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3. Loans

3 Months Ended

Mar. 31, 2017

Major classifications of loans at March 31, 2017 and December 31, 2016 are summarized as follows:

(Dollars in thousands)
	March 31, 2017		December 31, 2016
Real estate loans:
Construction and land development	$	65,438		61,749
Single-family residential		239,322		240,700
Single-family residential -
Banco de la Gente stated income		39,230		40,189
Commercial		247,940		247,521
Multifamily and farmland		29,078		21,047
Total real estate loans		621,008		611,206

Loans not secured by real estate:
Commercial loans		90,923		87,596
Farm loans		897		-
Consumer loans		9,634		9,832
All other loans		13,399		15,177

Total loans		735,861		723,811

Less allowance for loan losses		7,263		7,550

Total net loans	$	728,598		716,261

The Bank grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties, and also in Mecklenburg and Wake counties of North Carolina. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market. Risk characteristics of the major components of the Bank's loan portfolio are discussed below:

·

Construction and land development loans – The risk of loss is largely dependent on the initial estimate of whether the property's value at completion equals or exceeds the cost of property construction and the availability of take-out financing. During the construction phase, a number of factors can result in delays or cost overruns. If the estimate is inaccurate or if actual construction costs exceed estimates, the value of the property securing the loan may be insufficient to ensure full repayment when completed through a permanent loan, sale of the property, or by seizure of collateral. As of March 31, 2017, construction and land development loans comprised approximately 9% of the Bank's total loan portfolio.

·

Single-family residential loans – Declining home sales volumes, decreased real estate values and higher than normal levels of unemployment could contribute to losses on these loans. As of March 31, 2017, single-family residential loans comprised approximately 38% of the Bank's total loan portfolio, and include Banco's single-family residential stated income loans, which were approximately 5% of the Bank's total loan portfolio.

·

Commercial real estate loans – Repayment is dependent on income being generated in amounts sufficient to cover operating expenses and debt service. These loans also involve greater risk because they are generally not fully amortizing over a loan period, but rather have a balloon payment due at maturity. A borrower's ability to make a balloon payment typically will depend on being able to either refinance the loan or timely sell the underlying property. As of March 31, 2017, commercial real estate loans comprised approximately 34% of the Bank's total loan portfolio.

·

Commercial loans – Repayment is generally dependent upon the successful operation of the borrower's business. In addition, the collateral securing the loans may depreciate over time, be difficult to appraise, be illiquid or fluctuate in value based on the success of the business. As of March 31, 2017, commercial loans comprised approximately 12% of the Bank's total loan portfolio.

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management's opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The following tables present an age analysis of past due loans, by loan type, as of March 31, 2017 and December 31, 2016:

March 31, 2017
(Dollars in thousands)
	Loans 30-89 Days Past Due		Loans 90 or More Days Past Due		Total Past Due Loans		Total Current Loans		Total Loans		Accruing Loans 90 or More Days Past Due
Real estate loans:
Construction and land development	$	176		9		185		65,253		65,438		-
Single-family residential		2,859		119		2,978		236,344		239,322		-
Single-family residential -
Banco de la Gente stated income		4,688		54		4,742		34,488		39,230		-
Commercial		1,710		122		1,832		246,108		247,940		-
Multifamily and farmland		99		78		177		28,901		29,078		-
Total real estate loans		9,532		382		9,914		611,094		621,008		-

Loans not secured by real estate:
Commercial loans		333		-		333		90,590		90,923		-
Farm loans		-		-		-		897		897		-
Consumer loans		51		8		59		9,575		9,634		-
All other loans		-		-		-		13,399		13,399		-
Total loans	$	9,916		390		10,306		725,555		735,861		-

December 31, 2016
(Dollars in thousands)
	Loans 30-89 Days Past Due		Loans 90 or More Days Past Due		Total Past Due Loans		Total Current Loans		Total Loans		Accruing Loans 90 or More Days Past Due
Real estate loans:
Construction and land development	$	-		10		10		61,739		61,749		-
Single-family residential		4,890		80		4,970		235,730		240,700		-
Single-family residential -
Banco de la Gente stated income		5,250		249		5,499		34,690		40,189		-
Commercial		342		126		468		247,053		247,521		-
Multifamily and farmland		471		-		471		20,576		21,047		-
Total real estate loans		10,953		465		11,418		599,788		611,206		-

Loans not secured by real estate:
Commercial loans		273		-		273		87,323		87,596		-
Farm loans		-		-		-		-		-		-
Consumer loans		68		6		74		9,758		9,832		-
All other loans		3		-		3		15,174		15,177		-
Total loans	$	11,297		471		11,768		712,043		723,811		-

The following table presents non-accrual loans as of March 31, 2017 and December 31, 2016:

(Dollars in thousands)
	March 31, 2017		December 31, 2016
Real estate loans:
Construction and land development	$	20		22
Single-family residential		1,492		1,662
Single-family residential -
Banco de la Gente stated income		1,405		1,340
Commercial		562		669
Multifamily and farmland		78		78
Total real estate loans		3,557		3,771

Loans not secured by real estate:
Commercial loans		-		21
Consumer loans		27		33
Total	$	3,584		3,825

At each reporting period, the Bank determines which loans are impaired. Accordingly, the Bank's impaired loans are reported at their estimated fair value on a non-recurring basis. An allowance for each impaired loan that is collateral-dependent is calculated based on the fair value of its collateral. The fair value of the collateral is based on appraisals performed by REAS, a subsidiary of the Bank. REAS is staffed by certified appraisers that also perform appraisals for other companies. Factors, including the assumptions and techniques utilized by the appraiser, are considered by management. If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses. An allowance for each impaired loan that is not collateral dependent is calculated based on the present value of projected cash flows. If the recorded investment in the impaired loan exceeds the present value of projected cash flows, a valuation allowance is recorded as a component of the allowance for loan losses. Impaired loans under $250,000 are not individually evaluated for impairment with the exception of the Bank's troubled debt restructured ("TDR") loans in the residential mortgage loan portfolio, which are individually evaluated for impairment. Accruing impaired loans were $26.1 million, $23.5 million and $24.8 million at March 31, 2017, December 31, 2016 and March 31, 2016, respectively. Interest income recognized on accruing impaired loans was $372,000, $314,000 and $1.2 million for the three months ended March 31, 2017, the three months ended March 31, 2016 and the year ended December 31, 2016, respectively. No interest income is recognized on non-accrual impaired loans subsequent to their classification as non-accrual.

The following tables present impaired loans as of March 31, 2017 and December 31, 2016:

March 31, 2017
(Dollars in thousands)

	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance		Recorded Investment With Allowance		Recorded Investment in Impaired Loans		Related Allowance		Average Outstanding Impaired Loans		YTD Interest Income Recognized
Real estate loans:
Construction and land development	$	270		-		265		265		9		272		4
Single-family residential		4,950		698		3,912		4,610		43		5,444		69
Single-family residential -
Banco de la Gente stated income		18,206		-		17,639		17,639		1,140		17,187		237
Commercial		3,617		1,269		2,081		3,350		68		3,572		59
Multifamily and farmland		78		-		78		78		-		78		-
Total impaired real estate loans		27,121		1,967		23,975		25,942		1,260		26,553		369

Loans not secured by real estate:
Commercial loans		5		-		5		5		-		16		-
Consumer loans		200		-		192		192		3		229		3
Total impaired loans	$	27,326		1,967		24,172		26,139		1,263		26,798		372

December 31, 2016
(Dollars in thousands)

	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance		Recorded Investment With Allowance		Recorded Investment in Impaired Loans		Related Allowance		Average Outstanding Impaired Loans		YTD Interest Income Recognized
Real estate loans:
Construction and land development	$	282		-		278		278		11		330		13
Single-family residential		5,354		703		4,323		5,026		47		7,247		164
Single-family residential -
Banco de la Gente stated income		18,611		-		18,074		18,074		1,182		17,673		861
Commercial		3,750		1,299		2,197		3,496		166		4,657		152
Multifamily and farmland		78		-		78		78		-		78		-
Total impaired real estate loans		28,075		2,002		24,950		26,952		1,406		29,985		1,190

Loans not secured by real estate:
Commercial loans		27		-		27		27		-		95		-
Consumer loans		211		-		202		202		3		222		8
Total impaired loans	$	28,313		2,002		25,179		27,181		1,409		30,302		1,198

Changes in the allowance for loan losses for the three months ended March 31, 2017 and 2016 were as follows:

(Dollars in thousands)
	Real Estate Loans
	Construction and Land Development			Single- Family Residential			Single- Family Residential - Banco de la Gente Stated Income			Commercial		Multifamily and Farmland		Commercial			Farm		Consumer and All Other			Unallocated		Total
Three months ended March 31, 2017
Allowance for loan losses:
Beginning balance	$	1,152			2,126			1,377			1,593		52		675			-		204			371		7,550
Charge-offs		-			(20	)		-			-		-		(2	)		-		(109	)		-		(131	)
Recoveries		8			7			-			7		-		8			-		50			-		80
Provision		(191	)		(110	)		(49	)		55		21		(53	)		-		33			58		(236	)
Ending balance	$	969			2,003			1,328			1,655		73		628			-		178			429		7,263

Allowance for loan losses March 31, 2017
Ending balance: individually
evaluated for impairment	$	-			-			1,120			62		-		-			-		-			-		1,182
Ending balance: collectively
evaluated for impairment		969			2,003			208			1,593		73		628			-		178			429		6,081
Ending balance	$	969			2,003			1,328			1,655		73		628			-		178			429		7,263

Loans March 31, 2017:
Ending balance	$	65,438			239,322			39,230			247,940		29,078		90,923			897		23,033			-		735,861

Ending balance: individually
evaluated for impairment	$	-			1,630			16,303			2,736		-		-			-		-			-		20,669
Ending balance: collectively
evaluated for impairment	$	65,438			237,692			22,927			245,204		29,078		90,923			897		23,033			-		715,192

(Dollars in thousands)
	Real Estate Loans
	Construction and Land Development			Single- Family Residential			Single- Family Residential - Banco de la Gente Stated Income			Commercial			Multifamily and Farmland		Commercial			Farm		Consumer and All Other			Unallocated		Total
Three months ended March 31, 2016
Allowance for loan losses:
Beginning balance	$	2,185			2,534			1,460			1,917			-		842			-		172			479		9,589
Charge-offs		-			(59	)		-			(106	)		-		(29	)		-		(128	)		-		(322	)
Recoveries		3			8			-			5			-		6			-		43			-		65
Provision		(344	)		(8	)		(37	)		(28	)		-		(9	)		-		103			107		(216	)
Ending balance	$	1,844			2,475			1,423			1,788			-		810			-		190			586		9,116

Allowance for loan losses March 31, 2016:
Ending balance: individually
evaluated for impairment	$	-			95			1,107			170			-		-			-		-			-		1,372
Ending balance: collectively
evaluated for impairment		1,844			2,380			316			1,618			-		810			-		190			586		7,744
Ending balance	$	1,844			2,475			1,423			1,788			-		810			-		190			586		9,116

Loans March 31, 2016:
Ending balance	$	63,973			223,104			42,951			228,166			18,122		91,784			2		24,931			-		693,033

Ending balance: individually
evaluated for impairment	$	-			2,612			17,711			4,890			-		-			-		-			-		25,213
Ending balance: collectively
evaluated for impairment	$	63,973			220,492			25,240			223,276			18,122		91,784			2		24,931			-		667,820

The provision for loan losses for the three months ended March 31, 2017 was a credit of $236,000, as compared to a credit of $216,000 for the three months ended March 31, 2016. The increase in the credit to the provision for loan losses is primarily attributable to a reduction in the required level of the allowance for loan losses resulting from lower historical loss rates used to calculate the ASC 450-20 reserve as the elevated level of loan losses incurred in 2011 and 2012 are no longer included in the historical loss calculations.

The Company utilizes an internal risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 8. These risk grades are evaluated on an ongoing basis. A description of the general characteristics of the eight risk grades is as follows:

·	Risk Grade 1 – Excellent Quality: Loans are well above average quality and a minimal amount of credit risk exists. CD or cash secured loans or properly margined actively traded stock or bond secured loans would fall in this grade.
·	Risk Grade 2 – High Quality: Loans are of good quality with risk levels well within the Company's range of acceptability. The organization or individual is established with a history of successful performance though somewhat susceptible to economic changes.

·	Risk Grade 3 – Good Quality: Loans of average quality with risk levels within the Company's range of acceptability but higher than normal. This may be a new organization or an existing organization in a transitional phase (e.g. expansion, acquisition, market change).
·	Risk Grade 4 – Management Attention: These loans have higher risk and servicing needs but still are acceptable. Evidence of marginal performance or deteriorating trends is observed. These are not problem credits presently, but may be in the future if the borrower is unable to change its present course.

·	Risk Grade 5 – Watch: These loans are currently performing satisfactorily, but there has been some recent past due history on repayment and there are potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Company's position at some future date.
·	Risk Grade 6 – Substandard: A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or the collateral pledged (if there is any). There is a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. There is a distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

·

Risk Grade 7 – Doubtful: Loans classified as Doubtful have all the weaknesses inherent in loans classified as Substandard, plus 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. Doubtful is a temporary grade where a loss is expected but is presently not quantified with any degree of accuracy. Once the loss position is determined, the amount is charged off.

·

Risk Grade 8 – Loss: Loans classified as Loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this worthless loan even though partial recovery may be realized in the future. Loss is a temporary grade until the appropriate authority is obtained to charge the loan off.

The following tables present the credit risk profile of each loan type based on internally assigned risk grades as of March 31, 2017 and December 31, 2016:

March 31, 2017
(Dollars in thousands)
	Real Estate Loans
	Construction and Land Development		Single- Family Residential	Single- Family Residential - Banco de la Gente Stated Income	Commercial	Multifamily and Farmland	Commercial	Farm	Consumer	All Other	Total

1- Excellent Quality	$	-	10,648	-	-	-	462	-	941	-	12,051
2- High Quality		10,141	110,210	-	40,047	2,853	20,133	-	3,210	1,197	187,791
3- Good Quality		37,888	85,707	16,331	179,746	22,628	64,341	853	4,807	10,473	422,774
4- Management Attention		10,203	24,524	15,458	21,720	2,334	5,446	44	604	1,729	82,062
5- Watch		6,909	4,912	3,728	5,817	1,185	505	-	24	-	23,080
6- Substandard		297	3,321	3,713	610	78	36	-	44	-	8,099
7- Doubtful		-	-	-	-	-	-	-	-	-	-
8- Loss		-	-	-	-	-	-	-	4	-	4
Total	$	65,438	239,322	39,230	247,940	29,078	90,923	897	9,634	13,399	735,861

December 31, 2016
(Dollars in thousands)
	Real Estate Loans
	Construction and Land Development		Single- Family Residential	Single- Family Residential - Banco de la Gente Stated Income	Commercial	Multifamily and Farmland	Commercial	Farm	Consumer	All Other	Total

1- Excellent Quality	$	-	14,996	-	-	-	541	-	959	-	16,496
2- High Quality		9,784	109,809	-	39,769	2,884	26,006	-	3,335	2,507	194,094
3- Good Quality		33,633	82,147	16,703	176,109	14,529	55,155	-	4,842	10,921	394,039
4- Management Attention		10,892	25,219	15,580	24,753	2,355	5,586	-	619	1,749	86,753
5- Watch		7,229	4,682	3,943	4,906	1,201	246	-	31	-	22,238
6- Substandard		211	3,847	3,963	1,984	78	62	-	42	-	10,187
7- Doubtful		-	-	-	-	-	-	-	-	-	-
8- Loss		-	-	-	-	-	-	-	4	-	4
Total	$	61,749	240,700	40,189	247,521	21,047	87,596	-	9,832	15,177	723,811

Current year TDR modifications, past due TDR loans and non-accrual TDR loans totaled $4.7 million and $5.9 million at March 31, 2017 and December 31, 2016, respectively. The terms of these loans have been renegotiated to provide a concession to original terms, including a reduction in principal or interest as a result of the deteriorating financial position of the borrower. There were no performing loans classified as TDR loans at March 31, 2017. There was $81,000 in performing loans classified as TDR loans at December 31, 2016.

There were no new TDR modifications during the three months ended March 31, 2017 and 2016.

There were no loans modified as TDR that defaulted during the three months ended March 31, 2017 and 2016, which were within 12 months of their modification date. Generally, a TDR loan is considered to be in default once it becomes 90 days or more past due following a modification.

- Definition

The entire disclosure for claims held for amounts due a entity, excluding financing receivables. Examples include, but are not limited to, trade accounts receivables, notes receivables, loans receivables. Includes disclosure for allowance for credit losses.

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