Note 4. Loans and Allowance

Major categories of loans are as follows:

	2011			2010			2009
Mortgage:
Residential	$	107,664,598		$	102,199,134		$	95,683,441
Commercial		67,655,908			72,669,909			79,845,030
Construction and land development		5,091,870			5,363,232			1,742,515
Demand and time		7,193,074			7,193,070			9,800,625
Installment		50,118,030			46,860,351			53,222,692
		237,723,480			234,285,696			240,294,303
Unearned income on loans		(1,058,299	)		(1,035,292	)		(838,913	)
		236,665,181			233,250,404			239,455,390
Allowance for credit losses		(3,930,924	)		(3,399,516	)		(3,572,528	)

	$	232,734,257		$	229,850,888		$	235,882,862

The Bank has an automotive indirect lending program where vehicle collateralized loans made by dealers to consumers are acquired by the Bank. The Bank’s installment loan portfolio included approximately $31,907,000, $30,286,000, and $37,092,000 of such loans at December 31, 2011, 2010, and 2009, respectively.

The Bank makes loans to customers located primarily in Anne Arundel County and surrounding areas of Central Maryland. Although the loan portfolio is diversified, its performance will be influenced by the economy of the region.

Executive officers, directors, and their affiliated interests enter into loan transactions with the Bank in the ordinary course of business. These loans are made on the same terms, including interest rates and collateral, as those prevailing at the time for comparable loans with unrelated borrowers. They do not involve more than normal risk of collectibility or present other unfavorable terms. At December 31, 2011, 2010, and 2009, the amounts of such loans outstanding totaled $4,887,753, $5,109,539, and $5,137,397, respectively. During 2011, loan additions and repayments totaled $1,453,522 and $1,675,308, respectively.

Allowance for Loan Losses

Management has an established methodology 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 the loan portfolio into the following classifications:

Commercial and Industrial;

Commercial Real Estate;

Consumer and Indirect;

Residential Real Estate.

Each of these segments are reviewed and analyzed quarterly using the average historical charge-offs over a current three year period for their respective segments as well as the following qualitative factors:

Changes in the levels and trends in delinquencies, nonaccruals, classified assets and troubled debt restructurings

Changes in the nature and volume of the portfolio

Effects of any changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices

Changes in the experience, ability, and depth of management and staff

Changes in national and local economic conditions and developments, including the condition of various market segments

Changes in the concentration of credits within each pool

Changes in the quality of the Bank’s loan review system and the degree of oversight by the Board

Changes in external factors such as competition and the legal environment including Regulation B

Changes in the underlying collateral for collateral dependent loans

The above factors result in a FAS 5, as codified in FASB ASC 450-10- 20, calculated reserve for environmental factors.

All credit exposures graded at or above a rating of “4” with outstanding balances (see ratings on page 21) are to be reviewed no less than quarterly for the purpose of determining if a specific allocation is needed for that credit. The determination for a specific reserve is evaluated relative to the general reserve factor for assets of the same type and grade. If a specific reserve is appropriate and exceeds the general reserve factor, a specific reserve is to be established. Otherwise, the asset is included in the portfolio of assets that comprise the base upon which the general reserve is calculated. The establishment of a specific reserve does not necessarily mean that the credit with the specific reserve will definitely incur loss at the reserve level. It is only an estimation of potential loss based upon anticipated events. A specific reserve will not be established unless loss elements can be determined and quantified based on known facts. The total allowance reflects management’s estimate of loan losses inherent in the loan portfolio as of December 31, 2011.

The following table presents the total allowance by loan segment:

	Commercial						Consumer
	and			Commercial			and			Residential
2011	Industrial			Real Estate			Indirect			Real Estate			Unallocated			Total

Balance, beginning of year	$	263,251		$	2,108,223		$	829,517		$	196,275		$	2,250		$	3,399,516
Provision for credit losses		295,525			(165,691	)		256,886			402,163			(125,883	)		663,000
Recoveries		4,010			70,430			408,889			1,475			-			484,804
Loans charged off		(5,617	)		-			(606,678	)		(4,101	)		-			(616,396	)

Balance, end of year	$	557,169		$	2,012,962		$	888,614		$	595,812		$	(123,633	)	$	3,930,924

Individually evaluated for impairment:
Balance in allowance	$	455,735		$	1,641,711		$	44,235		$	411,423		$	-		$	2,553,104
Related loan balance		730,061			6,502,986			100,455			1,703,322			-			9,036,824

Collectively evaluated for impairment:
Balance in allowance	$	101,434		$	371,251		$	844,379		$	184,389		$	(123,633	)	$	1,377,820
Related loan balance		6,463,013			64,570,908			50,017,575			107,635,160			-			228,686,656

	Commercial						Consumer
	and			Commercial			and			Residential
2010	Industrial			Real Estate			Indirect			Real Estate			Unallocated			Total

Balance, beginning of year	$	237,461		$	2,380,024		$	842,901		$	162,142		$	(50,000	)	$	3,572,528
Provision for credit losses		(7,822	)		542,416			448,197			14,959			52,250			1,050,000
Recoveries		45,731			10,593			497,479			85,195			-			638,998
Loans charged off		(12,119	)		(824,810	)		(959,060	)		(66,021	)		-			(1,862,010	)

Balance, end of year	$	263,251		$	2,108,223		$	829,517		$	196,275		$	2,250		$	3,399,516

Individually evaluated for impairment:
Balance in allowance	$	180,736		$	1,691,887		$	20,000		$	32,146		$	-		$	1,924,769
Related loan balance		481,847			6,605,317			77,358			427,204			-			7,591,726

Collectively evaluated for impairment:
Balance in allowance	$	82,515		$	416,336		$	809,517		$	164,129		$	2,250		$	1,474,747
Related loan balance		6,711,223			69,844,314			46,782,993			103,355,240			-			226,693,770

	2009
Balance, beginning of year	$	2,021,690
Provision for credit losses		2,442,976
Recoveries		395,584
Loans charged off		(1,287,722	)

Balance, end of year	$	3,572,528

Credit Quality Information

The following table represents credit exposures by creditworthiness category for the year ending December 31, 2011. The use of creditworthiness categories to grade loans permits management to estimate a portion of credit risk. The Bank’s internal creditworthiness is based on experience with similarly graded credits. Loans that trend upward toward higher credit grades typically have less credit risk and loans that migrate downward typically have more credit risk.

The Bank’s internal risk ratings are as follows:

Superior – minimal risk. (normally supported by pledged deposits, United States government securities, etc.)

Above Average – low risk. (all of the risks associated with this credit based on each of the bank’s creditworthiness criteria are minimal)

Average – moderately low risk. (most of the risks associated with this credit based on each of the bank’s creditworthiness criteria are minimal)

Acceptable – moderate risk. (the weighted overall risk associated with this credit based on each of the bank’s creditworthiness criteria is acceptable)

Other Assets Especially Mentioned – moderately high risk. (possesses deficiencies which corrective action by the bank would remedy; potential watch list)

Substandard – (the bank is inadequately protected and there exists the distinct possibility of sustaining some loss if not corrected)

Doubtful – (weaknesses make collection or liquidation in full, based on currently existing facts, improbable)

Loss – (of little value; not warranted as a bankable asset)

Loans rated 1-4 are considered “Pass” for purposes of the risk rating chart below.

Risk ratings of loans by categories of loans are as follows:

	Commercial				Consumer
	and		Commercial		and		Residential
2011	Industrial		Real Estate		Indirect		Real Estate		Total

Pass	$	5,882,615	$	58,798,799	$	48,528,582	$	106,301,944		219,511,940
Special mention		327,048		4,736,458		1,324,580		1,333,217		7,721,303
Substandard		983,411		7,538,637		190,044		1,703,321		10,415,413
Doubtful		-		-		74,824		-		74,824
Loss		-		-		-		-		-

	$	7,193,074	$	71,073,894	$	50,118,030	$	109,338,482	$	237,723,480

Non-accrual		20,286		4,484,260		74,824		481,323		5,060,693
Troubled debt restructures		9,491		2,818,295		-		1,280,423		4,108,209
Number of TDRs contracts		1		1		-		1		3
Non-performing TDRs		-		2,818,295		-		-		2,818,295
Number of TDR accounts		-		1		-		-		1

	Commercial				Consumer
	and		Commercial		and		Residential
2010	Industrial		Real Estate		Indirect		Real Estate		Total

Pass	$	5,852,779	$	66,763,903	$	44,931,931	$	102,281,090	$	219,829,703
Special mention		642,248		686,338		1,543,756		809,127		3,681,469
Substandard		698,043		8,999,390		259,939		692,427		10,649,799
Doubtful		-		-		124,725		-		124,725
Loss		-		-		-		-		-

	$	7,193,070	$	76,449,631	$	46,860,351	$	103,782,644	$	234,285,696

Non-accrual		1,359,554		4,522,246		124,925		976,279		6,983,004
Troubled debt restructures		35,711		2,808,466		-		-		2,844,177
Number of TDRs accounts		1		1		-		-		2

At December 31, 2011, the recorded investment in new troubled debt restructurings totaled $1,280,423. During 2011, this troubled debt restructuring has continued to perform under the terms of the modified agreement.

At December 31, 2010, the recorded investment in new troubled debt restructurings totaled $0. During 2010, one troubled debt restructuring transpired totaling $2,808,466, however did not perform under the terms of the modified agreement and is included in impaired and nonaccrual loans.

The Bank has no commitments to loan additional funds to the borrowers of restructured, impaired, or non-accrual loans.

Current, past due, and nonaccrual loans by categories of loans are as follows:

					90 Days or
			30-89 Days		More and
2011	Current		Past Due		Still Accruing		Nonaccrual		Total

Commercial and industrial	$	7,134,672	$	38,116	$	-	$	20,286	$	7,193,074
Commercial real estate		66,589,634		-		-		4,484,260		71,073,894
Consumer and indirect		48,744,945		1,298,261		-		74,824		50,118,030
Residential real estate		108,703,963		134,591		18,605		481,323		109,338,482

	$	231,173,214	$	1,470,968	$	18,605	$	5,060,693	$	237,723,480

					90 Days or
			30-89 Days		More and
2010	Current		Past Due		Still Accruing		Nonaccrual		Total

Commercial and industrial	$	5,735,517	$	97,999	$	-	$	1,359,554	$	7,193,070
Commercial real estate		70,675,983		1,251,402		-		4,522,246		76,449,631
Consumer and indirect		45,155,344		1,580,082		-		124,925		46,860,351
Residential real estate		102,706,757		99,608		-		976,279		103,782,644

	$	224,273,601	$	3,029,091	$	-	$	6,983,004	$	234,285,696

Loans on which the accrual of interest has been discontinued totaled $5,060,693, $6,983,004, and $3,016,727 at December 31, 2011, 2010, and 2009, respectively. Interest that would have been accrued under the terms of these loans totaled $268,407, $145,148, and $105,365 for the years ended December 31, 2011, 2010, and 2009, respectively. Loans past due 90 days or more and still accruing interest totaled $18,605, $0 and $0 at December 31, 2011, 2010 and 2009, respectively.

Non-accrual loans with specific reserves at December 31, 2011 are comprised of:

Commercial loans – Two loans to one borrower totaling $20,286 with $20,286 of specific reserves established.

Residential Real Estate – One loan secured by residential property in the amount of $239,364 with a specific reserve established for this loan in the amount of $26,000.

Commercial Real Estate – Three loans to two borrowers in the amount of $4,484,261 secured by commercial and/or residential properties with specific reserves of $1,142,032 established for the loans.

Impaired Loans

When management identifies a loan as impaired, the impairment is measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, except when the sole (remaining) source of repayment for the loan is the operation or liquidation of the collateral. In these cases management used the current fair value of the collateral, less selling cost when foreclosure is probable, instead of discounted cash flows. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance.

When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is on nonaccrual status, all payments are applied to principal, under the cost recovery method. When the ultimate collectability of the total principal of an impaired loan is not in doubt and the loan is on nonaccrual status, contractual interest is credited to interest income when received, under the cash basis method.

The following table includes the recorded investment and unpaid principal balances for impaired financing receivables with the associated allowance amount, if applicable. Management determined the specific reserve in the allowance based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, except when the remaining source of repayment for the loan is the operation or liquidation of the collateral. In those cases, the current fair value of the collateral, less selling costs was used to determine the specific allowance recorded.

Also presented are the average recorded investments in the impaired loans and the related amount of interest recognized during the time within the period that the impaired loans were impaired. When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is on nonaccrual status, all payments are applied to principal, under the cost recovery method.

			Unpaid		Interest				Average
	Recorded		Principal		Income		Specific		Recorded
2011	Investment		Balance		Recognized		Reserve		Investment
Impaired loans with specific reserves:
Real-estate - mortgage:
Residential	$	1,703,322		1,703,322		62,320		411,423		1,708,158
Commercial		6,502,986		7,102,986		218,564		1,641,711		6,559,298
Consumer		100,455		100,455		10,423		44,235		103,733
Installment		-		-		-		-		-
Home Equity		-		-		-		-		-
Commercial		730,061		730,061		40,445		455,735		755,371
Total impaired loans with specific reserves	$	9,036,824		9,636,824		331,752		2,553,104		9,126,560

Impaired loans with no specific reserve:
Real-estate - mortgage:
Residential	$	260,564		260,564		7,149		n/a		245,128
Commercial		1,035,652		1,035,652		50,036		n/a		1,051,139
Consumer		25,000		25,000		-		n/a		-
Installment		264,868		264,868		-		n/a		-
Home Equity		-		-		-		n/a		-
Commercial		253,350		253,350		20,937		n/a		303,606
Total impaired loans with no specific reserve	$	1,839,434		1,839,434		78,122		-		1,599,873

			Unpaid		Interest				Average
	Recorded		Principal		Income		Specific		Recorded
2010	Investment		Balance		Recognized		Reserve		Investment
Impaired loans with specific reserves:
Real-estate - mortgage:
Residential	$	427,204		427,204		19,326		32,146		431,575
Commercial		6,605,317		7,205,317		417,554		1,691,887		6,513,982
Consumer		77,358		77,358		2,605		20,000		77,358
Installment		-		-		-		-		-
Home Equity		-		-		-		-		-
Commercial		481,847		481,847		30,651		180,736		502,870
Total impaired loans with specific reserves	$	7,591,726		8,191,726		470,136		1,924,769		7,525,785

Impaired loans with no specific reserve:
Real-estate - mortgage:
Residential	$	230,947		230,947		12,204		n/a		231,090
Commercial		2,394,073		2,394,073		67,082		n/a		3,285,175
Consumer		389,217		389,217		-		n/a		513,901
Installment		-		-		-		n/a		-
Home Equity		-		-		-		n/a		-
Commercial		853,485		853,485		45,407		n/a		973,839
Total impaired loans with no specific reserve	$	3,867,722		3,867,722		124,693		-		5,004,005