Note 11 – Allowance for Loan and Lease Losses

The Company’s allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses. The allowance is maintained at a level that is considered adequate to absorb probable losses on certain specifically identified impaired loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when cash payments are received subsequent to the charge off. We employ a systematic methodology, consistent with FASB guidelines on loss contingencies and impaired loans, for determining the appropriate level of the allowance for loan and lease losses and adjusting it to that level at least quarterly. Pursuant to our methodology, impaired loans and leases are individually analyzed and a criticized asset action plan is completed specifying the financial status of the borrower and, if applicable, the characteristics and condition of collateral and any associated liquidation plan. A specific loss allowance is created for each impaired loan, if necessary.

The following tables disclose the unpaid principal balance, recorded investment, average recorded investment, and interest income recognized for impaired loans on our books as of the dates indicated. Balances are shown by loan type, and are further broken out by those that required an allowance and those that did not, with the associated allowance disclosed for those that required such. Included in the valuation allowance for impaired loans shown in the tables below are specific reserves allocated to TDRs, totaling $1.063 million at September 30, 2019 and $1.048 million at December 31, 2018.

Impaired Loans

(dollars in thousands, unaudited)


	September 30, 2019
	Unpaid Principal Balance(1)		Recorded Investment(2)		Related Allowance		Average Recorded Investment		Interest Income Recognized(3)
With an allowance recorded
Real estate:
Other construction/land	$	505	$	387	$	86	$	402	$	23
1-4 family - closed-end		2,858		2,857		75		2,916		113
Equity lines		4,714		4,662		592		4,699		188
Multi-family residential		357		357		19		364		17
Commercial real estate- owner occupied		600		600		9		609		28
Commercial real estate- non-owner occupied		2,819		2,819		910		2,858		—
Farmland		—		—		—		—		—
Total real estate		11,853		11,682		1,691		11,848		369
Agricultural		5		6		1		6		—
Commercial and industrial		788		769		133		893		27
Consumer loans		745		706		234		720		40
Subtotal		13,391		13,163		2,059		13,467		436
With no related allowance recorded
Real estate:
Other construction/land		54		18		—		21		3
1-4 family - closed-end		995		957		—		968		—
Equity lines		158		133		—		138		—
Commercial real estate- owner occupied		1,570		1,450		—		1,473		—
Commercial real estate- non-owner occupied		—		—		—		—		—
Farmland		25		25		—		26		—
Total real estate		2,802		2,583		—		2,626		3
Agricultural		—		—		—		—		—
Commercial and industrial		62		41		—		55		—
Consumer loans		15		—		—		—		1
Subtotal		2,879		2,624		—		2,681		4
Total	$	16,270	$	15,787	$	2,059	$	16,148	$	440

(1)

Contractual principal balance due from customer.

(2)

Principal balance on Company’s books, less any direct charge offs.

(3)

Interest income is recognized on performing balances on a regular accrual basis.

Impaired Loans

(dollars in thousands, unaudited)


	December 31, 2018
	Unpaid Principal Balance(1)		Recorded Investment(2)		Related Allowance		Average Recorded Investment		Interest Income Recognized(3)
With an allowance recorded
Real estate:
Other construction/land	$	593	$	438	$	44	$	458	$	40
1-4 family - closed-end		3,325		3,325		75		3,221		175
Equity lines		4,603		4,550		656		4,563		206
Multi-family residential		373		373		25		379		20
Commercial real estate- owner occupied		842		723		135		757		40
Commercial real estate- non-owner occupied		1,572		1,425		3		1,482		107
Total real estate		11,308		10,834		938		10,860		588
Agricultural		6		6		1		3		—
Commercial and industrial		1,724		1,534		918		1,573		40
Consumer loans		813		764		151		807		61
Subtotal		13,851		13,138		2,008		13,243		689
With no related allowance recorded
Real estate:
Other construction/land		54		50		—		32		—
1-4 family - closed-end		357		307		—		584		3
Equity lines		224		166		—		222		—
Commercial real estate- owner occupied		502		502		—		181		—
Commercial real estate- non-owner occupied		—		—		—		2,004		—
Farmland		1,642		1,642		—		434		—
Total real estate		2,779		2,667		—		3,457		3
Agricultural		—		—		—		139		—
Commercial and industrial		238		211		—		—		—
Consumer loans		182		56		—		41		1
Subtotal		3,199		2,934		—		3,637		4
Total	$	17,050	$	16,072	$	2,008	$	16,880	$	693

(1)

Contractual principal balance due from customer.

(2)

Principal balance on Company’s books, less any direct charge offs.

(3)

Interest income is recognized on performing balances on a regular accrual basis.

The specific loss allowance for an impaired loan generally represents the difference between the book value of the loan and either the fair value of underlying collateral less estimated disposition costs, or the loan’s net present value as determined by a discounted cash flow analysis. The discounted cash flow approach is typically used to measure impairment on loans for which it is anticipated that repayment will be provided from cash flows other than those generated solely by the disposition or operation of underlying collateral. However, historical loss rates may be used by the Company to determine a specific loss allowance if those rates indicate a higher potential reserve need than the discounted cash flow analysis. Any change in impairment attributable to the passage of time is accommodated by adjusting the loss allowance accordingly.

For loans where repayment is expected to be provided by the disposition or operation of the underlying collateral, impairment is measured using the fair value of the collateral. If the collateral value, net of the expected costs of disposition, is less than the loan balance, then a specific loss reserve is established for the shortfall in collateral coverage. If the discounted collateral value is greater than or equal to the loan balance, no specific loss reserve is required. At the time a collateral-dependent loan is designated as nonperforming, a new appraisal is ordered and typically received within 30 to 60 days if a recent appraisal is not already available. We generally use external appraisals to determine the fair value of the underlying collateral for nonperforming real estate loans, although the Company’s licensed staff appraisers may update older appraisals based on current market conditions and property value trends. Until an updated appraisal is received, the Company uses the existing appraisal to determine the amount of the specific loss allowance that may be required. The specific loss allowance is adjusted, as necessary, once a new appraisal is received. Updated appraisals are generally ordered at least annually for collateral-dependent loans that remain impaired, and current appraisals were available or in process for 97% of the Company’s impaired real estate loan balances at September 30, 2019. Furthermore, the Company analyzes collateral-dependent loans on at least a quarterly basis, to determine if any portion of the recorded investment in such loans can be identified as uncollectible and would therefore constitute a confirmed loss. All amounts deemed to be uncollectible are promptly charged off against the Company’s allowance for loan and lease losses, with the loan then carried at the fair value of the collateral, as appraised, less estimated costs of disposition if applicable. Once a charge-off or write-down is recorded, it will not be restored to the loan balance on the Company’s accounting books.

Our methodology also provides for the establishment of a “general” allowance for probable incurred losses inherent in loans and leases that are not impaired. Unimpaired loan balances are segregated by credit quality, and are then evaluated in pools with common characteristics. At the present time, pools are based on the same segmentation of loan types presented in our regulatory filings. While this methodology utilizes historical loss data and other measurable information, the credit classification of loans and the establishment of the allowance for loan and lease losses are both to some extent based on Management’s judgment and experience. Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan and lease losses that Management believes is appropriate at each reporting date. Quantitative information includes our historical loss experience, delinquency and charge-off trends, and current collateral values. Qualitative factors include the general economic environment in our markets and, in particular, the condition of the agricultural industry and other key industries. Lending policies and procedures (including underwriting standards), the experience and abilities of lending staff, the quality of loan review, credit concentrations (by geography, loan type, industry and collateral type), the rate of loan portfolio growth, and changes in legal or regulatory requirements are additional factors that are considered. The total general reserve established for probable incurred losses on unimpaired loans was $9.141 million at September 30, 2019.

There were no material changes to the methodology used to determine our allowance for loan and lease losses during the three months ended September 30, 2019, although as outlined in Note 3 to the consolidated financial statements we will substantially update our methodology upon the adoption of ASU 2016‑13 on January 1, 2020. Moreover, we will continue to enhance our methodology as needed in order to comply with regulatory and accounting requirements, keep pace with the size and complexity of our loan and lease portfolio, and respond to pressures created by external forces. We engage outside firms on a regular basis to assess our methodology and perform independent credit reviews of our loan and lease portfolio. In addition, the FDIC and the California DBO review the allowance for loan and lease losses as an integral part of their audit and examination processes. Management believes that the current methodology is appropriate given our size and level of complexity.

The tables that follow detail the activity in the allowance for loan and lease losses for the periods noted:

Allowance for Credit Losses and Recorded Investment in Financing Receivables

(dollars in thousands, unaudited)


		Three months ended September 30, 2019
		Real Estate		Agricultural Products		Commercial and Industrial (1)		Consumer		Unallocated		Total
Allowance for credit losses:
Beginning balance	$	5,969	$	201	$	2,569	$	1,132	$	12	$	9,883
Charge-offs		—		—		(57)		(640)		—		(697)
Recoveries		187		—		172		305		—		664
Provision		568		(10)		177		629		(14)		1,350
Ending balance	$	6,724	$	191	$	2,861	$	1,426	$	(2)	$	11,200

	Nine months ended September 30, 2019
	Real Estate		Agricultural Products		Commercial and Industrial (1)		Consumer		Unallocated		Total
Allowance for credit losses:
Beginning balance	$	5,831	$	256	$	2,394	$	1,239	$	30	$	9,750
Charge-offs		—		—		(891)		(1,753)		—		(2,644)
Recoveries		516		—		646		882		—		2,044
Provision		377		(65)		712		1,058		(32)		2,050
Ending balance	$	6,724	$	191	$	2,861	$	1,426	$	(2)	$	11,200

Reserves:
Specific	$	1,691	$	1	$	133	$	234	$	—	$	2,059
General		5,033		190		2,728		1,192		(2)		9,141
Ending balance	$	6,724	$	191	$	2,861	$	1,426	$	(2)	$	11,200

Loans evaluated for impairment:
Individually	$	14,265	$	6	$	810	$	706	$	—	$	15,787
Collectively		1,393,489		49,099		331,840		7,445		—		1,781,873
Ending balance	$	1,407,754	$	49,105	$	332,650	$	8,151	$	—	$	1,797,660

		Year ended December 31, 2018
	Real Estate		Agricultural Products		Commercial and Industrial (1)		Consumer		Unallocated		Total
Allowance for credit losses:
Beginning balance	$	4,786	$	208	$	2,772	$	1,231	$	46	$	9,043
Charge-offs		(2,474)		—		(608)		(2,226)		—		(5,308)
Recoveries		374		23		148		1,120		—		1,665
Provision		3,145		25		82		1,114		(16)		4,350
Ending balance	$	5,831	$	256	$	2,394	$	1,239	$	30	$	9,750

Reserves:
Specific	$	937	$	2	$	918	$	151	$	—	$	2,008
General		4,894		254		1,476		1,088		30		7,742
Ending balance	$	5,831	$	256	$	2,394	$	1,239	$	30	$	9,750

Loans evaluated for impairment:
Individually	$	13,501	$	6	$	1,744	$	821	$	—	$	16,072
Collectively		1,440,429		49,097		218,289		8,041		—		1,715,856
Ending balance	$	1,453,930	$	49,103	$	220,033	$	8,862	$	—	$	1,731,928

(1)

Includes mortgage warehouse lines.