Note 8. Loans

The following table sets forth the classification of loans by class, including unearned fees, deferred costs and excluding the allowance for loan losses as of June 30, 2012 and December 31, 2011:


(In thousands)	June 30, 2012		December 31, 2011
SBA loans	$	66,469	$	71,843
SBA 504 loans		45,247		55,108
Commercial loans
Commercial other		28,134		26,542
Commercial real estate		271,542		246,824
Commercial real estate construction		10,655		9,738
Residential mortgage loans
Residential mortgages		128,652		123,843
Residential construction		-		2,205
Purchased residential mortgages		7,862		8,042
Consumer loans
Home equity		45,097		46,935
Consumer other		1,243		1,512
Total loans	$	604,901	$	592,592

Loans are made to individuals as well as commercial entities. Specific loan terms vary as to interest rate, repayment, and collateral requirements based on the type of loan requested and the credit worthiness of the prospective borrower. Credit risk, excluding SBA loans, tends to be geographically concentrated in that a majority of the loan customers are located in the markets serviced by the Bank. As a preferred SBA lender, a portion of the SBA portfolio is to borrowers outside the Company’s lending area. However, during late 2008, the Company withdrew from SBA lending outside of its primary trade area, but continues to offer SBA loan products as an additional credit product within its primary trade area. A description of the Company's different loan segments follows:

SBA Loans: SBA 7(a) loans, on which the SBA has historically provided guarantees of up to 90 percent of the principal balance, are considered a higher risk loan product for the Company than its other loan products. The Company’s SBA loans are generally sold in the secondary market with the nonguaranteed portion held in the portfolio as a loan held for investment. SBA loans are for the purpose of providing working capital, financing the purchase of equipment, inventory or commercial real estate and for other business purposes. Loans are guaranteed by the businesses' major owners. SBA loans are made based primarily on the historical and projected cash flow of the business and secondarily on the underlying collateral provided.

SBA 504 Loans: The SBA 504 program consists of real estate backed commercial mortgages where the Company has the first mortgage and the SBA has the second mortgage on the property. SBA 504 loans are made based primarily on the historical and projected cash flow of the business and secondarily on the underlying collateral provided. Generally, the Company has a 50 percent loan to value ratio on SBA 504 program loans at origination. Loan performance may be adversely affected by factors impacting the general economy or conditions specific to the real estate market such as geographic location and/or property type.

Commercial Loans: Commercial credit is extended primarily to middle market and small business customers. Commercial loans are generally made in the Company’s market place for the purpose of providing working capital, financing the purchase of equipment, inventory or commercial real estate and for other business purposes. Loans will generally be guaranteed in full or for a meaningful amount by the businesses' major owners. Commercial loans are made based primarily on the historical and projected cash flow of the business and secondarily on the underlying collateral provided. Loan performance may be adversely affected by factors impacting the general economy or conditions specific to the real estate market such as geographic location and/or property type.

Residential Mortgage and Consumer Loans: The Company originates mortgage and consumer loans including principally residential real estate and home equity lines and loans. Each loan type is evaluated on debt to income, type of collateral and loan to collateral value, credit history and Company relationship with the borrower.

Inherent in the lending function is credit risk, which is the possibility a borrower may not perform in accordance with the contractual terms of their loan. A borrower’s inability to pay their obligations according to the contractual terms can create the risk of past due loans and, ultimately, credit losses, especially on collateral deficient loans. The Company minimizes its credit risk by loan diversification and adhering to credit administration policies and procedures. Due diligence on loans begins when we initiate contact regarding a loan with a borrower. Documentation, including a borrower’s credit history, materials establishing the value and liquidity of potential collateral, the purpose of the loan, the source of funds for repayment of the loan, and other factors, are analyzed before a loan is submitted for approval. The loan portfolio is then subject to on-going internal reviews for credit quality, as well as independent credit reviews by an outside firm.

The Company's extension of credit is governed by the Credit Risk Policy which was established to control the quality of the Company's loans. These policies and procedures are reviewed and approved by the Board of Directors on a regular basis.

Credit Ratings:

For SBA 7(a), SBA 504 and commercial loans, management uses internally assigned risk ratings as the best indicator of credit quality. A loan’s internal risk rating is updated at least annually and more frequently if circumstances warrant a change in risk rating. The Company uses a 1 through 10 loan grading system that follows regulatory accepted definitions.

Pass: Risk ratings of 1 through 6 are used for loans that are performing, as they meet, and are expected to continue to meet, all of the terms and conditions set forth in the original loan documentation, and are generally current on principal and interest payments. These performing loans are termed “Pass”.

Special Mention: Criticized loans are assigned a risk rating of 7 and termed “Special Mention”, as the borrowers exhibit potential credit weaknesses or downward trends deserving management’s close attention. If not checked or corrected, these trends will weaken the Bank’s collateral and position. While potentially weak, these borrowers are currently marginally acceptable and no loss of interest or principal is anticipated. As a result, special mention assets do not expose an institution to sufficient risk to warrant adverse classification. Included in “Special Mention” could be turnaround situations, such as borrowers with deteriorating trends beyond one year, borrowers in start up or deteriorating industries, or borrowers with a poor market share in an average industry. "Special Mention" loans may include an element of asset quality, financial flexibility, or below average management. Management and ownership may have limited depth or experience. Regulatory agencies have agreed on a consistent definition of “Special Mention” as an asset with potential weaknesses which, if left uncorrected, may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. This definition is intended to ensure that the “Special Mention” category is not used to identify assets that have as their sole weakness credit data exceptions or collateral documentation exceptions that are not material to the repayment of the asset.

Substandard: Classified loans are assigned a risk rating of an 8 or 9, depending upon the prospect for collection, and deemed “Substandard”. A risk rating of 8 is used for borrowers with well-defined weaknesses that jeopardize the orderly liquidation of debt. The loan is inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Normal repayment from the borrower is in jeopardy, although no loss of principal is envisioned. There is a distinct possibility that a partial loss of interest and/or principal will occur if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified “Substandard”.

A risk rating of 9 is used for borrowers that have all the weaknesses inherent in a loan with a risk rating of 8, with the added characteristic that the weaknesses make collection of debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Serious problems exist to the point where partial loss of principal is likely. The possibility of loss is extremely high, but because of certain important, reasonably specific pending factors that may work to strengthen the assets, the loans’ classification as estimated losses is deferred until a more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures; capital injection; perfecting liens on additional collateral; and refinancing plans. Partial charge-offs are likely.

Loss: Once a borrower is deemed incapable of repayment of unsecured debt, the risk rating becomes a 10, the loan is termed a “Loss”, and charged-off immediately. Loans to such borrowers are considered uncollectible and of such little value that continuance as active assets of the Bank is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off these basically worthless assets even though partial recovery may be affected in the future.

For residential mortgage and consumer loans, management uses performing versus nonperforming as the best indicator of credit quality. Nonperforming loans consist of loans that are not accruing interest (nonaccrual loans) as a result of principal or interest being in default for a period of 90 days or more or when the ability to collect principal and interest according to the contractual terms is in doubt. These credit quality indicators are updated on an ongoing basis, as a loan is placed on nonaccrual status as soon as management believes there is sufficient doubt as to the ultimate ability to collect interest on a loan.

The tables below detail the Company’s loan portfolio by class according to their credit quality indicators discussed in the paragraphs above as of June 30, 2012:

June 30, 2012

SBA, SBA 504 & Commercial loans - Internal risk ratings

(In thousands)

Pass

Special mention

Substandard

Total

66,469

45,247

28,134

Commercial real estate

216,243

43,031

12,268

271,542

Commercial real estate construction

9,775

880

10,655

Total commercial loans

247,247

46,078

17,006

310,331

Total SBA, SBA 504 and commercial loans

329,873

59,573

32,601

422,047

Residential mortgage & Consumer loans - Performing/Nonperforming

(In thousands)

Performing

Nonperforming

Total

Residential mortgage loans

Residential mortgages

127,168

1,484

128,652

Purchased residential mortgages

4,693

3,169

7,862

Total residential mortgage loans

136,514

45,097

1,243

46,340

604,901

The tables below detail the Company’s loan portfolio by class according to their credit quality indicators discussed in the paragraphs above as of December 31, 2011:


	December 31, 2011
	SBA, SBA 504 & Commercial loans - Internal risk ratings
(In thousands)	Pass		Special mention		Substandard		Total
SBA loans	$	49,568	$	8,900	$	13,375	$	71,843
SBA 504 loans		39,566		5,543		9,999		55,108
Commercial loans
Commercial other		20,921		1,160		4,461		26,542
Commercial real estate		187,680		49,231		9,913		246,824
Commercial real estate construction		8,255		883		600		9,738
Total commercial loans		216,856		51,274		14,974		283,104
Total SBA, SBA 504 and commercial loans	$	305,990	$	65,717	$	38,348	$	410,055

	Residential mortgage & Consumer loans - Performing/Nonperforming
(In thousands)			Performing		Nonperforming		Total
Residential mortgage loans
Residential mortgages			$	122,012	$	1,831	$	123,843
Residential construction				36		2,169		2,205
Purchased residential mortgages				6,005		2,037		8,042
Total residential mortgage loans				128,053		6,037		134,090
Consumer loans
Home equity				46,676		259		46,935
Consumer other				1,503		9		1,512
Total consumer loans			$	48,179	$	268	$	48,447
Total loans							$	592,592

Nonperforming and Past Due Loans:

Nonperforming loans consist of loans that are not accruing interest (nonaccrual loans) as a result of principal or interest being in default for a period of 90 days or more or when the ability to collect principal and interest according to the contractual terms is in doubt. When a loan is classified as nonaccrual, interest accruals discontinue and all past due interest previously recognized as income is reversed and charged against current period income. Generally, until the loan becomes current, any payments received from the borrower are applied to outstanding principal, until such time as management determines that the financial condition of the borrower and other factors merit recognition of a portion of such payments as interest income. Loans past due 90 days or more and still accruing interest are not included in nonperforming loans and generally represent loans that are well collateralized and in a continuing process expected to result in repayment or restoration to current status.

The risk of loss is difficult to quantify and is subject to fluctuations in collateral values, general economic conditions and other factors. The current state of the economy and the downturn in the real estate market has resulted in increased loan delinquencies and defaults. In some cases, these factors have also resulted in significant impairment to the value of loan collateral. The Company values its collateral through the use of appraisals, broker price opinions, and knowledge of its local market. In response to the credit risk in its portfolio, the Company has increased staffing in its credit monitoring department and increased efforts in the collection and analysis of borrowers’ financial statements and tax returns.

The following tables set forth an aging analysis of past due and nonaccrual loans as of June 30, 2012 and December 31, 2011:

June 30, 2012

(In thousands)

30-59 days past due

60-89 days past due

90+ days and still accruing

Nonaccrual (1)

Total past due

Current

Total loans

SBA loans

506

169

241

3,345

4,262

62,207

66,469

SBA 504 loans

2,201

1,775

3,975

41,272

45,247

Commercial loans

Commercial other

1,100

1,157

26,977

28,134

Commercial real estate

1,538

172

286

8,636

10,631

260,911

271,542

Commercial real estate construction

10,655

Residential mortgage loans

Residential mortgages

1,665

228

1,881

1,484

5,258

123,394

128,652

Purchased residential mortgages

142

621

3,169

3,965

3,897

7,862

Consumer loans

Home equity

761

106

311

1,178

43,919

45,097

Consumer other

1,230

1,243

Total loans

6,870

1,296

2,443

19,831

30,441

574,460

604,901

(1) At June 30, 2012, nonaccrual loans included $871 thousand of troubled debt restructurings ("TDRs") and $526 thousand of loans guaranteed by the SBA. The remaining $20.5 million of TDRs are in accrual status because they are performing in accordance with their restructured terms.


	December 31, 2011
(In thousands)	30-59 days past due		60-89 days past due		90+ days and still accruing		Nonaccrual (1)		Total past due		Current		Total loans
SBA loans	$	879	$	225	$	247	$	5,858	$	7,208	$	64,635	$	71,843
SBA 504 loans		2,006		-		-		2,086		4,092		51,016		55,108
Commercial loans
Commercial other		1,158		-		192		815		2,165		24,377		26,542
Commercial real estate		2,493		3,119		949		7,104		13,666		233,158		246,824
Commercial real estate construction		-		-		-		600		600		9,138		9,738
Residential mortgage loans
Residential mortgages		3,519		1,310		-		1,831		6,660		117,183		123,843
Residential construction		-		-		36		2,169		2,205		0		2,205
Purchased residential mortgages		149		-		-		2,037		2,187		5,855		8,042
Consumer loans
Home equity		338		199		988		259		1,784		45,151		46,935
Consumer other		1		3		-		9		14		1,498		1,512
Total loans	$	10,545	$	4,856	$	2,411	$	22,769	$	40,581	$	552,011	$	592,592

(1) At December 31, 2011, nonaccrual loans included $3.6 million of TDRs and $939 thousand of loans guaranteed by the SBA. The remaining $17.4 million of TDRs are in accrual status because they are performing in accordance with their restructured terms.

Impaired Loans:

The Company has defined impaired loans to be all nonperforming loans and troubled debt restructurings. Management considers a loan impaired when, based on current information and events, it is determined that the company will not be able to collect all amounts due according to the loan contract. Impairment is evaluated in total for smaller-balance loans of a similar nature, (consumer and residential mortgage loans), and on an individual basis for other loans.

The following tables provide detail on the Company’s impaired loans with the associated allowance amount, if applicable, as of June 30, 2012 and December 31, 2011:


	June 30, 2012
(In thousands)	Outstanding principal balance		Specific reserves		Net exposure (balance less specific reserves)
With no related allowance:
SBA loans (1)	$	1,573	$	-	$	1,573
SBA 504 loans		4,668		-		4,668
Commercial loans
Commercial other		4,261		-		4,261
Commercial real estate		6,513		-		6,513
Total commercial loans		10,774		-		10,774
Total impaired loans with no related allowance		17,015		-		17,015

With an allowance:
SBA loans (1)		2,184		847		1,337
SBA 504 loans		1,443		132		1,311
Commercial loans
Commercial other		62		62		-
Commercial real estate		14,167		2,661		11,506
Total commercial loans		14,229		2,723		11,506
Total impaired loans with a related allowance		17,856		3,702		14,154

Total individually evaluated impaired loans:
SBA loans (1)		3,757		847		2,910
SBA 504 loans		6,111		132		5,979
Commercial loans
Commercial other		4,323		62		4,261
Commercial real estate		20,680		2,661		18,019
Total commercial loans		25,003		2,723		22,280
Total individually evaluated impaired loans		34,871		3,702		31,169

Homogeneous collectively evaluated impaired loans:
Residential mortgage loans
Residential mortgages		1,484		-		1,484
Purchased residential mortgages		3,169		-		3,169
Total residential mortgage loans		4,653		-		4,653
Consumer loans
Home equity		311		-		311
Consumer other		11		-		11
Total consumer loans		322		-		322
Total homogeneous collectively evaluated impaired loans		4,975		-		4,975

Total impaired loans	$	39,846	$	3,702	$	36,144

(1) Balances are reduced by amount guaranteed by the Small Business Administration of $526 thousand at June 30, 2012.


	December 31, 2011
(In thousands)	Outstanding principal balance		Specific reserves		Net exposure (balance less specific reserves)
With no related allowance:
SBA loans (1)	$	1,553	$	-	$	1,553
SBA 504 loans		5,331		-		5,331
Commercial loans
Commercial other		1,725		-		1,725
Commercial real estate		6,197		-		6,197
Total commercial loans		7,922		-		7,922
Total impaired loans with no related allowance		14,806		-		14,806

With an allowance:
SBA loans (1)		4,763		1,694		3,069
SBA 504 loans		1,127		1		1,126
Commercial loans
Commercial other		75		75		-
Commercial real estate		11,589		2,530		9,059
Commercial real estate construction		600		149		451
Total commercial loans		12,264		2,754		9,510
Total impaired loans with a related allowance		18,154		4,449		13,705

Total individually evaluated impaired loans:
SBA loans (1)		6,316		1,694		4,622
SBA 504 loans		6,458		1		6,457
Commercial loans
Commercial other		1,800		75		1,725
Commercial real estate		17,786		2,530		15,256
Commercial real estate construction		600		149		451
Total commercial loans		20,186		2,754		17,432
Total individually evaluated impaired loans		32,960		4,449		28,511

Homogeneous collectively evaluated impaired loans:
Residential mortgage loans
Residential mortgages		1,831		-		1,831
Residential construction		2,169		-		2,169
Purchased residential mortgages		2,037		-		2,037
Total residential mortgage loans		6,037		-		6,037
Consumer loans
Home equity		259		-		259
Consumer other		9		-		9
Total consumer loans		268		-		268
Total homogeneous collectively evaluated impaired loans		6,305		-		6,305

Total impaired loans	$	39,265	$	4,449	$	34,816

(1) Balances are reduced by amount guaranteed by the SBA of $939 thousand at December 31, 2011.

The following tables present the average recorded investments in impaired loans and the related amount of interest recognized during the time period in which the loans were impaired for the three and six months ended June 30, 2012 and 2011. The average balances are calculated based on the month-end balances of impaired loans. When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is on nonaccrual status, all payments are applied to principal under the cost recovery method, therefore no interest income is recognized. Any interest income recognized on a cash basis during the three and six months ended June 30, 2012 and 2011 was immaterial. The interest recognized on impaired loans noted below represents accruing troubled debt restructurings only.


	For the three months ended June 30,
	2012				2011
(In thousands)	Average recorded investment		Interest income recognized on impaired loans		Average recorded investment		Interest income recognized on impaired loans
SBA loans (1)	$	4,150	$	36	$	6,343	$	44
SBA 504 loans		6,443		69		9,131		92
Commercial loans
Commercial other		4,344		47		1,457		8
Commercial real estate		19,853		169		15,520		99
Commercial real estate construction		-		-		789		-
Residential mortgage loans
Residential mortgages		1,959		-		2,079		-
Residential construction		1,446		-		-		-
Purchased residential mortgages		2,362		-		2,101		-
Consumer loans
Home equity		328		-		348		-
Consumer other		10		-		3		-
Total	$	40,895	$	321	$	37,771	$	243

(1) Balances are reduced by the average amount guaranteed by the Small Business Administration of $529 thousand and $2.6 million for the three months ended June 30, 2012 and 2011, respectively.


	For the six months ended June 30,
	2012				2011
(In thousands)	Average recorded investment		Interest income recognized on impaired loans		Average recorded investment		Interest income recognized on impaired loans
SBA loans (1)	$	4,952	$	85	$	6,563	$	101
SBA 504 loans		6,453		140		9,693		232
Commercial loans
Commercial other		3,556		69		983		9
Commercial real estate		19,107		299		13,125		158
Commercial real estate construction		267		-		920		-
Residential mortgage loans
Residential mortgages		1,804		-		2,148		-
Residential construction		1,808		-		-		-
Purchased residential mortgages		2,184		-		2,122		-
Consumer loans
Home equity		306		-		288		-
Consumer other		10		-		2		-
Total	$	40,447	$	593	$	35,844	$	500

(1) Balances are reduced by the average amount guaranteed by the Small Business Administration of $584 thousand and $2.8 million for the six months ended June 30, 2012 and 2011, respectively.

Troubled Debt Restructurings:

The Company's loan portfolio also includes certain loans that have been modified in a troubled debt restructuring (“TDR”). TDRs occur when a creditor, for economic or legal reasons related to a debtor’s financial condition, grants a concession to the debtor that it would not otherwise consider, unless it results in a delay in payment that is insignificant. These concessions typically include reductions in interest rate, extending the maturity of a loan, or a combination of both. When the Company modifies a loan, management evaluates for any possible impairment using either the discounted cash flows method, where the value of the modified loan is based on the present value of expected cash flows, discounted at the contractual interest rate of the original loan agreement, or by using the fair value of the collateral less selling costs. If management determines that the value of the modified loan is less than the recorded investment in the loan, impairment is recognized by segment or class of loan, as applicable, through an allowance estimate or charge-off to the allowance. This process is used, regardless of loan type, and for loans modified as TDRs that subsequently default on their modified terms. Effective September 30, 2011, the Company adopted the amendments in Accounting Standards Update ("ASU") No. 2011-02, Receivables (Topic 310): A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring, and did not identify any additional TDRs as a result of this adoption.

TDRs of $21.4 million are included in the impaired loan numbers listed above, of which $871 thousand are in nonaccrual status. The remaining TDRs are in accrual status since they continue to perform in accordance with their restructured terms. There are no commitments to lend additional funds on these loans.

There were no loans modified during the three months ended June 30, 2012 that were deemed to be TDRs. In addition, there were no loans modified as TDRs within the previous 12 months where a concession was made and the loan subsequently defaulted at some point during the three months ended June 30, 2012. In this case, subsequent default is defined as being transferred to nonaccrual status.

The following table details loans modified during the six months ended June 30, 2012, including the number of modifications, the recorded investment at the time of the modification and the year-to-date impact to interest income as a result of the modification. There were no loans modified as TDRs within the previous 12 months where a concession was made and the loan subsequently defaulted at some point during the six months ended June 30, 2012. In this case, subsequent default is defined as being transferred to nonaccrual status.


	For the six months ended June 30, 2012
(In thousands, except number of contracts)	Number of contracts		Recorded investment at time of modification		Impact of interest rate change on income
Commercial loans
Commercial other		3	$	1,291	$	-
Commercial real estate		3		1,856		-
Total		6	$	3,147	$	-

During the six months ended June 30, 2012, TDRs consisted of interest only periods; there was no principal forgiveness. The following table shows the types of modifications done during the six months ended June 30, 2012, with the respective loan balances as of June 30, 2012:


	June 30, 2012
(In thousands)	Commercial other		Commercial real estate		Total
Type of modification:
Interest only	$	1,289	$	1,856	$	3,145
Total	$	1,289	$	1,856	$	3,145