5. Non-Covered Loans and Allowance for Non-Covered Loan Losses

Non-covered loans refer to loans not covered by the FDIC loss-share agreements. Covered loans are discussed in Note 6 to the consolidated financial statements. Non-covered loans summarized by portfolio segment are as follows (in thousands).


	December 31,
	2015		2014
Commercial and industrial (1)	$	2,155,773	$	1,758,851
Real estate		2,313,239		1,694,835
Construction and land development		705,356		413,643
Consumer		45,672		53,147
		5,220,040		3,920,476
Allowance for non-covered loan losses		(45,415)		(37,041)
Total non-covered loans, net of allowance	$	5,174,625	$	3,883,435

(1)Includes margin loans to customers and correspondents of $602.8 million and $378.4 million at December 31, 2015 and 2014, respectively.

The Bank has lending policies in place with the goal of establishing an asset portfolio that will provide a return on stockholders’ equity sufficient to maintain capital to assets ratios that meet or exceed established regulations. Loans are underwritten with careful consideration of the borrower’s financial condition, the specific purpose of the loan, the primary sources of repayment and any collateral pledged to secure the loan.

Underwriting procedures address financial components based on the size and complexity of the credit. The financial components include, but are not limited to, current and projected cash flows, shock analysis and/or stress testing, and trends in appropriate balance sheet and statement of operations ratios. The Bank’s loan policy provides specific underwriting guidelines by portfolio segment, including commercial and industrial, real estate, construction and land development, and consumer loans. The guidelines for each individual portfolio segment set forth permissible and impermissible loan types. With respect to each loan type, the guidelines within the Bank’s loan policy provide minimum requirements for the underwriting factors listed above. The Bank’s underwriting procedures also include an analysis of any collateral and guarantor. Collateral analysis includes a complete description of the collateral, as well as determined values, monitoring requirements, loan to value ratios, concentration risk, appraisal requirements and other information relevant to the collateral being pledged. Guarantor analysis includes liquidity and cash flow evaluation based on the significance with which the guarantors are expected to serve as secondary repayment sources.

The Bank maintains a loan review department that reviews credit risk in response to both external and internal factors that potentially impact the performance of either individual loans or the overall loan portfolio. The loan review process reviews the creditworthiness of borrowers and determines compliance with the loan policy. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel. Results of these reviews are presented to management and the Bank’s board of directors.

In connection with the Bank Transactions, the Company acquired non-covered loans both with and without evidence of credit quality deterioration since origination. The following table presents the carrying values and the outstanding balances of the non-covered PCI loans (in thousands).


	December 31,
	2015		2014
Carrying amount	$	72,054	$	48,909
Outstanding balance		92,682		67,740

Changes in the accretable yield for the non-covered PCI loans were as follows (in thousands).


	Year Ended December 31,
	2015		2014		2013
Balance, beginning of year	$	12,814	$	17,601	$	17,553
Additions		14,579		—		622
Reclassifications from (to) nonaccretable difference, net(1)		19,759		15,225		18,793
Disposals of loans		(2,371)		(4,927)		(3,692)
Accretion		(27,037)		(15,085)		(15,675)
Balance, end of year	$	17,744	$	12,814	$	17,601

(1)

Reclassifications from nonaccretable difference are primarily due to net increases in expected cash flows in the quarterly recasts. Reclassifications to nonaccretable difference occur when accruing loans are moved to nonaccrual and expected cash flows are no longer predictable and the accretable yield is eliminated.

The remaining nonaccretable difference for non-covered PCI loans was $28.5 million and $18.4 million at December 31, 2015 and 2014, respectively.

Impaired loans exhibit a clear indication that the borrower’s cash flow may not be sufficient to meet principal and interest payments, which is generally when a loan is 90 days past due unless the asset is both well secured and in the process of collection. Non-covered impaired loans include non-accrual loans, troubled debt restructurings (“TDRs”), PCI loans and partially charged-off loans.

The amounts shown in following tables include loans accounted for on an individual basis, as well as acquired Pooled Loans. For Pooled Loans, the recorded investment with allowance and the related allowance consider impairment measured at the pool level. Non-covered impaired loans are summarized by class in the following tables (in thousands).


	Unpaid		Recorded		Recorded		Total
	Contractual		Investment with		Investment with		Recorded		Related
December 31, 2015	Principal Balance		No Allowance		Allowance		Investment		Allowance
Commercial and industrial:
Secured	$	53,819	$	12,256	$	13,847	$	26,103	$	2,721
Unsecured		2,796		47		—		47		—
Real estate:
Secured by commercial properties		58,043		16,304		25,214		41,518		2,756
Secured by residential properties		16,507		9,875		2,690		12,565		175
Construction and land development:
Residential construction loans		395		—		221		221		8
Commercial construction loans and land development		8,060		3,397		1,646		5,043		174
Consumer		4,162		735		45		780		32
	$	143,782	$	42,614	$	43,663	$	86,277	$	5,866


	Unpaid		Recorded		Recorded		Total
	Contractual		Investment with		Investment with		Recorded		Related
December 31, 2014	Principal Balance		No Allowance		Allowance		Investment		Allowance
Commercial and industrial:
Secured	$	51,036	$	14,096	$	11,783	$	25,879	$	3,341
Unsecured		4,120		92		68		160		—
Real estate:
Secured by commercial properties		29,865		7,243		15,536		22,779		1,878
Secured by residential properties		4,701		1,583		1,390		2,973		85
Construction and land development:
Residential construction loans		—		—		—		—		—
Commercial construction loans and land development		16,108		8,062		1,819		9,881		154
Consumer		5,785		171		1,967		2,138		282
	$	111,615	$	31,247	$	32,563	$	63,810	$	5,740

Average investment in non-covered impaired loans is summarized by class in the following table (in thousands).


	Year Ended December 31,
	2015		2014		2013
Commercial and industrial:
Secured	$	25,991	$	30,626	$	51,670
Unsecured		104		802		2,432
Real estate:
Secured by commercial properties		32,149		29,517		45,887
Secured by residential properties		7,769		2,984		4,862
Construction and land development:
Residential construction loans		111		—		354
Commercial construction loans and land development		7,462		14,849		26,090
Consumer		1,459		3,324		2,293
	$	75,045	$	82,102	$	133,588

Non-covered non-accrual loans, excluding those classified as held for sale, are summarized by class in the following table (in thousands).


	December 31,		December 31,
	2015		2014
Commercial and industrial:
Secured	$	17,717	$	16,488
Unsecured		47		160
Real estate:
Secured by commercial properties		4,597		438
Secured by residential properties		999		1,253
Construction and land development:
Residential construction loans		—		—
Commercial construction loans and land development		114		703
Consumer		7		—
	$	23,481	$	19,042

At December 31, 2015 and 2014, non-covered non-accrual loans included non-covered PCI loans of $9.3 million and $6.6 million, respectively, for which discount accretion has been suspended because the extent and timing of cash flows from these non-covered PCI loans can no longer be reasonably estimated. In addition to the non-covered non-accrual loans in the table above, $1.6 million and $3.0 million of real estate loans secured by residential properties and classified as held for sale were in non-accrual status at December 31, 2015 and 2014, respectively.

Interest income, including recoveries and cash payments, recorded on non-covered impaired loans was $8.9 million, $3.3 million and $3.2 million during 2015, 2014 and 2013, respectively. Except as noted above, non-covered PCI loans are considered to be performing due to the application of the accretion method.

The Bank classifies loan modifications as TDRs when it concludes that it has both granted a concession to a debtor and that the debtor is experiencing financial difficulties. Loan modifications are typically structured to create affordable payments for the debtor and can be achieved in a variety of ways. The Bank modifies loans by reducing interest rates and/or lengthening loan amortization schedules. The Bank also reconfigures a single loan into two or more loans (“A/B Note”). The typical A/B Note restructure results in a “bad” loan which is charged off and a “good” loan or loans the terms of which comply with the Bank’s customary underwriting policies. The debt charged off on the “bad” loan is not forgiven to the debtor.

The outstanding balance of TDRs granted during 2015, 2014 and 2013, respectively, is shown in the following tables (in thousands). At December 31, 2015, the Bank had nominal unadvanced commitments to borrowers whose loans have been restructured in TDRs, compared with $0.5 million at December 31, 2014.


	Recorded Investment in Loans Modified by
			Interest Rate		Payment Term		Total
Year Ended December 31, 2015	A/B Note		Adjustment		Extension		Modification
Commercial and industrial:
Secured	$	—	$	—	$	82	$	82
Unsecured		—		—		—		—
Real estate:
Secured by commercial properties		—		—		1,040		1,040
Secured by residential properties		—		—		—		—
Construction and land development:
Residential construction loans		—		—		—		—
Commercial construction loans and land development		—		—		—		—
Consumer		—		—		—		—
	$	—	$	—	$	1,122	$	1,122


	Recorded Investment in Loans Modified by
			Interest Rate		Payment Term		Total
Year Ended December 31, 2014	A/B Note		Adjustment		Extension		Modification
Commercial and industrial:
Secured	$	—	$	—	$	2,465	$	2,465
Unsecured		—		—		—		—
Real estate:
Secured by commercial properties		—		—		317		317
Secured by residential properties		—		—		248		248
Construction and land development:
Residential construction loans		—		—		—		—
Commercial construction loans and land development		—		—		128		128
Consumer		—		—		—		—
	$	—	$	—	$	3,158	$	3,158


	Recorded Investment in Loans Modified by
			Interest Rate		Payment Term		Total
Year Ended December 31, 2013	A/B Note		Adjustment		Extension		Modification
Commercial and industrial:
Secured	$	—	$	—	$	10,390	$	10,390
Unsecured		—		—		—		—
Real estate:
Secured by commercial properties		—		—		279		279
Secured by residential properties		—		—		777		777
Construction and land development:
Residential construction loans		—		—		—		—
Commercial construction loans and land development		—		—		—		—
Consumer		—		—		—		—
	$	—	$	—	$	11,446	$	11,446

The following table presents information regarding TDRs granted during the twelve months preceding December 31, 2015 for which a payment was at least 30 days past due in 2015 (dollars in thousands). There were no TDRs granted during the twelve months preceding December 31, 2014 for which a payment was at least 30 days past due in 2014.


	Number of	Recorded
	Loans	Investment
Commercial and industrial:
Secured	—	$	—
Unsecured	—		—
Real estate:
Secured by commercial properties	1		1,040
Secured by residential properties	—		—
Construction and land development:
Residential construction loans	—		—
Commercial construction loans and land development	—		—
Consumer	—		—
	1	$	1,040

An analysis of the aging of the Bank’s non-covered loan portfolio is shown in the following tables (in thousands).


															Accruing Loans (Non-PCI)
	Loans Past Due		Loans Past Due		Loans Past Due		Total		Current		PCI		Total		Past Due
December 31, 2015	30-59 Days		60-89 Days		90 Days or More		Past Due Loans		Loans		Loans		Loans		90 Days or More
Commercial and industrial:
Secured	$	14,869	$	3,960	$	8,414	$	27,243	$	2,009,505	$	13,350	$	2,050,098	$	12
Unsecured		18		1		—		19		105,656		—		105,675		—
Real estate:
Secured by commercial properties		1,008		964		293		2,265		1,528,084		41,128		1,571,477		—
Secured by residential properties		726		35		336		1,097		729,018		11,647		741,762		—
Construction and land development:
Residential construction loans		343		—		—		343		103,819		221		104,383		—
Commercial construction loans and land development		733		1,845		114		2,692		593,352		4,929		600,973		—
Consumer		359		17		—		376		44,517		779		45,672		—
	$	18,056	$	6,822	$	9,157	$	34,035	$	5,113,951	$	72,054	$	5,220,040	$	12


															Accruing Loans (Non-PCI)
	Loans Past Due		Loans Past Due		Loans Past Due		Total		Current		PCI		Total		Past Due
December 31, 2014	30-59 Days		60-89 Days		90 Days or More		Past Due Loans		Loans		Loans		Loans		90 Days or More
Commercial and industrial:
Secured	$	6,073	$	964	$	8,022	$	15,059	$	1,620,000	$	13,374	$	1,648,433	$	—
Unsecured		35		3		—		38		110,312		68		110,418		—
Real estate:
Secured by commercial properties		67		—		—		67		1,173,504		22,341		1,195,912		—
Secured by residential properties		454		1,187		—		1,641		495,472		1,810		498,923		—
Construction and land development:
Residential construction loans		175		—		—		175		64,871		—		65,046		—
Commercial construction loans and land development		4,319		—		575		4,894		334,525		9,178		348,597		—
Consumer		414		37		—		451		50,558		2,138		53,147		—
	$	11,537	$	2,191	$	8,597	$	22,325	$	3,849,242	$	48,909	$	3,920,476	$	—

In addition to the non-covered loans shown in the table above, $50.8 million and $19.2 million of loans included in loans held for sale (with an unpaid principal balance of $51.1 million and $19.2 million, respectively) were 90 days past due and accruing interest at December 31, 2015 and 2014, respectively. These loans are guaranteed by U.S. government agencies and include loans that are subject to repurchase, or have been repurchased, by PrimeLending.

Management tracks credit quality trends on a quarterly basis related to: (i) past due levels, (ii) non-performing asset levels, (iii) classified loan levels, (iv) net charge-offs, and (v) general economic conditions in the state and local markets.

The Bank utilizes a risk grading matrix to assign a risk grade to each of the loans in its portfolio. A risk rating is assigned based on an assessment of the borrower’s management, collateral position, financial capacity, and economic factors. The general characteristics of the various risk grades are described below.

Pass — “Pass” loans present a range of acceptable risks to the Bank. Loans that would be considered virtually risk-free are rated Pass — low risk. Loans that exhibit sound standards based on the grading factors above and present a reasonable risk to the Bank are rated Pass — normal risk. Loans that exhibit a minor weakness in one or more of the grading criteria but still present an acceptable risk to the Bank are rated Pass — high risk.

Special Mention — “Special Mention” loans have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in a deterioration of the repayment prospects for the loans and weaken the Bank’s credit position at some future date. Special Mention loans are not adversely classified and do not expose the Bank to sufficient risk to require adverse classification.

Substandard — “Substandard” loans are inadequately protected by the current sound worth and paying capacity of the obligor or the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Many substandard loans are considered impaired.

PCI — “PCI” loans exhibited evidence of credit deterioration at acquisition that made it probable that all contractually required principal payments would not be collected.

The following tables present the internal risk grades of non-covered loans, as previously described, in the portfolio by class (in thousands).


December 31, 2015	Pass		Special Mention		Substandard		PCI		Total
Commercial and industrial:
Secured	$	1,975,639	$	—	$	61,109	$	13,350	$	2,050,098
Unsecured		105,569		—		106		—		105,675
Real estate:
Secured by commercial properties		1,517,049		1,536		11,764		41,128		1,571,477
Secured by residential properties		724,701		—		5,414		11,647		741,762
Construction and land development:
Residential construction loans		104,162		—		—		221		104,383
Commercial construction loans and land development		594,614		—		1,430		4,929		600,973
Consumer		44,736		35		122		779		45,672
	$	5,066,470	$	1,571	$	79,945	$	72,054	$	5,220,040


December 31, 2014	Pass		Special Mention		Substandard		PCI		Total
Commercial and industrial:
Secured	$	1,566,208	$	1,105	$	67,746	$	13,374	$	1,648,433
Unsecured		110,256		—		94		68		110,418
Real estate:
Secured by commercial properties		1,151,454		712		21,405		22,341		1,195,912
Secured by residential properties		492,549		—		4,564		1,810		498,923
Construction and land development:
Residential construction loans		65,046		—		—		—		65,046
Commercial construction loans and land development		338,078		—		1,341		9,178		348,597
Consumer		50,968		—		41		2,138		53,147
	$	3,774,559	$	1,817	$	95,191	$	48,909	$	3,920,476

Allowance for Loan Losses

It is management’s responsibility at the end of each quarter, or more frequently as deemed necessary, to analyze the level of the allowance for loan losses to ensure that it is appropriate for the estimated credit losses in the portfolio. Estimated credit losses are the probable current amount of loans that the Company will be unable to collect given facts and circumstances as of the evaluation date. When management determines that a loan or portion thereof is uncollectible, the loan, or portion thereof, is charged-off against the allowance for loan losses, or for acquired loans accounted for in pools, charged against the pool discount. Recoveries on charge-offs of loans acquired in the Bank Transactions that occurred prior to their acquisition represent contractual cash flows not expected to be collected and are recorded as accretion income. Recoveries on acquired loans charged-off subsequent to their acquisition are credited to the allowance for loan loss, except for recoveries on loans accounted for in pools, which are credited to the pool discount.

The Company has developed a methodology that seeks to determine an allowance within the scope of the Receivables and Contingencies Topics of the ASC. Each of the loans that has been determined to be impaired is within the scope of the Receivables Topic. Impaired loans that are equal to or greater than $0.5 million are individually evaluated using one of three impairment measurement methods as of the evaluation date: (1) the present value of expected future discounted cash flows on the loan, (2) the loan’s observable market price, or (3) the fair value of the collateral if the loan is collateral dependent. Specific reserves are provided in the estimate of the allowance based on the measurement of impairment under these three methods, except for collateral dependent loans, which require the fair value method. All non-impaired loans are within the scope of the Contingencies Topic. Estimates of loss for the Contingencies Topic are calculated based on historical loss, adjusted for qualitative or environmental factors. The Bank uses a rolling three year average net loss rate to calculate historical loss factors. The analysis is conducted by call report loan category, and further disaggregates commercial and industrial loans by collateral type. The analysis uses net charge-off experience by considering charge-offs and recoveries in determining the loss rate. The historical loss calculation for the quarter is calculated by dividing the current quarter net charge-offs for each loan category by the quarter ended loan category balance. The Bank utilizes a weighted average loss rate to better represent recent trends. The Bank weights the most recent four quarter average at 120% versus the oldest four quarters at 80%.

While historical loss experience provides a reasonable starting point for the analysis, historical losses are not the sole basis upon which the Company determines the appropriate level for the allowance for loan losses. Management considers recent qualitative or environmental factors that are likely to cause estimated credit losses associated with the existing portfolio to differ from historical loss experience, including but not limited to:

changes in the volume and severity of past due, nonaccrual and classified loans;

changes in the nature, volume and terms of loans in the portfolio;

changes in lending policies and procedures;

changes in economic and business conditions and developments that affect the collectability of the portfolio;

changes in lending management and staff;

changes in the loan review system and the degree of oversight by the Bank’s board of directors; and

any concentrations of credit and changes in the level of such concentrations.

Changes in the volume and severity of past due, nonaccrual and classified loans, as well as changes in the nature, volume and terms of loans in the portfolio are key indicators of changes that could indicate a necessary adjustment to the historical loss factors. The magnitude of the impact of these factors on the qualitative assessment of the allowance for loan loss changes from quarter to quarter.

The loan review program is designed to identify and monitor problem loans by maintaining a credit grading process, requiring that timely and appropriate changes be made to reviewed loans and coordinating the delivery of the information necessary to assess the appropriateness of the allowance for loan losses. Loans are evaluated for impaired status when: (i) payments on the loan are delayed, typically by 90 days or more (unless the loan is both well secured and in the process of collection), (ii) the loan becomes classified, (iii) the loan is being reviewed in the normal course of the loan review scope, or (iv) the loan is identified by the servicing officer as a problem.

In connection with the Bank Transactions, the Bank acquired loans both with and without evidence of credit quality deterioration since origination. PCI loans acquired in the PlainsCapital Merger are accounted for on an individual loan basis, while PCI loans acquired in each of the FNB Transaction and SWS Merger are accounted for in pools as well as on an individual loan basis. Cash flows expected to be collected are recast quarterly for each loan or pool. These evaluations require the continued use and updating of key assumptions and estimates such as default rates, loss severity given default and prepayment speed assumptions (similar to those used for the initial fair value estimate). Management judgment must be applied in developing these assumptions. If expected cash flows for a loan or pool decreases, an increase in the allowance for loan losses is made through a charge to the provision for loan losses. If expected cash flows for a loan or pool increase, any previously established allowance for loan losses is reversed and any remaining difference increases the accretable yield. This increase in accretable yield is taken into income over the remaining life of the loan.

Loans without evidence of credit impairment at acquisition are subsequently evaluated for any required allowance at each reporting date. An allowance for loan losses is calculated using a methodology similar to that described above for originated loans. The allowance as determined for each loan collateral type is compared to the remaining fair value discount for that loan collateral type. If greater, the excess is recognized as an addition to the allowance through a provision for loan losses. If less than the discount, no additional allowance is recorded. Charge-offs and losses first reduce any remaining fair value discount for the loan and once the discount is depleted, losses are applied against the allowance established for that loan.

The allowance for loan losses is subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance.

Changes in the allowance for non-covered loan losses, distributed by portfolio segment, are shown below (in thousands).


	Commercial and				Construction and
Year Ended December 31, 2015	Industrial		Real Estate		Land Development		Consumer		Total
Balance, beginning of year	$	18,999	$	11,131	$	6,450	$	461	$	37,041
Provision charged to (recapture from) operations		4,518		7,937		(386)		104		12,173
Loans charged off		(7,144)		(605)		—		(378)		(8,127)
Recoveries on charged off loans		3,681		520		—		127		4,328
Balance, end of year	$	20,054	$	18,983	$	6,064	$	314	$	45,415


	Commercial and				Construction and
Year Ended December 31, 2014	Industrial		Real Estate		Land Development		Consumer		Total
Balance, beginning of year	$	16,865	$	8,331	$	7,957	$	88	$	33,241
Provision charged to (recapture from) operations		6,116		2,696		(1,692)		627		7,747
Loans charged off		(6,926)		(114)		—		(359)		(7,399)
Recoveries on charged off loans		2,944		218		185		105		3,452
Balance, end of year	$	18,999	$	11,131	$	6,450	$	461	$	37,041


	Commercial and				Construction and
Year Ended December 31, 2013	Industrial		Real Estate		Land Development		Consumer		Total
Balance, beginning of year	$	1,845	$	977	$	582	$	5	$	3,409
Provision charged to operations		20,940		7,281		7,634		238		36,093
Loans charged off		(9,359)		(209)		(524)		(216)		(10,308)
Recoveries on charged off loans		3,439		282		265		61		4,047
Balance, end of year	$	16,865	$	8,331	$	7,957	$	88	$	33,241

The non-covered loan portfolio was distributed by portfolio segment and impairment methodology as shown below (in thousands).


	Commercial and				Construction and
December 31, 2015	Industrial		Real Estate		Land Development		Consumer		Total
Loans individually evaluated for impairment	$	11,354	$	97	$	—	$	—	$	11,451
Loans collectively evaluated for impairment		2,131,069		2,260,367		700,206		44,893		5,136,535
PCI Loans		13,350		52,775		5,150		779		72,054
	$	2,155,773	$	2,313,239	$	705,356	$	45,672	$	5,220,040


	Commercial and				Construction and
December 31, 2014	Industrial		Real Estate		Land Development		Consumer		Total
Loans individually evaluated for impairment	$	11,842	$	1,420	$	703	$	—	$	13,965
Loans collectively evaluated for impairment		1,733,567		1,669,264		403,762		51,009		3,857,602
PCI Loans		13,442		24,151		9,178		2,138		48,909
	$	1,758,851	$	1,694,835	$	413,643	$	53,147	$	3,920,476

The allowance for non-covered loan losses was distributed by portfolio segment and impairment methodology as shown below (in thousands).


	Commercial and				Construction and
December 31, 2015	Industrial		Real Estate		Land Development		Consumer		Total
Loans individually evaluated for impairment	$	1,380	$	—	$	—	$	—	$	1,380
Loans collectively evaluated for impairment		17,333		16,052		5,882		282		39,549
PCI Loans		1,341		2,931		182		32		4,486
	$	20,054	$	18,983	$	6,064	$	314	$	45,415


	Commercial and				Construction and
December 31, 2014	Industrial		Real Estate		Land Development		Consumer		Total
Loans individually evaluated for impairment	$	421	$	—	$	—	$	—	$	421
Loans collectively evaluated for impairment		15,658		9,168		6,296		179		31,301
PCI Loans		2,920		1,963		154		282		5,319
	$	18,999	$	11,131	$	6,450	$	461	$	37,041