accrual Status
	September 30, 2013		December 31, 2012
	(in thousands)
Commercial and industrial	$	85	$	216
Commercial real estate		175		354
Construction		—		319
Residential mortgage		1,772		2,729
Total loans receivable on non-accrual status	$	2,032	$	3,618

The amount of interest income that would have been recorded on non-accrual loans during the nine months ended September 30, 2013 and the year ended December 31, 2012, had payments remained in accordance with the original contractual terms, was $69,000 and $187,000, respectively.

The Corporation continuously monitors the credit quality of its loans receivable. In addition to its internal staff, the Corporation utilizes the services of a third party loan review firm to rate the credit quality of its loans receivable. Credit quality is monitored by reviewing certain credit quality indicators. Assets classified “Pass” are deemed to possess average to superior credit quality, requiring no more than normal attention. Assets classified as “Special Mention” have generally acceptable credit quality yet possess higher risk characteristics/circumstances than satisfactory assets. Such conditions include strained liquidity, slow pay, stale financial statements, or other conditions that require more stringent attention from the lending staff. These conditions, if not corrected, may weaken the loan quality or inadequately protect the Corporation’s credit position at some future date. Assets are classified “Substandard” if the asset has a well defined weakness that requires management’s attention to a greater degree than for loans classified special mention. Such weakness, if left uncorrected, could possibly result in the compromised ability of the loan to perform to contractual requirements. An asset is classified as “Doubtful” if it is inadequately protected by the net worth and/or paying capacity of the obligor or of the collateral, if any, that secures the obligation. Assets classified as doubtful include assets for which there is a “distinct possibility” that a degree of loss will occur if the inadequacies are not corrected. All loans past due 90 days or more and all impaired loans are included in the appropriate category below. The following table presents information, excluding net deferred costs, about the Corporation’s loan credit quality at September 30, 2013 and December 31, 2012:

Credit Quality Indicators
	September 30, 2013
	Pass		Special Mention		Substandard		Doubtful		Total
	(in thousands)
Commercial and industrial	$	225,081	$	2,785	$	1,346	$	—	$	229,212
Commercial real estate		508,679		12,457		10,538		—		531,674
Construction		41,640		—		1,087		—		42,727
Residential mortgage		149,572		981		2,381		—		152,934
Installment		665		—		124		—		789
Total loans	$	925,637	$	16,223	$	15,476	$	—	$	957,336

	December 31, 2012
	Pass		Special Mention		Substandard		Doubtful		Total
	(in thousands)
Commercial and industrial	$	176,818	$	3,281	$	1,583	$	—	$	181,682
Commercial real estate		462,266		18,945		16,181		—		497,392
Construction		38,303		810		1,164		—		40,277
Residential mortgage		163,769		993		4,332		—		169,094
Installment		967		—		137		—		1,104
Total loans	$	842,123	$	24,029	$	23,397	$	—	$	889,549

The following table provides an analysis of the impaired loans at September 30, 2013 and December 31, 2012:

	September 30, 2013
	Recorded Investment		Unpaid Principal Balance		Related Allowance
	(in thousands)
No Related Allowance Recorded
Commercial real estate	$	1,275	$	1,576	$	—
Total	$	1,275	$	1,576	$	—

With An Allowance Recorded
Commercial real estate	$	175	$	374	$	76
Residential mortgage		1,113		1,113		143
Total	$	1,288	$	1,487	$	219

Total
Commercial real estate	$	1,450	$	1,950	$	76
Residential mortgage		1,113		1,113		143
Total (including related allowance)	$	2,563	$	3,063	$	219

	December 31, 2012
	Recorded Investment		Unpaid Principal Balance		Related Allowance
	(in thousands)
No Related Allowance Recorded
Commercial real estate	$	1,500	$	1,950	$	—
Total	$	1,500		1,950	$	—

With An Allowance Recorded
Commercial real estate	$	4,180	$	4,180	$	493
Residential mortgage		1,255		1,255		152
Total	$	5,435	$	5,435	$	645

Total
Commercial real estate	$	5,680	$	6,130	$	493
Residential mortgage		1,255		1,255		152
Total (including related allowance)	$	6,935	$	7,385	$	645

The following table provides an analysis related to the average recorded investment and interest income recognized on impaired loans for the three and nine months ended September 30, 2013 and 2012.

	Three Months Ended September 30,								Nine Months Ended September 30,
	2013				2012				2013				2012
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized

Impaired loans with no related allowance recorded:

Commercial real estate	$	1,275	$	19	$	2,246	$	28	$	1,275	$	57	$	2,246	$	86
Total	$	1,275	$	19	$	2,246	$	28	$	1,275	$	57	$	2,246	$	86

Impaired loans with an allowance recorded:

Commercial real estate	$	175	$	—	$	4,180	$	34	$	2,202	$	68	$	4,180	$	103
Construction		—		—		—		—		—		—		2,066		16
Residential mortgage		1,226		10		4,304		—		1,226		31		3,876		26
Total	$	1,401	$	10	$	8,484	$	34	$	3,428	$	99	$	10,122	$	145

Total impaired loans:

Commercial real estate	$	1,450	$	19	$	6,426	$	62	$	3,477	$	125	$	6,426	$	189
Construction		—		—		—		—		—		—		2,066		16
Residential mortgage		1,226		10		4,304		—		1,226		31		3,876		26
Total	$	2,676	$	29	$	10,730	$	62	$	4,703	$	156	$	12,368	$	231

Included in impaired loans at September 30, 2013 are loans that are deemed troubled debt restructurings.

The following table provides an analysis of the aging of loans, excluding net deferred costs that are past due at September 30, 2013 and December 31, 2012:

Aging Analysis

	September 30, 2013
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Loans Receivable > 90 Days And Accruing
	(in thousands)
Commercial and Industrial	$	739	$	4,567	$	85	$	5,391	$	223,821	$	229,212	$	—
Commercial Real Estate		872		752		175		1,799		529,875		531,674		—
Construction		—		—		—		—		42,727		42,727		—
Residential Mortgage		1,326		39		1,772		3,137		149,797		152,934		—
Installment		2		—		—		2		787		789		—
Total	$	2,939	$	5,358	$	2,032	$	10,329	$	947,007	$	957,336	$	—

	December 31, 2012
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Loans Receivable > 90 Days And Accruing
	(in thousands)
Commercial and Industrial	$	590	$	—	$	216	$	806	$	180,876	$	181,682	$	—
Commercial Real Estate		1,012		703		354		2,069		495,323		497,392		—
Construction		—		—		319		319		39,958		40,277		—
Residential Mortgage		2,017		628		2,784		5,429		163,665		169,094		55
Installment		23		—		—		23		1,081		1,104		—
Total	$	3,642	$	1,331	$	3,673	$	8,646	$	880,903	$	889,549	$	55

The following table details the amount of loans receivable that are evaluated individually, and collectively, for impairment, and the related portion of the allowance for loan loss that is allocated to each loan portfolio segment:

Allowance for loan and lease losses

	September 30, 2013
	C & I		Comm R/E		Construction		Res Mtge		Installment		Unallocated		Total
	(in thousands)
Allowance for loan and lease losses:
Individually evaluated for impairment	$	—	$	76	$	—	$	143	$	—	$	—	$	219
Collectively evaluated for impairment		1,714		5,712		369		1,161		94		925		9,975
Total	$	1,714	$	5,788	$	369	$	1,304	$	94	$	925	$	10,194

Loans Receivable
Individually evaluated for impairment	$	—	$	1,450	$	—	$	1,113	$	—	$	—	$	2,563
Collectively evaluated for impairment		226,664		512,949		41,640		137,733		663		—		919,649
Loans acquired with discounts related to credit quality		2,548		17,275		1,087		14,088		126		—		35,124
Total	$	229,212	$	531,674	$	42,727	$	152,934	$	789	$	—	$	957,336

Allowance for loan and lease losses

	December 31, 2012
	C & I		Comm R/E		Construction		Res Mtge		Installment		Unallocated		Total
	(in thousands)
Allowance for loan and lease losses:
Individually evaluated for impairment	$	—	$	493	$	—	$	152	$	—	$	—	$	645
Collectively evaluated for impairment		2,424		4,830		313		1,380		113		532		9,592
Total	$	2,424	$	5,323	$	313	$	1,532	$	113	$	532	$	10,237

Loans Receivable
Individually evaluated for impairment	$	—	$	5,680	$	—	$	1,255	$	—	$	—	$	6,935
Collectively evaluated for impairment		177,644		470,797		38,172		146,930		973		—		834,516
Loans acquired with discounts related to credit quality		4,038		20,915		2,105		20,909		131		—		48,098
Total	$	181,682	$	497,392	$	40,277	$	169,094	$	1,104	$	—	$	889,549

The Corporation’s allowance for loan losses is analyzed quarterly. Many factors are considered, including growth in the portfolio, delinquencies, nonaccrual loan levels, and other factors inherent in the extension of credit. There have been no material changes to the allowance for loan loss methodology as disclosed in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2012.

A summary of the activity in the allowance for loan losses is as follows:

	Three Months Ended September 30, 2013
	C & I		Comm R/E		Construction		Res Mtge		Installment		Unallocated		Total
	(in thousands)
Balance at July 1,	$	2,422	$	5,333	$	318	$	1,341	$	29	$	759	$	10,202

Charge offs		(6)		—		—		—		(4)		—		(10)

Recoveries		—		—		—		—		2		—		2

Provision		(702)		455		51		(37)		67		166		—

Balance at September 30,	$	1,714	$	5,788	$	369	$	1,304	$	94	$	925	$	10,194

	Nine Months Ended September 30, 2013
	C & I		Comm R/E		Construction		Res Mtge		Installment		Unallocated		Total
	(in thousands)
Balance at January 1,	$	2,424	$	5,323	$	313	$	1,532	$	113	$	532	$	10,237

Charge offs		(6)		(50)		—		—		(20)		—		(76)

Recoveries		21		8		—		—		4		—		33

Provision		(725)		507		56		(228)		(3)		393		—

Balance at September 30,	$	1,714	$	5,788	$	369	$	1,304	$	94	$	925	$	10,194

	Three Months Ended September 30, 2012
	C & I		Comm R/E		Construction		Res Mtge		Installment		Unallocated		Total
	(in thousands)
Balance at July 1,	$	1,747	$	6,173	$	449	$	1,300	$	59	$	493	$	10,221

Charge offs		—		—		—		(207)		(3)		—		(210)

Recoveries		—		—		—		—		4		—		4

Provision		(55)		103		43		71		4		59		225

Balance at September 30,	$	1,692	$	6,276	$	492	$	1,164	$	64	$	552	$	10,240

	Nine Months Ended September 30, 2012
	C & I		Comm R/E		Construction		Res Mtge		Installment		Unallocated		Total
	(in thousands)
Balance at January 1,	$	1,527	$	5,972	$	707	$	1,263	$	51	$	82	$	9,602

Charge offs		—		—		—		(207)		(11)		—		(218)

Recoveries		—		—		540		85		6		—		631

Provision		165		304		(755)		23		18		470		225

Balance at September 30,	$	1,692	$	6,276	$	492	$	1,164	$	64	$	552	$	10,240

At September 30, 2013, there were no commitments to lend additional funds to borrowers whose loans were on non-accrual status or were contractually past due in excess of 90 days and still accruing interest, or whose terms have been modified in troubled debt restructurings.

The policy of the Corporation generally is to grant commercial, mortgage and installment loans to New Jersey residents and businesses within its market area. The borrowers’ abilities to repay their obligations are dependent upon various factors, including the borrowers’ income and net worth, cash flows generated by the borrowers’ underlying collateral, value of the underlying collateral, and priority of the lender’s lien on the property. Such factors are dependent upon various economic conditions and individual circumstances beyond the control of the Corporation. The Corporation is therefore subject to risk of loss. The Corporation believes its lending policies and procedures adequately minimize the potential exposure to such risks and that adequate provisions for loan losses are provided for all known and inherent risks. Collateral and/or personal guarantees are required for virtually all loans.

The Corporation added no new troubled debt restructurings during the three and nine months ended September 30, 2013.

Loans modified in a troubled debt restructuring totaled $2.8 million at September 30, 2013, of which $1.1 million were on non-accrual status. The remaining loans modified were current at the time of the restructuring and have complied with the terms of their restructure agreement. At December 31, 2012, loans modified in a troubled debt restructuring totaled $8.3 million, of which $1.5 million were on non-accrual status. The remaining loans modified were current at the time of the restructuring and have complied with the terms of their restructure agreement.

In an effort to proactively manage delinquent loans, the Corporation has selectively extended to certain borrowers concessions such as rate reductions, extension of maturity dates, principal or interest forgiveness, adjusted repayment terms, forbearance agreements, or combinations of two or more of these concessions. As of September 30, 2013, loans on which concessions were made with respect to adjusted repayment terms amounted to $1.5 million. Loans on which combinations of two or more concessions were made amounted to $1.3 million. The concessions granted included principal concessions, rate reduction, adjusted repayment, extended maturity and payment deferral.