Note 9 – Loans, allowance for loan losses and OREO

Management has an established methodology used to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. For purposes of determining the allowance for loan losses, the Bank has segmented certain loans in the portfolio by product type. Within these segments, the Bank has sub-segmented its portfolio by classes within the segments, based on the associated risks within these classes. The classifications set forth below do not correspond directly to the classifications set forth in the call report (Form FFIEC 041). Management has determined that the classifications set forth below are more appropriate for use in identifying and managing risk in the loan portfolio.

Loan Segments:		Loan Classes:
Commercial		Commercial and industrial loans
Commercial real estate		Commercial mortgages – owner occupied
		Commercial mortgages – non-owner occupied
		Commercial construction
Consumer		Consumer unsecured
		Consumer secured
Residential		Residential mortgages
		Residential consumer construction

A summary of loans, net is as follows (dollars in thousands):

	As of:
	Sept 30,	December 31,
	2012	2011

Commercial	$ 56,191	$ 59,623
Commercial real estate	152,398	150,622
Consumer	71,063	72,488
Residential	44,753	41,633

Total loans	324,405	324,366

Less allowance for loan losses	5,693	5,612

Net loans	$ 318,712	$ 318,754

The Bank’s internal risk rating system is in place to grade commercial and commercial real estate loans. Category ratings are reviewed periodically by lenders and the credit review area of the Bank based on the borrower’s individual situation. Additionally, internal and external monitoring and review of credits are conducted on an annual basis.

Below is a summary and definition of the Bank’s risk rating categories:

RATING 1	Excellent
RATING 2	Above Average
RATING 3	Satisfactory
RATING 4	Acceptable / Low Satisfactory
RATING 5	Monitor
RATING 6	Special Mention
RATING 7	Substandard
RATING 8	Doubtful
RATING 9	Loss

We segregate loans into the above categories based on the following criteria and we review the characteristics of each rating at least annually, generally during the first quarter. The characteristics of these ratings are as follows:

“Pass.” These are loans having risk ratings of 1 through 4. Pass loans are to persons or business entities with an acceptable financial condition, appropriate collateral margins, appropriate cash flow to service the existing loan, and an appropriate leverage ratio. The borrower has paid all obligations as agreed and it is expected that this type of payment history will continue. When necessary, acceptable personal guarantors support the loan.

“Monitor.” These are loans having a risk rating of 5. Monitor loans have currently acceptable risk but may have the potential for a specific defined weakness in the borrower’s operations and the borrower’s ability to generate positive cash flow on a sustained basis. The borrower’s recent payment history may currently or in the future be characterized by late payments. The Bank’s risk exposure is mitigated by collateral supporting the loan. The collateral is considered to be well-margined, well maintained, accessible and readily marketable.

“Special Mention.” These are loans having a risk rating of 6. Special Mention loans have weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the bank’s credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. These loans do warrant more than routine monitoring due to a weakness caused by adverse events.

“Substandard.” These are loans having a risk rating of 7. Substandard loans are considered to have specific and well-defined weaknesses that jeopardize the viability of the Bank’s credit extension. The payment history for the loan has been inconsistent and the expected or projected primary repayment source may be inadequate to service the loan. The estimated net liquidation value of the collateral pledged and/or ability of the personal guarantor(s) to pay the loan may not adequately protect the Bank. There is a distinct possibility that the Bank will sustain some loss if the deficiencies associated with the loan are not corrected in the near term. A substandard loan would not automatically meet our definition of impaired unless the loan is significantly past due and the borrower’s performance and financial condition provides evidence that it is probable that the Bank will be unable to collect all amounts due.

“Doubtful.” These are loans having a risk rating of 8. Doubtful rated loans have all the weaknesses inherent in a loan that is classified substandard but 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. The possibility of loss is extremely high.

·	“Loss.” These are loans having a risk rating of 9. Loss rated loans are not considered collectible under normal circumstances and there is no realistic expectation for any future payment on the loan. Loss rated loans are fully charged off.

Financing Receivables on Non-Accrual Status (dollars in thousands)
	As of
	September 30, 2012	December 31, 2011
Commercial	$ 1,985	$ 3,570
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	582	1,610
Commercial Mortgages-Non-Owner Occupied	1,395	2,794
Commercial Construction	729	782
Consumer
Consumer Unsecured	-	-
Consumer Secured	126	415
Residential:
Residential Mortgages	936	1,205
Residential Consumer Construction	-	-

Totals	$ 5,753	$ 10,375

We also classify other real estate owned (OREO) as a nonperforming asset. OREO represents real property owned by the Bank either through purchase at foreclosure or received from the borrower through a deed in lieu of foreclosure. OREO decreased to $2,267,000 on September 30, 2012 from $3,253,000 on December 31, 2011. The following table represents the changes in OREO balance during the Nine Months ended September 30, 2012.

OREO Changes (dollars in thousands)
	Nine Months ended September 30, 2012
Balance at the beginning of the year (net)	$ 3,253
Transfers from loans	2,100
Capitalized costs	5
Writedowns	(710)
Sales proceeds	(2,307)
(Loss) on disposition	(74)
Balance at the end of the period (net)	$ 2,267

		Impaired Loans (dollars in thousands)
		For the Nine Months Ended September 30, 2012
2012		Recorded Investment	Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
With No Related Allowance Recorded:
	Commercial	$ 2,279	$ 2,538	$ -	$ 2,818	$ 11
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	2,703	2,801	-	2,457	143
	Commercial Mortgage Non-Owner Occupied	5,261	5,456	-	5,071	172
	Commercial Construction	950	950	-	1,027	38
	Consumer
	Consumer Unsecured	-	-	-	-	-
	Consumer Secured	652	713	-	473	37
	Residential
	Residential Mortgages	1,968	1,999	-	1,415	86
	Residential Consumer Construction	-	-	-	-	-

With An Allowance Recorded:
	Commercial	$ 1,376	$ 1,377	$ 421	$ 2,172	$ 54
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	1,605	1,851	468	2,061	81
	Commercial Mortgage Non-Owner Occupied	754	754	87	1,672	25
	Commercial Construction	1,274	1,546	144	1,487	8
	Consumer
	Consumer Unsecured	1	1	1	1	-
	Consumer Secured	564	741	426	753	18
	Residential
	Residential Mortgages	1,336	1,683	201	1,629	34
	Residential Consumer Construction	-	-	-	-	-

Totals:
	Commercial	$ 3,655	$ 3,915	$ 421	$ 4,990	$ 65
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	4,308	4,652	468	4,518	224
	Commercial Mortgage Non-Owner Occupied	6,015	6,210	87	6,743	197
	Commercial Construction	2,224	2,496	144	2,514	46
	Consumer
	Consumer Unsecured	1	1	1	1	-
	Consumer Secured	1,216	1,454	426	1,226	55
	Residential
	Residential Mortgages	3,304	3,682	201	3,044	120
	Residential Consumer Construction	-	-	-	-	-
		$ 20,723	$ 22,410	$ 1,748	$ 23,036	$ 707

		Impaired Loans (dollars in thousands)
		For the Year Ended December 31, 2011
2011		Recorded Investment	Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
With No Related Allowance Recorded:
	Commercial	$ 3,357	$ 3,570	$ -	$ 8,978	$ 118
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	2,211	3,108	-	2,457	124
	Commercial Mortgage Non-Owner Occupied	4,880	5,170	-	5,418	227
	Commercial Construction	1,103	1,103	-	984	38
	Consumer
	Consumer Unsecured	-	-	-	-	-
	Consumer Secured	293	642	-	330	6
	Residential
	Residential Mortgages	862	1,007	-	633	15
	Residential Consumer Construction	-	-	-	33	-

With An Allowance Recorded:
	Commercial	$ 2,968	$ 3,052	$ 440	$ 2,170	$ 106
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	2,516	2,686	555	3,815	137
	Commercial Mortgage Non-Owner Occupied	2,590	3,129	228	1,858	117
	Commercial Construction	1,700	1,964	275	2,454	42
	Consumer
	Consumer Unsecured	-	-	-	286	-
	Consumer Secured	942	1,021	357	699	49
	Residential
	Residential Mortgages	1,922	2,180	128	1,847	89
	Residential Consumer Construction	-	-	-	-	-

Totals:
	Commercial	$ 6,325	$ 6,622	$ 440	$ 11,147	$ 224
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	4,727	5,794	555	6,272	261
	Commercial Mortgage Non-Owner Occupied	7,470	8,299	228	7,275	344
	Commercial Construction	2,803	3,067	275	3,438	80
	Consumer
	Consumer Unsecured	-	-	-	286	-
	Consumer Secured	1,235	1,663	357	1,029	55
	Residential
	Residential Mortgages	2,784	3,187	128	2,480	104
	Residential Consumer Construction	-	-	-	33	-
		$ 25,344	$ 28,632	$ 1,983	$ 31,960	$ 1,068

Allowance for Credit Losses and Recorded Investment in Financing Receivables
(dollars in thousands)
For the Nine Months Ended September 30, 2012

		Commercial
2012	Commercial	Real Estate	Consumer	Residential	Total

Allowance for Credit Losses:
Beginning Balance	$ 892	$ 2,677	$ 1,486	$ 557	$ 5,612
Charge-offs	(504)	(816)	(463)	(67)	(1,850)
Recoveries	18	112	18	7	155
Provision	592	785	218	181	1,776
Ending Balance	$ 998	$ 2,758	$ 1,259	$ 678	$ 5,693

Ending Balance: Individually evaluated for impairment	$ 421	$ 699	$ 427	$ 201	$ 1,748

Ending Balance: Collectively evaluated for impairment	577	2,059	832	477	3,945


Totals:	$ 998	$ 2,758	$ 1,259	$ 678	$ 5,693

Financing Receivables:

Ending Balance: Individually evaluated for impairment	3,655	12,546	1,217	3,305	20,723

Ending Balance: Collectively evaluated for impairment	52,536	139,852	69,846	41,448	303,682

Totals:	$ 56,191	$ 152,398	$ 71,063	$ 44,753	$ 324,405

Allowance for Credit Losses and Recorded Investment in Financing Receivables
(dollars in thousands)
For the Year Ended December 31, 2011

		Commercial
2011	Commercial	Real Estate	Consumer	Residential	Total

Allowance for Credit Losses:
Beginning Balance	$ 473	$ 2,897	$ 1,207	$ 890	$ 5,467
Charge-offs	(702)	(2,738)	(817)	(459)	(4,716)
Recoveries	16	3	31	4	54
Provision	1,105	2,515	1,065	122	4,807
Ending Balance	$ 892	$ 2,677	$ 1,486	$ 557	$ 5,612

Ending Balance: Individually evaluated for impairment	$ 440	$ 1,058	$ 357	$ 128	$ 1,983

Ending Balance: Collectively evaluated for impairment	452	1,619	1,129	429	3,629


Totals:	$ 892	$ 2,677	$ 1,486	$ 557	$ 5,612

Financing Receivables:

Ending Balance: Individually evaluated for impairment	6,325	15,000	1,235	2,784	25,344

Ending Balance: Collectively evaluated for impairment	53,298	135,622	71,253	38,849	299,022

Totals:	$ 59,623	$ 150,622	$ 72,488	$ 41,633	$ 324,366

	Age Analysis of Past Due Financing Receivables as of September 30, 2012 (dollars in thousands)
2012	30-59 Days Past Due	60-89 Days Past Due	Greater than 90 Days	Total Past Due	Current	Total Financing Receivables	Recorded Investment > 90 Days & Accruing
Commercial	$ 40	$ -	$ 1,986	$ 2,026	$ 54,165	$ 56,191	$ -
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	993	869	173	2,035	59,774	61,809	-
Commercial Mortgages-Non-Owner Occupied	291	-	1,396	1,687	80,390	82,077	-
Commercial Construction	-	-	320	320	8,192	8,512	-
Consumer:
Consumer Unsecured	16	1	-	17	3,451	3,468	-
Consumer Secured	261	365	172	798	66,797	67,595	-
Residential:
Residential Mortgages	548	298	810	1,656	38,815	40,471	-
Residential Consumer Construction	-	-	-	-	4,282	4,282	-
Total	$ 2,149	$ 1,533	$ 4,857	$ 8,539	$ 315,866	$ 324,405	$ -

	Age Analysis of Past Due Financing Receivables as of December 31, 2011 (dollars in thousands)
2011	30-59 Days Past Due	60-89 Days Past Due	Greater than 90 Days	Total Past Due	Current	Total Financing Receivables	Recorded Investment > 90 Days & Accruing
Commercial	$ 532	$ 26	$ 3,570	$ 4,128	$ 55,495	$ 59,623	$ -
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	2,614	130	1,610	4,354	56,400	60,754	-
Commercial Mortgages-Non-Owner Occupied	504	72	2,793	3,369	74,520	77,889	-
Commercial Construction	782	-	424	1,206	10,773	11,979	-
Consumer:
Consumer Unsecured	6	-	-	6	3,231	3,237	-
Consumer Secured	202	277	415	894	68,357	69,251	-
Residential:
Residential Mortgages	523	162	863	1,548	37,450	38,998	-
Residential Consumer Construction	-	-	-	-	2,635	2,635	-
Total	$ 5,163	$ 667	$ 9,675	$ 15,505	$ 308,861	$ 324,366	$ -

Credit Loss Disclosures
Credit Quality Information - by Class
September 30, 2012
(dollars in thousands)
2012	Pass	Monitor	Special	Substandard	Doubtful	Totals
			Mention
Commercial	$ 49,387	$ 1,629	$ 2,019	$ 3,156	$ -	$ 56,191
Commercial Real Estate:
Commercial Mortgages0Owner Occupied	53,012	1,490	2,999	4,176	132	61,809
Commercial Mortgages0Non0Owner Occupied	69,622	2,178	4,262	6,015	-	82,077
Commercial Construction	6,289	-	-	2,223	-	8,512
Consumer
Consumer Unsecured	3,467	-	-	1	-	3,468
Consumer Secured	64,219	1,349	833	1,194	-	67,595
Residential:
Residential Mortgages	36,680	-	486	3,305	-	40,471
Residential Consumer Construction	4,282	-	-	-	-	4,282

Totals	$ 286,958	$ 6,646	$ 10,599	$ 20,070	$ 132	$ 324,405

Credit Loss Disclosures
Credit Quality Information - by Class
December 31, 2011
(dollars in thousands)
2011	Pass	Monitor	Special	Substandard	Doubtful	Totals
			Mention
Commercial	$ 47,021	$ 3,978	$ 2,901	$ 5,723	$ -	$ 59,623
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	48,622	3,003	4,696	4,283	150	60,754
Commercial Mortgages-Non Owner Occupied	63,934	3,326	3,159	7,470	-	77,889
Commercial Construction	9,000	176	-	2,803	-	11,979
Consumer
Consumer Unsecured	3,237	-	-	-	-	3,237
Consumer Secured	67,295	488	304	1,164	-	69,251
Residential:
Residential Mortgages	35,109	557	548	2,784	-	38,998
Residential Consumer Construction	2,635	-	-	-	-	2,635

Totals	$ 276,853	$ 11,528	$ 11,608	$ 24,227	$ 150	$ 324,366

Troubled Debt Restructurings

There were no loan modifications classified as TDRs during the three and nine months ended September 30, 2012.

There were no loan modifications classified as TDRs during the three months ended September 30, 2011. The following table describes the loan modifications classified as TDRs during the nine months ended September 30, 2011:


For the Nine Months Ended September 30, 2011
(dollars in thousands)
Troubled Debt Restructurings That Subsequently Defaulted	Number of Contracts	Pre-Modification Outstanding Recorded Investment	Post-Modification Outstanding Recorded Investment

Commercial	5	$ 3,345,376	$ 3,345,376

There were no loan modifications classified as TDRs within the last twelve months that defaulted during the three months ended September 30, 2012 and 2011.

The following table describes Troubled Debt Restructurings made within the last twelve months that defaulted during the nine months ended September 30, 2012 and 2011, respectively.


For the Nine Months Ended September 30, 2012
(dollars in thousands)
Troubled Debt Restructurings That Subsequently Defaulted	Number of Contracts	Recorded Investment

Commercial	4	$ 798



For the Nine Months Ended September 30, 2011
(dollars in thousands)
Troubled Debt Restructurings That Subsequently Defaulted	Number of Contracts	Recorded Investment

Commercial	1	$ 183
Consumer	1	30
Residential	2	482
Total	4	695