Allowance for Noncovered Loan and Lease Losses and Unfunded Commitments and Letters of Credit

We maintain an allowance for loan and lease losses (“ALLL”) to absorb losses inherent in the loan portfolio. The size of the ALLL is determined through quarterly assessments of the probable estimated losses in the loan portfolio. Our methodology for making such assessments and determining the adequacy of the ALLL includes the following key elements:


1.	General valuation allowance consistent with the Contingencies topic of the FASB Accounting Standards Codification ("ASC").


2.	Classified loss reserves on specific relationships. Specific allowances for identified problem loans are determined in accordance with the Receivables topic of the FASB ASC.


3.	The unallocated allowance provides for other factors inherent in our loan portfolio that may not have been contemplated in the general and specific components of the allowance. This unallocated amount generally comprises less than 5% of the allowance. The unallocated amount is reviewed quarterly based on trends in credit losses, the results of credit reviews and overall economic trends.

The general valuation allowance is systematically calculated quarterly using quantitative and qualitative information about specific loan classes. The minimum required level an entity develops a methodology to determine its allowance for loan and lease losses is by general categories of loans, such as commercial business, real estate, and consumer. However, the Company’s methodology in determining its allowance for loan and lease losses is prepared in a more detailed manner at the loan class level, utilizing specific categories such as commercial business secured, commercial business unsecured, real estate commercial land, and real estate income property multifamily. The quantitative information uses historical losses from a specific loan class and incorporates the loan’s risk rating migration from origination to the point of loss.

A loan’s risk rating is primarily determined based upon the borrower’s ability to fulfill its debt obligation from a cash flow perspective. In the event there is financial deterioration of the borrower, the borrower’s other sources of income or repayment are also considered, including recent appraisal values for collateral dependent loans. The qualitative information takes into account general economic and business conditions affecting our market place, seasoning of the loan portfolio, duration of the business cycle, etc. to ensure our methodologies reflect the current economic environment and other factors as using historical loss information exclusively may not give an accurate estimate of inherent losses within the Company’s loan portfolio.

When a loan is deemed to be impaired, the Company has to determine if a specific valuation allowance is required for that loan. The specific valuation allowance is a reserve, calculated at the individual loan level, for each loan determined to be both, impaired and containing a value less than its recorded investment. The Company measures the impairment based on the discounted expected future cash flows, observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependent or if foreclosure is probable. The specific reserve for each loan is equal to the difference between the recorded investment in the loan and its determined impairment value.

The ALLL is increased by provisions for loan and lease losses (“provision”) charged to expense, and is reduced by loans charged off, net of recoveries. While the Company’s management believes the best information available is used to determine the ALLL, changes in market conditions could result in adjustments to the ALLL, affecting net income, if circumstances differ from the assumptions used in determining the ALLL.

We have used the same methodology for ALLL calculations during the six months ended June 30, 2012 and 2011. Adjustments to the percentages of the ALLL allocated to loan categories are made based on trends with respect to delinquencies and problem loans within each class of loans. The Company reviews the ALLL quantitative and qualitative methodology on a quarterly basis and makes adjustments when appropriate. The Company continues to strive towards maintaining a conservative approach to credit quality and will continue to prudently adjust our ALLL as necessary in order to maintain adequate reserves. The Company carefully monitors the loan portfolio and continues to emphasize the importance of credit quality while continuously strengthening loan monitoring systems and controls.

Once it is determined that all or a portion of a loan balance is uncollectable, and the amount can be reasonably estimated, the uncollectable portion of the loan is charged-off.

The following tables show a detailed analysis of the allowance for loan and lease losses for noncovered loans for the three and six months ended June 30, 2012 and 2011:



	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
	(in thousands)
Three months ended June 30, 2012
Commercial business
Secured	$	25,542	$	(2,028	)	$	375	$	2,616		$	26,505	$	3,528	$	22,977
Unsecured	786		(16		)	3		(1		)	772		136		636
Real estate:
One-to-four family residential	689		(334		)	2		316			673		90		583
Commercial & multifamily residential
Commercial land	693		(77		)	—		(346		)	270		—		270
Income property multifamily	10,249		(1,515		)	336		(344		)	8,726		49		8,677
Owner occupied	8,555		(247		)	486		243			9,037		—		9,037
Real estate construction:
One-to-four family residential
Land and acquisition	1,671		(298		)	376		(98		)	1,651		—		1,651
Residential construction	1,002		(599		)	79		715			1,197		18		1,179
Commercial & multifamily residential
Income property multifamily	223		(93		)	1		624			755		443		312
Owner occupied	44		—			—		24			68		—		68
Consumer	2,129		(374		)	86		208			2,049		1		2,048
Unallocated	700		—			—		(207		)	493		—		493
Total	$	52,283	$	(5,581	)	$	1,744	$	3,750		$	52,196	$	4,265	$	47,931
	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
	(in thousands)
Six months ended June 30, 2012
Commercial business
Secured	$	24,745	$	(4,382	)	$	989	$	5,153		$	26,505	$	3,528	$	22,977
Unsecured	689		(21		)	47		57			772		136		636
Real estate:
One-to-four family residential	654		(449		)	45		423			673		90		583
Commercial & multifamily residential
Commercial land	488		(382		)	—		164			270		—		270
Income property multifamily	9,551		(3,522		)	354		2,343			8,726		49		8,677
Owner occupied	9,606		(612		)	538		(495		)	9,037		—		9,037
Real estate construction:
One-to-four family residential
Land and acquisition	2,331		(503		)	423		(600		)	1,651		—		1,651
Residential construction	864		(599		)	79		853			1,197		18		1,179
Commercial & multifamily residential
Income property multifamily	665		(93		)	1		182			755		443		312
Owner occupied	35		—			—		33			68		—		68
Consumer	2,719		(1,467		)	459		338			2,049		1		2,048
Unallocated	694		—			—		(201		)	493		—		493
Total	$	53,041	$	(12,030	)	$	2,935	$	8,250		$	52,196	$	4,265	$	47,931



	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
	(in thousands)
Three months ended June 30, 2011
Commercial business
Secured	$	22,307	$	(834	)	$	233	$	614		$	22,320	$	330	$	21,990
Unsecured	618		—			359		(404		)	573		72		501
Real estate:
One-to-four family residential	1,100		(216		)	—		(37		)	847		—		847
Commercial & multifamily residential
Commercial land	555		(656		)	—		995			894		—		894
Income property multifamily	12,297		(275		)	13		2,674			14,709		301		14,408
Owner occupied	10,412		(623		)	—		(3,310		)	6,479		286		6,193
Real estate construction:
One-to-four family residential
Land and acquisition	3,295		(410		)	700		(733		)	2,852		148		2,704
Residential construction	2,118		(395		)	—		(19		)	1,704		—		1,704
Commercial & multifamily residential
Income property multifamily	127		(1,078		)	—		994			43		—		43
Owner occupied	68		—			—		(34		)	34		—		34
Consumer	2,418		(271		)	45		556			2,748		161		2,587
Unallocated	—		—			—		854			854		—		854
Total	$	55,315	$	(4,758	)	$	1,350	$	2,150		$	54,057	$	1,298	$	52,759
	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
	(in thousands)
Six months ended June 30, 2011
Commercial business
Secured	$	21,811	$	(4,121	)	$	329	$	4,301		$	22,320	$	330	$	21,990
Unsecured	738		(84		)	368		(449		)	573		72		501
Real estate:
One-to-four family residential	1,100		(664		)	—		411			847		—		847
Commercial & multifamily residential
Commercial land	634		(656		)	—		916			894		—		894
Income property multifamily	15,210		(640		)	55		84			14,709		301		14,408
Owner occupied	9,692		(623		)	31		(2,621		)	6,479		286		6,193
Real estate construction:
One-to-four family residential
Land and acquisition	3,769		(1,178		)	1,768		(1,507		)	2,852		148		2,704
Residential construction	2,292		(1,054		)	36		430			1,704		—		1,704
Commercial & multifamily residential
Income property multifamily	274		(1,565		)	—		1,334			43		—		43
Owner occupied	70		—			—		(36		)	34		—		34
Consumer	2,120		(1,196		)	108		1,716			2,748		161		2,587
Unallocated	3,283		—			—		(2,429		)	854		—		854
Total	$	60,993	$	(11,781	)	$	2,695	$	2,150		$	54,057	$	1,298	$	52,759

Changes in the allowance for unfunded commitments and letters of credit are summarized as follows:



	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2012		2011			2012		2011
	(in thousands)
Balance at beginning of period	$	1,665	$	1,660		$	1,535	$	1,165
Net changes in the allowance for unfunded commitments and letters of credit	—		(200		)	130		295
Balance at end of period	$	1,665	$	1,460		$	1,665	$	1,460

Risk Elements

The extension of credit in the form of loans to individuals and businesses is one of our principal commerce activities. Our policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management. We manage our credit risk through lending limit constraints, credit review, approval policies and extensive, ongoing internal monitoring. We also manage credit risk through diversification of the loan portfolio by type of loan, type of industry, type of borrower and by limiting the aggregation of debt to a single borrower.

The monitoring process for the loan portfolio includes periodic reviews of individual loans with risk ratings assigned to each loan. Based on the analysis, loans are given a risk rating of 1-10 based on the following criteria:


•	ratings of 1-3 indicate minimal to low credit risk,


•	ratings of 4-5 indicate an average credit risk with adequate repayment capacity when prolonged periods of adversity do not exist,


•	rating of 6 indicate higher than average risk requiring greater than routine attention by bank personnel due to conditions affecting the borrower, the borrower's industry or economic environment,


•	rating of 7 indicate potential weaknesses that, if left uncorrected, may result in deterioration of the repayment prospects for the asset or in the Company's credit position at some future date,


•	rating of 8 indicates a loss is possible if loan weaknesses are not corrected,


•	rating of 9 indicates loss is highly probable; however, the amount of loss has not yet been determined,


•	and a rating of 10 indicates the loan is uncollectable, and when identified is charged-off.

Loans with a risk rating of 1-6 are considered Pass loans and loans with risk ratings of 7, 8, 9 and 10 are considered Special Mention, Substandard, Doubtful and Loss, respectively. Loans with a risk rating of Substandard or worse are reported as classified loans in our allowance for loan and lease losses analysis. We review these loans to assess the ability of our borrowers to service all interest and principal obligations and, as a result, the risk rating may be adjusted accordingly. Risk ratings are reviewed and updated whenever appropriate, with more periodic reviews as the risk and dollar value of loss on the loan increases. In the event full collection of principal and interest is not reasonably assured, the loan is appropriately downgraded and, if warranted, placed on non-accrual status even though the loan may be current as to principal and interest payments. Additionally, we assess whether an impairment of a loan warrants specific reserves or a write-down of the loan.

The following is an analysis of the credit quality of our noncovered loan portfolio as of June 30, 2012 and December 31, 2011:



	June 30, 2012			December 31, 2011
	Weighted- Average Risk Rating	Recorded Investment Noncovered Loans		Weighted- Average Risk Rating	Recorded Investment Noncovered Loans
	(dollars in thousands)
Commercial business
Secured	4.87	$	1,062,863	4.89	$	981,417
Unsecured	4.31	45,273		4.25	47,406
Real estate:
One-to-four family residential	4.73	56,015		4.81	64,063
Commercial & multifamily residential
Commercial land	5.12	44,886		5.22	50,681
Income property multifamily	4.85	580,029		4.94	533,993
Owner occupied	5.05	384,971		5.05	404,789
Real estate construction:
One-to-four family residential
Land and acquisition	6.08	20,556		6.43	25,201
Residential construction	5.74	26,224		5.94	23,931
Commercial & multifamily residential
Income property multifamily	4.89	26,568		5.49	20,877
Owner occupied	4.59	22,122		4.55	12,790
Consumer	4.22	167,454		4.24	183,223
Total recorded investment of noncovered loans		$	2,436,961		$	2,348,371