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 September 30, 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 September 30, 2013 and December 31, 2012:



	September 30, 2013		December 31, 2012
Covered loans:	(dollars in thousands)
Commercial business	$	87,366	$	125,373
Real estate:
One-to-four family residential	44,966		57,150
Commercial and multifamily residential	181,634		233,106
Total real estate	226,600		290,256
Real estate construction:
One-to-four family residential	16,018		25,398
Commercial and multifamily residential	7,146		15,251
Total real estate construction	23,164		40,649
Consumer	37,212		44,516
Subtotal of covered loans	374,342		500,794
Less:
Valuation discount resulting from acquisition accounting	49,445		79,401
Allowance for loan losses	22,737		30,056
Covered loans, net of allowance for loan losses	$	302,160	$	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 and nine months ended September 30, 2013 and 2012:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	(in thousands)
Balance at beginning of period	$	140,511		$	214,061		$	166,888		$	259,669
Accretion	(12,243		)	(19,571		)	(40,240		)	(69,045		)
Disposals	(5,772		)	(3,146		)	(621		)	(8,218		)
Reclassifications from nonaccretable difference	(3,013		)	(2,861		)	(6,544		)	6,077
Balance at end of period	$	119,483		$	188,483		$	119,483		$	188,483

During the nine months ended September 30, 2013, the Company recorded a provision recapture for losses on covered loans of $1.7 million. Of this amount, $929 thousand was impairment recapture calculated in accordance with ASC 310-30 and $750 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 $1.7 million of provision recapture for covered loans was partially offset through noninterest income by a $1.3 million unfavorable adjustment to the change FDIC loss-sharing asset line item.

The changes in the ALLL for covered loans for the three and nine months ended September 30, 2013 and 2012 are summarized as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	(in thousands)
Balance at beginning of period	$	26,135		$	31,784		$	30,056		$	4,944
Loans charged off	(5,006		)	(977		)	(10,031		)	(2,574		)
Recoveries	2,555			2,342			4,391			3,406
Provision (recovery) for loan losses	(947		)	(3,992		)	(1,679		)	23,381
Balance at end of period	$	22,737		$	29,157		$	22,737		$	29,157

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



	Pass		Special Mention		Substandard		Doubtful		Loss		Total
September 30, 2013	(in thousands)
Covered loans:
Commercial business:
Secured	$	56,973	$	2,859	$	24,025	$	—	$	—	$	83,857
Unsecured	3,018		396		95		—		—		3,509
Real estate:
One-to-four family residential	36,419		1,854		6,693		—		—		44,966
Commercial and multifamily residential:
Commercial land	11,978		205		7,796		—		—		19,979
Income property	59,736		3,966		11,907		—		—		75,609
Owner occupied	73,045		114		12,887		—		—		86,046
Real estate construction:
One-to-four family residential:
Land and acquisition	4,688		2,759		2,398		—		—		9,845
Residential construction	2,587		—		3,586		—		—		6,173
Commercial and multifamily residential:
Income property	3,847		—		1,936		—		—		5,783
Owner occupied	1,083		—		280		—		—		1,363
Consumer	33,421		35		3,729		27		—		37,212
Total	$	286,795	$	12,188	$	75,332	$	27	$	—	374,342
Less:
Valuation discount resulting from acquisition accounting											49,445
Allowance for loan losses											22,737
Covered loans, net											$	302,160



	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 and nine months ended September 30, 2013 and 2012:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	(in thousands)
Covered OREO:
Balance at beginning of period	$	12,854		$	19,079		$	16,311		$	28,126
Transfers in	3,559			3,096			8,089			8,497
Additional OREO write-downs	(199		)	(730		)	(293		)	(2,769		)
Proceeds from sale of OREO property	(5,408		)	(6,822		)	(19,222		)	(25,202		)
Net gain on sale of OREO	1,924			1,888			7,845			7,859
Total covered OREO at end of period	$	12,730		$	16,511		$	12,730		$	16,511

The covered OREO is subject to 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 September 30, 2013, the FDIC loss-sharing asset is comprised of a $48.4 million FDIC indemnification asset and a $5.2 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 and nine months ended September 30, 2013 and 2012:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	(in thousands)
Balance at beginning of period	$	67,374		$	140,003		$	96,354		$	175,071
Adjustments not reflected in income
Cash received from the FDIC	(1,484		)	(14,881		)	(7,871		)	(49,194		)
FDIC reimbursable losses, net	(505		)	(494		)	522			587
Adjustments reflected in income
Amortization, net	(9,890		)	(9,694		)	(29,470		)	(33,418		)
Loan impairment (recapture)	(758		)	(3,193		)	(1,343		)	18,705
Sale of other real estate	(1,479		)	(1,315		)	(5,076		)	(4,881		)
Write-downs of other real estate	220			1,141			373			4,503
Other	81			110			70			304
Balance at end of period	$	53,559		$	111,677		$	53,559		$	111,677