Note 5 - Loans and allowance for loan losses

The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management’s judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

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 – owned occupied Commercial mortgages – non-owned occupied Commercial construction
Consumer	Consumer unsecured Consumer secured
Residential	Residential mortgages Residential consumer construction

The evaluation also considers the following risk characteristics of each loan segment:

Commercial loans carry risks associated with the successful operation of a business because the repayment of these loans may be dependent upon the profitability and cash flows of the business or project. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much precision.

Commercial real estate loans carry risks associated with a real estate project and other risks associated with the ownership of real estate. In addition, for real estate construction loans there is a risk that the project will not be finished according to schedule, the project will not be finished according to budget and the value of the collateral may, at any point in time, be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure unrelated to the project.

Consumer loans carry risks associated with the continued credit-worthiness of the borrower and the value of the collateral (e.g., rapidly-depreciating assets such as automobiles), or lack thereof. Consumer loans are more likely than real estate loans to be immediately adversely affected by job loss, divorce, illness or personal bankruptcy. Unsecured consumer loans carry additional risks associated with the continued credit-worthiness of borrowers who may be unable to meet payment obligations.

Residential mortgage and construction loans carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral. Equity lines of credit carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral.

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

Based on the above criteria, we segregate loans into the above categories for special mention, substandard, doubtful and loss from non-classified, or pass rated, loans. 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 provide 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 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.

The Bank grants primarily commercial, real estate, and installment loans to customers throughout its market area, which consists primarily of Region 2000 which includes the counties of Amherst, Appomattox, Bedford and Campbell and the cities of Bedford and Lynchburg, Virginia. The real estate portfolio can be affected by the condition of the local real estate market. The commercial and installment loan portfolio can be affected by the local economic conditions.

A summary of loans, net is as follows:

	December 31,
	2012	2011

Commercial	$ 55,084	$ 59,623
Commercial real estate	153,416	150,622
Consumer	70,639	72,488
Residential	46,318	41,633

Total loans	325,457	324,366

Less allowance for loan losses	5,535	5,612

Net loans	$ 319,922	$ 318,754

The amount of overdrafts reclassified as loans was $11 and $14 as of December 31, 2012 and 2011, respectively.

The Company’s officers, directors and their related interests have various types of loan relationships with the Bank. The total outstanding balances of these related party loans at December 31, 2012 and 2011 were $9,606 and $9,187 respectively (the December 31, 2011 balance has been adjusted to reflect executive officers added during 2012). During 2012, new loans and advances amounted to $3,186 and repayments amounted to $2,767. Management believes the terms and interest rates of these loans are similar to those for comparable loans with other borrowers of the Bank.

The following tables set forth information regarding impaired and non-accrual loans as of December 31, 2012 and 2011:

Financing Receivables on Non-Accrual Status
(Dollars in Thousands)

	As of December 31,
	2012	2011
Commercial	$ 2,100	$ 3,570
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	1,431	1,610
Commercial Mortgages-Non-Owner Occupied	853	2,793
Commercial Construction	849	782
Consumer
Consumer Unsecured	-	-
Consumer Secured	-	415
Residential:
Residential Mortgages	1,113	1,205
Residential Consumer Construction	-	-

Totals	$ 6,346	$ 10,375


		Impaired Loans
		For the Period Ending December 31, 2012
			Unpaid		Average	Interest
		Recorded	Principal	Related	Recorded	Income
2012		Investment	Balance	Allowance	Investment	Recognized
With No Related Allowance Recorded:
	Commercial	$ 2,530	$ 2,683	$ -	$ 2,944	$ 30
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	2,592	2,754	-	2,402	167
	Commercial Mortgage Non-Owner Occupied	6,369	6,528	-	5,625	330
	Commercial Construction	740	742	-	922	52
	Consumer
	Consumer Unsecured	-	-	-	-	-
	Consumer Secured	469	554	-	381	34
	Residential
	Residential Mortgages	2,138	2,263	-	1,500	112
	Residential Consumer Construction	-	-	-	-	-

With an Allowance Recorded:
	Commercial	$ 620	$ 780	$ 373	$ 1,794	$ 42
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	3,671	3,869	525	3,094	226
	Commercial Mortgage Non-Owner Occupied	840	842	189	1,715	42
	Commercial Construction	823	1,048	94	1,262	2
	Consumer
	Consumer Unsecured	1	1	1	1	-
	Consumer Secured	530	530	195	736	35
	Residential
	Residential Mortgages	1,015	1,303	160	1,469	42
	Residential Consumer Construction	-	-	-	-	-

Totals:
	Commercial	$ 3,150	$ 3,463	$ 373	$ 4,738	$ 72
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	6,263	6,623	525	5,496	393
	Commercial Mortgage Non-Owner Occupied	7,209	7,370	189	7,340	372
	Commercial Construction	1,563	1,790	94	2,184	54
	Consumer
	Consumer Unsecured	1	1	1	1	-
	Consumer Secured	999	1,084	195	1,117	69
	Residential
	Residential Mortgages	3,153	3,566	160	2,969	154
	Residential Consumer Construction	-	-	-	-	-
		$ 22,338	$ 23,897	$ 1,537	$ 23,845	$ 1,114

		Impaired Loans
		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

The following tables sets forth the allowance for loan losses activity for the years ended December 31, 2012 and 2011:

Allowance for Credit Losses and Recorded Investment in Financing Receivables

For the Year Ended December 31, 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	(739)	(1,061)	(697)	(102)	(2,599)
Recoveries	18	129	77	9	233
Provision	816	1,104	191	178	2,289
Ending Balance	$ 987	$ 2,849	$ 1,057	$ 642	$ 5,535

Ending Balance: Individually evaluated for impairment	$ 373	$ 808	$ 196	$ 160	$ 1,537

Ending Balance: Collectively evaluated for impairment	614	2,041	861	482	3,998


Totals:	$ 987	$ 2,849	$ 1,057	$ 642	$ 5,535

Financing Receivables:

Ending Balance: Individually evaluated for impairment	$ 3,150	$ 15,035	$ 1,000	$ 3,153	$ 22,338

Ending Balance: Collectively evaluated for impairment	51,934	138,381	69,639	43,165	303,119

Totals:	$ 55,084	$ 153,416	$ 70,639	$ 46,318	$ 325,457

Allowance for Credit Losses and Recorded Investment in Financing Receivables

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 December 31, 2012
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	$ 223	$ 14	$ 2,100	$ 2,337	$ 52,747	$ 55,084	$ -
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	351	-	168	519	59,412	59,931	-
Commercial Mortgages-Non-Owner Occupied	559	50	853	1,462	82,654	84,116	-
Commercial Construction	547	-	849	1,396	7,973	9,369	-
Consumer:
Consumer Unsecured	2	8	-	10	3,494	3,504	-
Consumer Secured	193	-	-	193	66,942	67,135	-
Residential:
Residential Mortgages	590	68	472	1,130	40,290	41,420	-
Residential Consumer Construction	-	-	-	-	4,898	4,898	-
Total	$ 2,465	$ 140	$ 4,442	$ 7,047	$ 318,410	$ 325,457	$ -

Age Analysis of Past Due Financing Receivables as of December 31, 2011
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

December 31, 2012

2012	Pass	Monitor	Special	Substandard	Doubtful	Totals
			Mention
Commercial	$ 49,162	$ 1,422	$ 1,350	$ 3,150	$ -	$ 55,084
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	49,717	2,952	1,000	6,262	-	59,931
Commercial Mortgages-Non-Owner Occupied	72,120	2,212	2,576	7,208	-	84,116
Commercial Construction	7,806	-	-	1,563	-	9,369
Consumer
Consumer Unsecured	3,503	-	-	1	-	3,504
Consumer Secured	63,948	1,343	867	977	-	67,135
Residential:
Residential Mortgages	37,784	-	483	3,153	-	41,420
Residential Consumer Construction	4,898	-	-	-	-	4,898

Totals	$ 288,938	$ 7,929	$ 6,276	$ 22,314	$ -	$ 325,457

Credit Loss Disclosures

Credit Quality Information - by Class

December 31, 2011

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 (TDRs)

For the Year Ended December 31, 2012
Troubled Debt Restructurings	Number of Contracts	Pre-Modification Outstanding Recorded Investment	Post-Modification Outstanding Recorded Investment

Commercial Real Estate	3	$572	$572

The two contracts above were modified in the form of interest rate reductions. After modification, each loan was individually reevaluated for impairment. As a result of the evaluation, it was determined that there was no additional impact to the allowance for loan loss.

For the Year Ended December 31, 2012
Troubled Debt Restructurings That Subsequently Defaulted	Number of Contracts	Recorded Investment

Commercial Real Estate	3	$ 798

For the Year Ended December 31, 2011
Troubled Debt Restructurings	Number of Contracts	Pre-Modification Outstanding Recorded Investment	Post-Modification Outstanding Recorded Investment

Commercial Real Estate	5	$2,718	$2,718

The five contracts referenced above were modified in the form of interest rate reductions. After modification, each loan was individually reevaluated for impairment. As a result of the evaluation, it was determined that there was no additional impact to the allowance for loan loss.


For the Year Ended December 31, 2011
Troubled Debt Restructurings That Subsequently Defaulted	Number of Contracts	Recorded Investment

Commercial	2	$ 3,596
Consumer	1	30
Total	3	$ 3,626