NOTE 3: LOANS AND ALLOWANCE FOR LOAN LOSSES

We extend commercial and consumer credit primarily to customers in the states of Oklahoma, Texas, Kansas, and Colorado. Our commercial lending operations are concentrated in Oklahoma City, Tulsa, Dallas, Wichita, and other metropolitan markets in Oklahoma, Texas, Kansas, and Colorado. As a result, the collectability of our loan portfolio can be affected by changes in the economic conditions in those states and markets. See “Note 9: Operating Segments” in the Notes to Unaudited Consolidated Financial Statements for more detail regarding loans by market. At March 31, 2017 and December 31, 2016, substantially all of our loans were collateralized with real estate, inventory, accounts receivable, and/or other assets or were guaranteed by agencies of the United States government.

Our loan classifications were as follows:




(Dollars in thousands)	At March 31, 2017		At December 31, 2016
Real estate mortgage:
Commercial	$	925,458	$	882,071
One-to-four family residential		210,495		199,123
Real estate construction:
Commercial		193,937		199,113
One-to-four family residential		18,426		20,946
Commercial		570,001		556,248
Installment and consumer		18,126		19,631
		1,936,443		1,877,132
Less: Allowance for loan losses		(27,543)		(27,546)
Total loans, net		1,908,900		1,849,586
Less: Loans held for sale (included above)		(4,980)		(4,386)
Net loans receivable	$	1,903,920	$	1,845,200

Concentrations of Credit. At March 31, 2017, $625.9 million, or 32%, and $431.6 million, or 22%, of our loans consisted of loans to individuals and businesses in the real estate and healthcare industries, respectively. We do not have any other concentrations of loans to individuals or businesses involved in a single industry totaling 10% or more of total loans.

Loans Held for Sale. We had loans held for sale of $5.0 million and $4.4 million at March 31, 2017 and December 31, 2016, respectively. The loans currently classified as held for sale, primarily residential mortgage loans, are carried at the lower of cost or market value. A substantial portion of our one-to-four family residential loans and loan servicing rights are sold to one buyer. These mortgage loans are generally sold within a one-month period from loan closing at amounts determined by the investor commitment based upon the pricing of the loan. These loans are available for sale in the secondary market.

Loan Servicing. We earn fees for servicing real estate mortgages and other loans owned by others. The fees are generally calculated on the outstanding principal balance of the loans serviced and are recorded as noninterest income when earned. The unpaid principal balance of real estate mortgage loans serviced for others totaled $459.0 million and $460.6 million at March 31, 2017 and December 31, 2016, respectively. Loan servicing rights are capitalized based on estimated fair value at the point of origination. The servicing rights are amortized over the period of estimated net servicing income.

Acquired Loans. On October 9, 2015, we completed the acquisition of First Commercial Bancshares (“Bancshares”) by merging Bancshares with and into us (the “Bancshares Merger”). In connection with the Bancshares Merger, First Commercial Bank was merged with and into Bank SNB, with Bank SNB being the surviving bank. We evaluated $200.0 million of the loans purchased in conjunction with the merger in accordance with the provisions of FASB ASC Topic 310-20, Nonrefundable Fees and Other Costs, and those loans were recorded with a $4.5 million discount. As a result, the fair value discount on these loans is being accreted into interest income over the weighted average life of the loans using a constant yield method. The remaining $7.8 million of loans evaluated were considered purchased credit impaired loans within the provisions of FASB ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, and were recorded with a $3.3 million discount. These purchased credit impaired loans will recognize interest income through accretion of the difference between the carrying amount of the loans and the expected cash flows.

Changes in the carrying amounts and accretable yields for all ACS 310-30 loans that were acquired were as follows for the three months ended March 31, 2017 and March 31, 2016:



	For the three months ended March 31,
	2017					2016
			Carrying				Carrying
	Accretable		amount		Accretable		amount
(Dollars in thousands)	Yield		of loans		Yield		of loans
Balance at beginning of period	$	630	$	4,632	$	807	$	7,914
Payments received		-		(815)				(504)
Net charge-offs		-		-		-		(122)
Accretion		(143)		-		(65)		-
Balance at end of period	$	487	$	3,817	$	742	$	7,288

Nonperforming / Past Due Loans. We identify past due loans based on contractual terms on a loan-by-loan basis and generally place loans, except for consumer loans, on nonaccrual when any portion of the principal or interest is ninety days past due and collateral is insufficient to discharge the debt in full. Interest accrual may also be discontinued earlier if, in management’s opinion, collection is unlikely. Generally, past due consumer installment loans are not placed on nonaccrual but are charged-off when they are four months past due. Accrued interest is written off when a loan is placed on nonaccrual status. Subsequent interest income is recorded when cash receipts are received from the borrower and collectability of the principal amount is reasonably assured.

Under generally accepted accounting principles and instructions to reports of condition and income of banking regulators, a nonaccrual loan may be returned to accrual status: (i) when none of its principal and interest is due and unpaid, repayment is expected, and there has been a sustained period (at least six months) of repayment performance; (ii) when the loan is well-secured, there is a sustained period of performance and repayment within a reasonable period is reasonably assured; or (iii) when the loan otherwise becomes well-secured and in the process of collection. Loans that have been restructured because of weakened financial positions of the borrowers also may be returned to accrual status if repayment is reasonably assured under the revised terms and there has been a sustained period of repayment performance.

Management strives to carefully monitor credit quality and to identify loans that may become nonperforming. At any time, however, there are loans included in the portfolio that will result in losses to us that have not been identified as nonperforming or potential problem loans. Because the loan portfolio contains a significant number of commercial (including energy banking credits) and commercial real estate loans with relatively large balances, the unexpected deterioration of one or a few such loans may cause a significant increase in nonperforming assets and may lead to a material increase in charge-offs and the provision for loan losses in future periods.

The following table shows the recorded investment in loans on nonaccrual status:




(Dollars in thousands)	At March 31, 2017		At December 31, 2016
Real estate mortgage:
Commercial	$	570	$	6,471
One-to-four family residential		2,730		2,766
Real estate construction:
Commercial		522		522
One-to-four family residential		448		448
Commercial		12,182		5,949
Other consumer		29		111
Total nonaccrual loans	$	16,481	$	16,267

During the first three months of 2017, $0.1 million of interest income was received on nonaccruing loans. If interest on all nonaccrual loans had been accrued for the three months ended March 31, 2017, additional interest income of $0.2 million would have been recorded.

The following table shows an age analysis of past due loans at March 31, 2017 and December 31, 2016:



			90 days +								Recorded loans
	30-89 days		past due and		Total past				Total		> 90 days and
(Dollars in thousands)	past due		nonaccrual		due		Current		loans		accruing
At March 31, 2017
Real estate mortgage:
Commercial	$	1,616	$	570	$	2,186	$	923,272	$	925,458	$	-
One-to-four family residential		376		2,838		3,214		207,281		210,495		108
Real estate construction:
Commercial		-		522		522		193,415		193,937		-
One-to-four family residential		-		448		448		17,978		18,426		-
Commercial		1,924		12,183		14,107		555,894		570,001		1
Other		295		30		325		17,801		18,126		1
Total	$	4,211	$	16,591	$	20,802	$	1,915,641	$	1,936,443	$	110

At December 31, 2016
Real estate mortgage:
Commercial	$	24	$	6,472	$	6,496	$	875,575	$	882,071	$	-
One-to-four family residential		631		2,903		3,534		195,589		199,123		138
Real estate construction:
Commercial		-		522		522		198,591		199,113		-
One-to-four family residential		-		448		448		20,498		20,946		-
Commercial		2,530		6,142		8,672		547,576		556,248		193
Other		359		123		482		19,149		19,631		12
Total	$	3,544	$	16,610	$	20,154	$	1,856,978	$	1,877,132	$	343

Impaired Loans. A loan is considered to be impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Each loan deemed to be impaired (loans on nonaccrual status and greater than $100,000, and all troubled debt restructurings) is evaluated on an individual basis using the discounted present value of expected cash flows based on the loan’s initial effective interest rate, the fair value of collateral, or the market value of the loan. Smaller balance and homogeneous loans, including mortgage and consumer loans, are collectively evaluated for impairment.

Interest payments on impaired loans are applied to principal until collectability of the principal amount is reasonably assured, and, at that time, interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged-off when deemed uncollectible.

Impaired loans as of March 31, 2017 and December 31, 2016 are shown in the following table:



	With No Specific Allowance				With A Specific Allowance
			Unpaid				Unpaid
	Recorded		Principal		Recorded		Principal		Related
(Dollars in thousands)	Investment		Balance		Investment		Balance		Allowance
At March 31, 2017
Commercial real estate	$	1,676	$	3,212	$	-	$	-	$	-
One-to-four family residential		1,152		1,434		1,593		1,617		63
Real estate construction		523		654		447		517		40
Commercial		707		2,571		11,493		14,023		3,481
Other		29		34		-		-		-
Total	$	4,087	$	7,905	$	13,533	$	16,157	$	3,584

At December 31, 2016
Commercial real estate	$	1,536	$	3,057	$	6,053	$	6,529	$	2,219
One-to-four family residential		1,188		1,535		1,593		1,698		63
Real estate construction		762		926		207		245		40
Commercial		1,032		2,861		4,963		7,480		1,346
Other		111		115		-		-		-
Total	$	4,629	$	8,494	$	12,816	$	15,952	$	3,668

The average recorded investment of loans classified as impaired and the interest income recognized on those loans for the three months ended March 31, 2017 and March 31, 2016 are shown in the following table:



	As of and for the three months ended March 31,
	2017				2016
	Average				Average
	Recorded		Interest		Recorded		Interest
(Dollars in thousands)	Investment		Income		Investment		Income
Commercial real estate	$	2,766	$	33	$	25,133	$	252
One-to-four family residential		3,245		1		4,067		-
Real estate construction		1,044		-		1,539		-
Commercial		8,360		91		13,169		8
Other		29		-		80		-
Total	$	15,444	$	125	$	43,988	$	260

Troubled Debt Restructurings. Our loan portfolio also includes certain loans that have been modified in troubled debt restructurings, where economic concessions have been granted to borrowers who have experienced financial difficulties. These concessions typically result from loss mitigation activities and can include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance, or other actions. Troubled debt restructurings are classified as impaired at the time of restructuring and are then further classified as nonperforming, potential problem, or performing restructured, as applicable. Loans modified in troubled debt restructurings may be returned to performing status after considering the borrowers’ sustained repayment for a reasonable period of at least six months.

When we modify loans in a troubled debt restructuring, an evaluation of any possible impairment is performed similar to the evaluation done with respect to other impaired loans based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan agreement, or use of the current fair value of the collateral, less selling costs for collateral dependent loans. If it is determined that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs, and unamortized premium or discount), an impairment is recognized through an allowance estimate or a charge-off to the allowance.

Troubled debt restructured loans outstanding as of March 31, 2017 and December 31, 2016 were as follows:



	At March 31, 2017				At December 31, 2016
(Dollars in thousands)	Accruing		Nonaccrual		Accruing		Nonaccrual
Commercial real estate	$	1,106	$	280	$	1,118	$	475
One-to-four family residential		15		45		15		46
Commercial		18		3,243		45		3,323
Total	$	1,139	$	3,568	$	1,178	$	3,844

At March 31, 2017 and December 31, 2016, we had no significant commitments to lend additional funds to debtors whose loan terms had been modified in a troubled debt restructuring.

Loans modified as troubled debt restructurings that occurred during the three months ended March 31, 2017 and March 31, 2016 are shown in the following table:



	For the three months ended March 31,
	2017				2016
	Number of		Recorded		Number of		Recorded
(Dollars in thousands)	Modifications		Investment		Modifications		Investment
Commercial		-		-		1		260
Total		-	$	-		1	$	260

The modifications of loans identified as troubled debt restructurings primarily related to payment reductions, payment extensions, and/or reductions in the interest rate. The financial impact of troubled debt restructurings is not significant.

There were no loans modified as a troubled debt restructuring that subsequently defaulted during the three months ended March 31, 2017 or March 31, 2016. Default, for this purpose, is deemed to occur when a loan is 90 days or more past due or transferred to nonaccrual and is within twelve months of restructuring.

Credit Quality Indicators. To assess the credit quality of loans, we categorize loans into risk categories based on relevant information about the ability of the borrowers to service their debts such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. This analysis is performed on a quarterly basis. We use the following definitions for risk ratings:

Special mention – Loans classified as special mention have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for these loans or of the institution’s credit position at some future date.

Substandard – Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligors or of the collateral pledged, if any. Loans so classified have one or more well-defined weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. These loans are considered potential problem or nonperforming loans depending on the accrual status of the loans.

Doubtful – Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. These loans are considered nonperforming.

Loans not meeting the criteria above that are analyzed as part of the above described process are considered to be pass rated loans. As of March 31, 2017 and December 31, 2016, based on the most recent analysis performed as of those dates, the risk category of loans by class was as follows:



	Commercial		1-4 Family		Real Estate
(Dollars in thousands)	Real Estate		Residential		Construction		Commercial		Other		Total
At March 31, 2017
Grade:
Pass	$	894,735	$	203,837	$	201,854	$	508,938	$	18,097	$	1,827,461
Special Mention		17,986		1,973		8,951		21,509		-		50,419
Substandard		12,737		4,685		1,558		39,257		29		58,266
Doubtful		-		-		-		297		-		297
Total	$	925,458	$	210,495	$	212,363	$	570,001	$	18,126	$	1,936,443

At December 31, 2016
Grade:
Pass	$	857,290	$	192,395	$	210,780	$	498,039	$	19,518	$	1,778,022
Special Mention		4,479		1,983		7,720		24,639		-		38,821
Substandard		20,302		4,745		1,559		33,175		113		59,894
Doubtful		-		-		-		395		-		395
Total	$	882,071	$	199,123	$	220,059	$	556,248	$	19,631	$	1,877,132

Allowance for Loan Losses. The allowance for loan losses is a reserve established through the provision for loan losses charged to operations. Loan amounts which are determined to be uncollectible are charged against this allowance, and recoveries, if any, are added to the allowance. The appropriate amount of the allowance is based on periodic review and evaluation of the loan portfolio and quarterly assessments of the probable losses inherent in the loan portfolio. The amount of the loan loss provision for a period is based solely upon the amount needed to cause the allowance to reach the level deemed appropriate after the effects of net charge-offs for the period.

Management believes the level of the allowance is appropriate to absorb probable losses inherent in the loan portfolio. The allowance for loan losses is determined in accordance with regulatory guidelines and generally accepted accounting principles and is comprised of two primary components, specific and general. There is no one factor, or group of factors, that produces the amount of an appropriate allowance for loan losses, as the methodology for assessing the allowance for loan losses makes use of evaluations of individual impaired loans along with other factors and analysis of loan categories. This assessment is highly qualitative and relies upon judgments and estimates by management.

The specific allowance is recorded based on the result of an evaluation consistent with ASC 310.10.35, Receivables: Subsequent Measurement, for each impaired loan. Collateral dependent loans are evaluated for impairment based upon the fair value of the collateral. The amount and level of the impairment allowance is ultimately determined by management’s estimate of the amount of expected future cash flows or, if the loan is collateral dependent, on the value of collateral, which may vary from period to period depending on changes in the financial condition of the borrower or changes in the estimated value of the collateral. Charge-offs against the allowance for impaired loans are made when and to the extent loans are deemed uncollectible. Any portion of a collateral dependent impaired loan in excess of the fair value of the collateral that is determined to be uncollectible is charged off.

The general component of the allowance is calculated based on ASC 450, Contingencies. Loans not evaluated for specific allowance are segmented into loan pools by type of loan. Commercial real estate pools are further segmented by market type for non-owner occupied and owner occupied collateral. Our primary markets are Oklahoma, Texas, Kansas, and Colorado. Estimated allowances are based on historical loss trends with adjustments factored in based on qualitative risk factors both internal and external to us. The historical loss trend is determined by loan pool and segmentation and is based on the actual loss history experienced by us over the most recent three years. The qualitative risk factors include, but are not limited to, economic and business conditions, changes in lending staff, lending policies and procedures, quality of loan review, changes in the nature and volume of the portfolios, loss and recovery trends, asset quality trends, and legal and regulatory considerations.

Independent appraisals on real estate collateral securing loans are obtained at origination. New appraisals are obtained periodically and following discovery of factors that may significantly affect the value of the collateral. Appraisals typically are received within 30 days of request. Results of appraisals on nonperforming and potential problem loans are reviewed promptly upon receipt and considered in the determination of the allowance for loan losses. We are not aware of any significant time lapses in the process that have resulted, or would result in, a significant delay in determination of a credit weakness, the identification of a loan as nonperforming, or the measurement of an impairment.

The following tables show the balance in the allowance for loan losses and the recorded investment in loans for the dates indicated by portfolio classification disaggregated on the basis of impairment evaluation method.



	Commercial		1-4 Family		Real Estate
(Dollars in thousands)	Real Estate		Residential		Construction		Commercial		Other		Total
At March 31, 2017
Balance at beginning of fiscal year	$	12,507	$	1,163	$	3,502	$	10,058	$	316	$	27,546
Loans charged-off		(2,029)		-		-		(12)		(116)		(2,157)
Recoveries		182		55		-		117		24		378
Provision for loan losses		1,353		2		(347)		676		92		1,776
Balance at end of period	$	12,013	$	1,220	$	3,155	$	10,839	$	316	$	27,543

Allowance for loan losses ending balance:
Individually evaluated for impairment	$	-	$	63	$	-	$	3,481	$	-	$	3,544
Collectively evaluated for impairment		12,013		1,157		3,115		7,358		316		23,959
Acquired with deteriorated credit quality		-		-		40		-		-		40
Total ending allowance balance	$	12,013	$	1,220	$	3,155	$	10,839	$	316	$	27,543

Loans receivable ending balance:
Individually evaluated for impairment	$	712	$	1,762	$	390	$	11,789	$	-	$	14,653
Collectively evaluated for impairment		922,999		207,541		211,318		557,989		18,126		1,917,973
Acquired with deteriorated credit quality		1,747		1,192		655		223		-		3,817
Total ending loans balance	$	925,458	$	210,495	$	212,363	$	570,001	$	18,126	$	1,936,443



	Commercial		1-4 Family		Real Estate
(Dollars in thousands)	Real Estate		Residential		Construction		Commercial		Other		Total
At March 31, 2016
Balance at beginning of fiscal year	$	12,716	$	700	$	2,533	$	9,965	$	192	$	26,106
Loans charged-off		(14)		(84)		-		(3,553)		(74)		(3,725)
Recoveries		201		43		-		145		23		412
Provision for loan losses		(1,782)		216		367		5,517		57		4,375
Balance at end of period	$	11,121	$	875	$	2,900	$	12,074	$	198	$	27,168

Allowance for loan losses ending balances:
Individually evaluated for impairment	$	914	$	135	$	40	$	3,038	$	-	$	4,127
Collectively evaluated for impairment		10,207		740		2,860		9,036		198		23,041
Acquired with deteriorated credit quality		-		-		-		-		-		-
Total ending allowance balance	$	11,121	$	875	$	2,900	$	12,074	$	198	$	27,168

Loans receivable ending balance:
Individually evaluated for impairment	$	20,341	$	560	$	390	$	13,153	$	43	$	34,487
Collectively evaluated for impairment		854,097		155,892		179,489		530,203		20,428		1,740,109
Acquired with deteriorated credit quality		4,384		1,626		777		466		35		7,288
Total ending loans balance	$	878,822	$	158,078	$	180,656	$	543,822	$	20,506	$	1,781,884