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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM

10-Q

(Mark One)

☒			QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2020

OR

☐			TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______ to ______

Commission File Number: 001-36094

THE COMMUNITY FINANCIAL CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Maryland						52-1652138
(State of Other Jurisdiction of Incorporation or Organization)						(I.R.S. Employer Identification No.)

3035 Leonardtown Road, Waldorf, MD, 20601

(Address of Principal Executive Offices) (Zip Code)

(301) 645-5601

(Registrant’s Telephone Number, Including Area Code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

Securities registered pursuant to Section 12(b) of Act:

Title of each class

Trading Symbol(s)

Name of each exchange on which registered

Common Stock, par value $0.01 per share

TCFC

The NASDAQ Stock Market LLC

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  ☒  No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes  ☒  No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer

☐

Accelerated Filer

☒

Non-accelerated Filer

☐

Smaller Reporting Company

☒

Emerging growth company

☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ☐ No ☒

As of July 31, 2020, the registrant had 5,913,238 shares of common stock outstanding. 

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TABLE OF CONTENTS

Table of Contents						Page
Forward-Looking Statements
PART I - FINANCIAL INFORMATION
Item 1 – Financial Statements (Unaudited)						1
Consolidated Balance Sheets						1
Consolidated Statements of Income						1
Consolidated Statements of Comprehensive Income						2
Consolidated Statements of Changes in Stockholders’ Equity						4
Consolidated Statements of Cash Flows						6
Notes to Consolidated Financial Statements						8
Item 2 – Management’s Discussion and Analysis (MD&A) of Financial Condition and Results of Operations						41
Item 3 – Quantitative and Qualitative Disclosures about Market Risk						80
Item 4 – Controls and Procedures						81
PART II - OTHER INFORMATION
Item 1 – Legal Proceedings						82
Item 1A – Risk Factors						82
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds						83
Item 3 – Defaults Upon Senior Securities						84
Item 4 – Mine Safety Disclosures						84
Item 5 – Other Information						84
Item 6 – Exhibits						85
SIGNATURES						86

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FORWARD-LOOKING STATEMENTS

Certain statements contained in this Report may not be based on historical facts and are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements can generally be identified by the fact that they do not relate strictly to historical or current facts. They often include words like “believe,” “expect,” “anticipate,” “estimate” and “intend” or future or conditional verbs such as “will,” “would,” “should,” “could” or “may.” Statements in this report that are not strictly historical are forward-looking and are based upon current expectations that may differ materially from actual results. These forward-looking statements include, without limitation, those relating to the Company’s and Community Bank of the Chesapeake’s future growth and management’s outlook or expectations for revenue, assets, asset quality, profitability, business prospects, net interest margin, non-interest revenue, allowance for loan losses, the level of credit losses from lending, liquidity levels, capital levels, or other future financial or business performance strategies or expectations, and any statements of the plans and objectives of management for future operations products or services, including the expected benefits from, and/or the execution of integration plans relating to any acquisition that we have undertaken or that undertake in the future; plans and cost savings regarding branch closings or consolidation; any statement of expectation or belief; projections related to certain financial metrics; and any statement of assumptions underlying the foregoing. These forward-looking statements express management’s current expectations or forecasts of future events, results and conditions, and by their nature are subject to and involve risks and uncertainties that could cause actual results to differ materially from those anticipated by the statements made herein. Factors that might cause actual results to differ materially from those made in such statements include, but are not limited to: risks, uncertainties and other factors relating to the COVID-19 pandemic (including the length of time that the pandemic continues, the ability of states and local governments to successfully implement the lifting of restrictions on movement and the potential imposition of further restrictions on movement and travel in the future; the effect of the pandemic on the general economy and on the businesses of our borrowers and their ability to make payments on their obligations; the remedial actions and stimulus measures adopted by federal, state and local governments; and the inability of employees to work due to illness, quarantine, or government mandates); the synergies and other expected financial benefits from any acquisition that we have undertaken or may undertake in the future, may not be realized within the expected time frames; changes in The Community Financial Corporation or Community Bank of the Chesapeake’s strategy; costs or difficulties related to integration matters might be greater than expected; availability of and costs associated with obtaining adequate and timely sources of liquidity; the ability to maintain credit quality; general economic trends; changes in interest rates; loss of deposits and loan demand to other financial institutions; substantial changes in financial markets; changes in real estate value and the real estate market; regulatory changes; the impact of government shutdowns or sequestration; the possibility of unforeseen events affecting the industry generally; the uncertainties associated with newly developed or acquired operations; the outcome of litigation that may arise; market disruptions and other effects of terrorist activities; and the matters described in “Item 1A Risk Factors” in the Company’s Annual Report on Form 10-K for the Year Ended December 31, 2019, and in its other Reports filed with the Securities and Exchange Commission (the “SEC”).

The Company’s forward-looking statements may also be subject to other risks and uncertainties, including those that it may discuss elsewhere in this Report or in its filings with the SEC, accessible on the SEC’s Web site at www.sec.gov. The Company undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unforeseen events, except as required under the rules and regulations of the SEC.

You are cautioned not to place undue reliance on the forward-looking statements contained in this document in that actual results could differ materially from those indicated in such forward-looking statements, due to a variety of factors. Any forward-looking statement speaks only as of the date of this Report, and we undertake no obligation to update these forward-looking statements to reflect events or circumstances that occur after the date of this Report.

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PART 1 - FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEETS

						(Unaudited)
(dollars in thousands, except per share amounts)						June 30, 2020						December 31, 2019
Assets
Cash and due from banks						$	103,914					$	25,065
Federal funds sold						29,456						—
Interest-bearing deposits with banks						13,051						7,404
Securities available for sale (AFS), at fair value						234,982						208,187
Equity securities carried at fair value through income						4,831						4,669
Non-marketable equity securities held in other financial institutions						209						209
Federal Home Loan Bank (FHLB) stock - at cost						4,691						3,447
Net U.S. Small Business Administration ("SBA") Paycheck Protection Program ("PPP") Loans						125,638						—
Portfolio Loans Receivable net of allowance for loan losses of $16,319 and $10,942						1,478,498						1,445,109
Net loans						1,604,136						1,445,109
Goodwill						10,835						10,835
Premises and equipment, net						20,972						21,662
Premises and equipment held for sale						430						430
Other real estate owned (OREO)						3,695						7,773
Accrued interest receivable						6,773						5,019
Investment in bank owned life insurance						37,619						37,180
Core deposit intangible						1,810						2,118
Net deferred tax assets						6,565						6,168
Right of use assets - operating leases						8,132						8,382
Other assets						1,655						3,879
Total Assets						$	2,093,756					$	1,797,536
Liabilities and Stockholders’ Equity
Deposits
Non-interest-bearing deposits						$	356,196					$	241,174
Interest-bearing deposits						1,314,168						1,270,663
Total deposits						1,670,364						1,511,837
Short-term borrowings						5,000						5,000
Long-term debt						67,336						40,370
Paycheck Protection Program Liquidity Facility ("PPPLF") Advance						126,801						—
Guaranteed preferred beneficial interest in junior subordinated debentures (TRUPs)						12,000						12,000
Subordinated notes - 6.25%						—						23,000
Lease liabilities - operating leases						8,296						8,495
Accrued expenses and other liabilities						14,517						15,340
Total Liabilities						1,904,314						1,616,042
Stockholders’ Equity
Common stock - par value $0.01; authorized - 15,000,000 shares; issued 5,911,715 and 5,900,249 shares, respectively						59						59
Additional paid in capital						95,687						95,474
Retained earnings						89,781						85,059
Accumulated other comprehensive income						4,517						1,504
Unearned ESOP shares						(602)						(602)
Total Stockholders’ Equity						189,442						181,494
Total Liabilities and Stockholders’ Equity						$	2,093,756					$	1,797,536

See notes to Consolidated Financial Statements

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CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

						Three Months Ended June 30,																		Six Months Ended June 30,
(dollars in thousands, except per share amounts)						2020						2019						2020						2019
Interest and Dividend Income
Loans, including fees						$	16,277					$	16,366					$	32,779					$	32,495
Interest and dividends on investment securities						1,341						1,677						2,810						3,300
Interest on deposits with banks						20						75						88						120
Total Interest and Dividend Income						17,638						18,118						35,677						35,915
Interest Expense
Deposits						1,937						3,966						4,981						7,734
Short-term borrowings						28						235						97						569
Long-term debt						449						658						1,022						1,316
Total Interest Expense						2,414						4,859						6,100						9,619
Net Interest Income						15,224						13,259						29,577						26,296
Provision for loan losses						3,500						375						7,600						875
Net Interest Income After Provision For Loan Losses						11,724						12,884						21,977						25,421
Noninterest Income
Loan appraisal, credit, and miscellaneous charges						35						38						49						96
Net gains on sale of investment securities						112						—						441						—
Unrealized gain on equity securities						40						65						115						121
Income from bank owned life insurance						220						222						439						439
Service charges						709						828						1,691						1,558
Referral fee income						1,143						100						1,645						100
Total Noninterest Income						2,259						1,253						4,380						2,314
Noninterest Expense
Compensation and benefits						4,714						4,881						9,902						9,684
Occupancy expense						736						753						1,470						1,559
Advertising						130						163						251						360
Data processing expense						924						755						1,852						1,475
Professional fees						477						606						1,103						1,024
Depreciation of premises and equipment						151						166						309						355
Telephone communications						53						66						96						118
Office supplies						30						33						61						70
FDIC Insurance						260						160						430						335
OREO valuation allowance and expenses						1,100						432						1,882						488
Core deposit intangible amortization						151						175						308						356
Other						671						926						1,416						1,697
Total Noninterest Expense						9,397						9,116						19,080						17,521
Income before income taxes						4,586						5,021						7,277						10,214
Income tax expense						1,136						1,394						1,079						2,710
Net Income						$	3,450					$	3,627					$	6,198					$	7,504
Earnings Per Common Share
Basic						$	0.59					$	0.65					$	1.05					$	1.35
Diluted						$	0.59					$	0.65					$	1.05					$	1.35

See notes to Consolidated Financial Statements

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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

						Three Months Ended June 30,																		Six Months Ended June 30,
(dollars in thousands)						2020						2019						2020						2019
Net Income						$	3,450					$	3,627					$	6,198					$	7,504
Net unrealized holding gains arising during period, net of tax expense of $449 and $576, and $908 and $1,098, respectively.						1,275						1,517						2,687						2,891
Reclassification adjustment for gains included in net income, net of tax expense of $29 and $0, and $115 and $0, respectively.						83						—						326						—
Comprehensive Income						$	4,808					$	5,144					$	9,211					$	10,395

See notes to Consolidated Financial Statements

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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

For the Three Months Ended June 30, 2020 and 2019

(dollars in thousands)						Common Stock						Additional Paid-in Capital						Retained Earnings						Accumulated Other Comprehensive Income (Loss)						Unearned ESOP Shares						Total
Balance at March 31, 2020						$	59					$	95,581					$	87,070					$	3,160					$	(602)					$	185,268
Net Income						—						—						3,450						—						—						3,450
Unrealized holding gain on investment securities net of tax expense $478						—						—						—						1,357						—						1,357
Cash dividend at $0.125 per common share						—						—						(708)						—						—						(708)
Dividend reinvestment						—						31						(31)						—						—						—
Net change in fair market value below cost of leveraged ESOP shares released						—						(12)						—						—						—						(12)
Stock based compensation						—						87						—						—						—						87
Balance at June 30, 2020						$	59					$	95,687					$	89,781					$	4,517					$	(602)					$	189,442

(dollars in thousands)						Common Stock						Additional Paid-in Capital						Retained Earnings						Accumulated Other Comprehensive Income (Loss)						Unearned ESOP Shares						Total
Balance at March 31, 2019						$	56					$	84,498					$	75,757					$	(473)					$	(757)					$	159,081
Net Income						—						—						3,627						—						—						3,627
Unrealized holding gain on investment securities net of tax benefit $576						—						—						—						1,517						—						1,517
Cash dividend at $0.125 per common share						—						—						(670)						—						—						(670)
Dividend reinvestment						—						25						(25)						—						—						—
Net change in fair market value below cost of leveraged ESOP shares released						—						(2)						—						—						—						(2)
Stock based compensation						—						92						—						—						—						92
Balance at June 30, 2019						$	56					$	84,613					$	78,689					$	1,044					$	(757)					$	163,645

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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

For the Six Months Ended June 30, 2020 and 2019

(dollars in thousands)						Common Stock						Additional Paid-in Capital						Retained Earnings						Accumulated Other Comprehensive Income (Loss)						Unearned ESOP Shares						Total
Balance at January 1, 2020						$	59					$	95,474					$	85,059					$	1,504					$	(602)					$	181,494
Net Income						—						—						6,198						—						—						6,198
Unrealized holding gain on investment securities net of tax expense $1,023						—						—						—						3,013						—						3,013
Cash dividend at $0.25 per common share						—						—						(1,410)						—						—						(1,410)
Dividend reinvestment						—						66						(66)						—						—						—
Net change in fair market value below cost of leveraged ESOP shares released						—						(16)						—						—						—						(16)
Stock based compensation						—						163						—						—						—						163
Balance at June 30, 2020						$	59					$	95,687					$	89,781					$	4,517					$	(602)					$	189,442

(dollars in thousands)						Common Stock						Additional Paid-in Capital						Retained Earnings						Accumulated Other Comprehensive Income (Loss)						Unearned ESOP Shares						Total
Balance at January 1, 2019						$	56					$	84,397					$	72,594					$	(1,847)					$	(718)					$	154,482
Net Income						—						—						7,504						—						—						7,504
Unrealized holding loss on investment securities net of tax expense $1,098						—						—						—						2,891						—						2,891
Cash dividend at $0.25 per common share						—						—						(1,341)						—						—						(1,341)
Dividend reinvestment						—						51						(51)						—						—						—
Net change in fair market value over cost of leveraged ESOP shares released						—						(4)						—						—						—						(4)
Net change in unearned ESOP shares						—						—						—						—						(39)						(39)
Repurchase of common stock						—						—						(17)						—						—						(17)
Stock based compensation						—						169						—						—						—						169
Balance at June 30, 2019						$	56					$	84,613					$	78,689					$	1,044					$	(757)					$	163,645

See notes to Consolidated Financial Statements

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CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

						Six Months Ended June 30,
(dollars in thousands)						2020						2019
Cash Flows from Operating Activities
Net income						$	6,198					$	7,504
Adjustments to reconcile net income to net cash provided by operating activities
Provision for loan losses						7,600						875
Depreciation and amortization						798						813
Net losses (gains) on the sale of OREO						9						(188)
Gains on sales of investment securities						(441)						—
Unrealized gains on equity securities						(115)						(121)
Net amortization of premium/discount on investment securities						25						(77)
Net accretion of merger accounting adjustments						(403)						(381)
Amortization of core deposit intangible						308						356
Amortization of right of use asset						250						—
Net change in right of use assets and lease liabilities						(198)						68
Increase in OREO valuation allowance						1,791						637
Increase in cash surrender value of bank owned life insurance						(439)						(439)
Increase in deferred income tax benefit						(1,418)						(320)
Increase in accrued interest receivable						(1,754)						(474)
Stock based compensation						163						169
Net change due to deficit of fair market value over cost of leveraged ESOP shares released						(16)						(4)
Increase in net deferred loan costs						(181)						(181)
Decrease in accrued expenses and other liabilities						(823)						(1,519)
Decrease (increase) in other assets						2,221						(843)
Net Cash Provided by Operating Activities						13,575						5,875
Cash Flows from Investing Activities
Purchase of AFS investment securities						(88,719)						(13,112)
Proceeds from redemption or principal payments of AFS investment securities						20,555						6,959
Purchase of HTM investment securities						—						(8,495)
Proceeds from maturities or principal payments of HTM investment securities						—						9,040
Proceeds from sale of AFS investment securities						45,773						—
Net (increase) decrease of FHLB stock						(1,244)						586
Loans originated or acquired						(365,577)						(226,582)
Principal collected on loans						199,535						182,797
Purchase of premises and equipment						(108)						(466)
Proceeds from sale of OREO						2,278						324
Net Cash Used in Investing Activities						(187,507)						(48,949)

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CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(continued)

						Six Months Ended June 30,
(dollars in thousands)						2020						2019
Net increase in deposits						$	158,527					$	64,814
Proceeds from long-term debt						163,163						10,000
Payments of long-term debt						(9,396)						(33)
Net decrease in short term borrowings						—						(25,000)
Payments of subordinated notes						(23,000)						—
Dividends paid						(1,410)						(1,341)
Net change in unearned ESOP shares						—						(39)
Repurchase of common stock						—						(17)
Net Cash Provided by Financing Activities						287,884						48,384
Increase in Cash and Cash Equivalents						113,952						5,310
Cash and Cash Equivalents - January 1						32,469						33,036
Cash and Cash Equivalents - June 30						$	146,421					$	38,346
Supplemental Disclosures of Cash Flow Information
Cash paid during the period for
Interest						$	6,868					$	9,524
Income taxes						$	2,532					$	3,853
Supplemental Schedule of Non-Cash Operating Activities
Issuance of common stock for payment of compensation						$	303					$	107
Transfer from loans to OREO						$	—					$	3,249
Financed amount of sale of OREO						$	—					$	280
Supplemental Schedule of Non-Cash Investing and Financing Activities
Right-of use assets and lease liability recorded upon adoption of ASC 842						$	—					$	9,992

See notes to Consolidated Financial Statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 1 – BASIS OF PRESENTATION AND NATURE OF OPERATIONS

Basis of Presentation

The Consolidated Financial Statements of The Community Financial Corporation (the “Company”) and its wholly-owned subsidiary, Community Bank of the Chesapeake (the “Bank”), and the Bank’s wholly-owned subsidiary, Community Mortgage Corporation of Tri-County, included herein are unaudited.

The Consolidated Financial Statements reflect all adjustments consisting only of normal recurring accruals that, in the opinion of management, are necessary to present fairly the Company’s financial condition, results of operations, and cash flows for the periods presented. Certain information and note disclosures normally included in Consolidated Financial Statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. Management believes that the disclosures are adequate to make the information presented not misleading. The balances as of December 31, 2019 have been derived from audited Consolidated Financial Statements. Additions to the Company’s accounting policies are disclosed in the 2019 Annual Report as well as the adoption of new accounting standards included in Note 1. The results of operations for the six months June 30, 2020 are not necessarily indicative of the results of operations to be expected for the remainder of the year or any other period.

These Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes included in the Company’s 2019 Annual Report on Form 10-K.

Reclassification

Certain items in prior Consolidated Financial Statements have been reclassified to conform to the current presentation.

Nature of Operations

The Company provides financial services to individuals and businesses through its offices in Southern Maryland, and Fredericksburg, Virginia. Its primary deposit products are demand, savings and time deposits, and its primary lending products are commercial and residential mortgage loans, commercial loans, construction and land development loans, home equity and second mortgages and commercial equipment loans.

Use of Estimates

The preparation of Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the Consolidated Financial Statements and the reported amount of income and expenses during the reporting periods. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, real estate acquired in the settlement of loans, fair value of financial instruments, fair value of assets acquired, and liabilities assumed in a business combination, evaluating other-than-temporary-impairment of investment securities and valuation of deferred tax assets.

COVID-19

The Company has evaluated subsequent events for potential recognition and/or disclosure through the date the unaudited Consolidated Financial Statements included in this Quarterly Report on Form 10-Q were issued. On March 11, 2020, the World Health Organization declared the outbreak of a novel coronavirus ("COVID-19") as a global pandemic. The COVID-19 pandemic has adversely impacted many of the Company's customers and impaired their ability to fulfill their financial obligations to the Company. In response to the likely effects on the economy of the pandemic, the Federal Open Market Committee reduced the target federal funds rate from a target range of 1.50% to 1.75% to a target range of 0% to 0.25%. These reductions in interest rates along with the other effects of the COVID-19 outbreak may adversely affect the Company's financial condition and results of operations. Please refer to Management's Discussion and Analysis for further discussion.

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New Accounting Policy

COVID-19 Deferrals

In keeping with regulatory guidance to work with borrowers during this unprecedented situation and as outlined in the Coronavirus Aid, Relief and Economic Security ("CARES") Act, the Company offered payment deferral programs for our business and individual customers who are adversely affected by the pandemic. Depending on the demonstrated need of the client, the Company deferred either the full loan payment or the principal component of the loan payment between 90 and 180 days. As of June 30, 2020, the Company had executed 312 loan deferrals on outstanding loan balances of $264.9 million, which represented 17.7% of gross portfolio loans. While interest and fees will still accrue to income, should eventual credit losses on these deferred payments emerge or if a loan is placed on nonaccrual status, interest income and fees accrued would need to be reversed. Given the ongoing uncertainty regarding the length and economic impact of the COVID-19 crisis and the effects of various government stimulus programs, the estimated number and dollar impact of loan deferrals the Company could execute is subject to change.

On March 22, 2020, federal banking regulatory agencies, including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, ("the agencies") issued an interagency statement on loan modifications and reporting for financial institutions working with customers affected by the Coronavirus. The interagency statement impacted accounting for loan modifications. Under Accounting Standards Codification 310-40, "Receivables - Troubled Debt Restructurings by Creditors," ("ASC 310-40"), a restructuring of debt constitutes a troubled debt restructure ("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. The agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers, who were current prior to any relief, are not to be considered TDRs. This includes short-term (e.g., up to six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented. The loan modifications must be executed between March 1, 2020, and the earlier of (A) 60 days after the date of termination of the National Emergency or (B) December 31, 2020. This interagency guidance is expected to have a material impact on the Company's Consolidated Financial Statements.

Under the CARES Act, borrowers who were making payments as required and were not considered past due prior to becoming affected by COVID-19 and then receive payment accommodations as a result of the effects of COVID-19 generally would not be reported as past due or nonaccrual for regulatory and financial reporting during the accommodation period. Consistent with regulatory guidance, if new information during the deferral period indicates that there is evidence of default, the Bank may change the classification rating (e.g., change from passing credit to substandard) and accrual status (e.g., change form accrual to non-accrual status) as deemed appropriate.

See Note 1 – Summary of Significant Accounting Policies included in the Company’s 2019 Annual Report on Form 10-K for a list of policies in effect as of December 31, 2019.

Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”)

ASU 2016-13 - Financial Instruments - Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments. ASU No. 2016-13 significantly changes how entities will measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. The standard will replace the current “incurred loss” approach with an “expected loss” model. The new model, referred to as the current expected credit loss (“CECL”) model, will apply to: (1) financial assets subject to credit losses and measured at amortized cost, and (2) certain off-balance sheet credit exposures. This includes, but is not limited to, loans, leases, held-to-maturity securities, loan commitments, and financial guarantees. The CECL model does not apply to available-for-sale (“AFS”) debt securities. For AFS debt securities with unrealized losses, entities will measure credit losses in a manner similar to their current method, except that the credit losses will be recognized as allowances rather than reductions in the amortized cost of the securities. As a result, entities will recognize improvements to estimated credit losses immediately in earnings rather than as interest income over time, as currently required. The ASU also simplifies the accounting model for purchase credit impaired (“PCI”) debt securities and loans. ASU 2016-13 also expands the disclosure requirements regarding an entity’s assumptions, models, and methods for estimating the allowance for loan and lease losses (“ALLL”). In addition, entities will disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (i.e., modified retrospective approach).

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The Company has formed a CECL committee with representatives from various departments. The committee has selected a third-party vendor solution to assist in the application of the ASU 2016-13. The committee continues to make progress in accordance with the Company's implementation plan for adoption. The Company has developed new expected credit loss estimation models, depending on the nature of each identified pool of financial assets with similar risk characteristics, and is currently reviewing and analyzing the different methodologies to estimate expected credit losses. The Company is also working on documenting new processes and controls, challenging estimated credit loss model assumptions and outputs, refining the qualitative framework as well as drafting policies and disclosures. Additionally, parallel runs will be enhanced throughout 2020 as the processes, controls, and policies are finalized. The adoption of the ASU 2016-13 could result in an increase or decrease in the allowance for loan losses as a result of changing from an “incurred loss” model to an “expected loss” model. Furthermore, ASU 2016-13 will necessitate the establishment of an allowance for expected credit losses for certain debt securities and other financial assets. While management is currently unable to reasonably estimate the impact of adopting ASU 2016-13, the impact of adoption will be significantly influenced by the composition, characteristics, and quality of the loan and securities portfolios as well as the prevailing economic conditions and forecasts as of the adoption date.

In December 2019, the FASB issued ASU No. 2019-10, Financial Instruments-Credit Losses (Topic 326). This update amends the effective date of ASU No. 2016-13 for certain entities, including smaller reporting companies until fiscal years beginning after December 15, 2022, including interim periods within those fiscal periods. Early adoption is permitted. The one-time determination date for identifying as a smaller reporting company was November 15, 2019. The Company met the definition of a smaller reporting company as of this date and plans to adopt the standard with the amended effective date. The Company continues to work through implementation and continues collecting and retaining loan and credit data and evaluating various loss estimation models. While we currently cannot reasonably estimate the impact of adopting this standard, we expect the impact will be influenced by the composition, characteristics and quality of our loan and securities portfolios, as well as the general economic conditions and forecasts as of the adoption date.

ASU 2017-04 - Intangibles - Goodwill and Other (Topic 350) - Simplifying the Test for Goodwill Impairment. ASU 2017-04 eliminates Step 2 from the goodwill impairment test which required entities to compute the implied fair value of goodwill. Under ASU 2017-04, an entity should perform an annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The Company adopted ASU 2017-04 on January 1, 2020 and it did not have a material impact on the Company’s Consolidated Financial Statements.

ASU 2018-13 - Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. In August 2018, the FASB issued ASU No. 2018-13. This ASU eliminates, adds and modifies certain disclosure requirements for fair value measurements. Among the changes, entities will no longer be required to disclose the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy but will be required to disclose the range and weighted average used to develop significant unobservable inputs for Level 3 fair value measurements. ASU No. 2018-13 is effective for interim and annual reporting periods beginning after December 15, 2019; early adoption is permitted. Entities are also allowed to early adopt any eliminated or modified disclosure requirements and delay adoption of the new disclosure requirements until their effective date. The Company adopted this standard and there was no material impact.

ASU 2019-04 - In April 2019, the FASB issued ASU No. 2019-4 which codifies improvements to Financial Instruments - Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), Financial Instruments (Topic 825). With respect to Topic 326, ASU 2019-04 clarifies the scope of the credit losses standard and addresses issues related to accrued interest receivable balances, recoveries, variable interest rates and prepayments, among other things. With respect to Topic 825, ASU 2019-04 clarifies the scope of the guidance for recognizing and measuring financial instruments, the requirement for remeasurement under ASC 820 when using the measurement alternative, which equity securities have to be remeasured at historical exchange rates, and certain disclosure requirements. The amendments to Topic 326 have the same effective dates as ASU 2016-13. The Company is currently evaluating the potential impact of Topic 326 amendments on the Company's Consolidated Financial Statements. The amendments to Topic 825 are effective for interim and annual reporting periods beginning after December 15, 2022 and are not expected to have a material impact on the Company's Consolidated Financial Statements.

ASU 2019-05 - Financial Instruments-Credit Losses (Topic 326). In May 2019, the FASB issued ASU No. 2019-05. This ASU allows entities to irrevocably elect, upon adoption of ASU 2016-13, the fair value option for financial instruments that (1) were previously recorded at amortized cost and (2) are within the scope of ASC 326-20 if the instruments are eligible for the fair value option under ASC 825-10. The fair value option election does not apply to held-to-maturity debt securities. Entities are required to make this election on an instrument-by-instrument basis. The Company plans to adopt ASU 2019-05 upon adoption of ASU 2016-13 unless an earlier adoption is permitted in an accounting update. The Company is evaluating the impact of electing the fair value option of ASU 2019-05 on the Company's Consolidated Financial Statements.

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ASU 2020-01 - Investments-Equity Securities (Topic 321), Investments-Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815). In January 2020, the FASB issued guidance to address accounting for the transition into and out of the equity method and measuring certain purchased options and forward contracts to acquire investments. This ASU is effective for the Company for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years with early adoption permitted. The Company does not expect these amendments to have a material impact on its Consolidated Financial Statements.

ASU 2020-02 - Financial Instruments-Credit Losses (Topic 326) and Leases (Topic 842). In February 2020, the FASB issued guidance to add and amend SEC paragraphs in the Accounting Standards Codification to reflect the issuance of SEC Staff Accounting Bulletin No. 119 related to the new credit losses standard and comments by the SEC staff related to the revised effective date of the new leases standard. The amendments were effective upon issuance. The Company does not expect these amendments to have a material effect on its Consolidated Financial Statements.

ASU 2020-03 - Codification Improvements to Financial Instruments. In March 2020, the FASB issued ASU No. 2020-03. The FASB has an ongoing project on its agenda for improving the Codification or correcting its unintended application. The items addressed in that project generally are not expected to have a significant effect on current accounting practice or create a significant administrative cost for most entities. The amendments in this Update affect a wide variety of Topics in the Codification and apply to all reporting entities within the scope of the affected accounting guidance but is not expected to have a material impact on the Company's Consolidated Financial Statements.

ASU 2020-04 - Reference Rate Reform (Topic 848). In March 2020, the FASB issued guidance to provide temporary optional guidance to ease the potential burden in accounting for reference rate reform. The amendments are effective as of March 12, 2020 through December 31, 2022. The Company does not expect these amendments to have a material effect on its Consolidated Financial Statements.

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NOTE 2 – SECURITIES

Amortized cost and fair values of AFS investment securities at June 30, 2020 were as follows:

						June 30, 2020
(dollars in thousands)						Amortized Cost						Gross Unrealized Gains						Gross Unrealized Losses						Estimated Fair Value
Securities available-for-sale ("AFS")
Asset-backed securities issued by GSEs and U.S. Agencies
Residential Mortgage Backed Securities ("MBS")						$	29,084					$	1,860					$	13					$	30,931
Residential Collateralized Mortgage Obligations ("CMOs")						128,466						3,643						176						131,933
U.S. Agency						1,243						68						—						1,311
Asset-backed securities issued by Others:
Residential CMOs						336						—						16						320
Student Loan Trust CMOs						25,684						28						682						25,030
Certificates of Deposit Fixed						250						—						—						250
U.S. government obligations						1,499						—						1						1,498
Municipal bonds						42,310						1,418						19						43,709
Total investment securities available-for-sale						$	228,872					$	7,017					$	907					$	234,982
Equity securities carried at fair value through income
CRA investment fund						$	4,831					$	—					$	—					$	4,831
Non-marketable equity securities
Other equity securities						$	209					$	—					$	—					$	209
Total investment securities						$	233,912					$	7,017					$	907					$	240,022

In December 2019, Management determined that it no longer had the positive intent to hold its investment in securities classified as HTM until maturity and does not intend to hold HTM securities in the future. The Company reclassified the entire held to maturity ("HTM") investment portfolio, totaling $83.1 million with unrealized holding gains of $810,000 to the AFS investments category. The reclassification resulted in an increase to accumulated other comprehensive income of $587,000 and to deferred tax liabilities of $223,000. The Bank's primary reasons for the reclassification were to better manage interest rate risks and provide additional on-balance sheet liquidity. Based on accounting rules, the Bank will not be able to designate any securities as HTM securities for a period of time. The Company's HTM portfolio was primarily composed of asset-backed securities issued by GSEs and U.S. Agencies.

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Amortized cost and fair values of AFS investment securities at December 31, 2019 were as follows:

						December 31, 2019
(dollars in thousands)						Amortized Cost						Gross Unrealized Gains						Gross Unrealized Losses						Estimated Fair Value
Securities available-for-sale ("AFS")
Asset-backed securities issued by GSEs and U.S. Agencies
Residential Mortgage Backed Securities ("MBS")						$	35,351					$	754					$	13					$	36,092
Residential Collateralized Mortgage Obligations ("CMOs")						145,479						1,839						386						146,932
U.S. Agency						9,671						122						60						9,733
Asset-backed securities issued by Others:
Residential CMOs						380						3						12						371
Callable GSE Agency Bonds						2,001						1						—						2,002
Certificates of Deposit Fixed						250						—						—						250
U.S. government obligations						1,490						—						1						1,489
Municipal bonds						11,491						—						173						11,318
Total investment securities available-for-sale						$	206,113					$	2,719					$	645					$	208,187
Equity securities carried at fair value through income
CRA investment fund						$	4,669					$	—					$	—					$	4,669
Non-marketable equity securities
Other equity securities						$	209					$	—					$	—					$	209
Total investment securities						$	210,991					$	2,719					$	645					$	213,065

At June 30, 2020 and December 31, 2019 securities with an amortized cost of $50.1 million and $47.4 million were pledged to secure certain customer deposits. At June 30, 2020, and December 31, 2019, no securities were pledged as collateral for advances from the FHLB of Atlanta.

During the quarter ended June 30, 2020, the Company recognized net gains of $112,000 on the sale of two AFS securities with aggregate carrying values of $3.4 million. During the year ended December 31, 2019, the Company recognized net gains of $226,000 on the sale of 20 AFS securities with aggregate carrying values of $31.6 million.

The Company’s investment portfolio includes securities that are in an unrealized loss position as of June 30, 2020, the details of which are included in the following table. Although these securities, if sold at June 30, 2020 would result in a pretax loss of $907,000, the Company has no intent to sell the applicable securities at such fair values, and maintains the Company has the ability to hold these securities until all principal has been recovered. It is more likely than not that the Company will not sell any securities at a loss for liquidity purposes. Declines in the fair values of these securities can be traced to general market conditions which reflect the prospect for the economy as a whole. When determining other-than-temporary impairment on securities, the Company considers such factors as adverse conditions specifically related to a certain security or to specific conditions in an industry or geographic area, the time frame securities have been in an unrealized loss position, the Company’s ability to hold the security for a period of time sufficient to allow for anticipated recovery in value, whether or not the security has been downgraded by a rating agency, and whether or not the financial condition of the security issuer has severely deteriorated. As of June 30, 2020, the Company considers all securities with unrealized loss positions to be temporarily impaired, and consequently, does not believe it will sustain any material realized losses as a result of the current temporary decline in fair value. No charges related to other-than-temporary impairment were made during the three and six months ended June 30, 2020 and the year ended December 31, 2019.

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AFS Securities

Gross unrealized losses and estimated fair value by length of time that individual AFS securities have been in a continuous unrealized loss position at June 30, 2020, and December 31, 2019 were as follows:

June 30, 2020						Less Than 12 Months																		More Than 12 Months																		Total
(dollars in thousands)						Fair Value						Unrealized Loss						Fair Value						Unrealized Loss						Fair Value						Unrealized Losses
Asset-backed securities issued by GSEs and U.S. Agencies						$	33,799					$	172					$	3,081					$	17					$	36,880					$	189
Asset-backed securities issued by Others						17,338						682						319						16						17,657						698
Municipal bonds						8,205						19						—						—						8,205						19
U.S. government obligations						1,499						1						—						—						1,499						1
						$	60,841					$	874					$	3,400					$	33					$	64,241					$	907

December 31, 2019						Less Than 12 Months																		More Than 12 Months																		Total
(dollars in thousands)						Fair Value						Unrealized Loss						Fair Value						Unrealized Loss						Fair Value						Unrealized Losses
Asset-backed securities issued by GSEs and U.S. Agencies						$	15,215					$	63					$	39,689					$	336					$	54,904					$	399
U.S. SBA Debentures						—						—						4,744						60						4,744						60
Asset-backed securities issued by Others						—						—						136						12						136						12
Municipal bonds						11,318						173						—						—						11,318						173
U.S. government obligations						1,489						1						—						—						1,489						1
						$	28,022					$	237					$	44,569					$	408					$	72,591					$	645

AFS asset-backed securities issued by GSEs are guaranteed by the issuer and U.S. government agency securities and bonds are guaranteed by the full faith and credit of the U.S. government. At June 30, 2020 and December 31, 2019, total unrealized losses were $907,000 and $645,000 of the portfolio amortized cost of $228.9 million and $206.1 million, respectively.

At June 30, 2020 and December 31, 2019, AFS asset-backed securities issued by GSEs and U.S. Agencies with unrealized losses had amortized cost of $37.1 million and $56.8 million, respectively, with the unrealized losses of $189,000 and $399,000, average lives of 7.43 years and 4.68 years and average durations of 7.03 years and 4.22 years, respectively. At June 30, 2020, AFS asset-backed securities issued by student loan trust and others with unrealized losses had amortized cost of $18.4 million with unrealized losses of $698,000, an average life of 6.60 years and an average duration of 6.17 years. The Company's amortized cost investment of $25.7 million in student loan trusts are 97% U.S. government guaranteed. At June 30, 2020 and December 31, 2019, AFS municipal bonds issued by states, political subdivisions, or agencies with unrealized losses had amortized cost of $8.2 million and $11.5 million, respectively, with unrealized losses of $19,000 and $173,000, an average life of 10.81 years and 9.51 years and an average duration of 9.40 years and 8.18 years, respectively. Management believes that the securities will either recover in market value or be paid off as agreed.

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NOTE 3 – LOANS

Loans consist of the following:

						June 30, 2020																		December 31, 2019
(dollars in thousands)						Total						% of Gross Loans						Total						% of Gross Loans
Portfolio Loans:
Commercial real estate						$	996,111					66.73		%				$	964,777					66.34		%
Residential first mortgages						165,670						11.10		%				167,710						11.53		%
Residential rentals						132,590						8.88		%				123,601						8.50		%
Construction and land development						37,580						2.52		%				34,133						2.35		%
Home equity and second mortgages						33,873						2.27		%				36,098						2.48		%
Commercial loans						63,249						4.24		%				63,102						4.34		%
Consumer loans						1,117						0.07		%				1,104						0.08		%
Commercial equipment						62,555						4.19		%				63,647						4.38		%
Gross portfolio loans						1,492,745						100.00		%				1,454,172						100.00		%
Less:
Net deferred costs						2,072						0.14		%				1,879						0.13		%
Allowance for loan losses						(16,319)						(1.09)		%				(10,942)						(0.75)		%
						(14,247)												(9,063)
Net portfolio loans						$	1,478,498											$	1,445,109
U.S. Small Business Administration ("SBA") Paycheck Protection Program ("PPP") loans						$	129,384											$	—
Net deferred fees						(3,746)												—
Net SBA PPP Loans						$	125,638											$	—
Total net loans						$	1,604,136											$	1,445,109
Gross Loans						$	1,622,129											$	1,454,172

The Company has segregated its loans into two categories; portfolio loans and U.S. SBA PPP loans. Portfolio loans include all loan portfolios except the U.S. SBA PPP loan portfolio.

In the second quarter of 2020, the Company offered COVID-19 payment deferral programs for our business and individual customers who are adversely affected by the pandemic. The full loan payments or the principal component of the loan payments were deferred between 90 and 180 days. As of June 30, 2020, the Company had executed 312 loan deferrals on outstanding loan balances of $264.9 million, which represented 17.7% of gross portfolio loans. See Note 1 for regulatory and accounting treatment.

Deferred Costs

Net deferred costs of $2.1 million at June 30, 2020 related to portfolio loans included deferred fees paid by customers of $3.2 million offset by deferred costs of $5.3 million, which include premiums paid for the purchase of residential first mortgages and deferred costs recorded in accordance with ASC 310-20 to capture loan origination costs. Net deferred loan costs of $1.9 million at December 31, 2019 included deferred fees paid by customers of $3.3 million offset by deferred costs of $5.2 million.

U.S. SBA PPP loan net deferred fees of $3.7 million at June 30, 2020 included deferred fees paid by the Small Business Administration of $4.5 million partially offset by deferred costs of $733,000.

Risk Characteristics of Portfolio Segments

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Concentrations of Credit - Loans are primarily made within the Company’s operating footprint of Southern Maryland and the greater Fredericksburg area of Virginia. Real estate loans can be affected by the condition of the local real estate market. Commercial and industrial loans can be affected by the local economic conditions. The commercial loan portfolio has business loans secured by real estate and real estate development loans. At June 30, 2020 and December 31, 2019, the Company had no loans outstanding with foreign entities.

The Company manages its credit products and exposure to credit losses (credit risk) by the following specific portfolio segments (classes), which are levels at which the Company develops and documents its allowance for loan loss methodology. These segments are:

U.S. SBA PPP Loans

The U.S. SBA PPP loan was created to address economic hardships anticipated as a result of the COVID-19 pandemic. As of June 30, 2020, the Company had originated 902 SBA PPP loans with balances of $129.4 million. The program is designed to provide a direct incentive for small businesses to keep their workers on the payroll. SBA will forgive loans if all employee retention criteria are met, and the funds are used for eligible expenses. U.S. SBA PPP loans carry a two or five years term at a 1% annual interest rate until the loan is either forgiven or paid. At June 30, 2020 99.74% or $129.0 million of these loans have a two year term. The Company recorded net deferred fees of $3.7 million during the second quarter of 2020 that are being amortized as a component of interest income through the contractual maturity date of each individual PPP loan. Net deferred fees include fees (deferred fees) paid to participant banks for each PPP loan underwritten and funded as well as costs incurred to underwrite the loans (deferred costs). PPP loan forgiveness will allow the Company to recognize remaining net deferred fees in the quarter of forgiveness.

The Company funded virtually all PPP loans with the Federal Reserve lending facility to fund banks offering SBA PPP loans (the Federal Reserve "PPPLF" program) at a 0.35% annual interest rate. The Company is participating in the Federal Reserve Bank's PPPLF Program. As of June 30, 2020, the Company's outstanding PPPLF advances were $126.8 million. Due to the expected temporary increase to assets and the 100% government guaranty, banking regulators have provided favorable regulatory capital treatment by excluding the activity and balances from regulatory capital ratios.

No credit issues are anticipated with SBA PPP loans as they are fully guaranteed by the Small Business Administration and the Bank's allowance for loan loss does not include an allowance for U.S. SBA PPP loans. Management believes the Company's employees have underwritten all PPP loans in good faith and in accordance with the program's guidelines. The U.S. SBA PPP guidelines indicate that lenders may rely on certifications of the borrower in order to determine eligibility and to rely on specified documents provided by the borrower to determine qualifying loan amount and eligibility for forgiveness. The guideline further specify that lenders will be held harmless for a borrowers’ failure to comply with program criteria.

Commercial Real Estate (“CRE”)

Commercial and other real estate projects include office buildings, retail locations, churches, other special purpose buildings and commercial construction. Commercial construction balances were 10.2% and 8.9% of the CRE portfolio at June 30, 2020 and December 31, 2019, respectively. The Bank offers both fixed-rate and adjustable-rate loans under these product lines. The primary security on a commercial real estate loan comprises the real property and the leases that produce income for the real property. Loans secured by commercial real estate are generally limited to 80% of the lower of the appraised value or sales price at origination and have an initial contractual loan payment period ranging from three to 20 years.

Loans secured by commercial real estate are larger and involve greater risks than one-to four-family residential mortgage loans. Because payments on loans secured by such properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy.

At June 30, 2020 and December 31, 2019, the largest outstanding commercial real estate loans were $21.0 million and $21.1 million, respectively, which were secured by commercial real estate and performing according to their terms.

Residential First Mortgages

Residential first mortgage loans are generally long-term loans, amortized on a monthly basis, with principal and interest due each month. The contractual loan payment period for residential loans typically ranges from ten to 30 years. The Bank’s experience indicates that real estate loans remain outstanding for significantly shorter time periods than their contractual terms. Borrowers may refinance or prepay loans at their option, without penalty. The Bank’s residential portfolio has both fixed-rate and adjustable-rate residential first mortgages. During the six months ended June 30, 2020 and the year ended December 31, 2019, the Bank purchased residential first mortgages of $21.9 million and $41.0 million, respectively.

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The annual and lifetime limitations on interest rate adjustments may constrain interest rate increases on these loans. There are also credit risks resulting from potential increased costs to the borrower as a result of repricing of adjustable-rate mortgage loans. During periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase due to the upward adjustment of interest cost to the borrower. The Bank’s adjustable rate residential first mortgage portfolio was $43.2 million or 2.9% of total gross portfolio loans of $1.5 billion at June 30, 2020 compared to $52.3 million or 3.6% of total gross portfolio loans of $1.5 billion at December 31, 2019.

The Bank generally retains the right to service loans sold for a payment based upon a percentage (generally 0.25% of the outstanding loan balance). As of June 30, 2020 and December 31, 2019, the Bank serviced $29.1 million and $32.9 million, respectively, in residential mortgage loans for others.

At June 30, 2020 and December 31, 2019, the largest outstanding residential first mortgage loan was $3.0 million which was secured by residences located in the Bank’s market area. The loan was performing according to terms.

Residential Rentals

Residential rental mortgage loans are amortizing, with principal and interest due each month. The loans are secured by income-producing 1-4 family units and apartments. As of June 30, 2020 and December 31, 2019, $103.3 million and $97.1 million, respectively, were 1-4 family units and $29.3 million and $26.5 million, respectively, were apartment buildings or multi-family units. Loans secured by residential rental properties are generally limited to 80% of the lower of the appraised value or sales price at origination and have an initial contractual loan payment period ranging from three to 20 years. The primary security on a residential rental loan is the related real property and the related leases that produce income. During periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase due to the upward adjustment of interest cost to the borrower. The Bank’s adjustable rate residential rental portfolio was $112.4 million or 7.5% of total gross portfolio loans of $1.5 billion at June 30, 2020 compared to $102.2 million or 7.0% of total gross portfolio loans of $1.5 billion at December 31, 2019.

Loans secured by residential rental properties involve greater risks than 1-4 family residential mortgage loans. Although, there are similar risk characteristics shared with commercial real estate loans, the balances for the loans secured by residential rental properties are generally smaller. Because payments on loans secured by residential rental properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to a greater extent to adverse conditions in the rental real estate market or the economy to a greater extent than similar owner-occupied properties.

At June 30, 2020 and December 31, 2019, the largest outstanding residential rental mortgage loan was $9.7 million which was secured by over 120 single family homes located in the Bank’s market area. The loan was performing according to its terms.

Construction and Land Development

The Bank offers loans for the construction of one-to-four family dwellings. Generally, these loans are secured by the real estate under construction as well as by guarantees of the principals involved. In addition, the Bank offers loans to acquire and develop land, as well as loans on undeveloped, subdivided lots for home building. The Bank’s construction and land development portfolio was $37.6 million or 2.5% of total gross portfolio loans of $1.5 billion at June 30, 2020 compared to $34.1 million or 2.4% of total gross portfolio loans of $1.5 billion at December 31, 2019.

A decline in demand for new housing might adversely affect the ability of borrowers to repay these loans. Construction and land development loans are inherently riskier than financing owner-occupied real estate. The Bank’s risk of loss is affected by the accuracy of the initial estimate of the market value of the completed project as well as the accuracy of the cost estimates made to complete the project. In addition, the volatility of the real estate market has made it increasingly difficult to ensure that the valuation of land associated with these loans is accurate. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the development. If the estimate of value proves to be inaccurate, a project’s value might be insufficient to assure full repayment. As a result of these factors, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the project rather than the ability of the borrower or guarantor to repay principal and interest. If the Bank forecloses on a project, there can be no assurance that the Bank will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.

At June 30, 2020 and December 31, 2019, the largest outstanding construction and land development loans were $7.7 million and $5.3 million, respectively, which were secured by land in the Bank’s market area.

Home Equity and Second Mortgage Loans

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The Bank maintains a portfolio of home equity and second mortgage loans. The Bank’s home equity and second mortgage portfolio was $33.9 million or 2.3% of total gross portfolio loans of $1.5 billion at June 30, 2020 compared to $36.1 million or 2.5% of total gross portfolio loans of $1.5 billion at December 31, 2019. These products contain a higher risk of default than residential first mortgages as in the event of foreclosure, the first mortgage would need to be paid off prior to collection of the second mortgage.

Commercial Loans

The Bank offers its business customers a variety of commercial loan products including term loans and lines of credit. Such loans are generally made for terms of five years or less. The portfolio consists primarily of demand loans and lines of credit. When making commercial business loans, the Bank considers the financial condition of the borrower, the borrower’s payment history of both corporate and personal debt, the projected cash flows of the business, the viability of the industry in which the borrower operates, the value of the collateral, and the borrower’s ability to service the debt from income. These loans are primarily secured by equipment, real property, accounts receivable or other security. Commercial loans are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. In the case of business failure, collateral would need to be liquidated to provide repayment for the loan. In many cases, the highly specialized nature of collateral would make full recovery from the sale of collateral unlikely.

The Bank’s commercial loan portfolio was $63.2 million or 4.2% of total gross portfolio loans of $1.5 billion at June 30, 2020 compared to $63.1 million or 4.3% of total gross portfolio loans of $1.5 billion at December 31, 2019. At June 30, 2020 and December 31, 2019, the largest outstanding commercial loans were $6.7 million and $2.8 million, respectively, which were secured by commercial real estate (all of which were located in the Bank’s market area), cash and investments. These loans were performing according to terms at June 30, 2020 and December 31, 2019.

Consumer Loans

Consumer loans consist of loans secured by automobiles, boats, recreational vehicles and trucks. The Bank also makes home improvement loans and offers both secured and unsecured personal lines of credit. Consumer loans entail greater risk from other loan types due to being secured by rapidly depreciating assets or the reliance on the borrower’s continuing financial stability.

Commercial Equipment Loans

These loans consist primarily of fixed-rate, short-term loans collateralized by a commercial customer’s equipment or secured by real property, accounts receivable, or other security. When making commercial equipment loans, the Bank considers the same factors it considers when underwriting a commercial business loan. Commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, repayment of commercial loans may depend substantially on the success of the business itself. In the case of business failure, collateral would need to be liquidated to repay the loan. In many cases, the highly specialized nature of collateral equipment would make full recovery from the sale of collateral problematic.

The Bank’s commercial equipment portfolio was $62.6 million or 4.2% of total gross portfolio loans of $1.5 billion at June 30, 2020 compared to $63.6 million or 4.4% of total gross portfolio loans of $1.5 billion at December 31, 2019. At June 30, 2020 and December 31, 2019, the largest outstanding commercial equipment loans were $2.0 million and $2.1 million, respectively, which were secured by commercial real estate (located in the Bank’s market area), cash and investments. These loans were performing according to terms at June 30, 2020 and December 31, 2019.

Non-accrual and Aging Analysis of Current and Past Due Loans

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Non-accrual loans as of June 30, 2020 and December 31, 2019 were as follows:

						June 30, 2020
(dollars in thousands)						Non-accrual Delinquent Loans						Number of Loans						Non-accrual Current Loans						Number of Loans						Total Non-accrual Loans						Total Number of Loans
Commercial real estate						$	18,083					18						$	1,878					5						$	19,961					23
Residential first mortgages						—						—						194						1						194						1
Residential rentals						—						—						281						2						281						2
Home equity and second mortgages						132						3						451						3						583						6
Commercial loans						1,807						2						—						—						1,807						2
Consumer loans						5						1						—						—						5						1
Commercial equipment						50						2						15						2						65						4
						$	20,077					26						$	2,819					13						$	22,896					39

						December 31, 2019
(dollars in thousands)						Non-accrual Delinquent Loans						Number of Loans						Non-accrual Current Loans						Number of Loans						Total Non-accrual Loans						Total Number of Loans
Commercial real estate						$	10,562					11						$	1,687					5						$	12,249					16
Residential first mortgages						—						—						830						3						830						3
Residential rentals						—						—						937						5						937						5
Home equity and second mortgages						177						3						271						3						448						6
Commercial loans						1,807						2						1,320						1						3,127						3
Commercial equipment						241						5						25						1						266						6
						$	12,787					21						$	5,070					18						$	17,857					39

Non-accrual loans increased $5.0 million from $17.9 million or 1.23% of total loans at December 31, 2019 to $22.9 million or 1.41% of total loans at June 30, 2020. Loans can be current but classified as non-accrual due to customer operating results or payment history. All interest accrued but not collected from loans that are placed on non-accrual or charged-off is reversed against interest income. In accordance with the Company’s policy, such interest income is recognized on a cash basis or cost-recovery method, until qualifying for return to accrual status.

At June 30, 2020, non-accrual loans of $22.9 million included 39 loans, of which $20.0 million, or 87% represented 21 loans and 10 customer relationships. Non-accrual loans of $2.8 million (12%) were current with all payments of principal and interest with no impairment at June 30, 2020. Delinquent non-accrual loans were $20.1 million (88%) with specific reserves of $0.1 million at June 30, 2020.

At December 31, 2019, non-accrual loans of $17.9 million included 39 loans, of which $15.0 million, or 84% represented 18 loans and seven customer relationships. During the year ended December 31, 2019, non-accrual loans decreased $1.4 million primarily as a result of a written off loan relationship. At December 31, 2019, there were $5.1 million (28%) of non-accrual loans current with all payments of principal and interest with no impairment and $12.8 million (72%) of delinquent non-accrual loans with a total of $522,000 specifically reserved.

Non-accrual loans included TDRs totaling $1.60 million and $1.40 million at June 30, 2020 and December 31, 2019, respectively. These loans were classified as non-accrual solely for the calculation of financial ratios. Loan delinquency (90 days or greater delinquent and 31-89 days delinquent) increased $12.6 million from $13.3 million, or 0.92% of loans, at December 31, 2019 to $25.9 million, or 1.74% of loans, at June 30, 2020.

Non-accrual loans, which did not have a specific allowance for impairment, amounted to $22.1 million and $11.7 million at June 30, 2020 and December 31, 2019, respectively. Interest due but not recognized on these balances at June 30, 2020 and December 31, 2019 was $689,000 and $318,000, respectively. Non-accrual loans with a specific allowance for impairment amounted to $870,000 and $6.1 million at June 30, 2020 and December 31, 2019, respectively. Interest due but not recognized on these balances at June 30, 2020 and December 31, 2019 was $105,000 and $302,000, respectively.

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The Company considers a loan to be past due or delinquent when the terms of the contractual obligation are not met by the borrower. PCI loans are included as a single category in the table below as management believes, regardless of their age, there is a lower likelihood of aggregate loss related to these loan pools. Additionally, PCI loans are discounted to allow for the accretion of income on a level yield basis over the life of the loan based on expected cash flows. Regardless of payment status, as long as cash flows can be reasonably estimated, the associated discount on these loan pools results in income recognition.

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Past due and PCI loans as of June 30, 2020 and December 31, 2019 were as follows:

						June 30, 2020
(dollars in thousands)						31-60 Days						61-89 Days						90 or Greater Days						Total Past Due						PCI Loans						Current						Total Loan Receivables
Commercial real estate						$	400					$	4,872					$	18,083					$	23,355					$	1,593					$	971,163					$	996,111
Residential first mortgages						51						—						—						51						—						165,619						165,670
Residential rentals						—						—						—						—						—						132,590						132,590
Construction and land dev.						—						220						—						220						—						37,360						37,580
Home equity and second mtg.						82						103						127						312						400						33,161						33,873
Commercial loans						—						—						1,807						1,807						—						61,442						63,249
Consumer loans						1						—						5						6						—						1,111						1,117
Commercial equipment						7						107						50						164						—						62,391						62,555
Total portfolio loans						$	541					$	5,302					$	20,072					$	25,915					$	1,993					$	1,464,837					$	1,492,745
U.S. SBA PPP loans						$	—					$	—					$	—					$	—					$	—					$	129,384					$	129,384

						December 31, 2019
(dollars in thousands)						31-60 Days						61-89 Days						90 or Greater Days						Total Past Due						PCI Loans						Current						Total Loan Receivables
Commercial real estate						$	—					$	217					$	10,563					$	10,780					$	1,738					$	952,259					$	964,777
Residential first mortgages						—						—						—						—						—						167,710						167,710
Residential rentals						—						—						—						—						295						123,306						123,601
Construction and land dev.						—						—						—						—						—						34,133						34,133
Home equity and second mtg.						98						23						177						298						391						35,409						36,098
Commercial loans						—						—						1,807						1,807						—						61,295						63,102
Consumer loans						—						—						—						—						—						1,104						1,104
Commercial equipment						52						159						231						442						—						63,205						63,647
Total portfolio loans						$	150					$	399					$	12,778					$	13,327					$	2,424					$	1,438,421					$	1,454,172

There were no loans that were past due 90 days or greater accruing interest at June 30, 2020 and December 31, 2019.

Impaired Loans and Troubled Debt Restructures (“TDRs”)

Troubled debt restructurings ("TDR") are those loans for which we have granted a concession to a borrower experiencing financial difficulties where we do not receive adequate compensation. TDRs are identified at the point when the borrower enters into a modification program.

Impaired loans, including TDRs, at June 30, 2020 and 2019 and at December 31, 2019 were as follows:

						June 30, 2020
(dollars in thousands)						Unpaid Contractual Principal Balance						Recorded Investment With No Allowance						Recorded Investment With Allowance						Total Recorded Investment						Related Allowance						Quarter Average Recorded Investment						Quarter Interest Income Recognized						YTD Average Recorded Investment						YTD Interest Income Recognized
Commercial real estate						$	21,360					$	20,315					$	842					$	21,157					$	60					$	21,191					$	88					$	21,243					$	238
Residential first mortgages						1,710						1,710						—						1,710						—						1,717						13						1,731						29
Residential rentals						643						643						—						643						—						648						12						653						18
Home equity and second mtg.						656						645						—						645						—						646						10						647						12
Commercial loans						1,807						1,807						—						1,807						—						1,807						—						1,807						—
Consumer loans						5						5						—						5						—						5						—						5						—
Commercial equipment						548						489						44						533						44						539						7						544						21
Total						$	26,729					$	25,614					$	886					$	26,500					$	104					$	26,553					$	130					$	26,630					$	318

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						June 30, 2019
(dollars in thousands)						Unpaid Contractual Principal Balance						Recorded Investment With No Allowance						Recorded Investment With Allowance						Total Recorded Investment						Related Allowance						Quarter Average Recorded Investment						Quarter Interest Income Recognized						YTD Average Recorded Investment						YTD Interest Income Recognized
Commercial real estate						$	20,933					$	18,512					$	2,406					$	20,918					$	289					$	20,975					$	214					$	21,075					$	410
Residential first mortgages						2,124						2,123						—						2,123						—						2,129						20						2,139						41
Residential rentals						971						971						—						971						—						978						17						985						30
Home equity and second mtg.						482						471						—						471						—						476						5						461						9
Commercial loans						2,638						1,807						819						2,626						700						2,629						27						2,649						54
Commercial equipment						367						131						218						349						192						357						2						369						4
Total						$	27,515					$	24,015					$	3,443					$	27,458					$	1,181					$	27,544					$	285					$	27,678					$	548

						December 31, 2019
(dollars in thousands)						Unpaid Contractual Principal Balance						Recorded Investment With No Allowance						Recorded Investment With Allowance						Total Recorded Investment						Related Allowance						YTD Average Recorded Investment						YTD Interest Income Recognized
Commercial real estate						$	20,914					$	15,919					$	4,788					$	20,707					$	417					$	21,035					$	813
Residential first mortgages						1,921						1,917						—						1,917						—						1,962						86
Residential rentals						941						937						—						937						—						967						56
Home equity and second mtg.						524						510						—						510						—						519						23
Commercial loans						3,127						1,807						1,320						3,127						210						3,284						152
Commercial equipment						808						585						203						788						201						826						35
Total						$	28,235					$	21,675					$	6,311					$	27,986					$	828					$	28,593					$	1,165

TDRs included in the impaired loan schedules above, as of June 30, 2020 and December 31, 2019 were as follows:

						June 30, 2020																		December 31, 2019
(dollars in thousands)						Dollars						Number of Loans						Dollars						Number of Loans
Commercial real estate						$	1,408					3						$	1,420					3
Residential first mortgages						257						2						64						1
Commercial equipment						524						3						565						4
Total TDRs						$	2,189					8						$	2,049					8
Less: TDRs included in non-accrual loans						(1,596)						(4)						(1,399)						(3)
Total accrual TDR loans						$	593					4						$	650					5

TDRs increased $140,000 during the six months ended June 30, 2020 due to principal paydowns of $29,000, the disposal of one TDR in the amount of $25,000 and the addition of one TDR in the amount of $194,000. The Company fully reserved four TDRs totaling $60,000 at June 30, 2020.

The Company had specific reserves of $87,000 on three TDR totaling $88,000 at December 31, 2019. During the year ended December 31, 2019, TDR disposals, which included payoffs and refinancing, included seven loans totaling $4.4 million. TDR loan principal curtailment was $236,000 for the year ended December 31, 2019. There was one TDR added during the year ended December 31, 2019 totaling $25,000.

Allowance for Loan Losses ("ALLL")

The following tables detail activity in the ALLL at and for the three and six months ended June 30, 2020 and 2019, respectively. An allocation of the allowance to one category of loans does not prevent the Company from using that allowance to absorb losses in a different category. There is no allowance for loan loss on the PCI portfolios.

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Three Months Ended						June 30, 2020
(dollars in thousands)						Beginning Balance						Charge-offs						Recoveries						Provisions						Ending Balance
Commercial real estate						$	9,083					$	(929)					$	—					$	3,114					$	11,268
Residential first mortgages						862						—						—						23						885
Residential rentals						702						—						—						357						1,059
Construction and land development						436						—						—						(8)						428
Home equity and second mortgages						258						(25)						—						26						259
Commercial loans						2,266						(1,026)						5						(83)						1,162
Consumer loans						15						—						—						—						15
Commercial equipment						1,439						(282)						15						71						1,243
						$	15,061					$	(2,262)					$	20					$	3,500					$	16,319
Six Months Ended						June 30, 2020
(dollars in thousands)						Beginning Balance						Charge-offs						Recoveries						Provisions						Ending Balance
Commercial real estate						$	7,398					$	(929)					$	—					$	4,799					$	11,268
Residential first mortgages						464						—						—						421						885
Residential rentals						397						—						—						662						1,059
Construction and land development						273						—						—						155						428
Home equity and second mortgages						149						(25)						1						134						259
Commercial loans						1,086						(1,026)						10						1,092						1,162
Consumer loans						10						—						—						5						15
Commercial equipment						1,165						(282)						28						332						1,243
						$	10,942					$	(2,262)					$	39					$	7,600					$	16,319

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Three Months Ended						June 30, 2019
(dollars in thousands)						Beginning Balance						Charge-offs						Recoveries						Provisions						Ending Balance
Commercial real estate						$	6,742					$	(4)					$	13					$	258					$	7,009
Residential first mortgages						722						—						—						(13)						709
Residential rentals						462						—						—						(4)						458
Construction and land development						148						(329)						—						427						246
Home equity and second mortgages						132						—						2						(3)						131
Commercial loans						1,406						—						5						(9)						1,402
Consumer loans						8						—						1						—						9
Commercial equipment						1,226						—						9						(281)						954
						$	10,846					$	(333)					$	30					$	375					$	10,918
Six Months Ended						June 30, 2019
(dollars in thousands)						Beginning Balance						Charge-offs						Recoveries						Provisions						Ending Balance
Commercial real estate						$	6,882					$	(4)					$	15					$	116					$	7,009
Residential first mortgages						755						—						—						(46)						709
Residential rentals						498						(53)						46						(33)						458
Construction and land development						310						(329)						—						265						246
Home equity and second mortgages						133						—						4						(6)						131
Commercial loans						1,482						—						10						(90)						1,402
Consumer loans						6						(4)						2						5						9
Commercial equipment						910						(685)						65						664						954
						$	10,976					$	(1,075)					$	142					$	875					$	10,918

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The following tables detail loan receivable and allowance balances disaggregated on the basis of the Company’s impairment methodology at June 30, 2020 and 2019 and December 31, 2019.

						June 30, 2020																																										December 31, 2019																																										June 30, 2019
(dollars in thousands)						Ending balance: individually evaluated for impairment						Ending balance: collectively evaluated for impairment						Purchase Credit Impaired						Total						Ending balance: individually evaluated for impairment						Ending balance: collectively evaluated for impairment						Purchase Credit Impaired						Total						Ending balance: individually evaluated for impairment						Ending balance: collectively evaluated for impairment						Purchase Credit Impaired						Total
Loan Receivables:
Commercial real estate						$	21,157					$	973,361					$	1,593					$	996,111					$	20,707					$	942,332					$	1,738					$	964,777					$	20,918					$	895,305					$	1,725					$	917,948
Residential first mortgages						1,710						163,960						—						165,670						1,917						165,793						—						167,710						2,123						154,096						451						156,670
Residential rentals						643						131,947						—						132,590						937						122,369						295						123,601						971						120,692						327						121,990
Construction and land development						—						37,580						—						37,580						—						34,133						—						34,133						—						35,662						—						35,662
Home equity and second mortgages						645						32,828						400						33,873						510						35,197						391						36,098						471						35,126						269						35,866
Commercial loans						1,807						61,442						—						63,249						3,127						59,975						—						63,102						2,626						64,991						—						67,617
Consumer loans						5						1,112						—						1,117						—						1,104						—						1,104						—						967						—						967
Commercial equipment						533						62,022						—						62,555						788						62,859						—						63,647						349						50,117						—						50,466
						$	26,500					$	1,464,252					$	1,993					$	1,492,745					$	27,986					$	1,423,762					$	2,424					$	1,454,172					$	27,458					$	1,356,956					$	2,772					$	1,387,186
Allowance for loan losses:
Commercial real estate						$	60					$	11,208					$	—					$	11,268					$	417					$	6,981					$	—					$	7,398					$	289					$	6,720					$	—					$	7,009
Residential first mortgages						—						885						—						885						—						464						—						464						—						709						—						709
Residential rentals						—						1,059						—						1,059						—						397						—						397						—						458						—						458
Construction and land development						—						428						—						428						—						273						—						273						—						246						—						246
Home equity and second mortgages						—						259						—						259						—						149						—						149						—						131						—						131
Commercial loans						—						1,162						—						1,162						210						876						—						1,086						700						702						—						1,402
Consumer loans						—						15						—						15						—						10						—						10						—						9						—						9
Commercial equipment						44						1,199						—						1,243						201						964						—						1,165						192						762						—						954
						$	104					$	16,215					$	—					$	16,319					$	828					$	10,114					$	—					$	10,942					$	1,181					$	9,737					$	—					$	10,918

At June 30, 2020 and December 31, 2019, the Bank’s allowance for loan losses totaled $16.3 million and $10.9 million, or 1.09% and 0.75%, respectively, of loan balances. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the portfolio with consideration given to the overall loss experience, current economic conditions, size, growth and composition of the loan portfolio, financial condition of the borrowers and other relevant factors that, in management’s judgment, warrant recognition in providing an adequate allowance.

The Company's allowance methodology considers quantitative historical loss factors and qualitative factors to determine the estimated level of incurred losses inherent in the Company's loan portfolios. The increased provision for loan losses ("PLL") recorded in the first three months of 2020 was due to growth in the loan portfolio and the uncertainty surrounding economic conditions as a result of the COVID-19 pandemic. The Company's ALLL increased $5.4 million or 49.14% to $16.3 million at June 30, 2020 compared to $10.9 million at December 31, 2019. The increased provision expense recorded in the first six months of 2020 was primarily due to the uncertainty surrounding economic conditions as a result of the COVID-19 pandemic and to a lesser degree growth in the commercial loan portfolio. In addition, the allowance in the second quarter of 2020 increased due to COVID-19 deferred loans. The allowance for loan losses as a percent of total loans may increase in future periods based on our belief that the credit quality of our loan portfolio could decline and loan defaults may increase as a result of the COVID-19 pandemic.

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Credit Quality Indicators

Credit quality indicators as of June 30, 2020 and December 31, 2019 were as follows:

Credit Risk Profile by Internally Assigned Grade

						Commercial Real Estate																		Construction and Land Dev.																		Residential Rentals
(dollars in thousands)						6/30/2020						12/31/2019						6/30/2020						12/31/2019						6/30/2020						12/31/2019
Unrated						$	150,661					$	102,695					$	1,950					$	2,075					$	47,992					$	38,139
Pass						826,315						840,403						35,630						32,058						84,236						84,811
Special mention						197						—						—						—						362						—
Substandard						18,938						21,679						—						—						—						651
Doubtful						—						—						—						—						—						—
Loss						—						—						—						—						—						—
Total						$	996,111					$	964,777					$	37,580					$	34,133					$	132,590					$	123,601

						Commercial Loans																		Commercial Equipment																		Total Commercial Portfolios
(dollars in thousands)						6/30/2020						12/31/2019						6/30/2020						12/31/2019						6/30/2020						12/31/2019
Unrated						$	16,018					$	16,754					$	26,153					$	26,045					$	242,774					$	185,708
Pass						45,424						43,221						36,358						37,399						1,027,963						1,037,892
Special mention						—						—						—						—						559						—
Substandard						1,807						3,127						44						203						20,789						25,660
Doubtful						—						—						—						—						—						—
Loss						—						—						—						—						—						—
Total						$	63,249					$	63,102					$	62,555					$	63,647					$	1,292,085					$	1,249,260

						Non-Commercial Portfolios **																		U.S. SBA PPP Loans																		Total All Portfolios
(dollars in thousands)						6/30/2020						12/31/2019						6/30/2020						12/31/2019						6/30/2020						12/31/2019
Unrated						$	166,782					$	164,991					$	129,384					$	—					$	538,940					$	350,699
Pass						32,780						38,718						—						—						1,060,743						1,076,610
Special mention						467						—						—						—						1,026						—
Substandard						631						1,203						—						—						21,420						26,863
Doubtful						—						—						—						—						—						—
Loss						—						—						—						—						—						—
Total						$	200,660					$	204,912					$	129,384					$	—					$	1,622,129					$	1,454,172

** Non-commercial portfolios are generally evaluated based on payment activity but may be risk graded if part of a larger commercial relationship or are credit impaired (e.g. non-accrual loans, TDRs).

Credit Risk Profile Based on Payment Activity

						Residential First Mortgages																		Home Equity and Second Mtg.																		Consumer Loans
(dollars in thousands)						6/30/2020						12/31/2019						6/30/2020						12/31/2019						6/30/2020						12/31/2019
Performing						$	165,670					$	167,710					$	33,746					$	35,921					$	1,112					$	1,104
Nonperforming						—						—						127						177						5						—
Total						$	165,670					$	167,710					$	33,873					$	36,098					$	1,117					$	1,104

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A risk-grading scale is used to assign grades to commercial relationships, which include commercial real estate, residential rentals, construction and land development, commercial loans and commercial equipment loans. Loans are graded at inception, annually thereafter when financial statements are received and at other times when there is an indication that a credit may have weakened or improved. Only commercial loan relationships with an aggregate exposure to the Bank of $1,000,000 or greater are subject to being risk rated.

Home equity and second mortgages and consumer loans are evaluated for creditworthiness in underwriting and are monitored based on borrower payment history. Residential first mortgages are evaluated for creditworthiness during credit due diligence before being purchased. Residential first mortgages, home equity and second mortgages and consumer loans are classified as unrated unless they are part of a larger commercial relationship that requires grading or have impairment quantified because of an event (e.g., TDRs or nonperforming loans).

Management regularly reviews credit quality indicators as part of its individual loan reviews and on a monthly and quarterly basis. The overall quality of the Bank’s loan portfolio is assessed using the Bank’s risk-grading scale, the level and trends of net charge-offs, nonperforming loans and delinquencies, the performance of TDRs and the general economic conditions in the Company’s geographical market. This review process is assisted by frequent internal reporting of loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potential problem loans. Credit quality indicators and allowance factors are adjusted based on management’s judgment during the monthly and quarterly review process. Loans subject to risk ratings are graded on a scale of one to ten. The Company considers loans rated substandard, doubtful and loss as classified assets for regulatory and financial reporting.

Ratings 1 thru 6 - Pass

Ratings 1 thru 6 have asset risks ranging from excellent-low risk to adequate. The specific rating assigned considers customer history of earnings, cash flows, liquidity, leverage, capitalization, consistency of debt service coverage, the nature and extent of customer relationship and other relevant specific business factors such as the stability of the industry or market area, changes to management, litigation or unexpected events that could have an impact on risks.

Rating 7 - OAEM (Other Assets Especially Mentioned) – Special Mention

These credits, while protected by the financial strength of the borrowers, guarantors or collateral, have reduced quality due to economic conditions, less than adequate earnings performance or other factors which require the lending officer to direct more than normal attention to the credit. Financing alternatives may be limited and/or command higher risk interest rates. OAEM loans are the first adversely classified assets on our watch list. These relationships are reviewed at least quarterly.

Rating 8 - Substandard

Substandard assets are assets that are inadequately protected by the sound worth or paying capacity of the borrower or of the collateral pledged. These assets have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard. The loans may have a delinquent history or combination of weak collateral, weak guarantor strength or operating losses. When a loan is assigned to this category the Bank may estimate a specific reserve in the loan loss allowance analysis. These assets listed may include assets with histories of repossessions or some that are non-performing bankruptcies. These relationships will be reviewed at least quarterly.

Rating 9 - Doubtful

Doubtful assets have many of the same characteristics of Substandard with the exception that the Bank has determined that loss is not only possible but is probable and the risk is close to certain that loss will occur. When a loan is assigned to this category the Bank will identify the probable loss and the loan will receive a specific reserve in the loan loss allowance analysis. These relationships will be reviewed at least quarterly.

Rating 10 – Loss

Once an asset is identified as a definite loss to the Bank, it will receive the classification of “loss.” There may be some future potential recovery; however, it is more practical to write off the loan at the time of classification. Losses will be taken in the period in which they are determined to be non-collectable.

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Purchased Credit-Impaired Loans and Acquired Loans

PCI loans had an unpaid principal balance of $2.4 million and a carrying value of $2.0 million at June 30, 2020. The carrying value of PCI loans represented 0.10% of total assets at June 30, 2020. Determining the fair value of the PCI loans at the time of acquisition required the Company to estimate cash flows expected to result from those loans and to discount those cash flows at appropriate rates of interest considering prepayment assumptions. For such loans, the excess of cash flows expected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans and is called accretable yield. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition reflects the impact of estimated credit losses and is called the nonaccretable difference. In accordance with GAAP, there was no carryover of a previously established allowance for loan losses from acquisition.

A summary of changes in the accretable yield for PCI loans for the three and six months ended June 30, 2020 and 2019 and the year ended December 31, 2019 follows:

						Three Months Ended June 30,																		Six Months Ended June 30,
(dollars in thousands)						2020						2019						2020						2019
Accretable yield, beginning of period						$	539					$	680					$	677					$	733
Additions						—						—						—						—
Accretion						(1)						(68)						(139)						(122)
Reclassification from (to) nonaccretable difference						24						156						24						156
Other changes, net						(148)						11						(148)						12
Accretable yield, end of period						$	414					$	779					$	414					$	779

At June 30, 2020 performing acquired loans, which totaled $65.1 million, included a $889,000 net acquisition accounting fair market value adjustment, representing a 1.35% discount; and PCI loans which totaled $2.0 million, included a $414,000 adjustment, representing a 17.19% discount. At December 31, 2019 acquired performing loans, which totaled $74.7 million, included a $1.2 million net acquisition accounting fair market value adjustment, representing a 1.55% discount; and PCI loans which totaled $2.4 million, included a $516,000 adjustment, representing a 17.55% discount.

During the three months ended June 30, 2020 and 2019 there was $181,000 and $209,000, respectively, of accretion interest.

Accounting standards require a periodic recast of the expected cash flows on the PCI loan portfolio. The recast was performed during the second quarter of 2020 and 2019 which resulted in a reclassification of $24,000 and $156,000, respectively, from the credit (nonaccretable) portion of the discount to the liquidity (accretable) portion of the discount.

The following is a summary of acquired and non-acquired loans as of June 30, 2020 and December 31, 2019:

BY ACQUIRED AND NON-ACQUIRED						June 30, 2020						%						December 31, 2019						%
Acquired loans - performing						$	65,087					4.01		%				$	74,654					5.13		%
Acquired loans - purchase credit impaired ("PCI")						1,993						0.12		%				2,424						0.17		%
Total acquired loans						67,080						4.14		%				77,078						5.30		%
U.S. SBA PPP loans						129,384						7.98		%				—						—		%
Non-acquired loans**						1,425,665						87.89		%				1,377,094						94.70		%
Gross loans						1,622,129												1,454,172
Net deferred costs (fees)						(1,674)						(0.10)		%				1,879						0.13		%
Total loans, net of deferred costs						$	1,620,455											$	1,456,051

______________________________

**Non-acquired loans include loans transferred from acquired pools following release of acquisition accounting FMV adjustments.

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NOTE 4 – GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill and other intangible assets are presented in the tables below.

(dollars in thousands)						As of June 30, 2020						As of December 31, 2019
Goodwill						$	10,835					$	10,835

						As of June 30, 2020																														As of December 31, 2019
(dollars in thousands)						Gross Carrying Amount						Accumulated Amortization						Net Intangible Assets						Gross Carrying Amount						Accumulated Amortization						Net Intangible Assets
Core deposit intangible						$	3,590					$	(1,780)					$	1,810					$	3,590					$	(1,472)					$	2,118

The estimated aggregate future amortization expense for intangible assets remaining as of June 30, 2020 is as follows:

(dollars in thousands)
Remainder of 2020						$	283
2021						495
2022						398
2023						302
2024						205
Thereafter						127
						$	1,810

As of June 30, 2020, the Company did not have impairment to goodwill or core deposit intangibles ("CDI"). At June 30, 2020 we had goodwill of $10.8 million or 5.72% of equity and CDI of $1.8 million or 0.96% of equity.

Due to COVID-19 management opted to perform a qualitative analysis to determine if a quantitative calculation of impairment should be considered. Based on the qualitative analysis, management concluded that it is not more likely than not that goodwill and CDI were impaired. It is possible that the length and severity of the COVID-19 crisis could cause the Company's goodwill or CDI to be impaired in future periods due to a sustained decline in the Company's stock price or other financial or qualitative measures. If management's assessment results in an impairment charge it would be recorded in that quarter. In the event that the Company concludes that all or a portion of its goodwill and CDI are impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. Such a charge would have no impact on tangible capital or regulatory capital.

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NOTE 5 - OTHER REAL ESTATE OWNED (“OREO”)

OREO assets are presented net of the valuation allowance. The Company considers OREO as classified assets for regulatory and financial reporting. OREO carrying amounts reflect management’s estimate of the realizable value of these properties incorporating current appraised values, local real estate market conditions and related costs. An analysis of OREO activity follows.

						Six Months Ended June 30,																		Years Ended December 31,
(dollars in thousands)						2020						2019						2019
Balance at beginning of year						$	7,773					$	8,111					$	8,111
Additions of underlying property						—						3,249						3,567
Disposals of underlying property						(2,287)						(416)						(3,004)
Valuation allowance						(1,791)						(637)						(901)
Balance at end of period						$	3,695					$	10,307					$	7,773

During the six months ended June 30, 2020 and 2019, OREO additions were zero and $3.2 million, respectively. During the six months ended June 30, 2019, additions of $3.2 million were for commercial real estate acquired at foreclosure on a $3.8 million classified loan relationship recorded at the estimated fair value at the date of foreclosure less selling cost, establishing a new costs basis.

During the six months ended June 30, 2020, the Company disposed of commercial real estate with carrying value totaling $2.3 million for proceeds of $2.3 million resulting in losses totaling $9,000. During the six months ended June 30, 2019, the Company recognized net gains of $188,000 on disposals of $416,000 for multiple residential lots of $65,000, commercial real estate of $316,000 and commercial equipment of $35,000. In connection with the sale of commercial real estate, the Bank provided a loan of $280,000. The transaction qualified for sales treatment under ASC Topic 610-20 “Other Income – Gains and Losses from the Derecognition of Nonfinancial Assets”.

To adjust properties to current appraised values, additions to the valuation allowance were taken for the six months ended June 30, 2020 and 2019 and the year ended December 31, 2019.

Expenses applicable to OREO assets included the following.

						Six Months Ended June 30,
(dollars in thousands)						2020						2019
Valuation allowance						$	1,791					$	637
Losses (gains) on dispositions						9						(188)
Operating expenses						82						39
						$	1,882					$	488

There were no impaired loans secured by residential real estate for which formal foreclosure proceedings were in process as of June 30, 2020 and December 31, 2019.

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NOTE 6 – DEPOSITS

Deposits consist of the following:

(dollars in thousands)						June 30, 2020																		December 31, 2019
									Balance						%						Balance						%
Noninterest-bearing demand						$	356,196					21.32		%				$	241,174					15.95		%
Interest-bearing:
Demand						547,639						32.79		%				523,802						34.65		%
Money market deposits						314,781						18.85		%				283,438						18.75		%
Savings						85,257						5.10		%				69,254						4.58		%
Certificates of deposit						366,491						21.94		%				394,169						26.07		%
Total interest-bearing						1,314,168						78.68		%				1,270,663						84.05		%
Total Deposits						$	1,670,364					100.00		%				$	1,511,837					100.00		%

The aggregate amount of certificates of deposit that exceed the FDIC insurance limit of $250,000 at June 30, 2020 and December 31, 2019 was $70.9 million and $86.6 million, respectively.

The FDIC’s examination policies require that the Company monitor all customer deposit concentrations at or above 2% of total deposits. At June 30, 2020, the Bank had three customer deposit relationships that exceeded 2% of total deposits, totaling $276.1 million which represented 16.5% of total deposits. At December 31, 2019, the Bank had two customer deposit relationships that exceeded 2% of total deposits, totaling $297.1 million which represented 19.6% of total deposits. The reported concentrations at June 30, 2020 and December 31, 2019 were with local municipal agencies.

NOTE 7 – COMMITMENTS & CONTINGENCIES

Operating Leases

A lease is defined as a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration. On January 1, 2019, the Company adopted ASU No. 2016-02 “Leases” (Topic 842) and all subsequent ASUs that modified Topic 842. For the Company, Topic 842 primarily affected the accounting treatment for operating lease agreements in which the Company is the lessee. All of the leases in which the Company is the lessee are for branches and office space. All of these leases are classified as operating leases, and therefore, were previously not recognized on the Company’s consolidated balance sheet.  With the adoption of Topic 842, operating lease agreements are required to be recognized on the consolidated balance sheet as a right-of-use-asset with a corresponding lease liability.

The table below details the Right of Use asset (net of accumulated amortization), lease liability and other information related to the Company's operating leases:

(dollars in thousands)						June 30, 2020						December 31, 2019
Operating Leases
Operating lease right of use asset, net						$	8,132					$	8,382
Operating lease liability						$	8,296					$	8,495
Weighted average remaining lease term						18.50 years						18.80 years
Weighted average discount rate						3.51		%				3.50		%
Remaining lease term - min						1.2 years						0.0 years
Remaining lease term - max						25.0 years						25.0 years

The right of use assets and lease liabilities are impacted by the length of the lease term and the discount rate used to present value the minimum lease payments. The Company's lease agreements often include one or more options to renew at the Company's discretion. If at lease inception, the Company considers the exercising of a renewal option to be reasonably certain, the Company will include the extended term in the calculation of the right of use asset and lease liability. Topic 842 requires the use of the rate implicit in the lease whenever this rate is readily determinable. As this rate is rarely determinable, the Company

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utilizes its incremental borrowing rate at lease inception over a similar term. For operating leases existing prior to January 1, 2019, the FHLB fixed advance rate which corresponded with the remaining lease term as of January 1, 2019 was used.

The table below details the Company's lease cost, which is included in occupancy expense in the Unaudited Consolidated Statements of Income.

						Three Months Ended June 30,																		Six Months Ended June 30,
(dollars in thousands)						2020						2019						2020						2019
Operating lease cost						$	198					$	217					$	397					$	436
Cash paid for lease liability						$	174					$	186					$	346					$	368

A maturity analysis of operating lease liabilities and reconciliation of the undiscounted cash flows to the total operating lease liability is as follows:

(dollars in thousands)						As of June 30, 2020
Lease payments due:
Within one year						$	704
After one but within two years						616
After two but within three years						608
After three but within four years						616
After four but within five years						634
After five years						8,450
Total undiscounted cash flows						$	11,628
Discount on cash flows						3,332
Total lease liability						$	8,296

NOTE 8 - GUARANTEED PREFERRED BENEFICIAL INTEREST IN JUNIOR SUBORDINATED DEBENTURES (“TRUPs”)

On June 15, 2005, Tri-County Capital Trust II (“Capital Trust II”), a Delaware business trust formed, funded and wholly-owned by the Company, issued $5.0 million of variable-rate capital securities in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 1.70%. The Trust used the proceeds from this issuance, along with the $155,000 for Capital Trust II’s common securities, to purchase $5.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. These capital securities qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust II and the junior subordinated debentures are scheduled to mature on June 15, 2035, unless called by the Company.

On July 22, 2004, Tri-County Capital Trust I (“Capital Trust I”), a Delaware business trust formed, funded and wholly owned by the Company, issued $7.0 million of variable-rate capital securities in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 2.60%. The Trust used the proceeds from this issuance, along with the Company’s $217,000 capital contribution for Capital Trust I’s common securities, to purchase $7.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. These debentures qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust I and the junior subordinated debentures are scheduled to mature on July 22, 2034, unless called by the Company.

NOTE 9 – SUBORDINATED NOTES

On February 15, 2020, the Company used $10.6 million in net proceeds from a common stock private placement offering and a cash dividend from the Bank to redeem the Company's outstanding $23.0 million of 6.25% fixed to floating rate subordinate notes. The subordinated notes qualified as Tier 2 regulatory capital.

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NOTE 10 – REGULATORY CAPITAL

The Bank’s primary regulator is the Federal Deposit Insurance Corporation (“FDIC”). The Bank is subject to regulation, supervision and regular examination by the Maryland Commissioner of Financial Regulation (the “Commissioner”) and the FDIC. The Company is subject to regulation, examination and supervision by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended (the “BHCA”).

The Company and Bank are subject to the Basel III Capital Rules which establish a comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee’s “Basel III” framework for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revised the risk-based capital requirements applicable to bank holding companies and depository institutions compared to the previous U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions’ regulatory capital ratios and replace the existing risk-weighting approach with a more risk-sensitive approach. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies’ rules.

The rules include a common equity Tier 1 capital to risk-weighted assets minimum ratio of 4.50%, a minimum ratio of Tier 1 capital to risk-weighted assets of 6.0%, require a minimum ratio (“Min. Ratio”) of Total Capital to risk-weighted assets of 8.0%, and require a minimum Tier 1 leverage ratio of 4.0%. A capital conservation buffer (“CCB”) is also established above the regulatory minimum capital requirements. The capital conservation buffer was phased-in over a three-year period before reaching its final level of 2.5% on January 1, 2019. Strict eligibility criteria for regulatory capital instruments were also implemented under the rules. The rules revised the definition and calculation of Tier 1 capital, Total Capital, and risk-weighted assets.

On April 13, 2020, the regulatory agencies published an interim final rule, which permits banking organizations to exclude from regulatory capital requirements Paycheck Protection Program ("PPP") covered loans pledged under the PPPLF. The interim final rule also clarifies that PPP covered loans as defined in section 7(a)(36) of the Small Business Act (15 U.S.C. 636(a)(36)) receive a zero percent risk weight.

The interim final rule modifies the agencies’ capital rule and allows PPPLF-eligible banking organizations to neutralize the regulatory effects of PPP covered loans on their risk-based capital ratios, as well as PPP covered loans pledged under the PPPLF on their leverage capital ratios. When calculating leverage capital ratios, a banking organization may exclude from average total consolidated assets and, as applicable, total leverage exposure a PPP covered loan as of the date that it has been pledged under the PPPLF. Accordingly, a PPP covered loan that has not been pledged as collateral in connection with an extension of credit under the PPPLF would be included in the calculation of the banking organization’s average total consolidated assets and, as applicable, total leverage exposure. No new extensions of credit will be made under the PPPLF after September 30, 2020, unless the Federal Reserve Board and U.S. Department of Treasury jointly determine to extend the facility.

As of June 30, 2020 and December 31, 2019, the Company and Bank were well-capitalized under the regulatory framework for prompt corrective action under the Basel III Capital Rules. Management believes, as of June 30, 2020 and December 31, 2019, that the Company and the Bank met all capital adequacy requirements to which they were subject. The Company’s and the Bank’s actual regulatory capital amounts and ratios are presented in the following table.

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Regulatory Capital and Ratios												The Company																		The Bank
(dollars in thousands)												June 30, 2020						December 31, 2019						June 30, 2020						December 31, 2019
Common equity												$	189,442					$	181,494					$	198,100					$	202,604
Goodwill												(10,835)						(10,835)						(10,835)						(10,835)
Core deposit intangible (net of deferred tax liability)												(1,339)						(1,534)						(1,339)						(1,534)
AOCI (gains) losses												(4,517)						(1,504)						(4,517)						(1,504)
Common Equity Tier 1 Capital												172,751						167,621						181,409						188,731
TRUPs												12,000						12,000						—						—
Tier 1 Capital												184,751						179,621						181,409						188,731
Allowable reserve for credit losses and other Tier 2 adjustments												16,370						10,993						16,370						10,993
Subordinated notes												—						23,000						—						—
Tier 2 Capital												$	201,121					$	213,614					$	197,779					$	199,724
Risk-Weighted Assets ("RWA")												$	1,553,884					$	1,508,352					$	1,551,903					$	1,506,766
Average Assets ("AA")												$	1,892,097					$	1,782,834					$	1,890,542					$	1,781,415
Regulatory Min. Ratio + CCB (1)
Common Tier 1 Capital to RWA						7.00		%				11.12		%				11.11		%				11.69		%				12.53		%
Tier 1 Capital to RWA						8.50						11.89						11.91						11.69						12.53
Tier 2 Capital to RWA						10.50						12.94						14.16						12.74						13.26
Tier 1 Capital to AA (Leverage) (2)						n/a						9.76						10.08						9.60						10.59

____________________________________

(1)The regulatory minimum capital ratio ("Min. Ratio") + the capital conservation buffer ("CCB").

(2)Tier 1 Capital to AA (Leverage) has no capital conservation buffer defined. PCA well capitalized is defined as 5.00%.

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NOTE 11 - FAIR VALUE MEASUREMENTS

The Company adopted FASB ASC Topic 820, “Fair Value Measurements” and FASB ASC Topic 825, “The Fair Value Option for Financial Assets and Financial Liabilities”, which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. FASB ASC Topic 820 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available for sale investment securities) or on a nonrecurring basis (for example, impaired loans).

FASB ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC Topic 820 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis such as loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Under FASB ASC Topic 820, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded, and the reliability of the assumptions used to determine the fair value. These hierarchy levels are:

Level 1 inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

Level 2 inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s quarterly valuation process. Transfers in and out of level 3 during a quarter are disclosed.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value:

Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis. Standard inputs include quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities (“GSEs”), municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

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Equity Securities Carried at Fair Value Through Income

Equity securities carried at fair value through income are recorded at fair value on a recurring basis. Standard inputs include quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 equity securities include those traded on an active exchange, such as the New York Stock Exchange. Level 2 equity securities include mutual funds with asset-backed securities issued by government sponsored entities (“GSEs”) as the underlying investment supporting the fund. Equity securities classified as Level 3 include mutual funds with asset-backed securities in less liquid markets.

Loans Receivable

The Company does not record loans at fair value on a recurring basis; however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan are considered impaired. Management estimates the fair value of impaired loans using one of several methods, including the collateral value, market value of similar debt, or discounted cash flows. Impaired loans not requiring a specific allowance are those for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At June 30, 2020 and December 31, 2019, substantially all of the impaired loans were evaluated based upon the fair value of the collateral.

In accordance with FASB ASC 820, impaired loans where an allowance is established based on the fair value of collateral (loans with impairment) require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price (e.g., contracted sales price), the Company records the loan as nonrecurring Level 2. When the fair value of the impaired loan is derived from an appraisal, the Company records the loan as nonrecurring Level 3. Fair value is re-assessed at least quarterly or more frequently when circumstances occur that indicate a change in the fair value. The fair values of impaired loans that are not measured based on collateral values are measured using discounted cash flows and considered to be Level 3 inputs.

Other Real Estate Owned

OREO is adjusted for fair value upon transfer of the loans to foreclosed assets. Subsequently, OREO is carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price (e.g., contracted sales price), the Company records the foreclosed asset as nonrecurring Level 2. When the fair value is derived from an appraisal, the Company records the foreclosed asset at nonrecurring Level 3.

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Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The tables below present the recorded amount of assets as of June 30, 2020 and December 31, 2019 measured at fair value on a recurring basis.

(dollars in thousands)						June 30, 2020
Description of Asset						Fair Value						Level 1						Level 2						Level 3
Available for sale securities
Asset-backed securities issued by GSEs and U.S. Agencies
MBS						$	30,931					$	—					$	30,931					$	—
CMOs						131,933						—						131,933						—
U.S. Agency						1,311						—						1,311						—
Asset-backed securities issued by Others:
Residential CMOs						320						—						320						—
Student Loan Trust CMOs						25,030						—						25,030						—
Callable GSE Agency Bonds						—						—						—						—
Certificates of Deposit Fixed						250						—						250						—
U.S. government obligations						1,498						—						1,498						—
Municipal bonds						43,709						—						43,709						—
Total available for sale securities						$	234,982					$	—					$	234,982					$	—
Equity securities carried at fair value through income
CRA investment fund						$	4,831					$	—					$	4,831					$	—
Non-marketable equity securities
Other equity securities						$	209					$	—					$	209					$	—

(dollars in thousands)						December 31, 2019
Description of Asset						Fair Value						Level 1						Level 2						Level 3
Available for sale securities
Asset-backed securities issued by GSEs and U.S. Agencies
MBS						$	36,092					$	—					$	36,092					$	—
CMOs						146,932						—						146,932						—
U.S. Agency						9,733						—						9,733						—
Asset-backed securities issued by others:
Residential CMOs						371						—						371						—
Callable GSE Agency Bonds						2,002						—						2,002						—
Certificates of Deposit Fixed						250						—						250						—
U.S. government obligations						1,489						—						1,489						—
Municipal bonds						11,318						—						11,318						—
Total available for sale securities						$	208,187					$	—					$	208,187					$	—
Equity securities carried at fair value through income
CRA investment fund						$	4,669					$	—					$	4,669					$	—
Non-marketable equity securities
Other equity securities						$	209					$	—					$	209					$	—

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Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

The Company may be required to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. GAAP. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a nonrecurring basis as of June 30, 2020 and December 31, 2019 were included in the tables below.

(dollars in thousands)						June 30, 2020
Description of Asset						Fair Value						Level 1						Level 2						Level 3
Loans with impairment
Commercial real estate						$	782					$	—					$	—					$	782
Commercial loans						—						—						—						—
Total loans with impairment						$	782					$	—					$	—					$	782
Premises and equipment held for sale						$	430					$	—					$	—					$	430
Other real estate owned						$	3,695					$	—					$	—					$	3,695

(dollars in thousands)						December 31, 2019
Description of Asset						Fair Value						Level 1						Level 2						Level 3
Loans with impairment
Commercial real estate						$	4,371					$	—					$	—					$	4,371
Commercial loans						1,110						—						—						1,110
Commercial equipment						2						—						—						2
Total loans with impairment						$	5,483					$	—					$	—					$	5,483
Premises and equipment held for sale						$	430					$	—					$	—					$	430
Other real estate owned						$	7,773					$	—					$	—					$	7,773

Loans with impairment had unpaid principal balances of $886,000 and $6.3 million at June 30, 2020 and December 31, 2019, respectively.

The following tables provide information describing the unobservable inputs used in Level 3 fair value measurements at June 30, 2020 and December 31, 2019.

June 30, 2020

Fair Value

Valuation Technique

Unobservable Inputs

Range (Weighted Average)

(dollars in thousands)

Description of Asset

Loans with impairment

$

782

Third party appraisals and in-house real estate evaluations of fair value

Management discount for property type and current market conditions

0% - 50% 12%

Premises and equipment held for sale

$

430

Third party appraisals, in-house real estate evaluations of fair value and contracts to sell.

Management discount for property type and current market conditions

0% - 25% 10%

Other real estate owned

$

3,695

Third party appraisals and in-house real estate evaluations of fair value

Management discount for property type and current market conditions

0% - 50% 40%

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December 31, 2019

Fair Value

Valuation Technique

Unobservable Inputs

Range (Weighted Average)

(dollars in thousands)

Description of Asset

Loans with impairment

$

5,483

Third party appraisals and in-house real estate evaluations of fair value

Management discount for property type and current market conditions

0% - 50% 13%

Premises and equipment held for sale

$

430

Third party appraisals, in-house real estate evaluations of fair value and contracts to sell.

Management discount for property type and current market conditions

0% - 25% 10%

Other real estate owned

$

7,773

Third party appraisals and in-house real estate evaluations of fair value

Management discount for property type and current market conditions

0% - 50% 18%

NOTE 12 - FAIR VALUE OF FINANCIAL INSTRUMENTS

Financial instruments require disclosure of fair value information, whether or not recognized in the consolidated balance sheets, when it is practical to estimate the fair value. A financial instrument is defined as cash, evidence of an ownership interest in an entity or a contractual obligation which requires the exchange of cash. Certain items are specifically excluded from the financial instrument fair value disclosure requirements, including the Company’s common stock, OREO, premises and equipment and other assets and liabilities.

The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Therefore, any aggregate unrealized gains or losses should not be interpreted as a forecast of future earnings or cash flows. Furthermore, the fair values disclosed should not be interpreted as the aggregate current value of the Company.

The Company’s estimated fair values of financial instruments are presented in the following tables.

June 30, 2020						Carrying Amount						Fair Value						Fair Value Measurements
Description of Asset (dollars in thousands)																								Level 1						Level 2						Level 3
Assets
Investment securities - AFS						$	234,982					$	234,982					$	—					$	234,982					$	—
Equity securities carried at fair value through income						4,831						4,831						—						4,831
Non-marketable equity securities in other financial institutions						209						209						—						209						—
FHLB Stock						4,691						4,691						—						4,691						—
Net loans receivable						1,604,136						1,568,460						—						—						1,568,460
Accrued Interest Receivable						6,773						6,773						—						6,773						—
Investment in BOLI						37,619						37,619						—						37,619						—
Liabilities
Savings, NOW and money market accounts						$	1,303,873					$	1,303,873					$	—					$	1,303,873					$	—
Time deposits						366,491						369,171						—						369,171						—
Short-term borrowings						5,000						5,020						—						5,020						—
Long-term debt						67,336						68,806						—						68,806						—
TRUPs						12,000						8,119						—						8,119						—

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See the Company’s methodologies disclosed in Note 20 of the Company’s 2019 Form 10-K for the fair value methodologies used as of December 31, 2019:

December 31, 2019						Carrying Amount						Fair Value						Fair Value Measurements
Description of Asset (dollars in thousands)																								Level 1						Level 2						Level 3
Assets
Investment securities - AFS						$	208,187					$	208,187					$	—					$	208,187					$	—
Equity securities carried at fair value through income						4,669						4,669						—						4,669						—
Non-marketable equity securities in other financial institutions						209						209						—						209						—
FHLB Stock						3,447						3,447						—						3,447						—
Net loans receivable						1,445,109						1,424,506						—						—						1,424,506
Accrued Interest Receivable						5,019						5,019						—						5,019						—
Investment in BOLI						37,180						37,180						—						37,180						—
Liabilities
Savings, NOW and money market accounts						$	1,117,668					$	1,117,668					$	—					$	1,117,668					$	—
Time deposits						394,169						396,492						—						396,492						—
Short-term borrowings						5,000						5,007						—						5,007						—
Long-term debt						40,370						40,588						—						40,588						—
TRUPs						12,000						10,129						—						10,129						—
Subordinated notes						23,000						23,031						—						23,031						—

At June 30, 2020 and December 31, 2019, the Company had outstanding loan commitments and standby letters of credit with customers of $41.2 million and $96.6 million, respectively, and $21.6 million and $22.3 million, respectively. Additionally, at June 30, 2020 and December 31, 2019, customers had $229.7 million and $230.5 million, respectively, available and unused on lines of credit, which include lines of credit for commercial customers, home equity loans as well as builder and construction lines. Based on the short-term lives of these instruments, the Company does not believe that the fair value of these instruments differs significantly from their carrying values.

The fair value estimates presented herein are based on pertinent information available to management as of June 30, 2020 and December 31, 2019. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these Consolidated Financial Statements since that date and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

NOTE 13 - ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following tables present the components of comprehensive income for the three and six months ended June 30, 2020 and 2019. The Company’s comprehensive gains and losses and reclassification adjustments were solely for securities for the three and six months ended June 30, 2020 and 2019. Reclassification adjustments are recorded in non-interest income.

(dollars in thousands)						Three Months Ended June 30, 2020																														Three Months Ended June 30, 2019
									Before Tax						Tax Effect						Net of Tax						Before Tax						Tax Effect						Net of Tax
Net unrealized holding gains arising during period						$	1,724					$	449					$	1,275					$	2,093					$	576					$	1,517
Reclassification adjustments						112						29						83						—						—						—
Other comprehensive income						$	1,836					$	478					$	1,358					$	2,093					$	576					$	1,517

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						Six Months Ended June 30, 2020																														Six Months Ended June 30, 2019
(dollars in thousands)						Before Tax						Tax Effect						Net of Tax						Before Tax						Tax Effect						Net of Tax
Net unrealized holding gains (losses) arising during period						$	3,595					$	908					$	2,687					$	3,989					$	1,098					$	2,891
Reclassification adjustments						441						115						326						—						—						—
Other comprehensive income (loss)						$	4,036					$	1,023					$	3,013					$	3,989					$	1,098					$	2,891

The following table presents the changes in each component of accumulated other comprehensive loss, net of tax, for the three and six months ended June 30, 2020 and 2019.

						Three Months Ended June 30, 2020						Three Months Ended June 30, 2019						Six Months Ended June 30, 2020						Six Months Ended June 30, 2019
(dollars in thousands)									Net Unrealized Gains And Losses						Net Unrealized Gains And Losses						Net Unrealized Gains And Losses						Net Unrealized Gains And Losses
Beginning of period						$	3,159					$	(473)					$	1,504					$	(1,847)
Other comprehensive gains, net of tax before reclassifications						1,275						1,517						2,687						2,891
Amounts reclassified from accumulated other comprehensive gain						83						—						326						—
Net other comprehensive income						1,358						1,517						3,013						2,891
End of period						$	4,517					$	1,044					$	4,517					$	1,044

NOTE 14 - EARNINGS PER SHARE (“EPS”)

Basic earnings per common share represent income available to common shareholders, divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued. There were no outstanding stock options at June 30, 2020 for the Company to apply the treasury method to account for potential common shares that may have been issued.

Basic and diluted earnings per share have been computed based on weighted-average common and common equivalent shares outstanding as follows:

(dollars in thousands, except per share amounts)						Three Months Ended June 30,																		Six Months Ended June 30,
												2020						2019						2020						2019
Net Income						$	3,450					$	3,627					$	6,198					$	7,504
Average number of common shares outstanding						5,894,009						5,559,821						5,890,607						5,558,984
Dilutive effect of common stock equivalents						—						—						—						—
Average number of shares used to calculate diluted EPS						5,894,009						5,559,821						5,890,607						5,558,984
Earnings Per Common Share
Basic						$	0.59					$	0.65					$	1.05					$	1.35
Diluted						$	0.59					$	0.65					$	1.05					$	1.35

NOTE 15 – INCOME TAXES

The Company files a consolidated federal income tax return with its subsidiaries. Deferred tax assets and liabilities are determined using the liability (or balance sheet) method which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. If it is more likely than not that some portion or the entire deferred tax asset will not be realized, deferred tax assets will be

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reduced by a valuation allowance. It is the Company’s policy to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense.

(dollars in thousands)						Three Months Ended June 30,																		Six Months Ended June 30,
												2020						2019						2020						2019
Current income tax expense						$	1,758					$	1,653					$	2,497					$	3,030
Deferred income tax expense (benefit)						(622)						(259)						(1,418)						(320)
Income tax (benefit) expense as reported						$	1,136					$	1,394					$	1,079					$	2,710
Effective tax rate						24.8		%				27.8		%				14.8		%				26.5		%

Net deferred tax assets totaled $6.6 million at June 30, 2020 and $6.2 million at December 31, 2019. No valuation allowance for deferred tax assets was recorded at June 30, 2020 as management believes it is more likely than not that deferred tax assets will be realized against deferred tax liabilities and projected future taxable income.

The decrease in income tax expense for the three and six months ended June 30, 2020 was primarily due to a change in the Company's state tax apportionment approach which was implemented during the first quarter of 2020 and included the impact of amended income tax filings of the Company and Bank. Management determined the change in tax position qualified as a change in estimate under FASB ASC Section 250.

The effective income tax rates differed from the statutory federal and state income tax rates during 2020 primarily due to an adjustment of $743,000 related to state apportionment of interest income on loans. The Company’s consolidated effective tax rate is expected to be between 25.40% and 26.06% in 2020. In addition, the effective income tax rates differed from the statutory federal and state income tax rates due to the effect of tax-exempt loans, life insurance policies, the income tax effects associated with stock-based compensation and certain non-deductible expenses for state income taxes.

The effective tax rate differed from the statutory federal and state income rates during 2019 primarily due to the effect of tax-exempt loans, life insurance policies, the income tax effects associated with stock-based compensation and certain non-deductible expenses for state income taxes.

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NOTE 16 - STOCK-BASED COMPENSATION

The Company has stock-based incentive arrangements to attract and retain key personnel. In May 2015, the 2015 Equity Compensation Plan (the “Plan”) was approved by shareholders, which authorizes the issuance of restricted stock, stock appreciation rights, stock units and stock options to the Board of Directors and key employees. Compensation expense for service-based awards is recognized over the vesting period. Performance-based awards are recognized based on a vesting schedule and the probability of achieving goals specified at the time of the grant. The Plan replaced the 2005 Equity Compensation Plan.

Stock-based compensation expense totaled $87,000 and $163,000 for the three and six months ended June 30, 2020 and $92,000 and $169,000, respectively, for the three and six months ended June 30, 2019. Stock-based compensation expense consisted of the vesting of grants of restricted stock. The Company has not granted any stock options since 2007 and all outstanding options expired on July 17, 2017.

The Company granted restricted stock in accordance with the Plan. The vesting period for outstanding restricted stock grants is between three and five years. As of June 30, 2020, and December 31, 2019, unrecognized stock compensation expense was $431,000 and $304,000, respectively. The following tables summarize the nonvested restricted stock awards outstanding at June 30, 2020 and December 31, 2019, respectively.

						Restricted Stock
									Number of Shares						Weighted Average Grant Date Fair Value
Nonvested at January 1, 2020						14,440						$	25.79
Granted						9,065						33.42
Vested						(5,473)						34.08
Cancelled						(359)						33.66
Nonvested at June 30, 2020						17,673						$	33.01

						Restricted Stock
									Number of Shares						Weighted Average Grant Date Fair Value
Nonvested at January 1, 2019						25,473						$	28.76
Granted						6,524						31.82
Vested						(17,557)						25.83
Nonvested at December 31, 2019						14,440						$	25.79

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ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS (“MD&A”) OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SELECTED FINANCIAL INFORMATION AND RATIOS

The following table shows selected historical consolidated financial data for the Company for the three and six months ended June 30, 2020 and 2019 and as of June 30, 2020 and December 31, 2019. You should read this table together with our Consolidated Financial Statements and related notes and Item 6. Selected Financial Data as presented in the Company’s Form 10-K for the year ended December 31, 2019.

						(Unaudited)																		(Unaudited)
						Three Months Ended June 30,																		Six Months Ended June 30,
						2020						2019						2020						2019
KEY OPERATING RATIOS
Return on average assets ("ROAA")						0.69		%				0.84		%				0.65		%				0.88		%
Pre-tax Pre-Provision ROAA**						1.62						1.25						1.57						1.30
Return on average common equity ("ROACE")						7.27						8.99						6.64						9.41
Pre-tax Pre-Provision ROACE**						17.03						13.37						15.95						13.91
Average total equity to average total assets						9.52						9.38						9.84						9.32
Interest rate spread						3.21						3.06						3.21						3.06
Net interest margin						3.34						3.33						3.39						3.32
Cost of funds						0.54						1.27						0.72						1.26
Cost of deposits						0.48						1.10						0.64						1.08
Cost of debt						1.06						3.97						1.61						3.81
Efficiency ratio						53.75						62.82						56.19						61.24
Non-interest expense to average assets						1.88						2.12						2.01						2.05
Net operating expense to average assets						1.43						1.83						1.55						1.78
Avg. int-earning assets to avg. int-bearing liabilities						125.51						121.15						124.99						120.84
Net charge-offs to average portfolio loans						0.61						0.09						0.30						0.14
COMMON SHARE DATA
Basic net income per common share						$	0.59					$	0.65					$	1.05					$	1.35
Diluted net income per common share						0.59						0.65						1.05						1.35
Cash dividends paid per common share						0.125						0.125						0.25						0.25
Weighted average common shares outstanding:
Basic						5,894,009						5,559,821						5,890,607						5,558,984
Diluted						5,894,009						5,559,821						5,890,607						5,558,984

_______________________________________

**Non-GAAP financial measure. See reconciliation of GAAP and non-GAAP measures.

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						(Unaudited)
(dollars in thousands, except per share amounts)						June 30, 2020						December 31, 2019
COMMON SHARE DATA
Book value per common share						$	32.05					$	30.76
Tangible book value per common share**						29.91						28.57
Common shares outstanding at end of period						5,911,715						5,900,249
OTHER DATA
Full-time equivalent employees						194						194
Branches						12						12
Loan Production Offices						4						4
CAPITAL RATIOS
Tier 1 capital to average assets						9.76		%				10.08		%
Tier 1 common capital to risk-weighted assets						11.12						11.11
Tier 1 capital to risk-weighted assets						11.89						11.91
Total risk-based capital to risk-weighted assets						12.94						14.16
Common equity to assets						9.05						10.10
Tangible common equity to tangible assets						8.50						9.44

_______________________________________

**Non-GAAP financial measure. See reconciliation of GAAP and non-GAAP measures.

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USE OF NON-GAAP FINANCIAL MEASURES

Statements included in management’s discussion and analysis include non-GAAP financial measures and should be read along with the accompanying tables, which provide a reconciliation of non-GAAP financial measures to GAAP financial measures. The Company’s management uses these non-GAAP financial measures and believes that non-GAAP financial measures provide additional useful information that allows readers to evaluate the ongoing performance of the Company. Non-GAAP financial measures should not be considered as an alternative to any measure of performance or financial condition as promulgated under GAAP, and investors should consider the Company’s performance and financial condition as reported under GAAP and all other relevant information when assessing the performance or financial condition of the Company. Non-GAAP financial measures have limitations as analytical tools, and investors should not consider them in isolation or as a substitute for analysis of the results or financial condition as reported under GAAP. See Non-GAAP reconciliation schedules that immediately follow:

RECONCILIATION OF NON-GAAP MEASURES (UNAUDITED) - THREE AND SIX MONTHS ENDED JUNE 30, 2020 AND 2019

Pre-Tax Pre-Provision ("PTPP") Income, PTPP Return on Average Assets ("ROAA") and PTPP Return on Average Common Equity ("ROACE")

We believe that pre-tax pre-provision income, which reflects our profitability before income taxes and loan loss provisions, allows investors to better assess our operating income and expenses in relation to our core operating revenue by removing the volatility that is associated with credit provisions and different state income tax rates for comparable institutions. We also believe that during a crisis such as the COVID-19 pandemic, this information is useful as the impact of the pandemic on the loan loss provisions of various institutions will likely vary based on the geography of the communities served by a particular institution.

						Three Months Ended June 30,																		Six Months Ended June 30,
(dollars in thousands)						2020						2019						2020						2019
Net income (as reported)						$	3,450					$	3,627					$	6,198					$	7,504
Provision for loan losses						3,500						375						7,600						875
Income tax expenses						1,136						1,394						1,079						2,710
Non-GAAP PTPP income						$	8,086					$	5,396					$	14,877					$	11,089
GAAP ROAA						0.69		%				0.84		%				0.65		%				0.88		%
Pre-tax Pre-Provision ROAA						1.62		%				1.25		%				1.57		%				1.30		%
GAAP ROACE						7.27		%				8.99		%				6.64		%				9.41		%
Pre-tax Pre-Provision ROACE						17.03		%				13.37		%				15.95		%				13.91		%
Average assets						$	1,995,552					$	1,721,196					$	1,896,488					$	1,710,253
Average equity						$	189,890					$	161,376					$	186,580					$	159,420

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RECONCILIATION OF NON-GAAP MEASURES (UNAUDITED)

Reconciliation of US GAAP total assets, common equity, common equity to assets and book value to Non-GAAP tangible assets, tangible common equity, tangible common equity to tangible assets and tangible book value.

This Form 10-Q, including the accompanying financial statement tables, contains financial information determined by methods other than in accordance with GAAP. This financial information includes certain performance measures, which exclude intangible assets. These non-GAAP measures are included because the Company believes they may provide useful supplemental information for evaluating the underlying performance trends of the Company.

(dollars in thousands, except per share amounts)						June 30, 2020						December 31, 2019						June 30, 2019
Total assets						$	2,093,756					$	1,797,536					$	1,756,448
Less: intangible assets
Goodwill						10,835						10,835						10,835
Core deposit intangible						1,810						2,118						2,450
Total intangible assets						12,645						12,953						13,285
Tangible assets						$	2,081,111					$	1,784,583					$	1,743,163
Total common equity						$	189,442					$	181,494					$	163,645
Less: intangible assets						12,645						12,953						13,285
Tangible common equity						$	176,797					$	168,541					$	150,360
Common shares outstanding at end of period						5,911,715						5,900,249						5,582,438
GAAP common equity to assets						9.05		%				10.10		%				9.32		%
Non-GAAP tangible common equity to tangible assets						8.50		%				9.44		%				8.63		%
GAAP common book value per share						$	32.05					$	30.76					$	29.31
Non-GAAP tangible common book value per share						$	29.91					$	28.57					$	26.93

CRITICAL ACCOUNTING POLICIES

Critical accounting policies are defined as those that involve significant judgments and uncertainties and could result in materially different results under different assumptions and conditions. The Company considers its determination of the allowance for loan losses ("ALLL"), the valuation of OREO and the valuation of deferred tax assets to be critical accounting policies. We believe that the most critical accounting policies upon which our financial condition and results of operation depend, and which involve the most complex subjective decisions or assessments, are included in the discussion entitled "Critical Accounting Policies" in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2019, as filed with the SEC.

For additional information regarding the ALLL, OREO and the valuation of deferred taxes, refer to Notes 1, 3, 6 and 14 in the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2019.

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OVERVIEW

Community Bank of the Chesapeake (the “Bank”) is headquartered in Southern Maryland with 12 branches located in Maryland and Virginia. The Bank is a wholly owned subsidiary of The Community Financial Corporation (the “Company”). The Company provides financial services to individuals and businesses through its offices in Southern Maryland and Fredericksburg, Virginia. Its primary deposit products are demand, savings and time deposits, and its primary lending products are commercial and residential mortgage loans, commercial loans, construction and land development loans, home equity and second mortgages and commercial equipment loans.

Our customer focus is to serve small and medium-sized commercial businesses with revenues between $5.0 million and $35.0 million as well as local municipal agencies and not-for-profits. Relationship teams provide customers with specific banker contacts and a support team to address product and service demands. Our ability to offer fast, flexible, local decision-making will continue to attract significant new business relationships. Excelling at customer service is a critical part of our culture, and our structure provides a consistent and superior level of professional service. The Bank’s marketing is directed towards increasing balances of transactional deposit accounts which will lessen the Bank’s dependence on higher-cost funding, such as certificates of deposit and borrowings.

The Company’s income is primarily earned from interest received on our loans and investments. Our primary source of funds for making these loans and investments is our deposits. One of the key measures of our success is our net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread. In addition to earning interest on our loans and investments, we earn income through fees and other charges for services to our clients.

On December 31, 2019, the Company issued a total of 312,747 shares of its common stock, par value $0.01 in a private placement offering. The Company received net proceeds of $10.6 million after deal expenses. On February 15, 2020, the Company used the proceeds and a cash dividend from the Bank to redeem the Company’s outstanding $23.0 million of 6.25% fixed-to-floating rate subordinated notes. The redemption of the $23.0 million in subordinated notes in February 2020 will reduce interest expense by approximately $1.4 million on an annualized basis and be accretive to earnings. The annualized positive impact on net interest margin is estimated to be between eight and nine basis points. The Company remains well capitalized at June 30, 2020 with a Tier 1 capital to average assets (leverage ratio) of 9.76% at June 30, 2020 compared to 10.08% at December 31, 2019.

Effects of COVID-19 on Company's Operations

The following sections discuss the risks and uncertainties, accounting treatments, specific COVID-19 programs and Company actions taken as of June 30, 2020 through the filing date of this Form 10-Q.

Risk Factors

The potential impacts to credit losses and other effects of the COVID-19 pandemic and the resulting low interest rate environment, may adversely affect the Company's financial condition and results of operations in future periods. See Part II, Item 1A, "Risk Factors" for additional information regarding the risks associated with COVID-19.

Economic Impact

The outbreak of COVID-19 has adversely impacted the economy in the Company's footprint. The pandemic could prevent our customers from fulfilling their financial obligations to the Company. The World Health Organization declared COVID-19 to be a global pandemic on March 11, 2020. The outbreak has caused significant disruptions in the U.S. and local economy. While there has been no material impact to the Company's employees or business to date, COVID-19 could potentially create business continuity issues for the Company.

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In March 2020, the U.S. economy deteriorated as a result of the COVID-19 pandemic and as of June 30, 2020, it remains unclear when the economy will reach a low point. Real first quarter 2020 Gross Domestic Product ("GDP"') declined 5.0% and most economists are predicting that personal consumption will remain suppressed until there is a vaccine, more effective therapeutic treatments and local and state government willingness to open their economies. Maryland and Virginia June 2020 unemployment rates according to the U.S. Bureau of Labor Statistics were 8.0% and 8.4%, respectively. Nationally, the unemployment rate declined by 2.2% percentage points to 11.1% in June, and the number of unemployed persons fell by 3.2 million to 17.8 million. Although unemployment fell in May and June, the jobless rate and the number of unemployed are up by 7.6% and 12.0 million, since February 2020. Decreases in the unemployment rate may not continue if spikes in COVID-19 infections and hospitalizations cause local and state governments to consider shutting down recently opened up economies.

Governmental and Regulatory Response

Congress, the President of the United States ("POTUS"), and the Federal Reserve have taken actions designed to cushion the economic fallout from the pandemic. The Coronavirus Aid, Relief and Economic Security ("CARES") Act was signed into law on March 27, 2020 as a $2 trillion legislative package. The CARES Act included direct financial aid to American families, economic stimulus to significantly impacted industry sectors, and emergency funding for hospitals and other health care providers. Included as part of the CARES Act was a loan program administered through the U.S. Small Business Administration ("SBA"), referred to as the paycheck protection program ("PPP"). Under the PPP, small businesses, sole proprietorships, independent contractors and self-employed individuals may apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. The Bank is participating as a lender in the PPP. In addition, the Bank has implemented commercial and retail loan deferral programs. Since the CARES Act passed additional stimulus relief has been provided to add additional funding to support small business programs, larger businesses and specific industries. There are on-going discussions between Congress and POTUS of additional stimulus bills and funding in the remainder of 2020. There have been additional clarifications to regulation and legislation since the original law was passed.

On April 9, 2020 and April 30, 2020, the Federal Reserve announced additional measures aimed at supporting small and mid-sized businesses, as well as state and local governments impacted by COVID-19. The Federal Reserve announced the Main Street Business Lending Program, which establishes three new loan facilities intended to facilitate lending to small and mid-sized businesses: (1) the Main Street New Loan Facility, or MSNLF, (2) the Main Street Expanded Loan Facility, or MSELF, and (3) the Main Street Priority Loan Facility, or MSPLF. MSNLF loans are unsecured term loans originated on or before April 24, 2020. MSPLF loans are unsecured term loans originated after April 24, 2020 that have different treatment from MSPLF loans in connection with borrowers' existing debt obligations. The program is designed for businesses with up to 15,000 employees or $5 billion in 2019 revenues. To obtain a loan, borrowers must confirm that they are seeking financial support because of COVID-19 and that they will not use proceeds from the loan to pay off debt (subject to certain exceptions).

The Federal Reserve provided an additional lending facility (the Federal Reserve "PPPLF" program) to fund banks offering SBA PPP loans to struggling small businesses. Lenders participating in the SBA PPP will be able to exclude loans financed by the facility from the leverage ratio. PPPLF advances will be non-recourse and have the same two-year term as the pledged PPP loan. Lenders will pay a fixed interest rate of 0.35% and receive 100% value for the pledged PPP loan collateral.

In addition, the Federal Reserve created a Municipal Liquidity Facility to support state and local governments with up to $500 billion in lending, with the Treasury Department backing $35 billion for the facility using funds appropriated by the CARES Act. The facility will make short-term financing available to cities with a population of at least 250,000 or counties with a population of at least 500,000. The Federal Reserve expanded both the size and scope of its Primary and Secondary Market Corporate Credit Facilities to support up to $750 billion in credit to corporate debt issuers. This will allow companies that were investment grade before the onset of COVID-19 but then subsequently downgraded after March 22, 2020 to gain access to the facility. Finally, the Federal Reserve announced that its Term Asset-Backed Securities Loan Facility will be scaled up in scope to include the triple A-rated tranche of commercial mortgage-backed securities and newly issued collateralized loan obligations. The size of the facility is $100 billion.

Our business is dependent upon the willingness and ability of customers to conduct banking and other financial transactions. If the global response to contain COVID-19 escalates further or is unsuccessful, the Company could experience a material adverse effect on its financial condition, results of operations and cash flows. While it is not possible to know the extent that the impact of COVID-19, and measures to curtail its spread, will have on the Company's operations, the Company is disclosing potentially material items of which it is aware.

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Financial position and results of operations

At June 30, 2020, the Company continued to be in a strong financial and operational condition. The Company had a Tier 1 leverage ratio of 9.76% and a Tier 1 risk-based capital ratio of 11.89%. Our ratio of nonperforming loans to total assets was 1.30% and the ratio of nonperforming loans to total portfolio loans was 1.57%. At and for the six months ended June 30, 2020, the Company's allowance for loan loss ("ALLL") and provision for loan losses were materially impacted. While we have not yet experienced any charge-offs related to COVID-19, our allowance calculation and resulting provision for loan losses are significantly impacted by changes in various qualitative factors. It is possible that our asset quality measures could worsen if the effects of COVID-19 are prolonged. For additional information, please refer to "Allowance for Loan Losses" below.

On March 3, 2020, the Federal Open Market Committee reduced the target federal funds rate by 50 basis points to a target range of 1.00% from 1.25%. This rate was further reduced to a target range of 0% to 0.25% on March 16, 2020. These reductions in interest rates and other effects of the COVID-19 outbreak may adversely affect the Company's financial condition and results of operations. As a result of the spread of COVID-19, economic uncertainties have arisen which could negatively impact net interest income and noninterest income.

As the COVID -19 pandemic and the governmental response to it have decreased economic activity, fee income may be affected due to a reduction in fee generating economic activity, reduced ability to collect fees charged, and regulatory pressure to waive or reduce fees incurred.

Our interest income could be reduced due to COVID-19 as customers may be unable to meet their obligations due to economic disruptions caused by the pandemic. Our interest income could be adversely affected in future periods as a result of the COVID-19 pandemic due to lower interest rates and the possibility of decreases in the size of our loan portfolio. As a result of the reductions in the targeted federal funds interest rate, as well as the impact of the COVID-19 pandemic, we expect that our net interest income and net interest margin could decrease in future periods.

Capital and liquidity

We believe the Company has sufficient capital to withstand an extended economic recession brought about by COVID-19. However, our reported and regulatory capital ratios could be adversely impacted by further credit losses. The Company relies on cash on hand as well as dividends from the Bank to service its debt, pay Company holding company expenses as well as to fund common shareholder dividends. If the Company's capital deteriorates and the Bank is unable to pay dividends for an extended period of time, the Company may not be able to service its debt, pay holding company expenses or fund common shareholder dividends. The Company maintains access to multiple sources of liquidity and wholesale funding markets have remained open during the pandemic. If wholesale funding costs are elevated for an extended period of time, it could have an adverse effect on the Company's net interest margin. If an extended recession caused large numbers of the Company's deposit customers to withdraw their funds, the Company might become more reliant on volatile or more expensive sources of funding.

The Company is participating in the Federal Reserve Bank's PPPLF Program. There were $126.8 million in advances under the PPPLF program as of June 30, 2020. As of July 22, 2020, the Company's outstanding PPPLF advances were $126.8 million. It is the Company's intention to fund most PPP loans through the PPPLF program and we will continue to originate PPP loans until the SBA funding is exhausted.

Asset valuation

We do not expect COVID-19 to affect our ability to timely value assets, however, this could change in future periods. While certain valuation assumptions and judgments could change to account for pandemic-related circumstances such as widening credit spreads or the value of loan collateral and other real estate owned ("OREO"), the Company does not anticipate significant changes in the methodology used to determine the fair value of assets measured in accordance with GAAP.

As of June 30, 2020, the Company did not have impairment to goodwill or core deposit intangibles ("CDI"). At June 30, 2020, we had goodwill of $10.8 million or 5.72% of equity and CDI of $1.8 million or 0.96% of equity. We will continue to evaluate the value of our intangible assets based on the estimated long-term severity of the COVID-19 crisis' impact on our business and local economy.

Due to COVID-19 management opted to perform a qualitative analysis to determine if a quantitative calculation of impairment should be considered. Based on the qualitative analysis, management concluded that it is not more likely than not that goodwill and CDI are impaired. It is possible that the length and severity of the COVID-19 crisis could cause the Company's goodwill or CDI to be impaired in future periods due to a sustained decline in the Company's stock price or other financial or qualitative measures. In the event that the Company concludes that all or a portion of its goodwill and CDI are impaired, a non-cash charge for the amount of such impairment would be recorded to earnings in that quarter. Such a charge would have no impact on tangible capital or regulatory capital.

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Processes, controls and business continuity plan

The Enterprise Risk Management Committee assists the Board of Directors with oversight responsibilities which include the assurance that policies and procedures exist to respond to, prepare, and execute responses to unforeseen circumstances, such as, natural disasters and pandemics. The Company has invoked its Board approved Pandemic Preparedness Plan. Management's Pandemic team, which includes members from Executive, Accounting, Risk, Information Technology, Lending, Operations, Human Resources, and Facilities meets bi-weekly and more frequently as needed. Executive management reports weekly or more as needed to the Chairman of the Board. The Board is updated on a regular basis and as needed by executive management and the Chairman of the Board.

Shortly after invoking the Plan, we moved some employees to remote work. We have implemented protocols for team member safety, and initiated strategies for monitoring and responding to local COVID-19 impacts - including critical customer relief efforts. The Company's preparedness efforts resulted in minimal impacts to operations as a result of COVID-19. Improvements to the Company's technology platforms over the last several years enabled the successful transition to a remote work environment for some employees whose job responsibilities can be carried out effectively from home.

We remain focused on the well-being of our employees. Executive management established regular communications with employees to keep them informed of benefits available to them and steps we are taking to keep them safe. To prepare for potential staffing shortages resulting from COVID-19 cases, the Pandemic team has assessed critical team members and determined appropriate contingency and succession plans are in place to ensure continued operations.

The Company does not anticipate incurring additional material costs related to deployment of our remote working strategy. The Company does not anticipate significant challenges to maintain its systems and controls in light of the measures the Company has taken to prevent the spread of COVID-19. The Company does not currently face any material resource constraints in its execution of business continuity plans.

Retail operations

The Company is committed to assisting our customers and communities in this time of need. During the second quarter we reopened our branch lobbies. We are limiting the number of customers in our branch locations and requiring customers and our employees to wear masks. Customer areas are sanitized after every interaction. We encourage our customers to make appointments to address their needs. Our branches have been supplied with masks, gloves and disinfectant materials for employees to use throughout the day. All facilities and ATMs are being cleaned daily.

We are helping our deposit customers. Some measures include assisting customers with stopping recurring transactions to eliminate overdraft fees and increasing deposit limits on our mobile App. We are monitoring the Customer Support Center staffing to ensure successful management of call volume. Customers are able to transact all business including onboarding and closing accounts through our online channel, the drive thru and branch staff.

During the pandemic, the Company continues to monitor the safety of our staff and customers. Our staffing is adequate to address the requests for time off by employees impacted by family related matters, such as health or child care issues.

Lending operations, accommodations to borrowers and Credit

COVID-19 Deferred Loans

In keeping with regulatory guidance to work with borrowers during this unprecedented situation and as outlined in the CARES Act, the Company offered payment deferral programs for our business and individual customers who are adversely affected by the pandemic. Depending on the demonstrated need of the client, the Company deferred either the full loan payment or the principal component of the loan payment between 90 and 180 days. As of June 30, 2020, the Company had executed 312 loan deferrals on outstanding loan balances of $264.9 million, which represented 17.7% of gross portfolio loans. While interest and fees will still accrue to income, should eventual credit losses on these deferred payments emerge or if a loan is placed on nonaccrual status, interest income and fees accrued would need to be reversed. Given the ongoing uncertainty regarding the length and economic impact of the COVID-19 crisis and the effects of various government stimulus programs, the estimated number and dollar impact of loan deferrals the Company could execute is subject to change.

On March 22, 2020, federal banking regulatory agencies, including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, ("the agencies") issued an interagency statement on loan modifications and reporting for financial institutions working with customers affected by the Coronavirus. The interagency statement impacted accounting for loan modifications. Under Accounting Standards Codification 310-40, "Receivables - Troubled Debt Restructurings by Creditors," ("ASC 310-40"), a restructuring of debt 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. The

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agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers, who were current prior to any relief, are not to be considered TDRs. This includes short-term (e.g., up to six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented. The loan modifications must be executed between March 1, 2020, and the earlier of (A) 60 days after the date of termination of the National Emergency or (B) December 31, 2020. This interagency guidance is expected to have a material impact on the Company's Consolidated Financial Statements; however, this impact cannot be quantified at this time.

We anticipate that a significant portion of the Bank's borrowers in the hotel, restaurant and retail industries will continue to endure significant economic distress, which has caused, and may continue to cause, them to draw on their existing lines of credit. This scenario may adversely affect their ability to repay existing indebtedness and may impact the value of collateral. These developments, together with economic conditions, could materially impact our commercial real estate portfolio, particularly with respect to real estate with exposure to specific industries, and the value of certain collateral securing our loans. As a result, our financial condition, capital levels and results of operations could be adversely affected.

None of the deferrals are reflected in the Company’s asset quality measures (i.e., non-performing loans) due to the provision of the CARES Act that permits U.S. financial institutions to temporarily suspend the U.S. GAAP requirements to treat such short-term loan modifications as TDRs. The Company is regularly contacting borrowers who have deferred loans to better understand their situation and the challenges faced. It is possible that the Company's asset quality measures could worsen if the effects of COVID-19 are prolonged. We expect the COVID-19 pandemic to have an adverse effect on our loan pipeline and the credit quality of our loan portfolio during the remainder of 2020. However, it is not possible to project the impact with any precision at this time.

Should economic conditions worsen, the Company could experience further increases in its required ALLL and record additional credit loss expense. Management's COVID-19 credit analysis is included in the Asset Quality discussion of this MD&A.

U.S. Small Business Administration Paycheck Protection Program loans

With the passage of the Paycheck Protection Program, administered by the Small Business Administration, the Company is actively assisting its customers and community businesses with applications for resources through the program. The U.S. SBA PPP loan is designed to provide a direct incentive for small businesses to keep their workers on the payroll. SBA will forgive loans if all employee retention criteria are met, and the funds are used for eligible expenses. U.S. SBA PPP loans carry a two to five year term at a at 1% annual interest rate until the loan is either forgiven or paid. The forgiveness window is expected to open during the third quarter of 2020 and we are optimistic that many of our PPP customers will take the opportunity to request forgiveness in the third and fourth quarters of 2020.

As of June 30, 2020, the Company had originated 902 SBA PPP loans with balances of $129.4 million. The Bank will continue to make PPP loans until the authorized funding is depleted. The Company has funded PPP loans with the Federal Reserve PPPLF facility. The Company recorded net deferred fees of $3.9 million during the second quarter that will be amortized as a component of interest income through the contractual maturity date of each individual PPP loan. Net deferred fees include fees (deferred fees) paid to participant banks for each PPP loan underwritten and funded as well as costs incurred to underwrite the loans (deferred costs). PPP loan forgiveness will allow the Company to recognize remaining net deferred fees in the quarter of forgiveness.

The Company funded virtually all PPP loans with the Federal Reserve PPPLF program lending facility to fund banks offering SBA PPP loans at a 0.35% annual interest rate. As of June 30, 2020, the Company's outstanding PPPLF advances were $126.8 million. Due to the expected temporary increase to assets and the full government guaranty, banking regulators have provided favorable regulatory capital treatment by excluding the activity and balances from regulatory capital ratios.

Due to the full guaranty of the SBA and the underwriting process the Bank's employees followed, there are no credit issues anticipated with SBA PPP loans. As a result, the Company did not establish an allowance for loan losses for PPP loans.

Subsequent events

The Company has evaluated subsequent events for potential recognition and/or disclosure through the date the unaudited Consolidated Financial Statements included in this Quarterly Report on Form 10-Q were issued.

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COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2020 AND 2019

Earnings Summary

The Company reported net income for the three months ended June 30, 2020 of $3.5 million or diluted earnings per share of $0.59 compared to net income of $3.6 million or $0.65 per diluted earnings per share for the three months ended June 30, 2019. The Company’s ROAA and ROACE were 0.69% and 7.27% for the three months ended June 30, 2020 compared to 0.84% and 8.99% in June 30, 2019.

The $177,000 decrease to net income in the second quarter of 2020 compared to the same quarter in 2019 was due to increased provision for loan losses related to the economic uncertainty of the COVID-19 pandemic and increased noninterest expense, partially offset by increased net interest income and noninterest income. Decreases to income before taxes were partially offset by decreased income tax expense for the comparable periods. The decrease in income tax expense was due to a change in the Company's state tax apportionment approach that was implemented in the first quarter of 2020 as well as lower pre-tax income. The Company's lower effective tax rate is more fully explained in the income tax expense section in the discussion of results for the six months ended June 30, 2020 in this MD&A.

						Three Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Interest and dividend income						$	17,638					$	18,118					$	(480)					(2.6)		%
Interest expense						2,414						4,859						(2,445)						(50.3)		%
Net interest income						15,224						13,259						1,965						14.8		%
Provision for loan losses						3,500						375						3,125						833.3		%
Noninterest income						2,259						1,253						1,006						80.3		%
Noninterest expense						9,397						9,116						281						3.1		%
Income before income taxes						4,586						5,021						(435)						(8.7)		%
Income tax (income) expense						1,136						1,394						(258)						(18.5)		%
Net income						$	3,450					$	3,627					$	(177)					(4.9)		%

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Net Interest Income

The following table shows the components of net interest income and the dollar and percentage changes for the periods presented.

						Three Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Interest and Dividend Income
Loans, including fees						$	16,277					$	16,366					$	(89)					(0.5)		%
Taxable interest and dividends on investment securities						1,341						1,677						(336)						(20.0)		%
Interest on deposits with banks						20						75						(55)						(73.3)		%
Total Interest and Dividend Income						17,638						18,118						(480)						(2.6)		%
Interest Expenses
Deposits						1,937						3,966						(2,029)						(51.2)		%
Short-term borrowings						28						235						(207)						(88.1)		%
Long-term debt						449						658						(209)						(31.8)		%
Total Interest Expenses						2,414						4,859						(2,445)						(50.3)		%
Net Interest Income (NII)						$	15,224					$	13,259					$	1,965					14.8		%

The primary component of the Company’s net income is its net interest income, which is the difference between income earned on assets and interest paid on the deposits and borrowings used to fund them. Net interest income is affected by the difference between the yields earned on the Company’s interest-earning assets and the rates paid on interest-bearing liabilities, as well as the relative amounts of such assets and liabilities. Net interest income, divided by average interest-earning assets, represents the Company’s net interest margin.

The sharp decline in interest rates during the first six months of 2020 not only reduced interest income on floating-rate commercial loans and liquid interest-earning assets, but it also reduced competitive pressures and depositor expectations concerning deposit interest rates. Due to a slightly liability-sensitive balance sheet, the Company increased its increasing net interest margin in the first quarter of 2020 and had stable margins during the second quarter of 2020 after adjusting for PPP loan and funding activity. Net interest margin was negatively impacted from the funding of U.S. SBA PPP loans of $129.4 million which resulted in approximately eight basis points of net interest margin compression for the three months ended June 30, 2020. Some compression of our net interest margin is foreseeable in the second half of 2020 with the possibility that interest-earning assets will reprice faster than interest-bearing liabilities. The Bank's loan growth may slow due to delays in business investment activity. Conversely, PPP loan forgiveness will positively impact margins and net interest income in the quarter(s) of forgiveness with the recognition of remaining net deferred fees.

Fluctuations in net interest income can result from the combination of changes in the average balances of asset and liability categories and changes in interest rates. Interest rates earned and paid are affected by general economic conditions, particularly changes in market interest rates, and by competitive factors, government policies and actions of regulatory authorities. The Federal Reserve decreased the targeted federal funds rate by a total of 75 basis points in the second half of 2019. In addition, in response to the COVID-19 pandemic, the Federal Reserve decreased the targeted federal funds interest rate by a total of 150 basis points in March 2020. These decreases impact the comparability of net interest income between 2019 and 2020.

The following table presents information on the average balances of the Company’s interest-earning assets and interest-bearing liabilities and interest earned or paid for the three months ended June 30, 2020 and 2019.

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						Three Months Ended June 30,
						2020																														2019
(dollars in thousands)						Average Balance						Interest						Avg. Yield/Cost						Average Balance						Interest						Avg. Yield/Cost
Assets
Commercial real estate						$	981,188					$	10,537					4.30		%				$	899,883					$	10,714					4.76		%
Residential first mortgages						168,958						1,397						3.31		%				154,740						1,401						3.62		%
Residential rentals						131,018						1,521						4.64		%				124,307						1,560						5.02		%
Construction and land development						39,856						445						4.47		%				35,054						513						5.85		%
Home equity and second mortgages						35,135						318						3.62		%				36,384						524						5.76		%
Commercial and equipment loans						131,186						1,554						4.74		%				114,219						1,639						5.74		%
SBA PPP loans						90,132						493						2.19		%				—						—						—		%
Consumer loans						1,119						12						4.29		%				885						15						6.78		%
Allowance for loan losses						(15,597)						—						—						(11,016)						—						0.00		%
Loan portfolio (1)						1,562,995						16,277						4.17		%				1,354,456						16,366						4.83		%
Taxable investment securities						211,917						1,248						2.36		%				232,010						1,677						2.89		%
Nontaxable investment securities						12,586						93						2.96		%				—						—						—		%
Interest-bearing deposits in other banks						17,384						11						0.25		%				2,395						26						4.34		%
Federal funds sold						15,893						9						0.23		%				5,755						49						3.41		%
Interest-Earning Assets ("IEAs")						1,820,775						17,638						3.87		%				1,594,616						18,118						4.54		%
Cash and cash equivalents						73,206																		20,306
Goodwill						10,835																		10,835
Core deposit intangible						1,909																		2,564
Other assets						88,827																		92,875
Total Assets						$	1,995,552																	$	1,721,196
Liabilities and Stockholders’ Equity
Noninterest-bearing demand deposits						$	332,642					$	—					—		%				$	218,381					$	—					—		%
Interest-bearing demand deposits
Savings						81,019						30						0.15		%				70,472						18						0.10		%
Interest-bearing demand and money market accounts						816,836						481						0.24		%				683,572						1,655						0.97		%
Certificates of deposit						373,129						1,426						1.53		%				472,118						2,293						1.94		%
Total interest-bearing deposits						1,270,984						1,937						0.61		%				1,226,162						3,966						1.29		%
Total Deposits						1,603,626						1,937						0.48		%				1,444,543						3,966						1.10		%
Long-term debt						67,342						276						1.64		%				20,189						148						2.93		%
Short-term borrowings						13,077						28						0.86		%				34,874						235						2.70		%
PPPLF Advance						87,332						76						0.35		%				—						—						—		%
Subordinated Notes						—						—						—		%				23,000						359						6.24		%
TRUPS - Guaranteed preferred beneficial interest in junior subordinated debentures						12,000						97						3.23		%				12,000						151						5.03		%
Total Debt						179,751						477						1.06		%				90,063						893						3.97		%
Interest-Bearing Liabilities ("IBLs")						1,450,735						2,414						0.67		%				1,316,225						4,859						1.48		%
Total Funds						1,783,377						2,414						0.54		%				1,534,606						4,859						1.27		%
Other liabilities						22,285																		25,214
Stockholders’ equity						189,890																		161,376
Total Liabilities and Stockholders’ Equity						$	1,995,552																	$	1,721,196
Net interest income												$	15,224																	$	13,259

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						Three Months Ended June 30,
						2020																														2019
(dollars in thousands)						Average Balance						Interest						Avg. Yield/Cost						Average Balance						Interest						Avg. Yield/Cost
Interest rate spread																		3.21		%																3.06		%
Net yield on interest-earning assets																		3.34		%																3.33		%
Avg. loans to avg. deposits																		97.47		%																93.76		%
Avg. transaction deposits to total avg. deposits **																		76.73		%																67.32		%
Ratio of average IEAs to average IBLs																		125.51		%																121.15		%

__________________________

(1)Average balance includes non-accrual loans. There are no tax equivalent adjustments. There was $181,000 and $209,000 of accretion interest during the three months ended June 30, 2020 and 2019, respectively.

**Transaction deposits excluded time deposits

The following table presents changes in interest income and interest expense of the Company for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate); and (2) changes in rate (changes in rate multiplied by old volume). Changes in rate-volume (changes in rate multiplied by the change in volume) have been allocated to changes due to volume.

For the Three Months Ended June 30, 2020 Compared to the Three Months Ended June 30, 2019
(dollars in thousands)						Volume						Due to Rate						Total
Interest income:
Loan portfolio (1)						$	2,172					$	(2,261)					$	(89)
Investment securities, federal funds sold and interest-bearing deposits						95						(486)						(391)
Total interest-earning assets						$	2,267					$	(2,747)					$	(480)
Interest-bearing liabilities:
Savings						$	4					$	8					$	12
Interest-bearing demand and money market accounts						78						(1,252)						(1,174)
Certificates of deposit						(378)						(489)						(867)
Long-term debt						193						(65)						128
Short-term borrowings						(47)						(160)						(207)
PPPLF Advance						76						—						76
Subordinated notes						—						(359)						(359)
Guaranteed preferred beneficial interest in junior subordinated debentures						—						(54)						(54)
Total interest-bearing liabilities						$	(74)					$	(2,371)					$	(2,445)
Net change in net interest income						$	2,341					$	(376)					$	1,965

___________________________________

(1)Average balance includes non-accrual loans. There are no tax equivalent adjustments. There was $181,000 and $209,000 of accretion interest during the three months ended June 30, 2020 and 2019, respectively.

Net interest income totaled $15.22 million for the three months ended June 30, 2020, which represents a $1.97 million or 14.8% increase from $13.26 million for the three months ended June 30, 2019. Net interest margin of 3.34% for the three months ended June 30, 2020 increased one basis point from 3.33% for the comparable period. The increase in net interest income and static net interest margin resulted primarily from significant decreases in interest expense from lower funding costs. Increased interest income from larger average balances to interest-earning assets nearly offset decreased interest income from lower asset yields.

Average total earning assets increased $226.2 million, or 14.2% for the three months ended June 30, 2020 to $1,820.8 million compared to $1,594.6 million for the three months ended June 30, 2019. The increase in average total earning assets for the three months ended June 30, 2020 from the comparable quarter in 2019, resulted primarily from a $208.5 million, or 15.4%,

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increase in average loans of which average U.S. SBA PPP loans represented $90.1 million and an increase of $17.6 million, or 0.1%, in average investments, federal funds sold and interest-bearing deposits. Interest income decreased $480,000 for the three months ended June 30, 2020 compared to the second quarter of 2019. The decrease in interest income resulted from lower interest yields accounting for $2.7 million partially offset by larger average balances of interest-earning assets contributing $2.3 million.

Average total interest-bearing liabilities increased $134.5 million, or 10.2%, for the three months ended June 30, 2020 to $1,450.7 million compared to $1,316.2 million for the three months ended June 30, 2019. During the same time, average noninterest-bearing demand deposits increased $114.3 million, or 52.3%, to $332.6 million compared to $218.4 million. Noninterest-bearing deposits increased due to customer acquisition efforts in the last 18 months and the Bank's participation in the U.S. SBA PPP program. Interest expense decreased $2.4 million for the three months ended June 30, 2020 compared to the second quarter of 2019. Lower interest rates accounted for $2.4 million of the decrease in interest expense and decreases in the average balance of interest-bearing liabilities and changes in the funding mix contributed $74,000. For the three-month comparative periods, total debt increased $89.7 million, which included an increase in average Federal Reserve's PPPLF advances of $87.3 million. During the three months ended June 30, 2020, average transaction accounts, which include all accounts except for time deposits, increased $258.1 million or 26.5% to $1,230.5 million from $972.4 million for the three months ended June 30, 2019. During the same time, average time deposits decreased $99.0 million or 21.0% to $373.1 million for the three months ended June 30, 2020.

Net interest margin of 3.34% for the three months ended June 30, 2020 was one basis points higher than the 3.33% for the three months ended June 30, 2019. The increase in net interest margin from the second quarter of 2019 resulted primarily from the Company’s overall funding costs decreasing at a faster rate than interest earning asset yields. Interest earning asset yields decreased 67 basis points from 4.54% for the three months ended June 30, 2019 to 3.87% for the three months ended June 30, 2020. The Company’s cost of funds decreased 73 basis points from 1.27% for the three months ended June 30, 2019 to 0.54% for the three months ended June 30, 2020. Net interest income was impacted by accretion interest of $181,000 and $209,000 for the three months ended June 30, 2020 and 2019, respectively. For the three months ended June 30, 2020, net interest margin was reduced eight basis points as a result of net U.S. SBA PPP loans and Federal Reserve PPPLF funding.

Provision for Loan Losses

The following table shows the dollar and percentage changes for the provision for loan losses for the periods presented.

						Three Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Provision for loan losses						$	3,500					$	375					$	3,125					833.33		%

The provision for loan losses is a function of the calculation of the allowance for loan loss on the Company's end of period loan portfolios. Net charge-offs of $2.2 million were recognized for the three months ended June 30, 2020 compared to net charge-offs of $303,000 for the three months ended June 30, 2019. The Company's allowance methodology considers quantitative historical loss factors and qualitative factors to determine the estimated level of incurred losses in the Company's loan portfolios. The increased provision recorded in the second quarter of 2020 was primarily due to the uncertainty surrounding economic conditions as a result of the COVID-19 pandemic, which included provisions related to COVID-19 deferred loans. See further discussion of the provision and the allowance under the caption “Asset Quality” in the Comparison of Financial Condition section of this MD&A.

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Noninterest Income

The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.

						Three Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Noninterest Income
Loan appraisal, credit, and miscellaneous charges						$	35					$	38					$	(3)					(7.9)		%
Net gains on sale of investment securities						112						—						112						—		%
Unrealized gains on equity securities						40						65						(25)						(38)		%
Income from bank owned life insurance						220						222						(2)						(0.9)		%
Service charges						709						828						(119)						(14.4)		%
Referral fee income						1,143						100						1,043						1,043.0		%
Total Noninterest Income						$	2,259					$	1,253					$	1,006					80.3		%

Noninterest income for the three months ended June 30, 2020 increased from the three months ended June 30, 2019. The increases were due to net gains on the sale of securities and increased interest rate protection referral fee income, partially offset by decreased service charge income. During 2019, the Bank added a new product and began referring customers to a third-party financial institution that offers interest rate protection for the length of a loan. Decreased service charges were primarily due to a reduction in NSF fess and income generated from investment advisory services. Noninterest income as a percentage of average assets was 0.45% and 0.29%, respectively, for the three months ended June 30, 2020 and 2019.

During the three months ended June 30, 2020, the Company recognized net gains of $112,000 on the sale of two AFS securities with an aggregate carrying value of $3.4 million.

Noninterest Expense

The following tables show the components of noninterest expense and the dollar and percentage changes for the periods presented.

						Three Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Noninterest Expense
Compensation and benefits						$	4,714					$	4,881					$	(167)					(3.4)		%
OREO valuation allowance and expenses						1,100						432						668						154.6		%
Sub-total						5,814						5,313						501						9.4		%
Operating Expenses
Occupancy expense						736						753						(17)						(2.3)		%
Advertising						130						163						(33)						(20.2)		%
Data processing expense						924						755						169						22.4		%
Professional fees						477						606						(129)						(21.3)		%
Depreciation of premises and equipment						151						166						(15)						(9.0)		%
Telephone communications						53						66						(13)						(19.7)		%
Office supplies						30						33						(3)						(9.1)		%
FDIC Insurance						260						160						100						62.5		%
Core deposit intangible amortization						151						175						(24)						(13.7)		%
Other						671						926						(255)						(27.5)		%
Total Operating Expenses						$	3,583					$	3,803					$	(220)					(5.8)		%
Total Noninterest Expense						$	9,397					$	9,116					$	281					3.1		%

Noninterest expense increased for the three months ended June 30, 2020 compared to the three months ended June 30, 2019. The increase in noninterest expense for the comparable periods was primarily due to increased OREO expenses of $668,000.

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Operating expenses decreased for the comparable periods as increases in data processing and FDIC insurance were offset by lower professional fees and other expenses. Compensation and benefits were lower in the second quarter of 2020 due to the allocation of $406,000 in deferred costs for U.S. SBA PPP loans originated during the second quarter of 2020. The Company's projected quarterly expense run rate for the remainder of 2020 remains between $9.2-$9.4 million. Adjusted noninterest expense, which excludes OREO related expenses decreased $387,000 to $8.3 million for the three months ended June 30, 2020 compared to $8.7 million for the three months ended June 30, 2019. 

The Company’s efficiency ratio¹ was 53.75% for the three months ended June 30, 2020 compared to 62.82% for the three months ended June 30, 2019. The Company’s net operating expense ratio² was 1.43% for the three months ended June 30, 2020 compared to 1.83% for the three months ended June 30, 2019. The efficiency and net operating expense ratios have improved (decreased) as the Company has been able to generate more noninterest income while controlling expense growth.

Expenses applicable to OREO assets included the following.

						Three Months Ended June 30,
(dollars in thousands)						2020						2019
Valuation allowance						$	1,059					$	576
Losses (gains) on dispositions						6						(178)
Operating expenses						35						34
						$	1,100					$	432

During the three months ended June 30, 2020, the Company disposed of a commercial building with a carrying value of $1.6 million for proceeds of $1.6 million resulting in a loss of $6,000. During the three months ended June 30, 2019, the Company recognized net gains of $178,000 on the disposal of $100,000 of commercial lots for proceeds of $278,000.

To adjust properties to current appraised values, additions to the valuation allowance were taken for the three months ended June 30, 2020 and 2019. OREO carrying amounts reflect management’s estimate of the realizable value of these properties incorporating current appraised values, local real estate market conditions and related costs. The second quarter of 2020 valuation adjustment of $1.1 million consisted of reductions of carrying value to $2.7 million for eight properties.

Income Tax Expense

For the three months ended June 30, 2020 the effective tax rate was 24.8%. The Company’s consolidated effective tax rate was 27.8% in the second quarter of 2019. The effective income tax rates differ during the second quarter of 2020 and 2019, respectively, from the statutory federal and state income tax rates primarily due to change in the Company's state tax apportionment, increases in tax-exempt loans and investments and the income tax effects associated with stock-based compensation and certain non-deductible expenses for state income taxes.

The decrease in income tax expense for the three months ended June 30, 2020 was due to lower income before taxes compared to the prior year and a change in the Company's state tax apportionment approach which was implemented during the first quarter of 2020. The year to date comparative impact is shown in the comparison of results of operations for the six months ended June 30, 2020 and 2019.

¹ Efficiency ratio is defined as noninterest expense divided by the sum of net interest income plus noninterest income.

² The net operating expense ratio is defined as noninterest expense less noninterest income divided by average assets.

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COMPARISON OF RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2020 AND 2019

Earnings Summary

The Company reported net income for the six months ended June 30, 2020 of $6.2 million or diluted earnings per share of $1.05 compared to net income of $7.5 million or $1.35 per diluted share for the six months ended June 30, 2019. The Company’s ROAA and ROACE were 0.65% and 6.64% for the six months ended June 30, 2020 compared to 0.88% and 9.41% for the six months ended June 30, 2019.

The decrease to net income in the first six months of 2020 compared to the same period in 2019 was due to increased provision for loan losses related to the economic uncertainty of the COVID-19 pandemic and increased noninterest expense partially offset by increases in net interest income of and non-interest income. Decreases to income before taxes were partially offset by decreased income tax expense for the comparable periods. The decrease in income tax expense was due to a change in the Company's state tax apportionment approach that was implemented in the first quarter of 2020 as well as lower pre-tax income. The Company's lower effective tax rate is more fully explained in the income tax expense section in the discussion of results for the six months ended June 30, 2020 in this MD&A.

						Six Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Interest and dividend income						$	35,677					$	35,915					$	(238)					(0.7)		%
Interest expense						6,100						9,619						(3,519)						(36.6)		%
Net interest income						29,577						26,296						3,281						12.5		%
Provision for loan losses						7,600						875						6,725						768.6		%
Noninterest income						4,380						2,314						2,066						89.3		%
Noninterest expense						19,080						17,521						1,559						8.9		%
Income before income taxes						7,277						10,214						(2,937)						(28.8)		%
Income tax expense						1,079						2,710						(1,631)						(60.2)		%
Net income						$	6,198					$	7,504					$	(1,306)					(17.4)		%

Net Interest Income

The following table shows the components of net interest income and the dollar and percentage changes for the periods presented.

						Six Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Interest and Dividend Income
Loans, including fees						$	32,779					$	32,495					$	284					0.9		%
Taxable interest and dividends on investment securities						2,810						3,300						(490)						(14.8)		%
Interest on deposits with banks						88						120						(32)						(26.7)		%
Total Interest and Dividend Income						35,677						35,915						(238)						(0.7)		%
Interest Expenses
Deposits						4,981						7,734						(2,753)						(35.6)		%
Short-term borrowings						97						569						(472)						(83.0)		%
Long-term debt						1,022						1,316						(294)						(22.3)		%
Total Interest Expenses						6,100						9,619						(3,519)						(36.6)		%
Net Interest Income (NII)						$	29,577					$	26,296					$	3,281					12.5		%

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The following table presents information on the average balances of the Company’s interest-earning assets and interest-bearing liabilities and interest earned or paid for the six months ended June 30, 2020 and 2019, respectively.

						Six Months Ended June 30,
						2020																														2019
(dollars in thousands)						Average Balance						Interest						Avg. Yield/Cost						Average Balance						Interest						Avg. Yield/Cost
Assets
Commercial real estate						$	968,112					$	21,782					4.50		%				$	893,950					$	21,182					4.74		%
Residential first mortgages						169,975						2,909						3.42		%				155,813						2,897						3.72		%
Residential rentals						131,469						2,874						4.37		%				124,264						3,084						4.96		%
Construction and land development						38,481						912						4.74		%				33,236						970						5.84		%
Home equity and second mortgages						35,582						771						4.33		%				36,583						1,050						5.74		%
Commercial and equipment loans						127,411						3,013						4.73		%				115,958						3,283						5.66		%
SBA PPP loans						46,516						493						2.12		%				—						—						—		%
Consumer loans						1,118						25						4.47		%				857						29						6.77		%
Allowance for loan losses						(13,400)						—						—						(11,078)						—						0.00		%
Loan portfolio (1)						1,505,264						32,779						4.36		%				1,349,583						32,495						4.82		%
Taxable investment securities						213,664						2,711						2.54		%				229,694						3,300						2.87		%
Non-taxable investment securities						6,337						99						3.12		%				—						—						—		%
Interest bearing deposits in other banks						11,966						63						1.05		%				3,357						71						4.23		%
Federal funds sold						9,960						25						0.50		%				3,267						49						3.00		%
Interest-Earning Assets ("IEAs")						1,747,191						35,677						4.08		%				1,585,901						35,915						4.53		%
Cash and cash equivalents						48,657																		18,991
Goodwill						10,835																		10,835
Core deposit intangible						1,986																		2,653
Other assets						87,819																		91,873
Total Assets						$	1,896,488																	$	1,710,253
Liabilities and Stockholders’ Equity
Noninterest-bearing demand deposits						$	289,473					$	—					—		%				$	213,876					$	—					—		%
Interest-bearing liabilities:
Savings						76,052						48						0.13		%				70,504						35						0.10		%
Interest-bearing demand and money market accounts						800,797						1,805						0.45		%				681,889						3,360						0.99		%
Certificates of deposit						381,828						3,128						1.64		%				461,101						4,339						1.88		%
Total Interest-bearing deposits						1,258,677						4,981						0.79		%				1,213,494						7,734						1.27		%
Total Deposits						1,548,150						4,981						0.64		%				1,427,370						7,734						1.08		%
Debt:
Long-term debt						61,219						536						1.75		%				20,306						293						2.89		%
Short-term borrowings						14,805						97						1.31		%				43,600						569						2.61		%
PPPLF Advances						43,666						76						0.35		%				—						—						—		%
Subordinated Notes						7,456						184						4.94		%				23,000						719						6.25		%
TRUPS - Guaranteed preferred beneficial interest in junior subordinated debentures						12,000						226						3.77		%				12,000						304						5.07		%
Total debt						139,146						1,119						1.61		%				98,906						1,885						3.81		%
Total Interest-Bearing Liabilities ("IBLs")						1,397,823						6,100						0.87		%				1,312,400						9,619						1.47		%
Total funds						1,687,296						6,100						0.72		%				1,526,276						9,619						1.26		%
Other liabilities						22,612																		24,557
Stockholders’ equity						186,580																		159,420
Total Liabilities and Stockholders’ Equity						$	1,896,488																	$	1,710,253
Net interest income												$	29,577																	$	26,296

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						Six Months Ended June 30,
						2020																														2019
(dollars in thousands)						Average Balance						Interest						Avg. Yield/Cost						Average Balance						Interest						Avg. Yield/Cost
Interest rate spread																		3.21		%																3.06		%
Net yield on interest-earning assets																		3.39		%																3.32		%
Avg. loans to avg. deposits																		97.23		%																94.55		%
Avg. transaction deposits to total avg. deposits **																		75.34		%																67.70		%
Ratio of average IEAs to average IBLs																		124.99		%																120.84		%
Cost of funds																		0.72		%																1.26		%
Cost of deposits																		0.64		%																1.08		%
Cost of debt																		1.61		%																3.81		%

__________________________

(1)Average balance includes non-accrual loans. There are no tax equivalent adjustments. There was $403,000 and $381,000 of accretion interest during the six months ended June 30, 2020 and 2019, respectively.

**Transaction deposits excluded time deposits

The following table presents changes in interest income and interest expense of the Company for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate); and (2) changes in rate (changes in rate multiplied by old volume). Changes in rate-volume (changes in rate multiplied by the change in volume) have been allocated to changes due to volume.

For the Six Months Ended June 30, 2020 compared to the Six Months Ended June 30, 2019
(dollars in thousands)						Volume						Due to Rate						Total
Interest income:
Loan portfolio (1)						$	3,390					$	(3,106)					$	284
Investment securities, federal funds sold and interest-bearing deposits						67						(589)						(522)
Total interest-earning assets						$	3,457					$	(3,695)					$	(238)
Interest-bearing liabilities:
Savings						4						9						13
Interest-bearing demand and money market accounts						268						(1,823)						(1,555)
Certificates of deposit						(649)						(562)						(1,211)
Long-term debt						358						(115)						243
Short-term borrowings						(189)						(283)						(472)
PPPLF Advance						76						—						76
Subordinated notes						(384)						(151)						(535)
Guaranteed preferred beneficial interest in junior subordinated debentures						—						(78)						(78)
Total interest-bearing liabilities						$	(516)					$	(3,003)					$	(3,519)
Net change in net interest income						$	3,973					$	(692)					$	3,281

___________________________________

(1)Average balance includes non-accrual loans. There are no tax equivalent adjustments. There was $403,000 and $381,000 of accretion interest during the six months ended June 30, 2020 and 2019, respectively.

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Net interest income totaled $29.6 million for the six months ended June 30, 2020, which represents a $3.3 million or 12.5% increase from $26.3 million for the six months ended June 30, 2019. As a result of organic growth, average total earning assets increased $161.3 million or 10.2%, for the six months ended June 30, 2020 to $1,747.2 million compared to $1,585.9 million for the six months ended June 30, 2019. The increase in average total earning assets for the six months ended June 30, 2020 from the comparable period in 2019, resulted primarily from a $155.7 million, or 11.5%, increase in average loans, of which average U.S. SBA PPP loans represented $46.5 million and an increase of $5.6 million, or 2.4%, increase in average investments, federal funds sold, and interest-bearing deposits. Interest income decreased $238,000 for the six months ended June 30, 2020 compared to the same period of 2019. The decrease in interest income resulted from larger average balances of interest-earning assets contributing $3.5 million and higher interest yields accounting for $3.7 million.

Average total interest-bearing liabilities increased $85.4 million, or 6.5%, for the six months ended June 30, 2020 to $1,397.8 million compared to $1,312.4 million for the six months ended June 30, 2019. During the same time, average noninterest-bearing demand deposits increased $75.6 million, or 35.3%, to $289.5 million compared to $213.9 million. Noninterest-bearing deposits increased due to customer acquisition efforts in the last 18 months and the Bank's participation in the U.S. SBA PPP program. Interest expense decreased $3.5 million for the six months ended June 30, 2020 compared to the same period of 2019. Lower interest rates accounted for $3.0 million of the decrease in interest expense and decreases in the average balance and change in the funding mix of interest-bearing liabilities contributed $516,000. For the six-month comparative periods, average total debt increased $40.2 million, which included an increase in average Federal Reserve's PPPLF advances of $43.7 million. During the six months ended June 30, 2020, average transaction accounts increased $200.1 million or 20.7% to $1,166.3 million from $966.3 million for the six months ended June 30, 2019. During the same time, average time deposits decreased $79.3 million or 17.2% to $381.8 million for the six months ended June 30, 2020.

Net interest margin of 3.39% for the six months ended June 30, 2020 was seven basis points higher than the 3.32% for the six months ended June 30, 2019. The increase in net interest margin from the first six months of 2019 resulted primarily from the Company’s interest earning asset yields decreasing at a slower rate than overall funding costs. Interest earning asset yields decreased 45 basis points from 4.53% for the six months ended June 30, 2019 to 4.08% for the six months ended June 30, 2020. The Company’s cost of funds decreased 54 basis points from 1.26% for the six months ended June 30, 2019 to 0.72% for the six months ended June 30, 2020. Net interest income was impacted by accretion interest of $403,000 and $381,000 for the six months ended June 30, 2020 and 2019, respectively. For the six months ended June 30, 2020, net interest margin was reduced four basis points as a result of net U.S. SBA PPP loans and Federal Reserve PPPLF funding.

Provision for Loan Losses

The following table shows the dollar and percentage changes for the provision for loan losses for the periods presented.

						Six Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Provision for loan losses						$	7,600					$	875					$	6,725					768.57		%

Net charge-offs of $2.2 million were recognized for the six months ended June 30, 2020 compared to net charge-offs of $933,000 for the six months ended June 30, 2019. The Company's allowance methodology considers quantitative historical loss factors and qualitative factors to determine the estimated level of incurred losses inherent in the Company's loan portfolios. The increased provision recorded in the second quarter of 2020 was primarily due to the uncertainty surrounding economic conditions as a result of the COVID-19 pandemic, which included provisions related to COVID-19 deferred loans. See further discussion of the provision and the allowance under the caption “Asset Quality” in the Comparison of Financial Condition section of this MD&A.

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Noninterest Income

The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.

						Six Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Noninterest Income
Loan appraisal, credit, and miscellaneous charges						$	49					$	96					$	(47)					(49.0)		%
Net gains on sale of investment securities						441						—						441						—		%
Unrealized gain on equity securities						115						121						(6)						(5)		%
Income from bank owned life insurance						439						439						—						—		%
Service charges						1,691						1,558						133						8.5		%
Referral fee income						1,645						100						1,545						1,545.0		%
Total Noninterest Income						$	4,380					$	2,314					$	2,066					89.3		%

Noninterest income for the six months ended June 30, 2020 increased compared to the six months ended June 30, 2019. The increases were due to increased referral fee income, gain on sales of investments and increased service charge income. Increased service charges were due to a larger customer base and the growth in organic deposits over the last two years. In addition, the Bank revamped its retail deposit account product offerings during the second half of 2019 and focused on adding more consumer checking accounts. The Bank's larger asset size and customer base contributed to the increase. Noninterest income as a percentage of assets was 0.46% and 0.27%, respectively, for the six months ended June 30, 2020 and 2019. The COVID-19 crisis has impacted spending habits of customers and reduced service fee income as well as curtailed expected commercial loan volume which impacts interest rate protection agreement referral fee opportunities. The economic environment could impact future noninterest income.

Noninterest Expense

The following tables show the components of noninterest expense and the dollar and percentage changes for the periods presented.

						Six Months Ended June 30,
(dollars in thousands)						2020						2019						$ Change						% Change
Noninterest Expense
Compensation and benefits						$	9,902					$	9,684					$	218					2.3		%
OREO valuation allowance and expenses						1,882						488						1,394						285.7		%
Sub-total						11,784						10,172						1,612						15.8		%
Operating Expense
Occupancy expense						1,470						1,559						(89)						(5.7)		%
Advertising						251						360						(109)						(30.3)		%
Data processing expense						1,852						1,475						377						25.6		%
Professional fees						1,103						1,024						79						7.7		%
Depreciation of premises and equipment						309						355						(46)						(13.0)		%
Telephone communications						96						118						(22)						(18.6)		%
Office supplies						61						70						(9)						(12.9)		%
FDIC Insurance						430						335						95						28.4		%
Core deposit intangible amortization						308						356						(48)						(13.5)		%
Other						1,416						1,697						(281)						(16.6)		%
Total Operating Expense						7,296						7,349						(53)						(0.7)		%
Total Noninterest Expense						$	19,080					$	17,521					$	1,559					8.9		%

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Noninterest expense for the six months ended June 30, 2020 compared to the six months ended June 30, 2019. The increase in noninterest expense for the comparable periods was primarily due to increased compensation and benefits and OREO expenses. Operating expenses decreased for the comparable periods as increases in data processing, professional fees and FDIC insurance were offset by decreases in all other operating expenses including occupancy, advertising, depreciation and other expenses. Adjusted noninterest expense, which excludes OREO related expenses increased $165,000 to $17.2 million for the six months ended June 30, 2020 compared to $17.0 million for the six months ended June 30, 2019. 

Year to date compensation and benefits for the six months ended were reduced $406,00 due to the allocation of deferred costs for U.S. SBA PPP loans originated during the second quarter of 2020. The Company's projected quarterly expense run rate for the remainder of 2020 remains between $9.2-$9.4 million.

The Company’s efficiency ratio was 56.19% for the six months ended June 30, 2020 compared to 61.24% for the six months ended June 30, 2019. The Company’s net operating expense ratio was 1.55% at June 30, 2020 compared to 1.78% at June 30, 2019. The efficiency and net operating expense ratios have improved (decreased) as the Company has been able to generate more noninterest income while controlling expense growth.

Expenses applicable to OREO assets included the following.

						Six Months Ended June 30,
(dollars in thousands)						2020						2019
Valuation allowance						$	1,791					$	637
Losses (gains) on dispositions						9						(188)
Operating expenses						82						39
						$	1,882					$	488

During the six months ended June 30, 2020, the Company disposed of commercial real estate with carrying value totaling $2.3 million for proceeds of $2.3 million resulting in losses totaling $9,000. During the six months ended June 30, 2019, the Company recognized net gains of $188,000 on disposals of $416,000 for multiple residential lots of $65,000, commercial real estate of $316,000 and commercial equipment of $35,000. In connection with the sale of commercial real estate, the Bank provided a loan of $280,000. The transaction qualified for sales treatment under ASC Topic 610-20 “Other Income – Gains and Losses from the Derecognition of Nonfinancial Assets”.

To adjust properties to current appraised values, additions to the valuation allowance were taken for the six months ended June 30, 2020 and 2019 and the year ended December 31, 2019. OREO carrying amounts reflect management’s estimate of the realizable value of these properties incorporating current appraised values, local real estate market conditions and related costs. For the first six months of 2020 the valuation adjustment of $1.8 million consisted of reductions of aggregate carrying value to $2.7 million for eight properties.

Income Tax Expense

For the six months ended June 30, 2020 the effective tax rate at 14.8% was lower than our normal expected range due to an adjustment to net current and deferred assets related to state apportionment of interest income on loans. This tax benefit was partially offset by certain holding company expenses that are not deductible for state purposes. The Company’s consolidated effective tax rate was 26.5% for the six months ended June 30, 2019.

The Company's new state tax apportionment approach was implemented during the first quarter of 2020 and included the impact of amended income tax filings of the Company and Bank. Management evaluated the tax position and determined the change in tax position qualified as a change in estimate under FASB ASC Section 250. The following table shows a breakdown of income tax expense for the six months ended June 30, 2020 split between the apportionment adjustment and a normalized 2020 income tax provision:

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						Six Months Ended June 30, 2020
(dollars in thousands)						Tax Provision						Effective Tax Rate
Income tax apportionment adjustment						$	(743)					(10.2)		%
Income taxes before apportionment adjustment						1,822						25.0		%
Income tax (benefit) expense as reported						$	1,079					14.8		%
Income before income taxes						$	7,277

The Company’s consolidated effective tax rate is expected to be between 25.40% and 26.06% for the third and fourth quarters of 2020.

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COMPARISON OF FINANCIAL CONDITION AT JUNE 30, 2020 AND DECEMBER 31, 2019

ASSETS

Total assets increased $296.2 million, or 16.5%, to $2.09 billion at June 30, 2020 compared to total assets of $1.80 billion at December 31, 2019 primarily due to increased net loans of $159.0 million with U.S. SBA PPP loans accounting for $129.4 million of the increase. In addition, total assets increased $28.2 million for investments, OREO decreased $4.1 million, cash increased $114.0 million and all other assets decreased $882,000. The differences in allocations between the cash and investment categories reflect operational needs. Total assets and on-balance sheet liquidity increased in the first six months of 2020 from organic loan and deposit growth as wells as COVID-19 government stimulus programs.

The following table shows the Company’s assets and the dollar and percentage changes for the periods presented.

(dollars in thousands)						June 30, 2020						December 31, 2019						$ Change						% Change
Cash and due from banks						$	103,914					$	25,065					$	78,849					314.6		%
Federal funds sold						29,456						—						29,456						—		%
Interest-bearing deposits with banks						13,051						7,404						5,647						76.3		%
Securities available for sale (AFS), at fair value						234,982						208,187						26,795						12.9		%
Equity securities carried at fair value through income						4,831						4,669						162						3.5		%
Non-marketable equity securities held in other financial institutions						209						209						—						—		%
FHLB stock - at cost						4,691						3,447						1,244						36.1		%
Net Loans						1,604,136						1,445,109						159,027						11.0		%
Goodwill						10,835						10,835						—						—		%
Premises and equipment, net						20,972						21,662						(690)						(3.2)		%
Premises and equipment held for sale						430						430						—						—		%
Other real estate owned (OREO)						3,695						7,773						(4,078)						(52.5)		%
Accrued interest receivable						6,773						5,019						1,754						34.9		%
Investment in bank owned life insurance						37,619						37,180						439						1.2		%
Core deposit intangible						1,810						2,118						(308)						(14.5)		%
Net deferred tax assets						6,565						6,168						397						6.4		%
Right of use assets, net operating leases						8,132						8,382						(250)						(3.0)		%
Other assets						1,655						3,879						(2,224)						(57.3)		%
Total Assets						$	2,093,756					$	1,797,536					$	296,220					16.5		%

Cash and Cash Equivalents

Cash and cash equivalents totaled $146.4 million at June 30, 2020, compared to $32.5 million at December 31, 2019. Total cash and cash equivalents fluctuate on a daily basis due to transactions in process and other liquidity demands. Management believes liquidity needs are satisfied by the current balance of cash and cash equivalents, access to traditional and wholesale funding sources, and the portions of the investment and loan portfolios that mature within one year. These sources of funds should enable the Company to meet cash obligations as they come due.

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Investment Securities and Credit Quality of Investment Securities

Investment securities and FHLB stock at June 30, 2020 and December 31, 2019, estimated fair values were $244.7 million, and $216.5 million, respectively. In December 2019, the Company reclassified the HTM portfolio to the AFS portfolio. The Bank's primary reasons for the reclassification were to better manage interest rate risks and provide additional on-balance sheet liquidity.

The Company did not hold any noninvestment grade securities at June 30, 2020 and December 31, 2019. At June 30, 2020, greater than 89%, or $208.2 million of the carrying value of AFS securities were rated AAA by Standard & Poor’s or the equivalent credit rating from another major rating agency compared to greater than 96%, or $200.5 million, at December 31, 2019. AFS securities are evaluated quarterly to determine whether a decline in their value is OTTI. No OTTI charge was recorded for the periods reported.

Gross unrealized losses at June 30, 2020 and December 31, 2019 for AFS securities were $907,000 and $645,000, respectively, of amortized cost of $228.9 million and $206.1 million, respectively. The change in unrealized losses was the result of changes in interest rates and other non-credit related factors, while credit risks remained stable. The Company intends to, and has the ability to, hold AFS securities with unrealized losses until they mature, at which time the Company will receive full value for the securities. Management believes that the AFS securities with unrealized losses will either recover in market value or be paid off as agreed.

The Bank holds over 69% or $158.8 million of its investment securities as asset-backed securities issued by GSEs or U.S. Agencies, GSE agency bonds or U.S. government obligations. The Company's amortized cost investment of $25.7 million in student loan trusts, which represent 11% of the AFS investment portfolio, are 97% U.S. government guaranteed. At June 30, 2020, the Company also had $42.3 million or 19% of AFS investments in municipal bonds.

At June 30, 2020 and December 31, 2019, AFS asset-backed securities issued by GSEs and U.S. Agencies had average lives of 4.59 years and 4.39 years and average durations of 4.34 years and 3.94 years and were guaranteed by their issuer as to credit risk, respectively. At June 30, 2020, AFS asset-backed securities issued by student loan trust and others had an average life of 6.54 years and an average duration of 6.14 years. At June 30, 2020 and December 31, 2019, AFS municipal bonds issued by states, political subdivisions or agencies had an average life of 10.44 years and 9.51 years and an average duration of 8.93 years and 8.18 years, respectively.

The tables below present the Standard & Poor’s (“S&P”) or equivalent credit rating from other major rating agencies for AFS securities at June 30, 2020 and December 31, 2019 by carrying value. The Company considers noninvestment grade securities rated BB+ or lower as classified assets for regulatory and financial reporting. GSE asset-backed securities and GSE agency bonds with S&P AA+ ratings were treated as AAA based on regulatory guidance.

June 30, 2020																		December 31, 2019
Credit Rating						Amount						Credit Rating						Amount
(dollars in thousands)												(dollars in thousands)
AAA						$	208,247					AAA						$	200,481
AA						24,454						AA						7,334
A						2,281						A						372
BB						—						BB						—
Total						$	234,982					Total						$	208,187

Earnings performance and liquidity of the investment portfolio is monitored and managed by management through monthly reporting and Asset and Liability Committee (“ALCO”) meetings. In addition, ALCO also monitors net interest income and interest rate risk for the Company. Analysis of expected cash inflows and outflows, including the investment securities portfolio, ensures liquidity is available to satisfy depositor requirements and the various credit needs of customers. Management believes the risk characteristics inherent in the investment portfolio are acceptable.

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Loan Portfolio

During the first six months of 2020, total net loans, which include portfolio loans and U.S. SBA PPP loans, increased 22.0% annualized or $159.0 million from $1,445.1 million at December 31, 2019 to $1,604.1 million at June 30, 2020. Portfolio loans include all loan portfolios except the U.S. SBA PPP loan portfolio. Net portfolio loans increased $33.4 million and net U.S. SBA PPP loans increased $125.6 million for the comparable period ends. The commercial real estate portfolio increased in total during the first six months of 2020, while increasing slightly as a percentage of gross portfolio loans. The Company’s loan pipeline was approximately $134.0 million at June 30, 2020 compared to $104.0 million at December 31, 2019.

The following is a breakdown of the Company’s loan portfolio at June 30, 2020 and December 31, 2019:

(dollars in thousands)						June 30, 2020						%						December 31, 2019						%						$ Change						Annualized % Change
BY LOAN TYPE
Portfolio Loans:
Commercial real estate						$	996,111					66.73		%				$	964,777					66.34		%				$	31,334					6.5		%
Residential first mortgages						165,670						11.10		%				167,710						11.53		%				(2,040)						(2.4)		%
Residential rentals						132,590						8.88		%				123,601						8.50		%				8,989						14.5		%
Construction and land development						37,580						2.52		%				34,133						2.35		%				3,447						20.2		%
Home equity and second mortgages						33,873						2.27		%				36,098						2.48		%				(2,225)						(12.3)		%
Commercial loans						63,249						4.24		%				63,102						4.34		%				147						0.5		%
Consumer loans						1,117						0.07		%				1,104						0.08		%				13						2.4		%
Commercial equipment						62,555						4.19		%				63,647						4.38		%				(1,092)						(3.4)		%
Gross portfolio loans						1,492,745						100.00		%				1,454,172						100.00		%				38,573						5.3		%
Net deferred costs						2,072						0.14		%				1,879						0.13		%				193						20.5		%
Allowance for loan losses						(16,319)						(1.09)		%				(10,942)						(0.75)		%				(5,377)						98.3		%
						(14,247)												(9,063)												(5,184)						114.4		%
Net portfolio loans						$	1,478,498											$	1,445,109											$	33,389					4.6		%
U.S. Small Business Administration ("SBA") Paycheck Protection Program ("PPP") loans						$	129,384											$	—											$	129,384					n/a
Net deferred fees						(3,746)												—												(3,746)						n/a
Net SBA PPP Loans						$	125,638											$	—											$	125,638					n/a
Total Net Loans						$	1,604,136											$	1,445,109											$	159,027					22.0		%
Gross Loans						$	1,622,129											$	1,454,172											$	167,957					23.1		%

Acquired loans at June 30, 2020 were $67.1 million or 4.5% of gross portfolio loans compared to and $77.1 million or 5.3% of gross portfolio loans at December 31, 2019.  At June 30, 2020, performing acquired loans totaled $65.1 million, net of a $0.9 million net acquisition accounting fair market value adjustment, representing a 1.35% discount; and PCI loans totaled $2.0 million, net of a $414,000 adjustment, representing a 17.19% discount. At December 31, 2019 acquired performing loans, which totaled $74.7 million, included a $1.2 million net acquisition accounting fair market value adjustment, representing a 1.55% discount; and PCI loans which totaled $2.4 million, included a $516,000 adjustment, representing a 17.55% discount.

During the three and six months ended June 30, 2020 and 2019 there were $181,000 and $403,000 and $209,000 and $381,000, respectively, of accretion interest recognized as a component of interest income.

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Non-Acquired Loan Portfolios

During the six months ended June 30, 2020, the non-acquired loan portfolios increased $48.6 million or at a 7.1% annualized rate. The following is a breakdown of the Company’s non-acquired loan portfolios at June 30, 2020 and December 31, 2019:

(dollars in thousands)						June 30, 2020						%						December 31, 2019						%						$ Change						Annualized % Change
Commercial real estate						$	948,139					66.50		%				$	911,850					66.22		%				$	36,289					8.0		%
Residential first mortgages						165,670						11.62		%				167,710						12.18		%				(2,040)						(2.4)		%
Residential rentals						124,225						8.71		%				113,090						8.21		%				11,135						19.7		%
Construction and land development						37,580						2.64		%				34,133						2.48		%				3,447						20.2		%
Home equity and second mortgages						24,637						1.73		%				24,863						1.81		%				(226)						(1.8)		%
Commercial loans						63,249						4.44		%				63,102						4.58		%				147						0.5		%
Consumer loans						1,056						0.07		%				1,011						0.07		%				45						8.9		%
Commercial equipment						61,109						4.29		%				61,335						4.45		%				(226)						(0.7)		%
						$	1,425,665					100.00		%				$	1,377,094					100.00		%				$	48,571					7.1		%

Loan Concentrations

At June 30, 2020 and December 31, 2019, commercial loans represented the largest component of the loan portfolio with a significant amount real estate secured. The Bank's commercial loans are concentrated in our market area; however, these loans are distributed among many different borrowers in numerous industries.

Non-owner occupied commercial real estate as a percentage of risk-based capital at June 30, 2020 and December 31, 2019 were $682 million or 345% and $639 million or 320%, respectively. Construction loans as a percentage of risk-based capital at June 30, 2020 and December 31, 2019 were $163 million or 82% and $147 million or 74%, respectively. Regulatory loan concentrations increased in the first six months of 2020 due primarily to a reduction in total regulatory capital from the redemption of the $23.0 million of 6.25% fixed-to-floating rate subordinated notes in February 2020.

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Asset Quality

The following tables show asset quality ratios at June 30, 2020 and December 31, 2019.

						(Unaudited)
(dollars in thousands, except per share amounts)						June 30, 2020						December 31, 2019						$ Change						% Change
ASSET QUALITY
Total assets						$	2,093,756					$	1,797,536					$	296,220					16.5		%
Gross portfolio loans (1)						1,492,745						1,454,172						38,573						2.7
Classified Assets						25,115						34,636						(9,521)						(27.5)
Allowance for loan losses						16,319						10,942						5,377						49.1
Past due loans - 31 to 89 days						5,843						549						5,294						964.3
Past due loans >=90 days						20,072						12,778						7,294						57.1
Total past due (delinquency) loans						25,915						13,327						12,588						94.5
Non-accrual loans (2)						22,896						17,857						5,039						28.2
Accruing troubled debt restructures (TDRs) (3)						593						650						(57)						(8.8)
Other real estate owned (OREO)						3,695						7,773						(4,078)						(52.5)
Non-accrual loans, OREO and TDRs						$	27,184					$	26,280					$	904					3.4		%
ASSET QUALITY RATIOS (1)
Classified assets to total assets						1.20		%				1.93		%
Classified assets to risk-based capital						12.49						16.21
Allowance for loan losses to total loans						1.09						0.75
Allowance for loan losses to non-accrual loans						71.27						61.28
Past due loans - 31 to 89 days to total loans						0.39						0.04
Past due loans >=90 days to total loans						1.34						0.88
Total past due (delinquency) to total loans						1.74						0.92
Non-accrual loans to total loans						1.53						1.23
Non-accrual loans and TDRs to total loans						1.57						1.27
Non-accrual loans and OREO to total assets						1.27						1.43
Non-accrual loans and OREO to total loans and OREO						1.78						1.75
Non-accrual loans, OREO and TDRs to total assets						1.30						1.46

____________________________________

(1)Portfolio loans include all loan portfolios except the U.S. SBA PPP loan portfolio. Asset quality ratios for loans exclude U.S. SBA PPP loans.

(2)Non-accrual loans include all loans that are 90 days or more delinquent and loans that are non-accrual due to the operating results or cash flows of a customer. Non-accrual loans can include loans that are current with all loan payments. At June 30, 2020 and December 31, 2019, the Company had current non-accrual loans of $2.8 million and $5.1 million, respectively.

(3)At June 30, 2020 and December 31, 2019, the Bank had total TDRs of $2.2 million and $2.0 million, respectively, with $1.6 million and $1.4 million, respectively, in non-accrual status. These loans are classified as non-accrual loans for the calculation of financial ratios.

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Allowance for Loan Losses

We expect the COVID-19 pandemic to have an adverse effect on the credit quality of our loan portfolio. Disruption to our customers could result in increased loan delinquencies and defaults. The Company's COVID-19 loan deferral commercial and retail programs could delay the identification and resolution of problem credits. The Company's second quarter 2020 allowance adjustment considered the additional work level on staff, the increased pace of change in regulations, and the number and dollar amount of deferred loans. No credit issues are anticipated with SBA PPP loans as they are guaranteed by the Small Business Administration and the Bank's allowance for loan loss does not include an allowance for U.S. SBA PPP loans.

Management’s determination of the adequacy of the allowance is based on a periodic evaluation of the portfolio with consideration given to: overall loss experience; current economic conditions; size, growth and composition of the loan portfolio; financial condition of the borrowers; current appraised values of underlying collateral and other relevant factors that, in management’s judgment, warrant recognition in determining an adequate allowance. Improvements to baseline charge-off factors for the periods used to evaluate the adequacy of the allowance as well as improvements in some qualitative factors, such as improvements in classified assets were offset by increases in other qualitative factors, such as increased economic factors. The baseline charge-off factor increased slightly in the second quarter of 2020 compared to the prior quarter due to larger than average charge-offs, but was not impacted significantly due to low charge-off activity for the periods used to evaluate the allowance. The specific allowance is based on management’s estimate of realizable value for particular loans. Management believes that the allowance is adequate. The following is a summary roll-forward of the allowance and a breakdown of the Company’s general and specific allowances as a percentage of gross loans at and for the three and six months ended June 30, 2020 and 2019 and year ended December 31, 2019:

						Three Months Ended June 30,																		Six Months Ended June 30,																		Year Ended
(dollars in thousands)						2020						2019						2020						2019						December 31, 2019
Beginning of period						$	15,061					$	10,846					$	10,942					$	10,976					$	10,976
Charge-offs						(2,262)						(333)						(2,262)						(1,075)						(2,375)
Recoveries						20						30						39						142						211
Net charge-offs						(2,242)						(303)						(2,223)						(933)						(2,164)
Provision for loan losses						3,500						375						7,600						875						2,130
End of period						$	16,319					$	10,918					$	16,319					$	10,918					$	10,942
Net charge-offs to average loans (annualized)						(0.57)		%				(0.09)		%				(0.30)		%				(0.14)		%				(0.16)		%

Breakdown of general and specific allowance as a percentage of gross loans

						June 30, 2020						June 30, 2019						December 31, 2019
General allowance						$	16,215					$	9,737					$	10,114
Specific allowance						104						1,181						828
						$	16,319					$	10,918					$	10,942
General allowance						1.09		%				0.70		%				0.70		%
Specific allowance						0.01		%				0.09		%				0.05		%
Allowance to gross loans						1.09		%				0.79		%				0.75		%
Allowance to non-acquired gross loans						1.14		%				0.84		%				0.79		%
Total acquired loans						$	67,080					$	91,125					$	77,078
Non-acquired loans**						$	1,425,665					$	1,296,061					$	1,377,094
Gross loans						$	1,492,745					$	1,387,186					$	1,454,172

____________________________________

** Non-acquired loans include loans transferred from acquired pools following release of acquisition accounting FMV adjustments.

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The Company recorded an increase in its provision for loan loss expense for the three and six months ended June 30, 2020 compared to the same periods in the prior year. Net charge -offs also increased. The Company's allowance methodology considers quantitative historical loss factors and qualitative factors to determine the estimated level of incurred losses in the Company's loan portfolios. The increased provision was due to the effects of the COVID pandemic which has resulted in economic contraction and to a lesser degree growth in the commercial loan portfolio. The economic contraction has also increased the number of borrowers requesting full or partial deferrals of loan payments. The 2020 net charge-offs were primarily from the resolution of two relationships that were both substandard and non-accrual, which decreased non-accrual loans and classified loans $5.1 million. U.S. SBA PPP loans are excluded from the Bank's allowance methodology as they are guaranteed by the U.S. government. Since December 31, 2019, the Company's general allowance increased and the specific allowance decreased as specifically identified impaired loans were resolved. Allowance for loan loss levels increased to 1.09% of total portfolio loans at June 30, 2020 compared to 0.75% at December 31, 2019. The allowance as a percentage of non-acquired loans increased 35 basis points to 1.14% at June 30, 2020 from 0.79% at December 31, 2019.

As noted in Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Effects of COVID-19 on Company's Operations, the pandemic has introduced increasing uncertainty around the local and national economy. Regulatory treatment of loan deferrals has been changed to encourage loan deferrals. Although the deferrals may lessen credit losses in the long run, they make our credit metrics less transparent, timely and useful. The increased volume of loan related work including processing deferrals, processing PPP loan requests and changing regulations increases inherent credit risks.

The loans with deferred payments which currently amount to $264.9 million or 17.7% of total gross portfolio loans as of June 30, 2020, are more likely to default in the future. In our evaluation of the deferred loan portfolio, management considered the length of the deferral period, the type and amount of collateral and customer industries. The analysis considered the impact to the allowance model if certain metrics were available (e.g., delinquency), but because of the COVID-19 deferral period will remain as lagging indicators. When the deferral periods end in the fourth quarter of 2020 and the first quarter of 2021, we plan to use customer specific qualitative metrics in our ALLL calculation.

The Company has established a process for tracking COVID-19 loans during the deferral period. COVID-19 deferral relationships will be reviewed by their lender each quarter and relevant information aggregated and reported to the Board and management. Due to the recent booking of these deferrals, reports are expected to be more informative late in the third quarter. Consistent with regulatory guidance, if new information during the deferral period indicates that there is evidence of default, the Bank may change the classification rating (e.g., change from passing credit to substandard) and accrual status (e.g., change form accrual to non-accrual status) as deemed appropriate.

Below are several schedules that provide information on the COVID-19 deferred loans. The schedules summarize the COVID-19 loan modifications by loan portfolio, the amount of interest recognized but not received, monthly interest and principal deferral amounts, maturity or next payment due dates and the Banks's industry classification using the North American Industry Classification System ("NAICS"). The NAICS is the standard used by Federal statistical agencies in classifying business establishments for the purpose of collecting, analyzing, and publishing statistical data related to the U.S. business. economy.

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COVID-19 Deferred Loans
(dollars in thousands)						6/30/2020						%						Number of Loans						Interest Recognized Not Received						Scheduled Monthly Principal						Scheduled Monthly Interest
Commercial real estate						$	228,117					86.14		%				153						$	2,259					$	813					$	831
Residential first mortgages						13,545						5.11		%				41						160						40						48
Residential rentals						8,643						3.26		%				26						110						33						38
Construction and land development						0						0.00		%				0						—						—						—
Home equity and second mortgages						394						0.15		%				5						6						2						1
Commercial loans						745						0.28		%				7						11						1						3
Consumer loans						11						0.00		%				3						—						—						—
Commercial equipment						13,395						5.06		%				77						116						221						48
Total						$	264,850					100.00		%				312						$	2,662					$	1,110					$	969

COVID-19 Deferred Loans - Next Payment Due By Month
(dollars in thousands)						Loan Balances						%						Number of Loans
July-20						$	11,629					4.39		%				18
August-20						17,530						6.62		%				21
September-20						5,480						2.07		%				31
October-20						96,349						36.38		%				113
November-20						113,013						42.67		%				99
December-20						15,768						5.95		%				21
January-21						5,081						1.92		%				9
Total						$	264,850					100.00		%				312

The following tables show the deferred loans by NAICS Industry Category and subcategory.

COVID-19 Deferred Loans by NAICS Industry
(dollars in thousands)						June 30, 2020						Number of Loans
Real Estate Rental and Leasing						$	122,155					93
Accommodation and Food Services						42,788						19
Other Services (except Public Administration)						35,110						24
Health Care and Social Assistance						18,541						32
Professional, Scientific, and Technical Services						7,472						13
Construction						6,396						24
Arts, Entertainment, and Recreation						4,396						5
Transportation and Warehousing						4,387						16
Retail Trade						2,120						11
Educational Services						1,698						3
Manufacturing						1,400						6
Other Industries, Residential Mortgages and Consumer **						18,387						66
Total						$	264,850					312
** No NAICS code has been assigned.

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COVID-19 Deferred Loans by Top Four NAICS Industries
(dollars in thousands)						6/30/2020						Number of Loans
Real Estate Rental and Leasing
Lessors of Nonresidential Buildings						$	98,884					53
Lessors of Residential Buildings and Dwellings						12,547						18
Other Activities Related to Real Estate						4,335						8
Lessors of Other Real Estate Property						3,506						6
Lessors of Mini-warehouses and Self-Storage Units						1,211						1
Other						1,672						7
						$	122,155					93
Accommodation and Food Services
Hotels (except Casino Hotels) and Motels						$	31,061					8
Full-Service Restaurants						4,552						6
Caterers						1,412						2
Limited-Service Restaurants						5,763						3
						$	42,788					19
Other Services (except Public Administration)
Religious Organizations						$	22,908					14
Civic and Social Organizations						10,220						4
Other						1,982						6
						$	35,110					24
Health Care and Social Assistance
Assisted Living Facilities for the Elderly						$	9,177					3
Offices of Physicians (except Mental Health Specialists)						3,781						10
Offices of Dentists						2,416						12
General Medical and Surgical Hospitals						1,927						1
Other						1,240						6
						$	18,541					32

Off Balance Sheet Credit Exposure Reserve

The Company's reserve for off balance sheet credit exposures was $51,000 and did not increase in the first six months of 2020. The Company is monitoring line of credit usage and has not seen substantive increases in usage or expected usage. Management believes that many of the Bank's customers presently have sufficient liquidity due to COVID-19 government stimulus programs. We will continue to monitor activity and expect potential increases in the off balance sheet reserve in the third or fourth quarters of 2020 as customers use available liquidity.

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Classified Assets and Special Mention Assets

Classified assets decreased $9.5 million from $34.6 million at December 31, 2019 to $25.1 million at June 30, 2020. Management considers classified assets to be an important measure of asset quality. The Company's risk rating process for classified loans are an important input into the Company's allowance methodology. Risk ratings are expected to be an important indicator beginning in the third quarter of 2020 in assessing credit risks of the COVID-19 deferred loans. The following is a breakdown of the Company’s classified and special mention assets at June 30, 2020, March 31, 2020 and December 31, 2019, 2018, 2017, and 2016, respectively:

(dollars in thousands)						As of
									6/30/2020						3/31/2020						12/31/2019						12/31/2018						12/31/2017						12/31/2016
Classified loans
Substandard						$	21,420					$	27,151					$	26,863					$	32,226					$	40,306					$	30,463
Doubtful						—						—						—						—						—						137
Total classified loans						21,420						27,151						26,863						32,226						40,306						30,600
Special mention loans						1,025						1,045						—						—						96						—
Total classified and special mention loans						$	22,445					$	28,196					$	26,863					$	32,226					$	40,402					$	30,600
Classified loans						21,420						27,151						26,863						32,226						40,306						30,600
Classified securities						—						—						—						482						651						883
Other real estate owned						3,695						6,338						7,773						8,111						9,341						7,763
Total classified assets						$	25,115					$	33,489					$	34,636					$	40,819					$	50,298					$	39,246
Total classified assets as a percentage of total assets						1.20		%				1.83		%				1.93		%				2.42		%				3.58		%				2.94		%
Total classified assets as a percentage of Risk Based Capital						12.49		%				17.00		%				12.21		%				21.54		%				32.10		%				26.13		%

In the second quarter of 2020 classified loans decreased $5.8 million from $27.2 million at March 31, 2020 to $21.4 million at June 30, 2020. The resolution of two relationships that were both substandard and non-accrual accounted for $5.1 million of the second quarter 2020 decrease.

Other Real Estate Owned

The OREO balance decreased $4.1 million from $7.8 million at December 31, 2019 to $3.7 million at June 30, 2020. During the six months ended June 30, 2020 there were no OREO additions. OREO disposals of $2.3 million netted losses of $9,000 on disposals for the six months ended June 30, 2020. To adjust properties to current appraised values, additions to the valuation allowance of $1.8 million were taken for the six months ended June 30, 2020. OREO carrying amounts reflect management’s estimate of the realizable value of these properties incorporating current appraised values, local real estate market conditions and related costs. Management remains focused on reducing OREO during 2020. Based on the June 30, 2020 OREO balance of $3.7 million and valuation adjustments made during the first six months of 2020, management does not expect an elevated level of OREO expense in the second half of 2020. See further discussion of expenses applicable to OREO under the caption “Noninterest Expense” in the Comparison of Results of Operations section of Management’s Discussion and Analysis.

Non-Performing Assets

Non-accrual loans and OREO to total gross portfolio loans and OREO increased three basis points from 1.75%  at December 31, 2019 to 1.78% at June 30, 2020. Non-accrual loans, OREO and TDRs to total assets decreased 16 basis points from 1.46% at December 31, 2019 to 1.30% at June 30, 2020. 

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Non-accrual loans increased $5.0 million from $17.9 million at December 31, 2019 to $22.9 million at June 30, 2020. The increase in non-accrual loans during the first six months 2020 was largely the result of several substandard classified relationships that before the COVID-19 crisis were performing. During the second quarter of 2020, non-accrual loans increased $6.5 million from $16.4 million at March 31, 2020 to $22.9 million at June 30, 2020. The net increase was primarily due to three relationships totaling $9.9 million that were substandard in the first quarter of 2020, current at March 31, 2020, and that were delinquent at June 30, 2020. As of June 30, 2020, the Company had not offered COVID-19 deferrals to customers that were substandard credits before the COVID-19 crisis. In addition, as of June 30, 2020 there were $1.7 million of non-accrual loans with approved COVID-19 loan deferrals not yet completed. These loans were current prior to the COVID-19 crisis and will not be considered delinquent loans or TDRs upon completion of the modification agreements. These increases to non-accruals were partially offset by decreases to non-accrual loans from the resolution of two relationships during the second quarter of 2020 totaling $5.1 million that were both substandard and non-accrual at March 31, 2020.

At June 30, 2020, $20.0 million or 87.4% of total non-accruals of $22.9 million related to 10 customer relationships. At December 31, 2019, $15.0 million or 84% of total non-accruals of $17.9 million related to seven customer relationships. Non-accrual loans of $2.8 million (12%) were current with all payments of principal and interest with no impairment at June 30, 2020. Delinquent non-accrual loans were $20.1 million (88%) with specific reserves of $88,000 at June 30, 2020.  

Loans can be current but classified as non-accrual due to customer operating results or payment history. All interest accrued but not collected from loans that are placed on non-accrual or charged-off is reversed against interest income. In accordance with the Company’s policy, interest income is recognized on a cash basis or cost-recovery method, until qualifying for return to accrual status.

Non-accrual loans included four TDRs at June 30, 2020 totaling $1.60 million and three TDR totaling $1.40 million at December 31, 2019. These loans were classified solely as non-accrual for the calculation of financial ratios. Loan delinquency (90 days or greater delinquent and 31-89 days delinquent) increased $12.6 million from $13.3 million or 0.92% of loans, at December 31, 2019 to $25.9 million, or 1.74% of loans, at June 30, 2020.

TDRs increased a net of $140,000 or 6.8%, from $2.05 million at December 31, 2019 to $2.19 million at June 30, 2020 due to principal paydowns of $29,000, the disposal of one TDR in the amount of $25,000 and the addition of one TDR in the amount of $194,000. The Company fully reserved four TDRs totaling $60,000 at June 30, 2020.

The Company had specific reserves of $87,000 on three TDRs totaling $88,000 at December 31, 2019. During the year ended December 31, 2019, TDR disposals, which included payoffs and refinancing consisted of seven loans totaling $4.4 million. TDR loan principal curtailment was $236,000 for the year ended December 31, 2019.There was one TDR added during the year ended December 31, 2019 totaling $25,000.

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LIABILITIES

The following table shows the Company’s liabilities and the dollar and percentage changes for the periods presented.

(dollars in thousands)						June 30, 2020						December 31, 2019						$ Change						% Change
Deposits
Non-interest-bearing deposits						$	356,196					$	241,174					$	115,022					47.7		%
Interest-bearing deposits						1,314,168						1,270,663						43,505						3.4		%
Total deposits						1,670,364						1,511,837						158,527						10.5		%
Short-term borrowings						5,000						5,000						—						—
Long-term debt						67,336						40,370						26,966						66.8		%
Paycheck Protection Program Liquidity Facility ("PPPLF") Advance						126,801						—						126,801						—		%
Guaranteed preferred beneficial interest in
junior subordinated debentures (TRUPs)						12,000						12,000						—						—		%
Subordinated notes - 6.25%						—						23,000						(23,000)						(100)		%
Lease liabilities - operating leases						8,296						8,495						(199)						(2.3)		%
Accrued expenses and other liabilities						14,517						15,340						(823)						(5.4)		%
Total Liabilities						$	1,904,314					$	1,616,042					$	288,272					17.8		%

Deposits and Borrowings

The Bank uses both retail deposits and wholesale funding. Retail deposits include municipal deposits. Wholesale funding includes short-term borrowings, long-term debt and brokered deposits. Retail deposits continue to be the most significant source of funds totaling $1,659.4 million or 95.2% of funding at June 30, 2020 compared to $1,510.8 million or 97.0% of funding at December 31, 2019. Wholesale funding, which consisted of FHLB advances and brokered deposits, was $83.3 million or 4.8% of funding at June 30, 2020 compared to $46.4 million or 3.0% of funding at December 31, 2019. The June 30, 2020 Federal Reserve Bank's PPPLF Program outstanding balance of $126.8 million is excluded from the preceding deposit and wholesale analysis

In addition to funding for operations, the Company had junior subordinated debentures of $12.0 million and subordinated notes of $23.0 million of 6.25% fixed-to-floating rate subordinated notes at December 31, 2019. On February 15, 2020, the Company redeemed the Company’s outstanding $23.0 million of 6.25% fixed-to-floating rate subordinated notes.

Total deposits increased $158.5 million or 10.49% (21.0% annualized) to $1,670.4 million at June 30, 2020 compared to $1,511.8 million at December 31, 2019. The $158.5 million increase was comprised of a $186.2 million increase to transaction deposits and a $27.7 million decrease to time deposits. Reciprocal deposits are included in transaction deposits and are used to maximize FDIC insurance available to our customers.

The Bank typically experiences a reduction in transaction deposits during the first quarter as our business customers use transaction account balances to pay expenses and taxes accrued in the prior year. In the first quarter of 2020, transaction deposits increased. During the second quarter deposit balances generally increase through the end of the year. The Bank continued to attract additional retail deposit customers during the first six months of 2020. Non-interest-bearing demand deposits increased $115.0 million or 47.7% to $356.2 million (21.3% of deposits) at June 30, 2020 compared to $241.2 million (15.95% of deposits) at December 31, 2019. The Bank increased on-balance sheet liquidity in the first and second quarters as deposit balances increased compared to the prior year. Customer deposit balances increased due to lower levels of consumer and business spending. We believe that deposit levels could decrease in future periods as a result of the distressed economic conditions in our market areas relating to the COVID-19 pandemic. However, it is not possible to project the impact with any precision at this time. We expected a temporary increase in deposit balances in the second quarter of 2020 due to our customers' participation in the SBA PPP loan program.

At June 30, 2020 and December 31, 2019, total deposits consisted of $1,659.4 million and $1,510.8 million in retail deposits and $11.0 million, and $1.0 million in wholesale deposits. Wholesale deposits include traditional brokered deposits and do not include the portion of reciprocal deposits classified as brokered deposits for call reporting purposes. The Bank increased retail deposits during the last two years as a result of the 2018 County First acquisition as well as targeted growth in relationships

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with local municipal agencies and continued organic growth in core markets. The current year increase in deposits has been impacted by government stimulus programs. The Bank's municipal customers typically utilize treasury and cash management services involving multiple accounts as well as other services and products such as payroll, lock box services, positive pay, and automated clearing house transactions. Most of the municipal relationships’ balances are maintained in reciprocal deposits. Management believes that the diversity and complexity of products and services utilized, safeguards the stability of these relationships.

For FDIC call reporting purposes reciprocal deposits are classified as brokered deposits when they exceed 20% of a bank’s liabilities or $5.0 billion. No reciprocal deposits were considered brokered deposits at June 30, 2020 while $31.4 million were considered brokered at December 31, 2019 for call reporting purposes.

The FDIC’s examination policies require that the Company monitor customer deposit concentrations that are 2% or more of total deposits. At June 30, 2020, the Bank had three customer deposit relationships that exceeded 2% of total deposits, totaling $276.1 million which represented 16.53% of total deposits. At December 31, 2019, two customer deposit relationship exceeded 2% of total deposits, totaling $297.1 million which represented 19.6% of total deposits. The reported concentrations at June 30, 2020 and December 31, 2019 were with local municipal agencies.

Details of the Company’s deposit portfolio at June 30, 2020 and December 31, 2019 are presented below:

						June 30, 2020																		December 31, 2019
(dollars in thousands)						Balance						%						Balance						%
Noninterest-bearing demand						$	356,196					21.32		%				$	241,174					15.95		%
Interest-bearing:
Demand						547,639						32.79		%				523,802						34.65		%
Money market deposits						314,781						18.85		%				283,438						18.75		%
Savings						85,257						5.10		%				69,254						4.58		%
Certificates of deposit						366,491						21.94		%				394,169						26.07		%
Total interest-bearing						1,314,168						78.68		%				1,270,663						84.05		%
Total Deposits						$	1,670,364					100.00		%				$	1,511,837					100.00		%
Transaction accounts						$	1,303,873					78.06		%				$	1,117,668					73.93		%

As of June 30, 2020, the Company had loans and securities pledged or in safekeeping at FHLB with a collateral value of $526.7 million. The Company had $296.9 million in loan collateral and $229.8 million of AFS securities collateral, partially offset by FHLB outstanding advances of $72.3 million, FHLB letters of credit of $43.0 million, and amounts pledged to municipalities of $53.7 million, resulting in total available collateral for FHLB borrowings of $357.7 million at June 30, 2020. The Bank used the Federal Reserve PPPLF to fund SBA PPP loans to ensure available borrowing availability from the FHLB was not impacted. Federal Reserve PPPLF advances are non-recourse and receive 100% value for the pledged PPP loan collateral. The SBA PPP loans that are pledged to the PPPLF are excluded from the leverage ratio according to regulatory policy as explained below.

The Company uses wholesale funding to supplement funding when loan growth exceeds core deposit growth and for asset-liability management purposes. Wholesale funding as a percentage of assets increased to 3.98% or $83.3 million at June 30, 2020 compared to 2.58% or $46.4 million at December 31, 2019. Wholesale funding includes brokered deposits and FHLB advances. During the last two years, liquidity strengthened with strong core deposit growth and balanced interest-earning asset growth. The Company's reliance on wholesale funding decreased from 18.63% of assets at December 31, 2017 to 3.98% of assets at June 30, 2020. The Company’s net loan to deposit ratio decreased from 95.6% at December 31, 2019 and to 88.5% at June 30, 2020. 

Advances from the FHLB are secured by the Bank’s stock in the FHLB, a portion of the Bank’s loan portfolio and certain investments. Generally, the Bank’s ability to borrow from the FHLB of Atlanta is limited by its available collateral and also by an overall limitation of 30% of assets. Further, short-term credit facilities are available at the Federal Reserve Bank of Richmond and other commercial banks. FHLB long-term debt consists of adjustable-rate advances with rates based upon LIBOR, fixed-rate advances, and convertible advances.

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Management has increased oversight and review of customer line of credit usage. If we were to experience increases in draws on customer lines of credit or decreased deposit levels in future periods as a result of the distressed economic conditions in our market areas relating to the COVID-19 pandemic, our level of borrowed funds could increase.

STOCKHOLDERS' EQUITY

Total stockholders’ equity increased due to net income of $6.2 million, an increase in accumulated other comprehensive income of $3.0 million and net stock related activities in connection with stock-based compensation and ESOP activity of $147,000. These increases to stockholders’ equity were partially offset by decreases due to common dividends paid of $1.4 million.

The Company had a book value per common share of $32.05 and $30.76, at June 30, 2020 and December 31, 2019, respectively. Tangible book value at June 30, 2020 and December 31, 2019 was $29.91 and $28.57. The Company’s ratio of tangible common equity to tangible assets decreased to 8.50% at June 30, 2020 from 9.44% at December 31, 2019 (see Non-GAAP reconciliation schedules). The Company’s Common Equity Tier 1 (“CET1”) ratio was 11.12% at June 30, 2020 and 11.11% at  December 31, 2019. The Company remains well capitalized at June 30, 2020 with a Tier 1 capital to average assets ("leverage ratio") of 9.76% at June 30, 2020 compared to 10.08% at December 31, 2019. In April 2020, banking regulators issued an interim final rule that excluded U.S. SBA PPP loans pledged under the PPPLF from the calculation of the leverage ratio. In addition, the interim final rule excluded U.S. SBA PPP loans from the calculation of risk-based capital ratios by assigning a zero percent risk weight.

The following table shows the Company’s equity and the dollar and percentage changes for the periods presented.

(dollars in thousands)						June 30, 2020						December 31, 2019						$ Change						% Change
Common Stock at par of $0.01						$	59					$	59					$	—					—		%
Additional paid in capital						95,687						95,474						213						0.2		%
Retained earnings						89,781						85,059						4,722						5.6		%
Accumulated other comprehensive income						4,517						1,504						3,013						(200.3)		%
Unearned ESOP shares						(602)						(602)						—						—		%
Total Stockholders’ Equity						$	189,442					$	181,494					$	7,948					4.4		%

LIQUIDITY AND CAPITAL RESOURCES

Capital Resources

The Company has no business other than holding the stock of the Bank and does not have significant operating cash needs, except for the payment of dividends declared on common stock, and the payment of interest on subordinated debentures and subordinated notes, and noninterest expense.

The Company evaluates capital resources by its ability to maintain adequate regulatory capital ratios. The Company and the Bank annually update a three-year strategic capital plan. In developing its plan, the Company considers the impact to capital of asset growth, income accretion, dividends, holding company liquidity, investment in markets and people and stress testing. Our capital position is reflected in stockholders’ equity, subject to certain adjustments for regulatory purposes. Stockholders’ equity, or capital, is a measure of our net worth, soundness, and viability. At June 30, 2020, we continue to remain in a well-capitalized position. Stockholders’ equity at June 30, 2020 was $189.4 million, compared to $181.5 million at December 31, 2019.

During the six months ended June 30, 2020 and 2019, the Company performed ongoing assessments using regulatory capital ratios and determined that the Company meets the new requirements specified in the Basel III rules upon full adoption of such requirements. Our subsidiary bank made the election to retain the AOCI treatment under the prior capital rules in a March 2015 regulatory filing.

Federal banking regulations require the Company and the Bank to maintain specified levels of capital. As of June 30, 2020, and December 31, 2019, the Company and Bank were well-capitalized under the regulatory framework for prompt corrective action under the Basel III Capital Rules. Management believes, as of June 30, 2020 and December 31, 2019, that the Company and the Bank met all capital adequacy requirements to which they were subject. See Note 10 of the Consolidated Financial Statements.

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Liquidity

Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position.

The Company believes there could be potential stresses on liquidity management as a direct result of the COVID-19 pandemic. As customers manage their own liquidity stress, we could experience an increase in the utilization of existing lines of credit. Management monitors liquidity for signs of stress resulting from the COVID-19 pandemic.

Based on management’s going concern evaluation, we believe that there are no conditions or events, considered in the aggregate, that raise substantial doubt about the Company’s or the Bank’s ability to continue as a going concern, within one year of the date of the issuance of the Consolidated Financial Statements.

Asset liquidity is provided by cash and assets that are readily marketable, or that will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in cash deposits with other banks. Liquidity is also provided by access to funding sources, which include core depositors and brokered deposits. Other sources of funds include our ability to borrow, such as purchasing federal funds from correspondent banks, sales of securities under agreements to repurchase and advances from the FHLB.

At June 30, 2020 and December 31, 2019, the Bank had $41.2 million and $96.6 million, respectively, in loan commitments outstanding. In addition, at June 30, 2020 and December 31, 2019, the Bank had $21.6 million and $22.3 million, respectively, in letters of credit and approximately $229.7 million and $230.5 million, respectively, available under lines of credit. Certificates of deposit due within one year of June 30, 2020 and December 31, 2019 totaled $287.8 million, or 78.52% and $309.0 million, or 78.40%, respectively, of total certificates of deposit outstanding. If maturing deposits do not remain, the Bank will be required to seek other sources of funds, including other certificates of deposit and borrowings. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposits. We believe, however, based on past experience that a significant portion of our certificates of deposit will remain with us. We have the ability to attract and retain deposits by adjusting the interest rates offered.

The Company’s principal sources of liquidity are cash on hand and dividends received from the Bank. The Bank is subject to various regulatory restrictions on the payment of dividends.

The Bank’s principal sources of funds for investment and operations are net income, deposits, sales of loans, borrowings, principal and interest payments on loans, principal and interest received on investment securities and proceeds from the maturity and sale of investment securities. The Bank’s principal funding commitments are for the origination or purchase of loans, the purchase of securities and the payment of maturing deposits. Deposits are considered the primary source of funds supporting the Bank’s lending and investment activities. The Bank also uses borrowings from the FHLB of Atlanta to supplement deposits. The amount of FHLB advances available to the Bank is limited to the lower of 30% of Bank assets or the amount supportable by eligible collateral including FHLB stock, loans and securities. In addition, the Bank has established unsecured and secured lines of credit with the Federal Reserve Bank and commercial banks.

For additional information on these agreements, including collateral, see Note 11 of the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2019.

The Bank’s most liquid assets are cash, cash equivalents and federal funds sold. The levels of such assets are dependent on the Bank’s operating, financing and investment activities at any given time. The variations in levels of cash and cash equivalents are influenced by deposit flows and anticipated future deposit flows.

Cash and cash equivalents as of June 30, 2020 totaled $146.4 million, an increase of $114.0 million from the December 31, 2019 total of $32.5 million. Ending cash balances increased primarily due to increases in net deposits, proceeds from long-term debt, and proceeds from sales and principal payments on investment securities. These increases were partially offset by the excess of loan originations over principal collected, the purchase of investment securities, and the payment of subordinated notes. Changes to the level of cash and cash equivalents have minimal impact on operational needs as the Bank has substantial sources of funds available from other sources.

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During the six months ended June 30, 2020, all financing activities provided $287.9 million in cash compared to $48.4 million in cash for the same period in 2019. The Company provided $239.5 million of additional cash from financing activities in the six months ended June 30, 2020 compared to the six months ended June 30, 2019. The increase was primarily due to $153.2 million in cash provided from long-term debt proceeds including $126.8 million in PPPL advances, increased net deposits of $93.7 million and $25.0 million from short term borrowings, offset by the payment of subordinated notes of $23.0 million, payments of long-term debt of $9.4 million, and an increase in dividends paid of $69,000.

During the six months ended June 30, 2020 all investing activities used $187.5 million in cash compared to $48.9 million in cash provided for the same period in 2019. The increase in cash used of $138.6 million was primarily the result of purchases of investment securities and cash used for the funding of loans originated, which increased $139.0 million from $226.6 million for the six months ended June 30, 2019 to $365.6 million for the six months ended June 30, 2020. Cash used decreased as principal received on loans for the six months ended June 30, 2020 increased over the prior year comparable period. Principal collected on loans increased $16.7 million from $182.8 million from the six months ended June 30, 2019 to $199.5 million for the six months ended June 30, 2020. Cash used increased $45.8 million and $13.6 million, respectively, as proceeds from the sales and principal payments of available for sale securities for the six months ended June 30, 2020 increased over the prior year comparable period.

Operating activities provided cash of $13.6 million, or $7.7 million more cash, for the six months ended June 30, 2020, compared to $5.9 million of cash provided for the same period of 2019.

For information on risks relating to liquidity, see Item 1A. "Risk Factors - Liquidity Risk", as presented in the Company's Form 10-K for the year ended December 31, 2019.

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ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Interest rate risk is defined as the exposure to changes in net interest income and capital that arises from movements in interest rates. Depending on the composition of the balance sheet, increasing or decreasing interest rates can negatively affect the Company’s results of operations and financial condition.

The Company measures interest rate risk over the short and long term. The Company measures interest rate risk as the change in net interest income (“NII") caused by a change in interest rates over twelve and twenty-four months. The Company’s NII simulations provide information about short-term interest rate risk exposure. The Company also measures interest rate risk by measuring changes in the values of assets and liabilities due to changes in interest rates. The economic value of equity (“EVE”) is defined as the present value of future cash flows from existing assets, minus the present value of future cash flows from existing liabilities. EVE simulations reflect the interest rate sensitivity of assets and liabilities over a longer time period, considering the maturities, average life and duration of all balance sheet accounts.

The Board of Directors has established an interest rate risk policy, which is administered by the Bank’s Asset Liability Committee (“ALCO”). The policy establishes limits on risk, which are quantitative measures of the percentage change in NII and EVE resulting from changes in interest rates. Both NII and EVE simulations assist in identifying, measuring, monitoring and controlling interest rate risk and are used by management and the ALCO Committee to ensure that interest rate risk exposure will be maintained within Board policy guidelines. The ALCO Committee reports quarterly to the Board of Directors. Mitigating strategies are used to maintain interest rate risk within established limits.

The Company’s interest rate risk (“IRR”) model uses assumptions which include factors such as call features, prepayment options and interest rate caps and floors included in investment and loan portfolio contracts. Additionally, the IRR model estimates the lives and interest rate sensitivity of the Company’s non-maturity deposits. These assumptions have a significant effect on model results. The assumptions are developed primarily based upon historical behavior of Bank customers. The Company also considers industry and regional data in developing IRR model assumptions. There are inherent limitations in the Company’s IRR model and underlying assumptions. When interest rates change, actual movements of interest-earning assets and interest-bearing liabilities, loan prepayments, and withdrawals of time and other deposits, may deviate significantly from assumptions used in the model. The Company prepares a current base case and several alternative simulations at least quarterly. Current interest rates are shocked by +/- 100, 200, 300, and 400 basis points (“bp”). In addition, the Company simulates additional rate curve scenarios (e.g., bear flattener). The Company may elect not to use particular scenarios that it determines are impractical in a current rate environment. The Company’s internal limits for parallel shock scenarios are as follows:

Shock in Basis Points						Net Interest Income						Economic Value of Equity
+ - 400						25%						40%
+ - 300						20%						30%
+ - 200						15%						20%
+ - 100						10%						10%

It is management’s goal to manage the Bank’s portfolios so that net interest income at risk over twelve and twenty-four-month periods and the economic value of equity at risk do not exceed policy guidelines at the various interest rate shock levels. At June 30, 2020 and December 31, 2019, the Company did not exceed any Board approved sensitivity limits. Measures of net interest income at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments.

The below schedule estimates the changes in NII over a twelve-month period for parallel rate shocks for up 200, up 100 and down 100 scenarios:

Estimated Changes in Net Interest Income
Change in Interest Rates:						+ 200 bp						+ 100 bp						-100 bp
Policy Limit						(15.00)		%				(10.00)		%				(10.00)		%
June 30, 2020						(4.30)		%				(2.49)		%				(3.77)		%
March 31, 2020						(6.04)		%				(2.28)		%				(6.42)		%
December 31, 2019						(8.06)		%				(3.21)		%				(2.50)		%

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Measures of equity value at risk indicate the ongoing economic value of the Company by considering the effects of changes in interest rates on all of the Company’s cash flows, and by discounting the cash flows to estimate the present value of assets and liabilities. The below schedule estimates the changes in the EVE at parallel shocks for up 200, up 100 and down 100 scenarios:

Estimated Changes in Economic Value of Equity
Change in Interest Rates:						+ 200 bp						+ 100 bp						-100 bp
Policy Limit						(20.00)		%				(10.00)		%				(10.00)		%
June 30, 2020						8.30		%				5.45		%				17.35		%
March 31, 2020						0.66		%				3.06		%				22.26		%
December 31, 2019						2.44		%				0.90		%				21.92		%

ITEM 4 - CONTROLS AND PROCEDURES

As of the end of the period covered by this report, management of the Company carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, (1) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) is accumulated and communicated to the Company’s management, including its principal executive and financial officers as appropriate to allow timely decisions regarding required disclosure. It should be noted that the design of the Company’s disclosure controls and procedures is based in part upon certain reasonable assumptions about the likelihood of future events, and there can be no reasonable assurance that any design of disclosure controls and procedures will succeed in achieving its stated goals under all potential future conditions, regardless of how remote, but the Company’s principal executive and financial officers have concluded that the Company’s disclosure controls and procedures are, in fact, effective at a reasonable assurance level. There were no changes in the Company’s internal control over financial reporting during the quarter ended June 30, 2020 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

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PART II - OTHER INFORMATION

Item 1 - Legal Proceedings

The Company is not involved in any pending legal proceedings. The Bank is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings, in the aggregate, are believed by management to be immaterial to the financial condition and results of operations of the Company.

Item 1A - Risk Factors 

The information below updates, and should be read in conjunction with, the risk factors disclosed in Part I, “Item 1A- Risk Factors” in the Form 10-K for the year ended December 31, 2019 that we filed with the Securities and Exchange Commission on March 4, 2020, and in the Form 10-Q that we filed with the Securities and Exchange Commission on May 8, 2020. These risk factors could materially affect our business, financial condition or future results. The risks described are not the only risks that we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results. Except as presented below, there have been no material changes in the risk factors as discussed in our Form 10-K.

The ongoing COVID-19 pandemic and measures intended to prevent its spread could have a material adverse effect on our business, results of operations and financial condition, and such effects will depend on future developments, which are highly uncertain and are difficult to predict.

Global health concerns relating to the COVID-19 outbreak and related government actions taken to reduce the spread of the virus have been weighing on the macroeconomic environment, and the outbreak has significantly increased economic uncertainty and reduced economic activity. The outbreak has resulted in authorities implementing numerous measures to try to contain the virus, such as travel bans and restrictions, quarantines, shelter in place or stay-at-home orders and business limitations and shutdowns. Such measures have significantly contributed to rising unemployment and negatively impacted consumer and business spending. Local jurisdictions have subsequently lifted stay-at-home orders and moved to phased reopening of businesses, although capacity restrictions and health and safety recommendations that encourage continued physical distancing and teleworking have limited the ability of businesses to return to pre-pandemic levels of activity. The United States government has taken steps to attempt to mitigate some of the more severe anticipated economic effects of the virus, including the passage of the CARES Act, but there can be no assurance that such steps will be effective or achieve their desired results in a timely fashion.

The outbreak has adversely impacted and is likely to further adversely impact our workforce and operations and the operations of our borrowers, customers and business partners. In particular, we may experience financial losses due to a number of operational factors impacting us or our borrowers, customers or business partners, including but not limited to:

•Demand for our products and services may decline, making it difficult to grow assets and income;

•Credit losses resulting from financial stress being experienced by our borrowers as a result of the outbreak and related governmental actions, particularly in the hospitality, energy, retail and restaurant industries, but across other industries as well;

•If the economy is unable to substantially reopen, and high levels of unemployment continue for an extended period of time, loan delinquencies, problem assets, and foreclosures may increase, resulting in increased charge-offs and reduced income;

•Collateral for loans, especially real estate, may decline in value, which could cause loan losses to increase;

•Our allowance for loan losses may have to be increased if borrowers experience financial difficulties beyond forbearance periods, which will adversely affect our net income;

•The net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us;

•As the result of the decline in the Federal Reserve Board’s target federal funds rate, the yield on our assets may decline to a greater extent than the decline in our cost of interest-bearing liabilities, reducing our net interest margin and spread and reducing net income;

•A material decrease in net income or a net loss over several quarters could result in a decrease in the rate of our quarterly cash dividend;

•Operational failures due to changes in our normal business practices necessitated by the outbreak and related governmental actions.

•Increased cyber and payment fraud risk, as cybercriminals attempt to profit from the disruption, given increased online and remote activity;

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•A prolonged weakness in economic conditions resulting in a reduction of future projected earnings could result in our recording a valuation allowance against our current outstanding deferred tax assets;

•We rely on third party vendors for certain services and the unavailability of a critical service due to the COVID-19 outbreak could have an adverse effect on us; and

•Federal Deposit Insurance Corporation premiums may increase if the agency experiences additional resolution costs.

As further discussed in the Effects of COVID-19 on Company's Operations section above, the pandemic has introduced increasing uncertainty around the local and national economy. Regulatory treatment of loan deferrals has been changed to encourage loan deferrals. Although the deferrals may lessen credit losses in the long run, they make our credit metrics less transparent, timely and useful. The increased volume of loan related work including processing deferrals, processing PPP loan requests and changing regulations increases inherent credit risks, and loans with deferred payments are more likely to default in the future. The Company believes there could be potential stresses on liquidity management as a direct result of the COVID-19 pandemic. As customers manage their own liquidity stress, we could experience an increase in the utilization of existing lines of credit.

Additionally, there could be potential stresses on our liquidity management as a direct result of the COVID-19 pandemic if customers, in managing their own liquidity stress, increase their utilization of existing lines of credit.

The spread of COVID-19 has caused us to modify our business practices (including restricting employee travel, and developing work from home and social distancing plans for our employees), and we may take further actions as may be required by government authorities or as we determine are in the best interests of our employees, customers and business partners. There is no certainty that such measures will be sufficient to mitigate the risks posed by the virus or will otherwise be satisfactory to government authorities.

The extent to which the coronavirus outbreak impacts our business, results of operations and financial condition will depend on future developments, which are highly uncertain and are difficult to predict, including, but not limited to, the duration and spread of the outbreak, its severity, the actions to contain the virus or treat its impact, and how quickly and to what extent normal economic and operating conditions can resume. Even after the COVID-19 outbreak has subsided, we may continue to experience materially adverse impacts to our business as a result of the virus’s global economic impact, including the availability of credit, adverse impacts on our liquidity and any recession that has occurred or may occur in the future.

There are no comparable recent events that provide guidance as to the effect the spread of COVID-19 as a global pandemic may have, and, as a result, the ultimate impact of the outbreak is highly uncertain and subject to change. We do not yet know the full extent of the impacts on our business, our operations or the global economy as a whole.

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds

(a)Not applicable

(b)Not applicable

(c)On May 4, 2015, the Board of Directors approved a repurchase plan (“2015 repurchase plan"). The 2015 repurchase plan authorizes the repurchase of up to 250,000 shares of outstanding common stock. The 2015 repurchase plan will continue until it is completed or terminated by the Company’s Board of Directors. As of June 30, 2020, 186,078 shares were available to be repurchased under the 2015 repurchase program. The following schedule shows repurchases during the three months ended June 30, 2020.

Period						(a) Total Number of Shares Purchased						(b) Average Price Paid per Share						Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs						(d) Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
April 1 - 30, 2020						—						—						—						186,078
May 1 - 31, 2020						—						—						—						186,078
June 1 - 30, 2020						—						—						—						186,078
Total						—						—						—						186,078

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Item 3 - Defaults Upon Senior Securities 

Not applicable. 

Item 4 – Mine Safety Disclosures 

Not applicable.

Item 5 - Other Information 

None 

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Item 6 – Exhibits

Number						Description
31						Rule 13a‑14(a) Certifications
32						Section 1350 Certifications
101						The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2020, formatted in iXBRL (Inline Extensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) the Consolidated Statements of Cash Flows; and (v) the Notes to the Consolidated Financial Statements.
104						Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101)

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

			THE COMMUNITY FINANCIAL CORPORATION
Date: August 5, 2020			By:			/s/ William J. Pasenelli
						William J. Pasenelli
						President and Chief Executive Officer

Date: August 5, 2020			By:			/s/ Todd L. Capitani
						Todd L. Capitani
						Chief Financial Officer

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