Note 5 – Covered Loans, Covered Other Real Estate and FDIC Indemnification Asset

Covered Loans

On April 15, 2011, TNB entered into a purchase and assumption agreement with the FDIC in which TNB agreed to assume all of the deposits and essentially all of the assets of Heritage. Loans comprise the majority of the assets acquired and all but $9.6 million are subject to loss share agreements with the FDIC whereby TNB is indemnified against a portion of the losses on covered loans and covered other real estate. The loans acquired from Heritage that are covered by a loss share agreement are presented as covered loans in the accompanying consolidated financial statements.

Trustmark will account for loans under FASB ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality,” when acquired loans are deemed to be impaired. An acquired loan is considered impaired when there is evidence of credit deterioration since the origination and it is probable at the date of acquisition that Trustmark would be unable to collect all contractually required payments. Acquired loans accounted for under FASB ASC Topic 310-30 will be referred to in this section as “acquired impaired loans.” Revolving credit agreements such as home equity lines are excluded from acquired impaired loan accounting requirements. Trustmark acquired $3.9 million of revolving credit agreements, at fair value, consisting mainly of home equity loans and commercial asset-based lines of credit, where the borrower had revolving privileges on the acquisition date. As such, Trustmark has accounted for such revolving covered loans in accordance with accounting requirements for purchased nonimpaired loans.

The acquired covered loans were recorded at their estimated fair value at the time of acquisition. Fair value of acquired loans is determined using a discounted cash flow model based on assumptions regarding the amount and timing of principal and interest payments, estimated prepayments, estimated default rates, estimated loss severity in the event of defaults and current market rates. Estimated credit losses are included in the determination of fair value; therefore, an allowance for loan losses is not recorded on the acquisition date.

For acquired impaired loans, Trustmark (a) calculated the contractual amount and timing of undiscounted principal and interest payments (the “undiscounted contractual cash flows”) and (b) estimated the amount and timing of undiscounted expected principal and interest payments (the “undiscounted expected cash flows”). Under acquired impaired loan accounting, the difference between the undiscounted contractual cash flows and the undiscounted expected cash flows is the nonaccretable difference. The nonaccretable difference represents an estimate of the loss exposure of principal and interest related to the covered acquired impaired loan portfolio and such amount is subject to change over time based on the performance of such covered loans. The carrying value of covered acquired impaired loans is reduced by payments received, both principal and interest, and increased by the portion of the accretable yield recognized as interest income.

The excess of expected cash flows at acquisition over the initial fair value of acquired impaired loans is referred to as the “accretable yield” and is recorded as interest income over the estimated life of the loans using the effective yield method if the timing and amount of the future cash flows is reasonably estimable. Increases in expected cash flows over those originally estimated increase the accretable yield and are recognized as interest income prospectively. Decreases in the amount and changes in the timing of expected cash flows compared to those originally estimated decrease the accretable yield and usually result in a provision for loan losses and the establishment of an allowance for loan losses.

Following acquisition, Trustmark aggregated certain loans into pools of loans with common credit risk characteristics such as loan type and risk rating. To establish accounting pools of loans purchased, loans were first categorized by similar purpose, similar collateral, and by their operational servicing center. As all loans were in a similar geographic region, no geographical information was considered for pooling. Within each category, loans were further segmented by ranges of risk determinants observed at the time of acquisition. For commercial loans, the primary risk determinant was the risk rating as assigned by Trustmark's internal credit officers. For consumer loans, the risk determinants included delinquency, FICO and loan to value. The statistical comparison of the pools reflected that each pool was comprised of loans generally of statistically similar characteristics, including loan type, loan risk and weighted average life. Each pool was then reviewed for statistical similarity of the pool constituents, including standard deviation of purchase price, weighted average life and concentration of largest loans. Loan pools were initially booked at the aggregate fair value of the loan pool constituents, based on the present value of Trustmark's expected cash flows from the loans. Certain purchased loans were not pooled and will be accounted for individually. Such loans consist of loans subject to accounting for purchased nonimpaired loans and loans that require more specific estimates of actual timing and amounts of cash flows due to the significant impairment of the borrower's ability to pay.

Under acquired impaired loan accounting, acquired loans are generally considered accruing and performing loans as the loans accrete interest income over the estimated life of the loan when expected cash flows are reasonably estimable. Accordingly, acquired impaired loans that are contractually past due are still considered to be accruing and performing loans as long as the estimated cash flows are received as expected. If the timing and amount of cash flows is not reasonably estimable, the loans may be classified as nonaccrual loans and interest income may be recognized on a cash basis or as a reduction of the principal amount outstanding.

The following table presents covered loans acquired as of the date of the Heritage acquisition and activity within covered loans during 2011 ($ in thousands):

At acquisition date:
Contractually required principal and interest	$	145,864
Nonaccretable difference		(38,345	)
Cash flows expected to be collected		107,519
Accretable yield		(13,579	)
Other revolving loans		3,830
Fair value at acquisition date	$	97,770

Covered loans acquired at fair value	$	97,770
Accretion to interest income		2,441
Payments received		(21,147	)
Carrying value at September 30, 2011	$	79,064

At September 30, 2011, covered loans, which are substantially located in Mississippi, consisted of the following ($ in thousands):

Loans secured by real estate:
Construction, land development and other land loans	$	4,024
Secured by 1-4 family residential properties		32,735
Secured by nonfarm, nonresidential properties		33,601
Other		5,294
Commercial and industrial loans		1,772
Consumer loans		158
Other loans		1,480
Covered loans	$	79,064

The following table presents changes in the accretable yield on covered loans acquired in the Heritage acquisition during 2011 ($ in thousands):

Accretable yield acquired	$	(13,579	)
Accretion to interest income		2,441
Carrying value at September 30, 2011	$	(11,138	)

Covered Other Real Estate

All other real estate acquired in a FDIC-assisted acquisition, such as Heritage, that is subject to a FDIC loss-share agreement is referred to as covered other real estate and reported separately in Trustmark's consolidated balance sheets. Covered other real estate is reported exclusive of expected reimbursement cash flows from the FDIC. Foreclosed covered loan collateral is transferred into covered other real estate at the collateral's net realizable value, less estimated selling costs.

Covered other real estate was initially recorded at its estimated fair value on the acquisition date based on similar market comparable valuations less estimated selling costs. Any subsequent valuation adjustments due to declines in fair value will be charged to noninterest expense, and will be mostly offset by noninterest income representing the corresponding increase to the FDIC indemnification asset for the offsetting loss reimbursement amount. Any recoveries of previous valuation adjustments will be credited to noninterest expense with a corresponding charge to noninterest income for the portion of the recovery that is due to the FDIC.

As of the date of the Heritage acquisition, Trustmark acquired $7.5 million in covered other real estate. At September 30, 2011, covered other real estate consisted of the following types of properties ($ in thousands):

Construction, land development and other land properties	$	1,624
1-4 family residential properties		934
Nonfarm, nonresidential properties		4,523
Other real estate properties		116
Total covered other real estate	$	7,197

FDIC Indemnification Asset

Trustmark has elected to account for amounts receivable under the loss-share agreement as an indemnification asset in accordance with FASB ASC Topic 805, “Business Combinations.” The FDIC indemnification asset was initially recorded at fair value, based on the discounted value of expected future cash flows under the loss-share agreement. The difference between the present value and the undiscounted cash flows Trustmark expects to collect from the FDIC will be accreted into noninterest income over the life of the FDIC indemnification asset.

The FDIC indemnification asset will be reviewed quarterly and adjusted for any changes in expected cash flows based on recent performance and expectations for future performance of covered loans and covered other real estate. These adjustments are measured on the same basis as the related covered loans and covered other real estate. Any increases in cash flow of the covered loans and covered other real estate over those expected will reduce the FDIC indemnification asset and any decreases in cash flow of the covered loans and covered other real estate under those expected will increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset will be recorded as adjustments to noninterest income.

The following table presents the FDIC indemnification asset acquired as of the date of the Heritage acquisition and activity within the FDIC indemnification asset during 2011 ($ in thousands):

Indemnification asset at acquisition date	$	33,333
Accretion		103
Carrying value at September 30, 2011	$	33,436

Pursuant to the clawback provisions of the Heritage loss share agreement, Trustmark may be required to reimburse the FDIC should actual losses be less than certain thresholds established in the agreement. To the extent that actual losses on covered loans and covered other real estate are less than estimated losses, the applicable clawback payable to the FDIC upon termination of the loss share agreement will increase. To the extent that actual losses on covered loans and covered other real estate are more than estimated losses, the applicable clawback payable to the FDIC upon termination of the loss share agreement will decrease. At September 30, 2011, Trustmark had no clawback payable to the FDIC.