Loans

Major classifications of loans at March 31, 2017 and December 31, 2016 are as follows (in thousands):



	March 31, 2017		December 31, 2016
Commercial and industrial	$	40,039	$	41,878
Commercial, secured by real estate	475,594		477,275
Residential real estate	260,853		265,788
Consumer	17,646		19,173
Agricultural	15,459		14,802
Other loans, including deposit overdrafts	609		633
	810,200		819,549
Deferred origination costs (fees), net	281		254
	810,481		819,803
Less allowance for loan losses	3,328		3,575
Loans, net	$	807,153	$	816,228

Loans acquired through mergers are recorded at fair value with no carryover of the acquired entity's previously established allowance for loan losses. The excess of expected cash flows over the estimated fair value of acquired loans is recognized as interest income over the remaining contractual lives of the loans using the level yield method. Subsequent decreases in expected cash flows will require additions to the allowance for loan losses. Subsequent improvements in expected cash flows result in the recognition of additional interest income over the then-remaining contractual lives of the loans.

Impaired loans acquired are accounted for under FASB Accounting Standards Codification ("ASC") 310-30. Factors considered in evaluating whether an acquired loan was impaired include delinquency status and history, updated borrower credit status, collateral information, and updated loan-to-value information. The difference between contractually required payments at the time of acquisition and the cash flows expected to be collected is referred to as the nonaccretable difference. The interest component of the cash flows expected to be collected is referred to as the accretable yield and is recognized as interest income over the remaining contractual life of the loan using the level yield method. Subsequent decreases in expected cash flows will require additions to the allowance for loan losses. Subsequent improvements in expected cash flows will result in a reclassification from the nonaccretable difference to the accretable yield.

Non-accrual, past-due, and accruing restructured loans as of March 31, 2017 and December 31, 2016 are as follows (in thousands):



	March 31, 2017		December 31, 2016
Non-accrual loans:
Commercial and industrial	$	—	$	—
Commercial, secured by real estate	2,609		4,312
Residential real estate	926		1,079
Consumer	—		—
Agricultural	334		334
Total non-accrual loans	3,869		5,725
Past-due 90 days or more and still accruing	12		23
Total non-accrual and past-due 90 days or more and still accruing	3,881		5,748
Accruing restructured loans	11,606		11,731
Total	$	15,487	$	17,479

The allowance for loan losses for the three months ended March 31, 2017 and 2016 are as follows (in thousands):



	Commercial & Industrial			Commercial, Secured by Real Estate			Residential Real Estate			Consumer			Agricultural			Other			Total
Three Months Ended March 31, 2017
Balance, beginning of period	$	350		$	2,179		$	885		$	96		$	60		$	5		$	3,575
Provision charged to expenses	(2		)	90			(107		)	23			6			5			15
Losses charged off	—			(262		)	(17		)	(45		)	—			(30		)	(354		)
Recoveries	5			—			48			17			—			22			92
Balance, end of period	$	353		$	2,007		$	809		$	91		$	66		$	2		$	3,328

Three Months Ended March 31, 2016
Balance, beginning of period	$	244		$	1,908		$	854		$	54		$	66		$	3		$	3,129
Provision charged to expenses	—			(35		)	66			61			(10		)	8			90
Losses charged off	—			(23		)	(28		)	(44		)	—			(23		)	(118		)
Recoveries	3			18			4			10			—			14			49
Balance, end of period	$	247		$	1,868		$	896		$	81		$	56		$	2		$	3,150

A breakdown of the allowance for loan losses and the loan portfolio by loan segment at March 31, 2017 and December 31, 2016 are as follows (in thousands):



	Commercial & Industrial		Commercial, Secured by Real Estate		Residential Real Estate		Consumer		Agricultural		Other		Total
March 31, 2017
Allowance for loan losses:
Individually evaluated for impairment	$	8	$	30	$	81	$	13	$	—	$	—	$	132
Collectively evaluated for impairment	345		1,977		728		78		66		2		3,196
Acquired credit impaired loans	—		—		—		—		—		—		—
Balance, end of period	$	353	$	2,007	$	809	$	91	$	66	$	2	$	3,328

Loans:
Individually evaluated for impairment	$	329	$	12,036	$	1,455	$	63	$	334	$	—	$	14,217
Collectively evaluated for impairment	39,332		458,586		257,439		17,672		15,132		138		788,299
Acquired credit impaired loans	405		4,654		2,426		9		—		471		7,965
Balance, end of period	$	40,066	$	475,276	$	261,320	$	17,744	$	15,466	$	609	$	810,481

December 31, 2016
Allowance for loan losses:
Individually evaluated for impairment	$	9	$	55	$	100	$	13	$	—	$	—	$	177
Collectively evaluated for impairment	341		1,832		785		83		60		5		3,106
Acquired credit impaired loans	—		292		—		—		—		—		292
Balance, end of period	$	350	$	2,179	$	885	$	96	$	60	$	5	$	3,575

Loans:
Individually evaluated for impairment	$	337	$	12,580	$	1,518	$	52	$	334	$	—	$	14,821
Collectively evaluated for impairment	41,466		458,059		262,266		19,192		14,475		178		795,636
Acquired credit impaired loans	98		6,305		2,471		17		—		455		9,346
Balance, end of period	$	41,901	$	476,944	$	266,255	$	19,261	$	14,809	$	633	$	819,803

The risk characteristics of LCNB's material loan portfolio segments are as follows:

Commercial and Industrial Loans. LCNB’s commercial and industrial loan portfolio consists of loans for various purposes, including loans to fund working capital requirements (such as inventory and receivables financing) and purchases of machinery and equipment. LCNB offers a variety of commercial and industrial loan arrangements, including term loans, balloon loans, and lines of credit. Most commercial and industrial loans have a variable rate, with adjustment periods ranging from one month to five years. Adjustments are generally based on a publicly available index rate plus a margin. The margin varies based on the terms and collateral securing the loan. Commercial and industrial loans are offered to businesses and professionals for short and medium terms on both a collateralized and uncollateralized basis. Commercial and industrial loans typically are underwritten on the basis of the borrower’s ability to make repayment from the cash flow of the business. Collateral, when obtained, may include liens on furniture, fixtures, equipment, inventory, receivables, or other assets. As a result, such loans involve complexities, variables, and risks that require thorough underwriting and more robust servicing than other types of loans.

Commercial, Secured by Real Estate Loans. Commercial real estate loans include loans secured by a variety of commercial, retail, and office buildings, religious facilities, multifamily (more than two-family) residential properties, construction and land development loans, and other land loans. Commercial real estate loan products generally amortize over five to twenty-five years and are payable in monthly principal and interest installments. Some have balloon payments due within one to ten years after the origination date. Many have adjustable interest rates with adjustment periods ranging from one to ten years, some of which are subject to established “floor” interest rates.

Commercial real estate loans are underwritten based on the ability of the property, in the case of income producing property, or the borrower’s business to generate sufficient cash flow to amortize the debt. Secondary emphasis is placed upon global debt service, collateral value, financial strength of any guarantors, and other factors. Commercial real estate loans are generally originated with a 75% maximum loan to appraised value ratio.

Residential Real Estate Loans. Residential real estate loans include loans secured by first or second mortgage liens on one to two-family residential property. Home equity lines of credit and mortgage loans secured by owner-occupied agricultural property are included in this category. First and second mortgage loans are generally amortized over five to thirty years with monthly principal and interest payments. Home equity lines of credit generally have a five year draw period with interest only payments followed by a repayment period with monthly payments based on the amount outstanding. LCNB offers both fixed and adjustable rate mortgage loans. Adjustable rate loans are available with adjustment periods ranging between one to ten years and adjust according to an established index plus a margin, subject to certain floor and ceiling rates. Home equity lines of credit have a variable rate based on the Wall Street Journal prime rate plus a margin.

LCNB does not originate reverse mortgage loans or residential real estate loans generally considered to be “subprime.”

Residential real estate loans are underwritten primarily based on the borrower’s ability to repay, prior credit history, and the value of the collateral. LCNB generally requires private mortgage insurance for first mortgage loans that have a loan to appraised value ratio of greater than 80%.

Consumer Loans. LCNB’s portfolio of consumer loans generally includes secured and unsecured loans to individuals for household, family and other personal expenditures. Secured loans include loans to fund the purchase of automobiles, recreational vehicles, boats, and similar acquisitions. Consumer loans made by LCNB generally have fixed rates and terms ranging up to 72 months, depending upon the nature of the collateral, size of the loan, and other relevant factors.

Consumer loans generally have higher interest rates, but pose additional risks of collectability and loss when compared to certain other types of loans. Collateral, if present, is generally subject to damage, wear, and depreciation. The borrower’s ability to repay is of primary importance in the underwriting of consumer loans.

Agricultural Loans. LCNB’s portfolio of agricultural loans includes loans for financing agricultural production or for financing the purchase of equipment used in the production of agricultural products. LCNB’s agricultural loans are generally secured by farm machinery, livestock, crops, vehicles, or other agricultural related collateral.

LCNB uses a risk-rating system to quantify loan quality. A loan is assigned to a risk category based on relevant information about the ability of the borrower to service the debt including, but not limited to, current financial information, historical payment experience, credit documentation, public information, and current economic trends. The categories used are:


•	Pass – loans categorized in this category are higher quality loans that do not fit any of the other categories described below.


•	Other Assets Especially Mentioned (OAEM) – loans in this category are currently protected but are potentially weak. These loans constitute a risk but not to the point of justifying a classification of substandard. The credit risk may be relatively minor yet constitute an undue risk in light of the circumstances surrounding a specific asset.


•	Substandard – loans in this category are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the possibility that LCNB will sustain some loss if the deficiencies are not corrected.


•	Doubtful – loans classified in this category have all the weaknesses inherent in loans classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

A breakdown of the loan portfolio by credit quality indicators at March 31, 2017 and December 31, 2016 is as follows (in thousands):



	Pass		OAEM		Substandard		Doubtful		Total
March 31, 2017
Commercial & industrial	$	39,432	$	239	$	395	$	—	$	40,066
Commercial, secured by real estate	445,157		6,378		23,741		—		475,276
Residential real estate	257,044		186		4,090		—		261,320
Consumer	17,682		—		62		—		17,744
Agricultural	13,931		—		1,535		—		15,466
Other	609		—		—		—		609
Total	$	773,855	$	6,803	$	29,823	$	—	$	810,481

December 31, 2016
Commercial & industrial	$	41,178	$	304	$	419	$	—	$	41,901
Commercial, secured by real estate	443,781		5,479		27,684		—		476,944
Residential real estate	261,839		442		3,974		—		266,255
Consumer	19,182		—		79		—		19,261
Agricultural	13,311		—		1,498		—		14,809
Other	633		—		—		—		633
Total	$	779,924	$	6,225	$	33,654	$	—	$	819,803

A loan portfolio aging analysis at March 31, 2017 and December 31, 2016 is as follows (in thousands):



	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days Past Due		Total Past Due		Current		Total Loans Receivable		Total Loans Greater Than 90 Days and Accruing
March 31, 2017
Commercial & industrial	$	8	$	—	$	—	$	8	$	40,058	$	40,066	$	—
Commercial, secured by real estate	201		—		622		823		474,453		475,276		—
Residential real estate	1,303		75		706		2,084		259,236		261,320		12
Consumer	26		8		—		34		17,710		17,744		—
Agricultural	—		60		334		394		15,072		15,466		—
Other	76		—		—		76		533		609		—
Total	$	1,614	$	143	$	1,662	$	3,419	$	807,062	$	810,481	$	12

December 31, 2016
Commercial & industrial	$	19	$	—	$	—	$	19	$	41,882	$	41,901	$	—
Commercial, secured by real estate	99		69		127		295		476,649		476,944		—
Residential real estate	686		80		727		1,493		264,762		266,255		20
Consumer	59		16		3		78		19,183		19,261		3
Agricultural	125		—		—		125		14,684		14,809		—
Other	115		—		—		115		518		633		—
Total	$	1,103	$	165	$	857	$	2,125	$	817,678	$	819,803	$	23

Impaired loans, including acquired credit impaired loans, at March 31, 2017 and December 31, 2016 are as follows (in thousands):



	Recorded Investment		Unpaid Principal Balance		Related Allowance
March 31, 2017
With no related allowance recorded:
Commercial & industrial	$	416	$	548	$	—
Commercial, secured by real estate	14,765		15,968		—
Residential real estate	3,190		4,188		—
Consumer	17		18		—
Agricultural	334		334		—
Other	471		628		—
Total	$	19,193	$	21,684	$	—

With an allowance recorded:
Commercial & industrial	$	318	$	318	$	8
Commercial, secured by real estate	1,925		1,925		30
Residential real estate	691		699		81
Consumer	55		55		13
Agricultural	—		—		—
Other	—		—		—
Total	$	2,989	$	2,997	$	132

Total:
Commercial & industrial	$	734	$	866	$	8
Commercial, secured by real estate	16,690		17,893		30
Residential real estate	3,881		4,887		81
Consumer	72		73		13
Agricultural	334		334		—
Other	471		628		—
Total	$	22,182	$	24,681	$	132

December 31, 2016
With no related allowance recorded:
Commercial & industrial	$	109	$	263	$	—
Commercial, secured by real estate	14,195		15,522		—
Residential real estate	3,238		4,286		—
Consumer	26		27		—
Agricultural	334		334		—
Other	455		629		—
Total	$	18,357	$	21,061	$	—

With an allowance recorded:
Commercial & industrial	$	326	$	326	$	9
Commercial, secured by real estate	4,690		4,946		347
Residential real estate	751		751		100
Consumer	43		43		13
Agricultural	—		—		—
Other	—		—		—
Total	$	5,810	$	6,066	$	469

Total:
Commercial & industrial	$	435	$	589	$	9
Commercial, secured by real estate	18,885		20,468		347
Residential real estate	3,989		5,037		100
Consumer	69		70		13
Agricultural	334		334		—
Other	455		629		—
Total	$	24,167	$	27,127	$	469

The following presents information related to the average recorded investment and interest income recognized on impaired loans, including acquired credit impaired loans, for the three months ended March 31, 2017 and 2016 (in thousands):



	2017				2016
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
Three Months Ended March 31,
With no related allowance recorded:
Commercial & industrial	$	261	$	26	$	978	$	29
Commercial, secured by real estate	15,859		186		17,631		387
Residential real estate	3,219		89		3,778		67
Consumer	21		—		41		7
Agricultural	334		—		422		12
Other	463		18		495		20
Total	$	20,157	$	319	$	23,345	$	522

With an allowance recorded:
Commercial & industrial	$	322	$	4	$	352	$	5
Commercial, secured by real estate	1,931		24		2,624		19
Residential real estate	704		8		834		10
Consumer	52		1		61		1
Agricultural	—		—		—		—
Other	—		—		—		—
Total	$	3,009	$	37	$	3,871	$	35

Total:
Commercial & industrial	$	583	$	30	$	1,330	$	34
Commercial, secured by real estate	17,790		210		20,255		406
Residential real estate	3,923		97		4,612		77
Consumer	73		1		102		8
Agricultural	334		—		422		12
Other	463		18		495		20
Total	$	23,166	$	356	$	27,216	$	557

Of the interest income recognized on impaired loans during the three months ended March 31, 2017 and 2016, approximately $0 and $0, respectively, were recognized on a cash basis.

Loan modifications that were classified as troubled debt restructurings during the three months ended March 31, 2017 and 2016 are as follows (dollars in thousands):



	2017					2016
	Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance		Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance
Three Months Ended March 31,
Commercial & industrial	—	$	—	$	—	—	$	—	$	—
Commercial, secured by real estate	—	—		—		1	299		372
Residential real estate	1	18		9		1	18		18
Consumer	1	14		14		1	17		17
Total	2	$	32	$	23	3	$	334	$	407

Each restructured loan is separately negotiated with the borrower and includes terms and conditions that reflect the borrower’s ability to pay the debt as modified. Modifications may include interest only payments for a period of time, temporary or permanent reduction of the loan’s interest rate, capitalization of delinquent interest, forgiveness of principal, or extensions of the maturity date. Post-modification balances of newly restructured troubled debt by type of modification for the three months ended March 31, 2017 and 2016 were as follows (dollars in thousands):



	Term Modification		Rate Modification		Interest Only		Principal Forgiveness		Combination		Total Modifications
Three Months Ended March 31, 2017
Commercial & industrial	$	—	$	—	$	—	$	—	$	—	$	—
Commercial, secured by real estate	—		—		—		—		—		—
Residential real estate	—		—		—		9		—		9
Consumer	14		—		—		—		—		14
Total	$	14	$	—	$	—	$	9	$	—	$	23

Three Months Ended March 31, 2016
Commercial & industrial	$	—	$	—	$	—	$	—	$	—	$	—
Commercial, secured by real estate	—		—		—		—		372		372
Residential real estate	18		—		—		—		—		18
Consumer	—		17		—		—		—		17
Total	$	18	$	17	$	—	$	—	$	372	$	407

LCNB is not committed to lend additional funds to borrowers whose loan terms were modified in a troubled debt restructuring.

Two commercial, secured by real estate loans to the same borrower totaling $1,236,000 that were modified during the fourth quarter 2016 subsequently defaulted in February 2017. There were no troubled debt restructurings that subsequently defaulted within twelve months of the restructuring date for the three months ended March 31, 2016 and that remained in default at period end.

Approximately $23,000 of impaired loans without a valuation allowance and $0 of impaired loans with a valuation allowance at March 31, 2017 consisted of loans that were modified during the three month ended March 31, 2017 and were determined to be troubled debt restructurings. Approximately $375,000 of impaired loans without a valuation allowance and $34,000 of impaired loans with a valuation allowance at March 31, 2016 consisted of loans that were modified during the three months ended March 31, 2016 and were determined to be troubled debt restructurings.

Mortgage loans sold to and serviced for the Federal Home Loan Mortgage Corporation and other investors are not included in the accompanying consolidated balance sheets. The unpaid principal balances of those loans at March 31, 2017 and December 31, 2016 were approximately $99,324,000 and $100,982,000, respectively.

The total recorded investment in residential consumer mortgage loans secured by residential real estate that was in the process of foreclosure at March 31, 2017 was $402,000.