4. Credit Quality of Loans and Allowance for Loan Losses

The loan portfolio consisted of the following (in thousands):

	September 30, 2013			December 31, 2012
Commercial, financial and agricultural	$	423,073		$	315,655
Lease financing receivable		5,340			5,769
Real estate - construction		76,213			75,334
Real estate - commercial		401,080			414,384
Real estate - residential		142,431			142,858
Installment loans to individuals		94,722			90,561
Other		2,164			2,379
		1,145,023			1,046,940
Less allowance for loan losses		(8,667	)		(7,370	)
	$	1,136,356		$	1,039,570

The Company monitors loan concentrations and evaluates individual customer and aggregate industry leverage, profitability, risk rating distributions, and liquidity for each major standard industry classification segment. At September 30, 2013, one industry segment concentration, the oil and gas industry, constituted more than 10% of the loan portfolio. The Company’s exposure in the oil and gas industry, including related service and manufacturing industries, totaled approximately $189.8 million, or 16.6% of total loans. Additionally, the Company’s exposure to loans secured by commercial real estate is monitored. At September 30, 2013, loans secured by commercial real estate (including commercial construction, farmland and multifamily loans) totaled approximately $458.9 million. Of the $458.9 million, $349.2 million represent CRE loans, 61.2% of which are secured by owner-occupied commercial properties. Of the $458.9 million in loans secured by commercial real estate, $2.5 million, or 0.5%, were on nonaccrual status at September 30, 2013.

Allowance for Loan Losses

The allowance for loan losses is a valuation account available to absorb probable losses on loans. All losses are charged to the allowance for loan losses when the loss actually occurs or when a determination is made that a loss is likely to occur. Recoveries are credited to the allowance for loan losses at the time of recovery. Quarterly, the probable level of losses in the existing portfolio is estimated through consideration of various factors. Based on these estimates, the allowance for loan losses is increased by charges to earnings and decreased by charge‑offs (net of recoveries).

The allowance is composed of general reserves and specific reserves. General reserves are determined by applying loss percentages to segments of the portfolio. The loss percentages are based on each segment’s historical loss experience, generally over the past twelve to eighteen months, and adjustment factors derived from conditions in the Company’s internal and external environment. All loans considered to be impaired are evaluated on an individual basis to determine specific reserve allocations in accordance with GAAP. Loans for which specific reserves are provided are excluded from the calculation of general reserves.

Loans acquired in business combinations are initially recorded at fair value, which includes an estimate of credit losses expected to be realized over the remaining lives of the loans, and therefore no corresponding allowance for loan losses is recorded for these loans at acquisition. Methods utilized to estimate any subsequently required allowance for loan losses for acquired loans not deemed credit-impaired at acquisition are similar to originated loans; however, the estimate of loss is based on the unpaid principal balance and then compared to any remaining unaccreted purchase discount. To the extent that the calculated loss is greater than the remaining unaccreted purchase discount, an allowance is recorded for such difference.

The Company has an internal loan review department that is independent of the lending function to challenge and corroborate the loan grade assigned by the lender and to provide additional analysis in determining the adequacy of the allowance for loan losses.

A rollforward of the activity within the allowance for loan losses by loan type and recorded investment in loans for the nine months ended September 30, 2013 and 2012 is as follows (in thousands):

	September 30, 2013
				Real Estate
	Coml, Fin, and Agric			Construction			Commercial			Residential			Consumer			Finance Leases Coml			Other		Total
Allowance for loan losses:
Beginning balance	$	1,535		$	2,147		$	2,166		$	936		$	543		$	41		$	2	$	7,370
Charge-offs		(461	)		-			(18	)		(129	)		(558	)		-			-		(1,166	)
Recoveries		61			5			21			34			92			-			-		213
Provision		3,090			(1,081	)		(661	)		(46	)		962			(16	)		2		2,250
Ending balance	$	4,225		$	1,071		$	1,508		$	795		$	1,039		$	25		$	4	$	8,667
Ending balance:
individually evaluated for impairment	$	419		$	36		$	54		$	55		$	134		$	-		$	-	$	698
Ending balance:
collectively evaluated for impairment	$	3,806		$	1,035		$	1,454		$	740		$	905		$	25		$	4	$	7,969


Loans:
Ending balance	$	423,073		$	76,213		$	401,080		$	142,431		$	94,722		$	5,340		$	2,164	$	1,145,023
Ending balance:
individually evaluated for impairment	$	1,450		$	164		$	2,285		$	994		$	322		$	-		$	-	$	5,215
Ending balance:
collectively evaluated for impairment	$	421,623		$	76,049		$	398,080		$	141,136		$	94,400		$	5,340		$	2,164	$	1,138,792
Ending balance:
loans acquired with deteriorated credit quality	$	-		$	-		$	715		$	301		$	-		$	-		$	-	$	1,016

	September 30, 2012
				Real Estate
	Coml, Fin, and Agric			Construction		Commercial			Residential			Consumer			Finance Leases Coml		Other		Total
Allowance for loan losses:
Beginning balance	$	1,734		$	1,661	$	2,215		$	936		$	710		$	19	$	1	$	7,276
Charge-offs		(683	)		-		(495	)		(126	)		(395	)		-		-		(1,699	)
Recoveries		169			9		-			3			66			-		-		247
Provision		574			378		282			114			197			4		1		1,550
Ending balance	$	1,794		$	2,048	$	2,002		$	927		$	578		$	23	$	2	$	7,374
Ending balance:
individually evaluated for impairment	$	461		$	40	$	64		$	-		$	95		$	-	$	-	$	660
Ending balance:
collectively evaluated for impairment	$	1,333		$	2,008	$	1,938		$	927		$	483		$	23	$	2	$	6,714

Loans:
Ending balance	$	266,046		$	57,727	$	293,579		$	110,735		$	73,334		$	5,041	$	2,371	$	808,833
Ending balance:
individually evaluated for impairment	$	2,302		$	926	$	3,144		$	1,771		$	299		$	-	$	-	$	8,442
Ending balance:
collectively evaluated for impairment	$	263,744		$	56,801	$	290,435		$	108,964		$	73,035		$	5,041	$	2,371	$	800,391

Non-Accrual and Past Due Loans

Loans are considered past due if the required principal and interest payment have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the probability of collection of interest is deemed insufficient to warrant further accrual. For loans placed on non-accrual status, the accrual of interest is discontinued and subsequent payments received are applied to the principal balance. Interest income is recorded after principal has been satisfied and as payments are received. Non-accrual loans may be returned to accrual status if all principal and interest amounts contractually owed are reasonably assured of repayment within a reasonable period and there is a period of at least six months to one year of repayment performance by the borrower depending on the contractual payment terms.

An age analysis of past due loans (including both accruing and non-accruing loans) is as follows (in thousands):

	September 30, 2013 ⁽¹⁾
	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 days and Accruing
Commercial, financial, and agricultural	$	1,934	$	150	$	1,454	$	3,538	$	419,535	$	423,073	$	33
Commercial real estate - construction		58		-		129		187		57,674		57,861		-
Commercial real estate - other		3,815		102		2,903		6,820		394,260		401,080		665
Consumer - credit card		36		3		33		72		5,773		5,845		33
Consumer - other		510		53		325		888		87,989		88,877		13
Residential - construction		-		-		-		-		18,352		18,352		-
Residential - prime		1,968		144		1,064		3,176		139,255		142,431		-
Residential - subprime		-		-		-		-		-		-		-
Other loans		127		4		-		131		2,033		2,164		-
Finance leases commercial		-		-		-		-		5,340		5,340		-
	$	8,448	$	456	$	5,908	$	14,812	$	1,130,211	$	1,145,023	$	744

	December 31, 2012 ⁽¹⁾
	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 days and Accruing
Commercial, financial, and agricultural	$	2,220	$	321	$	2,580	$	5,121	$	310,534	$	315,655	$	1,019
Commercial real estate - construction		66		96		101		263		58,087		58,350		-
Commercial real estate - other		4,123		2,108		3,577		9,808		404,576		414,384		952
Consumer - credit card		24		2		15		41		6,766		6,807		15
Consumer - other		421		134		186		741		83,013		83,754		-
Residential - construction		-		-		-		-		16,984		16,984		-
Residential - prime		1,140		239		1,121		2,500		140,358		142,858		-
Residential - subprime		-		-		-		-		-		-		-
Other loans		87		-		-		87		2,292		2,379		-
Finance leases commercial		-		-		-		-		5,769		5,769		-
	$	8,081	$	2,900	$	7,580	$	18,561	$	1,028,379	$	1,046,940	$	1,986

Non-accrual loans are as follows (in thousands):

	September 20, 2013 ⁽¹⁾		December 31, 2012 ⁽¹⁾
Commercial, financial, and agricultural	$	1,488	$	1,777
Commercial real estate – construction		166		941
Commercial real estate - other		2,363		3,009
Consumer - credit card		-		-
Consumer - other		352		409
Residential - construction		-		-
Residential - prime		1,391		2,140
Residential - subprime		-		-
Other loans		-		-
Finance leases commercial		-		-
	$	5,760	$	8,276

⁽¹⁾Balances have been adjusted from previously reported amounts for discounts associated with purchase credit impaired loans.

The amount of interest that would have been recorded on non-accrual loans, had the loans not been classified as non-accrual, totaled approximately $431,000 and $502,000 for the nine months ended September 30, 2013 and 2012, respectively. Interest actually received on non-accrual loans at September 30, 2013 and 2012 was $246,000 and $25,000, respectively.

Impaired Loans

Loans are considered impaired when, based upon current information, it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. All loans classified as special mention, substandard, or doubtful, based on credit risk rating factors, and are reviewed for impairment. An allowance for each impaired loan is calculated based on the present value of expected future cash flows discounted at the loan’s effective interest rate or at the loan’s observable market price or the fair value of the collateral if the loan is collaterally dependent. All impaired loans are reviewed, at a minimum, on a quarterly basis. Existing valuations are reviewed to determine if additional discounts or new appraisals are required. After this review, when comparing the resulting collateral valuation to the outstanding loan balance, if the discounted collateral value exceeds the loan balance no specific allocation is reserved. Acquired impaired loans are generally not subject to individual evaluation for impairment and are not reported with impaired loans or troubled debt restructurings, even if they would otherwise qualify for such treatment.

Loans that are individually evaluated for impairment are as follows (in thousands):

	September 30, 2013
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial, financial, and agricultural	$	423	$	563	$	-	$	520	$	3
Commercial real estate – construction		63		63		-		64		-
Commercial real estate – other		1,921		2,395		-		2,137		6
Consumer – other		74		74		-		67		1
Residential – prime		576		596		-		622		5
Subtotal:	$	3,057	$	3,691	$	-	$	3,410	$	15
With an allowance recorded:
Commercial, financial, and agricultural		1,027		1,141		419		1,029		2
Commercial real estate – construction		101		101		36		149		1
Commercial real estate – other		364		364		54		283		11
Consumer – other		248		248		134		252		1
Residential – prime		418		418		55		387		1
Subtotal:	$	2,158	$	2,272	$	698	$	2,100	$	16
Totals:
Commercial		3,899		4,627		509		4,182		23
Consumer		322		322		134		319		2
Residential		994		1,014		55		1,009		6
Grand total:	$	5,215	$	5,963	$	698	$	5,510	$	31

	December 31, 2012
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial, financial, and agricultural	$	564	$	675	$	-	$	861	$	5
Commercial real estate – construction		771		770		-		834		1
Commercial real estate – other		2,530		3,059		-		1,780		38
Consumer – other		114		122		-		81		1
Residential – prime		1,575		1,575		-		1,213		26
Subtotal:	$	5,554	$	6,201	$	-	$	4,769	$	71
With an allowance recorded:
Commercial, financial, and agricultural		1,072		1,072		391		1,128		21
Commercial real estate – construction		165		165		57		85		7
Commercial real estate – other		381		381		35		811		3
Consumer – other		216		216		114		228		6
Residential – prime		52		52		30		172		4
Subtotal:	$	1,886	$	1,886	$	627	$	2,424	$	41
Totals:
Commercial		5,483		6,122		483		5,499		75
Consumer		330		338		114		309		7
Residential		1,627		1,627		30		1,385		30
Grand total:	$	7,440	$	8,087	$	627	$	7,193	$	112

Credit Quality

The Company manages credit risk by observing written underwriting standards and lending policy established by the Board of Directors and management to govern all lending activities. The risk management program requires that each individual loan officer review his or her portfolio on a quarterly basis and assign recommended credit ratings on each loan. These efforts are supplemented by independent reviews performed by a loan review officer and other validations performed by the internal audit department. The results of the reviews are reported directly to the Audit Committee of the Board of Directors.

Loans can be classified into the following three risk rating grades: pass, special mention, and substandard/doubtful. Factors considered in determining a risk rating grade include debt service capacity, capital structure/liquidity, management, collateral quality, industry risk, company trends/operating performance, repayment source, revenue diversification/customer concentration, quality of financial information, and financing alternatives. Pass grade signifies the highest quality of loans to loans with reasonable credit risk, which may include borrowers with marginally adequate financial performance, but have the ability to repay the debt. Special mention loans have potential weaknesses that warrant extra attention from the loan officer and other management personnel, but still have the ability to repay the debt. Substandard classification includes loans with well-defined weaknesses with risk of potential loss. Loans classified as doubtful are considered to have little recovery value and are charged off.

The following tables present the classes of loans by risk rating (in thousands):

	September 30, 2013
Commercial Credit Exposure
Credit Risk Profile by Creditworthiness Category
	Commercial, Financial, and Agricultural		Commercial Real Estate Construction		Commercial Real Estate Other		Commercial Total		% of Total Commercial
Pass	$	415,480	$	56,932	$	378,331	$	850,743		96.46	%
Special mention		2,581		-		4,500		7,081		0.80	%
Substandard		4,771		929		18,145		23,845		2.70	%
Doubtful		241		-		104		345		0.04	%
	$	423,073	$	57,861	$	401,080	$	882,014		100.00	%

Residential Credit Exposure
Credit Risk Profile by Creditworthiness Category
	Residential Construction		Residential Prime		Residential Subprime		Residential Total		% of Total Residential
Pass	$	18,335	$	138,424	$	-	$	156,759		97.50	%
Special mention		-		727		-		727		0.45	%
Substandard		17		3,280		-		3,297		2.05	%
	$	18,352	$	142,431	$	-	$	160,783		100.00	%

Consumer and Commercial Credit Exposure
Credit Risk Profile Based on Payment Activity
	Consumer Credit Card		Consumer Other		Finance Leases Commercial		Other Loans		Total		% of Total
Performing	$	5,811	$	88,518	$	5,340	$	2,164	$	101,833		99.62	%
Nonperforming		34		359		-		-		393		0.38	%
	$	5,845	$	88,877	$	5,340	$	2,164	$	102,226		100.00	%

	December 31, 2012
Commercial Credit Exposure
Credit Risk Profile by Creditworthiness Category
	Commercial, Financial, and Agricultural		Commercial Real Estate Construction		Commercial Real Estate Other		Commercial Total		% of Total Commercial
Pass	$	304,219	$	54,737	$	396,077	$	755,033		95.76	%
Special Mention		5,748		684		6,224		12,656		1.61	%
Substandard		4,503		2,925		7,514		14,942		1.90	%
Doubtful		1,185		4		4,569		5,758		0.73	%
	$	315,655	$	58,350	$	414,384	$	788,389		100.00	%

Residential Credit Exposure
Credit Risk Profile by Creditworthiness Category
	Residential Construction		Residential Prime		Residential Subprime		Residential Total		% of Total Residential
Pass	$	16,785	$	137,681	$	-	$	154,466		96.64	%
Special mention		-		1,612		-		1,612		1.01	%
Substandard		199		3,565		-		3,764		2.35	%
	$	16,984	$	142,858	$	-	$	159,842		100.00	%

Consumer and Commercial Credit Exposure
Credit Risk Profile Based on Payment Activity
	Consumer Credit Card		Consumer Other		Finance Leases Commercial		Other Loans		Total		% of Total
Performing	$	6,792	$	83,347	$	5,769	$	2,379	$	98,287		99.57	%
Nonperforming		15		407		-		-		422		0.43	%
	$	6,807	$	83,754	$	5,769	$	2,379	$	98,709		100.00	%

Troubled Debt Restructurings

A troubled debt restructuring (“TDR”) is a restructuring of a debt made by the Company to a debtor for economic or legal reasons related to the debtor’s financial difficulties that it would not otherwise consider. The Company grants the concession in an attempt to protect as much of its investment as possible.

Information about the Company’s TDRs is as follows (in thousands):

	September 30, 2013
	Current		Past Due Greater than 30 Days		Nonaccrual TDRs		Total TDRs

Commercial, financial, and agricultural	$	23	$	-	$	343	$	366
Real estate - commercial		167		-		-		167
	$	190	$	-	$	343	$	533

	December 31, 2012
	Current		Past Due Greater than 30 Days		Nonaccrual TDRs		Total TDRs

Commercial, financial, and agricultural	$	-	$	-	$	353	$	353
Real estate - commercial		4,709		-		-		4,709
	$	4,709	$	-	$	353	$	5,062

The $4.5 million decrease from December 31, 2012 resulted primarily from payoffs related to two commercial credits previously classified as TDRs. During the three months ended September 30, 2013, there were no loans identified as a TDR, and there were no defaults on any loans that were modified as TDRs during the preceding twelve months. During the three months ended September 30, 2012, there were no new loans identified as TDRs, and there were no defaults on any loans that were modified as TDRs during the preceding twelve months. During the nine months ended September 30, 2013, one loan with a pre-modification balance of $27,000 was identified as a TDR, and there were no defaults on any loans that were modified as TDRs during the preceding twelve months. During the nine months ended September 30, 2012, there were no new TDRs identified. Three TDRs totaling $249,000 defaulted during the nine months ended September 30, 2012. For purposes of the determination of an allowance for loan losses on these TDRs, as an identified TDR, the Company considers a loss probable on the loan and, as a result is reviewed for specific impairment in accordance with the Company’s allowance for loan loss methodology. If it is determined losses are probable on such TDRs, either because of delinquency or other credit quality indicator, the Company establishes specific reserves for these loans. As of September 30, 2013, there were no commitments to lend additional funds to debtors owing sums to the Company whose terms have been modified in TDRs.