Allowance for Loan Losses

The Company provides for loan losses through the establishment of an allowance for loan losses which represents an estimated reserve for existing losses in the loan portfolio. A systematic methodology is used for determining the allowance that includes a quarterly review process, risk rating changes, and adjustments to the allowance. The loan portfolio is classified in eight segments and credit risk is evaluated separately in each segment. The appropriate level of the allowance is evaluated continually based on a review of significant loans, with a particular emphasis on nonaccruing, past due, and other loans that may require special attention. Other factors include general conditions in local and national economies; loan portfolio composition and asset quality indicators; and internal factors such as changes in underwriting policies, credit administration practices, experience, ability and depth of lending management, among others.

The following table summarizes the composition of the allowance for loan losses, by class of financing receivable and allowance, as of December 31, 2013 and 2012:



As of December 31,	2013		2012
Allowance for Loans Evaluated Individually for Impairment
Commercial
Real estate	$	890,000	$	1,523,000
Construction	272,000		969,000
Other	841,000		652,000
Municipal	—		—
Residential
Term	404,000		395,000
Construction	—		—
Home equity line of credit	54,000		—
Consumer	—		—
Total	$	2,461,000	$	3,539,000
Allowance for Loans Evaluated Collectively for Impairment
Commercial
Real estate	$	3,712,000	$	4,342,000
Construction	303,000		390,000
Other	1,435,000		1,398,000
Municipal	15,000		18,000
Residential
Term	695,000		714,000
Construction	21,000		11,000
Home equity line of credit	621,000		654,000
Consumer	573,000		592,000
Unallocated	1,678,000		842,000
Total	$	9,053,000	$	8,961,000
Total Allowance for Loan Losses
Commercial
Real estate	$	4,602,000	$	5,865,000
Construction	575,000		1,359,000
Other	2,276,000		2,050,000
Municipal	15,000		18,000
Residential
Term	1,099,000		1,109,000
Construction	21,000		11,000
Home equity line of credit	675,000		654,000
Consumer	573,000		592,000
Unallocated	1,678,000		842,000
Total	$	11,514,000	$	12,500,000

The allowance consists of four elements: (1) specific reserves for loans evaluated individually for impairment; (2) general reserves for each portfolio segment based on historical loan loss experience; (3) qualitative reserves judgmentally adjusted for local and national economic conditions, concentrations, portfolio composition, volume and severity of delinquencies and nonaccrual loans, trends of criticized and classified loans, changes in credit policies, and underwriting standards, credit administration practices, and other factors as applicable for each portfolio segment; and (4) unallocated reserves. All outstanding loans are considered in evaluating the appropriateness of the allowance.

A breakdown of the allowance for loan losses as of December 31, 2013 and 2012, by class of financing receivable and allowance element, is presented in the following tables:



As of December 31, 2013	Specific Reserves on Loans Evaluated Individually for Impairment		General Reserves on Loans Based on Historical Loss Experience		Reserves for Qualitative Factors		Unallocated Reserves		Total Reserves
Commercial
Real estate	$	890,000	$	1,927,000	$	1,785,000	$	—	$	4,602,000
Construction	272,000		157,000		146,000		—		575,000
Other	841,000		745,000		690,000		—		2,276,000
Municipal	—		—		15,000		—		15,000
Residential
Term	404,000		342,000		353,000		—		1,099,000
Construction	—		10,000		11,000		—		21,000
Home equity line of credit	54,000		343,000		278,000		—		675,000
Consumer	—		382,000		191,000		—		573,000
Unallocated	—		—		—		1,678,000		1,678,000
	$	2,461,000	$	3,906,000	$	3,469,000	$	1,678,000	$	11,514,000



As of December 31, 2012	Specific Reserves on Loans Evaluated Individually for Impairment		General Reserves on Loans Based on Historical Loss Experience		Reserves for Qualitative Factors		Unallocated Reserves		Total Reserves
Commercial
Real estate	$	1,523,000	$	2,369,000	$	1,973,000	$	—	$	5,865,000
Construction	969,000		213,000		177,000		—		1,359,000
Other	652,000		763,000		635,000		—		2,050,000
Municipal	—		—		18,000		—		18,000
Residential
Term	395,000		278,000		436,000		—		1,109,000
Construction	—		4,000		7,000		—		11,000
Home equity line of credit	—		315,000		339,000		—		654,000
Consumer	—		362,000		230,000		—		592,000
Unallocated	—		—		—		842,000		842,000
	$	3,539,000	$	4,304,000	$	3,815,000	$	842,000	$	12,500,000

Qualitative adjustment factors are taken into consideration when determining reserve estimates. These adjustment factors are based upon our evaluation of various current conditions, including those listed below.


•	General economic conditions.


•	Credit quality trends with emphasis on loan delinquencies, nonaccrual levels and classified loans.


•	Recent loss experience in particular segments of the portfolio.


•	Loan volumes and concentrations, including changes in mix.


•	Other factors, including changes in quality of the loan origination; loan policy changes; changes in credit risk management processes; Bank regulatory and external loan review examination results.

The qualitative portion of the allowance for loan losses was 0.40% of related loans as of December 31, 2013, compared to 0.44% of related loans as of December 31, 2012. The qualitative portion decreased $346,000 between December 31, 2012 and December 31, 2013 due to improving economic factors and Bank credit quality.

The unallocated component totaled $1,678,000 at December 31, 2013 compared to $842,000 as of December 31, 2012. In general, the unallocated component is available to cover imprecision or uncertainties to incorporate the range of probable outcomes inherent in estimates used for the allowance, which may change from period to period. The increase in the unallocated portion is deemed appropriate due to the following:


•	The potentially indeterminate effects of the Federal Reserve’s tapering of its purchases of Treasury bonds and mortgage-backed securities create the possibility of economic uncertainties in the region. Backing out of the quantitative easing, or stimulus program of this size is new. This increases uncertainty in the existing loan portfolio.


•	The U.S. faces a breach of the federal debt ceiling in the first quarter of 2014. Congress must successfully address the issue and failure to do so could bear negative consequences on the global, national, regional and local economies. This also adds to portfolio uncertainty and supports the higher unallocated at the review date.


•	Recently, in 2012 and forward, the Bank’s overall loss rate has exceeded its peer group. This may be due to a general lag effect and/or the extended foreclosure periods mandated by State law. A higher unallocated level is appropriate at this time to support this uncertainty of higher losses.

•

Estimating specific reserves on impaired loans presents challenges as external conditions, factors specific to individual credits and collateral values may change over subsequent periods. A review of specific reserves estimated on year end 2012 impaired loans found that 43% required adjustments in subsequent periods during 2013. This adjustment rate was in line with prior periods suggesting a risk of uncertainty and imprecision in the estimates thereby supporting some level of unallocated for unanticipated changes.

•

A recent internal analysis on OREO property sales found that properties sold, on average, approximately 18% below the appraised value of the property at the time of take in. Based on the analysis, Management has been applying a 20% additional discount factor, exclusive of the estimated costs to sell, to arrive at OREO take-in amounts. This will impact the allowance as these potential additional write downs would be taken against the allowance. The unallocated provides additional funds for these adjustments.

•

From 2009 to the present, a period of historically high losses for the Bank, the required reserve estimate as a percent of total loans averaged 1.33%, and ranged from a low of .88% to a high of 1.60%. In dollars, the range is from $10 million to$13 million. The current allowance level including the unallocated sits in the middle of this range. The present situation indicates improving economic conditions and Bank loan quality. The continued view of the economic recovery is one moving at a slow to moderate pace. Consequently, caution remains appropriate at the evaluation date regarding the direction of the economy, the uncertain consequences of the Federal Reserve monetary tightening and their potential collective impact on Bank loan portfolio quality. Such uncertainties support the unallocated position.

Commercial loans are comprised of three major classes, commercial real estate loans, commercial construction loans and other commercial loans. Commercial real estate is primarily comprised of loans to small businesses collateralized by owner-occupied real estate, while other commercial is primarily comprised of loans to small businesses collateralized by plant and equipment, commercial fishing vessels and gear, and limited inventory-based lending. Commercial real estate loans typically have a maximum loan-to-value of 75% based upon current appraisal information at the time the loan is made. Municipal loans are comprised of loans to municipalities in Maine for capitalized expenditures, construction projects or tax-anticipation notes. All municipal loans are considered general obligations of the municipality and are collateralized by the taxing ability of the municipality for repayment of debt.

Construction loans, both commercial and residential, comprise a very small portion of the portfolio, and at 24.5% of capital are well under the regulatory guidance of 100.0% of capital at December 31, 2013. Construction loans and non-owner-occupied commercial real estate loans are at 75.6% of total capital, well under regulatory guidance of 300.0% of capital at December 31, 2013.

The process of establishing the allowance with respect to the commercial loan portfolio begins when a loan officer initially assigns each loan a risk rating, using established credit criteria. Approximately 50% of the outstanding loans

and commitments are subject to review and validation annually by an independent consultant, as well as periodically by the Company's internal credit review function. The methodology employs Management's judgment as to the level of losses on existing loans based on internal review of the loan portfolio, including an analysis of a borrower's current financial position, and the consideration of current and anticipated economic conditions and their potential effects on specific borrowers and or lines of business. In determining the Company's ability to collect certain loans, Management also considers the fair value of underlying collateral. The risk rating system has eight levels, defined as follows:

1 Strong

Credits rated "1" are characterized by borrowers fully responsible for the credit with excellent capacity to pay principal and interest. Loans rated "1" may be secured with acceptable forms of liquid collateral.

2 Above Average

Credits rated "2" are characterized by borrowers that have better than average liquidity, capitalization, earnings and/or cash flow with a consistent record of solid financial performance.

3 Satisfactory

Credits rated "3" are characterized by borrowers with favorable liquidity, profitability and financial condition with adequate cash flow to pay debt service.

4 Average

Credits rated "4" are characterized by borrowers that present risk more than 1, 2 and 3 rated loans and merit an ordinary level of ongoing monitoring. Financial condition is on par or somewhat below industry averages while cash flow is generally adequate to meet debt service requirements.

5 Watch

Credits rated "5" are characterized by borrowers that warrant greater monitoring due to financial condition or unresolved and identified risk factors.

6 Other Assets Especially Mentioned (OAEM)

Loans in this category are currently protected but are potentially weak and constitute an undue and unwarranted credit risk, but not to the point of justifying a classification of substandard. OAEM have potential weaknesses which may, if not checked or corrected, weaken the asset or inadequately protect the Bank's credit position at some future date.

7 Substandard

Loans in this category are inadequately protected by the current paying capacity of the borrower or of the collateral, if any. These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Substandard loans are characterized by the distinct possibility that the Bank may sustain some loss if deficiencies are not corrected.

8 Doubtful

Loans classified "Doubtful" have the same weaknesses as those classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, based on currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is high, but because of certain important and reasonably specific pending factors which may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined.

The following table summarizes the risk ratings for the Company's commercial construction, commercial real estate, commercial other and municipal loans as of December 31, 2013:



	Commercial Real Estate		Commercial Construction		Commercial Other		Municipal Loans		All Risk- Rated Loans
1 Strong	$	16,000	$	—	$	265,000	$	—	$	281,000
2 Above average	14,565,000		804,000		6,719,000		16,230,000		38,318,000
3 Satisfactory	45,213,000		871,000		14,852,000		2,887,000		63,823,000
4 Average	100,343,000		14,938,000		45,792,000		—		161,073,000
5 Watch	32,326,000		26,000		10,439,000		—		42,791,000
6 OAEM	26,102,000		2,948,000		3,238,000		—		32,288,000
7 Substandard	27,115,000		795,000		13,622,000		—		41,532,000
8 Doubtful	263,000		—		362,000		—		625,000
Total	$	245,943,000	$	20,382,000	$	95,289,000	$	19,117,000	$	380,731,000

The following table summarizes the risk ratings for the Company's commercial construction, commercial real estate, commercial other and municipal loans as of December 31, 2012:



	Commercial Real Estate		Commercial Construction		Commercial Other		Municipal Loans		All Risk- Rated Loans
1 Strong	$	19,000	$	—	$	271,000	$	1,731,000	$	2,021,000
2 Above average	13,871,000		1,274,000		4,084,000		7,061,000		26,290,000
3 Satisfactory	34,454,000		2,312,000		14,578,000		3,487,000		54,831,000
4 Average	99,712,000		12,322,000		28,618,000		2,425,000		143,077,000
5 Watch	43,369,000		1,721,000		19,524,000		—		64,614,000
6 OAEM	26,302,000		79,000		5,300,000		—		31,681,000
7 Substandard	33,153,000		4,709,000		8,806,000		—		46,668,000
8 Doubtful	455,000		—		2,000		—		457,000
Total	$	251,335,000	$	22,417,000	$	81,183,000	$	14,704,000	$	369,639,000

Commercial loans are generally charged off when all or a portion of the principal amount is determined to be uncollectible. This determination is based on circumstances specific to a borrower including repayment ability, analysis of collateral and other factors as applicable.

Residential loans are comprised of two classes: term loans, which include traditional amortizing home mortgages, and construction loans, which include loans for owner-occupied residential construction. Residential loans typically have a 75% to 80% loan to value based upon current appraisal information at the time the loan is made. Home equity loans and lines of credit are typically written to the same underwriting standards. Consumer loans are primarily amortizing loans to individuals collateralized by automobiles, pleasure craft and recreation vehicles, typically with a maximum loan to value of 80% to 90% of the purchase price of the collateral. Consumer loans also include a small amount of unsecured short-term time notes to individuals.

Residential loans, consumer loans and home equity lines of credit are segregated into homogeneous pools with similar risk characteristics. Trends and current conditions are analyzed and historical loss experience is adjusted accordingly. Quantitative and qualitative adjustment factors for these segments are consistent with those for the commercial and municipal classes. Certain loans in the residential, home equity lines of credit and consumer classes identified as having the potential for further deterioration are analyzed individually to confirm impairment status, and to determine the need for a specific reserve, however there is no formal rating system used for these classes. Consumer loans greater than 120 days past due are generally charged off. Residential loans 90 days or more past due are placed on non-accrual status unless the loans are both well secured and in the process of collection.

There were no changes to the Company's accounting policies or methodology used to estimate the allowance for loan losses during the year ended December 31, 2013. Allowance for loan losses activity for the years ended December 31, 2013, 2012 and 2011 was as follows:



For the year ended December 31, 2013	Commercial										Residential				Home Equity Line of Credit
For the year ended December 31, 2013	Real Estate			Construction		Other		Municipal			Term		Construction		Home Equity Line of Credit		Consumer		Unallocated		Total
Allowance for loan losses:
Beginning balance	$	5,865,000		$	1,359,000	$	2,050,000	$	18,000		$	1,109,000	$	11,000	$	654,000	$	592,000	$	842,000	$	12,500,000
Chargeoffs	150,000			963,000		2,583,000		—			1,118,000		—		611,000		430,000		—		5,855,000
Recoveries	—			—		359,000		—			103,000		—		24,000		183,000		—		669,000
Provision (credit)	(1,113,000		)	179,000		2,450,000		(3,000		)	1,005,000		10,000		608,000		228,000		836,000		4,200,000
Ending balance	$	4,602,000		$	575,000	$	2,276,000	$	15,000		$	1,099,000	$	21,000	$	675,000	$	573,000	$	1,678,000	$	11,514,000
Ending balance specifically evaluated for impairment	$	890,000		$	272,000	$	841,000	$	—		$	404,000	$	—	$	54,000	$	—	$	—	$	2,461,000
Ending balance collectively evaluated for impairment	$	3,712,000		$	303,000	$	1,435,000	$	15,000		$	695,000	$	21,000	$	621,000	$	573,000	$	1,678,000	$	9,053,000
Related loan balances:
Ending balance	$	245,943,000		$	20,382,000	$	95,289,000	$	19,117,000		$	377,218,000	$	11,803,000	$	91,549,000	$	15,066,000	$	—	$	876,367,000
Ending balance specifically evaluated for impairment	$	14,935,000		$	1,284,000	$	6,698,000	$	—		$	17,786,000	$	—	$	1,648,000	$	—	$	—	$	42,351,000
Ending balance collectively evaluated for impairment	$	231,008,000		$	19,098,000	$	88,591,000	$	19,117,000		$	359,432,000	$	11,803,000	$	89,901,000	$	15,066,000	$	—	$	834,016,000



For the year ended December 31, 2012	Commercial									Residential				Home Equity Line of Credit
For the year ended December 31, 2012	Real Estate		Construction		Other		Municipal			Term		Construction		Home Equity Line of Credit		Consumer		Unallocated			Total
Allowance for loan losses:
Beginning balance	$	5,659,000	$	658,000	$	2,063,000	$	19,000		$	1,159,000	$	255,000	$	595,000	$	584,000	$	2,008,000		$	13,000,000
Chargeoffs	1,394,000		928,000		3,215,000		—			1,911,000		389,000		688,000		555,000		—			9,080,000
Recoveries	13,000		246,000		113,000		—			110,000		54,000		1,000		208,000		—			745,000
Provision (credit)	1,587,000		1,383,000		3,089,000		(1,000		)	1,751,000		91,000		746,000		355,000		(1,166,000		)	7,835,000
Ending balance	$	5,865,000	$	1,359,000	$	2,050,000	$	18,000		$	1,109,000	$	11,000	$	654,000	$	592,000	$	842,000		$	12,500,000
Ending balance specifically evaluated for impairment	$	1,523,000	$	969,000	$	652,000	$	—		$	395,000	$	—	$	—	$	—	$	—		$	3,539,000
Ending balance collectively evaluated for impairment	$	4,342,000	$	390,000	$	1,398,000	$	18,000		$	714,000	$	11,000	$	654,000	$	592,000	$	842,000		$	8,961,000
Related loan balances:
Ending balance	$	251,335,000	$	22,417,000	$	81,183,000	$	14,704,000		$	379,447,000	$	6,459,000	$	99,082,000	$	14,657,000	$	—		$	869,284,000
Ending balance specifically evaluated for impairment	$	15,774,000	$	3,354,000	$	5,861,000	$	—		$	19,444,000	$	—	$	1,311,000	$	—	$	—		$	45,744,000
Ending balance collectively evaluated for impairment	$	235,561,000	$	19,063,000	$	75,322,000	$	14,704,000		$	360,003,000	$	6,459,000	$	97,771,000	$	14,657,000	$	—		$	823,540,000



For the year ended December 31, 2011	Commercial									Residential				Home Equity Line of Credit
For the year ended December 31, 2011	Real Estate		Construction			Other		Municipal		Term		Construction		Home Equity Line of Credit		Consumer		Unallocated		Total
Allowance for loan losses:
Beginning balance	$	5,260,000	$	1,012,000		$	2,377,000	$	19,000	$	1,408,000	$	44,000	$	670,000	$	646,000	$	1,880,000	$	13,316,000
Chargeoffs	1,619,000		346,000			6,492,000		—		1,421,000		505,000		415,000		381,000		—		11,179,000
Recoveries	23,000		—			60,000		—		7,000		—		1,000		222,000		—		313,000
Provision (credit)	1,995,000		(8,000		)	6,118,000		—		1,165,000		716,000		339,000		97,000		128,000		10,550,000
Ending balance	$	5,659,000	$	658,000		$	2,063,000	$	19,000	$	1,159,000	$	255,000	$	595,000	$	584,000	$	2,008,000	$	13,000,000
Ending balance specifically evaluated for impairment	$	808,000	$	33,000		$	402,000	$	—	$	478,000	$	235,000	$	91,000	$	11,000	$	—	$	2,058,000
Ending balance collectively evaluated for impairment	$	4,851,000	$	625,000		$	1,661,000	$	19,000	$	681,000	$	20,000	$	504,000	$	573,000	$	2,008,000	$	10,942,000
Related loan balances:
Ending balance	$	255,424,000	$	32,574,000		$	86,982,000	$	16,221,000	$	341,286,000	$	10,469,000	$	105,244,000	$	16,788,000	$	—	$	864,988,000
Ending balance specifically evaluated for impairment	$	10,141,000	$	5,702,000		$	7,042,000	$	—	$	16,821,000	$	1,198,000	$	1,163,000	$	53,000	$	—	$	42,120,000
Ending balance collectively evaluated for impairment	$	245,283,000	$	26,872,000		$	79,940,000	$	16,221,000	$	324,465,000	$	9,271,000	$	104,081,000	$	16,735,000	$	—	$	822,868,000