NOTE 3. LOANS AND ALLOWANCE FOR CREDIT LOSSES

The Company makes residential mortgage, commercial and consumer loans to customers primarily in Talbot County, Queen Anne’s County, Kent County, Caroline County and Dorchester County in Maryland and in Kent County, Delaware. The following table provides information about the principal classes of the loan portfolio at December 31, 2016 and 2015.


(Dollars in thousands)	2016		2015
Construction	$	84,002	$	85,632
Residential real estate		325,768		307,063
Commercial real estate		382,681		330,253
Commercial		72,435		64,911
Consumer		6,639		7,255
Total loans		871,525		795,114
Allowance for credit losses		(8,726)		(8,316)
Total loans, net	$	862,799	$	786,798

In the normal course of banking business, loans are made to officers and directors and their affiliated interests. These loans are made on substantially the same terms and conditions as those prevailing at the time for comparable transactions with persons who are not related to the Company and are not considered to involve more than the normal risk of collectibility. As of December 31, 2016 and 2015, such loans outstanding, both direct and indirect (including guarantees), to directors, their associates and policy-making officers, totaled approximately $13.3 million and $22.0 million, respectively. During 2016 and 2015, loan additions were approximately $3.3 million and $5.5 million, respectively, and loan repayments were approximately $1.1 million and $2.4 million, respectively. Due to the consolidation of the former Bank subsidiaries and their Board of Directors during 2016, many directors who served on those boards no longer serve as members of the new consolidated Bank as of December 31, 2016. This resulted in approximately $10.8 million in outstanding loans to be excluded for reporting loans made to inside directors of the Company and its subsidiaries as of December 31, 2016. Net loan origination fees, included in balances above, totaled $509 thousand and $357 thousand as of December 31, 2016 and 2015, respectively.

In the normal course of banking business, risks related to specific loan categories are as follows:

Construction loans – Construction loans generally finance the construction of residential real estate for builders and individuals for single family dwellings. In addition, the Bank periodically finances the construction of commercial projects. Credit risk factors include the borrower’s ability to successfully complete the construction on time and within budget, changing market conditions which could affect the value and marketability of projects, changes in the borrower’s ability or willingness to repay the loan and potentially rising interest rates which can impact both the borrower’s ability to repay and the collateral value.

Residential real estate – Residential real estate loans are typically made to consumers and are secured by residential real estate. Credit risk arises from the borrower’s continuing financial stability, which can be adversely impacted by job loss, divorce, illness, or personal bankruptcy, among other factors. Also impacting credit risk would be a shortfall in the value of the residential real estate in relation to the outstanding loan balance in the event of a default or subsequent liquidation of the real estate collateral.

Commercial real estate – Commercial real estate loans consist of both loans secured by owner occupied properties and non-owner occupied where an established banking relationship exists and involves investment properties for warehouse, retail, and office space with a history of occupancy and cash flow. These loans are subject to adverse changes in the local economy and commercial real estate markets. Credit risk associated with owner occupied properties arises from the borrower’s financial stability and the ability of the borrower and the business to repay the loan. Non-owner occupied properties carry the risk of a tenant’s deteriorating credit strength, lease expirations in soft markets and sustained vacancies which can adversely impact cash flow.

Commercial – Commercial loans are secured or unsecured loans for business purposes. Loans are typically secured by accounts receivable, inventory, equipment and/or other assets of the business. Credit risk arises from the successful operation of the business which may be affected by competition, rising interest rates, regulatory changes and adverse conditions in the local and regional economy.

Consumer – Consumer loans include home equity loans and lines, installment loans and personal lines of credit. Credit risk is similar to residential real estate loans above as it is subject to the borrower’s continuing financial stability and the value of the collateral securing the loan.

The following tables include impairment information relating to loans and the allowance for credit losses as of December 31, 2016 and 2015.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Unallocated		Total
December 31, 2016
Loans individually
evaluated for impairment	$	8,007	$	7,778	$	6,088	$	-	$	99	$	-	$	21,972
Loans collectively
evaluated for impairment		75,995		317,990		376,593		72,435		6,540		-		849,553
Total loans	$	84,002	$	325,768	$	382,681	$	72,435	$	6,639	$	-	$	871,525

Allowance for credit
losses allocated to:
Loans individually
evaluated for impairment	$	1,639	$	317	$	185	$	-	$	-	$	-	$	2,141
Loans collectively
evaluated for impairment		1,148		1,636		2,425		1,145		231		-		6,585
Total loans	$	2,787	$	1,953	$	2,610	$	1,145	$	231	$	-	$	8,726

During 2016, due to the consolidation of Talbot and CNB, the processes and assumptions affecting the allowance methodology were re-evaluated for a more unified representation of the new consolidated bank. This re-evaluation resulted in a net change in the unallocated portion of the allowance of $776 thousand.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Unallocated		Total
December 31, 2015
Loans individually
evaluated for impairment	$	11,598	$	7,945	$	7,762	$	161	$	122	$	-	$	27,588
Loans collectively
evaluated for impairment		74,034		299,118		322,491		64,750		7,133		-		767,526
Total loans	$	85,632	$	307,063	$	330,253	$	64,911	$	7,255	$	-	$	795,114

Allowance for credit
losses allocated to:
Loans individually
evaluated for impairment	$	619	$	435	$	340	$	-	$	7	$	-	$	1,401
Loans collectively
evaluated for impairment		1,027		1,746		2,659		558		149		776		6,915
Total loans	$	1,646	$	2,181	$	2,999	$	558	$	156	$	776	$	8,316

The following tables provide information on impaired loans and any related allowance by loan class as of December 31, 2016 and 2015. The difference between the unpaid principal balance and the recorded investment is the amount of partial charge-offs that have been taken.


				Recorded		Recorded
	Unpaid			investment		investment			Average		Interest
	principal			with no		with an	Related		recorded		income
(Dollars in thousands)	balance			allowance		allowance	allowance		investment		recognized
December 31, 2016
Impaired nonaccrual loans:
Construction	$	7,247	$	-	$	3,818	$	1,621	$	5,707	$	-
Residential real estate		4,013		1,957		1,946		166		3,500		-
Commercial real estate		1,801		959		193		117		2,144		-
Commercial		-		-		-		-		108		-
Consumer		99		99		-		-		106		-
Total	$	13,160	$	3,015	$	5,957	$	1,904	$	11,565	$	-

Impaired accruing TDRs:
Construction	$	4,189	$	3,479	$	710	$	18	$	4,172	$	96
Residential real estate		3,875		2,829		1,046		151		4,663		195
Commercial real estate		4,936		1,573		3,363		68		5,090		174
Commercial		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total	$	13,000	$	7,881	$	5,119	$	237	$	13,925	$	465

Total impaired loans:
Construction	$	11,436	$	3,479	$	4,528	$	1,639	$	9,879	$	96
Residential real estate		7,888		4,786		2,992		317		8,163		195
Commercial real estate		6,737		2,532		3,556		185		7,234		174
Commercial		-		-		-		-		108		-
Consumer		99		99		-		-		106		-
Total	$	26,160	$	10,896	$	11,076	$	2,141	$	25,490	$	465



				Recorded		Recorded
	Unpaid			investment		investment			Average		Interest
	principal			with no		with an	Related		recorded		income
(Dollars in thousands)	balance			allowance		allowance	allowance		investment		recognized
December 31, 2015
Impaired nonaccrual loans:
Construction	$	11,850	$	4,647	$	2,882	$	588	$	8,176	$	-
Residential real estate		2,563		1,773		487		208		2,767		-
Commercial real estate		2,988		1,813		209		9		2,159		-
Commercial		175		161		-		-		126		-
Consumer		128		98		23		7		122		-
Total	$	17,704	$	8,492	$	3,601	$	812	$	13,350	$	-

Impaired accruing TDRs:
Construction	$	4,069	$	3,266	$	803	$	31	$	4,080	$	84
Residential real estate		5,686		2,380		3,306		227		6,947		312
Commercial real estate		5,740		1,702		4,038		331		5,943		254
Commercial		-		-		-		-		27		1
Consumer		-		-		-		-		-		-
Total	$	15,495	$	7,348	$	8,147	$	589	$	16,997	$	651

Total impaired loans:
Construction	$	15,919	$	7,913	$	3,685	$	619	$	12,256	$	84
Residential real estate		8,249		4,153		3,793		435		9,714		312
Commercial real estate		8,728		3,515		4,247		340		8,102		254
Commercial		175		161		-		-		153		1
Consumer		128		98		23		7		122		-
Total	$	33,199	$	15,840	$	11,748	$	1,401	$	30,347	$	651

The following tables provide a roll-forward for troubled debt restructurings as of December 31, 2016 and December 31, 2015.


	1/1/2016												12/31/2016
	TDR		New		Disbursements		Charge		Reclassifications/				TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)		Payoffs		Balance		Allowance
For the year ended
December 31, 2016
Accruing TDRs
Construction	$	4,069	$	-	$	120	$	-	$	-	$	-	$	4,189	$	18
Residential real estate		5,686		565		(405)		-		(1,595)		(376)		3,875		151
Commercial real estate		5,740		495		(724)		(117)		(458)		-		4,936		68
Commercial		-		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-		-
Total	$	15,495	$	1,060	$	(1,009)	$	(117)	$	(2,053)	$	(376)	$	13,000	$	237

Nonaccrual TDRs
Construction	$	4,960	$	2,570	$	(2,022)	$	(590)	$	(1,100)	$	-	$	3,818	$	1,621
Residential real estate		445		117		(531)		(23)		1,595		-		1,603		156
Commercial real estate		-		-		(117)		(258)		458		-		83		-
Commercial		-		-		-		-		-		-		-		-
Consumer		23		-		(23)		-		-		-		-		-
Total	$	5,428	$	2,687	$	(2,693)	$	(871)	$	953	$	-	$	5,504	$	1,777

Total	$	20,923	$	3,747	$	(3,702)	$	(988)	$	(1,100)	$	(376)	$	18,504	$	2,014


	1/1/2015													12/31/15
	TDR		New		Disbursements		Charge		Reclassifications/					TDR		Related
(Dollars in thousands)	Balance		TDRs		(Payments)		offs		Transfer In/(Out)			Payoffs		Balance		Allowance
For the year ended
December 31, 2015
Accruing TDRs
Construction	$	4,022	$	-	$	(95)	$	-	$	142		$	-	$	4,069	$	31
Residential real estate		6,368		1,837		(1,195)		-		(1,324)			-		5,686		227
Commercial real estate		6,237		-		(497)		-		-			-		5,740		331
Commercial		47		-		(6)		-		(41)			-		-		-
Consumer		-		-		-		-		-			-		-		-
Total	$	16,674	$	1,837	$	(1,793)	$	-	$	(1,223)		$	-	$	15,495	$	589

Nonaccrual TDRs
Construction	$	3,321	$	-	$	(214)	$	(1,058)	$	2,911		$	-	$	4,960	$	588
Residential real estate		3,382		-		(26)		-		(2,911)			-		445		141
Commercial real estate		346		-		(4)		(40)		(302)			-		-		-
Commercial		-		-		-		-		-			-		-		-
Consumer		25		-		(2)		-		-			-		23		7
Total	$	7,074	$	-	$	(246)	$	(1,098)	$	(302)		$	-	$	5,428	$	736

Total	$	23,748	$	1,837	$	(2,039)	$	(1,098)	$	(1,525)	*	$	-	$	20,923	$	1,325

* $1.3 million in subsequently modified TDRs were transferred from accruing TDR classification to accrual status during the third quarter of 2015, thus removing the TDR designation. In accordance with ASC 310-40-50-2 “Creditor Disclosure of Troubled Debt Restructurings,” an impaired loan that has been subsequently restructured in a troubled debt restructuring involving modification of terms need not be included in the disclosures in years after the restructuring if both of the following conditions exist: a) the subsequent restructuring agreement specifies an interest rate equal to or greater than the rate that the creditor was willing to accept at the time of the restructuring for a new loan with comparable risk; and b) the loan is not impaired based on the terms specified by the restructuring agreement. During the period ended December 31, 2015, three loans totaling $1.3 million met the conditions stipulated in ASC 310-40-50-2, and after a careful evaluation of well supported documentation by management, these loans were upgraded to accrual status.

The following tables provide information on loans that were modified and considered TDRs during 2016 and 2015.


		Premodification		Postmodification
		outstanding		outstanding
	Number of	recorded		recorded		Related
(Dollars in thousands)	contracts	investment		investment		allowance
TDRs:
For the year ended
December 31, 2016
Construction	-	$	-	$	-	$	-
Residential real estate	3		667		688		-
Commercial real estate	2		695		572		-
Commercial	-		-		-		-
Consumer	-		-		-		-
Total	5	$	1,362	$	1,260	$	-

For the year ended
December 31, 2015
Construction	-	$	-	$	-	$	-
Residential real estate	10		1,835		1,837		19
Commercial real estate	1		2,262		2,347		-
Commercial	-		-		-		-
Consumer	-		-		-		-
Total	11	$	4,097	$	4,184	$	19

During the year ended December 31, 2016, there were five TDRs which were modified. The modifications to these TDRs consisted of reductions in principal, interest and rate as well as payment frequency for one of the TDRs.

The following tables provide information on TDRs that defaulted during 2016 and 2015. Generally, a loan is considered in default when principal or interest is past due 90 days or more.


	Number of	Recorded		Related
(Dollars in thousands)	contracts	investment		allowance
TDRs that subsequently defaulted:
For the year ended
December 31, 2016
Construction	2	$	589	$	-
Residential real estate	1		23		-
Commercial real estate	2		375		-
Commercial	-		-		-
Consumer	-		-		-
Total	5	$	987	$	-

For the year ended
December 31, 2015
Construction	-	$	-	$	-
Residential real estate	-		-		-
Commercial real estate	2		279		-
Commercial	-		-		-
Consumer	-		-		-
Total	2	$	279	$	-

Management uses risk ratings as part of its monitoring of the credit quality in the Company’s loan portfolio. Loans that are identified as special mention, substandard or doubtful are adversely rated. They are assigned higher risk ratings than favorably rated loans in the calculation of the formula portion of the allowance for credit losses. At December 31, 2016, there were no nonaccrual loans classified as special mention or doubtful and $9.0 million of nonaccrual loans were identified as substandard. The comparable amounts at December 31, 2015 were special mention $0, substandard $12.1 million and doubtful $0, respectively.

The following tables provide information on loan risk ratings as of December 31, 2016 and 2015.


			Special
(Dollars in thousands)	Pass/Performing		Mention		Substandard		Doubtful		Total
December 31, 2016
Construction	$	72,641	$	4,195	$	7,166	$	-	$	84,002
Residential real estate		312,242		6,646		6,880		-		325,768
Commercial real estate		363,461		10,939		8,281		-		382,681
Commercial		71,313		857		265		-		72,435
Consumer		6,540		-		99		-		6,639
Total	$	826,197	$	22,637	$	22,691	$	-	$	871,525


			Special
(Dollars in thousands)	Pass/Performing		Mention		Substandard		Doubtful		Total
December 31, 2015
Construction	$	70,214	$	3,903	$	11,515	$	-	$	85,632
Residential real estate		290,857		8,837		7,369		-		307,063
Commercial real estate		302,438		18,699		9,116		-		330,253
Commercial		63,628		1,075		208		-		64,911
Consumer		7,107		26		122		-		7,255
Total	$	734,244	$	32,540	$	28,330	$	-	$	795,114

The following tables provide information on the aging of the loan portfolio as of December 31, 2016 and 2015.


		Accruing
				30-59 days			60-89 days			Greater than			Total
(Dollars in thousands)	Current			past due			past due			90 days			past due			Nonaccrual			Total
December 31, 2016
Construction	$	80,079		$	-		$	105		$	-		$	105		$	3,818		$	84,002
Residential real estate		317,992			1,778			2,095			-			3,873			3,903			325,768
Commercial real estate		375,552			3,219			2,758			-			5,977			1,152			382,681
Commercial		72,272			19			134			10			163			-			72,435
Consumer		6,515			13			2			10			25			99			6,639
Total	$	852,410		$	5,029		$	5,094		$	20		$	10,143		$	8,972		$	871,525
Percent of total loans		97.8	%		0.6	%		0.6	%		-	%		1.2	%		1.0	%		100.0	%


		Accruing
				30-59 days			60-89 days			Greater than			Total
(Dollars in thousands)	Current			past due			past due			90 days			past due			Nonaccrual			Total
December 31, 2015
Construction	$	78,082		$	21		$	-		$	-		$	21		$	7,529		$	85,632
Residential real estate		300,563			2,139			2,102			-			4,241			2,259			307,063
Commercial real estate		327,370			-			861			-			861			2,022			330,253
Commercial		64,670			49			31			-			80			161			64,911
Consumer		7,107			13			6			7			26			122			7,255
Total	$	777,792		$	2,222		$	3,000		$	7		$	5,229		$	12,093		$	795,114
Percent of total loans		97.8	%		0.3	%		0.4	%		-	%		0.7	%		1.5	%		100.0	%

The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for 2016 and 2015.

Allocation of a portion of the allowance to one loan class does not preclude its availability to absorb losses in other loan classes.


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Unallocated		Total
2016
Allowance for credit losses:
Beginning Balance	$	1,646	$	2,181	$	2,999	$	558	$	156	$	776	$	8,316

Charge-offs		(615)		(580)		(503)		(497)		(45)		-		(2,240)
Recoveries		35		298		25		428		16		-		802
Net charge-offs		(580)		(282)		(478)		(69)		(29)		-		(1,438)

Provision		1,721		54		89		656		104		(776)		1,848
Ending Balance	$	2,787	$	1,953	$	2,610	$	1,145	$	231	$	-	$	8,726


			Residential		Commercial
(Dollars in thousands)	Construction		real estate		real estate		Commercial		Consumer		Unallocated		Total
2015
Allowance for credit losses:
Beginning Balance	$	1,303	$	2,834	$	2,379	$	448	$	229	$	502	$	7,695

Charge-offs		(1,058)		(283)		(920)		(396)		(67)		-		(2,724)
Recoveries		125		398		379		319		49		-		1,270
Net charge-offs		(933)		115		(541)		(77)		(18)		-		(1,454)

Provision		1,276		(768)		1,161		187		(55)		274		2,075
Ending Balance	$	1,646	$	2,181	$	2,999	$	558	$	156	$	776	$	8,316

Foreclosure Proceedings

Consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure totaled $687 thousand and $581 thousand as of December 31, 2016 and 2015. At December 31, 2016 and 2015, there were 2 and 5 residential properties held in other real estate owned totaling $18 thousand and $460 thousand, respectively.

Performing TDRs were in compliance with their modified terms and there are no further commitments associated with these loans.