Note 5 - Loans and Allowance for Loan Losses

Loans held for investment are stated at the amount of unpaid principal, reduced by unearned income and an allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amounts outstanding. The Company defers and amortizes net loan origination fees and costs as an adjustment to yield. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes the collectability of the principal is unlikely.

The Company has lending policies and procedures in place that are designed to maximize loan income with an acceptable level of risk. Management reviews and approves these policies and procedures on an annual basis and makes changes as appropriate. Management receives and reviews monthly reports related to loan originations, quality, concentrations, delinquencies, nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions, both by type of loan and geographic location.

Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. Underwriting standards are designed to determine whether the borrower possesses sound business ethics and practices and to evaluate current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and, secondarily, on the underlying collateral provided by the borrower. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and include personal guarantees.

Agricultural loans are subject to underwriting standards and processes similar to commercial loans. These agricultural loans are based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. Most agricultural loans are secured by the agriculture related assets being financed, such as farm land, cattle or equipment, and include personal guarantees.

Real estate loans are also subject to underwriting standards and processes similar to commercial and agricultural loans. These loans are underwritten primarily based on projected cash flows and, secondarily, as loans secured by real estate. The repayment of real estate loans is generally largely dependent on the successful operation of the property securing the loans or the business conducted on the property securing the loan. Real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s real estate portfolio are generally diverse in terms of type and geographic location within Texas. This diversity helps reduce the exposure to adverse economic events that affect any single market or industry. Generally, real estate loans are owner occupied which further reduces the Company’s risk.

Consumer loan underwriting utilizes methodical credit standards and analysis to supplement the Company’s underwriting policies and procedures. The Company’s loan policy addresses types of consumer loans that may be originated and the collateral, if secured, which must be perfected. The relatively smaller individual dollar amounts of consumer loans that are spread over numerous individual borrowers also minimize the Company’s risk.

The allowance for loan losses is an amount management believes is appropriate to absorb probable losses that have been incurred on existing loans as of the balance sheet date based upon management’s review and evaluation of the loan portfolio. The allowance for loan losses is comprised of three elements: (i) specific reserves determined based on probable losses on specific classified loans; (ii) a general reserve that considers historical loss rates; and (iii) qualitative reserves based upon general economic conditions and other qualitative risk factors both internal and external to the Company. The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management’s periodic evaluation of the appropriateness of the allowance is based on general economic conditions, the financial condition of borrowers, the value and liquidity of collateral, delinquency, prior loan loss experience, and the results of periodic reviews of the portfolio. For purposes of determining our general reserve, the loan portfolio, less cash secured loans, government guaranteed loans and classified loans, is multiplied by the Company’s historical loss rate. Specific allocations are increased in accordance with deterioration in credit quality and a corresponding increase in risk of loss on a particular loan. In addition, we adjust our allowance for qualitative factors such as current local economic conditions and trends, including, without limitations, unemployment, changes in lending staff, policies and procedures, changes in credit concentrations, changes in the trends and severity of problem loans and changes in trends in volume and terms of loans. This qualitative reserve serves to estimate for additional areas of incurred losses in our portfolio that are not reflected in our historic loss factors.

Although we believe we use the best information available to make loan loss allowance determinations, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making our initial determinations. A further downturn in the economy and employment could result in increased levels of non-performing assets and charge-offs, increased loan provisions and reductions in income. Additionally, bank regulatory agencies periodically review our allowance for loan losses and methodology and could require additions to the loan loss allowance based on their judgment of information available to them at the time of their examination.

Accrual of interest is discontinued on a loan and payments are applied to principal when management believes, after considering economic and business conditions and collection efforts, the borrower’s financial condition is such that collection of interest is doubtful. Except consumer loans, generally all loans past due greater than 90 days, based on contractual terms, are placed on non-accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Consumer loans are generally charged-off when a loan becomes past due 90 days. For other loans in the portfolio, facts and circumstances are evaluated in making charge-off decisions.

Loans are considered impaired when, based on current information and events, management determines that it is probable we will be unable to collect all amounts due in accordance with the loan agreement, including scheduled principal and interest payments. If a loan is impaired, a specific valuation allowance is allocated, if necessary. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectable.

The Company’s policy requires measurement of the allowance for an impaired, collateral dependent loan based on the fair value of the collateral. Other loan impairments are measured based on the present value of expected future cash flows or the loan’s observable market price. At March 31, 2014 and 2013, and December 31, 2013, all significant impaired loans have been determined to be collateral dependent and the allowance for loss has been measured utilizing the estimated fair value of the collateral.

From time to time, the Company modifies its loan agreement with a borrower. A modified loan is considered a troubled debt restructuring when two conditions are met: (i) the borrower is experiencing financial difficulty and (ii) concessions are made by the Company that would not otherwise be considered for a borrower with similar credit risk characteristics. Modifications to loan terms may include a lower interest rate, a reduction of principal, or a longer term to maturity. For all impaired loans, including the Company’s troubled debt restructurings, the Company performs a periodic, well-documented credit evaluation of the borrower’s financial condition and prospects for repayment to assess the likelihood that all principal and interest payments required under the terms of the agreement will be collected in full. When doubt exists about the ultimate collectability of principal and interest, the troubled debt restructuring remains on non-accrual status and payments received are applied to reduce principal to the extent necessary to eliminate such doubt. This determination of accrual status is judgmental and is based on facts and circumstances related to each troubled debt restructuring. To date, these troubled debt restructurings have been such that, after considering economic and business conditions and collection efforts, the collection of interest is doubtful and therefore have been placed on non-accrual. Each of these loans is individually evaluated for impairment and a specific reserve is recorded based on probable losses, taking into consideration the related collateral and modified loan terms and cash flow. As of March 31, 2014 and 2013, and December 31, 2013, all of the Company’s troubled debt restructured loans are included in the non-accrual totals.

The Company originates certain mortgage loans for sale in the secondary market. Accordingly, these loans are classified as held for sale and are carried at the lower of cost or fair value on an aggregate basis. The mortgage loan sales contracts contain indemnification clauses should the loans default, generally in the first three to six months, or if documentation is determined not to be in compliance with regulations. The Company’s historic losses as a result of these indemnities have been insignificant.

Loans acquired, including loans acquired in a business combination, are initially recorded at fair value with no valuation allowance. Acquired loans are segregated between those considered to be credit impaired and those deemed performing. To make this determination, management considers such factors as past due status, non-accrual status and credit risk ratings. The fair value of acquired performing loans is determined by discounting expected cash flows, both principal and interest, at prevailing market interest rates. The difference between the fair value and principal balances due at acquisition date, the fair value discount, is accreted into income over the estimated life of each loan.

Purchased credit impaired loans are those loans that showed evidence of deterioration of credit quality since origination and for which it is probable, at acquisition, that the Company will be unable to collect all amounts contractually owed. Their fair value was initially based on the estimate of cash flows, both principal and interest, expected to be collected or estimated collateral values if cash flows are not estimable, discounted at prevailing market rates of interest. The difference between the cash flows expected at acquisition and the investment in the loan, is recognized as interest income on a level-yield method over the life of the loan, unless management was unable to reasonably forecast cash flows in which case the loans were placed on non-accrual. Contractually required payments for interest and principal that exceed the cash flows expected at acquisition are not recognized as a yield adjustment. Increases in expected cash flows subsequent to the initial investment are recognized prospectively through adjustment of the yield on the loan over its remaining life. Decreases in expected cash flows are recognized as impairment. Valuation allowances on these impaired loans reflect only losses incurred after the acquisition. The carrying amount of purchased credit impaired loans at March 31, 2014 and December 31, 2013 was $2,605,000 and $2,707,000, respectively, compared to a contractual balance of $3,844,000 and $3,970,000, respectively. There were no such amounts at March 31, 2013. Other purchased credit impaired loan disclosures were omitted due to immateriality.

Loans held-for-investment by class of financing receivables are as follows (in thousands):


	March 31,				December 31,
	2014		2013		2013
Commercial	$	607,281	$	513,422	$	596,730
Agricultural		65,121		55,247		75,928
Real estate		1,680,807		1,275,564		1,678,514
Consumer		335,079		283,782		333,113


Total loans held-for-investment	$	2,688,288	$	2,128,015	$	2,684,285

Loans held for sale totaled $10,429,000, $10,122,000 and $5,163,000 at March 31, 2014 and 2013 and December 31, 2013, respectively, which were recorded at cost as fair value exceeded cost.

The Company’s non-accrual loans, loans still accruing and past due 90 days or more and restructured loans are as follows (in thousands):


	March 31,				December 31,
	2014		2013		2013
Non-accrual loans*	$	24,710	$	22,509	$	27,926
Loans still accruing and past due 90 days or more		30		24		133
Restructured loans**		—		—		—


Total	$	24,740	$	22,533	$	28,059

*	Includes $2,605,000 and $2,707,000 of purchased credit impaired loans as of March 31, 2014 and December 31, 2013, respectively. There were no purchased credit impaired loan balances at March 31, 2013.

**	Restructured loans whose interest collection, after considering economic and business conditions and collection efforts, is doubtful are included in non-accrual loans. All of our restructured loans are included in non-accrual loans.

The Company’s recorded investment in impaired loans and the related valuation allowance are as follows (in thousands):


March 31, 2014				March 31, 2013				December 31, 2013
Recorded		Valuation		Recorded		Valuation		Recorded		Valuation
Investment		Allowance		Investment		Allowance		Investment		Allowance
$	24,710	$	5,283	$	22,509	$	5,793	$	27,926	$	5,338

The average recorded investment in impaired loans for the three months ended March 31, 2014 and 2013, and the year ended December 31, 2013 was approximately $26,770,000, $23,163,000 and $31,293,000, respectively. The Company had $27,553,000, $25,718,000 and $31,128,000 in non-accrual, past due 90 days still accruing and restructured loans and foreclosed assets at March 31, 2014 and 2013, and December 31, 2013, respectively. Non-accrual loans totaled $24,710,000, $22,509,000 and $27,926,000 at March 31, 2014 and 2013, and December 31, 2013, respectively, and consisted of the following amounts by class of financing receivables (in thousands):


	March 31,				December 31,
	2014		2013		2013
Commercial	$	2,809	$	1,133	$	4,281
Agricultural		109		473		131
Real estate		20,921		20,502		22,548
Consumer		871		401		966


Total	$	24,710	$	22,509	$	27,926

No additional funds are committed to be advanced in connection with impaired loans as of March 31, 2014.

The Company’s impaired loans and related allowance as of March 31, 2014 and 2013, and December 31, 2013, are summarized in the following table by class of financing receivables (in thousands). No interest income was recognized on impaired loans subsequent to their classification as impaired.


March 31, 2014	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance*		Recorded Investment With Allowance		Total Recorded Investment		Related Allowance		Three- month Average Recorded Investment
Commercial	$	3,250	$	258	$	2,551	$	2,809	$	1,200	$	2,956
Agricultural		123		15		94		109		36		111
Real Estate		28,028		5,387		15,534		20,921		3,865		22,764
Consumer		1,062		494		377		871		182		939

Total	$	32,463	$	6,154	$	18,556	$	24,710	$	5,283	$	26,770

*	Includes $2,605,000 of purchased credit impaired loans.


March 31, 2013	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance		Recorded Investment With Allowance		Total Recorded Investment		Related Allowance		Three- month Average Recorded Investment
Commercial	$	1,555	$	25	$	1,108	$	1,133	$	555	$	1,232
Agricultural		489		25		448		473		169		483
Real Estate		24,937		1,956		18,546		20,502		4,901		21,028
Consumer		466		77		324		401		168		420

Total	$	27,447	$	2,083	$	20,426	$	22,509	$	5,793	$	23,163

December 31, 2013	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance*		Recorded Investment With Allowance		Total Recorded Investment		Related Allowance		Average Recorded Investment
Commercial	$	4,764	$	934	$	3,348	$	4,282	$	1,079	$	5,017
Agricultural		139		17		114		131		41		144
Real Estate		31,704		5,794		16,753		22,547		4,006		25,060
Consumer		1,117		545		421		966		212		1,072

Total	$	37,724	$	7,290	$	20,636	$	27,926	$	5,338	$	31,293

*	Includes $2,707,000 of purchased credit impaired loans.

The Company recognized interest income on impaired loans prior to being recognized as impaired of approximately $685,000 during the year ended December 31, 2013. Such amounts for the three-month periods ended March 31, 2014 and 2013 were not significant.

From a credit risk standpoint, the Company rates its loans in one of four categories: (i) pass, (ii) special mention, (iii) substandard or (iv) doubtful. Loans rated as loss are charged-off.

The ratings of loans reflect a judgment about the risks of default and loss associated with the loan. The Company reviews the ratings on our credits as part of our on-going monitoring of the credit quality of our loan portfolio. Ratings are adjusted to reflect the degree of risk and loss that are felt to be inherent in each credit as of each reporting period. Our methodology is structured so that specific allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss).

Credits rated special mention show clear signs of financial weakness or deterioration in credit worthiness, however, such concerns are not so pronounced that the Company generally expects to experience significant loss within the short-term. Such credits typically maintain the ability to perform within standard credit terms and credit exposure is not as prominent as credits rated more harshly.

Credits rated substandard are those in which the normal repayment of principal and interest may be, or has been, jeopardized by reason of adverse trends or developments of a financial, managerial, economic or political nature, or important weaknesses exist in collateral. A protracted workout on these credits is a distinct possibility. Prompt corrective action is therefore required to strengthen the Company’s position, and/or to reduce exposure and to assure that adequate remedial measures are taken by the borrower. Credit exposure becomes more likely in such credits and a serious evaluation of the secondary support to the credit is performed.

Credits rated doubtful are those in which full collection of principal appears highly questionable, and which some degree of loss is anticipated, even though the ultimate amount of loss may not yet be certain and/or other factors exist which could affect collection of debt. Based upon available information, positive action by the Company is required to avert or minimize loss. Credits rated doubtful are generally also placed on non-accrual.

The following summarizes the Company’s internal ratings of its loans held-for-investment by class of financing receivables and portfolio segments, which are the same, at March 31, 2014 and December 31, 2013 (in thousands):


March 31, 2014	Pass		Special Mention		Substandard		Doubtful		Total
Commercial	$	595,060	$	5,079	$	7,142	$	—	$	607,281
Agricultural		64,755		103		261		2		65,121
Real Estate		1,614,094		19,043		47,529		141		1,680,807
Consumer		332,817		563		1,692		7		335,079

Total	$	2,606,726	$	24,788	$	56,624	$	150	$	2,688,288

December 31, 2013	Pass		Special Mention		Substandard		Doubtful		Total
Commercial	$	584,547	$	3,032	$	9,151	$	—	$	596,730
Agricultural		75,382		245		298		3		75,928
Real Estate		1,609,242		20,773		48,352		147		1,678,514
Consumer		330,870		639		1,595		9		333,113

Total	$	2,600,041	$	24,689	$	59,396	$	159	$	2,684,285

At March 31, 2014 and December 31, 2013, the Company’s past due loans are as follows (in thousands):


March 31, 2014	15-59 Days Past Due*		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans		90 Days Past Due Still Accruing
Commercial	$	3,903	$	187	$	177	$	4,267	$	603,014	$	607,281	$	—
Agricultural		535		58		5		598		64,523		65,121		4
Real Estate		16,515		1,192		1,991		19,698		1,661,109		1,680,807		11
Consumer		1,624		343		146		2,113		332,966		335,079		15

Total	$	22,577	$	1,780	$	2,319	$	26,676	$	2,661,612	$	2,688,288	$	30


December 31, 2013	15-59 Days Past Due*		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans		90 Days Past Due Still Accruing
Commercial	$	5,303	$	287	$	420	$	6,010	$	590,720	$	596,730	$	—
Agricultural		355		—		—		355		75,573		75,928		—
Real Estate		13,787		2,489		1,876		18,152		1,660,362		1,678,514		55
Consumer		2,708		582		277		3,567		329,546		333,113		78

Total	$	22,153	$	3,358	$	2,573	$	28,084	$	2,656,201	$	2,684,285	$	133

*	The Company monitors commercial, agricultural and real estate loans after such loans are 15 days past due. Consumer loans are monitored after such loans are 30 days past due.

The allowance for loan losses as of March 31, 2014 and 2013, and December 31, 2013, is presented below. Management has evaluated the appropriateness of the allowance for loan losses by estimating the probable losses in various categories of the loan portfolio, which are identified below (in thousands):


	March 31,				December 31,
	2014		2013		2013
Allowance for loan losses provided for:
Loans specifically evaluated as impaired	$	5,283	$	5,793	$	5,338
Remaining portfolio		29,410		28,879		28,562


Total allowance for loan losses	$	34,693	$	34,672	$	33,900

The following table details the allowance for loan losses at March 31, 2014 and December 31, 2013 by portfolio segment (in thousands). There were no allowances for purchased credit impaired loans at March 31, 2014 or December 31, 2013. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.


March 31, 2014	Commercial		Agricultural		Real Estate		Consumer		Total

Loans individually evaluated for impairment	$	2,743	$	83	$	7,299	$	351	$	10,476
Loans collectively evaluated for impairment		3,902		202		18,330		1,783		24,217

Total	$	6,645	$	285	$	25,629	$	2,134	$	34,693

December 31, 2013	Commercial		Agricultural		Real Estate		Consumer		Total

Loans individually evaluated for impairment	$	2,755	$	125	$	7,215	$	378	$	10,473
Loans collectively evaluated for impairment		3,685		258		17,725		1,759		23,427

Total	$	6,440	$	383	$	24,940	$	2,137	$	33,900

Changes in the allowance for loan losses for the three months ended March 31, 2014 and 2013 are summarized as follows by portfolio segment (in thousands):


Three months ended March 31, 2014	Commercial			Agricultural			Real Estate			Consumer			Total
Beginning balance	$	6,440		$	383		$	24,940		$	2,137		$	33,900
Provision for loan losses		335			(99	)		1,233			221			1,690
Recoveries		88			3			187			122			400
Charge-offs		(218	)		(2	)		(731	)		(346	)		(1,297	)


Ending balance	$	6,645		$	285		$	25,629		$	2,134		$	34,693


Three months ended March 31, 2013	Commercial			Agricultural			Real Estate			Consumer			Total
Beginning balance	$	7,343		$	1,541		$	24,063		$	1,892		$	34,839
Provision for loan losses		(672	)		(86	)		1,120			39			401
Recoveries		121			11			28			95			255
Charge-offs		(288	)		—			(350	)		(185	)		(823	)


Ending balance	$	6,504		$	1,466		$	24,861		$	1,841		$	34,672

The Company’s recorded investment in loans as of March 31, 2014 and December 31, 2013 related to the balance in the allowance for loan losses on the basis of the Company’s impairment methodology was as follows (in thousands). Purchased credit impaired loans of $2,605,000 and $2,707,000 at March 31, 2014 and December 31, 2013, respectively, are included in loans individually evaluated for impairment.


March 31, 2014	Commercial		Agricultural		Real Estate		Consumer		Total

Loans individually evaluated for impairment	$	12,221	$	366	$	66,713	$	2,262	$	81,562
Loans collectively evaluated for impairment		595,060		64,755		1,614,094		332,817		2,606,726

Total	$	607,281	$	65,121	$	1,680,807	$	335,079	$	2,688,288


December 31, 2013	Commercial		Agricultural		Real Estate		Consumer		Total

Loans individually evaluated for impairment	$	12,183	$	546	$	69,272	$	2,243	$	84,244
Loans collectively evaluated for impairment		584,547		75,382		1,609,242		330,870		2,600,041

Total	$	596,730	$	75,928	$	1,678,514	$	333,113	$	2,684,285

The Company’s loans that were modified in the three months ended March 31, 2014 and 2013 and considered troubled debt restructurings are as follows (in thousands):


	Three Months Ended March 31, 2014						Three Months Ended March 31, 2013
			Pre- Modification		Post- Modification				Pre- Modification		Post- Modification
			Recorded		Recorded				Recorded		Recorded
	Number		Investment		Investment		Number		Investment		Investment
Commercial		4	$	97	$	97		2	$	120	$	120
Agricultural		—		—		—		1		24		24
Real Estate		1		76		76		4		796		796
Consumer		3		11		11		—		—		—

Total		8	$	184	$	184		7	$	940	$	940

The balances below provide information as to how the loans were modified as troubled debt restructured loans during the three months ended March 31, 2014 and 2013 (in thousands):


	Three Months Ended March 31, 2014						Three Months Ended March 31, 2013
	Adjusted Interest Rate		Extended Maturity		Combined Rate and Maturity		Adjusted Interest Rate		Extended Maturity		Combined Rate and Maturity
Commercial	$	—	$	97	$	—	$	—	$	120	$	—
Agricultural		—		—		—		—		24		—
Real Estate		—		76		—		272		350		174
Consumer		—		8		3		—		—		—

Total	$	—	$	181	$	3	$	272	$	494	$	174

During the three months ended March 31, 2013, eleven loans were modified as a troubled debt restructured loans within the previous 12 months and for which there was a payment default. There were no such defaults in the three months ended March 31, 2014. A default for purposes of this disclosure is a troubled debt restructured loan in which the borrower is 90 days past due or results in the foreclosure and repossession of the applicable collateral. The loans are as follows (dollars in thousands):


	Three Months Ended March 31, 2013
	Number		Balance
Commercial		5	$	217
Agriculture		—		—
Real Estate		5		931
Consumer		1		19

Total		11	$	1,167

As of March 31, 2014, the Company has no commitments to lend additional funds to loan customers whose terms have been modified in troubled debt restructurings.

Our subsidiary bank has established a line of credit with the Federal Home Loan Bank of Dallas to provide liquidity and meet pledging requirements for those customers eligible to have securities pledged to secure certain uninsured deposits. At March 31, 2014, $1,565,974,000 in loans held by our bank subsidiary were subject to blanket liens as security for this line of credit. At March 31, 2014, $76,092,000 in advances were outstanding and $40,100,000 in letters of credit were outstanding under this line of credit. The letters of credit were pledged as collateral for public funds held by our bank subsidiary.