Allowance For Loan Losses

6 Months Ended

Jun. 30, 2011

Allowance For Loan Losses

Allowance For Loan Losses

10. Allowance for Loan Losses

The allowance for loan losses ("ALLL"), which is utilized to absorb actual losses in the loan portfolio, is maintained at a level consistent with management's best estimate of probable loan losses incurred as of the balance sheet date. The Company's allowance for loan losses is also assessed quarterly by management. This assessment includes a methodology that separates the total loan portfolio into homogeneous loan classifications for purposes of evaluating risk. The required allowance is calculated by applying a risk adjusted reserve requirement to the dollar volume of loans within a homogenous group. The Company has grouped its loans into pools according to the loan segmentation regime employed on schedule RC-C of the FFIEC's Consolidated Report of Condition and Income. Major loan portfolio subgroups include: risk graded commercial loans, mortgage loans, home equity loans, retail loans and retail credit lines. Management also analyzes the loan portfolio on an ongoing basis to evaluate current risk levels, and risk grades are adjusted accordingly. While management uses the best information available to make evaluations, future adjustments may be necessary, if economic or other conditions differ substantially from the assumptions used.

For all loan classes management applies two primary components during the loan review process to determine proper allowance levels. The two components are a specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated. The methodology to analyze the adequacy of the allowance for loan losses is as follows:

• identification of specific impaired loans by loan category;

• specific loans that could have potential loss;

• calculation of specific allowances where required for the impaired loans based on collateral and other objective and quantifiable evidence;

• determination of homogenous pools by loan category and risk grade, reduced by the impaired loans;

• application of historical loss percentages to pools to determine the allowance allocation; and

• application of qualitative and environmental (Q&E) factor adjustment percentages to historical losses for trends or changes in the loan portfolio.

The reserve for unfunded commitments is calculated by determining the type of commitment and the remaining unfunded commitment for each loan. Based on the type of commitment, an expected usage percentage to the remaining unfunded balance is applied. The expected usage percentage is multiplied by the historical losses and Q&E factors for each loans pool as defined in the regular Allowance for Loan Loss calculation to determine the appropriate level of reserve. The expected usage percentages for each commitment type are as follows:

• Construction draws – 100%

• Equity lines of credit – 50%

• Letters of Credit – 10%

Historical Loss Rates: Historical loss data has been catalogued by the Company for each pool. The risk-graded pool to which the loss is assigned is the risk-grade assigned to the loan at the quarter end, four quarters earlier. Historical loss recoveries are similarly entered, if significant and applied against the nonclassified pools according to the Call Report designations of the loans originally charged. Historical loss data is also used to estimate the loss horizon for each pool.

Q&E Loss Factors: The methodology incorporates various internal and external qualitative and environmental factors as described in the Interagency Policy Statement on the Allowance for Loan and Lease Losses dated December 2006. Input for these factors is determined on the basis of management observation, judgment, and experience. The factors utilized by the Company for all loan classes are as follows:

a) Standard – Accounts for inherent uncertainty in using the past as a predictor of the future. Uniform across all segments.

b) Volume – Accounts for historical growth characteristics of the portfolio over the loss recognition period.

c) Terms – Measures risk derived from granting terms outside of policy and underwriting guidelines.

d) Staff – Reflects staff competence in various types of lending.

e) Delinquency – Reflects increased risk deriving from higher delinquency rates.

f) Nonaccrual – Reflects increased risk of loans with characteristics that merit nonaccrual status.

g) Migration – Accounts for the changing level of risk inherent in loans as they migrate into, or away from, more adverse risk grades.

h) Concentration – Measures increased risk derived from concentration of credit exposure in particular industry segments within the portfolio.

i) Production – Measures impact of anticipated growth and potential risk derived from new loan production.

j) Process – Measures increased risk derived from more demanding processing requirements directed towards risk mitigation.

k) Economic – Impact of general and local economic factors are the largest single factor affecting portfolio risk and effect is felt uniformly across pools.

l) Competition – Measures risk associated with bank's potential response to competitors' relaxed credit requirements.

m) Regulatory and Legal – Measures risk from exposure to regulations, legislation, and legal code that result in increased risk of loss.

Each pool is assigned an "additional" potential loss percentage by assessing its characteristics against each of the factors listed above.

Calculation and Summary: A general reserve amount for each loan pool is calculated by adding the historical loss rate to the total Q&E factors, and applying the combined percentage to the pool loan balances.

Reserves are generally divided into three allocation segments:

1. Individual Reserves. Individual reserves are calculated against loans evaluated individually and deemed most likely to be impaired. Management determines which loans will be considered for potential impairment review. This does not mean that an individual reserve will necessarily be calculated for each loan considered for impairment, only for those noted during this process as likely to be potentially impaired. Loans to be considered will generally include:

• All commercial loans classified substandard or worse

• Any other loan in a nonaccrual status

• Any loan, consumer or commercial, that has already been modified such that it meets the definition of Troubled Debt Restructure ("TDR")

The individual reserve must be verified at least quarterly, and recalculated whenever additional relevant information becomes available. All information related to the calculation of the individual reserve, including internal or external collateral valuations, assumptions, calculations, etc. must be documented. Assigning an individual reserve based on rough estimates or unsupported conclusions is not permitted.

Individual reserve amounts may not be carried indefinitely.

• When the amount of the actual loss becomes reasonably quantifiable, the amount of the loss should be charged off against the ALLL, whether or not all liquidation and recovery efforts have been completed.

• If the total amount of the individual reserve that will eventually be charged off cannot yet be determined, but some portion of the individual reserve can be viewed as an imminent loss, that smaller portion should be charged off against the ALLL and the individual reserve reduced by a corresponding amount. It is acceptable to retain an estimate of remaining loss as a "special reserve" only when the estimate is not reasonably quantifiable.

2. Formula Reserves. Formula reserves are held against loans evaluated collectively. Loans are grouped by type or by risk grade, or some combination of the two. Loss estimates are based on historical loss rates for each respective loan group, adjusted for appropriate environmental factors established by the Bank. These factors should include:

• Levels and trends in delinquencies and impaired loans

• Estimated effects of changes to underwriting standards, lending policies, etc.

• Experience, depth and ability of lending management and other relevant staff

• National and local economic trends and conditions

• Effects of changes in credit concentrations

Formula reserves represent the Bank's best estimate of losses that may be inherent, or embedded, within the group of loans, even if it is not apparent at this time which loans within any group or pool represent those embedded losses.

3. Unallocated Reserves. If individual reserves represent estimated losses tied to any specific loan and formula reserves represent estimated losses tied to a pool of loans but not yet to any specific loan, then unallocated reserves represent an estimate of losses that are expected, but are not yet tied to any loan or group of loans. Unallocated reserves are generally the smallest of the three overall reserve segments and are set based on qualitative factors.

All information related to the calculation of the three segments including data analysis, assumptions, calculations, etc. are documented. Assigning specific individual reserve amounts, formula reserve factors, or unallocated reserve amounts based on unsupported assumptions or conclusions is not permitted.

The Bank lends primarily in North Carolina. As of June 30, 2011, a substantial majority of the principal amount of the loans held for investment in its portfolio was to businesses and individuals in North Carolina. This geographic concentration subjects the loan portfolio to the general economic conditions within this area. The risks created by this concentration have been considered by management in the determination of the adequacy of the allowance for loan losses. Management believes the allowance for loan losses is adequate to cover estimated losses on loans at each balance sheet date.

During the three- and six-month periods ending June 30, 2011, the Bank charged-off $45.7 million and $91.6 million in loans, respectively. The majority of the loans that were charged-off were loans that had been in impairment status for more than six months and had specific reserves assigned to them in prior periods. Due to these loans having specific reserves assigned to the outstanding balance of the loan, it was not necessary for the Bank to have a provision greater than the charge-off value in the second quarter of 2011. The Bank also noted positive trends in the loan portfolio during the second quarter of 2011 that included reductions in: nonaccruing loans of $117.2 million, loans 90 days or more past due and still accruing of $4.8 million, loans 30-89 days past due of $57.1 million, and classified loans of $151.4 million. These improvements over December 31, 2010 were considered in the analysis of the adequacy of the allowance for loan loss at June 30, 2011.

An analysis of the changes in the allowance for loan losses is as follows:

(dollars in thousands)	Three Months Ended June 30,						Six Months Ended June 30,
	2011			2010			2011			2010
Balance, beginning of period	$	68,729		$	55,663		$	93,687		$	49,229
Provision for losses charged to continuing operations		33,580			27,236			53,763			36,726
Net charge-offs:
Charge-offs		(45,662	)		(14,067	)		(91,571	)		(17,574	)
Recoveries		2,719			503			3,487			954
Net charge-offs		(42,943	)		(13,564	)		(88,084	)		(16,620	)
Provision for losses charged to discontinued operations		—			425			—			425
Balance, end of period	$	59,366		$	69,760		$	59,366		$	69,760
Annualized net charge-offs during the period to average loans		15.06	%		3.54	%		14.76	%		2.17	%
Annualized net charge-offs during the period to allowance for loan losses		290.14	%		77.99	%		299.21	%		48.04	%
Allowance for loan losses to loans held for investment (1)		5.83	%		4.58	%		5.83	%		4.58	%

(1) Excludes discontinued operations.

The allowance for loan losses, as a percentage of loans held for investment, amounted to 5.83% at June 30, 2011, compared to 4.58% at June 30, 2010. At December 31, 2010, the allowance for loan losses, as a percentage of loans held for investment, was 7.18%.

The credit quality indicator presented for all classes within the loan portfolio is a widely used and standard system representing the degree of risk of nonpayment. The risk-grade categories presented in the following table are:

Pass - Loans categorized as Pass are higher quality loans that have adequate sources of repayment and little risk of collection.

Special Mention - A Special Mention loan has 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 the institution's credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

Substandard - A Substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified 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. Loss potential, while existing in the aggregate amount of Substandard loans, does not have to exist in individual assets classified Substandard.

Doubtful - A loan classified as Doubtful has all the weaknesses inherent in one classified Substandard 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. The possibility of loss is extremely high, but because of certain important and reasonable specific pending factors, which may work to the advantage of strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans.

Loans categorized as Special Mention are considered Criticized. Loans categorized as Substandard or Doubtful are considered Classified.

The following table presents loan and lease balances by credit quality indicator as of June 30, 2011:

(dollars in thousands)	Nonclassified/ Pass (Ratings 1-5)		Special Mention (Rating 6)		Substandard (Rating 7)		Doubtful (Rating 8)		Total
Commercial and agricultural	$	56,404	$	4,610	$	6,139	$	501	$	67,654
Real estate - construction		59,537		10,788		75,091		21,367		166,783
Real estate - mortgage:
1-4 family residential		326,488		13,604		33,604		3,911		377,607
Commercial		227,797		56,590		67,945		8,145		360,477
Consumer		44,728		145		590		290		45,753
Total	$	714,954	$	85,737	$	183,369	$	34,214	$	1,018,274

The following table presents loan and lease balances by credit quality indicator as of December 31, 2010:

(dollars in thousands)	Nonclassified/ Pass (Ratings 1-5)		Special Mention (Rating 6)		Substandard (Rating 7)		Doubtful (Rating 8)		Total
Commercial and agricultural	$	71,325	$	6,375	$	10,882	$	5,165	$	93,747
Real estate - construction		76,317		46,596		111,365		42,698		276,976
Real estate - mortgage:
1-4 family residential		324,369		18,398		34,662		11,430		388,859
Commercial		283,557		59,439		84,666		67,199		494,861
Consumer		48,620		—		609		303		49,532
Total	$	804,188	$	130,808	$	242,184	$	126,795	$	1,303,975

The following table presents ALLL activity by portfolio segment for the three-month period as of June 30, 2011:

	For Three Months Ended June 30, 2011
	Commercial and Agriculture			Real Estate - Construction			Real Estate - Mortgage						Consumer			Total
(dollars in thousands)							1-4 Family Residential			Commercial
Allowance for loan losses:
Beginning balance at April 1, 2011	$	8,719		$	32,947		$	9,751		$	15,668		$	1,644		$	68,729
Charge-offs		(4,192	)		(21,510	)		(4,585	)		(14,002	)		(1,373	)		(45,662	)
Recoveries		467			714			469			693			376			2,719
Provision		1,533			16,268			3,395			11,260			1,124			33,580
Ending balance at June 30, 2011	$	6,527		$	28,419		$	9,030		$	13,619		$	1,771		$	59,366

The following table presents ALLL activity by portfolio segment for the six-month period as of June 30, 2011:

	For Six Months Ended June 30, 2011
	Commercial and Agriculture			Real Estate - Construction			Real Estate - Mortgage						Consumer			Total
(dollars in thousands)							1-4 Family Residential			Commercial
Allowance for loan losses:
Beginning balance at January 1, 2011	$	11,144		$	46,792		$	7,742		$	26,851		$	1,158		$	93,687
Charge-offs		(8,467	)		(44,172	)		(6,621	)		(30,180	)		(2,131	)		(91,571	)
Recoveries		533			904			562			742			746			3,487
Provision		3,317			24,895			7,347			16,206			1,998			53,763
Ending balance at June 30, 2011	$	6,527		$	28,419		$	9,030		$	13,619		$	1,771		$	59,366
Portion of ending balance:
Individually evaluated for impairment	$	2,581		$	18,427		$	5,286		$	6,365		$	395		$	33,054
Collectively evaluated for impairment		3,946			9,992			3,744			7,254			1,376			26,312
Total ALLL evaluated for impairment	$	6,527		$	28,419		$	9,030		$	13,619		$	1,771		$	59,366
Loans held for investment:
Ending balance at June 30, 2011	$	67,654		$	166,783		$	377,607		$	360,477		$	45,753		$	1,018,274
Portion of ending balance:
Individually evaluated for impairment	$	5,371		$	95,249		$	30,244		$	63,644		$	480		$	194,988
Collectively evaluated for impairment		62,283			71,534			347,363			296,833			45,273			823,286
Total loans evaluated for impairment	$	67,654		$	166,783		$	377,607		$	360,477		$	45,753		$	1,018,274

The following table presents ALLL activity by portfolio segment for the year ended December 31, 2010:

(dollars in thousands)							Real Estate - Mortgage
	Commercial and Agriculture			Real Estate - Construction			1-4 Family Residential			Commercial			Consumer			Total
Allowance for loan losses:
Beginning balance at January 1, 2010	$	3,543		$	23,932		$	8,311		$	12,729		$	946		$	49,461
Charge-offs		(9,832	)		(53,374	)		(9,060	)		(15,418	)		(3,566	)		(91,250	)
Recoveries		585			52			178			271			1,635			2,721
Provision		16,848			76,182			8,313			29,269			2,143			132,755
Ending balance at December 31, 2010	$	11,144		$	46,792		$	7,742		$	26,851		$	1,158		$	93,687
Portion of ending balance:
Individually evaluated for impairment	$	7,451		$	35,281		$	5,448		$	22,708		$	—		$	70,888
Collectively evaluated for impairment		3,693			11,511			2,294			4,143			1,158			22,799
Total ALLL evaluated for impairment	$	11,144		$	46,792		$	7,742		$	26,851		$	1,158		$	93,687
Loans held for investment:
Ending balance at December 31, 2010	$	93,747		$	276,976		$	388,859		$	494,861		$	49,532		$	1,303,975
Portion of ending balance:
Individually evaluated for impairment	$	14,176		$	152,465		$	41,109		$	132,537		$	188		$	340,475
Collectively evaluated for impairment		79,571			124,511			347,750			362,324			49,344			963,500
Total loans evaluated for impairment	$	93,747		$	276,976		$	388,859		$	494,861		$	49,532		$	1,303,975

The following table presents loans and leases on nonaccrual status by loan class for the dates indicated below:

(dollars in thousands)	June 30, 2011		December 31, 2010
Commercial and agricultural	$	5,886	$	13,274
Real estate - construction		95,895		144,605
Real estate - mortgage:
1-4 family residential		33,367		34,994
Commercial		72,191		131,866
Consumer		550		329
Total	$	207,889	$	325,068

As of June 30, 2011, there were $9.5 million of nonaccrual loans that were classified as held for sale. The Bank had no nonaccrual loans classified as held for sale at December 31, 2010.

The following table presents an aging analysis of accruing and nonaccruing loans as of June 30, 2011:

	Past Due								Current		Total Loans		90 or More Days Past Due and Accruing
(dollars in thousands)	30-59 Days		60-89 Days		90 or More Days		Total
Commercial and agricultural	$	338	$	796	$	4,186	$	5,320	$	62,334	$	67,654	$	—
Real estate - construction		2,018		3,885		62,803		68,706		98,077		166,783		—
Real estate - mortgage:
1-4 family residential		2,105		1,461		21,978		25,544		352,063		377,607		—
Commercial		5,965		4,059		32,309		42,333		318,144		360,477		—
Consumer		369		5		319		693		45,060		45,753		—
Total	$	10,795	$	10,206	$	121,595	$	142,596	$	875,678	$	1,018,274	$	—

The following table presents an aging analysis of accruing and nonaccruing loans as of December 31, 2010:

	Past Due								Current		Total Loans		90 or More Days Past Due and Accruing
(dollars in thousands)	30-59 Days		60-89 Days		90 or More Days		Total
Commercial and agricultural	$	1,610	$	3,622	$	5,186	$	10,418	$	83,329	$	93,747	$	48
Real estate - construction		21,687		10,532		98,099		130,318		146,658		276,976		212
Real estate - mortgage:
1-4 family residential		11,199		7,016		22,505		40,720		348,139		388,859		4,167
Commercial		9,798		12,430		74,271		96,499		398,362		494,861		380
Consumer		199		44		160		403		49,129		49,532		11
Total	$	44,493	$	33,644	$	200,221	$	278,358	$	1,025,617	$	1,303,975	$	4,818

A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments or principal and interest when due according to the contractual terms of the loan agreement. The following table presents impaired loans, segregated by portfolio segment, and the corresponding reserve for impaired loan losses as of June 30, 2011:

(dollars in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:
Commercial and agricultural	$	2,452	$	3,521	$	—
Real estate - construction		41,846		66,966		—
Real estate - mortgage:
1-4 family residential		14,626		16,655		—
Commercial		36,536		49,153		—
Consumer		110		130		—
With an allowance recorded:
Commercial and agricultural	$	3,660	$	4,149	$	2,581
Real estate - construction		54,049		65,236		18,427
Real estate - mortgage:
1-4 family residential		18,772		20,581		5,286
Commercial		27,794		31,438		6,365
Consumer		440		442		395
Total:
Commercial and agricultural	$	6,112	$	7,670	$	2,581
Real estate - construction		95,895		132,202		18,427
Real estate - mortgage:
1-4 family residential		33,398		37,236		5,286
Commercial		64,330		80,591		6,365
Consumer		550		572		395

The following table presents impaired loans, segregated by portfolio segment, the corresponding reserve for impaired loan losses and the average recorded investment as of December 31, 2010:

(dollars in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment
With no related allowance recorded:
Commercial and agricultural	$	4,530	$	6,108	$	—	$	5,970
Real estate - construction		56,638		73,579		—		74,440
Real estate - mortgage:
1-4 family residential		26,737		29,173		—		29,720
Commercial		45,042		52,565		—		54,674
Consumer		205		207		—		192
With an allowance recorded:
Commercial and agricultural	$	9,707	$	11,054	$	7,451	$	8,228
Real estate - construction		95,890		112,858		35,281		86,329
Real estate - mortgage:
1-4 family residential		14,727		15,855		5,448		11,563
Commercial		87,716		96,436		22,708		84,015
Consumer		—		—		—		—
Total:
Commercial and agricultural	$	14,237	$	17,162	$	7,451	$	14,198
Real estate - construction		152,528		186,437		35,281		160,769
Real estate - mortgage:
1-4 family residential		41,464		45,028		5,448		41,283
Commercial		132,758		149,001		22,708		138,689
Consumer		205		207		—		192

Interest income recognized after the above loans became impaired was immaterial as of December 31, 2010.

Average recorded investment and interest income recognized on impaired loans, segregated by portfolio segment, is shown in the following table as of June 30, 2011:

	Three Months Ended June 30, 2011				Six Months Ended June 30, 2011
(dollars in thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial and agricultural	$	3,086	$	—	$	3,756	$	—
Real estate - construction		61,867		—		60,795		—
Real estate - mortgage:
1-4 family residential		19,685		1		20,692		1
Commercial		58,170		1		52,421		1
Consumer		161		—		249		—
With an allowance recorded:
Commercial and agricultural	$	5,879	$	—	$	6,738	$	—
Real estate - construction		60,059		—		65,267		—
Real estate - mortgage:
1-4 family residential		17,589		—		17,242		—
Commercial		32,829		1		64,386		1
Consumer		282		—		195		—
Total:
Commercial and agricultural	$	8,965	$	—	$	10,494	$	—
Real estate - construction		121,926		—		126,062		—
Real estate - mortgage:
1-4 family residential		37,274		1		37,934		1
Commercial		90,999		2		116,807		2
Consumer		443		—		444		—