Note 7. Covered Assets and Indemnification Asset

Covered Loans

Loans acquired in a FDIC-assisted acquisition that are subject to a loss-share agreement are referred to as “covered loans” and reported separately in our statements of financial condition. Covered loans are reported exclusive of the cash flow reimbursements expected from the FDIC.

Acquired loans are valued as of acquisition date in accordance with ASC 805. Loans purchased with evidence of credit deterioration since origination for which it is probable that all contractually required payments will not be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”). Because of the significant fair value discounts associated with the acquired portfolios, the concentration of real estate related loans (to finance or secured by real estate collateral) and the decline in real estate values in the regions serviced, and after considering the underwriting standards of the acquired originating bank, the Company elected to account for all acquired loans under ASC 310-30. Under ASC 805 and ASC 310-30, loans are to be recorded at fair value at acquisition date, factoring in credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for loan losses is not carried over or recorded as of the acquisition date. We have aggregated the acquired loans into various loan pools based on multiple layers of common risk characteristics for the purpose of determining their respective fair values as of their acquisition dates, and for applying the subsequent recognition and measurement provisions for income accretion and impairment testing.

The covered loans acquired are, and will continue to be, subject to the Company’s internal and external credit review and monitoring. To the extent there is experienced or projected credit deterioration on the acquired loan pools subsequent to amounts estimated at the previous remeasurement date, this deterioration will be measured, and a provision for credit losses will be charged to earnings. Additionally, provision for credit losses will be recorded on advances on covered loans subsequent to acquisition date in a manner consistent with the allowance for non-covered loan and lease losses. These provisions will be mostly offset by an increase to the FDIC indemnification asset, which is recognized in non-interest income.

Covered Loans

The following table presents the major types of covered loans as of December 31, 2012 and December 31, 2011:

(in thousands)



	December 31, 2012
	Evergreen		Rainier		Nevada Security		Total
Commercial real estate
Term & multifamily	$	72,888	$	199,685	$	105,436	$	378,009
Construction & development		4,941		637		6,133		11,711
Residential development		3,840		-		5,954		9,794
Commercial
Term		9,961		2,230		11,333		23,524
LOC & other		4,984		7,081		2,932		14,997
Residential
Mortgage		3,948		22,059		1,818		27,825
Home equity loans & lines		3,478		17,178		2,786		23,442
Consumer & other		1,855		4,143		53		6,051
Total	$	105,895	$	253,013	$	136,445	$	495,353
Allowance for covered loans								(18,275)
Total							$	477,078



	December 31, 2011
	Evergreen		Rainier		Nevada Security		Total
Commercial real estate
Term & multifamily	$	99,346	$	248,206	$	126,502	$	474,054
Construction & development		7,241		711		6,868		14,820
Residential development		7,809		227		9,727		17,763
Commercial
Term		14,911		5,807		13,432		34,150
LOC & other		8,776		8,854		5,796		23,426
Residential
Mortgage		6,320		27,320		1,863		35,503
Home equity loans & lines		4,660		21,055		3,370		29,085
Consumer & other		2,394		5,541		35		7,970
Total	$	151,457	$	317,721	$	167,593	$	636,771
Allowance for covered loans								(14,320)
Total							$	622,451

The outstanding contractual unpaid principal balance, excluding purchase accounting adjustments, at December 31, 2012 was $137.7 million, $297.0 million and $198.4 million, for Evergreen, Rainier, and Nevada Security, respectively, as compared to $209.5 million, $379.0 million and $260.2 million, for Evergreen, Rainier, and Nevada Security, respectively, at December 31, 2011.

In estimating the fair value of the covered loans at the acquisition date, we (a) calculated the contractual amount and timing of undiscounted principal and interest payments and (b) estimated the amount and timing of undiscounted expected principal and interest payments. The difference between these two amounts represents the nonaccretable difference.

On the acquisition date, the amount by which the undiscounted expected cash flows exceed the estimated fair value of the acquired loans is the “accretable yield”. The accretable yield is then measured at each financial reporting date and represents the difference between the remaining undiscounted expected cash flows and the current carrying value of the loans.

The following table presents the changes in the accretable yield for the years ended December 31, 2012 and 2011 for each respective acquired loan portfolio:


(in thousands)
	December 31, 2012
	Evergreen		Rainier		Nevada Security		Total
Balance, beginning of period	$	56,479	$	120,333	$	61,021	$	237,833
Accretion to interest income		(21,237)		(30,325)		(19,969)		(71,531)
Disposals		(9,688)		(19,705)		(5,214)		(34,607)
Reclassifications from nonaccretable difference		9,013		32,165		10,515		51,693
Balance, end of period	$	34,567	$	102,468	$	46,353	$	183,388


(in thousands)
	December 31, 2011
	Evergreen		Rainier		Nevada Security		Total
Balance, beginning of period	$	90,770	$	172,614	$	73,515	$	336,899
Accretion to interest income		(26,240)		(35,382)		(22,580)		(84,202)
Disposals		(10,575)		(19,893)		(4,595)		(35,063)
Reclassifications from nonaccretable difference		2,524		2,994		14,681		20,199
Balance, end of period	$	56,479	$	120,333	$	61,021	$	237,833

Allowance for Covered Loan and Lease Losses

The following table summarizes activity related to the allowance for covered loan and lease losses by covered loan portfolio segment for the years ended December 31, 2012 and 2011, respectively:


(in thousands)
	December 31, 2012
	Commercial						Consumer
	Real Estate		Commercial		Residential		& Other		Total
Balance, beginning of period	$	8,939	$	3,964	$	991	$	426	$	14,320
Charge-offs		(2,921)		(1,613)		(596)		(659)		(5,789)
Recoveries		1,264		733		237		105		2,339
Provision		4,847		1,896		172		490		7,405
Balance, end of period	$	12,129	$	4,980	$	804	$	362	$	18,275


(in thousands)
	December 31, 2011
	Commercial						Consumer
	Real Estate		Commercial		Residential		& Other		Total
Balance, beginning of period	$	2,465	$	176	$	56	$	24	$	2,721
Charge-offs		(3,177)		(660)		(1,657)		(1,192)		(6,686)
Recoveries		1,348		512		142		142		2,144
Provision		8,303		3,936		2,450		1,452		16,141
Balance, end of period	$	8,939	$	3,964	$	991	$	426	$	14,320

The following table presents the allowance and recorded investment in covered loans by portfolio segment as of December 31, 2012 and 2011:

(in thousands)



	December 31, 2012
	Commercial						Consumer
	Real Estate		Commercial		Residential		& Other		Total
Allowance for covered loans and leases:
Loans acquired with deteriorated credit quality (1)	$	11,756	$	4,559	$	755	$	315	$	17,385
Collectively evaluated for impairment (2)		373		421		49		47		890
Total	$	12,129	$	4,980	$	804	$	362	$	18,275
Covered loans and leases:
Loans acquired with deteriorated credit quality (1)	$	393,464	$	25,402	$	46,382	$	3,360	$	468,608
Collectively evaluated for impairment (2)		6,050		13,119		4,885		2,691		26,745
Total	$	399,514	$	38,521	$	51,267	$	6,051	$	495,353



	December 31, 2011
	Commercial						Consumer
	Real Estate		Commercial		Residential		& Other		Total
Allowance for covered loans and leases:
Loans acquired with deteriorated credit quality (1)	$	8,491	$	3,366	$	955	$	395	$	13,207
Collectively evaluated for impairment (2)		448		598		36		31		1,113
Total	$	8,939	$	3,964	$	991	$	426	$	14,320
Covered loans and leases:
Loans acquired with deteriorated credit quality (1)	$	503,575	$	39,427	$	59,980	$	5,410	$	608,392
Collectively evaluated for impairment (2)		3,062		18,149		4,608		2,560		28,379
Total	$	506,637	$	57,576	$	64,588	$	7,970	$	636,771

(1) In accordance with ASC 310-30, the valuation allowance is netted against the carrying value of the covered loan and lease balance.

(2) The allowance on covered loan and lease losses includes an allowance on covered loan advances on acquired loans subsequent to acquisition.

The valuation allowance on covered loans was reduced by recaptured provision of $3.8 million and $3.5 million for the years ended December 31, 2012 and 2011, respectively.

Covered Credit Quality Indicators

Covered loans are risk rated in a manner consistent with non-covered loans. As previously noted, the Company’s risk rating methodology assigns risk ratings ranging from 1 to 10, where a higher rating represents higher risk. The 10 risk rating groupings are described fully in Note 6. The below table includes both loans acquired with deteriorated credit quality accounted for under ASC 310-30 and covered loan advances on acquired loans subsequent to acquisition.

The following table summarizes our internal risk rating grouping by covered loans, net as of December 31, 2012 and December 31, 2011:

(in thousands)



	December 31, 2012
			Special
	Pass/Watch		Mention		Substandard		Doubtful		Loss		Total
Commercial real estate
Term & multifamily	$	243,723	$	47,880	$	62,811	$	14,925	$	-	$	369,339
Construction & development		1,792		195		4,315		3,386		-		9,688
Residential development		-		391		6,658		1,309		-		8,358
Commercial
Term		9,020		3,401		4,986		2,021		-		19,428
LOC & other		11,498		354		1,080		1,181		-		14,113
Residential
Mortgage		27,596		-		-		-		-		27,596
Home equity loans & lines		22,790		-		77		-		-		22,867
Consumer & other		5,689		-		-		-		-		5,689
Total	$	322,108	$	52,221	$	79,927	$	22,822	$	-	$	477,078



	December 31, 2011
			Special
	Pass/Watch		Mention		Substandard		Doubtful		Loss		Total
Construction & development
Term & multifamily	$	329,273	$	58,610	$	68,521	$	12,343	$	-	$	468,747
Construction & development		1,552		1,410		6,733		3,410		-		13,105
Residential development		1,187		405		8,394		5,808		-		15,794
Commercial
Term		18,006		1,661		8,244		3,228		-		31,139
LOC & other		13,605		2,756		5,607		556		-		22,524
Residential
Mortgage		35,233		-		-		-		-		35,233
Home equity loans & lines		28,223		-		143		-		-		28,366
Consumer & other		7,543		-		-		-		-		7,543
Total	$	434,622	$	64,842	$	97,642	$	25,345	$	-	$	622,451

Covered Other Real Estate Owned

All other real estate owned (“OREO”) acquired in FDIC-assisted acquisitions that are subject to a FDIC loss-share agreement are referred to as “covered OREO” and reported separately in our statements of financial position. Covered OREO is reported exclusive of expected reimbursement cash flows from the FDIC. Foreclosed covered loan collateral is transferred into covered OREO at the collateral’s net realizable value, less selling costs.

Covered OREO was initially recorded at its estimated fair value on the acquisition date based on similar market comparable valuations less estimated selling costs. Subsequent to acquisition, loan collateral transferred to OREO is at its net realizable value. Any subsequent valuation adjustments due to declines in fair value will be charged to non-interest expense, and will be mostly offset by non-interest income representing the corresponding increase to the FDIC indemnification asset for the offsetting loss reimbursement amount. Any recoveries of previous valuation adjustments will be credited to non-interest expense with a corresponding charge to non-interest income for the portion of the recovery that is due to the FDIC.

The following table summarizes the activity related to the covered OREO for the years ended December 31, 2012 and 2011:

(in thousands)



	2012		2011
Balance, beginning of period	$	19,491	$	29,863
Additions to covered OREO		6,987		15,271
Dispositions of covered OREO		(11,458)		(16,934)
Valuation adjustments in the period		(4,646)		(8,709)
Balance, end of period	$	10,374	$	19,491

FDIC Indemnification Asset

The Company has elected to account for amounts receivable under the loss-share agreement as an indemnification asset in accordance with FASB ASC 805, Business Combinations. The FDIC indemnification asset is initially recorded at fair value, based on the discounted value of expected future cash flows under the loss-share agreement. The difference between the present value and the undiscounted cash flows the Company expects to collect from the FDIC will be accreted into non-interest income over the life of the FDIC indemnification asset.

Subsequent to initial recognition, the FDIC indemnification asset is reviewed quarterly and adjusted for any changes in expected cash flows based on recent performance and expectations for future performance of the covered assets. These adjustments are measured on the same basis as the related covered loans and covered other real estate owned. Any increases in cash flow of the covered assets over those expected will reduce the FDIC indemnification asset and any decreases in cash flow of the covered assets under those expected will increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset are recorded as adjustments to non-interest income. The resulting carrying value of the indemnification asset represents the amounts recoverable from the FDIC for future expected losses, and the amounts due from the FDIC for claims related to covered losses the Company have incurred less amounts due back to the FDIC relating to shared recoveries.

The following table summarizes the activity related to the FDIC indemnification asset for each respective acquired portfolio for years ended December 31, 2012 and 2011:


(in thousands)
	December 31, 2012
	Evergreen		Rainier		Nevada Security		Total
Balance, beginning of period	$	28,547	$	28,272	$	34,270	$	91,089
Change in FDIC indemnification asset		(9,611)		(6,355)		732		(15,234)
Transfers to due from FDIC and other		(4,060)		(6,807)		(12,190)		(23,057)
Balance, end of period	$	14,876	$	15,110	$	22,812	$	52,798


(in thousands)
	December 31, 2011
	Evergreen		Rainier		Nevada Security		Total
Balance, beginning of period	$	40,606	$	43,726	$	62,081	$	146,413
Change in FDIC indemnification asset		1,357		(7,343)		(182)		(6,168)
Transfers to due from FDIC and other		(13,416)		(8,111)		(27,629)		(49,156)
Balance, end of period	$	28,547	$	28,272	$	34,270	$	91,089