Note 6. Loan Quality

Management utilizes a risk rating scale ranging from 1 (Prime) to 9 (Loss) to evaluate loan quality. This risk rating scale is used primarily for commercial purpose loans. Consumer purpose loans are identified as either pass or substandard. Substandard consumer loans are loans that are 90 days or more past due and still accruing or on nonaccrual. Loans rated 1 – 4 are considered pass credits. Loans that are rated 5 are pass credits, but have been identified as credits that are likely to warrant additional attention and monitoring. Loans rated 6 (Other Assets Especially Mentioned - OAEM) or worse begin to receive enhanced monitoring and reporting by the Bank. Loans rated 7 (Substandard) or 8 (Doubtful) exhibit the greatest financial weakness and present the greatest possible risk of loss to the Bank. Nonaccrual loans are rated no better than 7. The following factors represent some of the factors used in determining the risk rating of a borrower: cash flow, debt coverage, liquidity, management, and collateral. Risk ratings, for pass credits, are generally reviewed annually for term debt and at renewal for revolving or renewing debt. The Bank monitors loan quality by reviewing four measurements: (1) loans rated 6 (OAEM) or worse (collectively “watch list”), (2) delinquent loans, (3) other real estate owned (OREO), and (4) net-charge-offs. Management compares trends in these measurements with the Bank’s internally established targets, as well as its national peer group.

Watch list loans exhibit financial weaknesses that increase the potential risk of default or loss to the Bank. However, inclusion on the watch list, does not by itself, mean a loss is certain. The watch list includes both performing and nonperforming loans. Watch list loans totaled $104.3 million at year-end compared to $93.5 million at the prior year end. The watch list is comprised of $32.7 million rated 6, $68.8 million rated 7 and $2.8 million rated 8. The loan, rated 8, represents one loan of a total $8.1 million relationship (see Table 13, credit 8) and is secured by land for a residential real estate development. When initially rated an 8 at September 30, 2012, there was not sufficient collateral to support the entire $8.1 million relationship and the doubtful balance represented the potential collateral shortage. The Bank is in the process of negotiating additional collateral to fully secure the loan and has maintained the 8 rating. The Bank has no loans rated 9 (Loss). The Bank’s Loan Management Committee reviews these loans and risk ratings on a quarterly basis in order to proactively identify and manage problem loans. In addition, a committee meets monthly to discuss possible workout strategies for OREO and all credits rated 7 or worse. Management also tracks other commercial loan risk measurements including high loan to value loans, concentrations, participations and policy exceptions and reports these to the Credit Risk Oversight Committee of the Board of Directors. The Bank also uses a third-party consultant to assist with internal loan review with an overarching goal of reviewing 60% of commercial loans each year. The FDIC defines certain supervisory loan-to-value lending limits. The Bank’s internal loan-to-value limits are all equal to, or have lower loan-to-value limits, than the supervisory loan to value limits. At December 31, 2012, the Bank had loans of $33.4 million that exceeded the supervisory limit.

The following table reports on the credit rating for those loans in the portfolio that are assigned an individual credit rating as of December 31, 2012 and 2011:




(Dollars in thousands)	Pass		OAEM		Substandard		Doubtful		Total

December 31, 2012
Residential Real Estate 1-4 Family
First liens	$	139,549	$	6,277	$	8,773	$	-	$	154,599
Junior liens and lines of credit		40,584		175		1,529		-		42,288
Total		180,133		6,452		10,302		-		196,887
Residential real estate - construction		11,284		2,922		1,226		-		15,432
Commercial, industrial and agricultural real estate		299,075		20,221		41,828		2,750		363,874
Commercial, industrial and agricultural		148,195		3,120		15,419		-		166,734
Consumer		10,636		-		16		-		10,652
Total	$	649,323	$	32,715	$	68,791	$	2,750	$	753,579



December 31, 2011
Residential Real Estate 1-4 Family
First liens	$	130,680	$	3,733	$	7,484	$	-	$	141,897
Junior liens and lines of credit		47,329		377		430		-		48,136
Total		178,009		4,110		7,914		-		190,033
Residential real estate - construction		19,253		941		1,088		-		21,282
Commercial, industrial and agricultural real estate		291,967		41,675		25,332		-		358,974
Commercial, industrial and agricultural		168,207		7,649		6,838		-		182,694
Consumer		13,320		-		107		-		13,427
Total	$	670,756	$	54,375	$	41,279	$	-	$	766,410

Delinquent loans are a result of borrowers’ cash flow and/or alternative sources of cash being insufficient to repay loans. The Bank’s likelihood of collateral liquidation to repay the loans becomes more probable the further behind a borrower falls, particularly when loans reach 90 days or more past due. Management monitors the performance status of loans by the use of an aging report. The aging report can provide an early indicator of loans that may become severely delinquent and possibly result in a loss to the Bank. The following table presents the aging of payments in the loan portfolio as of December 31, 2012 and 2011:



(Dollars in thousands)			Loans Past Due and Still Accruing										Total
	Current		30-59 Days		60-89 Days		90 Days+		Total		Non-Accrual		Loans
December 31, 2012
Residential Real Estate 1-4 Family
First liens	$	147,236	$	2,862	$	797	$	120	$	3,779	$	3,584	$	154,599
Junior liens and lines of credit		40,741		449		228		112		789		758		42,288
Total		187,977		3,311		1,025		232		4,568		4,342		196,887
Residential real estate - construction		14,875		-		-		-		-		557		15,432
Commercial, industrial and agricultural real estate		334,822		64		329		-		393		28,659		363,874
Commercial, industrial and agricultural		163,387		161		35		315		511		2,836		166,734
Consumer		10,339		258		39		16		313		-		10,652
Total	$	711,400	$	3,794	$	1,428	$	563	$	5,785	$	36,394	$	753,579



December 31, 2011
Residential Real Estate 1-4 Family
First liens	$	134,105	$	2,574	$	953	$	2,516	$	6,043	$	1,749	$	141,897
Junior liens and lines of credit		46,311		1,121		121		301		1,543		282		48,136
Total		180,416		3,695		1,074		2,817		7,586		2,031		190,033
Residential real estate - construction		21,161		-		-		121		121		-		21,282
Commercial, industrial and agricultural real estate		337,462		2,961		2,646		1,627		7,234		14,278		358,974
Commercial, industrial and agricultural		179,907		113		1,127		100		1,340		1,447		182,694
Consumer		12,917		287		116		107		510		-		13,427
Total	$	731,863	$	7,056	$	4,963	$	4,772	$	16,791	$	17,756	$	766,410

Nonaccruing loans generally represent Management’s determination that the borrower will be unable to repay the loan in accordance with its contractual terms and that collateral liquidation may or may not fully repay both interest and principal. It is the Bank’s policy to evaluate the probable collectability of principal and interest due under terms of loan contracts for all loans 90-days or more past due, nonaccrual loans or impaired loans. Further, it is the Bank’s policy to discontinue accruing interest on loans that are not adequately secured and in the process of collection. Upon determination of nonaccrual status, the Bank subtracts any current year accrued and unpaid interest from its income, and any prior year accrued and unpaid interest from the allowance for loan losses. Management continually monitors the status of nonperforming loans, the value of any collateral and potential of risk of loss. Nonaccrual loans are rated no better than 7 (Substandard).

Loan quality has declined during 2012, as measured by the balance of nonperforming loans (nonaccrual and loans past due 90-days or more). Nonperforming loans have increased by $14.4 million with the majority of the increase coming in the commercial real estate sector. The nonaccrual table that follows identifies the most significant loans in nonaccrual status. These nonaccrual loans account for 82% of the total nonaccrual balance and credits 5 – 11 added $20.4 million to nonaccrual during 2012. Also included in the nonaccrual total is $11.4 million of loans classified as troubled debt restructurings (TDR). A TDR loan is maintained on nonaccrual status until a satisfactory repayment history is established. All of the Bank’s TDR loans are in compliance with the modified terms and it is likely that some will be able to be returned to performing status in 2013. It is possible that other nonaccrual loans could be removed from nonaccrual status in 2013. However, it is also possible that other loans may become delinquent and nonperforming loans could remain at a high level due to lengthy workout periods on these loans.

All loans on the watch list that are not on nonaccrual or past due 90 days or more are considered potential problem loans. These loans are rated 6 or 7 due to a financial weakness that has the potential to increase the risk of loss to the Bank. However, due to the performing status or other mitigating factors such as collateral or personal guarantees, the loans remain on an accruing status. Potential problem loans at December 31, 2012 totaled $67.3 million compared to $71.0 million at December 31, 2011.

The following table presents a summary of nonperforming assets as of December 31, of each year:



	2012			2011

			% of Loan			% of Loan
(Dollars in thousands)	Balance		Segment	Balance		Segment

Nonaccrual loans
Residential Real Estate 1-4 Family
First liens	$	3,584	2.3	$	1,749	1.2
Junior liens and lines of credit		758	1.8		282	0.6
Total		4,342	2.2		2,031	1.1
Residential real estate - construction		557	3.6		-	-
Commercial, industrial and agricultural real estate		28,659	7.9		14,278	4.0
Commercial, industrial and agricultural		2,836	1.7		1,447	0.8
Consumer		-	-		-	-
Total nonaccrual loans		36,394			17,756

Loans past due 90 days or more and not included above
Residential Real Estate 1-4 Family
First liens		120			2,516
Junior liens and lines of credit		112			301
Total		232			2,817
Residential real estate - construction		-			121
Commercial, industrial and agricultural real estate		-			1,627
Commercial, industrial and agricultural		315			100
Consumer		16			107
Total loans past due 90 days or more and still accruing		563			4,772

Total nonaccrual and loans past due 90 days or more		36,957			22,528

Repossessed assets		-			6
Other real estate owned		5,127			3,224
Total nonperforming assets	$	42,084		$	25,758

The following table provides additional information on significant nonaccrual loans.

December 31, 2012

(Dollars in thousands)

ALL

Nonaccrual

Last

Balance

Reserve

Date

Collateral

Location

Appraisal(1)

Credit 1

2,491

Dec-10

1st, 2nd and 3rd lien on 600+ acres of farm real estate, and equipment inventory

Apr-12

Agricultural

4,344

Credit 2

3,588

Dec-10

1st lien on 92 acres undeveloped commercial real estate

Jan-12

Commercial Real Estate

3,899

Credit 3

1,001

Aug-11

1st lien on commercial and residential properties and 70 acres

Oct-11

Commercial and residential real estate

1,280

Credit 4

2,422

Sep-11

Liens on commercial real estate - performance theaters and business assets

MO & PA

Feb-12

Commercial real estate

4,887

Credit 5

2,670

Mar-12

1st and 2nd liens on commercial real estate, residential real estate and business assets

Dec-12

Residential real estate development

4,808

Credit 6

2,069

Jun-12

1st lien residential development land - 75 acres

Mar-12

Residential real estate development

2nd lien residential real estate

2,550

Credit 7

1,634

Apr-12

1st and 2nd liens on residential real estate

May-12

Residential real estate development

2,001

Credit 8

8,050

Sep-12

1st lien residential real estate development -376 acres and other commercial and residential properties

Dec-11

Residential real estate development

9,860

Credit 9

1,812

Mar-12

Accounts receivable, inventory and 1st lien on real estate

Sep-11

Commercial and industrial

3,889

Credit 10

2,201

Oct-12

1st lien commercial refrigerated warehouse

Dec-11

Commercial real estate

5,995

Credit 11

1,914

Oct-12

1st lien on farmland

May-12

Agricultural

2,666

29,852

(1) Appraisal value, as reported, does not reflect the pay-off of any senior liens or the cost to liquidate the collateral, but does reflect only the Bank’s share of the collateral if it is a participated loan.

Credit 1 was approved as a loan restructuring and was returned to accrual status in March 2013. Credit 2 was charged down by $1.6 million in the first quarter of 2012 due to a reduced appraisal value. This credit is part of a participated loan and it is likely that the lead bank will begin foreclosure action in 2013. Credit 3 is in the process of foreclosure. Credit 4 is a TDR that is performing in accordance with the modified terms. This credit is part of a shared national credit and it is unlikely to return to accrual status until approved by the lead regulatory agency. Credit 5 is a TDR that is performing in accordance with the modified terms and is on nonaccrual until a satisfactory repayment history is established. Credit 6 was written down by $259 thousand in 2012. Foreclosure action has been initiated on this credit. Credit 7 is exploring external financing to pay off its loan and is considering restructuring options from the Bank, but it is unknown if these efforts will be successful. Credit 8 is in the process of negotiating with the Bank for additional collateral and possible loan restructuring. Credit 9 is a TDR. Two plant facilities were sold through a court approved bankruptcy in January 2013. The Bank expects to receive a pay down on this credit from the sale, but the amount is unknown at this time. Credit 10 is a participated loan and the Bank is in discussion with the lead bank on a workout strategy. Credit 11 is a TDR and is performing in accordance with its modified terms.

Interest not recognized on nonaccrual loans was $800 thousand, $319 thousand and $535 thousand for the years ended December 31, 2012, 2011 and 2010, respectively. In addition to monitoring nonaccrual loans, the Bank also closely monitors impaired loans and troubled debt restructurings. A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Nonaccrual loans, excluding consumer purpose loans, and TDR loans are considered impaired and the Bank reviews all other loans rated 7 or worse for impaired status. Impaired loans totaled $39.4 million at year-end 2012 compared to $28.0 million at December 31, 2011. The increase in impaired loans occurred primarily in the commercial real estate category. The majority of the increase was the addition of credits 6 and 8 from the nonaccrual table as impaired loans. See the following table for additional information on impaired loans.



	Impaired Loans
	With No Allowance				With Allowance
(Dollars in thousands)			Unpaid					Unpaid
	Recorded		Principal		Recorded		Principal		Related
December 31, 2012	Investment		Balance		Investment		Balance		Allowance
Residential Real Estate 1-4 Family
First liens	$	3,504	$	3,715	$	80	$	80	$	20
Junior liens and lines of credit		691		707		-		-		-
Total		4,195		4,422		80		80		20
Residential real estate - construction		557		567		-		-		-
Commercial, industrial and agricultural real estate		28,346		31,937		2,603		3,194		357
Commercial, industrial and agricultural		2,495		2,584		1,088		1,145		470
Consumer		-		-		-		-		-
Total	$	35,593	$	39,510	$	3,771	$	4,419	$	847



December 31, 2011
Residential Real Estate 1-4 Family
First liens	$	176	$	177	$	3,723	$	3,867	$	495
Junior liens and lines of credit		28		30		134		134		3
Total		204		207		3,857		4,001		498
Residential real estate - construction		-		-		43		43		-
Commercial, industrial and agricultural real estate		11,072		12,092		10,550		12,050		1,591
Commercial, industrial and agricultural		94		109		2,214		2,352		870
Consumer		-		-		-		-		-
Total	$	11,370	$	12,408	$	16,664	$	18,446	$	2,959



	Twelve Months Ended				Twelve Months Ended
	December 31, 2012				December 31, 2011
	Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
Residential Real Estate 1-4 Family
First liens	$	4,070	$	58	$	2,170	$	190
Junior liens and lines of credit		744		1		317		14
Total		4,814		59		2,487		204
Residential real estate - construction		458		-		7,147		-
Commercial, industrial and agricultural real estate		26,815		151		19,152		530
Commercial, industrial and agricultural		4,060		111		2,342		79
Consumer		-		-		1		-
Total	$	36,147	$	321	$	31,129	$	813

A loan is considered a troubled debt restructuring if the creditor (the Bank), for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. The Bank reviews all loans rated 5 or worse when it is providing a loan restructure, modification or new credit facility to determine if the action is a TDR. If a TDR loan is placed on nonaccrual status, it remains on nonaccrual status for at least six months to ensure performance. All TDR loans are in compliance with their modified terms. The largest TDR loans are referenced as credits 4, 5, 9 and 11 on the nonaccrual table above. All of the TDR loans are commercial purpose loans except for three consumer loans totaling $322 thousand. The following table identifies TDR loans as of December 31, 2012 and 2011:



				Troubled Debt Restructings
				That Have Defaulted on
(Dollars in thousands)	Troubled Debt Restructings			Modified Terms YTD
	Number of	Recorded		Number of	Recorded
	Contracts	Investment		Contracts	Investment
December 31, 2012
Real estate construction	2	$	1,482	-	$	-
Residential real estate	4		467
Commercial, industrial and agricultural	2		1,812
Commercial, industrial and agricultural real estate	11		7,669	-		-
Total	19	$	11,430	-	$	-



December 31, 2011
Residential real estate	2	$	93
Commercial, industrial and agricultural real estate	9		8,023	-	$	-
Total	11	$	8,116	-	$	-

The following table reports the performing status of TDR loans. The performing status is determined by the loans compliance with the modified terms.



(Dollars in thousands)		December 31, 2012				December 31, 2011
		Performing	Nonperforming			Performing	Nonperforming
Real estate construction	$	1,482	$	-	$	-	$	-
Residential real estate		467		-		93		-
Commercial, industrial and agriculture		1,812		-		-		-
Commercial, industrial and agriculture real estate		7,669		-		8,023		-
Total	$	11,430	$	-	$	8,116	$	-

The following table reports the recorded investment in new TDR loans made during the year ended December 31, 2012.



(Dollars in thousands)	New During Period
	Number of	Pre-TDR		After-TDR		Current
Twelve Months Ended December 31, 2012	Contracts	Modification		Modification		Balance
Real estate construction	3	$	2,073	$	1,897	$	1,482
Residential real estate	2		371		390		379
Commercial, industrial and agricultural	2		2,223		2,223		1,812
Commercial, industrial and agricultural real estate	4		2,616		3,006		2,957
Total	11	$	7,283	$	7,516	$	6,630

The following table reports the type of loan concession granted for new TDR loans made during 2012 and the recorded investment as of December 31, 2012.



(Dollars in thousands)	New During Period
	Number of	Pre-TDR		After-TDR		Current
Twelve Months Ended December 31, 2012	Contracts	Modification		Modification		Balance
Maturity	2	$	2,223	$	2,223	$	1,812
Multiple	9		5,060		5,293		4,818
	11	$	7,283	$	7,516	$	6,630

The following table reports new TDR loans during 2011 and the recorded investment as of December 31, 2012.



(Dollars in thousands)	New During Period
	Number of	Pre-TDR		After-TDR		Recorded
Twelve Months Ended December 31, 2011	Contracts	Modification		Modification		Investment
Residential real estate	2	$	94	$	94	$	88
Commercial, industrial and agricultural	1		2,856		2,856		-
Commercial, industrial and agricultural real estate	6		6,378		4,510		4,432
	9	$	9,328	$	7,460	$	4,520

The type of loan concession granted for new TDR loans during 2011 and the recorded investment as of December 31, 2012.



(Dollars in thousands)	New During Period
	Number of	Pre-TDR		After-TDR		Recorded
Twelve Months Ended December 31, 2011	Contracts	Modification		Modification		Investment
Maturity	1	$	263	$	263	$	246
Rate	3		2,950		2,950		88
Payment	5		6,115		4,247		4,186
	9	$	9,328	$	7,460	$	4,520

The Bank holds $5.1 million of other real estate owned, comprised of ten properties compared to $3.2 million and seven properties at December 31, 2011. The largest property ($2.8 million, property 2 in table below) was added in 2012 and represents a failed residential real estate development in central Pennsylvania. During 2012, the Bank recorded losses on the sales of, or write-downs on OREO of $582 thousand that is recorded in other income. Included in this total is a fourth quarter 2012 write-down of $349 thousand on property number 1 shown in table below. A write-down of $800 thousand was recorded on property number 2 through the allowance for loan losses shortly after acquisition.

The following table provides additional information on significant other real estate owned properties.



December 31, 2012

(Dollars in thousands)	Date						Last
	Acquired		Balance	Collateral	Location		Appraisal

Property 1	2011	$	1,970	unimproved and improved real estate for residential development on four separate tracts totaling 150 acres	PA		Nov-12
						$	2,141

Property 2	2012		2,758	1st, 2nd, and 3rd liens residential development land - four tracts with 294 acres	PA		Aug-12
						$	3,292
		$	4,728

At December 31, 2012, the Bank had $121 thousand of residential properties in the process of foreclosure compared to $1.0 million at the end of 2011.

Allowance for Loan Losses:

Management performs a monthly evaluation of the adequacy of the allowance for loan losses (ALL). The ALL is determined by segmenting the loan portfolio based on the loan’s collateral. The Bank further classifies the portfolio based on the primary purpose of the loan, either consumer or commercial. When calculating the ALL, consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, historical charge-offs, the adequacy of the underlying collateral (if collateral dependent) and other relevant factors. The Bank begins enhanced monitoring of all loans rated 6 (OAEM) or worse, and obtains a new appraisal or asset valuation for any loan rated 7 (substandard) or worse. Management, at its discretion, may determine that additional adjustments to the appraisal or valuation are required. Valuation adjustments will be made as necessary based on factors, including, but not limited to: the economy, deferred maintenance, industry, type of property/equipment, age of the appraisal, etc. and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. If an appraisal is not available, Management may make its best estimate of the real value of the collateral or use last known market value and apply appropriate discounts. If an adjustment is made to the collateral valuation, this will be documented with appropriate support and reported to the Loan Management Committee. When determining the allowance for loan losses, certain factors involved in the evaluation are inherently subjective and require material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans. Management monitors the adequacy of the allowance for loan losses on an ongoing basis and reports its adequacy quarterly to the Credit Risk Oversight Committee of the Board of Directors. Management believes that the allowance for loan losses at December 31, 2012 is adequate.

The analysis for determining the ALL is consistent with guidance set forth in generally accepted accounting principles (GAAP) and the Interagency Policy Statement on the Allowance for Loan and Lease Losses. The analysis has two components, specific and general allocations. The specific component addresses specific reserves established for impaired loans. A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Collateral values discounted for market conditions and selling costs are used to establish specific allocations for impaired loans. However, it is possible that as a result of the credit analysis, a specific reserve is not required for an impaired loan. Despite an increase in impaired loans in 2012, the specific ALL allocation for these loans declined. The largest loans added to the impaired list are adequately secured and required no specific ALL. Charge-offs on impaired loans in 2012 were the primary reason for the decline in the specific ALL allocation. See the previous impaired loan discussion for a table that reports impaired loans and the specific reserve established for impaired loans.

The general allocation component addresses the reserves established for pools of homogenous loans. The general component includes a quantitative and qualitative analysis. When calculating the general allocation, the Bank segregates its loan portfolio into the following sectors based primarily on the type of supporting collateral: residential real estate, commercial, industrial or agricultural real estate; commercial and industrial (C&I non-real estate), and consumer. The residential real estate sector is further segregated by first lien loans, junior liens and home equity products, and residential real estate construction. The quantitative analysis uses the Bank’s eight quarter rolling historical loan loss experience adjusted for factors derived from current economic and market conditions that have been determined to have an effect on the probability and magnitude of a loss. The historical loss experience factor was 1.05% of gross loans at December 31, 2012, compared to .70% at the prior year-end. The increase is due primarily to the increase in charge-offs during the eight quarter historical review period. The qualitative analysis utilizes a risk matrix that incorporates qualitative and environmental factors such as: loan volume, management, loan review process, credit concentrations, competition, and legal and regulatory issues. These factors are each risk rated from minimal to high risk and in total can add up to a qualitative factor of 37.5 basis points. At December 31, 2012, the qualitative factor was 21.5 basis points, compared to 18.5 basis points at December 31, 2011. These factors are determined on the basis of Management’s observation, judgment and experience.

Real estate appraisals and collateral valuations are an important part of the Bank’s process for determining potential loss on collateral dependent loans and thereby have a direct effect on the determination of loan reserves, charge-offs and the calculation of the allowance for loan losses. As long as the loan remains a performing loan, no further updates to appraisals are required. If a loan or relationship migrates to risk rating of 7 or worse, an evaluation for impairment status is made based on the current information available at the time of downgrade and a new appraisal or collateral valuation is obtained. We believe this practice complies with the regulatory guidance dated December 12, 2010.

In determining the allowance for loan losses, Management, at its discretion, may determine that additional adjustments to the fair value obtained from an appraisal or collateral valuation are required. Adjustments will be made as necessary based on factors, including, but not limited to the economy, deferred maintenance, industry, type of property or equipment etc., and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank.

The following table shows, by loan segment, the activity in the ALL, for the years ended December 31, 2012, 2011 and 2010:



							Commercial
	Residential Real Estate 1-4 Family						Industrial &		Commercial
			Junior Liens &				Agricultural		Industrial &
(Dollars in thousands)	First Liens		Lines of Credit		Construction		Real Estate		Agricultural		Consumer		Total

Allowance at December 31, 2009	$	550	$	278	$	3,087	$	4,175	$	752	$	95	$	8,937
Charge-offs		(107)		(165)		(982)		(1,736)		(232)		(452)		(3,674)
Recoveries		19		10		53		18		61		142		303
Provision		138		229		438		901		997		532		3,235
Allowance at December 31, 2010	$	600	$	352	$	2,596	$	3,358	$	1,578	$	317	$	8,801

Allowance at December 31, 2010	$	600	$	352	$	2,596	$	3,358	$	1,578	$	317	$	8,801
Charge-offs		(324)		(202)		(2,352)		(3,817)		(115)		(237)		(7,047)
Recoveries		30		10		-		306		11		88		445
Provision		743		148		978		5,410		177		68		7,524
Allowance at December 31, 2011	$	1,049	$	308	$	1,222	$	5,257	$	1,651	$	236	$	9,723

Allowance at December 31, 2011	$	1,049	$	308	$	1,222	$	5,257	$	1,651	$	236	$	9,723
Charge-offs		(251)		(71)		-		(3,298)		(861)		(236)		(4,717)
Recoveries		1		25		-		13		21		88		148
Provision		114		44		(323)		4,478		809		103		5,225
Allowance at December 31, 2012	$	913	$	306	$	899	$	6,450	$	1,620	$	191	$	10,379

The following table shows, by loan segment, the loans that were evaluated for the ALL under a specific reserve (individually) and those that were evaluated under a general reserve (collectively), and the amount of the allowance established in each category as of December 31, 2012 and 2011:



							Commercial
	Residential Real Estate 1-4 Family						Industrial &		Commercial
			Junior Liens &				Agricultural		Industrial &
(Dollars in thousands)	First Liens		Lines of Credit		Construction		Real Estate		Agricultural		Consumer		Total

December 31, 2012
Loans evaluated for allowance:
Individually	$	3,583	$	692	$	557	$	30,949	$	3,583	$	-	$	39,364
Collectively		151,016		41,596		14,875		332,925		163,151		10,652		714,215
Total	$	154,599	$	42,288	$	15,432	$	363,874	$	166,734	$	10,652	$	753,579

Allowance established for loans evaluated:
Individually	$	20	$	3	$	-	$	357	$	467	$	-	$	847
Collectively		893		303		899		6,093		1,153		191		9,532
Allowance at December 31, 2012	$	913	$	306	$	899	$	6,450	$	1,620	$	191	$	10,379

December 31, 2011
Loans evaluated for allowance:
Individually	$	3,899	$	162	$	43	$	21,622	$	2,308	$	-	$	28,034
Collectively		137,998		47,974		21,239		337,352		180,386		13,427		738,376
Total	$	141,897	$	48,136	$	21,282	$	358,974	$	182,694	$	13,427	$	766,410

Allowance established for loans evaluated:
Individually	$	495	$	3	$	-	$	1,591	$	870	$	-	$	2,959
Collectively		554		305		1,222		3,666		781		236		6,764
Allowance at December 31, 2011	$	1,049	$	308	$	1,222	$	5,257	$	1,651	$	236	$	9,723

The following table shows the allocation of the allowance for loan losses by loan category as of December 31, 2012 and 2011:



(Dollars in thousands)	2012			2011
			% of			% of
Residential real estate 1-4 family		Balance	Allowance		Balance	Allowance
First liens	$	913	9	$	1,049	11
Junior liens and lines of credit		306	3		308	3
Total		1,219	12		1,357	14
Residential real estate construction		899	8		1,222	13
Commercial, industrial and agricultural real estate		6,450	62		5,257	54
Commercial, industrial and agricultural		1,620	16		1,651	17
Consumer		191	2		236	2
	$	10,379	100	$	9,723	100

The percentage of the loans in each category to total gross loans at December 31, 2012 and 2011 is as follows:



	2012	2011
Residential real estate 1-4 family
First liens	21%	19%
Junior liens and lines of credit	6%	6%
Total	27%	25%
Residential real estate construction	2%	3%
Commercial, industrial and agricultural real estate	48%	47%
Commercial, industrial and agricultural	22%	24%
Consumer	1%	1%
	100%	100%

The allocation of the allowance for loan losses is based on estimates and is not intended to imply limitations on the usage of the allowance. The entire allowance is available to absorb any losses without regard to the category in which the loan is classified.

The Bank added $5.2 million to the allowance for loan losses (ALL) thorough the provision for loan loss expense in 2012 compared to $7.5 million in the prior year. Net charge-offs totaled $4.6 million for the year and as a result, the ALL increased by $656 thousand. The increase in provision expense was due to a higher level of loan charge-offs and Management’s intention to ensure adequate ALL coverage for future losses due to weakening credit quality. The net loan charge-off ratio decreased to .60% for the year compared to .86% for the prior year and the ALL coverage ratio increased to 1.38% compared to 1.27% at the prior year-end.

Charged-off loans usually result from: (1) a borrower being legally relieved of loan repayment responsibility through bankruptcy, (2) insufficient proceeds from the sale of collateral to repay a loan; or (3) the borrower and/or guarantor does not own other marketable assets that, if sold, would generate sufficient sale proceeds to repay a loan.

The Bank recorded net loan charge-offs of $4.6 million in 2012, $2.0 million less than in 2011, but still the second highest net charge-off level in the last five years. Gross charge-offs declined by $2.3 million year over year with the decrease occurring in the residential real estate construction category. The largest gross charge-offs occurred in the commercial real estate sector for $3.3 million in 2012. Within this sector, four charge-offs accounted for $3.1 million of the total. One loan was charged down by $1.6 million due to an annual appraisal update that resulted in a lower valuation for the second consecutive year. A second was written down by $259 thousand based on appraisals and prior to starting foreclosure action. These two loans are Credits 2 and 6, respectively in the nonaccrual table previously presented. A third write-down ($400 thousand) was taken on another loan that is also on nonaccrual status. The fourth charge-off mentioned was for $800 thousand as the property was moved to OREO (Property 2 of the other real estate owned table previously presented). The charge-offs in the C&I category consisted primarily of one loan for $249 thousand (real estate related) and one loan for $305 thousand (restaurant). If nonperforming loans remain at the current level, it is possible that net charge-offs will remain higher than historical averages.