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, 2013 and December 31, 2012:


(In thousands)	June 30, 2013		December 31, 2012
SBA loans held to maturity	$	52,279	$	58,593
SBA 504 loans		39,070		41,438
Commercial loans
Commercial other		29,325		24,043
Commercial real estate		279,468		264,439
Commercial real estate construction		14,683		13,082
Residential mortgage loans
Residential mortgages		148,052		125,232
Purchased residential mortgages		6,664		6,862
Consumer loans
Home equity		42,860		45,152
Consumer other		2,143		1,258
Total loans held for investment	$	614,544	$	580,099
SBA loans held for sale		7,772		6,937
Total loans	$	622,316	$	587,036

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. 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. 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 guaranteed portion of the Company’s SBA loans is 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.

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.

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 startup 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 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, 2013:


	June 30, 2013
	SBA, SBA 504 & Commercial loans - Internal risk ratings
(In thousands)	Pass		Special mention		Substandard		Total
SBA loans held to maturity	$	42,726	$	3,264	$	6,289	$	52,279
SBA 504 loans		27,763		5,725		5,582		39,070
Commercial loans
Commercial other		25,784		1,391		2,150		29,325
Commercial real estate		250,416		23,267		5,785		279,468
Commercial real estate construction		14,506		-		177		14,683
Total commercial loans		290,706		24,658		8,112		323,476
Total SBA, SBA 504 and commercial loans	$	361,195	$	33,647	$	19,983	$	414,825

	Residential mortgage & Consumer loans - Performing/Nonperforming
(In thousands)			Performing		Nonperforming		Total
Residential mortgage loans
Residential mortgages			$	145,583	$	2,469	$	148,052
Purchased residential mortgages				4,918		1,746		6,664
Total residential mortgage loans				150,501		4,215		154,716
Consumer loans
Home equity				41,906		954		42,860
Consumer other				2,143		-		2,143
Total consumer loans				44,049		954		45,003
Total residential mortgage and consumer loans			$	194,550	$	5,169	$	199,719

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, 2012:


	December 31, 2012
	SBA, SBA 504 & Commercial loans - Internal risk ratings
(In thousands)	Pass		Special mention		Substandard		Total
SBA loans held to maturity	$	45,680	$	4,376	$	8,537	$	58,593
SBA 504 loans		28,726		5,860		6,852		41,438
Commercial loans
Commercial other		20,187		1,669		2,187		24,043
Commercial real estate		229,516		30,733		4,190		264,439
Commercial real estate construction		12,880		202		-		13,082
Total commercial loans		262,583		32,604		6,377		301,564
Total SBA, SBA 504 and commercial loans	$	336,989	$	42,840	$	21,766	$	401,595

	Residential mortgage & Consumer loans - Performing/Nonperforming
(In thousands)			Performing		Nonperforming		Total
Residential mortgage loans
Residential mortgages			$	122,711	$	2,521	$	125,232
Purchased residential mortgages				3,872		2,990		6,862
Total residential mortgage loans				126,583		5,511		132,094
Consumer loans
Home equity				44,844		308		45,152
Consumer other				1,249		9		1,258
Total consumer loans				46,093		317		46,410
Total residential mortgage and consumer loans			$	172,676	$	5,828	$	178,504

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. 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, 2013 and December 31, 2012:


	June 30, 2013
(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 held to maturity	$	522	$	13	$	-	$	3,524	$	4,059	$	48,220	$	52,279
SBA 504 loans		272		2,178		425		1,986		4,861		34,209		39,070
Commercial loans
Commercial other		28		196		-		1,085		1,309		28,016		29,325
Commercial real estate		1,347		165		-		1,416		2,928		276,540		279,468
Commercial real estate construction		-		-		-		177		177		14,506		14,683
Residential mortgage loans
Residential mortgages		1,131		1,219		-		2,469		4,819		143,233		148,052
Purchased residential mortgages		2		69		4		1,746		1,821		4,843		6,664
Consumer loans
Home equity		1,312		33		-		954		2,299		40,561		42,860
Consumer other		13		2		-		-		15		2,128		2,143
Total loans held for investment	$	4,627	$	3,875	$	429	$	13,357	$	22,288	$	592,256	$	614,544
SBA loans held for sale		-		-		-		-		-		7,772		7,772
Total loans	$	4,627	$	3,875	$	429	$	13,357	$	22,288	$	600,028	$	622,316

(1)	At June 30, 2013, nonaccrual loans included $1.7 million of troubled debt restructurings ("TDRs") and $736 thousand of loans guaranteed by the SBA. The remaining $10.6 million of TDRs are in accrual status because they are performing in accordance with their restructured terms.


	December 31, 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 held to maturity	$	1,912	$	296	$	-	$	4,633	$	6,841	$	51,752	$	58,593
SBA 504 loans		5,037		-		-		2,562		7,599		33,839		41,438
Commercial loans
Commercial other		-		-		109		1,122		1,231		22,812		24,043
Commercial real estate		3,763		-		-		3,323		7,086		257,353		264,439
Commercial real estate construction		-		202		-		-		202		12,880		13,082
Residential mortgage loans
Residential mortgages		2,651		1,878		-		2,521		7,050		118,182		125,232
Purchased residential mortgages		134		78		-		2,990		3,202		3,660		6,862
Consumer loans
Home equity		833		-		-		308		1,141		44,011		45,152
Consumer other		-		-		-		9		9		1,249		1,258
Total loans held for investment	$	14,330	$	2,454	$	109	$	17,468	$	34,361	$	545,738	$	580,099
SBA loans held for sale		-		-		-		-		-		6,937		6,937
Total loans	$	14,330	$	2,454	$	109	$	17,468	$	34,361	$	552,675	$	587,036

(1)	At December 31, 2012, nonaccrual loans included $1.1 million of TDRs and $1.8 million of loans guaranteed by the SBA. The remaining $13.6 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 SBA, SBA 504, and commercial loans.

The following table provides detail on the Company’s impaired loans that are individually evaluated for impairment with the associated allowance amount, if applicable, as of June 30, 2013:


	June 30, 2013
(In thousands)	Unpaid principal balance		Recorded investment		Specific reserves
With no related allowance:
SBA loans held to maturity (1)	$	1,639	$	756	$	-
SBA 504 loans		3,152		3,152		-
Commercial loans
Commercial other		2,021		2,021		-
Commercial real estate		4,518		4,469		-
Total commercial loans		6,539		6,490		-
Total impaired loans with no related allowance		11,330		10,398		-

With an allowance:
SBA loans held to maturity (1)		2,784		2,506		1,079
SBA 504 loans		2,386		1,986		479
Commercial loans
Commercial other		26		13		13
Commercial real estate		3,155		3,021		125
Commercial real estate construction		202		177		37
Total commercial loans		3,383		3,211		175
Total impaired loans with a related allowance		8,553		7,703		1,733

Total individually evaluated impaired loans:
SBA loans held to maturity (1)		4,423		3,262		1,079
SBA 504 loans		5,538		5,138		479
Commercial loans
Commercial other		2,047		2,034		13
Commercial real estate		7,673		7,490		125
Commercial real estate construction		202		177		37
Total commercial loans		9,922		9,701		175
Total individually evaluated impaired loans	$	19,883	$	18,101	$	1,733

(1)	Balances are reduced by amount guaranteed by the SBA of $736 thousand at June 30, 2013.

The following table provides detail on the Company’s impaired loans that are individually evaluated for impairment with the associated allowance amount, if applicable, as of December 31, 2012:


	December 31, 2012
(In thousands)	Unpaid principal balance		Recorded investment		Specific reserves
With no related allowance:
SBA loans held to maturity (1)	$	1,352	$	866	$	-
SBA 504 loans		5,812		5,555		-
Commercial loans
Commercial other		2,032		2,033		-
Commercial real estate		5,220		4,752		-
Total commercial loans		7,252		6,785		-
Total impaired loans with no related allowance		14,416		13,206		-

With an allowance:
SBA loans held to maturity (1)		3,355		2,846		1,159
SBA 504 loans		1,297		1,297		217
Commercial loans
Commercial other		126		38		38
Commercial real estate		6,014		5,979		587
Total commercial loans		6,140		6,017		625
Total impaired loans with a related allowance		10,792		10,160		2,001

Total individually evaluated impaired loans:
SBA loans held to maturity (1)		4,707		3,712		1,159
SBA 504 loans		7,109		6,852		217
Commercial loans
Commercial other		2,158		2,071		38
Commercial real estate		11,234		10,731		587
Total commercial loans		13,392		12,802		625
Total individually evaluated impaired loans	$	25,208	$	23,366	$	2,001

(1)	Balances are reduced by amount guaranteed by the SBA of $1.8 million at December 31, 2012.

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, 2013 and 2012. 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. The interest income recognized on impaired loans noted below represents primarily accruing troubled debt restructurings and nominal amounts of income recognized on a cash basis for well-collateralized impaired loans.


	For the three months ended June 30,
	2013				2012
(In thousands)	Average recorded investment		Interest income recognized on impaired loans		Average recorded investment		Interest income recognized on impaired loans
SBA loans held to maturity (1)	$	3,421	$	84	$	4,150	$	36
SBA 504 loans		5,372		51		6,443		69
Commercial loans
Commercial other		2,049		23		4,344		47
Commercial real estate		10,418		86		19,853		169
Commercial real estate construction		194		-		-		-
Residential mortgage loans
Residential mortgages		2,705		-		1,959		-
Residential construction		-		-		1,446		-
Purchased residential mortgages		1,735		-		2,362		-
Consumer loans
Home equity		623		8		328		-
Consumer other		-		-		10		-
Total	$	26,517	$	252	$	40,895	$	321

(1)	Balances are reduced by the average amount guaranteed by the Small Business Administration of $921 thousand and $529 thousand for the three months ended June 30, 2013 and 2012, respectively.


	For the six months ended June 30,
	2013				2012
(In thousands)	Average recorded investment		Interest income recognized on impaired loans		Average recorded investment		Interest income recognized on impaired loans
SBA loans held to maturity (1)	$	3,482	$	141	$	4,952	$	85
SBA 504 loans		6,428		139		6,453		140
Commercial loans
Commercial other		2,045		85		3,556		69
Commercial real estate		10,722		169		19,107		299
Commercial real estate construction		164		-		267		-
Residential mortgage loans
Residential mortgages		2,731		-		1,804		-
Residential construction		-		-		1,808		-
Purchased residential mortgages		1,942		-		2,184		-
Consumer loans
Home equity		480		16		306		-
Consumer other		2		-		10		-
Total	$	27,996	$	550	$	40,447	$	593

(1)	Balances are reduced by the average amount guaranteed by the Small Business Administration of $1.3 million and $584 thousand for the six months ended June 30, 2013 and 2012, 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 the loan is collateral-dependent. 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.

TDRs of $12.3 million and $14.7 million are included in the impaired loan numbers listed above as of June 30, 2013 and December 31, 2012, respectively. Specific reserves for these TDRs were $382 thousand and $659 thousand as of June 30, 2013 and December 31, 2012, respectively. At June 30, 2013, $1.7 million of TDRs were in nonaccrual status, compared to $1.1 million at December 31, 2012. 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 or six months ended June 30, 2013 or 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 or six months ended June 30, 2013 or 2012. In this case, subsequent default is defined as 90 days past due or transferred to nonaccrual status.

The following table details loans modified during the six months ended June 30, 2013 and 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.


	For the six months ended June 30,
	2013						2012
(In thousands, except number of contracts)	Number of contracts		Recorded investment at time of modification		Impact of interest rate change on income		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		1		2,684		17		3		1,856		-
Total		1	$	2,684	$	17		6	$	3,147	$	-

To date, the Company’s TDRs consisted of interest rate reductions, interest only periods and maturity extensions. There has been no principal forgiveness. The following tables show the types of modifications done during the six months ended June 30, 2013 and 2012, with the respective loan balances as of those period ends:


	For the six months ended June 30, 2013
(In thousands)	Commercial real estate		Total
Type of modification:
Interest only with reduced interest rate	$	2,684	$	2,684
Total TDRs	$	2,684	$	2,684


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