8. Loans

The Corporation grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans throughout southcentral Pennsylvania and northern Maryland. The ability of the Corporation's debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

The loans receivable portfolio is segmented into commercial, residential mortgage, home equity lines of credit, and consumer loans. Commercial loans consist of the following classes: commercial and industrial, commercial real estate, and commercial real estate construction.

The accrual of interest on residential mortgage and commercial loans is discontinued at the time the loan is 90 days past due unless the credit is well secured and in process of collection. Consumer loans (consisting of home equity lines of credit and consumer loan classes) are typically charged off no later than 120 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued, but not collected, for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Allowance for Credit Losses

The allowance for credit losses consists of the allowance for loan losses and the reserve for unfunded lending commitments. The allowance for loan losses is established as losses are estimated to occur through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The reserve for unfunded lending commitments represents management's estimate of losses inherent in its unfunded loan commitments and is recorded in other liabilities on the consolidated statement of condition. The amount of the unfunded lending commitments is not material to the consolidated statements.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard, or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers pools of loans by loan class including commercial loans not considered impaired, as well as smaller balance homogeneous loans, such as residential real estate, home equity, and other consumer loans. These pools of loans are evaluated for loss exposure based upon historical loss rates for each of these categories of loans, adjusted for qualitative risk factors.

These qualitative risk factors include:

· lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices;

· national, regional and local economic and business conditions, as well as the condition of various market segments, including the impact on the value of underlying collateral for collateral dependent loans;

· the nature and volume of the portfolio and terms of loans;

· the experience, ability and depth of lending management and staff;

· the volume and severity of past due, classified and nonaccrual loans, as well as other loan modifications; and,

· the existence and effect of any concentrations of credit and changes in the level of such concentrations.

Each factor is assigned a value to reflect improving, stable or declining conditions based on management's best judgment using relevant information available at the time of the evaluation. Adjustments to the factors are supported through documentation of changes in conditions in a narrative accompanying the allowance for loan loss calculation.

The unallocated component of the allowance 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.

A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and commercial construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

A specific allocation within the allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of substantially all of the Corporation's impaired loans are measured based on the estimated fair value of the loan's collateral.

For commercial loans secured by real estate, estimated fair values of collateral are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal, and the condition of the property. Appraised values are discounted based on the age of the appraisal, special use nature of the property, or condition of the property to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value.

For commercial and industrial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower's financial statements, inventory reports, accounts receivable aging reports, equipment appraisals, or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Corporation does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

Loans whose terms are modified are classified as troubled debt restructured loans if the Corporation grants such borrowers concessions that it would not otherwise consider and it is deemed that those borrowers are experiencing financial difficulty. Concessions granted under a troubled debt restructuring generally involve a temporary reduction in interest rate, continuance of a below market interest rate, or an extension of a loan's stated maturity date. Nonaccrual troubled debt restructurings may be restored to accrual status if principal and interest payments, under the modified terms, are current for a sustained period of time and, based on a well-documented credit evaluation of the borrower's financial condition, there is reasonable assurance of repayment. Loans classified as troubled debt restructurings are generally designated as impaired.

The allowance calculation methodology includes further segregation of loan classes into credit quality rating categories. The borrower's overall financial condition, repayment sources, guarantors, and value of collateral, if appropriate, are generally evaluated annually for commercial loans or when credit deficiencies arise, such as delinquent loan payments.

Credit quality risk ratings include regulatory classifications of special mention, substandard, doubtful and loss. Loans classified special mention have potential weaknesses that deserve management's close attention. If uncorrected, the potential weaknesses may result in deterioration of the repayment prospects.

Loans classified substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They include loans that are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified doubtful have all the weaknesses inherent in loans classified substandard with the added characteristic that collection or liquidation in full, on the basis of current conditions and facts, is highly improbable. Loans classified as a loss are considered uncollectible and are charged to the allowance for loan losses. Loans not classified are rated pass.

In addition, federal and state regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses and may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management. Based on management's comprehensive analysis of the loan portfolio, management believes the current level of the allowance for loan losses is adequate.

Commercial and Industrial Lending - The Corporation originates commercial and industrial loans primarily to businesses located in its primary market area and surrounding areas. These loans are used for various business purposes which include short-term loans and lines of credit to finance machinery and equipment purchases, inventory, and accounts receivable. Generally, the maximum term for loans extended on machinery and equipment is based on the projected useful life of such machinery and equipment. Most business lines of credit are written on demand and may be renewed annually.

Commercial and industrial loans are generally secured with short-term assets; however, in many cases, additional collateral such as real estate is provided as additional security for the loan. Loan-to-value maximum values have been established by the Corporation and are specific to the type of collateral. Collateral values may be determined using invoices, inventory reports, accounts receivable aging reports, collateral appraisals, etc.

In underwriting commercial and industrial loans, an analysis is performed to evaluate the borrower's character and capacity to repay the loan, the adequacy of the borrower's capital and collateral, as well as the conditions affecting the borrower. Evaluation of the borrower's past, present and future cash flows is also an important aspect of the Corporation's analysis.

Commercial loans generally present a higher level of risk than other types of loans due primarily to the effect of general economic conditions.

Commercial Real Estate Lending - The Corporation engages in commercial real estate lending in its primary market area and surrounding areas. The Corporation's commercial real estate portfolio is secured primarily by commercial retail space, office buildings, and hotels. Generally, commercial real estate loans have terms that do not exceed 20 years, have loan-to-value ratios of up to 80% of the appraised value of the property, and are typically secured by personal guarantees of the borrowers.

In underwriting these loans, the Corporation performs a thorough analysis of the financial condition of the borrower, the borrower's credit history, and the reliability and predictability of the cash flow generated by the property securing the loan. Appraisals on properties securing commercial real estate loans originated by the Corporation are performed by independent appraisers.

Commercial real estate loans generally present a higher level of risk than other types of loans due primarily to the effect of general economic conditions and the complexities involved in valuing the underlying collateral.

Commercial Real Estate Construction Lending - The Corporation engages in commercial real estate construction lending in its primary market area and surrounding areas. The Corporation's commercial real estate construction lending consists of commercial and residential site development loans, as well as commercial building construction and residential housing construction loans.

The Corporation's commercial real estate construction loans are generally secured with the subject property. Terms of construction loans depend on the specifics of the project, such as estimated absorption rates, estimated time to complete, etc.

In underwriting commercial real estate construction loans, the Corporation performs a thorough analysis of the financial condition of the borrower, the borrower's credit history, and the reliability and predictability of the projected cash flow generated by the project using feasibility studies, market data, and other pertinent information. Appraisals on properties securing commercial real estate construction loans originated by the Corporation are performed by independent appraisers.

Commercial real estate construction loans generally present a higher level of risk than other types of loans due primarily to the effect of general economic conditions and the uncertainties surrounding total construction costs.

Residential Mortgage Lending - One-to-four family residential mortgage loan originations are generated by the Corporation's marketing efforts, its present customers, walk-in customers, and referrals. These loans originate primarily within the Corporation's market area or with customers primarily from the market area.

The Corporation offers fixed-rate and adjustable-rate mortgage loans with terms up to a maximum of 30 years for both permanent structures and those under construction. The Corporation's one-to-four family residential mortgage originations are secured primarily by properties located in its primary market area and surrounding areas. The majority of the Corporation's residential mortgage loans originate with a loan-to-value of 80% or less. Loans in excess of 80% are required to have private mortgage insurance.

In underwriting one-to-four family residential real estate loans, the Corporation evaluates both the borrower's ability to make monthly payments and the value of the property securing the loan. Properties securing real estate loans made by the Corporation are appraised by independent appraisers. The Corporation generally requires borrowers to obtain an attorney's title opinion or title insurance, as well as fire and property insurance (including flood insurance, if necessary) in an amount not less than the amount of the loan. The Corporation has not engaged in subprime residential mortgage originations.

Residential mortgage loans present a moderate level of risk due primarily to general economic conditions, as well as a weakened housing market.

Home Equity Lines of Credit Lending - The Corporation originates home equity lines of credit primarily within the Corporation's market area or with customers primarily from the market area. Home equity lines of credit are generated by the Corporation's marketing efforts, its present customers, walk-in customers, and referrals.

Home equity lines of credit are secured by the borrower's primary residence with a maximum loan-to-value of 90% and a maximum term of 20 years. In underwriting home equity lines of credit, a thorough analysis of the borrower's financial ability to repay the loan as agreed is performed. The ability to repay is determined by the borrower's employment history, current financial condition, and credit background.

Home equity lines of credit generally present a moderate level of risk due primarily to general economic conditions, as well as a weakened housing market.

Consumer Lending - The Corporation offers a variety of unsecured and secured consumer loans, including those for vehicles and mobile homes and those secured by savings deposits. These loans originate primarily within the Corporation's market area or with customers primarily from the market area.

Consumer loan terms vary according to the type and value of collateral and the creditworthiness of the borrower. In underwriting consumer loans, a thorough analysis of the borrower's financial ability to repay the loan as agreed is performed. The ability to repay is determined by the borrower's employment history, current financial condition, and credit background.

Consumer loans may entail greater credit risk than residential mortgage loans or home equity lines of credit, particularly in the case of consumer loans which are unsecured or are secured by rapidly depreciable assets such as automobiles or recreational equipment. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

The following table presents the classes of the loan portfolio summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Corporation's internal risk rating system as of September 30, 2011, and December 31, 2010:

In thousands	Pass		Special Mention		Substandard		Doubtful		Total
SEPTEMBER 30, 2011
Commercial and industrial	$	55,357	$	4,152	$	4,477	$	—	$	63,986
Commercial real estate	198,842		15,838		15,388		—		230,068
Commercial real estate construction	5,789		12,475		2,903		—		21,167
Residential mortgage	291,337		4,052		3,441		—		298,830
Home equity lines of credit	50,358		1,654		555		—		52,567
Consumer	15,391		—		—		—		15,391
	$	617,074	$	38,171	$	26,764	$	—	$	682,009

DECEMBER 30, 2010
Commercial and industrial	$	43,448	$	5,041	$	4,187	$	—	$	52,676
Commercial real estate	193,731		14,530		17,689		—		225,950
Commercial real estate construction	11,009		10,963		4,663		—		26,635
Residential mortgage	289,833		2,882		4,282		—		296,997
Home equity lines of credit	46,383		2,081		393		—		48,857
Consumer	14,176		—		—		—		14,176
	$	598,580	$	35,497	$	31,214	$	—	$	665,291

The following table summarizes information relative to impaired loans by loan portfolio class as of September 30, 2011, and December 31, 2010:

Impaired Loans with Allowance

Impaired Loans with
No Allowance

In thousands

Recorded
Investment

Unpaid
Principal
Balance

Related
Allowance

Recorded
Investment

Unpaid
Principal
Balance

SEPTEMBER 30, 2011

Commercial and industrial

3,126

1,135

264

1,379

Commercial real estate

142

6,521

7,318

Commercial real estate construction

—

2,903

7,481

Residential mortgage

573

1,487

2,005

3,841

1,253

11,175

18,183

	Impaired loans with Allowance						Impaired Loans with No Allowance
In thousands	Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance
DECEMBER 31, 2010
Commercial and industrial	$	869	$	1,869	$	547	$	68	$	68
Commercial real estate	4,326		4,326		726		3,955		4,184
Commercial real estate construction	4,216		7,716		729		172		232
Residential mortgage	97		97		57		954		1,312
	$	9,508	$	14,008	$	2,059	$	5,149	$	5,796

The following table summarizes information relative to average impaired loans and related interest income by loan portfolio class for the three and nine months ended September 30, 2011:

	Three Months Ended September 30, 2011				Nine Months Ended September 30, 2011
In thousands	Average Recorded Investment		Interest Income		Average Recorded Investment		Interest Income
Commercial and industrial	$	1,863	$	—	$	1,154	$	—
Commercial real estate	6,534		—		7,435		44
Commercial real estate construction	3,214		—		3,676		—
Residential mortgage	1,908		—		1,473		—
	$	13,519	$	—	$	13,738	$	44

The following table presents nonaccrual loans by loan portfolio class as of September 30, 2011, and December 31, 2010:

In thousands	September 30, 2011		December 31, 2010
Commercial and industrial	$	3,390	$	937
Commercial real estate	6,663		8,281
Commercial real estate construction	2,903		4,388
Residential mortgage	2,060		1,051
	$	15,016	$	14,657

The following table summarizes information relative to troubled debt restructurings by loan portfolio class:

In thousands	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
SEPTEMBER 30, 2011
Commercial and industrial	$	490	$	245
Commercial real estate	$	371	$	146
Commercial real estate construction	$	1,548	$	862

DECEMBER 31, 2010
Commercial and industrial	$	490	$	439
Commercial real estate	$	371	$	168
Commercial real estate construction	$	1,548	$	1,536

All of the Corporation's troubled debt restructured loans are also nonaccrual impaired loans, which resulted in a specific allocation and, subsequently, a charge-off as appropriate. As of September 30, 2011, charge-offs associated with troubled debt restructured loans while under a forbearance agreement totaled $589,000. As of September 30, 2011, there were no defaulted troubled debt restructures as all troubled debt restructured loans were current with respect to their associated forbearance agreements. One forbearance agreement was negotiated during 2009 and modified during 2011, while the other two were negotiated during 2010.

There are forbearance agreements on all loans currently classified as troubled debt restructures, and all of these agreements have resulted in additional principal repayment. The terms of these forbearance agreements vary whereby principal payments have been decreased, interest rates have been reduced, and/or the loan will be repaid as collateral is sold.

As a result of adopting the amendments in Accounting Standards Update No. 2011-02, the Corporation reassessed all troubled debt restructurings that occurred on or after the beginning of the current fiscal year of January 1, 2011, for identification as troubled debt restructurings. The Corporation identified no loans for which the allowance for loan losses had previously been measured under a general allowance of credit losses methodology that are now considered troubled debt restructurings in accordance with Accounting Standards Update No. 2011-02.

The performance and credit quality of the loan portfolio is also monitored by analyzing the age of the loans receivable as determined by the length of time a recorded payment is past due.

The following table presents the classes of the loan portfolio summarized by the past due status:

In thousands	30-59 Days Past Due		60-89 Days Past Due		Nonaccrual and Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Loans Receivable >90 Days and Accruing
SEPTEMBER 30, 2011
Commercial and industrial	$	41	$	31	$	3,389	$	3,461	$	60,525	$	63,986	$	—
Commercial real estate	2,229		980		6,724		9,933		220,135		230,068		61
Commercial real estate construction	—		—		2,904		2,904		18,263		21,167		—
Residential mortgage	592		814		3,077		4,483		294,347		298,830		1,017
Home equity lines of credit	236		6		162		404		52,163		52,567		162
Consumer	6		—		—		6		15,385		15,391		—
	$	3,104	$	1,831	$	16,256	$	21,191	$	660,818	$	682,009	$	1,240

DECEMBER 31, 2010
Commercial and industrial	$	105	$	—	$	937	$	1,042	$	51,634	$	52,676	$	—
Commercial real estate	1,903		744		8,281		10,928		215,022		225,950		—
Commercial real estate construction	—		—		4,388		4,388		22,247		26,635		—
Residential mortgage	3,182		492		2,035		5,709		291,288		296,997		984
Home equity lines of credit	115		13		13		141		48,716		48,857		13
Consumer	16		—		—		16		14,160		14,176		—
	$	5,321	$	1,249	$	15,654	$	22,224	$	643,067	$	65,291	$	997

The following tables summarize the allowance for loan losses and recorded investment in financing receivables:

In thousands	Commercial and Industrial			Commercial Real Estate			Commercial Real Estate Construction			Residential Mortgage			Home Equity Lines of Credit			Consumer			Unallocated			Total
AS OF AND FOR THE PERIOD ENDED SEPTEMBER 30, 2011
Allowance for Loan Losses
Beginning balance - July 1, 2011	$	1,934		$	6,187		$	576		$	3,581		$	365		$	390		$	1,667		$	14,700
Charge-offs	(39		)	(102		)	(77		)	(265		)	(10		)	(5		)	—			(498		)
Recoveries	8			—			—			—			—			2			—			10
Provisions	1,119			212			91			183			172			(2		)	(575		)	1,200
Ending balance	$	3,022		$	6,297		$	590		$	3,499		$	527		$	385		$	1,092		$	15,412

Beginning balance - January 1, 2011	$	2,074		$	6,346		$	1,154		$	3,108		$	341		$	520		$	1,709		$	15,252
Charge-offs	(662		)	(1,237		)	(1,155		)	(385		)	(10		)	(30		)	—			(3,479		)
Recoveries	25			—			—			2			—			2			—			29
Provisions	1,585			1,188			591			774			196			(107		)	(617		)	3,610
Ending balance	$	3,022		$	6,297		$	590		$	3,499		$	527		$	385		$	1,092		$	15,412
Ending balance: individually evaluated for impairment	$	1,135		$	24		$	—		$	94		$	—		$	—		$	—		$	1,253
Ending balance: collectively evaluated for impairment	$	1, 887		$	6,273		$	590		$	3,405		$	527		$	385		$	1,092		$	14,159

Loans Receivables
Ending balance	$	63,986		$	230,068		$	21,167		$	298,830		$	52,567		$	15,391		$	—		$	682,009
Ending balance: individually evaluated for impairment	$	3, 390		$	6,663		$	2,903		$	2,060		$	—		$	—		$	—		$	15,016
Ending balance: collectively evaluated for impairment	$	60,596		$	223,405		$	18,264		$	296,770		$	52,567		$	15,391		$	—		$	666,993

In thousands	Commercial and Industrial		Commercial Real Estate		Commercial Real Estate Construction		Residential Mortgage		Home Equity Lines of Credit		Consumer		Unallocated		Total
AS OF DECEMBER 31, 2010
Allowance for Loan Losses
Ending balance	$	2,074	$	6,346	$	1,154	$	3,108	$	341	$	520	$	1,709	$	15,252
Ending balance: individually evaluated for impairment	$	547	$	726	$	729	$	57	$	—	$	—	$	—	$	2,059
Ending balance: collectively evaluated for impairment	$	1,527	$	5,620	$	425	$	3,051	$	341	$	520	$	1,709	$	13,193

Loans Receivables
Ending balance	$	52,676	$	225,950	$	26,635	$	296,997	$	48,857	$	14,176	$	—	$	665,291
Ending balance: individually evaluated for impairment	$	937	$	8,281	$	4,388	$	1,051	$	—	$	—	$	—	$	14,657
Ending balance: collectively evaluated for impairment	$	51,739	$	217,669	$	22,247	$	295,946	$	48,857	$	14,176	$	—	$	650,634

No additional funds are committed to be advanced in connection with impaired loans.