NOTE 3 – LOANS AND ALLOWANCE FOR CREDIT LOSSES

Portfolio loans were as follows at year end (dollars in thousands):

The totals above are shown net of deferred fees and costs.  Deferred fees on loans totaled $1.3 million and $1.3 million at December 31, 2023 and 2022, respectively.  Deferred costs on loans totaled $1.5 million and $1.4 million at December 31, 2023 and 2022, respectively.

The following tables present the activity in the allowance for credit losses by portfolio segment for the years ended December 31, 2023 and 2022 (dollars in thousands):

(1) - Beginning January 1, 2023, calculation is based on CECL methodology.  Prior to January 1, 2023, calculation was based on probable incurred loss methodology.

The following table presents gross charge-offs for the year ended December 31, 2023 by portfolio class and origination year (dollars in thousands):

Collateral dependent loans are loans for which the repayment is expected to be provided substantially through the operation or sale of the collateral and the borrower is experiencing financial difficulty.  Under CECL for collateral dependent loans, the Company has adopted the practical expedient to measure the allowance on the fair value of collateral.  

The allowance is calculated on an individual loan basis of the shortfall between the fair value of the loan's collateral, which is adjusted for liquidation costs/discounts, and the loan's amortized cost.  If the fair value of the collateral exceeds the loan's amortized cost, no allowance is necessary.  The Company's policy is to obtain appraisals on any significant pieces of collateral.  For real estate collateral that is industries that are undergoing significant stress, or properties that are specialized use or have limited marketability, higher discounts are applied in determining fair value.

There have been no significant changes to the types of collateral securing the Company's collateral dependent loans.

The amortized cost of collateral-dependent loans by class as of December 31, 2023 was as follows (dollars in thousands):

The following tables present the balance in the allowance for credit losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2022 (dollars in thousands):

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2022 (dollars in thousands):

Nonaccrual loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.  The following tables present the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of December 31, 2023 and 2022 (dollars in thousands):

No interest income was recognized on nonaccrual loans during the years ended December 31, 2023 and 2022.

The following table presents the aging of the recorded investment in past due loans as of December 31, 2023 by class of loans (dollars in thousands):

The following table presents the aging of the recorded investment in past due loans as of December 31, 2022 by class of loans (dollars in thousands):

At times, the Company will modify terms of a loan to allow the customer to mitigate the risk of foreclosure by meeting a lower loan payment requirement based upon their current cash flow.  These may also include loans that renewed at existing contractual rates, but below market rates for comparable credit.  For commercial loans, these modifications typically include an interest only period and, in some cases, a lowering of the interest rate on the loan.  In some cases, the modification will include separating the note into two notes with the first note structured to be supported by current cash flows and collateral, and the second note made for the remaining unsecured debt.  The second note is charged off immediately and collected only after the first note is paid in full.  This modification type is commonly referred to as an A-B note structure.  For consumer mortgage loans, the restructuring typically includes a lowering of the interest rate to provide payment and cash flow relief.  For each restructuring, a comprehensive credit underwriting analysis of the borrower’s financial condition and prospects of repayment under the revised terms is performed to assess whether the structure can be successful and that cash flows will be sufficient to support the restructured debt.  An analysis is also performed to determine whether the restructured loan should be on accrual status.  Generally, if the loan is on accrual status at the time of restructure, it will remain on accrual status after the restructuring.  In some cases, a nonaccrual loan may be placed on accrual status at restructuring if the loan’s actual payment history demonstrates it would have cash flowed under the restructured terms.  After six consecutive payments under the restructured terms, a nonaccrual restructured loan is reviewed for possible upgrade to accrual status. 

As with other individually reviewed loans, an allowance for credit loss is estimated for each such modification made to borrowers experiencing financial difficulty based on the most likely source of repayment for each loan. For commercial real estate loans that are collateral dependent, the allowance is computed based on the fair value of the underlying collateral, less estimated costs to sell. For individually reviewed commercial loans where repayment is expected from cash flows from business operations, the allowance is computed based on a discounted cash flow computation. Certain groups of such loans, such as residential mortgages, have common characteristics and for them the allowance is computed based on a discounted cash flow computation on the change in weighted rate for the pool. The allowance allocations for commercial modifications to borrowers experiencing financial difficulty where we have reduced the contractual interest rate are computed by measuring cash flows using the new payment terms discounted at the original contractual rate.

The following table presents information regarding modifications to borrowers experiencing financial difficulty as of December 31, 2023 (dollars in thousands):

At December 31, 2023, approximately 50% of the balance of modified loans to borrowers experiencing financial difficulty involved interest rate reductions, 36% involved extensions of maturity and the remainder were a combination of capitalized interest, renewals at below market rates and A-B note restructures.  At December 31, 2023, the amortized cost of these modified loans was $1.6 million, $1.2 million and $471,000, respectively.  There have been no payment defaults for all modifications to borrowers experiencing financial difficulty within the past twelve months.  Additionally, all such modifications were current at December 31, 2023.  All of the modifications involving interest rate reductions occurred prior to 2015 and the financial statement effect of these interest rate reductions was immaterial.

The following table presents the amount of accruing modifications that were on nonaccrual status prior to the modification, accruing at the time of modification and those that were upgraded to accruing status after receiving six consecutive monthly payments in accordance with the modified terms as of December 31, 2023 (dollars in thousands):

There was one commercial loan modification and two consumer loan modifications made to borrowers experiencing financial difficulty during the year ended December 31, 2023. The pre-modification balance of these loans totaled $628,000 and there were no writedowns upon modification. There were three consumer loan modifications made to borrowers experiencing financial difficulty during the year ended December 31, 2022.  The pre-modification balance of these loans totaled $449,000 and there were no writedowns upon modification.  

Payment defaults on modifications to borrowers experiencing financial difficulty have been minimal and during the twelve months ended December 31, 2023 and 2022, the balance of loans that became delinquent by more than 90 days past due or that were transferred to nonaccrual within 12 months of restructuring were not material.

Credit Quality Indicators:   The Company categorizes loans into risk categories based on relevant information about the ability of the borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company analyzes commercial loans individually and classifies these relationships by credit risk grading. The Company uses an eight point grading system, with grades 5 through 8 being considered classified, or watch, credits. The higher the risk grade, the stronger likelihood of loss. At grade 7, a loan is placed on nonaccrual status. All commercial loans are assigned a grade at origination, at each renewal or any amendment. When a credit is first downgraded to a watch credit (either through renewal, amendment, loan officer identification or the loan review process), an Administrative Loan Review (“ALR”) is generated by the credit department and the loan officer. All watch credits have an ALR completed quarterly which analyzes the collateral position and cash flow of the borrower and its guarantors. Management meets quarterly with loan officers to discuss each of these credits in detail and to help formulate solutions where progress has stalled. When necessary, the loan officer proposes changes to the assigned loan grade as part of the ALR. Additionally, Loan Review reviews all loan grades upon origination, renewal or amendment and again as loans are selected though the loan review process. The credit will stay on the ALR until either its grade has improved to a 4 or the credit relationship is at a zero balance. The Company uses the following definitions for the risk grades in ascending order of likelihood of loss:

1. Excellent - Loans supported by extremely strong financial condition or secured by the Bank’s own deposits. Minimal risk to the Bank and the probability of serious rapid financial deterioration is extremely small.

2. Above Average - Loans supported by sound financial statements that indicate the ability to repay or borrowings secured (and margined properly) with marketable securities. Nominal risk to the Bank and probability of serious financial deterioration is highly unlikely. The overall quality of these credits is very high.

3. Good Quality - Loans supported by satisfactory asset quality and liquidity, good debt capacity coverage, and good management in all critical positions. Loans are secured by acceptable collateral with adequate margins. There is a slight risk of deterioration if adverse market conditions prevail.

4. Acceptable Risk - Loans carrying an acceptable risk to the Bank, which may be slightly below average quality. The borrower has limited financial strength with considerable leverage. There is some probability of deterioration if adverse market conditions prevail. These credits should be monitored closely by the Relationship Manager.

5. Marginally Acceptable - Loans are of marginal quality with above normal risk to the Bank. The borrower shows acceptable asset quality but very little liquidity with high leverage. There is inconsistent earning performance without the ability to sustain adverse market conditions. The primary source of repayment is questionable, but the secondary source of repayment still remains an option. Very close attention by the Relationship Manager and management is needed.

6. Substandard - Loans are inadequately protected by the net worth and paying capacity of the borrower or the collateral pledged. The primary and secondary sources of repayment are questionable. Heavy debt condition may be evident and volume and earnings deterioration may be underway. It is possible that the Bank will sustain some loss if the deficiencies are not immediately addressed and corrected.

7. Doubtful - Loans supported by weak or no financial statements, as well as the ability to repay the entire loan, are questionable. Loans in this category are normally characterized less than adequate collateral, insolvent, or extremely weak financial condition. A loan classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses makes collection or liquidation in full highly questionable. The possibility of loss is extremely high, however, activity may be underway to minimize the loss or maximize the recovery.

8. Loss - Loans are considered uncollectible and of little or no value as a bank asset.

The following table summarizes loan ratings by grade for commercial loans as of December 31, 2023 (dollars in thousands):

As of December 31, 2022, the risk grade category of commercial loans by class of loans was as follows (dollars in thousands):

The Company considers the performance of the loan portfolio and its impact on the allowance for credit losses. For consumer loan classes, the Company also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity. The following tables present the recorded investment in consumer loans by year of origination and based on delinquency status at December 31, 2023 (dollars in thousands):