LOANS AND ALLOWANCE FOR LOAN LOSSES

General. The Bank provides to its customers a full range of short- to medium-term commercial, agricultural, Small Business Administration guaranteed, mortgage, home equity, and personal loans, both secured and unsecured. The Bank also makes real estate mortgage and construction loans.

The following table presents loans at December 31, 2011 and 2010 by class:



	December 31, 2011			December 31, 2010
	(in thousands)
Construction and land development	$	202,803		$	300,877
Commercial real estate:
Owner occupied	348,931			309,198
Non-owner occupied	242,827			312,231
Residential mortgages:
1-4 family	179,047			174,536
Multifamily	39,881			29,268
Home equity lines of credit	201,220			209,319
Commercial	177,047			199,696
Consumer and other	58,283			65,003
Total	1,450,039			1,600,128
Less: Net deferred loan origination fees	885			411
Allowance for loan losses	(32,848		)	(37,752		)
Loans, net	$	1,418,076		$	1,562,787

Real Estate Loans. Real estate loans include construction and land development loans, commercial real estate loans, home equity lines of credit, and residential mortgages.

Commercial real estate loans totaled $591.8 million and $621.4 million at December 31, 2011 and 2010, respectively. This lending has involved loans secured by owner-occupied commercial buildings for office, storage and warehouse space, as well as non-owner occupied commercial buildings. The Bank generally requires the personal guaranty of borrowers and a demonstrated cash flow capability sufficient to service the debt. Loans secured by commercial real estate may be larger in size and may involve a greater degree of risk than one-to-four family residential mortgage loans. Payments on such loans are often dependent on successful operation or management of the properties.

Construction/development lending totaled $202.8 million and $300.9 million at December 31, 2011 and 2010, respectively. The Bank originates one-to-four family residential construction loans for the construction of custom homes (where the home buyer is the borrower) and provides financing to builders and consumers for the construction of pre-sold homes. The Bank generally receives a pre-arranged permanent financing commitment from an outside banking entity prior to financing the construction of pre-sold homes. The Bank also makes commercial real estate construction loans, primarily for owner-occupied properties. The Bank limits its construction lending risk through adherence to established underwriting procedures.

Residential one-to-four family loans amounted to $179.0 million and $174.5 million at December 31, 2011 and 2010, respectively. The Bank’s residential mortgage loans are typically construction loans that convert into permanent financing and are secured by properties located within the Bank’s market areas.

Commercial Loans. At December 31, 2011 and 2010, the Bank’s commercial loan portfolio totaled $177.0 million and $199.7 million, respectively. Commercial loans include both secured and unsecured loans for working capital, expansion, and other business purposes. Short-term working capital loans are secured by accounts receivable, inventory and/or equipment. The Bank also makes term commercial loans secured by equipment and real estate. Lending decisions are based on an evaluation of the financial strength, cash flow, management and credit history of the borrower, and the quality of the collateral securing the loan. With few exceptions, the Bank requires personal guarantees and secondary sources of repayment. Commercial loans generally provide greater yields and reprice more frequently than other types of loans, such as real estate loans.

Loans to Individuals. Loans to individuals (consumer loans) include automobile loans, boat and recreational vehicle financing, and miscellaneous secured and unsecured personal loans and totaled $58.3 million and $65.0 million at December 31, 2011 and 2010, respectively. Consumer loans generally can carry significantly greater risks than other loans, even if secured, if the collateral consists of rapidly depreciating assets such as automobiles and equipment. Repossessed collateral securing a defaulted consumer loan may not provide an adequate source of repayment of the loan. Consumer loan collections are sensitive to job loss, illness and other personal factors. The Bank manages the risks inherent in consumer lending by following established credit guidelines and underwriting practices designed to minimize risk of loss.

Loan Approvals. The Bank’s loan policies and procedures establish the basic guidelines governing its lending operations. The guidelines address the type of loans that the Bank seeks, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. All loans or credit lines are subject to approval procedures and amount limitations. These limitations apply to the borrower’s total outstanding indebtedness to the Bank, including any indebtedness as a guarantor. The policies are reviewed and approved at least annually by the Board of Directors of the Bank. The Bank supplements its own supervision of the loan underwriting and approval process with periodic loan reviews by independent, outside professionals experienced in loan review. Responsibility for loan review and loan underwriting resides with the Chief Credit Officer position. This position is responsible for loan underwriting and approval. On an annual basis, the Board of Directors of the Bank determines officers lending authority. Authorities may include loans, letters of credit, overdrafts, uncollected funds and such other authorities as determined by the Board of Directors.

Substantially all of the Company's loans have been granted to customers in the Piedmont, foothills, northwestern mountains, and the Research Triangle regions of North Carolina and the upstate region of South Carolina.

In the normal course of business, the Company makes loans to directors and officers of the Company and its subsidiaries. All loans and commitments made to such officers and directors and to companies in which they are officers, or have significant ownership interest, have been made on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers. Loans to directors, officers and related parties are subject to comparable loan features and present the same credit risk as those of non-related parties. An analysis of these related party loans for the year ended December 31, 2010 and 2009 is as follows:



	2011			2010
Balance, beginning of year	$	17,712,228		$	20,329,480
New loans	1,403,414			2,046,131
Repayments	(3,332,098		)	(4,663,383		)
Balance, end of year	$	15,783,544		$	17,712,228

Credit Review and Evaluation. The Bank has a credit risk review department that reports to the Chief Credit Officer. The focus of the department is on policy compliance and proper grading of higher credit risk loans as well as new and existing loans on a sample basis. Additional reporting for problem/criticized assets has been developed along with an after-the-fact loan review.

The Bank uses a risk grading program to facilitate the evaluation of probable inherent loan losses and the adequacy of the allowance for loan losses for real estate, commercial and consumer loans. In this program, risk grades are initially assigned by loan officers, reviewed by regional credit officers, and reviewed by internal credit review analysts on a test basis. The Bank strives to maintain the loan portfolio in accordance with conservative loan underwriting policies that result in loans specifically tailored to the needs of the Bank’s market area. Every effort is made to identify and minimize the credit risks associated with such lending strategies.

Loans over $20,000 are risk graded on a scale from 1 (highest quality) to 8 (loss). Acceptable loans at inception are grades 1 through 4, and these grades have underwriting requirements that at least meet the minimum requirements of a secondary market source. If borrowers do not meet credit history requirements, other mitigating criteria such as substantial liquidity and low loan-to-value ratios could be considered and would generally have to be met in order to make the loan. The Bank’s loan policy states that a guarantor may be necessary if reasonable doubt exists as to the borrower’s ability to repay. The Board of Directors has authorized the loan officers to have individual approval authority for risk grade 1 through 4 loans up to maximum exposure limits for each customer. New or renewed loans that are graded 5 (special mention) or lower must have approval from a regional credit officer. Any changes in risk assessments as determined by loan officers, credit administrators, regulatory examiners and management are also considered.

The risk grades, normally assigned by the loan officers when the loan is originated and reviewed by the regional credit officers, are based on several factors including historical data, current economic factors, composition of the portfolio, and evaluations of the total loan portfolio and assessments of credit quality within specific loan types. In some cases the risk grades are assigned by regional executives, depending upon dollar exposure. Because these factors are dynamic, the provision for loan losses can fluctuate. Credit quality reviews are based primarily on analysis of borrowers’ cash flows, with asset values considered only as a second source of payment. Regional credit officers work with lenders in underwriting, structuring and risk grading the Bank’s credits. The Risk Review Officer focuses on lending policy compliance, credit risk grading, and credit risk reviews on larger dollar exposures. Management uses the information developed from the procedures above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in determining the appropriate levels of the allowance for loan losses.

The following is a summary of the credit risk grade definitions for all loan types. These credit risk indicators were last updated in December 2011:

“1” — Highest Quality- These loans represent a credit extension of the highest quality. The borrower’s historic (at least five years) cash flows manifest extremely large and stable margins of coverage. Balance sheets are conservative, well capitalized, and liquid. After considering debt service for proposed and existing debt, projected cash flows continue to be strong and provide ample coverage. The borrower typically reflects broad geographic and product diversification and has access to alternative financial markets.

“2” — Good Quality- These loans have a sound primary and secondary source of repayment. The borrower may have access to alternative sources of financing, but sources are not as widely available as they are to a higher graded borrower. This loan carries a normal level of risk, with minimal loss exposure. The borrower has the ability to perform according to the terms of the credit facility. The margins of cash flow coverage are satisfactory but vulnerable to more rapid deterioration than the highest quality loans.

“3” — Satisfactory- The borrowers are a reasonable credit risk and demonstrate the ability to repay the debt from normal business operations. Risk factors may include reliability of margins and cash flows, liquidity, dependence on a single product or industry, cyclical trends, depth of management, or limited access to alternative financing sources. Historic financial information may indicate erratic performance, but current trends are positive. Quality of financial information is adequate, but is not as detailed and sophisticated as information found on higher graded loans. If adverse circumstances arise, the impact on the borrower may be significant.

“4” — Satisfactory – Merits Attention- These credit facilities have potential developing weaknesses that deserve extra attention from the account manager and other management personnel. If the developing weakness is not corrected or mitigated, there may be deterioration in the ability of the borrower to repay the bank’s debt in the future.

“5” — Watch or Special Mention - These loans are typically existing loans, made using the passing grades outlined above, that have deteriorated to the point that cash flow is not consistently adequate to meet debt service or current debt service coverage is based on projections. Secondary sources of repayment may include specialized collateral or real estate that is not readily marketable or undeveloped, making timely collection in doubt.

“6” — Substandard- Loans and other credit extensions bearing this grade are considered inadequately protected by the current sound worth and debt service capacity of the borrower or of any pledged collateral. These obligations, even if apparently protected by collateral value, have well-defined weaknesses related to adverse financial, managerial, economic, market, or political conditions jeopardizing repayment of principal and interest as originally intended. Clear loss potential, however, does not have to exist in any individual assets classified as substandard.

“7” — Substandard Impaired (also includes any loans over 90 days past due, excluding sold mortgages )- Loans and other credit extensions graded “7” have all the weaknesses inherent in those graded “6,” with the added characteristic that the severity of the weaknesses makes collection or liquidation in full highly questionable or improbable based upon currently existing facts, conditions, and values. The probability of some loss is extremely high.

“8” — Loss- Loans in this classification are considered uncollectible and cannot be justified as a viable asset of the bank. Such loans are to be charged-off or charged-down. This classification does not mean the loan has absolutely no recovery value, but that it is neither practical nor desirable to defer writing off this loan even though partial recovery may be obtained in the future.

The following is a summary of credit quality indicators by class at December 31, 2011 and 2010:



Real Estate Credit Exposure as of December 31, 2011
			Commercial Real Estate
	Construction		Owner occupied		Non-owner occupied		1-4 Family		Multifamily		Home Equity
	(Amounts in thousands)
High Quality	$	—	$	126	$	—	$	423	$	—	$	132
Good Quality	543		32		117		1,701		—		7,545
Satisfactory	30,446		110,051		61,416		98,992		8,789		125,932
Merits Attention	93,974		180,173		134,247		57,310		28,824		58,576
Special Mention	41,739		23,326		24,307		9,112		697		4,807
Substandard	5,054		10,069		11,162		3,586		629		2,006
Substandard Impaired	31,047		25,154		11,578		7,923		942		2,222
Loss	—		—		—		—		—		—
	$	202,803	$	348,931	$	242,827	$	179,047	$	39,881	$	201,220

Other Credit Exposures as of December 31, 2011
	Commercial		Consumer and other
	(Amounts in thousands)
High Quality	$	2,690	$	1,831
Good Quality	5,472		1,482
Satisfactory	55,309		27,508
Merits Attention	80,064		25,607
Special Mention	12,224		1,189
Substandard	10,367		118
Substandard Impaired	10,921		548
Loss	—		—
	$	177,047	$	58,283



Real Estate Credit Exposure as of December 31, 2010
			Commercial Real Estate
	Construction		Owner occupied		Non-owner occupied		1-4 Family		Multifamily		Home Equity
	(Amounts in thousands)
High Quality	$	—	$	132	$	—	$	440	—		$	153
Good Quality	612		1,535		195		1,924		—		8,465
Satisfactory	53,704		98,531		73,825		95,541		7,964		132,155
Merits Attention	124,699		150,494		163,648		55,300		19,922		57,513
Special Mention	49,369		27,478		37,018		6,966		90		4,938
Substandard	37,798		15,132		24,219		7,117		311		3,012
Substandard Impaired	34,695		15,896		13,326		7,248		981		3,083
Loss	—		—		—		—		—		—
	$	300,877	$	309,198	$	312,231	$	174,536	$	29,268	$	209,319

Other Credit Exposures as of December 31, 2010
	Commercial		Consumer and other
	(Amounts in thousands)
High Quality	$	5,005	$	1,952
Good Quality	6,620		1,589
Satisfactory	63,472		34,841
Merits Attention	78,188		24,424
Special Mention	31,311		1,224
Substandard	6,391		311
Substandard Impaired	8,709		662
Loss	—		—
	$	199,696	$	65,003

Nonaccrual loans and past due loans. Nonperforming assets include loans classified as nonaccrual, foreclosed bank-owned property and loans past due 90 days or more on which interest is still being accrued. It is the general policy of the Bank to stop accruing interest for all classes of loans past due 90 days or when it is apparent that the collection of principal and/or interest is doubtful. In addition, certain restructured loans are placed on nonaccrual status until sufficient evidence of timely payment is obtained. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is reversed against interest income in the current period. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. There were no financing receivables past due over 90 days accruing interest as of December 31, 2011 and 2010.

Nonperforming loans as of December 31, 2011 totaled $70.4 million, or 4.78% of total loans, compared with $65.4 million, or 3.96% of total loans, as of December 31, 2010. The Bank aggressively pursues the collection and repayment of all loans. Other nonperforming assets, such as repossessed and foreclosed collateral is aggressively liquidated by the Bank’s collection department. The total number of loans on nonaccrual status has increased from 490 to 505 since December 31, 2010. The increase in nonperforming loans from December 31, 2010 to December 31, 2011 is related primarily to continued deterioration of previously classified loans and the addition of troubled debt restructured loans which will remain on nonaccrual status until sufficient payment evidence is obtained.

The following is a breakdown of nonaccrual loans as of December 31, 2011 and 2010:



	December 31, 2011		December 31, 2010
Financing Receivables on Nonaccrual status	(Amounts in thousands)
Construction	$	26,575	$	25,833
Commercial Real Estate:
Owner occupied	16,339		12,829
Non-owner occupied	7,634		10,767
Mortgages:
1-4 Family first lien	7,271		7,889
Multifamily	942		967
Home Equity lines of credit	2,222		3,068
Commercial	8,896		3,420
Consumer and other	475		627
Total	$	70,354	$	65,400

Past due loans reported in the following table do not include loans granted forbearance terms since payments terms have been modified or extended, although the loans are past due based on original contract terms. All loans with forbearance terms are included and reported as impaired loans.

Loans are considered past due if the required principal and interest income have not been received as of the date such payments were due. The Bank has no loans greater than 90 days past due still accruing interest at December 31, 2011 or 2010.

The following table presents the Bank’s aged analysis of past due loans:



	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans
December 31, 2011	(Amounts in thousands)
Construction	$	2,265	$	402	$	15,538	$	18,205	$	184,598	$	202,803
Commercial real estate:
Owner occupied	4,342		1,215		3,727		9,284		339,647		348,931
Non-owner occupied commercial	9,723		86		4,679		14,488		228,339		242,827
Commercial	586		1,432		2,087		4,105		172,942		177,047
Mortgages:
Secured 1-4 family- first lien	3,441		1,049		2,955		7,445		171,602		179,047
Multifamily	277		—		896		1,173		38,708		39,881
Home equity lines of credit	—		634		856		1,490		199,730		201,220
Consumer and other	375		61		128		564		57,719		58,283
Total	$	21,009	$	4,879	$	30,866	$	56,754	$	1,393,285	$	1,450,039
December 31, 2010
Construction	$	5,747	$	3,951	$	11,542	$	21,240	$	279,637	$	300,877
Commercial real estate:
Owner occupied commercial	5,814		1,635		5,464		12,913		296,285		309,198
Non-owner occupied	1,616		722		530		2,868		309,363		312,231
Commercial	1,086		949		241		2,276		197,420		199,696
Mortgages:
Secured 1-4 family- first lien	3,457		1,988		5,643		11,088		163,448		174,536
Multifamily	845		150		40		1,035		28,233		29,268
Home equity lines of credit	2,388		211		2,045		4,644		204,675		209,319
Consumer and other	669		285		232		1,186		63,817		65,003
Total	$	21,622	$	9,891	$	25,737	$	57,250	$	1,542,878	$	1,600,128

Impaired Loans. Management considers certain loans graded “substandard impaired” (loans graded 7) or “loss” (loans graded 8) to be individually impaired and may consider “substandard” loans (loans graded 6) individually impaired depending on the borrower’s payment history. The Bank measures impairment based upon probable cash flows or the value of the collateral. Collateral value is assessed based on collateral value trends, liquidation value trends, and other liquidation expenses to determine logical and credible discounts that may be needed. Updated appraisals are required for all impaired loans and typically at renewal or modification of larger loans if the appraisal is more than 12 months old.

Impaired loans for all classes of loans typically include nonaccrual loans, loans over 90 days past due still accruing, troubled debt restructured loans and other potential problem loans considered impaired based on other underlying factors. Troubled debt restructured loans are those for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral of interest or principal have been granted due to the borrower’s weakened financial condition. Interest on troubled debt restructured loans is accrued at the restructured rates when it is anticipated that no loss of original principal will occur and a sustained payment performance period is obtained. Due to the borrowers’ inability to make the payments required under the original loan terms, the Bank modifies the terms by granting a longer amortized repayment structure or reduced interest rates. Potential problem loans are loans which are currently performing and are not included in nonaccrual or restructured loans above, but about which we have serious doubts as to the borrower’s ability to comply with present repayment terms. These loans are likely to be included later in nonaccrual, past due or troubled debt restructured loans, so they are considered by management in assessing the adequacy of the allowance for loan losses.

The following table presents the Bank's investment in loans considered to be impaired and related information on those impaired loans as of December 31, 2011 and 2010.



							Year to Date
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
December 31, 2011	(Amounts in thousands)
Impaired loans without a related allowance for loan losses
Construction	$	28,067	$	40,045	$	—	$	27,010	$	234
Commercial real estate:
Owner occupied	17,586		20,070		—		15,319		272
Non-owner occupied	8,639		11,255		—		8,803		210
Commercial	6,381		6,436		—		4,280		132
Mortgages:
Secured 1-4 family real estate	3,843		4,285		—		3,051		35
Multifamily	295		309		—		302		—
Open ended secured 1-4 family	525		694		—		686		—
Consumer and other	—		—		—		—		—
Impaired loans with a related allowance for loan losses
Construction	$	1,011	$	1,011	$	570	$	7,195	$	50
Commercial real estate:
Owner occupied	6,459		6,533		585		4,044		53
Non-owner occupied	975		1,363		143		3,255		8
Commercial	2,914		2,920		2,511		3,655		92
Mortgages:
Secured 1-4 family real estate	498		517		45		1,473		6
Multifamily	300		319		135		421		—
Open ended secured 1-4 family	403		412		112		654		4
Consumer and other	—		—		—		100		—
Total impaired loans
Construction	$	29,078	$	41,056	$	570	$	34,205	$	284
Commercial real estate:
Owner occupied	24,045		26,603		585		19,363		325
Non-owner occupied	9,614		12,618		143		12,058		218
Commercial	9,295		9,356		2,511		7,935		224
Mortgages:
Secured 1-4 family real estate	4,341		4,802		45		4,524		41
Multifamily	595		628		135		723		—
Open ended secured 1-4 family	928		1,106		112		1,340		4
Consumer and other	—		—		—		100		—
Total impaired loans individually reviewed for impairment	$	77,896	$	96,169	$	4,101	$	80,248	$	1,096



	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
December 31, 2010	(in thousands)
Impaired loans without a related allowance for loan losses
Construction	$	21,677	$	32,573	—		$	11,427	$	230
Commercial real estate:
Owner occupied commercial real estate	11,573		13,892		—		5,109		207
Non-owner occupied commercial real estate	5,732		6,660		—		2,380		99
Commercial	1,998		2,630		—		1,226		45
Mortgages:
Secured 1-4 family real estate	3,122		4,056		—		1,427		64
Multifamily	310		315		—		192		13
Open ended secured 1-4 family	953		961		—		294		12
Consumer and other	—		—		—		72		5
Impaired loans with a related allowance for loan losses
Construction	$	11,116	$	12,845	$	2,141	$	16,379	$	263
Commercial real estate:
Owner occupied commercial real estate	5,077		5,104		860		4,416		134
Non-owner occupied commercial real estate	6,484		6,861		1,096		5,758		141
Commercial	5,435		5,435		1,318		4,266		101
Mortgages:
Secured 1-4 family real estate	2,133		2,225		343		3,270		57
Multifamily	469		476		82		159		9
Open ended secured 1-4 family	898		898		439		780		14
Consumer and other	134		135		35		73		3
Total impaired loans
Construction	$	32,793	$	45,418	$	2,141	$	27,806	$	493
Commercial real estate:
Owner occupied commercial real estate	16,650		18,996		860		9,525		341
Non-owner occupied commercial real estate	12,216		13,521		1,096		8,138		240
Commercial	7,433		8,065		1,318		5,492		146
Mortgages:
Secured 1-4 family real estate	5,255		6,281		343		4,697		121
Multifamily	779		791		82		351		22
Open ended secured 1-4 family	1,851		1,859		439		1,074		26
Consumer and other	134		135		35		145		8
Total impaired loans individually reviewed for impairment	$	77,111	$	95,066	$	6,314	$	57,228	$	1,397

Impaired loans acquired without a related allowance for loan losses includes loans for which no additional reserves have been recorded in excess of credit discounts for purchased impaired loans. Impaired loans acquired with subsequent deterioration and related allowance for loan losses are loans in which additional impairment has been identified in excess of credit discounts resulting in additional reserves. These additional reserves are included in the allowance for loan losses related to purchased impaired loans and were $49,000 and $47,000 as of December 31, 2011 and 2010, respectively. The following table presents information regarding the change in all purchased impaired loans from the Company’s acquisition of American Community on April 17, 2009 through December 31, 2011.



	Contractual Principal Receivable			Nonaccretable Difference			Carrying Amount
	(Amounts in thousands)
Balance at April 15, 2009	$	14,513		$	3,825		$	10,688
Change due to payoff received	(457		)	(63		)	(394		)
Transfer to foreclosed real estate	(4,339		)	(266		)	(4,073		)
Change due to charge-offs	(4,329		)	(2,999		)	(1,330		)
Balance at December 31, 2009	$	5,388		$	497		$	4,891
Change due to payoff received	(1,528		)	(20		)	(1,508		)
Transfer to foreclosed real estate	(1,345		)	(159		)	(1,186		)
Change due to charge-offs	(860		)	(246		)	(614		)
Balance at December 31, 2010	$	1,655		$	72		$	1,583
Change due to payoff received	(300		)	(27		)	(273		)
Transfer to foreclosed real estate	(830		)	—			(830		)
Change due to charge-offs	(51		)	$	—		(51		)
Balance at December 31, 2011	$	474		$	45		$	429

At December 31, 2011, the outstanding balance of purchased impaired loans from American Community, which includes principal, interest and fees due, was $429,000. Because of the uncertainty of the expected cash flows, the Company is accounting for each purchased impaired loan under the cost recovery method, in which all cash payments are applied to principal. Thus, there is no accretable yield associated with the above loans.

Troubled Debt Restructured Loans. Total amount of troubled debt restructured loans outstanding as of December 31, 2011 were $43.5 million with related reserves of $2.3 million. Approximately $17.2 million of troubled debt restructured loans are accruing interest as of December 31, 2011, as these loans have sufficient evidence of paying according to the new restructured terms.

In April 2011, the FASB issued guidance regarding “A Creditor's Determination of Whether a Restructuring is a Troubled Debt Restructuring.” The provisions of this new standard provide additional guidance related to determining whether a creditor has granted a concession, including factors and examples for creditors to consider in evaluating whether a restructuring results in a delay in payment that is insignificant, prohibiting creditors from using the borrower's effective rate test to evaluate whether a concession has been granted to the borrower, and adding factors for creditors to use in determining whether a borrower is experiencing financial difficulties. As a result, the Company added approximately $2.6 million in loans now considered to be troubled debt restructured loans.

The following table includes the recorded investment and number of modifications for troubled debt restructured loans for the year ended December 31, 2011. The Company reports the recorded investment in the loans prior to a modification and also the recorded investment in the loans after the loans were restructured.



	Year ended December 31, 2011
	Number of loans	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Adjustment to Reserves as a Result of the Restructuring
Below market interest rate:	(Amounts in thousands)
Construction	5	$	5,768	$	5,341	$	274
Secured 1-4 family mortgages	1	150		150		—
	6	$	5,918	$	5,491	$	274
Extended payment terms:
Construction	8	$	2,704	$	2,696	$	—
Commercial real estate:
Non-owner occupied	3	1,133		536		—
Owner occupied commercial	13	10,445		9,983		315
Secured 1-4 family mortgages	2	327		303		5
Commercial	3	346		346		—
	29	$	14,955	$	13,864	$	320
Principal payment reduction:
Construction	4	$	3,302	$	1,942	$	—
Owner occupied commercial real estate	1	240		240		—
Home equity lines of credit	1	165		165		—
Commercial	2	64		64		—
	8	$	3,771	$	2,411	$	—

Total	43	$	24,644	$	21,766	$	594

The following table presents loans that were modified as troubled debt restructurings within the previous 12 months and for which there was a payment default during the year ended December 31, 2011.



	For the Year Ended December 31, 2011
	Number of loans	Recorded Investment
	(Amounts in thousands)
Extended payment terms:
Construction	1	$	221
Owner occupied commercial real estate	2	124
Commercial	3	346
Secured 1-4 family- first lien	1	120
	7	$	811

Principal payment reduction:
Construction	1	$	797
Owner occupied commercial real estate	1	240
	2	$	1,037

Total	9	$	1,848

Allowance for Loan Losses. The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate for probable losses that have been incurred within the existing portfolio of loans. The primary risks inherent in the Bank’s loan portfolio, including the adequacy of the allowance or reserve for loan losses, are based on management’s assumptions regarding, among other factors, general and local economic conditions, which are difficult to predict and are beyond the Bank’s control. In estimating these risks, and the related loss reserve levels, management also considers the financial conditions of specific borrowers and credit concentrations with specific borrowers, groups of borrowers, and industries.

The allowance for loan losses is adjusted by direct charges to provision expense. Losses on loans are charged against the allowance for loan losses in the accounting period in which they are determined by management to be uncollectible. Recoveries during the period are credited to the allowance for loan losses. The provision for loan losses was $20.8 million for the year ended December 31, 2011 as compared to $24.3 million for the year ended December 31, 2010; and $48.4 million for the year ended December 31, 2009. The provision expense is determined by the Bank’s allowance for loan losses model. The components of the model are specific reserves for impaired loans and a general allocation for unimpaired loans. The general allocation has two components, an estimate based on historical loss experience and an additional estimate based on internal and external environmental factors due to the uncertainty of historical loss experience in predicting current embedded losses in the portfolio that will be realized in the future.

The portion of the general allocation on environmental factors includes estimates of losses related to interest rate trends, unemployment trends, real estate characteristics, past due and nonaccrual trends, watch list trends, charge-off trends, and underwriting and servicing assessments. During the second quarter of 2011, a new environmental factor was added to reflect changes in real estate market values over the average life of construction and permanent real estate loans. The application of this new factor during the year resulted in additional reserves of approximately $1.3 million. Markets served by the Bank continue to experience softening from the general economy and declines in real estate values. The real estate characteristics component includes trends in real estate concentrations, exceptions to FDIC guidelines for loan-to-value ratios, and changes in real estate market values. Other factors impacting the allowance at December 31, 2011 were watch list trends, unemployment rate trends, and underwriting and servicing assessments.

The following table presents changes in the allowance for loan losses for the years ended December 31, 2011 and 2010:



	December 31, 2010		Charge-offs		Recoveries		Provision			December 31, 2011
	(Amounts in thousands)
Construction	$	12,014	$	11,391	$	2,010	$	5,581		$	8,214
Commercial real estate:
Owner occupied	5,958		3,611		136		3,309			5,792
Non-owner occupied	7,150		4,014		53		1,479			4,668
Commercial	4,335		3,494		423		4,448			5,712
Mortgages:
Secured 1-4 family- first lien	3,706		2,509		174		2,355			3,726
Multifamily	424		11		—		392			805
Open ended secured 1-4 family	3,298		3,151		106		3,057			3,310
Consumer and other	867		652		184		222			621
Total	$	37,752	$	28,833	$	3,086	$	20,843		$	32,848

	December 31, 2009		Charge-offs		Recoveries		Provision			December 31, 2010
	(Amounts in thousands)
Construction	$	19,978	$	19,484	$	483	$	11,037		$	12,014
Commercial real estate:
Owner occupied	6,423		3,030		211		2,354			5,958
Non-owner occupied	9,756		3,322		11		705			7,150
Commercial	3,299		4,226		409		4,853			4,335
Mortgages:
Secured 1-4 family- first lien	3,926		3,178		69		2,889			3,706
Multifamily	493		—		42		(111		)	424
Open ended secured 1-4 family	3,401		2,832		69		2,660			3,298
Consumer and other	1,349		748		304		(38		)	867
	$	48,625	$	36,820	$	1,598	$	24,349		$	37,752

During the first quarter of 2011, the Company underwent a review of loan classifications within the portfolio and noted approximately $40.9 million in reclassifications between non-owner occupied and owner occupied commercial real estate. As a result, allowances for loan losses in those categories were impacted as reserve percentages on certain loans may have increased or decreased based on new classifications.



As of December 31, 2011	Reserves for loans individually evaluated for impairment		Loans individually evaluated for impairment		Reserves for loans collectively evaluated for impairment		Loans collectively evaluated for impairment
	(Amounts in thousands)
Construction	$	570	$	29,078	$	7,644	173,725
Commercial real estate:
Owner occupied	585		24,045		5,207		324,886
Non-owner occupied	143		9,614		4,525		233,213
Commercial	2,511		9,295		3,201		167,752
Mortgages:
Secured 1-4 family- first lien	45		4,341		3,681		174,706
Multifamily	135		595		670		39,286
Open ended secured 1-4 family	112		928		3,198		200,292
Consumer and other	—		—		621		58,283
	$	4,101	$	77,896	$	28,747	1,372,143
As of December 31, 2010
	Reserves for loans individually evaluated for impairment		Loans individually evaluated for impairment		Reserves for loans collectively evaluated for impairment		Loans collectively evaluated for impairment
	(Amounts in thousands)
Construction	$	2,141	$	32,793	$	9,873	$	268,084
Commercial real estate:
Owner occupied	860		16,650		5,098		292,548
Non owner occupied	1,096		12,216		6,054		300,015
Commercial	1,318		7,433		3,016		192,262
Mortgages:
Secured 1-4 family- first lien	343		5,255		3,363		169,281
Multifamily	82		779		342		28,489
Open ended secured 1-4 family	439		1,851		2,859		207,468
Consumer and other	35		134		832		64,869
	$	6,314	$	77,111	$	31,437	$	1,523,016

The following table presents changes in the allowance for loan losses for the years ended December 31, 2009:



	For the year ended December 31, 2009
	(in thousands)
Balance, beginning of year	$	22,355

Charge-offs:
Real estate loans	(15,009		)
Installment loans	(1,255		)
Credit card and related plans	(107		)
Commercial and all other	(6,176		)
Leases	(256		)
	(22,803		)
Recoveries:
Real estate loans	204
Installment loans	85
Credit card and related plans	2
Commercial and all other	333
Leases	10
	634

Net charge-offs	(22,169		)

Provision for loan losses	48,439
Allowance acquired from Cardinal State Bank	—
Balance, end of year	$	48,625

The allowance model is applied to determine the specific allowance balance for impaired loans and the general allowance balance for unimpaired loans grouped by loan type.

The Company’s loan charge-off policy for all loan classes is to charge down loans to net realizable value once a portion of the loan is determined to be uncollectable, and the underlying collateral shortfall is assessed. Unsecured loans (primarily consumer loans) are charged off against the reserve once the loan becomes 90 days past due or it is determined that a portion of the loan is uncollectable. Secured loans (primarily construction, real estate, commercial and other loans) are moved to nonaccrual status when the loan becomes 90 days delinquent or a portion of the loan is determined to be uncollectable and supporting collateral is not considered to be sufficient to cover potential losses. Nonaccrual loans are reviewed at least quarterly to determine if all or a portion of the loan is uncollectable. Nonaccrual loans that are determined to be solely collateral dependent are promptly charged down to net realizable value upon determination that they are impaired.

In addition to the allowance for loan losses, the Company also estimates probable losses related to unfunded lending commitments, such as letters of credit, financial guarantees and unfunded loan commitments. Unfunded lending commitments are analyzed and segregated by loan classification. These classifications, in conjunction with an analysis of historical loss experience, current economic conditions, performance trends within specific portfolio segments and any other pertinent information, result in the estimation of the reserve for unfunded lending commitments. The reserve for credit losses related to unfunded lending commitments was $227,000 and $204,000 as of December 31, 2011 and 2010, respectively and is included in other liabilities on the consolidated balance sheet.

The Company maintains reserves for mortgage loans sold to agencies and investors in the event that, either through error or disagreement between the parties, the Company is required to indemnify the purchase. The reserves take into consideration risks associated with underwriting, key factors in the mortgage industry, loans with specific reserve requirements, past due loans and potential indemnification by the Company and are included in other liabilities on the balance sheet. Reserves are estimated based on consideration of factors in the mortgage industry such as declining collateral values and rising levels of delinquency, default and foreclosure, coupled with increased incidents of quality reviews at all levels of the mortgage industry seeking justification for pushing back losses to loan originators and wholesalers. As of December 31, 2011, the Company had reserves for mortgage loans sold of $1.8 million, and charges against reserves for the year ended December 31, 2011 were $809,282. For the year ended December 31, 2011 the Company recorded $640,893 in provision expense related to potential repurchase and warranties exposure on the $471.6 million in loan sales that occurred during that period. As of December 31, 2010, the Company had reserves for mortgage loans sold of $2.0 million and charges against reserves for the year ended December 31, 2010 were $637,000. For the year ended December 31, 2010 the Company recorded $883,000 in provision expense related to potential repurchase and warranties exposure on the $937.0 million in loan sales that occurred during that period. Provision expense related to potential repurchase and warranties exposure for the year ended December 31, 2009 was $1.4 million.