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 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 based upon the consideration of an appropriate look back period.

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 marketplace, 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 2012, 2011 and 2010. 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.

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 years ended December 31, 2012, 2011 and 2010:



	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
Year ended December 31, 2012	(in thousands)
Noncovered loans:
Commercial business:
Secured	$	24,745	$	(10,029	)	$	1,354	$	11,200		$	27,270	$	113	$	27,157
Unsecured	689		(144		)	194		14			753		92		661
Real estate:
One-to-four family residential	654		(549		)	285		304			694		112		582
Commercial and multifamily residential:
Commercial land	488		(526		)	63		435			460		—		460
Income property	9,551		(4,030		)	905		4,607			11,033		1,040		9,993
Owner occupied	9,606		(918		)	631		(2,957		)	6,362		38		6,324
Real estate construction:
One-to-four family residential:
Land and acquisition	2,331		(989		)	1,059		(1,230		)	1,171		—		1,171
Residential construction	864		(617		)	429		(41		)	635		—		635
Commercial and multifamily residential:
Income property	665		(93		)	66		(322		)	316		—		316
Owner occupied	35		—			—		67			102		—		102
Consumer	2,719		(2,534		)	1,171		1,081			2,437		—		2,437
Unallocated	694		—			—		317			1,011		—		1,011
Total	$	53,041	$	(20,429	)	$	6,157	$	13,475		$	52,244	$	1,395	$	50,849



	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
Year Ended December 31, 2011	(in thousands)
Noncovered loans:
Commercial business:
Secured	$	21,811	$	(7,270	)	$	1,154	$	9,050		$	24,745	$	954	$	23,791
Unsecured	738		(639		)	1,444		(854		)	689		97		592
Real estate:
One-to-four family residential	1,100		(717		)	80		191			654		96		558
Commercial and multifamily residential:
Commercial land	634		(660		)	12		502			488		—		488
Income property	15,210		(1,407		)	414		(4,666		)	9,551		63		9,488
Owner occupied	9,692		(1,620		)	33		1,501			9,606		185		9,421
Real estate construction:
One-to-four family residential:
Land and acquisition	3,769		(1,419		)	1,978		(1,997		)	2,331		—		2,331
Residential construction	2,292		(1,068		)	113		(473		)	864		59		805
Commercial and multifamily residential:
Income property	274		(2,213		)	—		2,604			665		—		665
Owner occupied	70		—			—		(35		)	35		—		35
Consumer	2,120		(3,918		)	351		4,166			2,719		30		2,689
Unallocated	3,283		—			—		(2,589		)	694		—		694
Total	$	60,993	$	(20,931	)	$	5,579	$	7,400		$	53,041	$	1,484	$	51,557



	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)		Ending Balance		Specific Reserve		General Allocation
Year ended December 31, 2010	(in thousands)
Noncovered loans:
Commercial business:
Secured	$	20,409	$	(12,779	)	$	1,218	$	12,963	$	21,811	$	600	$	21,211
Unsecured	1,560		(2,100		)	1,171		107		738		75		663
Real estate:
One-to-four family residential	1,072		(406		)	15		419		1,100		—		1,100
Commercial and multifamily residential:
Commercial land	664		(2,165		)	—		2,135		634		—		634
Income property	9,860		(1,969		)	124		7,195		15,210		59		15,151
Owner occupied	6,690		(2,039		)	2		5,039		9,692		—		9,692
Real estate construction:
One-to-four family residential:
Land and acquisition	5,711		(8,409		)	1,199		5,268		3,769		3		3,766
Residential construction	2,304		(2,447		)	474		1,961		2,292		62		2,230
Commercial and multifamily residential:
Income property	2,453		(3,107		)	775		153		274		175		99
Owner occupied	36		—			—		34		70		—		70
Consumer	1,282		(3,982		)	649		4,171		2,120		—		2,120
Unallocated	1,437		—			—		1,846		3,283		—		3,283
Total	$	53,478	$	(39,403	)	$	5,627	$	41,291	$	60,993	$	974	$	60,019

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



	Years Ended December 31,
	2012		2011		2010
	(in thousands)
Beginning balance	$	1,535	$	1,165	$	775
Net changes in the allowance for unfunded commitments and letters of credit	380		370		390
Ending balance	$	1,915	$	1,535	$	1,165

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 indicates 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 indicates 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 nonaccrual 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 December 31, 2012 and 2011:



	Pass		Special Mention		Substandard		Doubtful		Loss		Total
December 31, 2012	(in thousands)
Noncovered loans:
Commercial business:
Secured	$	1,011,722	$	29,222	$	65,607	$	—	$	—	$	1,106,551
Unsecured	44,788		26		529		—		—		45,343
Real estate:
One-to-four family residential	40,346		406		3,440		—		—		44,192
Commercial and multifamily residential:
Commercial land	43,401		—		3,926		—		—		47,327
Income property	581,671		3,688		29,453		—		—		614,812
Owner occupied	357,063		1,848		36,262		—		—		395,173
Real estate construction:
One-to-four family residential:
Land and acquisition	12,741		1,351		4,404		—		—		18,496
Residential construction	28,705		1,142		1,817		—		—		31,664
Commercial and multifamily residential:
Income property	28,342		—		—		—		—		28,342
Owner occupied	36,211		—		—		—		—		36,211
Consumer	151,049		75		6,475		—		—		157,599
Total	$	2,336,039	$	37,758	$	151,913	$	—	$	—	2,525,710
Less:
Allowance for loan losses											52,244
Noncovered loans, net											$	2,473,466



	Pass		Special Mention		Substandard		Doubtful		Loss		Total
December 31, 2011	(in thousands)
Noncovered loans:
Commercial business:
Secured	$	908,883	$	18,703	$	53,447	$	384	$	—	$	981,417
Unsecured	46,732		318		356		—		—		47,406
Real estate:
One-to-four family residential	58,517		2,040		3,506		—		—		64,063
Commercial and multifamily residential:
Commercial land	44,166		5		6,510		—		—		50,681
Income property	492,922		16,002		25,069		—		—		533,993
Owner occupied	351,928		13,590		39,266		—		5		404,789
Real estate construction:
One-to-four family residential:
Land and acquisition	12,349		2,684		10,168		—		—		25,201
Residential construction	16,764		1,649		5,518		—		—		23,931
Commercial and multifamily residential:
Income property	12,812		—		8,065		—		—		20,877
Owner occupied	12,790		—		—		—		—		12,790
Consumer	176,304		859		6,060		—		—		183,223
Total	$	2,134,167	$	55,850	$	157,965	$	384	$	5	2,348,371
Less:
Allowance for loan losses											53,041
Noncovered loans, net											$	2,295,330