Loans Receivable, Credit Quality for Loans and the Allowance for Loan Losses | Note 5 - Loans Receivable, Credit Quality for Loans and the Allowance for Loan Losses The loan portfolio comprises the major component of Riverview’s earning assets and is the highest yielding asset category. Loans receivable are summarized as follows for the periods presented: (Dollars in thousands) June 30, December 31, Commercial $ 46,330 $ 46,076 Commercial real estate 206,721 205,500 Commercial land and land development 9,166 18,599 Residential real estate 112,514 117,669 Home equity lines of credit 18,909 17,437 Consumer installment 4,853 4,564 Total loans 398,493 409,845 Allowance for loan losses (3,609 ) (4,365 ) Total loans, net $ 394,884 $ 405,480 The Bank takes a balanced approach to its lending activities, managing risk associated with its loan portfolio by maintaining diversification within the portfolio, consistently applying prudent underwriting standards, engaging in ongoing monitoring efforts with attention to portfolio dynamics and mix, and using procedures that are consistently applied and updated on an annual basis. The Bank contracts with an independent third party each year to conduct a credit review of the loan portfolio to provide an independent assessment of asset quality through, among other things, an evaluation of how the Bank’s established underwriting criteria is applied in originating credits. Separately, every loan booked and every loan application turned down undergoes an internal review for conformity with established policies and compliance with lending laws. The Bank has maintained its loan underwriting criteria, and management believes its standards are conservative. All of the Bank’s loans are to domestic borrowers. The Bank’s management monitors the loan portfolio on a regular basis, performing a detailed analysis of loans by portfolio segment. Portfolio segments represent pools of loans with similar risk characteristics. There are eight portfolio segments - commercial loans; non-owner occupied commercial real estate loans; owner occupied commercial real estate loans; one-to-four family investment property loans; commercial land/land development/construction loans; residential real estate loans; home equity lines of credit; and consumer loans. For the purpose of estimating the allowance for loan losses, purchased loan participations in the segments for commercial loans, non-owner occupied commercial real estate loans, owner occupied commercial real estate loans, one-to-four family investment property loans, and commercial land/land development/construction loans are also separately evaluated. In addition, the Company separately evaluates the acquired Union Bank and Citizens portfolios. Internal policy requires that the Chief Credit Officer make a quarterly report to the Board of Directors to discuss the status of the loan portfolio and any related credit quality issues. These reports include, but are not limited to, information on past due and nonaccrual loans, impaired loans, the allowance for loan losses, changes in the allowance for loan losses, credit quality indicators and foreclosed assets. Past Due Loans and Nonaccrual Loans Loans are considered to be past due when they are not paid in accordance with contractual terms. Past due loans are monitored by portfolio segment and by severity of delinquency: 30-59 days past due; 60-89 days past due; and 90 days and greater past due. The accrual of interest is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. A loan may remain on accrual status if it can be documented that it is well secured and in the process of collection. When a loan is placed on nonaccrual status, all unpaid interest credited to income in the current calendar year is reversed and all unpaid interest accrued in prior calendar years is charged against the allowance for loan losses. Interest payments received on nonaccrual loans are either applied against principal or reported as interest income according to management’s judgment as to the collectability of principal. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with contractual terms for a reasonable period of time and the ultimate collectability of the total contractual principal and interest is no longer in doubt. The following table presents an aging of loans receivable by loan portfolio segments as of June 30, 2016 and December 31, 2015, and includes nonaccrual loans and loans past due 90 days or more and still accruing: (In thousands) 30-59 Days 60-89 Days 90 Days Total Current Total Recorded June 30, 2016: Commercial $ 741 $ 1 $ 215 $ 957 $ 45,373 $ 46,330 $ — Commercial real estate: Non-owner occupied 2,232 — — 2,232 102,398 104,630 — Owner occupied 381 — 285 666 76,196 76,862 — 1-4 family investment 130 576 30 736 24,493 25,229 30 Commercial land and land development 218 — — 218 8,948 9,166 — Residential real estate 640 194 568 1,402 111,112 112,514 319 Home equity lines of credit 112 30 — 142 18,767 18,909 — Consumer 1 — — 1 4,852 4,853 — Total $ 4,455 $ 801 $ 1,098 $ 6,354 $ 392,139 $ 398,493 $ 349 30-59 Days 60-89 Days 90 Days Total Current Total Recorded December 31, 2015 Commercial $ 34 $ — $ 1,007 $ 1,041 $ 45,035 $ 46,076 $ — Commercial real estate: Non-owner occupied — — 24 24 110,431 110,455 — Owner occupied 172 447 270 889 68,758 69,647 — 1-4 family investment 131 — 265 396 25,002 25,398 — Commercial land and land development — 250 — 250 18,349 18,599 — Residential real estate 1,163 1,025 595 2,783 114,886 117,669 89 Home equity lines of credit 46 412 36 494 16,943 17,437 — Consumer 10 — 1 11 4,553 4,564 — Total $ 1,556 $ 2,134 $ 2,198 $ 5,888 $ 403,957 $ 409,845 $ 89 Loan balances above include net deferred loan fees of $873,000 and $764,000 at June 30, 2016 and December 31, 2015, respectively. Included within the loan portfolio are loans in which the Bank discontinued the accrual of interest due to the deterioration in the financial condition of the borrower. Such loans approximated $1,575,000 and $3,182,000 at June 30, 2016 and December 31, 2015, respectively. If the nonaccrual loans had performed in accordance with their original terms, interest income would have increased by $28,000 for the three months ended June 30, 2016 and $56,000 for the six months ended June 30, 2016. These amounts compare to an increase in interest income of $45,000 for the three months ended June 30, 2015 and $88,000 for the six months ended June 30, 2015. The following table presents loans by loan portfolio segments that were on a nonaccrual status as of June 30, 2016 and December 31, 2015: (In thousands) June 30, December 31, Commercial $ 355 $ 1,143 Commercial real estate: Non-owner occupied — 24 Owner occupied 493 766 1-4 family investment 120 328 Residential real estate 607 885 Home equity lines of credit — 36 Total $ 1,575 $ 3,182 Impaired Loans A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. The Bank further identifies all loans in nonaccrual status and troubled debt restructured loans as impaired loans, except for large groups of smaller balance homogeneous loans that are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures, unless the loans are the subject of a restructuring agreement. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. When the measure of an impaired loan results in a realizable value that is less than the recorded investment in the loan, the difference is recorded as a specific valuation allowance against that loan, and the Bank then makes the appropriate adjustment to the allowance for loan losses. The following presents impaired loans by loan portfolio segments for the periods presented: June 30, 2016 Three Months Ended Six Months Ended (In thousands) Recorded Unpaid Related Average Interest Average Interest Loans with no related allowance recorded: Commercial $ 848 $ 848 $ — $ 850 $ 7 $ 852 $ 14 Commercial real estate: Non-owner occupied 2,150 2,150 — 2,156 20 2,160 39 Owner occupied 972 972 — 976 18 981 37 1-4 family investment 854 854 — 861 7 868 14 Residential real estate 2,365 2,502 — 2,522 30 2,555 61 Home equity lines of credit 361 361 — 403 4 404 7 $ 7,550 $ 7,687 $ — $ 7,768 $ 86 $ 7,820 $ 172 Loans with an allowance recorded: Commercial $ 131 $ 131 $ 1 $ 132 $ — $ 134 $ — Commercial real estate: Owner Occupied 207 207 2 209 — 212 — Residential real estate 119 119 33 120 1 120 2 $ 457 $ 457 $ 36 $ 461 $ 1 $ 466 $ 2 Total Commercial $ 979 $ 979 $ 1 $ 982 $ 7 $ 986 $ 14 Commercial real estate: Non-owner occupied 2,150 2,150 — 2,156 20 2,160 39 Owner occupied 1,179 1,179 2 1,185 18 1,193 37 1-4 family investment 854 854 0 861 7 868 14 Residential real estate 2,484 2,621 33 2,642 31 2,675 63 Home equity lines of credit 361 361 — 403 4 404 7 $ 8,007 $ 8,144 $ 36 $ 8,229 $ 87 $ 8,286 $ 174 December 31, 2015 Three Months Ended Six Months Ended (In thousands) Recorded Unpaid Related Average Interest Average Interest Loans with no related allowance recorded: Commercial $ 994 $ 994 $ — $ 511 $ 20 $ 512 $ 27 Commercial real estate: Non-owner occupied 2,163 2,163 — 2,182 20 2,184 39 Owner occupied 1,462 1,462 — 1,198 31 1,007 46 1-4 family investment 879 879 — 814 6 817 11 Commercial land and land development — — — 219 — 218 — Residential real estate 2,526 2,644 — 2,431 41 2,530 86 Home equity lines of credit 400 400 — 445 16 448 16 $ 8,424 $ 8,562 $ — $ 7,800 $ 134 $ 7,716 $ 225 Loans with an allowance recorded: Commercial $ 793 $ 1,193 $ 700 $ 1,062 $ — $ 866 $ 15 Commercial real estate: Non-owner occupied 24 155 1 — — — — 1-4 family investment 186 193 7 193 — 192 — Residential real estate 121 121 7 123 1 123 2 $ 1,124 $ 1,662 $ 715 $ 1,378 $ 1 $ 1,181 $ 17 Total Commercial $ 1,787 $ 2,187 $ 700 $ 1,573 $ 20 $ 1,378 $ 42 Commercial real estate: Non-owner occupied 2,187 2,318 1 2,182 20 2,184 39 Owner occupied 1,462 1,462 — 1,198 31 1,007 46 1-4 family investment 1,065 1,072 7 1,007 6 1,009 11 Commercial land and land development — — — 219 — 218 — Residential real estate 2,647 2,785 7 2,554 42 2,653 88 Home equity lines of credit 400 400 — 445 16 448 16 $ 9,548 $ 10,224 $ 715 $ 9,178 $ 135 $ 8,897 $ 242 The recorded investment in impaired loans decreased by $1,541,000 at June 30, 2016 as compared to December 31, 2015. This decrease resulted primarily from the charge-off of one large commercial loan in the amount of $723,000, and the transfer of two commercial real estate loans in the amount of $457,000 to other real estate owned, offset by payments and payoffs received on impaired loans. Impaired loans also include all loans modified and identified as troubled debt restructurings (“TDRs”). A loan is deemed to be a TDR when the Bank agrees to a modification to the terms of a loan resulting in a concession made by the Bank in an effort to mitigate potential loss arising from a borrower’s financial difficulty. As of June 30, 2016, there were twenty nine restructured loans, totaling $6,853,000, involving twenty two separate and unrelated borrowers who were experiencing financial difficulty. The modifications to these loans included reductions in interest rates, extension of maturity dates, lengthening of amortization schedules and provisions for interest only payments. There are no commitments to extend additional funds to any of these borrowers. At December 31, 2015, there were thirty-two restructured loans, totaling $7,083,000, involving twenty six separate and unrelated borrowers who were experiencing financial difficulty. The following table presents the number of loans and recorded investment in loans restructured and identified as TDRs for the three and six months ended June 30, 2015. There were no defaults or TDRs occurring within 12 months of modification during the three and six month periods ended June 30, 2016 and 2015. Defaulted loans are those for which payment is 30 days or more past due under the modified terms. There were no troubled debt restructurings during the three and six months ended June 30, 2016. Three Months Ended June 30, 2015 Six Months Ended June 30, 2015 (In thousands, except contracts data) Number of Pre-Modification Post-Modification Number of Pre-Modification Post-Modification Troubled Debt Restructurings: Commercial real estate: Owner occupied — $ — $ — 1 $ 149 $ 149 Residential real estate — — — 3 473 473 Allowance for Loan Losses The allowance for loan losses is composed of individual valuation allowances deemed necessary to absorb probable and quantifiable losses based upon current knowledge of the loan portfolio, and loan pool valuation allowances, allocated and unallocated, deemed necessary to absorb losses which are not specifically identified but are inherent in the portfolio. Management evaluates the adequacy of the allowance on a quarterly basis. If the allowance for loan losses is not sufficient to cover actual loan losses, provisions for loan losses may be recorded and, as a result, the Bank’s earnings may be reduced. Individual valuation allowances are established in connection with specific loan reviews and the asset classification process, including the procedures for impairment testing. Such a valuation, which includes a review of loans for which full collectability in accordance with contractual terms is not reasonably assured, considers the estimated fair value of the underlying collateral less the costs to sell, or the present value of expected future cash flows, or the loan’s observable market value. Any shortfall that exists from this analysis results in a specific allowance for the loan. Pursuant to policy, loan losses must be recognized in the period the loans, or portions thereof, are deemed uncollectible. Assumptions and judgments by management in conjunction with outside sources are used to determine whether full collectability of a loan is reasonably assured or not. These assumptions and judgments are also used to determine the estimates of the fair value of the underlying collateral or the present value of expected future cash flows or the loan’s observable market value. Individual valuation allowances could differ materially as a result of changes in these assumptions and judgments. Individual loan analyses are performed quarterly on specific loans considered to be impaired. The results of the individual valuation allowances are aggregated and included in the overall allowance for loan losses. Loan pool valuation allowances represent loss allowances that have been established to recognize the inherent risks associated with the Bank’s lending activity, but which, unlike individual allowances, have been allocated to unimpaired loans within the following eight portfolio segments: commercial loans; non-owner occupied commercial real estate loans; owner occupied commercial real estate loans; one-to-four family investment property loans; commercial land/land development/construction loans; residential real estate loans; home equity lines of credit; and consumer loans. Loan participations purchased in each of the segments for commercial loans, non-owner occupied commercial real estate loans, owner occupied commercial real estate loans, one-to-four family investment property loans, and commercial land/land development/ construction loans are also separately evaluated. In addition, separate evaluations are made for the acquired Union Bank and Citizens loan portfolios. The Bank measures estimated credit losses in each of these groups of loans based, in part, on the historical loss rate of each group. The historical loss rate is calculated based on the average annualized net charge-offs over the most recent eight calendar quarters. Loss factors are ascribed to loan segments based on the relative risk in each segment as indicated by historical loss ratios, the level of criticized/classified assets, and the nature of each segment in terms of collateral and inherent risk of the loan type. Management believes that historical losses or even recent trends in losses do not, by themselves, form a sufficient basis to determine the appropriate level for the allowance. Management therefore also considers the following qualitative factors that are likely to cause estimated credit losses associated with each of the portfolio segments to differ from historical loss experience: • Changes in lending policies and procedures, including changes in underwriting standards; • Changes in national, regional and local economic and business conditions and developments that affect the collectability of the portfolio; • Changes in the nature and volume of the portfolio and in the terms of loans; • Changes in the experience, ability and depth of lending management and other relevant staff; • Changes in the volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified loans; • Changes in the quality of the Bank’s loan review system; • The existence and effect of any concentrations of credit, and the changes in the level of such concentrations; and • The effect of other external factors, such as competition and legal and regulatory requirements. Each portfolio segment is examined quarterly with regard to the impact of each of these factors on the quality and risk profile of the pool, and adjustments ranging from zero to fifty basis points per factor are calculated. The sum of these qualitative factor adjustments are added to the historical loss ratio for each segment, and the resulting percentage is applied to the loan balance of the segment to arrive at the required loan pool valuation allowance. An unallocated valuation allowance estimate is also made. Management determines the unallocated portion, which represents the difference between the reported allowance for loan losses and the calculated allowance for loan losses, based generally on the following criteria: • risk of imprecision in the specific and general reserve allocations; • other potential exposure in the loan portfolio, including the risks associated with the growing book of loans in the Berks, Schuylkill and Somerset County regions; • other potential exposure in the acquired Union Bank and Citizens loan portfolios; • variances in management’s assessment of national and local economic conditions; and • other internal or external factors that management believes appropriate at the time. The loan pool valuation allowance for each segment, along with the unallocated valuation allowance, is totaled and added to the individual valuation allowance for impaired loans to arrive at the total allowance for loan losses. These evaluations are inherently subjective because, even though they are based on objective data, it is management’s interpretation of the data that determines the amount of the appropriate allowance. If the evaluations prove to be incorrect, the allowance for loan losses may not be sufficient to cover losses inherent in the loan portfolio, resulting in additions to the allowance for loan losses and a reduction in the Bank’s earnings. Loan Charge Offs Charge offs of commercial and industrial loans and commercial real estate and construction loans are recorded promptly upon determination that all or a portion of any loan balance is uncollectible. A loan is considered uncollectible when the borrower is 90 days or more delinquent in principal or interest repayment and the following conditions exist: • It is unlikely that the borrower will have the ability to pay the debt in a timely manner; • Collateral value is insufficient to cover the outstanding indebtedness; and • Guarantors do not provide adequate support. All unsecured consumer loans are charged-off when they become 120 days delinquent or when it is determined that the debt is uncollectible. Overdrafts are charged off when it is determined that recovery is not likely, or the overdraft becomes 45 days old, whichever comes first. All secured consumer loans, except those secured by a primary or secondary residence, are charged off when they become 120 days delinquent, or when it is determined that the debt is uncollectible. Uncollateralized portions of residential real estate loans and consumer loans secured by real estate are charged off no later than when they are 180 days past due. Current appraisals are obtained to determine the appropriate carrying balance with any exposed portion of the loan principal balance being charged off. The allowance for loan losses is presented by loan portfolio segments with the outstanding balances of loans for the periods presented: Commercial Real Estate (In thousands) Commercial Non-Owner Owner 1-4 Family Commercial – Residential Home Consumer Unallocated Total Allowance for Loan Losses for the Three Months Ended June 30, 2016: Beginning balance $ 566 $ 1,320 $ 621 $ 270 $ 93 $ 650 $ 104 $ 30 $ 63 $ 3,717 Charge-offs — — — 41 249 8 — 5 — 303 Recoveries 36 — — — — 2 — 1 — 39 Provision (44 ) (135 ) 11 54 326 (9 ) 6 10 (63 ) 156 Ending balance $ 558 $ 1,185 $ 632 $ 283 $ 170 $ 635 $ 110 $ 36 $ 0 $ 3,609 Ending balance: individually evaluated for impairment $ 1 $ — $ 2 $ — $ — $ 33 $ — $ — $ — $ 36 Ending balance: collectively evaluated for impairment $ 557 $ 1,185 $ 630 $ 283 $ 170 $ 602 $ 110 $ 36 $ — $ 3,573 Allowance for Loan Losses for the Three Months Ended June 30, 2015: Beginning balance $ 363 $ 1,297 $ 731 $ 395 $ 113 $ 672 $ 107 $ 19 $ 38 $ 3,735 Charge-offs — — — 11 — 12 10 16 — 49 Recoveries 8 — — — — — — 1 — 9 Provision 269 (6 ) (12 ) 14 3 20 19 18 125 450 Ending balance $ 640 $ 1,291 $ 719 $ 398 $ 116 $ 680 $ 116 $ 22 $ 163 $ 4,145 Ending balance: individually evaluated for impairment $ 272 $ — $ — $ 14 $ — $ 6 $ — $ — $ — $ 292 Ending balance: collectively evaluated for impairment $ 368 $ 1,291 $ 719 $ 384 $ 116 $ 674 $ 116 $ 22 $ 163 $ 3,853 Commercial Real Estate (In thousands) Commercial Non-Owner Owner 1-4 Family Commercial – Residential Home Consumer Unallocated Total Allowance for Loan Losses for the Six Months Ended June 30, 2016: Beginning balance $ 1,298 $ 1,372 $ 552 $ 303 $ 202 $ 520 $ 93 $ 25 $ — $ 4,365 Charge-offs 723 24 — 41 249 8 — 16 — 1,061 Recoveries 46 — — — — 2 — 2 — 50 Provision (63 ) (163 ) 80 21 217 121 17 25 — 255 Ending balance $ 558 $ 1,185 $ 632 $ 283 $ 170 $ 635 $ 110 $ 36 $ — $ 3,609 Ending balance: individually evaluated for impairment $ 1 $ — $ 2 $ — $ — $ 33 $ — $ — $ — $ 36 Ending balance: collectively evaluated for impairment $ 557 $ 1,185 $ 630 $ 283 $ 170 $ 602 $ 110 $ 36 $ — $ 3,573 Allowance for Loan Losses for the Six Months Ended June 30, 2015: Beginning balance $ 330 $ 1,380 $ 713 $ 369 $ 115 $ 701 $ 104 $ 15 $ 65 $ 3,792 Charge-offs — — 39 11 — 27 10 22 — 109 Recoveries 8 — — — — — — 4 — 12 Provision 302 (89 ) 45 40 1 6 22 25 98 450 Ending balance $ 640 $ 1,291 $ 719 $ 398 $ 116 $ 680 $ 116 $ 22 $ 163 $ 4,145 Ending balance: individually evaluated for impairment $ 272 $ — $ — $ 14 $ — $ 6 $ — $ — $ — $ 292 Ending balance: collectively evaluated for impairment $ 368 $ 1,291 $ 719 $ 384 $ 116 $ 674 $ 116 $ 22 $ 163 $ 3,853 Commercial Real Estate (In thousands) Commercial Non-Owner Owner 1-4 Family Commercial – Residential Home Consumer Unallocated Total Loans as of June 30, 2016: Ending balance $ 46,330 $ 104,630 $ 76,862 $ 25,229 $ 9,166 $ 112,514 $ 18,909 $ 4,853 $ 398,493 Ending balance: individually evaluated for impairment $ 979 $ 2,150 $ 1,179 $ 854 $ — $ 2,484 $ 361 $ — $ 8,007 Ending balance: collectively evaluated for impairment $ 45,351 $ 102,480 $ 75,683 $ 24,375 $ 9,166 $ 110,030 $ 18,548 $ 4,853 $ 390,486 Loans as of December 31, 2015: Ending balance $ 46,076 $ 110,455 $ 69,647 $ 25,398 $ 18,599 $ 117,669 $ 17,437 $ 4,564 $ 409,845 Ending balance: individually evaluated for impairment $ 1,787 $ 2,187 $ 1,462 $ 1,065 $ — $ 2,647 $ 400 $ — $ 9,548 Ending balance: collectively evaluated for impairment $ 44,289 $ 108,268 $ 68,185 $ 24,333 $ 18,599 $ 115,022 $ 17,037 $ 4,564 $ 400,297 Credit Quality Indicators The Bank has established a credit risk rating system to quantify the risk in the Bank’s loan portfolio. This system is a critical tool for managing the Bank’s lending activities and for evaluating appropriate loan loss reserves. This rating system is dynamic, and risk ratings are subject to change at any time when circumstances warrant. The system rates the strength of the borrower and is designed to be a tool for management to manage the Bank’s credit risk and provide an early warning system for negative migration of credits. The system also provides for recognition of improvement in credits. Risk ratings move dynamically, both negatively and positively. Each new, renewed or modified credit facility is given a risk rating that takes into consideration factors that affect credit quality. The primary determinants of the risk rating assigned are based upon the reliability of the primary source of repayment and the past, present, and projected financial condition of the borrower. The rating also reflects current economic and industry conditions. Major factors used in determining the rating include the following variables: • Capitalization; • Liquidity; • Cash flow; • Revenue and earnings trends; • Management strength or weakness; • Quality of financial information; • Reputation and credit history; • Industry, including economic climate. In addition, the following factors may affect the risk rating derived from the above factors: Collateral Guarantors The Bank assigns risk ratings based on a scale from 1 to 8 with 1 being the highest quality rating and 8 being the lowest quality grade. • Levels 1-4 are “Pass” grades; • Level 5 is “Special Mention” (criticized loan); • Level 6 is “Substandard” (classified loan); • Level 7 is “Doubtful” (classified loan); • Level 8 is “Loss” (classified loan). Risk Rating Definitions 1 - Excellent This category is reserved for loans that contain a virtual absence of any credit risk. The loan is secured by properly margined cash collateral (in accordance with loan policy). Loans that are fully guaranteed by the U.S. government, or any agency thereof, would also fit this category. 2 - Good Loans in this category would be characterized by nominal risk and strong repayment certainty. This category includes loans to companies or individuals that are paying as agreed and that are either unsecured or secured where reliance is placed on non-liquid or less than good quality liquid collateral. 3 - Satisfactory Loans in this category are considered to exhibit an average level of credit risk. However, these loans have certain risk characteristics, whether due to management, industry, economic or financial concerns. Credits with satisfactory liquidity and leverage, with losses considered to be of a temporary nature for which there is only minor concern, are included in this category. Loans for start-up businesses or loans to firms exhibiting high leverage may receive this rating. Loans in this category also include borrowers whose underlying financial strength may be relatively weak. However, risk of loss of loans in this category is considered minimal due to adequate, well-margined and controlled collateral. 4 - Watch Loans in this category typically are experiencing some negative trends due to financial, operational, economic, or regulatory reasons. A deteriorating collateral position or guarantor, in isolation, may also justify this rating. Such loans must have elevated monitoring as a result of negative trends which, if not addressed, could result in an unacceptable increase in credit risk. 5 - Special Mention A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in a deterioration of the repayment prospects for the loan or in the Bank’s credit position at some future date. Special mention loans are not adversely classified and do not expose the Bank to sufficient risk to warrant an adverse classification. Loans for which economic or market conditions are beginning to adversely affect the borrower may be so rated. An adverse trend in the borrower’s operations or an imbalanced position in the balance sheet which has not reached a point where the liquidation is jeopardized may be best handled by this rating. Loans in which actual weaknesses are evident and significant are considered for more serious criticism. In cases where the credit is weak but trends are improving, and/or collateral support is within normal advance margins, consideration is given for the next higher rating. 6 - Substandard A substandard loan is inadequately protected by the current sound worth and paying capacity of the borrower or by the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. These loans, even if apparently protected by collateral value, have well-defined weaknesses related to adverse financial, managerial, economic, market, or political conditions which have clearly jeopardized repayment of principal and interest as originally intended. These loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans rated below this category are placed on nonaccrual status. 7 - Doubtful A doubtful loan has all of the weaknesses inherent in a loan classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of current facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending events that may work to strengthen the asset, its classification as a loss is deferred until its most exact status may be determined. Generally, pending events should be resolved within a relatively short period and the rating will be adjusted based on the new information. Because of high probability of loss, loans rated doubtful are placed in non-accrual status. 8 - Loss Loans classified loss are considered uncollectible and of such little value that their continuance as a bankable asset is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though a partial recovery may be effected in the future. When access to collateral, rather than the value of the collateral, is a problem, a less severe classification may be appropriate. However, the Bank will not maintain an asset on the balance sheet if realizing its value would require long-term litigation or other lengthy recovery efforts. Losses are recorded in the period the asset becomes uncollectible. The following table presents the credit quality indicators and total credit exposure for each segment in the loan portfolio by internally assigned grades as of June 30, 2016 and December 31, 2015: Commercial Real Estate (In thousands) Commercial Non- Owner 1-4 Family Commercial – Residential Home Consumer Total June 30, 2016 1 – Excellent $ 241 $ — $ — $ — $ — $ — $ — $ 106 $ 347 2 – Good 2,607 34 1,134 28 179 — — — 3,982 3 – Satisfactory 40,563 94,055 69,844 18,123 8,738 108,872 18,185 4,747 363,127 4 – Watch 1,046 5,377 2,895 5,168 249 398 335 — 15,468 5 – Special Mention 475 2,252 1,466 1,254 — 161 28 — 5,636 6 – Substandard 1,398 2,912 1,523 656 — 3,0 |