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3. Loans

9 Months Ended

Sep. 30, 2020

Major classifications of loans at September 30, 2020 and December 31, 2019 are summarized as follows:

(Dollars in thousands)
	September 30, 2020		December 31, 2019
Real estate loans:
Construction and land development	$	96,866		92,596
Single-family residential		272,246		269,475
Single-family residential - Banco de la Gente non-traditional		28,099		30,793
Commercial		318,596		291,255
Multifamily and farmland		49,584		48,090
Total real estate loans		765,391		732,209

Loans not secured by real estate:
Commercial loans		182,862		100,263
Farm loans		851		1,033
Consumer loans		7,341		8,432
All other loans		13,787		7,937

Total loans		970,232		849,874

Less allowance for loan losses		9,892		6,680

Total net loans	$	960,340		843,194

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, Wake and Durham 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 September 30, 2020, construction and land development loans comprised approximately 10% 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 September 30, 2020, single-family residential loans comprised approximately 31% of the Bank’s total loan portfolio, and include Banco’s non-traditional single-family residential loans, which were approximately 3% 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 September 30, 2020, commercial real estate loans comprised approximately 33% 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 September 30, 2020, commercial loans comprised approximately 19% of the Bank’s total loan portfolio, including $98.4 million in Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) loans.

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 of 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 September 30, 2020 and December 31, 2019:

September 30, 2020
(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	$	8		—		8		96,858		96,866		—
Single-family residential		837		378		1,215		271,031		272,246		—
Single-family residential - Banco de la Gente non-traditional		428		131		559		27,540		28,099		84
Commercial		—		—		—		318,596		318,596		—
Multifamily and farmland		—		—		—		49,584		49,584		—
Total real estate loans		1,273		509		1,782		763,609		765,391		84

Loans not secured by real estate:
Commercial loans		130		—		130		182,732		182,862		—
Farm loans		—		—		—		851		851		—
Consumer loans		84		2		86		7,255		7,341		—
All other loans		—		—		—		13,787		13,787		—
Total loans	$	1,487		511		1,998		968,234		970,232		84

December 31, 2019
(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	$	803		—		803		91,793		92,596		—
Single-family residential		3,000		126		3,126		266,349		269,475		—
Single-family residential - Banco de la Gente non-traditional		4,834		413		5,247		25,546		30,793		—
Commercial		504		176		680		290,575		291,255		—
Multifamily and farmland		—		—		—		48,090		48,090		—
Total real estate loans		9,141		715		9,856		722,353		732,209		—

Loans not secured by real estate:
Commercial loans		432		—		432		99,831		100,263		—
Farm loans		—		—		—		1,033		1,033		—
Consumer loans		170		22		192		8,240		8,432		—
All other loans		—		—		—		7,937		7,937		—
Total loans	$	9,743		737		10,480		839,394		849,874		—

The following table presents non-accrual loans as of September 30, 2020 and December 31, 2019:

(Dollars in thousands)
	September 30, 2020		December 31, 2019
Real estate loans:
Construction and land development	$	—		—
Single-family residential		1,019		1,378
Single-family residential - Banco de la Gente non-traditional		1,733		1,764
Commercial		451		256
Total real estate loans		3,203		3,398

Loans not secured by real estate:
Commercial loans		255		122
Consumer loans		17		33
Total	$	3,475		3,553

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 $21.0 million, $21.3 million and $21.4 million at September 30, 2020, December 31, 2019 and September 30, 2019, respectively. Interest income recognized on accruing impaired loans was $934,000, $1.3 million, and $1.0 million for the nine months ended September 30, 2020, the year ended December 31, 2019 and the nine months ended September 30, 2019, respectively. No interest income is recognized on non-accrual impaired loans subsequent to their classification as non-accrual.

The following table presents impaired loans as of September 30, 2020:

September 30, 2020
(Dollars in thousands)

	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance		Recorded Investment With Allowance		Recorded Investment in Impaired Loans		Related Allowance
Real estate loans:
Construction and land development	$	113		—		113		113		4
Single-family residential		5,110		388		4,309		4,697		18
Single-family residential - Banco de la Gente stated income		13,854		—		13,055		13,055		865
Commercial		2,579		351		2,206		2,557		13
Multifamily and farmland		—		—		—		—		—
Total impaired real estate loans		21,656		739		19,683		20,422		900

Loans not secured by real estate:
Commercial loans		569		255		259		514		2
Consumer loans		53		—		49		49		1
Total impaired loans	$	22,278		994		19,991		20,985		903

The following table presents the average impaired loan balance and the interest income recognized by loan class for the three and nine months ended September 30, 2020 and 2019.

(Dollars in thousands)
	Three months ended								Nine months ended
	September 30, 2020				September 30, 2019				September 30, 2020				September 30, 2019
	Average Balance		Interest Income Recognized		Average Balance		Interest Income Recognized		Average Balance		Interest Income Recognized		Average Balance		Interest Income Recognized
Real estate loans:
Construction and land development	$	153		—		188		3		123		7		232		9
Single-family residential		5,107		63		4,360		70		4,451		181		4,724		188
Single-family residential - Banco de la Gente stated income		13,402		197		14,805		241		13,785		617		14,916		732
Commercial		2,665		31		1,808		26		2,772		103		1,823		71
Multifamily and farmland		—		—		—		—		—		—		—		—
Total impaired real estate loans		21,327		291		21,161		340		21,131		908		21,695		1,000

Loans not secured by real estate:
Commercial loans		494		7		153		16		553		22		127		20
Consumer loans		74		1		94		1		57		4		102		5
Total impaired loans	$	21,895		299		21,408		357		21,741		934		21,924		1,025

The following table presents impaired loans as of and for the year ended December 31, 2019:

December 31, 2019
(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	$	183		—		183		183		7		231		12
Single-family residential		5,152		403		4,243		4,646		36		4,678		269
Single-family residential - Banco de la Gente non-traditional		15,165		—		14,371		14,371		944		14,925		956
Commercial		1,879		—		1,871		1,871		7		1,822		91
Total impaired real estate loans		22,379		403		20,668		21,071		994		21,656		1,328

Loans not secured by real estate:
Commercial loans		180		92		84		176		—		134		9
Consumer loans		100		—		96		96		2		105		7
Total impaired loans	$	22,659		495		20,848		21,343		996		21,895		1,344

Changes in the allowance for loan losses for the three and nine months ended September 30, 2020 and 2019 were as follows:

(Dollars in thousands)
		Real Estate Loans
		Construction and Land Development		Single-Family Residential		Single-Family Residential - Banco de la Gente Non-traditional		Commercial		Multifamily and Farmland		Commercial		Farm	Consumer and All Other		Unallocated	Total
Nine months ended September 30, 2020:
Allowance for loan losses:
Beginning balance	$	694		1,274		1,073		1,305		120		688		—	138		1,388	6,680
Charge-offs		(5	)	(65	)	—		(7	)	—		(109	)	—	(343	)	—	(529	)
Recoveries		2		59		—		45		—		27		—	148		—	281
Provision		573		482		(11	)	751		(4	)	355		—	254		1,060	3,460
Ending balance	$	1,264		1,750		1,062		2,094		116		961		—	197		2,448	9,892


Allowance for loan losses:
Beginning balance	$	1,531		1,813		1,114		2,051		115		980		—	162		1,667	9,433
Charge-offs		—		(65	)	—		—		—		—		—	(87	)	—	(152	)
Recoveries		—		34		—		11		—		2		—	42		—	89
Provision		(267	)	(32	)	(52	)	32		1		(21	)	—	80		781	522
Ending balance	$	1,264		1,750		1,062		2,094		116		961		—	197		2,448	9,892

Allowance for loan losses at September 30, 2020:
Ending balance: individually evaluated for impairment	$	2		4		859		11		—		—		—	—		—	876
Ending balance: collectively evaluated for impairment		1,262		1,746		203		2,083		116		961		—	197		2,448	9,016
Ending balance	$	1,264		1,750		1,062		2,094		116		961		—	197		2,448	9,892

Loans at September 30, 2020:
Ending balance	$	96,866		272,246		28,099		318,596		49,584		182,862		851	21,128		—	970,232

Ending balance: individually evaluated for impairment	$	8		1,582		11,630		1,685		—		255		—	—		—	15,160
Ending balance: collectively evaluated for impairment	$	96,858		270,664		16,469		316,911		49,584		182,607		851	21,128		—	955,072

(Dollars in thousands)
		Real Estate Loans
		Construction and Land Development		Single-Family Residential		Single-Family Residential - Banco de la Gente Non-traditional		Commercial		Multifamily and Farmland	Commercial		Farm	Consumer and All Other		Unallocated	Total
Nine months ended September 30, 2019:
Allowance for loan losses:
Beginning balance	$	813		1,325		1,177		1,278		83	626		—	161		982	6,445
Charge-offs		(21	)	(42	)	—		—		—	(389	)	—	(459	)	—	(911	)
Recoveries		44		59		—		27		—	80		—	157		—	367
Provision		(141	)	22		(87	)	(26	)	35	333		—	303		238	677
Ending balance	$	695		1,364		1,090		1,279		118	650		—	162		1,220	6,578

Three months ended September 30, 2019:
Allowance for loan losses:
Beginning balance	$	763		1,312		1,116		1,334		110	548		—	161		1,197	6,541
Charge-offs		—		(19	)	—		—		—	(388	)	—	(144	)	—	(551	)
Recoveries		41		6		—		4		—	66		—	49		—	166
Provision		(109	)	65		(26	)	(59	)	8	424		—	96		23	422
Ending balance	$	695		1,364		1,090		1,279		118	650		—	162		1,220	6,578

Allowance for loan losses at September 30, 2019:
Ending balance: individually evaluated for impairment	$	—		2		948		10		—	—		—	—		—	960
Ending balance: collectively evaluated for impairment		695		1,362		142		1,269		118	650		—	162		1,220	5,618
Ending balance	$	695		1,364		1,090		1,279		118	650		—	162		1,220	6,578

Loans at September 30, 2019:
Ending balance	$	95,622		269,304		31,673		281,607		47,266	99,382		1,101	19,644		—	845,599

Ending balance: individually
Ending balance: individually evaluated for impairment	$	11		1,719		13,196		1,628		—	100		—	—		—	16,654
Ending balance: collectively evaluated for impairment	$	95,611		267,585		18,477		279,979		47,266	99,282		1,101	19,644		—	828,945

The provision for loan losses for the three months ended September 30, 2020 was $522,000, compared to $422,000 for the three months ended September 30, 2019. The increase in the provision for loan losses is primarily attributable to increases in the qualitative factors applied in the Company’s Allowance for Loan and Lease Losses (“ALLL”) model due to the impact to the economy from the COVID-19 pandemic and a $26.2 million increase in loans, excluding $98.4 million in PPP loans, from September 30, 2019 to September 30, 2020. PPP loans are excluded from ALLL as PPP loans are 100 percent guaranteed by the SBA. The ALLL model also includes reserves on $119.7 million in loans with payment modifications made in 2020 as a result of the COVID-19 pandemic. Reserves associated with COVID-19 payment modifications were $1.6 million at June 30, 2020 and September 30, 2020. Loans with payment modifications associated with the COVID-19 pandemic include $79.2 million in loans secured by commercial real estate, $23.0 million in loans secured by residential real estate, $8.7 in loans secured by other real estate, $8.0 million in commercial loans not secured by real estate and $765,000 in consumer loans not secured by real estate at September 30, 2020. These payment modifications are primarily interest only payments for three to six months. Loans with COVID-19 related payment modifications that have reverted to their original terms are still included with reserves associated with COVID-19 payment modifications at September 30, 2020. There is still uncertainty about the ongoing and future effects of national and local policy decisions on these borrowers that could still limit their ability to adhere to their original payment terms. Approximately 12% of loans with COVID-19 payment modifications at September 30, 2020 have received secondary payment modifications as a result of the COVID-19 pandemic. Loan payment modifications associated with the COVID-19 pandemic are not classified as TDR due to Section 4013 of the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”), which provides that a qualified loan modification is exempt by law from classification as a TDR pursuant to GAAP.

The provision for loan losses for the nine months ended September 30, 2020 was $3.5 million, compared to $677,000 for the nine months ended September 30, 2019. The increase in the provision for loan losses is primarily attributable to increases in the qualitative factors applied in the Company’s ALLL model due to the impact to the economy from the COVID-19 pandemic and a $26.2 million increase in loans, excluding $98.4 million in SBA PPP loans, from September 30, 2019 to September 30, 2020. PPP loans are excluded from ALLL as PPP loans are 100 percent guaranteed by the SBA. The ALLL model also includes reserves on $119.7 million in loans with payment modifications made in 2020 as a result of the COVID-19 pandemic.

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. Certificates of deposit 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 September 30, 2020 and December 31, 2019:

September 30, 2020
(Dollars in thousands)
		Real Estate Loans
		Construction and Land Development	Single-Family Residential	Single-Family Residential - Banco de la Gente non-traditional	Commercial	Multifamily and Farmland	Commercial	Farm	Consumer	All Other	Total

1- Excellent Quality	$	230	9,184	—	—	—	739	—	675	—	10,828
2- High Quality		17,962	125,821	—	30,959	261	24,377	—	2,373	1,643	203,396
3- Good Quality		70,142	112,716	10,896	236,533	44,393	143,379	785	3,917	11,424	634,185
4- Management Attention		5,506	18,472	12,643	41,687	4,344	12,555	66	336	720	96,329
5- Watch		2,939	2,997	2,003	8,517	586	1,500	—	7	—	18,549
6- Substandard		87	3,056	2,557	900	—	312	—	33	—	6,945
7- Doubtful		—	—	—	—	—	—	—	—	—	—
8- Loss		—	—	—	—	—	—	—	—	—	—
Total	$	96,866	272,246	28,099	318,596	49,584	182,862	851	7,341	13,787	970,232

December 31, 2019
(Dollars in thousands)
		Real Estate Loans
		Construction and Land Development	Single-Family Residential	Single-Family Residential - Banco de la Gente non-traditional	Commercial	Multifamily and Farmland	Commercial	Farm	Consumer	All Other	Total

1- Excellent Quality	$	—	8,819	—	—	—	330	—	693	—	9,842
2- High Quality		32,029	128,757	—	21,829	256	20,480	—	2,708	1,860	207,919
3- Good Quality		52,009	107,246	12,103	231,003	42,527	72,417	948	4,517	5,352	528,122
4- Management Attention		5,487	18,409	13,737	35,095	4,764	6,420	85	458	725	85,180
5- Watch		3,007	3,196	2,027	3,072	543	492	—	8	—	12,345
6- Substandard		64	3,048	2,926	256	—	124	—	48	—	6,466
7- Doubtful		—	—	—	—	—	—	—	—	—	—
8- Loss		—	—	—	—	—	—	—	—	—	—
Total	$	92,596	269,475	30,793	291,255	48,090	100,263	1,033	8,432	7,937	849,874

Current year TDR modifications, past due TDR loans and non-accrual TDR loans totaled $2.6 million and $4.3 million at September 30, 2020 and December 31, 2019, 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 September 30, 2020 and December 31, 2019.

There were no new TDR modifications during the nine months ended September 30, 2020 and 2019.

There were no loans modified as TDR that defaulted during the nine months ended September 30, 2020 and 2019, 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.

On March 27, 2020, President Trump signed the CARES Act, which established a $2 trillion economic stimulus package, including cash payments to individuals, supplemental unemployment insurance benefits and a $349 billion loan program administered through the PPP. Under the PPP, small businesses, sole proprietorships, independent contractors and self-employed individuals may apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. The Bank is participating as a lender in the PPP. The Bank originated $64.5 million in PPP loans during the initial round of PPP funding. A second round of PPP funding, signed into law by President Trump on April 24, 2020, provided $320 billion additional funding for the PPP. As of September 30, 2020, the Bank had originated $34.5 million in PPP loans during the second round of PPP funding. Total PPP loans originated as of September 30, 2020 amounted to $98.8 million. The Bank has received $4.0 million in fees from the SBA for PPP loans originated as of September 30, 2020. The Bank has recognized $361,000 PPP loan fee income as of September 30, 2020.

The Bank has continued to modify payments on loans due to the COVID-19 pandemic. At September 30, 2020, loans totaling $119.7 million had payment modifications due to the COVID-19 pandemic. Loans with payment modifications associated with the COVID-19 pandemic include $79.2 million in loans secured by commercial real estate, $23.0 million in loans secured by residential real estate, $8.7 in loans secured by other real estate, $8.0 million in commercial loans not secured by real estate and $765,000 in consumer loans not secured by real estate at September 30, 2020. These payment modifications are primarily interest only payments for three to nine months. Loan payment modifications associated with the COVID-19 pandemic are not classified as TDR due to Section 4013 of the CARES Act, which provides that a qualified loan modification is exempt by law from classification as a TDR pursuant to GAAP.