Note 6. Loans

The following table presents the company’s composition of loans, net of capitalized origination costs and unearned income, in dollar amounts and as a percentage of total loans held for investment as of the dates stated:



	September 30, 2012		December 31, 2011
	Amount	Percent of Total	Amount	Percent of Total
Commercial and industrial	$ 173,137	50.75%	$ 168,417	51.64%
Commercial real estate	137,922	40.43%	126,525	38.80%
Residential real estate	24,407	7.15%	25,847	7.93%
Consumer	5,687	1.67%	5,350	1.63%
Loans held for investment	341,153	100.00%	326,139	100.00%
Allowance for loan and lease losses	(4,658)		(4,280)
Loans held for investment, net of allowance	336,495		321,859
Loans held for sale	74,632		-
Total loans	$ 411,127		$ 321,859

Loans held for investment included unearned fees, net of capitalized origination costs, of $233 thousand and $288 thousand, as of September 30, 2012 and December 31, 2011, respectively. As of September 30, 2012, $135.2 million of loans were pledged as collateral for borrowing capacity.

Loans Held for Sale

In the first quarter of 2012, the Bank entered into a sub-participation agreement with a major commercial bank (the “participating bank”) that extends credit nationwide to mortgage companies that originate single-family residential mortgage loans for sale in the secondary market. Pursuant to the sub-participation agreement, the Bank purchases participations from the participating bank with respect to selected non-bank mortgage originators that seek funding to facilitate the origination of mortgage loans. The originators underwrite and close mortgage loans consistent with established standards of approved investors and, once the loans close, the originators deliver the loans to the investors. Typically, the Bank, together with the participating bank, purchase up to an aggregate of a 99% participation interest with the originators financing the remaining 1%. These loans are held for short periods, usually less than 30 days and more typically 10-25 days. Accordingly, these loans are classified as held for sale and are carried at the lower of cost or fair value, determined on an aggregate basis.

Loans Held for Investment

The following table presents the company’s loans held for investment by regulatory risk ratings classification and by loan type as of the dates stated. As defined by the Federal Reserve and adopted by the company, “special mention” loans are defined as having potential weaknesses that deserve management’s close attention; “substandard” loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any; and “doubtful” loans have all the weaknesses inherent in substandard loans, with the added characteristic that the weaknesses make collection in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Loans not categorized as special mention, substandard or doubtful are classified as “pass”.



	September 30, 2012
	Pass	Special Mention	Substandard	Doubtful	Total Loans
Commercial and industrial	$ 167,396	$ 1,937	$ 3,804	$ -	$ 173,137
Commercial real estate	125,115	5,436	7,371	-	137,922
Residential real estate	23,113	341	953	-	24,407
Consumer	5,085	191	240	-	5,516
Overdrafts	171	-	-	-	171
Total loans	$ 320,880	$ 7,905	$ 12,368	$ -	$ 341,153

	December 31, 2011
	Pass	Special Mention	Substandard	Doubtful	Total Loans
Commercial and industrial	$ 165,590	$ 562	$ 1,923	$ 342	$ 168,417
Commercial real estate	104,493	9,650	11,837	545	126,525
Residential real estate	25,083	181	583	-	25,847
Consumer	4,966	274	45	-	5,285
Overdrafts	65	-	-	-	65
Total loans	$ 300,197	$ 10,667	$ 14,388	$ 887	$ 326,139

Allowance for Loan and Lease Losses

The allowance for loan and lease losses consists of (1) a component for collective loan impairment recognized and measured pursuant to Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 450, “Contingencies”, and (2) a component for individual loan impairment recognized pursuant to FASB ASC Topic 310, “Receivables.” A loan is impaired when, based on current information and events, it is probable that all amounts due (principal and interest) according to the contractual terms of the loan agreement will not be collected.

The allowance for loan and lease losses is determined based on a periodic evaluation of the loan portfolio. This evaluation is a combination of quantitative and qualitative analysis. Quantitative factors include loss history for similar types of loans as are originated by the company. In evaluating the loan portfolio, qualitative factors, such as general economic conditions, nationally and in the company’s target markets, are considered, as well as threats of outlier events, such as the unexpected deterioration of a significant borrower. These quantitative and qualitative factors and estimates may be subject to significant change. Increases to the allowance for loan and lease losses are made by charges to the provision for loan and lease losses, which is reflected in the consolidated statements of operations and comprehensive income. Loans deemed to be uncollectible are charged against the allowance for loan and lease losses at the time of determination, and recoveries of previously charged-off amounts are credited to the allowance for loan and lease losses.

In assessing the adequacy of the allowance for loan and lease losses as of the end of a reporting period, loan risk ratings are evaluated. Each loan is assigned two risk ratings at origination. One risk rating is based on the company’s assessment of the borrower’s financial capacity, and the other is based on the assessment of the quality of collateral. In addition to the assessment of risk ratings, internal observable data related to trends within the loan portfolio, such as concentrations, aging of the portfolio, changes to policies and procedures, and external observable data such as industry and general economic trends is considered.

Although various data and information sources are used to establish the allowance for loan and lease losses, future adjustments to the allowance for loan and lease losses may be necessary, if conditions, circumstances or events are substantially different from the assumptions used in making the assessments. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review the company’s allowance for loan and lease losses. Such agencies may require additions to the allowance for loan and lease losses based on their judgments of information available to them at the time of their examination.

The following table presents the allowance for loan and lease loss activity, by loan category, as of the dates stated:



	For the three months ended September 30,
	2012	2011
Balance at beginning of period	$ 4,323	$ 2,986
Charge-offs:
Commercial and industrial	51	312
Commercial real estate	119	723
Residential real estate	-	21
Consumer	-	(1)
Overdrafts	1	4
Total charge-offs	171	1,059
Recoveries:
Commercial and industrial	-	25
Commercial real estate	-	-
Residential real estate	-	-
Consumer	3	-
Overdrafts	-	-
Total recoveries	3	25
Net charge-offs	168	1,034
Provision for loan and lease losses	476	1,620
Less: Amount for unfunded commitments	27	(151)
Balance at end of period	$ 4,658	$ 3,421

	For the nine months ended September 30,
	2012	2011
Balance at beginning of period	$ 4,280	$ 1,766
Charge-offs:
Commercial and industrial	51	312
Commercial real estate	900	973
Residential real estate	-	71
Consumer	-	3
Overdrafts	8	11
Total charge-offs	959	1,370
Recoveries:
Commercial and industrial	-	67
Commercial real estate	19	8
Residential real estate	-	-
Consumer	3	-
Overdrafts	2	1
Total recoveries	24	76
Net charge-offs	935	1,294
Provision for loan and lease losses	1,383	3,100
Less: Amount for unfunded commitments	(70)	(151)
Balance at end of period	$ 4,658	$ 3,421

The following table presents the allowance for loan and lease losses and the amount individually and collectively evaluated for impairment by loan type as of the dates stated:



	September 30, 2012
		Individually Evaluated	Collectively Evaluated
	Total Amount	for Impairment	for Impairment
Balance at end of period applicable to:
Commercial and industrial	$ 1,115	$ 277	$ 838
Commercial real estate	3,365	1,103	2,262
Residential real estate	152	7	145
Consumer	26	16	10
Total allowance for loan and lease losses	$ 4,658	$ 1,403	$ 3,255

	December 31, 2011
		Individually Evaluated	Collectively Evaluated
	Total Amount	for Impairment	for Impairment
Balance at end of period applicable to:
Commercial and industrial	$ 748	$ -	$ 748
Commercial real estate	3,370	1,318	2,052
Residential real estate	133	-	133
Consumer	29	-	29
Total allowance for loan and lease losses	$ 4,280	$ 1,318	$ 2,962

As of September 30, 2012, there were nine commercial and industrial loans totaling $2.5 million, 17 commercial real estate loans totaling $5.1 million, two residential real estate loans totaling $388 thousand, and one consumer loan totaling $64 thousand that were individually evaluated for impairment. Of the 29 total loans individually evaluated for impairment, four commercial and industrial loans in the amount of $754 thousand, 14 commercial real estate loans totaling $3.6 million, two residential real estate loans totaling $388 thousand, and one consumer loan totaling $64 thousand were identified as credit-impaired loans acquired in the VBB Acquisition. Of the 14 commercial real estate loans, five totaling $193 thousand are related to a single borrower. As of December 31, 2011, there were three commercial real estate loans totaling $3.2 million that were individually evaluated for impairment.

Acquired loans are initially recorded at estimated fair value as of the date of acquisition; therefore, any related allowance for loan and lease losses is not carried over or established at acquisition. The difference between contractually required amounts receivable and the acquisition date fair value of loans that are not deemed credit-impaired at acquisition is accreted (recognized) into income over the life of the loan either on a straight-line basis or based on the underlying principal payments on the loan. Any change in credit quality subsequent to acquisition for these loans is reflected in the allowance for loan and lease losses.

Loans acquired with evidence of credit deterioration since origination and for which it is probable at the date of acquisition that all contractually required principal and interest payments will not be collected are accounted for under FASB ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality” (“ASC 310-30”). A portion of the loans acquired in the VBB Acquisition were deemed by management to be credit-impaired loans qualifying for accounting under ASC 310-30.

Acquired loans for which the timing or amount of expected future cash flows cannot be predicted are accounted for on cost recovery, whereby principal and interest payments are recorded as a reduction of the carrying value of the loan receivable, and the fair value adjustment is not recognized into income until which time the company has recovered its full carrying value of the loan receivable.

Pursuant to the merger with First Bankshares, the acquired loans were adjusted to estimated fair value with a discount of $7.6 million. As of July 29, 2011, the loans acquired in the Paragon Transaction and the VBB Acquisition were also adjusted to estimated fair value by recording a discount of $1.8 million and $14.0 million, respectively.

For acquired loans deemed impaired at acquisition (credit-impaired loans), the excess of cash flows expected to be collected over the estimated fair value of purchased credit-impaired loans is referred to as the accretable yield and accreted into interest income over the remaining life of the loan, or pool of loans, using the effective yield method. The difference between contractually required payments due and the cash flows expected to be collected, on an undiscounted basis, is referred to as the nonaccretable difference. As of September 30, 2012 and December 31, 2011, the company had $613 thousand and $308 thousand, respectively, of nonaccretable difference related to the credit-impaired loans acquired in the VBB Acquisition.

In applying ASC 310-30 to acquired loans, the company must estimate the amount and timing of cash flows expected to be collected. The estimation of the amount and timing of expected cash flows to be collected requires significant judgment, including default rates, the amount and timing of prepayments and the liquidation value of underlying collateral, in addition to other factors. ASC 310-30 allows the purchaser to estimate cash flows on credit-impaired loans on a loan-by-loan basis or aggregate credit-impaired loans into one or more pools if the loans have common risk characteristics. The company has estimated cash flows expected to be collected on a loan-by-loan basis.

ASC 310-30 requires periodic re-evaluation of expected cash flows for acquired credit-impaired loans subsequent to acquisition date. Decreases in expected cash flows attributable to credit will generally result in an impairment charge to earnings such that the accretable yield remains unchanged. Increases in expected cash flows will result in an increase in the accretable yield, which is a reclassification from the nonaccretable difference. The increased accretable yield is recognized in income over the remaining period of expected cash flows from the loan. No changes have been made to the accretable yield estimates during the first quarter of 2012.

During the third quarter of 2012, the company re-evaluated expected cash flows resulting in an impairment charge of $231 thousand due to deterioration in the timing and/or amount of cash flows of certain loans since the prior quarter measurement. This impairment amount is reported as a provision for loan and lease losses in the consolidated statements of operations and comprehensive income and a component of allowance for loan and lease losses. If upon remeasurement in a future period, a loan for which an impairment charge has been taken is expected to have cash flows that exceed those previously determined, some portion of the impairment could be reversed.

The following table presents the accretion activity as of the dates stated. Disposals represent reductions of discounts through the resolution of acquired loans at amounts less than the contractually owed receivable.



	September 30, 2012	December 31, 2011
Balance at beginning of period	$ 14,007	$ 3,833
Additions	-	15,787
Accretion	(2,658)	(3,568)
Disposals	(2,309)	(2,045)
Balance at end of period	$ 9,040	$ 14,007

The following table presents the age analysis of loans past due as of the dates stated:



	September 30, 2012
	31-90 days	Greater than	Total
	Past Due	90 days	Past Due
Commercial and industrial	$ 516	$ 1,874	$ 2,390
Commercial real estate	-	2,940	2,940
Residential real estate	630	39	669
Consumer	-	2	2
Total	$ 1,146	$ 4,855	$ 6,001

	December 31, 2011
	31-90 days	Greater than	Total
	Past Due	90 days	Past Due
Commercial and industrial	$ 1,536	$ 514	$ 2,050
Commercial real estate	804	5,223	6,027
Residential real estate	269	125	394
Consumer	22	-	22
Total	$ 2,631	$ 5,862	$ 8,493

The following table presents nonaccrual loans and other real estate owned (“OREO”) as of the dates stated. A loan is considered nonaccrual if it is greater than 90 days past due as to interest and principal or when there is serious doubt as to collectability, unless the estimated net realized value of collateral is sufficient to assure collection of principal balance and accrued interest. As of September 30, 2012, there were no loans past due greater than 90 days for which interest was accruing.



	September 30, 2012	December 31, 2011
Commercial and industrial	$ 1,874	$ 514
Commercial real estate	2,940	5,223
Residential real estate	39	125
Consumer	2	-
Total nonaccrual loans	$ 4,855	$ 5,862
Other real estate owned	321	808
Total nonperforming assets	$ 5,176	$ 6,670

In accordance with Accounting Standards Update (“ASU”) No. 2011-02, “Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring”, the company assesses all restructurings for potential identification as troubled debt restructurings (“TDRs”). A modification of a loan’s terms constitutes a TDR if the creditor grants a concession to the borrower for economic or legal reasons related to the borrower’s financial difficulties that it would not otherwise consider. Modifications of terms for loans that are included as TDRs may involve either an increase or reduction of the interest rate, extension of the term of the loan, or deferral of principal payments, regardless of the period of the modification. As of September 30, 2012, the company had identified 10 loans as TDRs, which totaled $1.2 million. Of this amount, seven loans totaling $343 thousand were identified as credit-impaired loans acquired in the VBB Acquisition and are related to a single borrower. Nine of the 10 loans were nonperforming at September 30, 2012. At December 31, 2011, one loan in the amount of $124 thousand was identified as a TDR.