Loans and Allowance for Credit Losses

6 Months Ended

Jun. 30, 2011

Loans and Allowance for Credit Losses

Loans and Allowance for Credit Losses

4.  Loans and Allowance for Credit Losses

The Bank makes loans to customers primarily in the Washington, D.C. metropolitan statistical area and surrounding communities. A substantial portion of the Bank’s loan portfolio consists of loans to businesses secured by real estate and other business assets.

Loans, net of unamortized net deferred fees, at June 30, 2011 and December 31, 2010 are summarized by type as follows:

	June 30, 2011					December 31, 2010
(dollars in thousands)	Amount			%		Amount			%
Commercial	$	482,680		25	%	$	411,744		26	%
Investment - commercial real estate	719,450			37	%	619,714			37	%
Owner occupied - commercial real estate	242,266			12	%	223,986			13	%
Real estate mortgage - residential	36,794			2	%	15,926			1	%
Construction - commercial and residential (1)	370,588			19	%	308,081			18	%
Home equity	90,827			5	%	89,936			5	%
Other consumer	5,871			—		6,113			—
Total loans	1,948,476			100	%	1,675,500			100	%
Less: Allowance for Credit Losses	(27,475		)			(24,754		)
Net loans	$	1,921,001				$	1,650,746

(1) Includes loans for land acquisition and development.

Unamortized net deferred fees amounted to $5.1 million and $4.1 million at June 30, 2011 and December 31, 2010.

As of June 30, 2011 and December 31, 2010, the Bank serviced $28.0 million and $28.1 million, respectively, of SBA loans participations which are not reflected as loan balances on the Consolidated Balance Sheets.

Loan Origination / Risk Management

The Bank’s goal is to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of economic downturn or other negative influences. Plans for mitigating inherent risks in managing loan assets include: carefully enforcing loan policies and procedures, evaluating each borrower’s business plan during the underwriting process and throughout the loan term, identifying and monitoring primary and alternative sources for loan repayment, and obtaining collateral to mitigate economic loss in the event of liquidation. Specific loan reserves are established based upon credit and/or collateral risks on an individual loan basis. A risk rating system is employed to proactively estimate loss exposure and provide a measuring system for setting general and specific reserve allocations.

The composition of the Bank’s loan portfolio is heavily weighted toward commercial real estate, both owner occupied and investment real estate. At June 30, 2011, real estate commercial, real estate residential and real estate construction combined represented approximately 70% of the loan portfolio. These loans are underwritten to mitigate lending risks typical of this type of loan such as declines in real estate values, changes in borrower cash flow and general economic conditions. The Bank typically requires a maximum loan to value of 80% or less and minimum cash flow debt service coverage of 1.15 to 1.0. Personal guarantees are generally required, but may be limited.  In making real estate commercial mortgage loans, the Bank generally requires that interest rates adjust not less frequently than five years.

The Bank is also an active traditional commercial lender providing loans for a variety of purposes, including cash flow, equipment and account receivable financing. This loan category represents approximately 25% of the loan portfolio at June 30, 2011 and is generally variable or adjustable rate. Commercial loans meet reasonable underwriting standards, including appropriate collateral, and cash flow necessary to support debt service. Personal guarantees are generally required, but may be limited. SBA loans represent 2% of the commercial loan category of loans. In originating SBA loans, the Company assumes the risk of non-payment on the uninsured portion of the credit. The Company generally sells the insured portion of the loan generating noninterest income from the gains on sale, as well as servicing income on the portion participated. SBA loans are subject to the same cash flow analyses as other commercial loans. SBA loans and the Section 7A lending program in particular, are subject to a maximum loan size established by the SBA.

Approximately 5% of the loan portfolio at June 30, 2011 consists of home equity loans and lines of credit and other consumer loans. These credits, while making up a smaller portion of the loan portfolio, demand the same emphasis on underwriting and credit evaluation as other types of loans advanced by the Bank.

From time to time the Company may make loans for its own portfolio or through its higher risk loan affiliate, ECV, which under its operating agreement conducts lending only to real estate projects, where the Company’s directors or lending officers have significant expertise. Such loans, which are made to finance projects (which may also be financed at the Bank level), may have higher risk characteristics than loans made by the Bank, such as lower priority interests and/or higher loan to value ratios. The Company seeks an overall financial return on these transactions commensurate with the risks and structure of each individual loan. Certain transactions bear current interest at a rate with a significant premium to normal market rates. Other loan transactions carry a standard rate of current interest, and may also earn additional interest based on a percentage of the profits of the underlying project or a fixed rate.

Loans are secured primarily by duly recorded first deeds of trust. In some cases, the Bank may accept a recorded junior trust position.  In general, borrowers will have a proven ability to build, lease, manage and/or sell a commercial or residential project and demonstrate satisfactory financial condition.  Additionally, an equity contribution toward the project is customarily required.

Construction loans require that the financial condition and experience of the general contractor and major subcontractors be satisfactory to the Bank.  Guaranteed, fixed price contracts are required whenever appropriate, along with payment and performance bonds or completion bonds for larger scale projects.

Loans intended for residential land acquisition, lot development and construction are made on the premise that the land: 1) is or will be developed for building sites for residential structures, and; 2) will ultimately be utilized for construction or improvement of residential zoned real properties, including the creation of housing.  Residential development and construction loans will finance projects such as single family subdivisions, planned unit developments, townhouses, and condominiums.  Residential land acquisition, development and construction loans generally are underwritten with a maximum term of 36 months, including extensions approved at origination.

Commercial land acquisition and construction loans are secured by real property where loan funds will be used to acquire land and to construct or improve appropriately zoned real property for the creation of income producing or owner user commercial properties.  Borrowers are generally required to put equity into each project at levels determined by the appropriate Loan Committee.  Commercial land acquisition and construction loans generally are underwritten with a maximum term of 24 months.

All construction draw requests must be presented in writing on American Institute of Architects documents and certified by the contractor, the borrower and the borrower’s architect.  Each draw request shall also include the borrower’s soft cost breakdown certified by the borrower or its Chief Financial Officer.  Prior to an advance, the Bank or its contractor inspects the project to determine that the work has been completed, to justify the draw requisition.

Commercial permanent loans are secured by improved real property which is generating income in the normal course of operation.  Debt service coverage, assuming stabilized occupancy, must be satisfactory to support a permanent loan.  The debt service coverage ratio is ordinarily at least 1.15:1.  As part of the underwriting process, debt service coverage ratios are stress tested assuming a 200 basis point increase in interest rates from their current levels.

Commercial permanent loans generally are underwritten with a term not greater than 10 years or the remaining useful life of the property, whichever is lower.  The preferred term is between 5 to 7 years, with amortization to a maximum of 25 years.

Personal guarantees are generally received from the principals, and only in instances where the loan-to-value is sufficiently low and the debt service is sufficiently high is consideration given to either limiting or not requiring personal recourse.

The Company’s loan portfolio includes loans made for real estate Acquisition, Development and Construction (“ADC”) purposes, including both investment and owner occupied projects. ADC loans amounted to $370.6 million at June 30, 2011.  ADC loans containing loan funded interest reserves represent approximately 21% of the outstanding ADC loan portfolio at June 30, 2011.  The decision to establish a loan-funded interest reserve is made upon origination of the ADC loan and is based upon a number of factors considered during underwriting of the credit including (i) the feasibility of the project; (ii) the experience of the sponsor; (iii) the creditworthiness of the borrower and guarantors; (iv) borrower’s equity contribution; and (v) the level of collateral protection.  When appropriate, an interest reserve provides an effective means of addressing the cash flow characteristics of a properly underwritten ADC loan.  The Company does not significantly utilize interest reserves in other loan products.  The Company recognizes that one of the risks inherent in the use of interest reserves is the potential masking of underlying problems with the project and/or the borrower’s ability to repay the loan.  In order to mitigate this inherent risk, the Company employs a series of reporting and monitoring mechanisms on all ADC loans, whether or not an interest reserve is provided, including (i) construction and development timelines which are monitored on an ongoing basis which track the progress of a given project to the timeline projected at origination; (ii) a construction loan administration department independent of lending function; (iii) third party independent construction loan inspection reports; (iv) monthly interest reserve monitoring reports detailing the balance of the interest reserves approved at origination and the days of interest carry represented by the reserve balances as compared to the then current anticipated time to completion and/or sale of speculative projects; and (v) quarterly commercial real estate construction meetings among senior Company management which includes monitoring of current and projected real estate market conditions. If a project has not performed as expected, it is not the customary practice of the Company to increase loan funded interest reserves.

The following table details activity in the allowance for credit losses by portfolio segment for the three and six months ended June 30, 2011.  Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

				Investment			Owner occupied			Real Estate			Construction
				Commercial			Commercial			Mortgage			Commercial and			Home		Other
(dollars in thousands)	Commercial			Real Estate			Real Estate			Residential			Residential			Equity		Consumer			Total
Three Months Ended June 30, 2011
Allowance for credit losses:
Balance at beginning of period	$	8,553		$	6,657		$	2,189		$	161		$	6,478		$	1,452	$	92		$	25,582
Loans charged-off	(1,114		)	(245		)	—			(94		)	—			—		(6		)	(1,459		)
Recoveries of loans previously charged-off	11			126			—			—			—			—		—			137
Net loan charged-off	(1,103		)	(119		)	—			(94		)	—			—		(6		)	(1,322		)
Provision for credit losses	1,600			765			(143		)	298			653			56		(14		)	3,215
Balance at end of period	$	9,050		$	7,303		$	2,046		$	365		$	7,131		$	1,508	$	72		$	27,475
Six Months Ended June 30, 2011
Allowance for credit losses:
Balance at beginning of period	$	8,630		$	6,668		$	2,064		$	115		$	5,745		$	1,441	$	91		$	24,754
Loans charged-off	(1,800		)	(277		)	—			(94		)	(741		)	—		(6		)	(2,918		)
Recoveries of loans previously charged-off	14			126			—			—			167			1		—			308
Net loan charged-off	(1,786		)	(151		)	—			(94		)	(574		)	1		(6		)	(2,610		)
Provision for credit losses	2,206			786			(18		)	344			1,960			66		(13		)	5,331
Balance at end of period	$	9,050		$	7,303		$	2,046		$	365		$	7,131		$	1,508	$	72		$	27,475

			Investment		Owner occupied		Real Estate		Construction
			Commercial		Commercial		Mortgage		Commercial and		Home		Other
(dollars in thousands)	Commercial		Real Estate		Real Estate		Residential		Residential		Equity		Consumer		Total
For the Period Ended June 30, 2011
Allowance for credit losses:
Individually evaluated for impairment	$	2,051	$	817	$	65	$	—	$	1,045	$	220	$	4	$	4,202
Collectively evaluated for impairment	6,999		6,486		1,981		365		6,086		1,288		68		23,273
Total	$	9,050	$	7,303	$	2,046	$	365	$	7,131	$	1,508	$	72	$	27,475
Recorded investment in loans:
Individually evaluated for impairment	$	13,417	$	9,184	$	3,472	$	—	$	21,425	$	284	$	8	$	47,790
Collectively evaluated for impairment	469,263		710,266		238,794		36,794		349,163		90,543		5,863		1,900,686
Total	$	482,680	$	719,450	$	242,266	$	36,794	$	370,588	$	90,827	$	5,871	$	1,948,476

At June 30, 2011, the nonperforming loans acquired from Fidelity & Trust Financial Corporation (“Fidelity”) have a carrying value of $4.7 million and an unpaid principal balance of $14.2 million and were evaluated separately in accordance with ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality.”  The various impaired loans were recorded at estimated fair value with any excess being charged-off or treated as a non-accretable discount. Subsequent downward adjustments to the valuation of impaired loans acquired will result in additional loan loss provisions and related allowance for credit losses. Subsequent upward adjustments to the valuation of impaired loans acquired will result in accretable discount. No adjustments have been made to the fair value amounts of impaired loans subsequent to the allowable period of adjustment from the date of acquisition.

Credit Quality Indicators

The Company uses several credit quality indicators to manage credit risk in an ongoing manner. The Company’s primary credit quality indicators are to use an internal credit risk rating system that categorizes loans into pass, watch, special mention, or classified categories. Credit risk ratings are applied individually to those classes of loans that have significant or unique credit characteristics that benefit from a case-by-case evaluation. These are typically loans to businesses or individuals in the classes which comprise the commercial portfolio segment. Groups of loans that are underwritten and structured using standardized criteria and characteristics, such as statistical models (e.g., credit scoring or payment performance), are typically risk rated and monitored collectively. These are typically loans to individuals in the classes which comprise the consumer portfolio segment.

The following are the definitions of the Company’s credit quality indicators:

Pass:	Loans in all classes that comprise the commercial and consumer portfolio segments that are not adversely rated, are contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. Management believes that there is a low likelihood of loss related to those loans that are considered pass.
Watch:	Loan paying as agreed with generally acceptable asset quality; however Borrower’s performance has not met expectations. Balance sheet and/or income statement has shown deterioration to the point that the company could not sustain any further setbacks. Credit is expected to be strengthened through improved company performance and/or additional collateral within a reasonable period of time.
Special Mention:	Loans in the classes that comprise the commercial portfolio segment that have potential weaknesses that deserve management’s close attention. If not addressed, these potential weaknesses may result in deterioration of the repayment prospects for the loan. The special mention credit quality indicator is not used for classes of loans that comprise the consumer portfolio segment. Management believes that there is a moderate likelihood of some loss related to those loans that are considered special mention.
Classified:	Classified (a) Substandard - Loans inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual loans classified substandard.
	Classified (b) Doubtful - Loans that have all the weaknesses inherent in a loan classified substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors, which may work to the advantage and strengthening of the assets, its classification as an estimated loss is deferred until its more exact status may be determined.

The Company’s credit quality indicators are periodically updated on a case-by-case basis. The following table presents by class and by credit quality indicator, the recorded investment in the Company’s loans and leases as of June 30, 2011.

									Total
(dollars in thousands)	Pass		Watch		Substandard		Doubtful		Loans
Commercial	$	439,692	$	29,571	$	12,567	$	850	$	482,680
Investment - commercial real estate	696,964		13,302		9,184		—		719,450
Owner occupied - commercial real estate	233,203		5,591		3,472		—		242,266
Real estate mortgage — residential	36,794		—		—		—		36,794
Construction - commercial and residential	335,897		13,266		21,425		—		370,588
Home equity	90,543		—		284		—		90,827
Other consumer	5,863		—		8		—		5,871
Total	$	1,838,956	$	61,730	$	46,940	$	850	$	1,948,476

Nonaccrual and Past Due Loans

 Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The following presents by class of loan, information related to nonaccrual loans as of the periods ended June 30, 2011 and December 31, 2010.

(dollars in thousands)	June 30, 2011		December 31, 2010
Commercial	$	4,649	$	5,137
Investment - commercial real estate	4,520		5,038
Owner occupied - commercial real estate	295		—
Real estate mortgage - residential	1,047		760
Construction - commercial and residential	20,056		13,520
Home equity	645		297
Other consumer	9		535
Total nonperforming loans (1)(2)	$	31,221	$	25,287

(1)Excludes TDRs returned to performing status totaling $3.1 million at June 30, 2011. These loans have demonstrated a period of a least six months of performance under the modified terms.

(2)Gross interest income that would have been recorded in 2011 if nonaccrual loans shown above had been current and in accordance with their original terms was $961 thousand, no interest was recorded on such loans. See Note 1 to the Consolidated Financial Statements for a description of the Company’s policy for placing loans on nonaccrual status.

The following table presents by class, an aging analysis and the recorded investments in loans past due as of June 30, 2011and December 31, 2010.

	Loans		Loans		Loans						Total Recorded
	30-59 Days		60-89 Days		90 Days or		Total Past		Current		Investment in
(dollars in thousands)	Past Due		Past Due		More Past Due		Due Loans		Loans		Loans
June 30, 2011
Commercial	$	4,748	$	614	$	4,649	$	10,011	$	472,669	$	482,680
Investment - commercial real estate	2,755		3,700		4,520		10,975		708,475		719,450
Owner occupied - commercial real estate	2,097		562		295		2,954		239,312		242,266
Real estate mortgage — residential	87		1,251		1,047		2,385		34,409		36,794
Construction - commercial and residential	1,000		8,243		20,056		29,299		341,289		370,588
Home equity	—		644		645		1,289		89,538		90,827
Other consumer	25		1		9		35		5,836		5,871
Total	$	10,712	$	15,015	$	31,221	$	56,948	$	1,891,528	$	1,948,476

	Loans		Loans		Loans						Total Recorded
	30-59 Days		60-89 Days		90 Days or		Total Past		Current		Investment in
(dollars in thousands)	Past Due		Past Due		More Past Due		Due Loans		Loans		Loans
December 31, 2010
Commercial	$	1,175	$	1,497	$	5,136	$	7,808	$	403,936	$	411,744
Investment - commercial real estate	3,758		2,096		5,039		10,893		608,821		619,714
Owner occupied - commercial real estate	368		3,177		—		3,545		220,441		223,986
Real estate mortgage — residential	107		—		760		867		15,059		15,926
Construction - commercial and residential	12,028		8,122		14,056		34,206		273,875		308,081
Home equity	1,199		—		297		1,496		88,440		89,936
Other consumer	64		—		—		64		6,049		6,113
Total	$	18,699	$	14,892	$	25,288	$	58,879	$	1,616,621	$	1,675,500

Impaired Loans

Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

The following table presents by class, information related to impaired loans for the periods ended June 30, 2011 and December 31, 2010.

	Unpaid		Recorded		Recorded
	Contractual		Investment		Investment		Total				Average		Interest
	Principal		With No		With		Recorded		Related		Recorded		Income
(dollars in thousands)	Balance		Allowance		Allowance		Investment		Allowance		Investment		Recognized
Commercial	$	4,649	$	2,003	$	1,437	$	3,440	$	1,208	$	3,653	$	—
Investment - commercial real estate	7,861		3,662		2,199		5,861		793		5,585		—
Owner occupied - commercial	295		—		230		230		65		153		—
Real estate mortgage — residential	1,047		1,047		—		1,047		—		1,039		—
Construction - commercial and residential	21,138		6,069		13,942		20,011		1,045		17,797		—
Home equity	645		187		238		425		220		266		—
Other consumer	9		—		5		5		4		2		—
Total impaired loans at June 30, 2011	$	35,644	$	12,968	$	18,051	$	31,019	$	3,335	$	28,495	$	—

	Unpaid		Recorded		Recorded
	Contractual		Investment		Investment		Total				Average		Interest
	Principal		With No		With		Recorded		Related		Recorded		Income
(dollars in thousands)	Balance		Allowance		Allowance		Investment		Allowance		Investment		Recognized
Commercial	$	5,136	$	1,527	$	1,995	$	3,522	$	1,615	$	4,480	$	131
Investment - commercial real estate	7,182		2,156		2,188		4,344		695		3,736		87
Owner occupied - commercial	—		—		—		—		—		263		—
Real estate mortgage — residential	760		760		—		760		—		510		23
Construction - commercial and residential	15,055		7,775		5,206		12,981		1,075		19,147		136
Home equity	297		112		100		212		85		170		13
Other consumer	—		—		—		—		—		4,253		—
Total impaired loans at December 31, 2010	$	28,430	$	12,330	$	9,489	$	21,819	$	3,470	$	32,559	$	390