
5.	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 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 or a recovery of previous provisions. 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 three months ended March 31, 2013 and 2012. 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 three months ended March 31, 2013 and 2012:



	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
Three months ended March 31, 2013	(in thousands)
Noncovered loans:
Commercial business
Secured	$	27,270	$	(988	)	$	79	$	510		$	26,871	$	67	$	26,804
Unsecured	753		(326		)	34		289			750		84		666
Real estate:
One-to-four family residential	694		(116		)	—		79			657		108		549
Commercial & multifamily residential
Commercial land	460		—			10		(37		)	433		—		433
Income property	11,033		(783		)	79		(918		)	9,411		18		9,393
Owner occupied	6,362		—			4		(908		)	5,458		34		5,424
Real estate construction:
One-to-four family residential
Land and acquisition	1,171		(32		)	2,139		(2,288		)	990		74		916
Residential construction	635		(101		)	—		4			538		—		538
Commercial & multifamily residential
Income property	316		—			—		66			382		—		382
Owner occupied	102		—			—		6			108		—		108
Consumer	2,437		(171		)	47		51			2,364		—		2,364
Unallocated	1,011		—			—		2,146			3,157		—		3,157
Total	$	52,244	$	(2,517	)	$	2,392	$	(1,000	)	$	51,119	$	385	$	50,734



	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
Three months ended March 31, 2012	(in thousands)
Noncovered loans:
Commercial business
Secured	$	24,745	$	(2,354	)	$	614	$	2,537		$	25,542	$	451	$	25,091
Unsecured	689		(5		)	44		58			786		141		645
Real estate:
One-to-four family residential	654		(116		)	43		108			689		72		617
Commercial & multifamily residential
Commercial land	488		(305		)	—		510			693		—		693
Income property	9,551		(2,008		)	18		2,688			10,249		1,087		9,162
Owner occupied	9,606		(365		)	53		(739		)	8,555		16		8,539
Real estate construction:
One-to-four family residential
Land and acquisition	2,331		(204		)	47		(503		)	1,671		—		1,671
Residential construction	864		—			—		138			1,002		18		984
Commercial & multifamily residential
Income property	665		—			—		(442		)	223		—		223
Owner occupied	35		—			—		9			44		—		44
Consumer	2,719		(1,093		)	373		130			2,129		—		2,129
Unallocated	694		—			—		6			700		—		700
Total	$	53,041	$	(6,450	)	$	1,192	$	4,500		$	52,283	$	1,785	$	50,498

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



	Three Months Ended
	March 31,
	2013		2012
	(in thousands)
Balance at beginning of period	$	1,915	$	1,535
Net changes in the allowance for unfunded commitments and letters of credit	—		130
Balance at end of period	$	1,915	$	1,665

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 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 March 31, 2013 and December 31, 2012:



	Pass		Special Mention		Substandard		Doubtful		Loss		Total
March 31, 2013	(in thousands)
Noncovered loans:
Commercial business:
Secured	$	1,062,881	$	31,333	$	63,004	$	—	$	—	$	1,157,218
Unsecured	44,087		70		158		—		—		44,315
Real estate:
One-to-four family residential	40,866		252		2,806		—		—		43,924
Commercial and multifamily residential:
Commercial land	44,229		115		3,794		—		—		48,138
Income property	625,209		1,918		28,595		—		—		655,722
Owner occupied	376,995		2,758		20,021		—		—		399,774
Real estate construction:
One-to-four family residential:
Land and acquisition	16,372		1,219		3,903		—		—		21,494
Residential construction	29,858		788		510		—		—		31,156
Commercial and multifamily residential:
Income property	24,479		—		—		—		—		24,479
Owner occupied	42,192		—		—		—		—		42,192
Consumer	147,957		29		4,813		—		1		152,800
Total	$	2,455,125	$	38,482	$	127,604	$	—	$	1	2,621,212
Less:
Allowance for loan and lease losses											51,119
Noncovered loans, net											$	2,570,093



	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 and lease losses											52,244
Noncovered loans, net											$	2,473,466