Note 4. Loans and Allowance for Loan Losses

For financial reporting purposes, Pinnacle Financial classifies its loan portfolio based on the underlying collateral utilized to secure each loan. This classification is consistent with those utilized in the Quarterly Report of Condition and Income filed with the Federal Deposit Insurance Corporation (FDIC).

Commercial loans receive risk ratings by the assigned financial advisor that are subject to validation by our independent loan review department. Risk ratings are categorized as pass, special mention, substandard, substandard-impaired or doubtful-impaired. Pinnacle Financial believes that our categories follow those outlined by our primary regulator. At September 30, 2011, approximately 75% of our loan portfolio was analyzed as a commercial loan type with a specifically assigned risk rating in the allowance for loan loss assessment. Consumer loans and small business loans are generally not assigned an individual risk rating but are evaluated as either accrual or nonaccrual based on the performance of the loan. However, certain consumer real estate-mortgage loans and certain consumer and other loans do receive a specific risk rating due to the loan proceeds being used for commercial purposes even though the collateral may be of a consumer loan nature.

Risk ratings are subject to continual review by the loan officer. At least annually and in many cases twice per year, our credit policy requires that each risk-rated loan is subject to a formal credit risk review to be performed by the respective loan officer. Each loan grade is also subject to review by our independent loan review department. Currently, our independent loan review department targets reviews of at least 70% of our risk rated portfolio annually. Included in the 70% coverage are independent loan reviews of loans in targeted portfolio segments such as certain consumer loans, land loans, loans assigned to a particular lending officer and/or loan types in certain geographies.

The following table presents our loan balances by primary loan classification and the amount classified within each risk rating category. Pass rated loans include all credits other than those included in special mention, substandard and doubtful which are defined as follows:

Special mention loans have potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in Pinnacle Financial's credit position at some future date.

Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize collection of the debt. Substandard loans are characterized by the distinct possibility that Pinnacle Financial will sustain some loss if the deficiencies are not corrected.

Substandard-impaired loans are substandard loans that have been placed on nonaccrual.

Doubtful-impaired loans have all the characteristics of substandard loans with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Pinnacle Financial considers all doubtful loans to be impaired and places the loan on nonaccrual status.

The following table outlines the amount of each loan classification categorized into each risk rating class as of September 30, 2011 and December 31, 2010 (in thousands):

	Performing Loans								Impaired Loans
September 30, 2011	Pass		Special Mention		Substandard (1)		Total Performing		Substandard Impaired		Doubtful Impaired		Total Impaired		Total Loans
Commercial real estate - mortgage	$	970,124	$	28,556	$	79,362	$	1,078,042	$	9,291	$	-	$	9,291	$	1,087,333
Consumer real estate - mortgage		662,096		17,717		21,051		700,864		9,211		1,919		11,130		711,994
Construction and land development		206,149		23,080		28,029		257,258		21,402		-		21,402		278,660
Commercial and industrial		1,037,303		24,774		20,740		1,082,817		11,313		907		12,220		1,095,037
Consumer and other		66,794		734		-		67,528		597		-		597		68,125
	$	2,942,466	$	94,861	$	149,182	$	3,186,509	$	51,814	$	2,826	$	54,640	$	3,241,149

December 31, 2010
Commercial real estate - mortgage	$	947,593	$	46,520	$	87,960		1,082,073	$	11,351	$	1,191	$	12,542	$	1,094,615
Consumer real estate - mortgage		661,234		12,384		22,834		696,452		4,622		4,413		9,035		705,487
Construction and land development		188,470		29,670		69,607		287,747		43,203		311		43,514		331,261
Commercial and industrial		918,414		13,511		65,426		997,351		13,347		1,393		14,740		1,012,091
Consumer and other		66,916		65		973		67,954		879		153		1,032		68,986
	$	2,782,627	$	102,150	$	246,800	$	3,131,577	$	73,402	$	7,461	$	80,863	$	3,212,440

(1)

Potential problem loans, which are not included in nonperforming assets, amounted to approximately $131.0 million at September 30, 2011, compared to $223.1 million at December 31, 2010. At September 30, 2011 and December 31, 2010, approximately $18.2 million and $20.5 million, respectively of substandard loans were deemed to be troubled debt restructurings and were not included in potential problem loans. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower's ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the Office of the Comptroller of the Currency, or OCC, Pinnacle National's primary regulator, for loans classified as substandard, excluding the impact of substandard nonperforming loans and substandard troubled debt restructurings.

The information presented above for December 31, 2010 has been reclassified from the presentation in our Annual Report on Form 10-K for the year ended December 31, 2010 to conform to the September 30, 2011 presentation. Consumer loans previously classified as performing have been further classified into special mention and substandard.

At September 30, 2011 and December 31, 2010, there were no loans classified as nonaccrual that were not deemed to be impaired. At September 30, 2011 and December 31, 2010, all impaired loans were on nonaccruing interest status. The principal balances of these nonaccrual loans amounted to $54.6 million and $80.9 million at September 30, 2011 and December 31, 2010, respectively, and are included in the table above. For the three months ended September 30, 2011 the average balance of impaired loans was $67.9 million as compared to $108.4 million for the twelve months ended December 31, 2010. At the date such loans were placed on nonaccrual status, Pinnacle Financial reversed all previously accrued interest income against current year earnings. Had nonaccruing loans been on accruing status, interest income would have been higher by $4.0 million and $7.6 million for the nine months ended September 30, 2011 and September 30, 2010, respectively, and $678,000 and $1.3 million for the three months ended September 30, 2011 and September 30, 2010, respectively.

The following table details the recorded investment, unpaid principal balance and related allowance and average recorded investment of our impaired loans at September 30, 2011 and December 31, 2010 by loan category and the amount of interest income recognized on a cash basis throughout the quarter and year then ended, respectively, on these loans that remain on our balance sheet (in thousands):

	At September 30, 2011						For the nine months ended September 30, 2011
	Recorded investment		Unpaid principal balance		Related allowance(1)		Average recorded investment		Interest income recognized

Impaired loans with no recorded allowance:
Commercial real estate – mortgage	$	8,097	$	9,528	$	-	$	9,304	$	5
Consumer real estate – mortgage		7,938		11,189		-		10,996		-
Construction and land development		12,677		13,583		-		13,621		37
Commercial and industrial		3,290		5,276		-		5,196		-
Consumer and other		-		-		-		-		-
Total	$	32,002	$	39,576	$	-	$	39,117	$	42


Impaired loans with a recorded allowance:
Commercial real estate – mortgage	$	1,194	$	2,151	$	99	$	2,136	$	-
Consumer real estate – mortgage		3,192		4,938		266		4,840		1
Construction and land development		8,724		11,425		2,016		11,826		-
Commercial and industrial		8,931		11,206		3,074		10,352		-
Consumer and other		597		903		50		902		-
Total	$	22,638	$	30,623	$	5,505	$	30,056	$	1

Total Impaired Loans	$	54,640	$	70,199	$	5,505	$	69,173	$	43

	At December 31, 2010						For the year ended December 31, 2010
	Recorded investment		Unpaid principal balance		Related allowance(1)		Average recorded investment		Interest income recognized

Impaired loans with no recorded allowance:
Commercial real estate – mortgage	$	10,585	$	12,468	$	-	$	12,478	$	278
Consumer real estate – mortgage		4,063		5,041		-		5,041		83
Construction and land development		31,106		35,525		-		35,631		188
Commercial and industrial		2,865		5,501		-		5,501		9
Consumer and other		272		368		-		368		-
Total	$	48,891	$	58,903	$	-	$	59,019	$	558

Impaired loans with a recorded allowance:
Commercial real estate – mortgage	$	1,957	$	2,328	$	176	$	2,328	$	55
Consumer real estate – mortgage		4,972		5,869		568		5,875		143
Construction and land development		12,408		12,619		3,825		12,623		234
Commercial and industrial		11,875		13,005		3,998		12,996		324
Consumer and other		760		846		390		846		17
Total	$	31,972	$	34,667	$	8,957	$	34,668	$	773

Total Impaired Loans	$	80,863	$	93,570	$	8,957	$	93,687	$	1,331

(1)

Collateral dependent loans are typically charged-off to their net realizable value pursuant to regulatory requirements and no specific allowance is carried related to those loans.

Pinnacle Financial's policy is that once a loan is classified as impaired and placed on nonaccrual status, interest income is subsequently recognized to the extent cash payments are received while the loan is classified as nonaccrual, but each payment is reviewed on a case-by-case basis to determine if the payment should be applied to interest or principal pursuant to regulatory guidelines. Pinnacle Financial recognized $50,000 and $1,340,000 of interest income from cash payments received during the nine months ended September 30, 2011 and the year ended December 31, 2010 while the underlying loans were placed on impaired status.

Impaired loans also include loans that Pinnacle National has elected to formally restructure when, due to the weakening credit status of a borrower, the restructuring may facilitate a repayment plan that seeks to minimize the potential losses that Pinnacle National may have to otherwise incur. If on nonaccruing status as of the date of restructuring, the loans are included in nonperforming loans and are classified as impaired loans. Loans that have been restructured that were performing as of the restructure date are reported as troubled debt restructurings. At September 30, 2011 and December 31, 2010, there were $18.2 million and $20.5 million, respectively, of troubled debt restructurings that were performing as of the restructure date. Troubled commercial loans are restructured by specialists within our Special Asset Group and all restructurings are approved by committees and credit officers separate and apart from the normal loan approval process. These specialists are trained to reduce Pinnacle Financial's overall risk and exposure to loss in the event of a restructuring through obtaining either or all of the following: improved documentation, additional guaranties, increase in curtailments, reduction in collateral release terms, additional collateral or other similar strategies.

As a result of adopting the amendments in Accounting Standards Update No. 2011-02 in the third quarter of 2011, Pinnacle Financial reassessed all restructurings that occurred on or after January 1, 2011 for identification as troubled debt restructurings. Pinnacle Financial identified as troubled debt restructurings certain receivables for which the allowance for loan losses had previously been measured under the general allowance for loan losses methodology. Upon identifying those receivables as troubled debt restructurings, Pinnacle Financial accounted for these loans under the guidance in ASC 310-10-35. The amendments in Accounting Standards Update No. 2011-02 require prospective application of the impairment measurement guidance in Section 310-10-35 for those receivables newly identified as a troubled debt restructuring. At September 30, 2011, the recorded investment in receivables for which the allowance for loan losses was previously measured under a general allowance for loan losses methodology and are now individually measured for impairment as outlined under ASC 310-10-35, troubled debt restructurings totaled $5.2 million, and the allowance for loan losses associated with those receivables, on the basis of a current evaluation of loss, was $553,000.

The following table outlines the amount of each troubled debt restructuring categorized by loan classification as of September 30, 2011 and December 31, 2010 (dollars in thousands):

	September 30, 2011						December 31, 2010
	Number of contracts		Pre Modification Outstanding Recorded Investment		Post Modification Outstanding Recorded Investment, net of related allowance		Number of contracts		Pre Modification Outstanding Recorded Investment		Post Modification Outstanding Recorded Investment, net of related allowance
Commercial real estate – mortgage		6	$	11,888	$	11,881		9	$	16,129	$	15,992
Consumer real estate – mortgage		8		3,153		3,044		1		560		560
Construction and land development		-		-		-		-		-		-
Commercial and industrial		15		3,146		2,700		2		3,779		3,778
Consumer and other		-		-		-		-		-		-
		29	$	18,187	$	17,625		12	$	20,468	$	20,330

Pinnacle Financial has not had any troubled debt restructurings that subsequently defaulted. A default is defined as an occurrence which violates the terms of the receivable's contract.

In addition to the loan metrics above, Pinnacle Financial analyzes its commercial loan portfolio to determine if a concentration of credit risk exists to any industries. Pinnacle Financial utilizes broadly accepted industry classification systems in order to classify borrowers into various industry classifications. Pinnacle Financial has a credit exposure (loans outstanding plus unfunded lines of credit) exceeding 25% of Pinnacle National's total risk-based capital to borrowers in the following industries at September 30, 2011 with the comparative exposures for December 31, 2010:

	(dollars in thousands)
	September 30, 2011		December 31, 2010
Lessors of nonresidential buildings	$	488,995	$	502,268
Lessors of residential buildings		177,232		132,668
Land subdividers		127,005		144,550

The table below presents past due balances at September 30, 2011 and December 31, 2010, by loan classification allocated between performing and impaired status (in thousands):

	At September 30, 2011
	30-89 days past due and performing		90 days or more past due and performing		Total past due and performing		Impaired (1)		Current and performing		Total Loans

Commercial real estate:
Owner-occupied	$	1,141	$	-	$	1,141	$	7,557	$	546,997	$	555,695
All other		375		-		375		1,734		529,529		531,638
Consumer real estate – mortgage		3,318		991		4,309		11,130		696,555		711,994
Construction and land development		396		-		396		21,402		256,862		278,660
Commercial and industrial		1,534		920		2,454		12,220		1,080,363		1,095,037
Consumer and other		438		-		438		597		67,090		68,125
	$	7,202	$	1,911	$	9,113	$	54,640	$	3,177,396	$	3,241,149

	At December 31, 2010
	30-89 days past due and performing		90 days or more past due and performing		Total past due and performing		Impaired (1)		Current and performing		Total Loans

Commercial real estate:
Owner-occupied	$	1,602	$	-	$	1,602	$	10,037	$	520,260	$	531,899
All other		362		-		362		2,505		559,849		562,716
Consumer real estate – mortgage		3,544		-		3,544		9,035		692,908		705,487
Construction and land development		2,157		38		2,195		43,514		285,552		331,261
Commercial and industrial		1,636		100		1,736		14,740		995,615		1,012,091
Consumer and other		152		-		152		1,032		67,802		68,986
	$	9,453	$	138	$	9,591	$	80,863	$	3,121,986	$	3,212,440

(1)

Approximately $25.5 million and $33.2 million of impaired loans as of September 30, 2011 and December 31, 2010, respectively, are currently performing pursuant to their contractual terms. All impaired loans as of these dates are on nonaccrual status. Troubled debt restructurings are not included in impaired loans.

The following table shows the allowance allocation by loan classification for performing and impaired loans at September 30, 2011 and December 31, 2010 (in thousands):

	Performing Loans				Impaired Loans				Total Allowance for Loan Losses
	September 30, 2011		December 31, 2010		September 30, 2011		December 31, 2010		September 30, 2011		December 31, 2010
Commercial real estate – mortgage	$	20,689	$	19,076	$	99	$	176	$	20,788	$	19,252
Consumer real estate – mortgage		10,008		9,330		266		568		10,274		9,898
Construction and land development		10,698		15,297		2,016		3,825		12,714		19,122
Commercial and industrial		18,021		17,428		3,074		3,998		21,095		21,426
Consumer and other		1,131		1,484		50		390		1,181		1,874
Unallocated		8,819		11,003		-		-		8,819		11,003
	$	69,366	$	73,618	$	5,505	$	8,957	$	74,871	$	82,575

The following table details the changes in the allowance for loan losses from January 1, 2010 to December 31, 2010 to September 30, 2011 by loan classification (in thousands):


	Commercial real estate – mortgage			Consumer real estate – mortgage			Construction and land development			Commercial and industrial			Consumer and other			Unallocated			Total

Balances, January 1, 2010	$	22,505		$	10,725		$	23,027		$	26,332		$	2,456		$	6,914		$	91,959
Charged-off loans		(9,041	)		(6,769	)		(27,526	)		(23,555	)		(652	)		-			(67,543	)
Recovery of previously charged-off loans		343			377			2,618			874			252			-			4,464
Provision for loan losses		5,445			5,565			21,003			17,775			(182	)		4,089			53,695
Balances, December 31, 2010	$	19,252		$	9,898		$	19,122		$	21,426		$	1,874		$	11,003		$	82,575
Charged-off loans		(2,735	)		(4,275	)		(6,861	)		(12,367	)		(963	)		-			(27,201	)
Recovery of previously charged-off loans		118			401			1,286			1,219			114			-			3,138
Provision for loan losses		4,153			4,250			(833	)		10,817			156			(2,189	)		16,359
Balances, September 30, 2011	$	20,788		$	10,274		$	12,714		$	21,095		$	1,181		$	8,819		$	74,871

The adequacy of the allowance for loan losses is assessed at the end of each calendar quarter. The level of the allowance is based upon evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect the borrowers' ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, historical loss experience, industry and peer bank loan quality indications and other pertinent factors, including regulatory recommendations.

At September 30, 2011, Pinnacle Financial had granted loans and other extensions of credit amounting to approximately $10.9 million to current directors, executive officers, and their related entities, of which $9.4 million had been drawn upon. At December 31, 2010, Pinnacle Financial had granted loans and other extensions of credit amounting to approximately $22.6 million to directors, executive officers, and their related entities, of which approximately $18.1 million had been drawn upon. The terms on these loans and extensions are on substantially the same terms customary for other persons similarly situated for the type of loan involved. None of these loans to directors, executive officers, and their related entities were impaired at September 30, 2011.

Residential Lending

At September 30, 2011, Pinnacle Financial had approximately $23.8 million of mortgage loans held-for-sale compared to approximately $16.2 million at December 31, 2010. These loans are marketed to potential investors prior to closing the loan with the borrower such that there is an agreement for the subsequent sale of the loan between the eventual investor and Pinnacle Financial prior to the loan being closed with the borrower. Pinnacle Financial sells loans to third-party investors on a loan-by-loan basis and has not entered into any forward commitments with investors for future bulk loan sales. All of these loan sales transfer servicing rights to the buyer. During the three and nine months ended September 30, 2011, Pinnacle Financial recognized $1.3 million and $2.7 million, respectively, in gains on the sale of these loans compared to $1.3 million and $2.7 million, respectively, during the three and nine months ended September 30, 2010.

These mortgage loans held-for-sale are originated internally and are primarily to borrowers in Pinnacle National's geographic market footprint. These sales are typically on a best efforts basis to investors that follow conventional government sponsored entities (GSE) and the Department of Housing and Urban Development/U.S. Department of Veterans Affairs (HUD/VA) guidelines. Generally, loans sold to the HUD/VA are underwritten by Pinnacle National while the majority of the loans sold to other investors are underwritten by the purchaser of the loans.

Each purchaser has specific guidelines and criteria for sellers of loans, and the risk of credit loss with regard to the principal amount of the loans sold is generally transferred to the purchasers upon sale. While the loans are sold without recourse, the purchase agreements require Pinnacle National to make certain representations and warranties regarding the existence and sufficiency of file documentation and the absence of fraud by borrowers or other third parties such as appraisers in connection with obtaining the loan. If it is determined that the loans sold were in breach of these representations or warranties, Pinnacle National has obligations to either repurchase the loan for the unpaid principal balance and related investor fees or make the purchaser whole for the economic benefits of the loan.

From inception of Pinnacle National's mortgage department in January 2003 through September 30, 2011, Pinnacle National originated and sold approximately 10,250 mortgage loans totaling $2.182 billion to third-party purchasers. Of the approximately 10,250 mortgage loans, Pinnacle underwrote approximately 2,450 conventional loans at a 80% or less loan-to-value that were sold to other investors and underwrote 2,010 loans that were sold to the HUD/VA. To date, repurchase activity pursuant to the terms of these representations and warranties has been insignificant and has resulted in insignificant losses to Pinnacle National. The remaining mortgage loans were underwritten by the purchasers of those loans, but funded by Pinnacle until settlement with the purchaser.

Based on information currently available, management believes that it does not have significant exposure to contingent losses that may arise relating to the representations and warranties that it has made in connection with its mortgage loan sales.

Due to the current focus on foreclosure practices of financial institutions nationwide, Pinnacle National evaluated its foreclosure process related to home equity and consumer mortgage loans within its loan portfolio. At September 30, 2011, Pinnacle National has $705.1 million of home equity and consumer mortgage loans which are secured by first or second liens on residential properties. Foreclosure activity in this portfolio has been minimal. Any foreclosures on these loans are handled by designated Pinnacle National personnel and external legal counsel, as appropriate, following established policies regarding legal and regulatory requirements. Pinnacle National has not imposed any freezes on foreclosures. Based on information currently available, management believes that it does not have material exposure to faulty foreclosure practices.