5. Non-Covered Loans and Allowance for Non-Covered Loan Losses

Non-covered loans refer to loans not covered by the FDIC loss-share agreements. The non-covered loan portfolio at September 30, 2013 includes loans acquired as a part of the FNB Transaction totaling $49.7 million, of which $17.6 million are categorized as non-covered PCI loans. Covered loans are discussed in Note 6 to the consolidated financial statements. Non-covered loans summarized by portfolio segment are as follows (in thousands).

	September 30,			December 31,
	2013			2012
Commercial and industrial	$	1,625,422		$	1,660,293
Real estate	1,322,054			1,184,914
Construction and land development	310,392			280,483
Consumer	52,356			26,706
	3,310,224			3,152,396
Allowance for non-covered loan losses	(33,180		)	(3,409		)
Total non-covered loans, net of allowance	$	3,277,044		$	3,148,987

The Bank has lending policies in place with the goal of establishing an asset portfolio that will provide a return on stockholders’ equity sufficient to maintain capital to assets ratios that meet or exceed established regulations. Loans are underwritten with careful consideration of the borrower’s financial condition, the specific purpose of the loan, the primary sources of repayment and any collateral pledged to secure the loan.

Underwriting procedures address financial components based on the size or complexity of the credit. The financial components include, but are not limited to, current and projected cash flows, shock analysis and/or stress testing, and trends in appropriate balance sheet and statement of operations ratios. Collateral analysis includes a complete description of the collateral, as well as determining values, monitoring requirements, loan to value ratios, concentration risk, appraisal requirements and other information relevant to the collateral being pledged. Guarantor analysis includes liquidity and cash flow analysis based on the significance the guarantors are expected to serve as secondary repayment sources. The Bank’s underwriting standards are governed by adherence to its loan policy. The loan policy provides for specific guidelines by portfolio segment, including commercial and industrial, real estate, construction and land development, and consumer loans. Within each individual portfolio segment, permissible and impermissible loan types are explicitly outlined. Within the loan types, minimum requirements for the underwriting factors listed above are provided.

The Bank maintains a loan review department that reviews credit risk in response to both external and internal factors that potentially impact the performance of either individual loans or the overall loan portfolio. The loan review process reviews the creditworthiness of borrowers and determines compliance with the loan policy. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel. Results of these reviews are presented to management and the Bank’s Board of Directors.

In connection with the PlainsCapital Merger and the FNB Transaction, the Company acquired non-covered loans both with and without evidence of credit quality deterioration since origination. The following table presents the carrying values and the outstanding contractual balances of the non-covered PCI loans (in thousands).

	September 30,		December 31,
	2013		2012
Carrying amount	$	139,224	$	166,780
Outstanding balance	187,370		222,674

Changes in the accretable yield for the non-covered PCI loans were as follows (in thousands).

	Three Months Ended			Nine Months Ended
	September 30, 2013			September 30, 2013
Balance, beginning of period	$	20,118		$	17,553
Additions	1,923			1,923
Increases in expected cash flows	4,697			16,834
Disposals of loans	(441		)	(2,273		)
Accretion	(4,854		)	(12,594		)
Balance, end of period	$	21,443		$	21,443

Impaired loans exhibit a clear indication that the borrower’s cash flow may not be sufficient to meet principal and interest payments, which is generally when a loan is 90 days past due unless the asset is both well secured and in the process of collection. Non-covered impaired loans include non-accrual loans, troubled debt restructurings (“TDRs”), PCI loans and partially charged-off loans.

Non-covered PCI loans are summarized by class in the following tables (in thousands). In addition to the non-covered PCI loans, there were $1.1 million of additional non-covered impaired loans at September 30, 2013.

	Unpaid						Total
	Contractual		Nonaccretable		Accretable		Recorded		Related
September 30, 2013	Principal Balance		Difference		Yield		Investment		Allowance
Commercial and industrial:
Secured	$	71,924	$	16,557	$	4,401	$	56,831	$	2,732
Unsecured	9,678		5,062		3,937		1,676		—
Real estate:
Secured by commercial properties	51,525		11,704		7,236		42,077		205
Secured by residential properties	6,141		1,140		904		4,636		73
Construction and land development:
Residential construction loans	—		—		—		—		—
Commercial construction loans and land development	35,012		9,637		3,940		24,641		1
Consumer	13,090		3,265		1,025		9,363		—
	$	187,370	$	47,365	$	21,443	$	139,224	$	3,011

	Unpaid						Total
	Contractual		Nonaccretable		Accretable		Recorded
December 31, 2012	Principal Balance		Difference		Yield		Investment
Commercial and industrial:
Secured	$	91,633	$	24,982	$	6,114	$	67,967
Unsecured	12,198		8,707		472		3,419
Real estate:
Secured by commercial properties	66,736		15,816		7,294		55,519
Secured by residential properties	8,690		2,251		557		6,728
Construction and land development:
Residential construction loans	995		493		40		708
Commercial construction loans and land development	42,330		9,113		3,067		32,362
Consumer	92		16		9		77
	$	222,674	$	61,378	$	17,553	$	166,780

Average investment in non-covered PCI loans is summarized by class in the following table (in thousands).

	Three Months Ended		Nine Months Ended
	September 30, 2013		September 30, 2013
Commercial and industrial:
Secured	$	55,797	$	62,399
Unsecured	1,826		2,548
Real estate:
Secured by commercial properties	45,114		48,798
Secured by residential properties	5,400		5,682
Construction and land development:
Residential construction loans	—		354
Commercial construction loans and land development	25,916		28,502
Consumer	4,715		4,720
	$	138,768	$	153,003

Non-covered non-accrual loans at September 30, 2013, excluding those classified as held for sale, are summarized by class in the following table (in thousands).

Commercial and industrial:
Secured	$	16,099
Unsecured	23
Real estate:
Secured by commercial properties	1,856
Secured by residential properties	161
Construction and land development:
Residential construction loans	—
Commercial construction loans and land development	1,073
Consumer	—
	$	19,212

At September 30, 2013, non-covered non-accrual loans included non-covered PCI loans of $18.1 million for which discount accretion has been suspended because the extent and timing of cash flows from these non-covered PCI loans can no longer be reasonably estimated. All non-covered PCI loans at December 31, 2012 were considered to be performing due to the application of the accretion method. In addition to the non-covered non-accrual loans in the table above, $2.7 million and $1.8 million of real estate loans secured by residential properties and classified as held for sale were in non-accrual status at September 30, 2013 and December 31, 2012, respectively.

Interest income recorded on non-covered non-accrual loans for the three and nine months ended September 30, 2013 was nominal.

The Bank classifies loan modifications as TDRs when it concludes that it has both granted a concession to a debtor and that the debtor is experiencing financial difficulties. Loan modifications are typically structured to create affordable payments for the debtor and can be achieved in a variety of ways. The Bank modifies loans by reducing interest rates and/or lengthening loan amortization schedules. The Bank also reconfigures a single loan into two or more loans (“A/B Note”). The typical A/B Note restructure results in a “bad” loan which is charged off and a “good” loan or loans the terms of which comply with the Bank’s customary underwriting policies. The debt charged off on the “bad” loan is not forgiven to the debtor.

Information regarding TDRs granted is shown in the following tables (in thousands). All TDRs granted relate to non-covered PCI loans. At September 30, 2013, the Bank had $0.3 million in unadvanced commitments to borrowers whose loans have been restructured in TDRs.

	Recorded Investment in Loans Modified by
			Interest Rate		Payment Term		Total
Three months ended September 30, 2013	A/B Note		Adjustment		Extension		Modification
Commercial and industrial:
Secured	$	—	$	—	$	333	$	333
Unsecured	—		—		—		—
Real estate:
Secured by commercial properties	—		—		—		—
Secured by residential properties	—		—		—		—
Construction and land development:
Residential construction loans	—		—		—		—
Commercial construction loans and land development	—		—		—		—
Consumer	—		—		—		—
	$	—	$	—	$	333	$	333

	Recorded Investment in Loans Modified by
			Interest Rate		Payment Term		Total
Nine months ended September 30, 2013	A/B Note		Adjustment		Extension		Modification
Commercial and industrial:
Secured	$	—	$	—	$	9,764	$	9,764
Unsecured	—		—		—		—
Real estate:
Secured by commercial properties	—		—		276		276
Secured by residential properties	—		—		905		905
Construction and land development:
Residential construction loans	—		—		—		—
Commercial construction loans and land development	—		—		500		500
Consumer	—		—		—		—
	$	—	$	—	$	11,445	$	11,445

An analysis of the aging of the Bank’s non-covered loan portfolio is shown in the following tables (in thousands).

															Accruing Loans
	Loans Past Due		Loans Past Due		Loans Past Due		Total		Current		PCI		Total		Past Due
September 30, 2013	30-59 Days		60-89 Days		90 Days or More		Past Due Loans		Loans		Loans		Loans		90 Days or More
Commercial and industrial:
Secured	$	1,099	$	1,065	$	1,395	$	3,559	$	1,451,740	$	56,831	$	1,512,130	$	1,118
Unsecured	475		1,339		23		1,837		109,779		1,676		113,292		—
Real estate:
Secured by commercial properties	—		132		—		132		1,004,464		42,077		1,046,673		—
Secured by residential properties	698		20		—		718		270,027		4,636		275,381		—
Construction and land development:
Residential construction loans	—		—		—		—		57,205		—		57,205		—
Commercial construction loans and land development	—		112		—		112		228,434		24,641		253,187		—
Consumer	101		21		10		132		42,861		9,363		52,356		10
	$	2,373	$	2,689	$	1,428	$	6,490	$	3,164,510	$	139,224	$	3,310,224	$	1,128

															Accruing Loans
	Loans Past Due		Loans Past Due		Loans Past Due		Total		Current		PCI		Total		Past Due
December 31, 2012	30-59 Days		60-89 Days		90 Days or More		Past Due Loans		Loans		Loans		Loans		90 Days or More
Commercial and industrial:
Secured	$	7,844	$	348	$	2,131	$	10,323	$	1,473,242	$	67,967	$	1,551,532	$	2,000
Unsecured	3		—		—		3		105,339		3,419		108,761		—
Real estate:
Secured by commercial properties	714		—		—		714		868,070		55,519		924,303		—
Secured by residential properties	755		101		—		856		253,027		6,728		260,611		—
Construction and land development:
Residential construction loans	—		—		—		—		47,461		708		48,169		—
Commercial construction loans and land development	63		—		—		63		199,889		32,362		232,314		—
Consumer	84		—		—		84		26,545		77		26,706		—
	$	9,463	$	449	$	2,131	$	12,043	$	2,973,573	$	166,780	$	3,152,396	$	2,000

Management tracks credit quality trends on a quarterly basis related to: (i) past due levels, (ii) non-performing asset levels, (iii) classified loan levels, (iv) net charge-offs, and (v) general economic conditions in the state and local markets.

The Bank utilizes a risk grading matrix to assign a risk grade to each of the loans in its portfolio. A risk rating is assigned based on an assessment of the borrower’s management, collateral position, financial capacity, and economic factors. The general characteristics of the various risk grades are described below.

Pass — “Pass” loans present a range of acceptable risks to the Bank. Loans that would be considered virtually risk-free are rated Pass — low risk. Loans that exhibit sound standards based on the grading factors above and present a reasonable risk to the Bank are rated Pass — normal risk. Loans that exhibit a minor weakness in one or more of the grading criteria but still present an acceptable risk to the Bank are rated Pass — high risk.

Special Mention — “Special Mention” loans have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in a deterioration of the repayment prospects for the loans and weaken the Bank’s credit position at some future date. Special Mention loans are not adversely classified and do not expose the Bank to sufficient risk to require adverse classification.

Substandard — “Substandard” loans are inadequately protected by the current sound worth and paying capacity of the obligor or the collateral pledged, if any. Loans so classified must 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. Many substandard loans are considered impaired.

PCI — “PCI” loans exhibited evidence of credit deterioration at acquisition that made it probable that all contractually required principal payments would not be collected.

The following tables present the internal risk grades of non-covered loans, as previously described, in the portfolio by class (in thousands).

September 30, 2013	Pass		Special Mention		Substandard		PCI		Total
Commercial and industrial:
Secured	$	1,430,645	$	6,269	$	18,385	$	56,831	$	1,512,130
Unsecured	111,381		13		222		1,676		113,292
Real estate:
Secured by commercial properties	1,003,771		505		320		42,077		1,046,673
Secured by residential properties	266,949		—		3,796		4,636		275,381
Construction and land development:
Residential construction loans	57,205		—		—		—		57,205
Commercial construction loans and land development	227,192		874		480		24,641		253,187
Consumer	42,950		32		11		9,363		52,356
	$	3,140,093	$	7,693	$	23,214	$	139,224	$	3,310,224

December 31, 2012	Pass		Special Mention		Substandard		PCI		Total
Commercial and industrial:
Secured	$	1,476,420	$	2,515	$	4,630	$	67,967	$	1,551,532
Unsecured	105,142		200		—		3,419		108,761
Real estate:
Secured by commercial properties	868,784		—		—		55,519		924,303
Secured by residential properties	253,883		—		—		6,728		260,611
Construction and land development:
Residential construction loans	47,461		—		—		708		48,169
Commercial construction loans and land development	199,952		—		—		32,362		232,314
Consumer	26,629		—		—		77		26,706
	$	2,978,271	$	2,715	$	4,630	$	166,780	$	3,152,396

The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses inherent in the existing portfolio of loans. Management has responsibility for determining the level of the allowance for loan losses, subject to review by the Audit Committee of our Board of Directors and the Loan Review Committee of the Bank’s Board of Directors.

It is management’s responsibility at the end of each quarter, or more frequently as deemed necessary, to analyze the level of the allowance for loan losses to ensure that it is appropriate for the estimated credit losses in the portfolio consistent with the Interagency Policy Statement on the Allowance for Loan and Lease Losses and the Receivables and Contingencies Topics of the ASC. Estimated credit losses are the probable current amount of loans that the Company will be unable to collect given facts and circumstances as of the evaluation date. When management determines that a loan or portion thereof is uncollectible, the loan, or portion thereof, is charged off against the allowance for loan losses. Any subsequent recovery of charged-off loans is added back to the allowance for loan losses. As a result of the PlainsCapital Merger on November 30, 2012, the Bank’s loan portfolio is now designated into two populations: acquired loans and originated loans. The allowance for loan losses is calculated separately for the acquired and originated loans.

Originated Loans

The Company has developed a methodology that seeks to determine an allowance within the scope of the Receivables and Contingencies Topics of the ASC. Each of the loans that has been determined to be impaired is within the scope of the Receivables Topic and is individually evaluated for impairment using one of three impairment measurement methods as of the evaluation date: (1) the present value of expected future discounted cash flows on the loan, (2) the loan’s observable market price, or (3) the fair value of the collateral if the loan is collateral dependent. Specific reserves are provided in the estimate of the allowance based on the measurement of impairment under these three methods, except for collateral dependent loans, which require the fair value method. All non-impaired loans are within the scope of the Contingencies Topic. Estimates of loss for the Contingencies Topic are calculated based on historical loss experience by loan portfolio segment adjusted for changes in trends, conditions, and other relevant factors that affect repayment of loans as of the evaluation date. While historical loss experience provides a reasonable starting point for the analysis, historical losses, or recent trends in losses, are not the sole basis upon which to determine the appropriate level for the allowance for loan losses. Management considers recent qualitative or environmental factors that are likely to cause estimated credit losses associated with the existing portfolio to differ from historical loss experience, including but not limited to: changes in lending policies and procedures; changes in underwriting standards; changes in economic and business conditions and developments that affect the collectability of the portfolio; the condition of various market segments; changes in the nature and volume of the portfolio and in the terms of loans; changes in lending management and staff; changes in the volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans; changes in the loan review system; changes in the value of underlying collateral for collateral-dependent loans; and any concentrations of credit and changes in the level of such concentrations.

The loan review program is designed to identify and monitor problem loans by maintaining a credit grading process, requiring that timely and appropriate changes be made to reviewed loans and coordinating the delivery of the information necessary to assess the appropriateness of the allowance for loan losses. Loans are evaluated for impairment when: (i) payments on the loan are delayed, typically by 90 days or more (unless the loan is both well secured and in the process of collection), (ii) the loan becomes classified, (iii) the loan is being reviewed in the normal course of the loan review scope, or (iv) the loan is identified by the servicing officer as a problem.

Homogeneous loans, such as consumer installment loans, residential mortgage loans and home equity loans, are not individually reviewed and are generally risk graded at the same levels. The risk grade and reserves are established for each homogeneous pool of loans based on the expected net charge-offs from current trends in delinquencies, losses or historical experience and general economic conditions. At September 30, 2013 and December 31, 2012, there were no material delinquencies in these types of loans.

Acquired Loans

Purchased loans acquired in a business combination are recorded at their estimated fair value on their purchase date and with no carryover of the related allowance for loan losses. Performing acquired loans are subsequently evaluated for any required allowance at each reporting date. An allowance for loan losses is calculated using a methodology similar to that described above for originated loans. The allowance as determined for each loan is compared to the remaining fair value discount for that loan. If greater, the excess is recognized as an addition to the allowance through a provision for loan losses. If less than the discount, no additional allowance is recorded. Charge-offs and losses first reduce any remaining fair value discount for the loan and once the discount is depleted, losses are applied against the allowance established for that loan.

For PCI loans, cash flows expected to be collected are recast quarterly for each loan. These evaluations require the continued use and updating of key assumptions and estimates such as default rates, loss severity given default and prepayment speed assumptions, similar to those used for the initial fair value estimate. Management judgment must be applied in developing these assumptions. If expected cash flows for a loan decreases, an increase in the allowance for loan losses is made through a charge to the provision for loan losses. If expected cash flows for a loan increase, any previously established allowance for loan losses is reversed and any remaining difference increases the accretable yield which will be taken into income over the remaining life of the loan.

The allowance is subject to regulatory examinations and determinations as to appropriateness, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance.

Changes in the allowance for non-covered loan losses, distributed by portfolio segment, are shown below (in thousands).

	Commercial and						Construction and
Three months ended September 30, 2013	Industrial			Real Estate			Land Development			Consumer			Total
Balance, beginning of period	$	13,806		$	5,339		$	7,050		$	42		$	26,237
Provision charged to operations	8,879			1,776			6			(3		)	10,658
Loans charged off	(3,220		)	(53		)	(524		)	(3		)	(3,800		)
Recoveries on charged off loans	42			26			2			15			85
Balance, end of period	$	19,507		$	7,088		$	6,534		$	51		$	33,180

	Commercial and						Construction and
Nine months ended September 30, 2013	Industrial			Real Estate			Land Development			Consumer			Total
Balance, beginning of period	$	1,845		$	977		$	582		$	5		$	3,409
Provision charged to operations	22,519			6,033			6,323			77			34,952
Loans charged off	(7,314		)	(149		)	(524		)	(74		)	(8,061		)
Recoveries on charged off loans	2,457			227			153			43			2,880
Balance, end of period	$	19,507		$	7,088		$	6,534		$	51		$	33,180

The non-covered loan portfolio was distributed by portfolio segment and impairment methodology as shown below (in thousands).

	Commercial and				Construction and
September 30, 2013	Industrial		Real Estate		Land Development		Consumer		Total
Loans individually evaluated for impairment	$	940	$	161	$	—	$	—	$	1,101
Loans collectively evaluated for impairment	1,565,975		1,275,180		285,751		42,993		3,169,899
PCI Loans individually evaluated for impairment	58,507		46,713		24,641		9,363		139,224
	$	1,625,422	$	1,322,054	$	310,392	$	52,356	$	3,310,224

	Commercial and				Construction and
December 31, 2012	Industrial		Real Estate		Land Development		Consumer		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment	1,588,907		1,122,667		247,413		26,629		2,985,616
PCI Loans individually evaluated for impairment	71,386		62,247		33,070		77		166,780
	$	1,660,293	$	1,184,914	$	280,483	$	26,706	$	3,152,396

The allowance for non-covered loan losses was distributed by portfolio segment and impairment methodology as shown below (in thousands).

	Commercial and				Construction and
September 30, 2013	Industrial		Real Estate		Land Development		Consumer		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment	16,775		6,810		6,533		51		30,169
PCI Loans individually evaluated for impairment	2,732		278		1		—		3,011
	$	19,507	$	7,088	$	6,534	$	51	$	33,180

	Commercial and				Construction and
December 31, 2012	Industrial		Real Estate		Land Development		Consumer		Total
Loans individually evaluated for impairment	$	—	$	—	$	—	$	—	$	—
Loans collectively evaluated for impairment	1,845		977		582		5		3,409
PCI Loans individually evaluated for impairment	—		—		—		—		—
	$	1,845	$	977	$	582	$	5	$	3,409