NOTE 6. ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is maintained at a level considered adequate to provide for our estimate of probable credit losses inherent in the loan portfolio. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. Loans are charged against the allowance for loan losses when we believe that collectability is unlikely. While we use the best information available to make our evaluation, future adjustments may be necessary if there are significant changes in conditions.

The allowance is comprised of three distinct reserve components: (1) specific reserves related to loans individually evaluated, (2) quantitative reserves related to loans collectively evaluated, and (3) qualitative reserves related to loans collectively evaluated. A summary of the methodology we employ on a quarterly basis with respect to each of these components in order to evaluate the overall adequacy of our allowance for loan losses is as follows.

Specific Reserve for Loans Individually Evaluated

First, we identify loan relationships having aggregate balances in excess of $500,000 and that may also have credit weaknesses. Such loan relationships are identified primarily through our analysis of internal loan evaluations, past due loan reports, and loans adversely classified by regulatory authorities. Each loan so identified is then individually evaluated to determine whether it is impaired – that is, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the underlying loan agreement. Substantially all of our impaired loans are and historically have been collateral dependent, meaning repayment of the loan is expected to be provided solely from the sale of the loan's underlying collateral. For such loans, we measure impairment based on the fair value of the loan's collateral, which is generally determined utilizing current appraisals. A specific reserve is established in an amount equal to the excess, if any, of the recorded investment in each impaired loan over the fair value of its underlying collateral, less estimated costs to sell. Our policy is to re-evaluate the fair value of collateral dependent loans at least every twelve months unless there is a known deterioration in the collateral's value, in which case a new appraisal is obtained.

Quantitative Reserve for Loans Collectively Evaluated

Second, we stratify the loan portfolio into the following ten loan pools: land and land development, construction, commercial, commercial real estate -- owner-occupied, commercial real estate -- non-owner occupied, conventional residential mortgage, jumbo residential mortgage, home equity, consumer, and other. Loans within each pool are then further segmented between (1) loans which were individually evaluated for impairment and not deemed to be impaired, (2) larger-balance loan relationships exceeding $2 million which are assigned an internal risk rating in conjunction with our normal ongoing loan review procedures and (3) smaller-balance homogenous loans.

Quantitative reserves relative to each loan pool are established as follows: for all loan segments detailed above an allocation equaling 100% of the respective pool's average 12 month historical net loan charge-off rate (determined based upon the most recent twelve quarters) is applied to the aggregate recorded investment in the pool of loans.

Qualitative Reserve for Loans Collectively Evaluated

Third, we consider the necessity to adjust our average historical net loan charge-off rates relative to each of the above ten loan pools for potential risks factors that could result in actual losses deviating from prior loss experience. For example, if we observe a significant increase in delinquencies within the conventional mortgage loan pool above historical trends, an additional allocation to the average historical loan charge-off rate is applied. Such qualitative risk factors considered are: (1) levels of and trends in delinquencies and impaired loans, (2) levels of and trends in charge-offs and recoveries, (3) trends in volume and term of loans, (4) effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practice, (5) experience, ability, and depth of lending management and other relevant staff, (6) national and local economic trends and conditions, (7) industry conditions, and (8) effects of changes in credit concentrations.

An analysis of the allowance for loan losses for the years ended December 31, 2011, 2010 and 2009 is as follows:


Dollars in thousands		2011		2010		2009

Balance, beginning of year	$	17,224	$	17,000	$	16,933
Losses:
Commercial		506		601		479
Commercial real estate
Owner occupied		508		2,266		99
Non-owner occupied		78		6,974		370
Construction and development
Land and land development		3,568		6,974		14,444
Construction		-		963		2,503
Residential real estate
Non-jumbo		3,178		2,052		1,612
Jumbo		1,511		973		1,551
Home equity		346		798		757
Consumer		162		321		295
Other		86		191		150
Total		9,943		22,113		22,260
Recoveries:
Commercial		35		39		129
Commercial real estate
Owner occupied		37		5		19
Non-owner occupied		55		268		3
Construction and development
Land and land development		43		330		1,583
Construction		-		1		32
Real estate - mortgage
Non-jumbo		83		51		29
Jumbo		14		15		-
Home equity		1		84		-
Consumer		112		162		97
Other		51		32		110
Total		431		987		2,002
Net losses		9,512		21,126		20,258
Provision for loan losses		10,000		21,350		20,325
Balance, end of year	$	17,712	$	17,224	$	17,000

Activity in the allowance for loan losses by loan class during 2011 is as follows:


		Construction & Land
			Development
		Land &								Commercial Real Estate						Residential Real Estate
		Land &										Non	-
		Devlop- Construc-						Commer-		Owner			Owner		Non	-				Home		Con	-
Dollars in thousands			ment		tion				cial	Occupied			Occupied			jumbo		Jumbo		Equity			sumer			Other		Total

Allowance for loan losses
Beginning balance		$	7,901	$	322			$	323	$	1,108		$	2,941	$	2,419	$	1,316		$	600	$	263		$	31	$	17,224
Charge-offs			3,568		-				506		508			78		3,178		1,511			346		162			86		9,943
Recoveries			43		-				35		37			55		83		14			1		112			51		431
Provision			2,885		(202	)			918		698			365		3,263		1,512			576		(52	)		37		10,000
Ending balance		$	7,261	$	120			$	770	$	1,335		$	3,283	$	2,587	$	1,331		$	831	$	161		$	33	$	17,712

Allowance related to:
Loans individually
evaluated for impairment		$	2,901	$	29			$	247	$	464		$	456	$	209	$	275		$	163	$	2		$	-	$	4,746
Loans collectively
evaluated for impairment			4,360		91				523		871			2,827		2,378		1,056			668		159			33		12,966
Loans acquired with
deteriorated credit quality			-		-				-		-			-		-		-			-		-			-		-
Total		$	7,261	$	120			$	770	$	1,335		$	3,283	$	2,587	$	1,331		$	831	$	161		$	33	$	17,712

Loans
Loans individually
evaluated for impairment	$	29,862		$	735			$	2,969	$	12,278		$	9,790	$	4,860	$	18,147		$	407	$	8		$	-	$	79,056
Loans collectively
evaluated for impairment			63,173		2,201				96,055		146,476		260,436			216,873		43,388		50,491			22,317			2,762		904,172
Loans acquired with
deteriorated credit quality			-		-				-		-			-		-		-			-		-			-		-
Total	$	93,035		$	2,936		$	99,024		$	158,754	$	270,226		$	221,733	$	61,535	$	50,898		$	22,325		$	2,762	$	983,228