NOTE 6: ALLOWANCE FOR CREDIT LOSSES

Effective on January 1, 2020 upon adoption of Topic 326, the Company’s ACL for the loan portfolio has two main components: a reserve for expected losses determined from the historical loss rates, adjusted for qualitative factors, and forecasted expected losses on the segments associated with the individual loan classes with similar risk characteristics, or general reserve, and a separate allowance representing the reserves assigned to individually evaluated loans that do not share similar risk characteristics with other loans, or specific reserve. The Company defines the loan class to be the grouping of the loan receivable based on risk characteristics and the method for monitoring and assessing credit risk, which is represented by the loan type or major category of loans.

For specific reserves, loans identified as not sharing similar risk characteristics with other assets are individually evaluated for the net amount expected to be collected and reserves are determined for them outside of general reserve computation. For determination of credit losses on loans individually evaluated, the Company utilizes various methods such as discounted cash flow analysis, appraisal valuation on collateral, among others, to determine any impairment of the loan and need for additional allowance for expected losses.

For the general reserve computation, the Company selected an aged-based vintage model, or the Vintage model, based on the model’s ability to predict credit risks associated with the loan portfolio and capture the expected life of loan losses associated with each segment of loans. The Company primarily manages credit quality and determines credit risk of its loans based on the risk grade assigned to each individual loan within the loan class. See risk grade discussion later in this footnote. The factors considered include the age of the loan, interest rate, loan size, payment structure, term, risk ratings, loan to value, collateral type, geographical pattern, and industrial sector. The breakdown of the loan classes into portfolio segments was a judgement election based upon identified risk criteria. The Company has limited specific historical loss experience to directly tie to an attribute and thus the use of one factor over another is based on management’s perceived risk of the identified factor in combination with the data analyzed.

After consideration of the factors previously discussed, the Company determined segmenting the portfolio into 16 segments, plus overdrafts, based on the identified risk characteristics present within each segment. These risk characteristics are determined based on call code, collateral types, and loan terms. The Company believes that this segmentation best represents the portfolio segments at a level to develop the systematic methodology in the determination of the ACL. Certain loans were aggregated and disaggregated to align with the concentrations of risk and expected loss exposures associated with those loans. Oil and gas loans were carved out of commercial and industrial loans and oil and gas real estate loans were carved out of commercial real estate loans due to the inherent risk related to the oil and gas industry, the volatile nature of the price of oil and its potential impact on the local economy of the Company’s primary geographical area. Commercial and industrial loans were divided into two pools based on terms greater than one year and less than or equal to one year. Commercial and industrial loans with terms less than or equal to one year are typically revolving credits and have different risk characteristics based on the short-term nature of the loan than commercial and industrial loans with terms longer than one year. Commercial real estate loans are split out further into owner occupied and non-owner occupied based on their different risk profiles. Community development loans were split-out as a separate component of construction and multi-family residential loans based on the unique underwriting of these loans and some underlying guarantees which impact the risk profile of these loans. The remaining construction loans were split between 1-4 family primary construction and 1-4 family single family residential construction loans as they are deemed to have differing risk profiles. The loans were then subdivided by year of origination or vintage, as determined by an identifiable credit decision date. See the table that follows this discussion.

Historical net losses are used to calculate a historical loss rate for each vintage within each portfolio segment and then subjective adjustments for internal and external qualitative risk factors are applied to the historical loss rates to generate a total expected loss rate for each vintage within each portfolio segment. For portfolio segments of loans with no historical losses, the Company is using the weighted average of its the annual historical loss rates as a proxy loss rate floor or, specifically for oil and gas and oil and gas real estate portfolio segments, historical average loss rate based on peer group data.

There are multiple qualitative factors, both internal and external, that could impact potential collectability of the underlying loans. The various internal factors that may be considered include, among other things, (i) effectiveness of loan policies, procedures and internal controls; (ii) portfolio growth and changes in loan concentrations; (iii) changes in loan quality; (iv) experience, ability and effectiveness of lending management and staff; (v) legal and regulatory compliance requirements associated with underwriting, originating and servicing a loan and the impact of exceptions; and (vi) the effectiveness of the internal loan review function. The various external factors that may be considered include, among other things, (i) current national and local economic conditions; (ii) changes in the political, legal and regulatory landscape; (iii) industry trends, in particular those related to loan quality and (iv) forecasted changes in the economy.

As part of this assessment, the Company considers the need to adjust historical information to reflect the extent to which current conditions and forecasts differ from the conditions that existed for the period over which historical information was evaluated. The Company uses an economic forecast qualitative factor as noted above to adjust the expected loss rates for the effects of forecasted changes in the economy. The Company uses economic indicators and indexes including, but not limited to, inflation indexes, unemployment rates, fluctuations of interest rates, economic growth, government expenditures, gross domestic product indexes, productivity indicators, leading indexes and debt levels and narratives such as those supplied by the Federal Reserve’s beige book and Moody’s Analytics that provide information for determining an appropriate impact ratio for macro-economic conditions. The Company has determined that a two-year forecast period provides a balance between the level of forecast periods reasonably available and forecast accuracy. The Company utilized, at adoption and during the three-month period ending March 31, 2020, an immediate reversion to historical levels after the two-year forecast period. The Company believes a two-year period is the limit of a reasonable and supportable forecast and chose to revert to historical levels immediately afterward as current adjusted loss history is the more relevant indicator of expected losses beyond the forecast period.

The historical loss rates, adjusted for current conditions and forecasting assumptions, are multiplied by the respective loan’s amortized cost balances in each vintage within each segment to compute an estimated quantitative reserve for expected losses in the portfolio. The quantitative reserve for expected loan losses and the qualitative reserve for expected loan losses combined together make up the total estimated loan loss reserve.

Loan amortized costs, as defined by GAAP, includes principal, deferred fees or costs associated with the loan, premiums, discounts and accrued interest. The Company made a policy election to exclude accrued interest in the determination of an ACL. The Company continues its policy of reversing previously accrued interest when it has been deemed uncollectible and accrued interest receivable is included in other assets in the consolidated balance sheets. Loans available for sale are excluded from the computation of expected loan loss as they are carried at the lower of cost or market value.

As part of the implementation of ASU 2016-13, the Company changed its methodology for determining the ACLs for loans. As a result of this adoption, the percentage of the ACL for loans to loans increased from 0.96% to 0.99%, effective January 1, 2020. At March 31, 2020, the percentage of the ACL for loans to total loans increased to 1.16%, reflecting the impact of current and forecasted economic factors for the local and national economy due to the impact of COVID-19 and the drop in the price of oil and gas during the first quarter of 2020. The Company’s total factors ranged from 0.67% to 2.42% at January 1, 2020 and ranged from 0.85% to 2.61% at March 31, 2020 and all factors were reassessed at the end of the first quarter. At the time of the assessment, there was limited economic forecasted data related to COVID-19 and the drop in the price of oil and gas. The increase in the ACL related to these events reflects the Company’s assessment based on the information available at March 31, 2020.

Risk Grading

As part of the on‑going monitoring of the credit quality of the Company’s loan portfolio, management assigns and tracks loan grades as described below that are used as credit quality indicators.

Pass—Credits in this category contain an acceptable amount of risk.

Special Mention—Credits in this category contain more than the normal amount of risk and are referred to as “special mention” in accordance with regulatory guidelines. These credits possess clearly identifiable temporary weaknesses or trends that, if not corrected or revised, may result in a condition that exposes the Company to a higher level of risk of loss.

Substandard—Credits in this category are “substandard” in accordance with regulatory guidelines and of unsatisfactory credit quality with well‑defined weaknesses or weaknesses that jeopardize the liquidation of the debt. Credits in this category are inadequately protected by the current sound worth and paying capacity of the obligor or the collateral pledged, if any. Often, the assets in this category will have a valuation allowance representative of management’s estimated loss that is probable to be incurred. Loans deemed substandard and on nonaccrual status are considered impaired and are individually evaluated for impairment.

Doubtful—Credits in this category are considered “doubtful” in accordance with regulatory guidelines, are placed on nonaccrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near‑term event which lacks certainty. Generally, these credits will have a valuation allowance based upon management’s best estimate of the losses probable to occur in the liquidation of the debt.

Loss—Credits in this category are considered “loss” in accordance with regulatory guidelines and are considered uncollectible and of such little value as to question their continued existence as assets on the Company’s financial statements. Such credits are to be charged off or charged down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. This category does not intend to imply that the debt or some portion of it will never be paid, nor does it in any way imply that the debt will be forgiven.

The methodology used by the Company in the determination of its ACL, which is performed at least on a quarterly basis, is designed to be responsive to changes in the credit quality of the loan portfolio as well as forecasted economic conditions. The credit quality of the loan portfolio is assessed through different processes. At origination, a risk grade is assigned to each loan based on underwriting procedures and criteria. The Company monitors the credit quality of the loan portfolio on an on-going basis by performing loan reviews, both internally and through a third-party vendor, on loans meeting certain risk and exposure criteria. Through these reviews, loans that require risk grade changes are approved by executive management. In addition, executive management reviews classified and criticized loans on to assess changes in credit quality of the underlying loan, and when determined appropriate based on an individual evaluation, approve specific reserves. The review of the appropriateness of the ACL, which includes evaluation of historical loss trends, qualitative adjustments and forecasted economic conditions applied to general reserves, is performed by executive management and presented to the board of directors for their review on a quarterly basis as part of our interim and annual consolidated financial statements.

The loans by risk grades, loan class and vintage at March 31, 2020 were as follows:


(Dollars in thousands)	2020		2019		2018		2017		2016		Prior		Revolving Loans		Converted Revolving Loans		Total
Commercial and industrial:
Pass	$	16,734	$	120,547	$	67,560	$	19,418	$	12,466	$	9,688	$	270,877	$	11,585	$	528,875
Special mention		33		266		—		15		—		—		436		—		750
Substandard		1,000		786		464		39		354		2,406		4,012		3,964		13,025
Total commercial and industrial		17,767		121,599		68,024		19,472		12,820		12,094		275,325		15,549		542,650
Commercial real estate:
Pass		57,116		213,693		214,659		139,415		86,079		129,764		36,851		2,322		879,899
Special mention		—		—		—		—		1,587		—		—		11,000		12,587
Substandard		—		1,926		4,967		216		1,600		3,200		—		—		11,909
Total commercial real estate		57,116		215,619		219,626		139,631		89,266		132,964		36,851		13,322		904,395
Construction and development:
Pass		35,419		184,260		196,235		45,597		8,477		35,240		40,564		—		545,792
Substandard		—		519		1,500		10,532		—		—		—		—		12,551
Total construction and development		35,419		184,779		197,735		56,129		8,477		35,240		40,564		—		558,343
1-4 family residential:
Pass		7,110		35,961		66,602		49,164		27,973		70,808		11,094		1,277		269,989
Special mention		—		—		40		—		392		386		—		—		818
Substandard		—		547		—		249		20		3,034		—		1,485		5,335
Total 1-4 family residential		7,110		36,508		66,642		49,413		28,385		74,228		11,094		2,762		276,142
Multi-family residential:
Pass		7,770		8,527		23,743		50,750		4,361		172,001		—		—		267,152
Total multi-family residential		7,770		8,527		23,743		50,750		4,361		172,001		—		—		267,152
Consumer:
Pass		3,020		6,506		3,443		2,528		323		411		19,689		2,208		38,128
Substandard		—		—		—		—		—		5		—		—		5
Total consumer		3,020		6,506		3,443		2,528		323		416		19,689		2,208		38,133
Agriculture:
Pass		936		1,701		547		162		38		5		3,975		79		7,443
Substandard		—		—		—		—		—		27		50		—		77
Total agriculture		936		1,701		547		162		38		32		4,025		79		7,520
Other:
Pass		623		15,233		5,026		162		128		1,551		35,662		17,424		75,809
Substandard		—		—		1,381		—		1,241		—		5,645		—		8,267
Total other		623		15,233		6,407		162		1,369		1,551		41,307		17,424		84,076
Total	$	129,761	$	590,472	$	586,167	$	318,247	$	145,039	$	428,526	$	428,855	$	51,344	$	2,678,411

Loans by risk grades and loan class as of the date shown below were as follows:


			Special
(Dollars in thousands)	Pass		Mention		Substandard		Total Loans
December 31, 2019
Commercial and industrial	$	513,417	$	2,963	$	11,227	$	527,607
Real estate:
Commercial real estate		876,207		18,570		5,969		900,746
Construction and development		515,247		12,565		—		527,812
1-4 family residential		274,731		594		4,867		280,192
Multi-family residential		277,209		—		—		277,209
Consumer		36,566		—		216		36,782
Agriculture		9,733		50		29		9,812
Other		79,860		—		6,653		86,513
Total loans	$	2,582,970	$	34,742	$	28,961	$	2,646,673

Charge-offs and recoveries by loan class and vintage for the three months ended March 31, 2020 were as follows:


(Dollars in thousands)	2020		2019		2018		2017		2016		Prior		Revolving Loans		Total
Commercial and industrial:
Charge-off	$	—	$	—	$	—	$	(29)	$	—	$	—	$	(1)	$	(30)
Recovery		—		2		87		16		10		133		180		428
Total commercial and industrial		—		2		87		(13)		10		133		179		398
1-4 family residential:
Charge-off		—		—		—		—		—		—		—		—
Recovery		—		—		—		—		—		1		—		1
Total 1-4 family residential		—		—		—		—		—		1		—		1
Consumer:
Charge-off		—		—		(8)		(95)		—		—		—		(103)
Recovery		3		—		—		—		—		1		—		4
Total consumer		3		—		(8)		(95)		—		1		—		(99)
Other:
Charge-off		—		—		—		—		—		—		—		—
Recovery		—		—		—		1		—		—		—		1
Total other		—		—		—		1		—		—		—		1
Total	$	3	$	2	$	79	$	(107)	$	10	$	135	$	179	$	301

Activity in the total ACL for loans for the three months ended March 31, 2020 and 2019, was as follows:


			Real Estate
	Commercial				Construction
	and		Commercial		and		1-4 family		Multi-family
(Dollars in thousands)	industrial		real estate		development		residential		residential		Consumer		Agriculture		Other		Total
March 31, 2020
Beginning balance	$	7,671	$	7,975	$	4,446	$	2,257	$	1,699	$	388	$	74	$	770	$	25,280
Impact of CECL adoption		852		(140)		100		(275)		294		(25)		64		4		874
Provision (recapture) for credit losses for loans		614		1,741		1,249		447		420		213		(9)		64		4,739
Charge-offs		(30)		—		—		—		—		(103)		—		—		(133)
Recoveries		428		—		—		1		—		4		—		1		434
Net (charge-offs) recoveries		398		—		—		1		—		(99)		—		1		301
Ending balance	$	9,535	$	9,576	$	5,795	$	2,430	$	2,413	$	477	$	129	$	839	$	31,194
Period-end amount allocated to:
Specific reserve	$	409	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	409
General reserve		9,126		9,576		5,795		2,430		2,413		477		129		839		30,785
Total	$	9,535	$	9,576	$	5,795	$	2,430	$	2,413	$	477	$	129	$	839	$	31,194



			Real Estate
	Commercial				Construction
	and		Commercial		and		1-4 family		Multi-family
(Dollars in thousands)	industrial		real estate		development		residential		residential		Consumer		Agriculture		Other		Total
March 31, 2019
Beginning balance	$	7,719	$	6,730	$	4,298	$	2,281	$	1,511	$	387	$	62	$	705	$	23,693
Provision (recapture) for credit losses for loans		903		52		402		(33)		(54)		(36)		(12)		(75)		1,147
Charge-offs		(280)		—		—		—		—		(4)		—		—		(284)
Recoveries		74		2		—		1		—		10		—		—		87
Net (charge-offs) recoveries		(206)		2		—		1		—		6		—		—		(197)
Ending balance	$	8,416	$	6,784	$	4,700	$	2,249	$	1,457	$	357	$	50	$	630	$	24,643
Period-end amount allocated to:
Specific reserve	$	582	$	33	$	—	$	77	$	—	$	—	$	—	$	96	$	788
General reserve		7,834		6,751		4,700		2,172		1,457		357		50		534		23,855
Total	$	8,416	$	6,784	$	4,700	$	2,249	$	1,457	$	357	$	50	$	630	$	24,643

The ACL for loans by loan class as of the periods indicated was as follows:



	March 31, 2020				December 31, 2019
(Dollars in thousands)	Amount		Percent		Amount		Percent
Commercial and industrial	$	9,535	30.6	%	$	7,671	30.3	%
Real estate:
Commercial real estate		9,576	30.7	%		7,975	31.6	%
Construction and development		5,795	18.6	%		4,446	17.6	%
1-4 family residential		2,430	7.8	%		2,257	8.9	%
Multi-family residential		2,413	7.7	%		1,699	6.7	%
Consumer		477	1.5	%		388	1.5	%
Agriculture		129	0.4	%		74	0.3	%
Other		839	2.7	%		770	3.1	%
Total allowance for credit losses for loans	$	31,194	100.0	%	$	25,280	100.0	%

Allocation of a portion of the ACL to one class of loans above does not preclude its availability to absorb losses in other classes.

The loans evaluated individually and the related specific ACL at the dates shown below were as follows:


	March 31, 2020						December 31, 2019
(Dollars in thousands)	Recorded Investment		Specific ACL		Net		Recorded Investment		Specific ACL		Net
Loans evaluated individually
Commercial and industrial	$	1,528	$	409	$	1,119	$	999	$	416	$	583
Commercial real estate		5,818		—		5,818		1,404		—		1,404
Construction and development		519		—		519		—		—		—
1-4 family residential		3,703		—		3,703		3,651		15		3,636
Consumer		—		—		—		210		—		210
Other		8,267		—		8,267		6,653		6		6,647
Total	$	19,835	$	409	$	19,426	$	12,917	$	437	$	12,480

At March 31, 2020, the Company had one 1-4 family residential collateral dependent loan with a principal balance of $32,000.

The Company has unfunded commitments, comprised of letters of credit and commitments to extend credit that are not unconditionally cancellable by the Company. See Note 16: Commitments and Contingencies and Financial Instruments with Off-Balance-Sheet Risk. Unfunded commitments have similar characteristics as funded loans based on segment type and their expected credit losses were determined using the Vintage model and established qualitative factors. Activity in the ACL for unfunded commitments for the three months ended March 31, 2020, was as follows:



(Dollars in thousands)	March 31, 2020

Beginning balance	$	378
Impact of CECL adoption		2,981
Provision for credit losses for unfunded commitments		310
Ending balance	$	3,669