
	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.

The $4.3 million provision expense reflects a change in estimate for the allowance for loan losses for loans acquired in the West Coast Bank transaction. The change was the result of moving from the initial fair value accounting for those loans, which included a net loan discount of $88.8 million, to our standard allowance methodology. Our standard allowance methodology takes into account the $19.7 million in net loan discount accretion recorded in earnings subsequent to the acquisition. The provision resulted in a $2.8 million reduction to net income and reduced earnings per diluted common share by $0.05 and $0.06 for the current quarter and year-to-date period, respectively.

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 nine months ended September 30, 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 and nine months ended September 30, 2013 and 2012:



	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
Three months ended September 30, 2013	(in thousands)
Noncovered loans:
Commercial business
Secured	$	30,572	$	(392	)	$	743	$	3,187		$	34,110	$	241	$	33,869
Unsecured	821		(363		)	111		491			1,060		43		1,017
Real estate:
One-to-four family residential	672		(47		)	39		677			1,341		103		1,238
Commercial & multifamily residential
Commercial land	691		(9		)	126		(260		)	548		—		548
Income property	9,695		(132		)	154		85			9,802		—		9,802
Owner occupied	4,515		(516		)	52		637			4,688		26		4,662
Real estate construction:
One-to-four family residential
Land and acquisition	769		—			366		(410		)	725		73		652
Residential construction	204		—			95		426			725		—		725
Commercial & multifamily residential
Income property	241		—			—		17			258		—		258
Owner occupied	80		—			—		(12		)	68		—		68
Consumer	2,455		(453		)	112		405			2,519		—		2,519
Unallocated	983		—			—		(983		)	—		—		—
Total	$	51,698	$	(1,912	)	$	1,798	$	4,260		$	55,844	$	486	$	55,358
	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
Nine months ended September 30, 2013	(in thousands)
Noncovered loans:
Commercial business
Secured	$	27,270	$	(2,236	)	$	1,135	$	7,941		$	34,110	$	241	$	33,869
Unsecured	753		(794		)	184		917			1,060		43		1,017
Real estate:
One-to-four family residential	694		(191		)	180		658			1,341		103		1,238
Commercial & multifamily residential
Commercial land	460		(20		)	153		(45		)	548		—		548
Income property	11,033		(950		)	260		(541		)	9,802		—		9,802
Owner occupied	6,362		(1,084		)	96		(686		)	4,688		26		4,662
Real estate construction:
One-to-four family residential
Land and acquisition	1,171		(32		)	2,541		(2,955		)	725		73		652
Residential construction	635		(101		)	108		83			725		—		725
Commercial & multifamily residential
Income property	316		—			—		(58		)	258		—		258
Owner occupied	102		—			—		(34		)	68		—		68
Consumer	2,437		(1,262		)	353		991			2,519		—		2,519
Unallocated	1,011		—			—		(1,011		)	—		—		—
Total	$	52,244	$	(6,670	)	$	5,010	$	5,260		$	55,844	$	486	$	55,358



	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
Three months ended September 30, 2012	(in thousands)
Noncovered loans:
Commercial business
Secured	$	26,505	$	(3,744	)	$	194	$	3,007		$	25,962	$	315	$	25,647
Unsecured	772		(31		)	83		(56		)	768		100		668
Real estate:
One-to-four family residential	673		(49		)	157		(216		)	565		69		496
Commercial & multifamily residential
Commercial land	270		(55		)	—		207			422		1		421
Income property	8,726		(436		)	357		387			9,034		—		9,034
Owner occupied	9,037		(101		)	89		(694		)	8,331		245		8,086
Real estate construction:
One-to-four family residential
Land and acquisition	1,651		(307		)	404		(279		)	1,469		—		1,469
Residential construction	1,197		(18		)	—		3			1,182		—		1,182
Commercial & multifamily residential
Income property	755		—			63		(456		)	362		—		362
Owner occupied	68		—			—		23			91		—		91
Consumer	2,049		(500		)	350		267			2,166		—		2,166
Unallocated	493		—			—		682			1,175		—		1,175
Total	$	52,196	$	(5,241	)	$	1,697	$	2,875		$	51,527	$	730	$	50,797
	Beginning Balance		Charge-offs			Recoveries		Provision (Recovery)			Ending Balance		Specific Reserve		General Allocation
Nine months ended September 30, 2012	(in thousands)
Noncovered loans:
Commercial business
Secured	$	24,745	$	(8,126	)	$	1,184	$	8,159		$	25,962	$	315	$	25,647
Unsecured	689		(52		)	130		1			768		100		668
Real estate:
One-to-four family residential	654		(499		)	202		208			565		69		496
Commercial & multifamily residential
Commercial land	488		(437		)	—		371			422		1		421
Income property	9,551		(3,959		)	710		2,732			9,034		—		9,034
Owner occupied	9,606		(712		)	628		(1,191		)	8,331		245		8,086
Real estate construction:
One-to-four family residential
Land and acquisition	2,331		(809		)	827		(880		)	1,469		—		1,469
Residential construction	864		(617		)	79		856			1,182		—		1,182
Commercial & multifamily residential
Income property	665		(93		)	64		(274		)	362		—		362
Owner occupied	35		—			—		56			91		—		91
Consumer	2,719		(1,968		)	809		606			2,166		—		2,166
Unallocated	694		—			—		481			1,175		—		1,175
Total	$	53,041	$	(17,272	)	$	4,633	$	11,125		$	51,527	$	730	$	50,797

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



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2013		2012		2013		2012
	(in thousands)
Balance at beginning of period	$	2,465	$	1,665	$	1,915	$	1,535
Net changes in the allowance for unfunded commitments and letters of credit	200		250		750		380
Balance at end of period	$	2,665	$	1,915	$	2,665	$	1,915

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.

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.

Pass loans are generally considered to have sufficient sources of repayment in order to repay the loan in full in accordance with all terms and conditions. Special mention loans have 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. 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. Substandard loans reflect loans where a loss is possible if loan weaknesses are not corrected. Doubtful loans have a high probability of loss, however, the amount of loss has not yet been determined. Loss loans are considered uncollectable and when identified, are charged off.

The following is an analysis of the credit quality of our noncovered loan portfolio as of September 30, 2013 and December 31, 2012:



	Pass		Special Mention		Substandard		Doubtful		Loss		Total
September 30, 2013	(in thousands)
Noncovered loans:
Commercial business:
Secured	$	1,362,097	$	38,018	$	87,232	$	—	$	1	$	1,487,348
Unsecured	74,705		23		260		—		—		74,988
Real estate:
One-to-four family residential	94,947		1,687		7,455		—		—		104,089
Commercial and multifamily residential:
Commercial land	128,624		2,140		4,068		—		—		134,832
Income property	1,097,644		7,304		35,357		—		150		1,140,455
Owner occupied	721,373		1,521		18,000		—		—		740,894
Real estate construction:
One-to-four family residential:
Land and acquisition	8,003		172		4,065		—		—		12,240
Residential construction	34,950		3,980		1,457		—		—		40,387
Commercial and multifamily residential:
Income property	87,791		—		249		—		—		88,040
Owner occupied	39,064		—		—		—		—		39,064
Consumer	324,274		331		6,789		—		1		331,395
Total	$	3,973,472	$	55,176	$	164,932	$	—	$	152	4,193,732
Less:
Allowance for loan and lease losses											55,844
Noncovered loans, net											$	4,137,888



	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