NOTE 7. Allowance for Loan Losses

The Allowance for Loan Losses (“the Allowance”) is management’s best estimate of probable losses inherent in its loan portfolio. Accordingly, the methodology is based on historical loss experience by loan segment and class with adjustments for current events and conditions. The Company’s process for determining the appropriate level of the Allowance for probable loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including levels of and trends related to past due and nonaccrual loans, net charge-offs or recoveries, and other factors.

The level of the Allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the Allowance is dependent upon a variety of factors beyond the Company’s control including, among other things, the performance of the Company’s loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classification.

The Company’s Allowance consists of three elements: (1) specific valuation allowances based on probable losses on specific loans, (2) general valuation allowances based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted as necessary to reflect the impact of current conditions, and (3) unallocated general valuation allowances based on general economic conditions and other qualitative risk factors both internal and external to the Company.

The specific valuation allowance is an allocated allowance for impaired loans. This analysis is based upon a specific analysis for each impaired loan that is collateral dependent, including appraisals and in-house evaluations on loans secured by real property, management’s assessment of the current market, recent payment history, and an evaluation of other sources of repayment. The Company obtains appraisals on real and personal property that secure its loans during the loan origination process in accordance with regulatory guidance and its loan policy.

The general valuation allowance is a general allocated allowance for all other loans that were not impaired as of the balance sheet date. The Company uses a formula-based approach that includes average historical loss factors that are adjusted for qualitative factors to establish this portion of the Allowance. The Company first disaggregates the overall loan portfolio into the following segments: commercial, real estate construction one-to-four family, real estate construction other, real estate term owner occupied, real estate term non-owner occupied, real estate term other, consumer secured by 1^st deeds of trust, and other consumer loans. Then the Company further disaggregates each segment into the following classes: pass, special mention, substandard, doubtful and loss. After the portfolio has been disaggregated into these segments and classes, the Company calculates a general reserve for each segment and class based on the average five year loss history for each segment and class. This general reserve is then adjusted for qualitative factors, by segment and class. Qualitative factors are based on management’s assessment of current trends that may cause losses inherent in the current loan portfolio to differ significantly from historical losses. Some factors that management considers in determining the qualitative adjustment to the general reserve include our concentration of large borrowers, national and local economic trends, business conditions, underwriting policies and standards, trends in local real estate markets, effects of various political activities, peer group data, and internal factors such as underwriting policies and expertise of the Company’s employees.

The unallocated general valuation portion of the Allowance is based on several factors, including the level of the Allowance as compared to total loans and nonperforming loans in light of current economic conditions. This portion of the Allowance is deemed “unallocated” because it is not allocated to any segment or class of the loan portfolio. This portion of the Allowance provides for coverage of credit losses inherent in the loan portfolio but not captured in the credit loss factors that are utilized in the risk rating-based component or in the specific impairment component of the Allowance and acknowledges the inherent imprecision of all loss prediction models. This portion of the Allowance is based upon management’s evaluation of various factors that are not directly measured in the determination of the allocated portions of the Allowance. Such factors include uncertainties in identifying triggering events that directly correlate to subsequent loss rates, uncertainties in economic conditions, risk factors that have not yet manifested themselves in loss allocation factors, and historical loss experience data that may not precisely correspond to the current portfolio. In addition, the unallocated reserve may fluctuate based upon the direction of various risk indicators. Examples of such factors include the risk as to current and prospective economic conditions, the level and trend of charge offs or recoveries, and the risk of heightened imprecision or inconsistency of appraisals used in estimating real estate values. Although this allocation process may not accurately predict credit losses by loan type or in aggregate, the total allowance for credit losses is available to absorb losses that may arise from any loan type or category.

Loans identified as losses by management, internal loan review and/or bank examiners are charged-off.

The following tables detail activity in the Allowance for the periods indicated:



(In Thousands)	Commercial		Real estate construction one-to-four family		Real estate construction other		Real estate term owner occupied		Real estate term non-owner occupied		Real estate term other		Consumer secured by 1st deed of trust		Consumer other		Unallocated		Total

2012
Balance, beginning of period	$	6,783	$	468	$	1,169	$	1,272	$	2,975	$	788	$	374	$	418	$	2,256	$	16,503
Charge-Offs		(496)		-		-		(274)		-		(280)		-		(122)		-		(1,172)
Recoveries		2,518		48		-		-		-		50		-		20		-		2,636
Provision (benefit)		(2,497)		513		(843)		443		1,090		(19)		(30)		72		(288)		(1,559)
Balance, end of period	$	6,308	$	1,029	$	326	$	1,441	$	4,065	$	539	$	344	$	388	$	1,968	$	16,408
Balance, end of period:
Individually evaluated
for impairment	$	444	$	215	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	659
Balance, end of period:
Collectively evaluated
for impairment	$	5,864	$	814	$	326	$	1,441	$	4,065	$	539	$	344	$	388	$	1,968	$	15,749

2011
Balance, beginning of period	$	6,374		459	$	576	$	1,029		2,890		351		337	$	404	$	1,986	$	14,406
Charge-Offs		(1,225)		-		(133)		-		-		(90)		-		(71)		-		(1,519)
Recoveries		1,426		1		90		-		-		54		-		46		-		1,617
Provision (benefit)		208		7		637		243		85		473		37		39		270		1,999
Balance, end of period	$	6,783	$	468	$	1,169	$	1,272	$	2,975	$	788	$	374	$	418	$	2,256	$	16,503
Balance, end of period:
Individually evaluated
for impairment	$	620	$	-	$	494	$	-	$	67	$	-	$	-	$	-	$	-	$	1,181
Balance, end of period:
Collectively evaluated
for impairment	$	6,163	$	468	$	675	$	1,272	$	2,908	$	788	$	374	$	418	$	2,256	$	15,322

The following is a detail of the recorded investment in the loan portfolio, segregated by amounts evaluated individually or collectively in the Allowance at the periods indicated:



(In Thousands)	Commercial		Real estate construction one-to-four family		Real estate construction other		Real estate term owner occupied		Real estate term non-owner occupied		Real estate term other		Consumer secured by 1st deed of trust		Consumer other		Total

December 31, 2012
Balance, end of period	$	273,432	$	32,573	$	21,061	$	78,107	$	234,643	$	31,809	$	17,714	$	18,305	$	707,644
Balance, end of period:
Individually evaluated
for impairment	$	2,452	$	794	$	2,748	$	1,083	$	2,260	$	3,505	$	93	$	158	$	13,093
Balance, end of period:
Collectively evaluated
for impairment	$	270,980	$	31,779	$	18,313	$	77,024	$	232,383	$	28,304	$	17,621	$	18,147	$	694,551

December 31, 2011
Balance, end of period	$	252,689	$	21,859	$	18,323	$	81,481	$	195,454	$	38,925	$	20,212	$	19,622	$	648,565
Balance, end of period:
Individually evaluated
for impairment	$	3,673	$	-	$	2,355	$	925		1,864	$	486		97	$	52	$	9,452
Balance, end of period:
Collectively evaluated
for impairment	$	249,016	$	21,859	$	15,968	$	80,556	$	193,590	$	38,439	$	20,115	$	19,570	$	639,113

The following represents the balance of the Allowance for the periods indicated segregated by segment and class: December 31, 2012



(In Thousands)	Total		Commercial		Real estate construction 1-4 family		Real estate construction other		Real estate term owner occupied		Real estate term non-owner occupied		Real estate term other		Consumer secured by 1st deeds of trust		Consumer other		Unallocated

December 31, 2012
Individually evaluated for
impairment:
AQR Substandard	$	284	$	284	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
AQR Doubtful		374		160		214		-		-		-		-		-		-		-
Collectively evaluated for
impairment:
AQR Pass		12,930		5,520		711		326		1,242		3,961		539		280		351		-
AQR Special Mention		490		321		16		-		51		34		-		56		12		-
AQR Substandard		362		23		88		-		148		70		-		8		25		-
Unallocated		1,968		-		-		-		-		-		-		-		-		1,968
	$	16,408	$	6,308	$	1,029	$	326	$	1,441	$	4,065	$	539	$	344	$	388	$	1,968

December 31, 2011
Individually evaluated for
impairment:
AQR Pass	$	24	$	19	$	-	$	-	$	-	$	-	$	5	$	-	$	-	$	-
AQR Special Mention		82		20		-		-		-		62		-		-		-		-
AQR Substandard		499		5		-		494		-		-		-		-		-		-
AQR Doubtful		212		212		-		-		-		-		-		-		-		-
AQR Loss		364		364		-		-		-		-		-		-		-		-
Collectively evaluated for
impairment:
AQR Pass		11,164		5,259		468		258		1,152		2,805		520		361		341		-
AQR Special Mention		971		860		-		-		33		53		5		7		13		-
AQR Substandard		926		44		-		417		87		54		254		6		64		-
AQR Doubtful		5		-		-		-		-		1		4		-		-		-
Unallocated		2,256		-		-		-		-		-		-		-		-		2,256
	$	16,503	$	6,783	$	468	$	1,169	$	1,272	$	2,975	$	788	$	374	$	418	$	2,256