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 classes and credit risk is evaluated separately in each class. 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 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 March 31, 2014, December 31, 2013, and March 31, 2013, by class of financing receivable and allowance element, is presented in the following tables:



As of March 31, 2014	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	$	1,019,000	$	1,707,000	$	1,774,000	$	—	$	4,500,000
Construction	276,000		154,000		160,000		—		590,000
Other	834,000		690,000		717,000		—		2,241,000
Municipal	—		—		15,000		—		15,000
Residential
Term	574,000		303,000		355,000		—		1,232,000
Construction	—		10,000		12,000		—		22,000
Home equity line of credit	83,000		343,000		282,000		—		708,000
Consumer	—		323,000		194,000		—		517,000
Unallocated	—		—		—		1,830,000		1,830,000
	$	2,786,000	$	3,530,000	$	3,509,000	$	1,830,000	$	11,655,000



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 March 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	$	1,473,000	$	2,177,000	$	2,229,000	$	—	$	5,879,000
Construction	760,000		150,000		154,000		—		1,064,000
Other	535,000		781,000		799,000		—		2,115,000
Municipal	—		—		18,000		—		18,000
Residential
Term	337,000		336,000		440,000		—		1,113,000
Construction	—		4,000		5,000		—		9,000
Home equity line of credit	—		522,000		337,000		—		859,000
Consumer	—		345,000		229,000		—		574,000
Unallocated	—		—		—		1,089,000		1,089,000
	$	3,105,000	$	4,315,000	$	4,211,000	$	1,089,000	$	12,720,000

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 March 31, 2014 and December 31, 2013. The qualitative portion increased $40,000 between December 31, 2013 and March 31, 2014 due to slippage in economic factors.

The unallocated component of the allowance totaled $1,830,000 at March 31, 2014, or 16% of the total reserve. This compares to $1,678,000 as of December 31, 2013. The fluctuation in the unallocated component is supported by 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 ambiguities 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 direction of the economy remains uncertain and its impact on the Bank’s loan portfolio is indeterminate.


•	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 may be appropriate at this time to support this.

•

External conditions and factors specific to individual credits and collateral values may bring rise to unforeseen variations in specific reserves on impaired loans in 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 completed on OREO property sales found that properties sold, on average, approximately 19% 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 cost to sell factor, 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 would provide additional funds for these adjustments.

•

The years from 2009 through 2013, a period of historically high losses for the Bank, the required reserve estimate as a percent of total loans averaged 1.31%, and ranged from a low of .88% to a high of 1.60%. In dollars the range is $8.7 million to $13.9 million. The current ALLL level including the unallocated is in the middle of the range. The current 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.


•	In more general terms, 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.

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 as such 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 25.7% of capital are well under the regulatory guidance of 100.0% of capital at March 31, 2014. Construction loans and non-owner-occupied commercial real estate loans are at 75.9% of total capital, well under regulatory guidance of 300.0% of capital at March 31, 2014.

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 consulting firm, 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 sound worth and paying capacity of the borrower or of the collateral pledged, if any. Loans so classified 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 the 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 real estate, commercial construction, commercial other, and municipal loans as of March 31, 2014:



	Commercial Real Estate		Commercial Construction		Commercial Other		Municipal Loans		All Risk- Rated Loans
1 Strong	$	15,000	$	—	$	261,000	$	—	$	276,000
2 Above Average	9,287,000		773,000		7,458,000		15,926,000		33,444,000
3 Satisfactory	44,918,000		1,080,000		16,864,000		1,864,000		64,726,000
4 Average	102,361,000		16,388,000		46,447,000		—		165,196,000
5 Watch	33,079,000		—		10,828,000		—		43,907,000
6 OAEM	26,951,000		2,668,000		3,883,000		—		33,502,000
7 Substandard	23,576,000		777,000		11,495,000		—		35,848,000
8 Doubtful	—		—		40,000		—		40,000
Total	$	240,187,000	$	21,686,000	$	97,276,000	$	17,790,000	$	376,939,000

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



	Commercial Real Estate		Commercial Construction		Commercial Other		Municipal Loans		All Risk- Rated Loans
1 Strong	$	19,000	$	—	$	259,000	$	1,641,000	$	1,919,000
2 Above Average	12,288,000		271,000		6,262,000		7,589,000		26,410,000
3 Satisfactory	36,187,000		2,410,000		16,846,000		3,419,000		58,862,000
4 Average	103,957,000		9,505,000		32,430,000		2,368,000		148,260,000
5 Watch	37,703,000		22,000		15,679,000		—		53,404,000
6 OAEM	25,057,000		3,001,000		4,768,000		—		32,826,000
7 Substandard	34,530,000		1,881,000		13,628,000		—		50,039,000
8 Doubtful	439,000		—		2,000		—		441,000
Total	$	250,180,000	$	17,090,000	$	89,874,000	$	15,017,000	$	372,161,000

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. One- to four-family residential real estate loans and home equity loans are written down or charged-off no later than 180 days past due, or for residential real estate secured loans having a borrower in bankruptcy, within 60 days of receipt of notification of filing from the bankruptcy court, whichever is sooner. This is subject to completion of a current assessment of the value of the collateral with any outstanding loan balance in excess of the fair value of the property, less costs to sell, written down or charged-off.

There were no changes to the Company's accounting policies or methodology used to estimate the allowance for loan losses during the three months ended March 31, 2014.

The following table presents allowance for loan losses activity by class for the three months ended March 31, 2014, and allowance for loan loss balances by class and related loan balances by class as of March 31, 2014:



	Commercial							Municipal		Residential				Home Equity Line of Credit		Consumer			Unallocated		Total
	Real Estate			Construction		Other				Term		Construction
For the three months ended March 31, 2014
Beginning 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
Charge offs	20,000			—		174,000		—		119,000		—		12,000		70,000			—		395,000
Recoveries	1,000			—		64,000		—		4,000		—		1,000		66,000			—		136,000
Provision (credit)	(83,000		)	15,000		75,000		—		248,000		1,000		44,000		(52,000		)	152,000		400,000
Ending balance	$	4,500,000		$	590,000	$	2,241,000	$	15,000	$	1,232,000	$	22,000	$	708,000	$	517,000		$	1,830,000	$	11,655,000
Allowance for loan losses as of March 31, 2014
Ending balance specifically evaluated for impairment	$	1,019,000		$	276,000	$	834,000	$	—	$	574,000	$	—	$	83,000	$	—		$	—	$	2,786,000
Ending balance collectively evaluated for impairment	$	3,481,000		$	314,000	$	1,407,000	$	15,000	$	658,000	$	22,000	$	625,000	$	517,000		$	1,830,000	$	8,869,000
Related loan balances as of March 31, 2014
Ending balance	$	240,187,000		$	21,686,000	$	97,276,000	$	17,790,000	$	372,479,000	$	12,360,000	$	92,202,000	$	14,934,000		$	—	$	868,914,000
Ending balance specifically evaluated for impairment	$	15,260,000		$	1,492,000	$	5,258,000	$	—	$	16,924,000	$	—	$	1,653,000	$	—		$	—	$	40,587,000
Ending balance collectively evaluated for impairment	$	224,927,000		$	20,194,000	$	92,018,000	$	17,790,000	$	355,555,000	$	12,360,000	$	90,549,000	$	14,934,000		$	—	$	828,327,000

The following table presents allowance for loan losses activity by class for the year-ended December 31, 2013 and allowance for loan loss balances by class and related loan balances by class as of December 31, 2013:



	Commercial							Municipal			Residential				Home Equity Line of Credit		Consumer		Unallocated		Total
	Real Estate			Construction		Other					Term		Construction
For the year ended December 31, 2013
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
Charge offs	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
Allowance for loan losses as of December 31, 2013
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 as of December 31, 2013
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

The following table presents allowance for loan losses activity by class for the three months ended March 31, 2013, and allowance for loan loss balances by class and related loan balances by class as of March 31, 2013:



	Commercial						Municipal		Residential					Home Equity Line of Credit		Consumer		Unallocated		Total
	Real Estate		Construction		Other				Term		Construction
For the three months ended March 31, 2013
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
Charge offs	54,000		403,000		288,000		—		200,000		—			362,000		127,000		—		1,434,000
Recoveries	—		—		103,000		—		2,000		—			1,000		48,000		—		154,000
Provision (credit)	68,000		108,000		250,000		—		202,000		(2,000		)	566,000		61,000		247,000		1,500,000
Ending balance	$	5,879,000	$	1,064,000	$	2,115,000	$	18,000	$	1,113,000	$	9,000		$	859,000	$	574,000	$	1,089,000	$	12,720,000
Allowance for loan losses as of March 31, 2013
Ending balance specifically evaluated for impairment	$	1,473,000	$	760,000	$	535,000	$	—	$	337,000	$	—		$	—	$	—	$	—	$	3,105,000
Ending balance collectively evaluated for impairment	$	4,406,000	$	304,000	$	1,580,000	$	18,000	$	776,000	$	9,000		$	859,000	$	574,000	$	1,089,000	$	9,615,000
Related loan balances as of March 31, 2013
Ending balance	$	250,180,000	$	17,090,000	$	89,874,000	$	15,017,000	$	376,029,000	$	4,222,000		$	96,536,000	$	14,529,000	$	—	$	863,477,000
Ending balance specifically evaluated for impairment	$	17,534,000	$	2,347,000	$	5,550,000	$	—	$	20,262,000	$	—		$	1,683,000	$	—	$	—	$	47,376,000
Ending balance collectively evaluated for impairment	$	232,646,000	$	14,743,000	$	84,324,000	$	15,017,000	$	355,767,000	$	4,222,000		$	94,853,000	$	14,529,000	$	—	$	816,101,000