Note 4. Loans and Allowance for Loan Losses

The following table sets forth the Company's gross loans by major categories as of December 31, 2019 and 2018:


	December 31,
(dollars in thousands)	2019		2018

Consumer	$	12,076	$	13,071
Residential real estate		81,033		82,637
Indirect		102,384		116,698
Commercial		11,907		14,284
Construction		3,317		2,317
Commercial real estate		74,021		70,113
Total loans receivable		284,738		299,120
Allowance for loan losses		(2,066)		(2,541)
Net loans receivable	$	282,672	$	296,579

The Company disaggregates its loan portfolio into groups of loans with similar risk characteristics for purposes of estimating the allowance for loan losses and monitoring and assessing credit quality.

The Company's loan groups include consumer, residential real estate, indirect automobile, commercial, construction and commercial real estate. 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 indirect loan group included $102.4 million and $116.7 million of such loans at December 31, 2019 and 2018, 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.

Included in loans are loans due from directors, executive officers and other related parties of $0.4 million at December 31, 2019, and $0.5 million at December 31, 2018. 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. The Board of Directors approves loans to directors, executive officers and other related parties to confirm that collateral requirements, terms and rates are comparable to other borrowers and are in compliance with underwriting policies. The following presents the activity in amount due from directors and other related parties for the years ended December 31, 2019 and 2018.


	December 31,
(dollars in thousands)	2019		2018

Balance at beginning of year	$	504	$	403
Additions		582		468
Repayments		(715)		(367)
Balance at end of year	$	371	$	504

Allowance for Loan Losses

To control and monitor credit risk, management has an internal credit process in place to determine whether credit standards are maintained along with in-house loan administration accompanied by oversight and review procedures. Oversight and review procedures include the monitoring of the portfolio credit quality, early identification of potential problem credits and the management of problem credits. As part of the oversight and review process, the Company maintains an allowance for loan losses to absorb estimated and probable 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:

Consumer

Residential Real Estate

Indirect

Commercial

Construction

Commercial Real Estate

The analysis for determining the allowance is consistent with guidance set forth in GAAP and the Interagency Policy Statement on the Allowance for Loan and Lease Losses. Pursuant to Bank policy, the allowance is evaluated quarterly by management and is based upon management's review of the collectability of loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrowers' ability to repay, estimated value of any underlying collateral and prevailing economic conditions. Each loan segment is reviewed and analyzed using the average historical charge-offs over the current and preceding four-year periods for their respective segments as well as the following qualitative factors:

Changes in asset quality including past due (30 ‑ 89 days) loans, nonaccrual loans, classified assets, watch list loans all in relation to total loans. Also policy exceptions in relationship to loan volume.

Changes in the rate and direction of the loan volume of the portfolio.

Concentration of credit including the percentage, changes, and relative to goals.

Changes in macro-economic factors including the rates and direction of unemployment, median income and population.

Changes in internal factors including external loan review required reserve changes, internal review penetration, internal required reserve changes and weighted required reserve trends.

Changes in the charge offs and recoveries adjusted for rate and direction.

The allowance consists of specific and general reserves. The specific reserves relate to loans classified as impaired, primarily including nonaccrual and troubled debt restructurings (“TDRs”). The reserve for these loans is established when the discounted cash flows, collateral value, or observable market price, whichever is appropriate, of the impaired loan is lower than the carrying value. For impaired loans, any measured impairment is charged off against the loan and allowance for those loans that are collateral dependent in the applicable reporting period.

The general reserve covers loans that are not classified as impaired and primarily includes new loan originations. The general reserve requirement is based on historical loss experience and the qualitative factors noted above that have been determined to have an effect on the probability and magnitude of a loss.

The following table presents the total allowance by loan segment:



December 31, 2019			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Total

Balance, beginning of year	$	161	$	864	$	988	$	241	$	4	$	283	$	2,541
Charge-offs		(69)		(16)		(504)		(27)		—		—		(616)
Recoveries		16		5		225		10		—		—		256
Provision for loan losses		14		(264)		208		(186)		7		106		(115)

Balance, end of year	$	122	$	589	$	917	$	38	$	11	$	389	$	2,066

Individually evaluated for impairment:
Balance in allowance	$	15	$	—	$	—	$	—	$	—	$	—	$	15
Related loan balance		86		631		—		—		—		3,680		4,397

Collectively evaluated for impairment:
Balance in allowance	$	107	$	589	$	917	$	38	$	11	$	389	$	2,051
Related loan balance		11,990		80,402		102,384		11,907		3,317		70,341		280,341



December 31, 2018			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Total

Balance, beginning of year	$	214	$	1,061	$	774	$	237	$	12	$	291	$	2,589
Charge-offs		(208)		(589)		(341)		—		—		(13)		(1,151)
Recoveries		48		2		183		14		—		—		247
Provision for loan losses		107		390		372		(10)		(8)		5		856

Balance, end of year	$	161	$	864	$	988	$	241	$	4	$	283	$	2,541

Individually evaluated for impairment:
Balance in allowance	$	22	$	—	$	—	$	204	$	—	$	—	$	226
Related loan balance		138		854		—		204		—		1,054		2,250

Collectively evaluated for impairment:
Balance in allowance	$	139	$	864	$	988	$	37	$	4	$	283	$	2,315
Related loan balance		12,933		81,783		116,698		14,080		2,317		69,059		296,870

Management believes the allowance for loan losses is at an appropriate level to absorb inherent probable losses in the portfolio.

The following table rolls forward the Company’s activity for nonaccrual loans during the years 2019 and 2018:




		Residential				Commercial
	Consumer	Real Estate	Indirect	Commercial	Construction	Real Estate	Totals
(dollars in thousands)
December 31, 2017	185	2,124	88	48	318	507	3,270
Transfers into nonaccrual	290	246	636	27	—	2,295	3,494
Transfers to OREO	—	—	—	—	—	—	—
Loans paid down/payoffs	(27)	(633)	(132)	(48)	(318)	(2,077)	(3,235)
Loans returned to accrual status	(58)	(192)	(135)	—	—	(63)	(448)
Loans charged off	(204)	(589)	(341)	—	—	—	(1,134)

December 31, 2018	186	956	116	27	—	662	1,947
Transfers into nonaccrual	135	571	702	86	—	2,746	4,240
Transfers to OREO	—	—	—	—	—	—	—
Loans paid down/payoffs	(55)	(782)	(76)	(86)	—	(269)	(1,268)
Loans returned to accrual status	(88)	—	(133)	—	—	—	(221)
Loans charged off	(41)	(17)	(486)	(27)	—	—	(571)

December 31, 2019	137	728	123	—	—	3,139	4,127

Credit Quality Information

In addition to monitoring the performance status of the loan portfolio, the Company utilizes a risk rating scale (1-8) to evaluate loan asset quality for all loans. Loans that are rated 1-4 are classified as “pass” credits. For the pass rated loans, management believes there is a low risk of loss related to these loans and as necessary, credit may be strengthened through improved borrower performance and/or additional collateral. Loans rated a 5 (Special Mention) are pass credits, but are loans that have been identified that warrant additional attention and monitoring and represent “criticized” assets. Loans rated a 6 (Substandard) or higher are considered “criticized” loans and represent an increased level of credit risk. The use and application of these risk ratings by the Bank conform to the Bank's policy and regulatory definitions.

The Bank’s internal risk ratings are as follows:

1 – 4 (Pass) - Pass credits are loans in grades “superior” through “acceptable”. These are at least considered to be credits with acceptable risks and would be granted in the normal course of lending operations.

5 (Special Mention) - Special mention credits have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the credits or in the Bank’s credit position at some future date. If weaknesses cannot be identified, classifying as special mention is not appropriate. Special mention credits are not adversely classified and do not expose the Bank to sufficient risk to warrant an adverse classification. No apparent loss of principal or interest is expected.

6 (Substandard) - Substandard credits are inadequately protected by the current worth and paying capacity of the obligor or by the collateral pledged. Financial statements normally reveal some or all of the following: poor trends, lack of earnings and cash flow, excessive debt, lack of liquidity, and the absence of creditor protection. Credits so classified must have a well-defined weakness, or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

7 (Doubtful) - A doubtful credit has all the weaknesses inherent in a substandard asset 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, but because of certain important and reasonably specific pending factors that may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral, and refinancing plans. Doubtful classification for an entire credit should be avoided when collection of a specific portion appears highly probable with the adequately secured portion graded Substandard.

In the normal course of loan portfolio management, loan originators are responsible for continuous assessment of credit risk arising from the individual borrowers within their portfolio and assigning appropriate risk ratings. Credit Administration is responsible for ensuring the integrity and operation of the risk rating system and maintenance of the watch list. The Bank contracts with an independent 3rd party loan review firm that reviews and validates the internal credit risk program on an annual basis. Results of these reviews are presented to the Audit Committee for approval and then to management for implementation. The loan review process compliments and reinforces the risk identification and assessment decisions made by the lenders and credit personnel as well as the Bank’s policies and procedures.

The following table provides information with respect to the Company's risk ratings by loan portfolio segment:



December 31, 2019			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate			Total

Pass	$	11,939	$	80,305	$	102,261	$	11,907	$	3,317	$	70,341	$	280,070
Special mention		—		—		—		—		—		—		—
Substandard		137		728		44		—		—		3,680		4,589
Doubtful		—		—		79		—		—		—		79
Loss		—		—		—		—		—		—		—

	$	12,076	$	81,033	$	102,384	$	11,907	$	3,317	$	74,021	$	284,738

Nonaccrual		137		728		123		—		—		3,139		4,127
Troubled debt restructures		41		—		—		—		—		—		41
Number of TDRs accounts		1		—		—		—		—		—		1
Non-performing TDRs		41		—		—		—		—		—		41
Number of non-performing TDR accounts		1		—		—		—		—		—		1



December 31, 2018			Residential								Commercial
(dollars in thousands)	Consumer		Real Estate		Indirect		Commercial		Construction		Real Estate		Total

Pass	$	12,888	$	82,111	$	115,724	$	14,284	$	2,317	$	69,900	$	297,224
Special mention		—		424		645		—		—		—		1,069
Substandard		183		102		244		—		—		213		742
Doubtful		—		—		85		—		—		—		85
Loss		—		—		—		—		—		—		—

	$	13,071	$	82,637	$	116,698	$	14,284	$	2,317	$	70,113	$	299,120

Nonaccrual		186		956		116		27		—		662		1,947
Troubled debt restructures		44		—		—		204		—		—		248
Number of TDRs accounts		1		—		—		1		—		—		2
Non-performing TDRs		44		—		—		—		—		—		44
Number of non-performing TDR accounts		1		—		—		—		—		—		1

Troubled Debt Restructurings

The restructuring of a loan constitutes a TDR if the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider in the normal course of business. A concession may include an extension of repayment terms which would not normally be granted, a reduction of interest rate or the forgiveness of principal and/or accrued interest. If the debtor is experiencing financial difficulty and the creditor has granted a concession, the Company will make the necessary disclosures related to the TDR. In certain cases, a modification may be made in an effort to retain a customer who is not experiencing financial difficulty. This type of modification is not considered to be a TDR. Once a loan has been modified and is considered a TDR, it is reported as an impaired loan. All TDRs are evaluated individually for impairment on a quarterly basis as part of the allowance for credit losses calculation. A specific allowance for TDR loans is established when the discounted cash flows, collateral value or observable market price, whichever is appropriate, of the TDR is lower than the carrying value. If a loan deemed a TDR has performed for at least six months at the level prescribed by the modification, it is not considered to be non-performing; however, it will generally continue to be reported as impaired, but may be returned to accrual status. A TDR is deemed in default on its modified terms once a contractual payment is 30 or more days past due.

There were no new loans modified as TDRs for the years ended December 31, 2019 and 2018.

At December 31, 2019, the recorded investment in TDR’s reflected one loan in the amount of $40,951 which is on nonaccrual. At December 31, 2018, the recorded investment in TDR’s reflected one loan in the amount of $204,500 which is performing under the terms of the modified agreement and one loan in the amount of $43,521 which was on nonaccrual.

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

Asset Quality

The following table presents the loan portfolio segments summarized by aging categories of performing loans and nonaccrual loans as of December 31, 2019 and 2018:


					90 Days or
			30-89 Days		More and
December 31, 2019	Current		Past Due		Still Accruing		Nonaccrual		Total
(dollars in thousands)
Consumer	$	11,865	$	74	$	—	$	137	$	12,076
Residential Real Estate		80,192		92		21		728		81,033
Indirect		101,605		656		—		123		102,384
Commercial		11,907		—		—		—		11,907
Construction		3,317		—		—		—		3,317
Commercial Real Estate		70,882		—		—		3,139		74,021

	$	279,768	$	822	$	21	$	4,127	$	284,738


					90 Days or
			30-89 Days		More and
December 31, 2018	Current		Past Due		Still Accruing		Nonaccrual		Total
(dollars in thousands)
Consumer	$	12,669	$	216	$	—	$	186	$	13,071
Residential Real Estate		80,923		732		26		956		82,637
Indirect		115,890		692		—		116		116,698
Commercial		14,171		86		—		27		14,284
Construction		2,317		—		—		—		2,317
Commercial Real Estate		69,451		—		—		662		70,113

	$	295,421	$	1,726	$	26	$	1,947	$	299,120

Loans on which the accrual of interest has been discontinued totaled $4.1 million and $1.9 million at December 31, 2019 and 2018, respectively. The Bank recognizes interest income on non-accrual loans using a cash basis method for the time they are on non-accrual. Interest income that was recognized on these non-accrual loans totaled $0.1 million and $0.2 million for the years ended December 31, 2019 and 2018. Loans past due 90 days or more and still accruing interest totaled $21,000, and $26,000 at December 31, 2019 and 2018, respectively. Management believes these particular loans are well secured and in the process of full collection of all amounts owed.

Nonaccrual loans with specific reserves at December 31, 2019 are comprised of:

Consumer – One loan to in the amount of $40,951 with $14,655 of specific reserves established for the loans.

Impaired Loans

The following table presents information with respect to impaired loans. 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 estimated selling costs is used to determine the specific allowance recorded.



			Unpaid		Interest				Average
December 31, 2019	Recorded		Principal		Income		Specific		Recorded
(dollars in thousands)	Investment		Balance		Recognized		Reserve		Investment
Impaired loans with specific reserves:
Consumer	$	26	$	41	$	2	$	15	$	50
Residential Real Estate		—		—		—		—		—
Indirect		—		—		—		—		—
Commercial		—		—		—		—		—
Construction		—		—		—		—		—
Commercial Real Estate		—		—		—		—		—
Total impaired loans with specific reserves	$	26	$	41	$	2	$	15	$	50

Impaired loans with no specific reserve:
Consumer	$	96	$	96	$	8		n/a	$	122
Residential Real Estate		728		1,497		14		n/a		1,928
Indirect		123		123		6		n/a		—
Commercial		—		—		—		n/a		—
Construction		—		—		—		n/a		—
Commercial Real Estate		3,680		3,680		81		n/a		3,845
Total impaired loans with no specific reserve	$	4,627	$	5,396	$	109		—	$	5,895


			Unpaid		Interest				Average
December 31, 2018	Recorded		Principal		Income		Specific		Recorded
(dollars in thousands)	Investment		Balance		Recognized		Reserve		Investment
Impaired loans with specific reserves:
Consumer	$	89	$	89	$	3	$	22	$	136
Residential Real Estate		—		—		—		—		—
Indirect		—		—		—		—		—
Commercial		—		204		12		204		211
Construction		—		—		—		—		—
Commercial Real Estate		—		—		—		—		—
Total impaired loans with specific reserves	$	89	$	293	$	15	$	226	$	347

Impaired loans with no specific reserve:
Consumer	$	96	$	96	$	2		n/a	$	50
Residential Real Estate		956		1,725		4		n/a		1,981
Indirect		116		116		—		n/a		—
Commercial		—		—		—		n/a		—
Construction		—		—		—		n/a		—
Commercial Real Estate		1,267		1,267		39		n/a		1,148
Total impaired loans with no specific reserve	$	2,435	$	3,204	$	45		—	$	3,179