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 March 31, 2013, the net present value of the Bank’s estimated clawback liability is $3.8 million, which is included in other liabilities on the consolidated balance sheets.

The following is an analysis of our covered loans, net of related allowance for losses as of March 31, 2013 and December 31, 2012:



	March 31, 2013		December 31, 2012
Covered loans:	(dollars in thousands)
Commercial business	$	113,876	$	125,373
Real estate:
One-to-four family residential	49,639		57,150
Commercial and multifamily residential	220,037		233,106
Total real estate	269,676		290,256
Real estate construction:
One-to-four family residential	22,165		25,398
Commercial and multifamily residential	14,032		15,251
Total real estate construction	36,197		40,649
Consumer	42,103		44,516
Subtotal of covered loans	461,852		500,794
Less:
Valuation discount resulting from acquisition accounting	69,150		79,401
Allowance for loan losses	29,489		30,056
Covered loans, net of allowance for loan losses	$	363,213	$	391,337

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 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 three months ended March 31, 2013 and 2012:



	Three Months Ended March 31,
	2013			2012
	(in thousands)
Balance at beginning of period	$	166,888		$	259,669
Accretion	(14,477		)	(27,658		)
Disposals	(774		)	(1,799		)
Reclassifications from nonaccretable difference	7,149			9,465
Balance at end of period	$	158,786		$	239,677

During the three months ended March 31, 2013, the Company recorded a provision expense for losses on covered loans of $980 thousand. Of this amount, $1.3 million was impairment expense calculated in accordance with ASC 310-30 and $300 thousand 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 $980 thousand of provision expense for covered loans was partially offset through noninterest income by a $784 thousand increase in the FDIC loss-sharing asset.

The changes in the ALLL for covered loans for the three months ended March 31, 2013 and 2012 are summarized as follows:



	Three Months Ended March 31,
	2013			2012
	(in thousands)
Balance at beginning of period	$	30,056		$	4,944
Loans charged off	(2,382		)	(562		)
Recoveries	835			437
Provision charged to expense	980			15,685
Balance at end of period	$	29,489		$	20,504

The following is an analysis of the credit quality of our covered loan portfolio as of March 31, 2013 and 2012:



	Pass		Special Mention		Substandard		Doubtful		Loss		Total
March 31, 2013	(in thousands)
Covered loans:
Commercial business:
Secured	$	71,555	$	1,672	$	34,476	$	—	$	—	$	107,703
Unsecured	4,502		—		1,671		—		—		6,173
Real estate:
One-to-four family residential	40,030		331		9,278		—		—		49,639
Commercial and multifamily residential:
Commercial land	16,047		—		9,456		—		—		25,503
Income property	82,120		3,232		16,189		—		—		101,541
Owner occupied	76,454		398		16,141		—		—		92,993
Real estate construction:
One-to-four family residential:
Land and acquisition	6,449		2,796		4,892		—		—		14,137
Residential construction	2,812		—		5,216		—		—		8,028
Commercial and multifamily residential:
Income property	4,374		—		7,079		—		—		11,453
Owner occupied	1,099		—		1,480		—		—		2,579
Consumer	37,255		419		4,402		27		—		42,103
Total	$	342,697	$	8,848	$	110,280	$	27	$	—	461,852
Less:
Valuation discount resulting from acquisition accounting											69,150
Allowance for loan losses											29,489
Covered loans, net											$	363,213



	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

The following table sets forth activity in covered OREO at carrying value for the three months ended March 31, 2013 and 2012:



	Three Months Ended March 31,
	2013			2012
	(in thousands)
Covered OREO:
Balance at beginning of period	$	16,311		$	28,126
Transfers in	1,405			2,468
Additional OREO write-downs	(65		)	(1,505		)
Proceeds from sale of OREO property	(6,438		)	(8,025		)
Net gain on sale of OREO	2,598			3,366
Total covered OREO at end of period	$	13,811		$	24,430

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

FDIC Loss-sharing Asset

At March 31, 2013, the FDIC loss-sharing asset is comprised of a $75.5 million FDIC indemnification asset and a $7.6 million FDIC receivable. 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 three months ended March 31, 2013 and 2012:



	Three Months Ended March 31,
	2013			2012 (1)
	(in thousands)
Balance at beginning of period	$	96,354		$	175,071
Adjustments not reflected in income
Cash received from the FDIC	(3,119		)	(14,804		)
FDIC reimbursable losses, net	363			462
Adjustments reflected in income
Amortization, net	(9,779		)	(13,873		)
Loan impairment	784			12,548
Sale of other real estate	(1,346		)	(2,067		)
Write-downs of other real estate	52			1,629
Other	(194		)	95
Balance at end of period	$	83,115		$	159,061

__________

(1) Reclassified to conform to the current period’s presentation.