Note 6 – 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 comprised the majority of the assets acquired and $97.8 million, or 91% of total loans acquired, are subject to the loss-share agreement with the FDIC whereby TNB is indemnified against a portion of the losses on covered loans and covered other real estate.

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.

Trustmark accounts for acquired impaired loans under FASB ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality.” An acquired loan is considered impaired when there is evidence of credit deterioration since origination and it is probable at the date of acquisition that Trustmark would be unable to collect all contractually required payments. Revolving credit agreements such as home equity lines are excluded from acquired impaired loan accounting requirements. Trustmark acquired $3.8 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.

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 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. Improvements 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. 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.

During the fourth quarter of 2011, Trustmark re-estimated the expected cash flows on the acquired loans of Heritage as required by FASB ASC Topic 310-30. The analysis resulted in improvements in the estimated future cash flows of the acquired loans that remain outstanding as well as lower expected remaining losses on those loans. Due to the re-estimated cash flows on the acquired loans, Trustmark increased the carrying value of covered loans by $4.5 million. The accretable yield of the covered loans was also increased by $7.6 million as a result of the improvements in the estimated expected cash flows.

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 of covered loans at acquisition date		97,770
Activity during 2011:
Accretion to interest income (1)		4,890
Payments received		(30,337	)
Changes in expected cash flows		4,481
Less allowance for loan losses		(502	)
Carrying value at December 31, 2011	$	76,302

(1) Includes $543 thousand of accretion for covered loans not accounted for under FASB ASC Topic 310-30.

At December 31, 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	$	4,209
Secured by 1-4 family residential properties		31,874
Secured by nonfarm, nonresidential properties		30,889
Other		5,126
Commercial and industrial loans		2,971
Consumer loans		290
Other loans		1,445
Covered loans		76,804
Less allowance for loan losses		502
Net covered loans	$	76,302

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		4,347
Change in expected cash flows		(7,644	)
Accretable yield at December 31, 2011	$	(16,876	)

No allowance for loan losses was brought forward on any of the acquired loans as any credit deterioration evident in the loans was included in the determination of the fair value of the loans at the acquisition date. Updates to expected cash flows for covered loans accounted for under FASB ASC Topic 310-30 may result in a provision for loan losses and the establishment of an allowance for loan losses to the extent the amount and timing of expected cash flows decrease compared to those originally estimated at acquisition. Trustmark established an allowance for loan losses associated with covered loans during the fourth quarter of 2011 as a result of valuation procedures performed during the period.

The following table presents the components of the allowance for loan losses on covered loans acquired in the Heritage acquisition at December 31, 2011 ($ in thousands):

Provision for covered loan losses	$	624
Loans charged-off		(218	)
Recoveries		96
Net charge-offs		(122	)
Balance at December 31, 2011	$	502

Under FASB ASC Topic 310-30, 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. At December 31, 2011, there were no acquired impaired covered loans accounted for under FASB ASC Topic 310-30 classified as nonaccrual loans. At December 31, 2011, approximately $491 thousand of covered loans not accounted for under FASB ASC Topic 310-30 were classified as nonaccrual loans.

Covered Other Real Estate

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 are charged to noninterest expense, and are 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 $7.5 million in covered other real estate. For the year ended December 31, 2011, changes and gains (losses), net on covered other real estate were as follows ($ in thousands):

	2011
Other real estate at acquisition	$	7,485
Transfers from covered loans		632
FASB ASC 310-30 adjustment for the residual recorded investment		(264	)
Net transfers from covered loans		368
Disposals		(1,489	)
Writedowns		(33	)
Balance at end of period	$	6,331

Gain (loss), net on the sale of covered other real estate included in ORE/Foreclosure expenses	$	286

At December 31, 2011, covered other real estate consisted of the following types of properties ($ in thousands):

Construction, land development and other land properties	$	1,304
1-4 family residential properties		889
Nonfarm, nonresidential properties		4,022
Other real estate properties		116
Total covered other real estate	$	6,331

FDIC Indemnification Asset

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 at acquisition date and the undiscounted cash flows TNB expects to collect from the FDIC is accreted into noninterest income over the life of the FDIC indemnification asset. The FDIC indemnification asset is presented net of any true-up provision, pursuant to the provisions of the loss-share agreement, due to the FDIC at the termination of the loss-share agreement.

Pursuant to the provisions of the Heritage loss-share agreement, TNB may be required to make a true-up payment to the FDIC at the termination of the loss-share agreement should actual losses be less than certain thresholds established in the agreement. TNB calculates the projected true-up payable to the FDIC quarterly and records a FDIC true-up provision for the present value of the projected true-up payable to the FDIC at the termination of the loss-share agreement. At December 31, 2011, TNB's FDIC true-up provision totaled $601 thousand.

The FDIC indemnification asset is reduced as expected losses on covered loans and covered other real estate decline or as loss-share claims are submitted to the FDIC. The FDIC indemnification asset is revalued concurrent with the loan re-estimation 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 reduce the FDIC indemnification asset, and any decreases in cash flow of the covered loans and covered other real estate under those expected increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset are recorded as adjustments to noninterest income.

During the fourth quarter of 2011, Trustmark re-estimated the expected cash flows on the acquired loans of Heritage as required by FASB ASC Topic 310-30. The analysis resulted in improvements in the estimated future cash flows of the acquired loans that remain outstanding as well as lower expected remaining losses on those loans. The improvements in the estimated expected cash flows of the covered loans resulted in a reduction of the expected loss-share receivable from the FDIC. During the fourth quarter of 2011, other income included a write-down of the FDIC indemnification asset of $4.2 million on covered loans as a result of loan pay offs and improved cash flow projections and lower loss expectations for loan pools.

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		185
Loss-share payments received from FDIC		(986	)
Change in expected cash flows		(4,157	)
Change in FDIC true-up provision		(27	)
Carrying value at December 31, 2011	$	28,348