Covered Assets and FDIC Loss-sharing Asset

Covered Assets

Covered assets consist of loans and OREO acquired in certain FDIC-assisted acquisitions during 2010 and 2011, for which the Bank entered into loss-sharing agreements, whereby the FDIC will cover a substantial portion of future losses on loans (and related unfunded loan commitments), OREO and certain accrued interest on loans during the terms of the agreements. Under the terms of the loss-sharing agreements, the FDIC will absorb 80% of losses and share in 80% of loss recoveries up to specified amounts. With respect to loss-sharing agreements for two acquisitions completed in 2010, after those specified amounts, the FDIC will absorb 95% of losses and share in 95% of loss recoveries. The loss-sharing provisions of the agreements for commercial and single-family mortgage loans are in effect for five and ten years, respectively, from the acquisition dates and the loss recovery provisions are in effect for eight and ten years, respectively, from the acquisition dates.

Ten years and forty-five days after the acquisition dates, the Bank shall pay to the FDIC a clawback in the event the losses from the acquisitions fail to reach stated levels. The amount of the clawback is determined by a formula specified in each individual loss-sharing agreement. As of December 31, 2012 and 2011, the net present value of the Bank’s estimated clawback liability is $3.6 million and $3.7 million, respectively, which is included in other liabilities on the Consolidated Balance Sheet.

The following is an analysis of our covered loans, net of related allowance for losses as of December 31, 2012 and 2011:



	December 31, 2012		December 31, 2011
Covered loans:	(dollars in thousands)
Commercial business	$	125,373	$	195,737
Real estate:
One-to-four family residential	57,150		79,328
Commercial and multifamily residential	233,106		311,308
Total real estate	290,256		390,636
Real estate construction:
One-to-four family residential	25,398		54,402
Commercial and multifamily residential	15,251		23,661
Total real estate construction	40,649		78,063
Consumer	44,516		56,877
Subtotal of covered loans	500,794		721,313
Less:
Valuation discount resulting from acquisition accounting	79,401		184,440
Allowance for loan losses	30,056		4,944
Covered loans, net of valuation discounts and allowance for loan losses	$	391,337	$	531,929

Acquired impaired loans are accounted for under ASC 310-30 and initially measured at fair value based on expected future cash flows over the life of the loans. Acquired loans that have common risk characteristics are aggregated into pools. The Company remeasures contractual and expected cash flows, at the pool-level, on a quarterly basis.

Contractual cash flows are calculated based upon the loan pool terms after applying a prepayment factor. Calculation of the applied prepayment factor for contractual cash flows is the same as described below for expected cash flows.

Inputs to the determination of expected cash flows include cumulative default and prepayment data as well as loss severity and recovery lag information. Cumulative default and prepayment data are calculated via a transition matrix. The transition matrix is a matrix of probability values that specifies the probability of a loan pool transitioning into a particular delinquency state (e.g. 0-30 days past due, 31 to 60 days, etc.) given its delinquency state at the remeasurement date. Loss severity factors are based upon either actual charge-off data within the loan pools or industry averages and recovery lags are based upon the collateral within the loan pools.

Acquired impaired loans are also subject to the Company’s internal and external credit review and are risk rated using the same criteria as loans originated by the Company. However, risk ratings are not a clear indicator of losses on acquired loans as the loans were acquired with a significant discount and a majority of the losses are recoverable from the FDIC under the loss-sharing agreements.

Losses attributable to draws on acquired loans, advanced subsequent to the loan acquisition date, are accounted for under ASC 450-20 and those amounts are also subject to the Company’s internal and external credit review. An allowance for loan losses is estimated in a similar manner as the originated loan portfolio, and a provision for loan losses is charged to earnings as necessary.

The excess of cash flows expected to be collected over the initial fair value of acquired impaired loans is referred to as the accretable yield and is accreted into interest income over the estimated life of the acquired loans using the effective yield method. Other adjustments to the accretable yield include changes in the estimated remaining life of the acquired loans, changes in expected cash flows and changes of indices for acquired loans with variable interest rates.

The following table shows the changes in accretable yield for acquired loans for the years ended December 31, 2012, 2011, and 2010:



	Years Ended December 31,
	2012			2011			2010
	(in thousands)
Balance at beginning of period	$	259,669		$	256,572		$	—
Additions resulting from acquisitions	—			59,810			122,705
Accretion	(86,671		)	(90,378		)	(45,956		)
Disposals	(12,856		)	(31,483		)	(9,014		)
Reclassifications from nonaccretable difference	6,746			65,148			188,837
Balance at end of period	$	166,888		$	259,669		$	256,572

During the year ended December 31, 2012, the Company recorded a provision for losses on covered loans of $25.9 million. Of this amount, $29.4 million was impairment calculated in accordance with ASC 310-30 and $3.5 million was a provision recapture to adjust the allowance for loss calculated under ASC 450-20 for draws on acquired loans. The impact to earnings of the $25.9 million of provision recapture for covered loans was substantially offset through noninterest income by an increase in the FDIC loss-sharing asset. For the year ended December 31, 2011, the Company recorded a provision recapture for loan losses of $1.6 million which was partially offset by a decrease to the FDIC loss-sharing asset and for the year ended December 31, 2010, the Company recorded a provision for losses on covered loans of $6.1 million which was partially offset by an increase to the FDIC loss-sharing asset.

The changes in the ALLL for covered loans for the years ended December 31, 2012, 2011, and 2010 are summarized as follows:



	Years Ended December 31,
	2012			2011			2010
	(in thousands)
Balance at beginning of year	$	4,944		$	6,055		$	—
Loans charged off	(5,112		)	(1,488		)	—
Recoveries	4,332			2,025			—
Provision charged to expense	25,892			(1,648		)	6,055
Balance at end of year	$	30,056		$	4,944		$	6,055

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



	Pass		Special Mention		Substandard		Doubtful		Loss		Total
December 31, 2012	(in thousands)
Covered loans:
Commercial business:
Secured	$	71,621	$	1,823	$	45,150	$	—	$	—	$	118,594
Unsecured	4,988		—		1,791		—		—		6,779
Real estate:
One-to-four family residential	44,782		1,344		11,024		—		—		57,150
Commercial and multifamily residential:
Commercial land	16,336		—		10,292		—		—		26,628
Income property	81,205		864		23,315		—		—		105,384
Owner occupied	82,222		3,318		15,554		—		—		101,094
Real estate construction:
One-to-four family residential:
Land and acquisition	4,817		3,273		5,743		—		—		13,833
Residential construction	6,050		—		5,515		—		—		11,565
Commercial and multifamily residential:
Income property	4,419		—		7,901		—		—		12,320
Owner occupied	1,107		—		1,824		—		—		2,931
Consumer	38,973		381		5,162		—		—		44,516
Total	$	356,520	$	11,003	$	133,271	$	—	$	—	500,794
Less:
Valuation discount resulting from acquisition accounting											79,401
Allowance for loan losses											30,056
Covered loans, net											$	391,337



	Pass		Special Mention		Substandard		Doubtful		Loss		Total
December 31, 2011	(in thousands)
Covered loans:
Commercial business:
Secured	$	103,472	$	6,239	$	73,793	$	1,209	$	1	$	184,714
Unsecured	7,608		741		2,659		15		—		11,023
Real estate:
One-to-four family residential	56,948		2,210		20,170		—		—		79,328
Commercial and multifamily residential:
Commercial land	21,947		1,213		21,027		—		—		44,187
Income property	109,339		4,013		35,567		—		—		148,919
Owner occupied	89,555		3,673		24,974		—		—		118,202
Real estate construction:
One-to-four family residential:
Land and acquisition	4,834		1,535		17,646		1,289		—		25,304
Residential construction	8,264		371		20,463		—		—		29,098
Commercial and multifamily residential:
Income property	2,928		2,779		13,657		—		—		19,364
Owner occupied	1,142		—		3,155		—		—		4,297
Consumer	48,067		255		8,150		357		48		56,877
Total	$	454,104	$	23,029	$	241,261	$	2,870	$	49	721,313
Less:
Valuation discount resulting from acquisition accounting											184,440
Allowance for loan losses											4,944
Covered loans, net											$	531,929

The Company did not acquire any loans accounted for under ASC 310-30 during 2012. The following table shows loans acquired during 2011 for which it was probable at acquisition that all contractually required payments would not be collected:



	First Heritage Bank			Summit Bank
	May 27, 2011			May 20, 2011
	(in thousands)
Contractually required payments of interest and principal	$	151,611		$	127,823
Nonaccretable difference	(34,052		)	(34,301		)
Cash flows expected to be collected(1)	117,559			93,522
Accretable yield	(36,071		)	(23,739		)
Carrying value of acquired loans	$	81,488		$	69,783

_________

(1) Represents undiscounted expected principal and interest cash flows

The following table sets forth activity in covered OREO at carrying value for the years ended December 31, 2012 and 2011:



	December 31, 2012			December 31, 2011
	(in thousands)
Covered OREO:
Balance, beginning of period	$	28,126		$	14,443
Established through acquisitions	—			10,387
Transfers in	14,166			15,522
OREO improvements	—			5
Additional OREO write-downs	(3,484		)	(666		)
Proceeds from sale of OREO property	(33,315		)	(20,619		)
Net gain on sale of OREO	10,818			9,054
Total covered OREO, end of period	$	16,311		$	28,126

The covered OREO is covered by loss-sharing agreements with the FDIC in which the FDIC will assume 80% of additional write-downs and losses on covered OREO sales, or 95%, if applicable, of additional write-downs and losses on covered OREO sales if the minimum loss share thresholds are met.

FDIC Loss-sharing Asset

At December 31, 2012 and 2011, the FDIC loss-sharing asset is comprised of an FDIC indemnification asset of $87.7 million and $157.5 million, respectively, and an FDIC receivable of $8.6 million and $17.6 million, respectively. The indemnification represents the cash flows the Company expects to collect from the FDIC under the loss-sharing agreements and the FDIC receivable represents the reimbursable amounts from the FDIC that have not yet been received.

For covered loans, the Company remeasures contractual and expected cash flows on a quarterly basis. When the quarterly remeasurement process results in a decrease in expected cash flows due to an increase in expected credit losses, impairment is recorded. As a result of this impairment, the indemnification asset is increased to reflect anticipated future cash to be received from the FDIC. Consistent with the loss-sharing agreements between the Company and the FDIC, the amount of the increase to the indemnification asset is measured as 80% of the resulting impairment.

Alternatively, when the quarterly remeasurement results in an increase in expected future cash flows due to a decrease in expected credit losses, the nonaccretable difference decreases and the effective yield of the related loan portfolio is increased. As a result of the improved expected cash flows, the indemnification asset would be reduced first by the amount of any impairment previously recorded and, second, by increased amortization over the remaining life of the related loss-sharing agreement.

The following table shows a detailed analysis of the FDIC-loss sharing asset for the years ending December 31, 2012 and 2011:



	2012			2011 (1)
	(in thousands)
Balance at beginning of period	$	175,071		$	205,991
Adjustments not reflected in income:
Established through acquisitions	—			68,734
Cash received from the FDIC	(54,649		)	(54,200		)
FDIC reimbursable losses, net	399			4,042
Adjustments reflected in income:
Amortization, net	(42,940		)	(46,049		)
Loan impairment (recapture)	20,714			(1,318		)
Sale of other real estate	(7,789		)	(4,346		)
Write-downs of other real estate	5,190			1,474
Other	358			743
Balance at end of period	$	96,354		$	175,071