NOTE 4 LOANS AND ALLOWANCE FOR LOAN LOSSES

The composition of the loan portfolio, net of deferred origination fees and cost, and unearned income is summarized as follows (dollars in thousands):

	March 31, 2014		December 31, 2013
Commercial and agricultural:
Commercial and industrial	$	144,681	$	144,787
Agricultural		534		576
Commercial mortgages:
Construction		29,692		27,440
Commercial mortgages		367,175		345,707
Residential mortgages		196,396		195,997
Consumer loans:
Credit cards		1,583		1,756
Home equity lines and loans		95,827		95,905
Indirect consumer loans		170,853		164,846
Direct consumer loans		17,824		18,852
Total loans, net of deferred origination fees and costs, and unearned income	$	1,024,565	$	995,866
Interest receivable on loans		2,367		2,597
Total recorded investment in loans	$	1,026,932	$	998,463

The Corporation's concentrations of credit risk by loan type are reflected in the preceding table. The concentrations of credit risk with standby letters of credit, committed lines of credit and commitments to originate new loans generally follow the loan classifications in the table above.

The following tables present the activity in the allowance for loan losses by portfolio segment for the three-month periods ending March 31, 2014 and 2013 (dollars in thousands):

	Three Months Ended
	March 31, 2014
Allowance for loan losses	Commercial and Agricultural			Commercial Mortgages			Residential Mortgages			Consumer Loans			Unallocated		Total
Beginning balance:	$	1,979		$	6,243		$	1,517		$	3,037		$	-	$	12,776
Charge Offs:		(55	)		(44	)		(7	)		(467	)		-		(573	)
Recoveries:		92			38			-			183			-		313
Net recoveries (charge offs)		37			(6	)		(7	)		(284	)		-		(260	)
Provision		(71	)		247			42			421			-		639
Ending balance	$	1,945		$	6,484		$	1,552		$	3,174		$	-	$	13,155

	Three Months Ended
	March 31, 2013
Allowance for loan losses	Commercial and Agricultural			Commercial Mortgages			Residential Mortgages			Consumer Loans			Unallocated			Total
Beginning balance:	$	1,707		$	4,428	$		1,566		$	2,706		$	26	$	10,433
Charge Offs:		(17	)		-			(44	)		(197	)		-		(258	)
Recoveries:		142			9			-			68			-		219
Net recoveries (charge-offs)		125			9			(44	)		(129	)		-		(39	)
Provision		161			236			35			25			(26)		431
Ending balance	$	1,993		$	4,673		$	1,557		$	2,602		$	-	$	10,825

The following tables present the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of March 31, 2014 and December 31, 2013 (dollars in thousands):

	March 31, 2014
Allowance for loan losses	Commercial and Agricultural		Commercial Mortgages		Residential Mortgages		Consumer Loans		Unallocated		Total
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	549	$	192	$	-	$	3	$	-	$	744
Collectively evaluated for impairment		1,396		4,802		1,540		3,171		-		10,909
Loans acquired with deteriorated credit quality		-		1,490		12		-		-		1,502
Total ending allowance balance	$	1,945	$	6,484	$	1,552	$	3,174	$	-	$	13,155

	December 31, 2013
Allowance for loan losses	Commercial and Agricultural		Commercial Mortgages		Residential Mortgages		Consumer Loans		Unallocated		Total
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	576	$	466	$	-	$	4	$	-	$	1,046
Collectively evaluated for impairment		1,403		4,407		1,497		3,033		-		10,340
Loans acquired with deteriorated credit quality		-		1,370		20		-		-		1,390
Total ending allowance balance	$	1,979	$	6,243	$	1,517	$	3,037	$	-	$	12,776

	March 31, 2014
Loans:	Commercial and Agricultural		Commercial Mortgages		Residential Mortgages		Consumer Loans		Total
Loans individually evaluated for impairment	$	2,208	$	9,544	$	114	$	129	$	11,995	1,
Loans collectively evaluated for impairment		142,675		379,366		196,518		286,616		1,005,175
Loans acquired with deteriorated credit quality		655		8,841		266		-		9,762
Total ending loans balance	$	145,538	$	397,751	$	196,898	$	286,745	$	1,026,932

	December 31, 2013
Loans:	Commercial and Agricultural		Commercial Mortgages		Residential Mortgages		Consumer Loans		Total
Loans individually evaluated for impairment	$	2,946	$	10,703	$	117	$	131	$	13,897
Loans collectively evaluated for impairment		142,108		354,636		196,147		281,979		974,870
Loans acquired with deteriorated credit quality		678		8,757		261		-		9,696
Total ending loans balance	$	145,732	$	374,096	$	196,525	$	282,110	$	998,463

The following tables present loans individually evaluated for impairment recognized by class of loans as of March 31, 2014 and December 31, 2013, the average recorded investment and interest income recognized by class of loans as of the three-month periods ended March 31, 2014 and 2013 (dollars in thousands):

	March 31, 2014						December 31, 2013
With no related allowance recorded:	Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated		Unpaid Principal Balance			Recorded Investment		Allowance for Loan Losses Allocated
Commercial and agricultural:
Commercial and industrial	$	1,398	$	1,403	$	-	$	1,906	$	1,909	$	-
Commercial mortgages:
Construction		2,286		2,273		-		2,329		2,319		-
Commercial mortgages other		6,479		6,490		-		7,406		7,439		-
Residential mortgages		114		114		-		117		117		-
Consumer loans:
Home equity lines and loans		69		71		-		71		73		-
With an allowance recorded:
Commercial and agricultural:
Commercial and industrial		804		805		549		1,037		1,037		576
Commercial mortgages:
Commercial mortgages other		783		781		192		951		945		466
Consumer loans:
Home equity lines and loans		57		58		3		58		58		4
Total	$	11,990	$	11,995	$	744	$	13,875	$	13,897	$	1,046

		Three Months Ended March 31, 2014			Three Months Ended March 31, 2013
With no related allowance recorded:		Average Recorded Investment		Interest Income Recognized (1)		Average Recorded Investment		Interest Income Recognized (1)
Commercial and agricultural:
Commercial and industrial	$	1,656	$	14	$	1,458	$	17
Commercial mortgages:
Construction		2,296		25		474		-
Commercial mortgages other		7,005		63		5,583		53
Residential mortgages		115		-		130		-
Consumer loans:
Home equity lines & loans		72		1		23		-
With an allowance recorded:
Commercial and agricultural:
Commercial and industrial		921		-		387		-
Commercial mortgages:
Commercial mortgages other		863		-		361		-
Consumer loans:
Home equity lines and loans		58		1		29		-
Direct consumer loans		-		-		8		-
Total	$	12,986	$	104	$	8,453	$	70

(1)	Cash basis interest income approximates interest income recognized.

The following tables present the recorded investment in past due and non-accrual status by class of loans as of March 31, 2014 and December 31, 2013 (dollars in thousands):

March 31, 2014	Current		30-89 Days Past Due		90 Days or more Past Due and accruing			Loans acquired with deteriorated credit quality	Non-Accrual (1)			Total
Commercial and agricultural:
Commercial and industrial	$	142,750	$	520	$	-	$	655	$	1,078	$	145,003
Agricultural		535		-		-		-		-		535
Commercial mortgages:
Construction		27,037		-		1,451		774		496		29,758
Commercial mortgages others		356,618		1,002		-		8,067		2,306		367,993
Residential mortgages		189,719		3,073		-		266		3,840		196,898
Consumer loans:
Credit cards		1,568		8		7		-		-		1,583
Home equity lines and loans		95,235		280		-		-		543		96,058
Indirect consumer loans		169,838		1,091		-		-		293		171,222
Direct consumer loans		17,822		49		-		-		11		17,882
Total	$	1,001,122	$	6,023	$	1,458	$	9,762	$	8,567	$	1,026,932

(1) Includes all loans on non-accrual status regardless of the number of days such loans were delinquent as of March 31, 2014.

December 31, 2013	Current		30-89 Days Past Due		90 Days or more Past Due and accruing				Loans acquired with deteriorated credit quality	Non-Accrual (1)			Total
Commercial and agricultural:
Commercial and industrial	$	143,100	$	29	$	-		$	678	$	1,348	$	145,155
Agricultural		577		-		-			-		-		577
Commercial mortgages:
Construction		24,742		-		1,454			774		540		27,510
Commercial mortgages other		335,123		1,138		-			7,983		2,342		346,586
Residential mortgages		187,448		5,458		-	`		261		3,358		196,525
Consumer loans:
Credit cards		1,729		9		19			-		-		1,757
Home equity lines and loans		95,349		150		-			-		635		96,134
Indirect consumer loans		163,810		1,235		-			-		249		165,294
Direct consumer loans		18,830		50		-			-		45		18,925
Total	$	970,708	$	8,069	$	1,473		$	9,696	$	8,517	$	998,463

(1) Includes all loans on non-accrual status regardless of the number of days such loans were delinquent as of December 31, 2013.

Troubled Debt Restructurings:

As of March 31, 2014 and December 31, 2013, the Corporation has a recorded investment in troubled debt restructurings of $7.3 million and $7.9 million, respectively. There were specific reserves of $0.2 million and $0.3 million allocated for troubled debt restructurings at March 31, 2014 and December 31, 2013, respectively. As of March 31, 2014, troubled debt restructurings totaling $6.5 million were accruing interest under the modified terms and $0.8 million were on non-accrual status. As of December 31, 2013, troubled debt restructurings totaling $6.8 million were accruing interest under the modified terms and $1.1 million were on non-accrual status. The Corporation has not committed to lend additional amounts as of March 31, 2014 to customers with outstanding loans that are classified as troubled debt restructurings. The Corporation had committed additional amounts totaling up to $0.2 million as of December 31, 2013 to customers with outstanding loans that are classified as troubled debt restructurings.

During the three months ended March 31, 2014 and 2013, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: reduced scheduled payments for greater than three months or an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk.

The following table presents loans by class modified as troubled debt restructurings that occurred during the three months ended March 31, 2014 and March 31, 2013 (dollars in thousands):

March 31, 2014	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled debt restructurings:
Commercial and agricultural:
Commercial and industrial		1	$	503	$	503
Commercial mortgages:
Commercial mortgages		2		367		323
Total		3	$	870	$	826


March 31, 2013
Troubled debt restructurings:
Commercial and agricultural:
Commercial and industrial	2	$	431	$	431
Consumer loans:
Home equity lines and loans	2	$	104		104
Total	4	$	535	$	535

The troubled debt restructurings described above did not increase the allowance for loan losses and resulted in less than $0.1 million in charge offs during the three months ended March 31, 2014. The troubled debt restructurings described above increased the allowance for loan losses by less than $0.1 million and resulted in no charge offs during the three months ended March 31, 2013.

There were no payment defaults on any loans previously modified as troubled debt restructurings during the three months ending March 31, 2014 or March 31, 2013, within twelve months following the modification. A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.

Credit Quality Indicators

The Corporation establishes a risk rating at origination for all commercial loans. The main factors considered in assigning risk ratings include, but are not limited to: historic and future debt service coverage, collateral position, operating performance, liquidity, leverage, payment history, management ability, and the customer’s industry. Commercial relationship managers monitor all loans in their respective portfolios for any changes in the borrower’s ability to service their debt and affirm the risk ratings for the loans at least annually.

For the retail loans, which include lines of credit, installment, mortgage, and home equity loans, once a loan is properly approved and closed, the Corporation evaluates credit quality based upon loan repayment.

The Corporation uses the risk rating system to identify criticized and classified loans. Commercial relationships within the criticized and classified risk ratings are analyzed quarterly. The Corporation uses the following definitions for criticized and classified loans (which are consistent with regulatory guidelines):

Special Mention – Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or the institution’s credit position at some future date.

Substandard – Loans classified as substandard are inadequately protected by the current net worth and paying capability of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful – Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. Loans listed as not rated are included in groups of homogeneous loans. Based on the analyses performed as of March 31, 2014 and December 31, 2013, the risk category of the recorded investment of loans by class of loans is as follows (dollars in thousands):

	March 31, 2014
		Not Rated		Pass		Loans acquired with deteriorated credit quality		Special Mention		Substandard		Doubtful
Commercial and agricultural:
Commercial and industrial		$	-	$	134,207	$	655	$	6,068	$	3,268	$	805
Agricultural			-		535		-		-		-		-
Commercial mortgages:
Construction			-		25,101		774		3,061		822		-
Commercial mortgages other			-		333,719		8,067		16,394		9,753		60
Residential mortgages			192,792		-		266		-		3,840		-
Consumer loans:
Credit cards			1,583		-		-		-		-		-
Home equity lines and loans			95,439		-		-		-		619		-
Indirect consumer loans			170,920		-		-		-		302		-
Direct consumer loans			17,871		-		-		-		11		-
Total		$	478,605	$	493,562	$	9,762	$	25,523	$	18,615	$	865

	December 31, 2013
		Not Rated		Pass		Loans acquired with deteriorated credit quality		Special Mention		Substandard		Doubtful
Commercial and agricultural:
Commercial and industrial		$	-	$	133,615	$	678	$	5,117	$	4,724	$	1,021
Agricultural			-		577		-		-		-		-
Commercial mortgages:
Construction			-		23,087		774		2,783		866		-
Commercial mortgages other			-		313,956		7,983		13,611		11,036		-
Residential mortgages			192,995		-		261		-		3,269		-
Consumer loans
Credit cards			1,757		-		-		-		-		-
Home equity lines and loans			95,422		-		-		-		712		-
Indirect consumer loans			165,045		-		-		-		249		-
Direct consumer loans			18,880		-		-		-		45		-
Total		$	474,099	$	471,235	$	9,696	$	21,511	$	20,901	$	1,021

The Corporation considers the performance of the loan portfolio and its impact on the allowance for loan losses. For residential and consumer loan classes, the Corporation also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity. The following table presents the recorded investment in residential and consumer loans based on payment activity as of March 31, 2014 and December 31, 2013 (dollars in thousands):

	March 31, 2014
			Consumer Loans
	Residential Mortgages		Credit Card		Home Equity Lines and Loans		Indirect Consumer Loans		Other Direct Consumer Loans
Performing	$	193,058	$	1,576	$	95,515	$	170,929	$	17,871
Non-Performing		3,840		7		543		293		11
Total	$	196,898	$	1,583	$	96,058	$	171,222	$	17,882

	December 31, 2013
			Consumer Loans
	Residential Mortgages		Credit Card		Home Equity Lines and Loans		Indirect Consumer Loans		Other Direct Consumer Loans
Performing	$	193,167	$	1,738	$	95,499	$	165,045	$	18,880
Non-Performing		3,358		19		635		249		45
	$	196,525	$	1,757	$	96,134	$	165,294	$	18,925

At the time of the merger with Fort Orange Financial Corp., the Corporation identified certain loans with evidence of deteriorated credit quality, and the probability that the Corporation would be unable to collect all contractually required payments from the borrower. These loans are classified as PCI loans. The Corporation adjusted its estimates of future expected losses, cash flows, and renewal assumptions on the PCI loans during the current year. These adjustments were made for changes in expected cash flows due to loans refinanced beyond original maturity dates, impairments recognized subsequent to the acquisition, advances made for taxes or insurance to protect collateral held and payments received in excess of amounts originally expected.

The table below summarizes the changes in total contractually required principal and interest cash payments, management’s estimate of expected total cash payments and carrying value of the PCI loans from January 1, 2014 to March 31, 2014 (dollars in thousands):

	Balance at December 31, 2013			Income Accretion		All Other Adjustments			Balance at March 31, 2014
Contractually required principal and interest	$	11,230		$	-	$	(157	)	$	11,073
Contractual cash flows not expected to be collected (nonaccretable discount)		(543	)		-		108			(435	)
Cash flows expected to be collected		10,687			-		(49	)		10,638
Interest component of expected cash flows (accretable yield)		(991	)		199		(84	)		(876	)
Fair value of loans acquired with deteriorating credit quality	$	9,696		$	199	$	(133	)	$	9,762