Center Financial 10-Q 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2011
Commission file number: 000-50050
Center Financial Corporation
(Exact name of Registrant as specified in its charter)
Registrants telephone number, including area code(213) 251-2222
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
x Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):
Yes ¨ No x
As of November 4, 2011, there were 39,919,952 outstanding shares of the issuers Common Stock with no par value.
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED)
AS OF SEPTEMBER 30 AND DECEMBER 31
See accompanying notes to interim consolidated financial statements.
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (UNAUDITED)
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30
See accompanying notes to interim consolidated financial statements.
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30
See accompanying notes to interim consolidated financial statements.
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)-(Continued)
FOR THE NINE MONTHS ENDED SEPTEMBER 30
See accompanying notes to interim consolidated financial statements.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. THE BUSINESS OF CENTER FINANCIAL CORPORATION
Center Financial Corporation (Center Financial) is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the BHC Act), and is headquartered in Los Angeles, California. Center Financial was incorporated on April 19, 2000 and acquired all of the issued and outstanding shares of Center Bank (the Bank) in October 2002. Currently, Center Financials direct subsidiaries include the Bank and Center Capital Trust I. Center Financial exists primarily for the purpose of holding the stock of the Bank and of the other subsidiary and for providing access to capital and funding for the Bank. Center Financial, the Bank, and Center Capital Trust I are collectively referred to herein as the Company, unless the context indicates otherwise.
The Bank is a California state-chartered and Federal Deposit Insurance Corporation (FDIC) insured financial institution, which was incorporated in 1985 and commenced operations in March 1986. The Banks headquarters are located at 3435 Wilshire Boulevard, Suite 700, Los Angeles, California 90010. The Bank provides comprehensive financial services for small to medium sized business owners, primarily in Southern California. The Bank specializes in commercial loans, most of which are secured by real property, to small business customers. In addition, the Bank is a Preferred Lender of Small Business Administration (SBA) loans and provides trade finance loans. The Banks primary market is the Southern California area, including Los Angeles, Orange, San Bernardino, and San Diego counties, primarily focused in areas with high concentrations of Korean-Americans.
The Bank currently has 21 full-service branch offices, 18 of which are located in California. The Bank also operates two Loan Production Offices in Seattle and Denver. In December 2003, Center Financial formed a wholly owned subsidiary, Center Capital Trust I, a Delaware statutory business trust, for the exclusive purpose of issuing and selling trust preferred securities. Center Financials principal source of income is generally dividends from the Bank and equity earnings in the Bank. The expenses of Center Financial, including interest on junior subordinated debentures issued to Center Capital Trust I, legal and accounting fees and NASDAQ listing fees have been and will generally be paid by the cash on hand or from dividends paid by the Bank.
2. BASIS OF PRESENTATION
The interim consolidated financial statements include the accounts of Center Financial and the Bank. Center Capital Trust I is not consolidated as disclosed in Note 12.
The interim consolidated financial statements are presented in accordance with U. S. generally accepted accounting principles (GAAP) for unaudited financial statements. The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for the fair statement of results for the periods presented. All adjustments are of a normal and recurring nature. Results for the three and nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for any other interim period or for the year as a whole. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted. The interim consolidated financial statements should be read in conjunction with the audited financial statements and notes included in the Companys annual report on Form 10-K, as amended, for the year ended December 31, 2010.
Use of estimates
Management has made a number of estimates and assumptions related to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the interim consolidated financial statements and the reported amounts of revenues and expenses during the reporting period to prepare these interim consolidated financial statements in accordance with GAAP. Actual results could differ from those estimates. Material estimates subject to change in the near term include, among other items, the allowance for loan losses, investment securities, the carrying value of other real estate owned, the carrying value of intangible assets, the carrying value of the FDIC loss share receivable and the realization of deferred tax assets.
Reclassifications have been made to the prior year financial statements to conform to the current presentation.
3. SIGNIFICANT ACCOUNTING POLICIES
Accounting policies are fully described in Note 2 to the consolidated financial statements in Center Financials Annual Report on Form 10-K, as amended, for the year ended December 31, 2010 and there have been no material changes noted.
Trouble Debt Restructured Loans
The amendments in ASU 2011-02 require prospective application of the impairment measurement guidance in ASC 310-10-35 for those receivables newly identified as impaired. As a result of adopting the amendments in ASU 2011-02, the Company reassessed all restructurings that occurred on or after January 1, 2011 for identification as a TDR. A loan is classified as a troubled debt restructured when a borrower is experiencing financial difficulties that lead to a restructuring of the loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. These concessions may include interest rate reductions, principal forgiveness, extension of maturity date and other actions intended to minimize potential losses. Generally, a nonaccrual loan that is restructured remains on nonaccrual for a period of six months to demonstrate that the borrower can meet the restructured terms. However, the borrowers performance prior to the restructuring or other significant events at the time of restructuring may be considered in assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status after a shorter performance period. If the borrowers performance under the new terms is not reasonably assured, the loan remains classified as a nonaccrual loan. The Company usually identified as TDRs certain receivables for which the ALLL had previously been measured under a general ALLL methodology. Upon identifying those receivables as TDRs, the Company identified them as impaired under the guidance in ASC 310-10-35 and established a specific or formula allowance.
4. RECENT ACCOUNTING PRONOUNCEMENTS
In January 2010, the FASB issued FASB ASU 2010-06, Improving Disclosures about Fair Value Measurements, which amends ASC 820 to require additional disclosures regarding fair value measurements. Specifically, the ASU requires disclosure of the amounts of significant transfers between Level 1 and Level 2 of the fair value hierarchy and the reasons for these transfers, the reasons for any transfers in or out of Level 3, and information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements on a gross basis. In addition to these new disclosure requirements, the ASU also amends ASC 820 to clarify certain existing disclosure requirements. For example, the ASU clarifies that reporting entities are required to provide fair value measurement disclosures for each class of assets and liabilities. Previously separate fair value disclosures were required for each major category of assets and liabilities. ASU 2010-06 also clarifies the requirement to disclose information about both the valuation techniques and inputs used in estimating Level 2 and Level 3 fair value measurements. Except for the requirement to disclose information about purchases, sales, issuances, and settlements in the reconciliation of recurring Level 3 measurements on a gross basis, these disclosures are effective for the quarter ended March 31, 2010. The requirement to separately disclose purchases, sales, issuances, and settlements of recurring Level 3 measurements became effective for the Company for the quarter ended March 31, 2011. The Company adopted this new accounting guidance as of January 1, 2010 and 2011, respectively, and the impact of adoption was not material on the consolidated financial statements.
In July 2010, the FASB issued FASB ASU 2010-20, Receivables (Topic 310) Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which required more information about credit quality. The ASU requires an entity to provide additional disclosures including, but not limited to, a rollforward schedule of the allowance for credit losses (with the ending allowance balance further disaggregated based on impairment methodology) and the related ending balance of the finance receivable presented by portfolio segment, and the aging of past due financing receivables at the end of the period, the nature and extent of troubled debt restructurings that occurred during the period and their impact on the allowance for credit losses, the nature and extend of troubled debt restructurings that occurred within the last year, that have defaulted in the current reporting period, and their impact on the allowance for credit losses, the nonaccrual status of financing receivables, and impaired financing receivables, presented by class. The new disclosures of information as of the end of a reporting period are effective for both interim and annual reporting periods ending after December 15, 2010 for public companies. The Company adopted this new accounting guidance as of December 31, 2010.
In December 2010, the FASB issued FASB ASU 2010-29, Disclosure of Supplementary ProForma Information for Business Combinations, a consensus of the FASB Emerging Issues Task Force (Issue No. 10-G), which requires that the pro forma information be presented as if the business combination occurred at the beginning of the prior annual reporting period for purposes of calculating both the current reporting period and the prior reporting period pro forma financial information. The ASU also requires that this disclosure be accompanied by a narrative description of the amount and nature of material nonrecurring pro forma adjustments. The amendments in this ASU are effective for business combinations with effective dates on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Prospective application is required with early adoption permitted. The Company does not anticipate the new guidance will have a material impact on the consolidated financial statements as this relates to only pro-forma disclosure.
In April 2011, the FASB issued FASB ASU 2011-02, Receivables (Topic 310) A Creditors Determination whether a Restructuring Is A Troubled Debt Restructuring, which provides additional guidance for determining whether the creditor has granted a concession and whether the debtor is experiencing financial difficulty. A troubled debt restructuring (TDR) is a restructuring of a debt if the creditor for economic or legal reasons related to the debtors financial difficulties grants a concession to the debtor that it would not otherwise consider. Public entities are required to adopt this ASU for interim and annual periods beginning on or after June 15, 2011. For purposes of TDR disclosure, the ASU applies retrospectively to restructurings occurring on or after the beginning of the annual period of adoption, or January 1, 2011 for the Company. However, any changes in the method used to measure impairment apply prospectively. Beginning in the period the ASU is adopted, public entities are subject to the requirements to disclose the activity-based information about TDRs that was previously deferred by ASU 2011-01. The Company adopted this guidance during the quarterly period ending September 30, 2011 as disclosed in Note 7, and the impact of adoption was not material on the consolidated financial statements.
In May 2011, the FASB issued FASB ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in the U.S. GAAP and IFRSs, to provide largely identical guidance about fair value measurement and disclosure requirements with the International Accounting Standards Boards new International Financial Reporting Standards (IFRS) 13, Fair Value Measurement. The new guidance does not extend the use of fair value but, rather, provides guidance about how fair value should be applied where it already is required or permitted under U.S. GAAP. Most of the changes are clarifications of existing guidance or wording changes to align with IFRS 13. A public entity is required to apply this ASU prospectively for interim and annual periods beginning after December 15, 2011. Early adoption is not permitted for a public entity. In the period of adoption, a reporting entity will be required to disclose a change, if any, in valuation technique and related inputs that result from applying the ASU and to quantify the total effect, if practicable. The Company does not anticipate the adoption of this ASU will have a significant impact on the consolidated financial statements.
In June 2011, the FASB issued FASB ASU 2011-05, Presentation of Comprehensive Income. To improve comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income, the ASU eliminates the option to present other comprehensive income in the statement of changes in equity. Under this ASU, an entity will have the option to present the components of net income and comprehensive income in either one or two consecutive financial statements. An entity should apply the ASU retrospectively. For a public entity, the ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company does not anticipate the adoption of this ASU will have a significant impact on the consolidated financial statements.
5. BUSINESS COMBINATION
On December 9, 2010, Center Financial and Nara Bancorp, Inc. (Nara Bancorp) entered into a definitive agreement to merge. Under the terms of the merger agreement, Center Financial shareholders will receive a fixed ratio of 0.7804 of a share of Nara Bancorp common stock in exchange for each share of Center Financial common stock they own. At the closing date of the merger, Nara Bancorp shareholders will own approximately 55% of the combined company and Center Financial shareholders will own approximately 45%. The combined company will operate under a new name that will be determined prior to the closing. In addition, at the closing or as soon as possible thereafter, it is anticipated that Nara Bank, a California state-chartered bank and a wholly-owned subsidiary of Nara Bancorp, will merge with and into the Bank, with the Bank as the surviving bank after the bank merger.
The boards of directors of both companies have unanimously approved the transaction. Both our shareholders and Nara Bancorps have approved the merger at separate meetings, both held on September 21, 2011. On November 7, 2011, the Company announced receipt of approval from the FDIC of the planned merger of Nara Bank and Center Bank. This represents the final regulatory approval required for the merger of the two companies. Approvals have previously been received from the DFI and the FRB. The merger is expected to close by end of November 2011, subject to customary closing conditions.
6. INVESTMENT SECURITIES
The following table summarizes the amortized cost, fair value and distribution of the Companys investment securities as of September 30, 2011 and December 31, 2010:
The following table shows the Companys investments with gross unrealized losses and related fair values, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of September 30, 2011 and December 31, 2010.
The Company considers numerous factors to determine any other-than-temporary impairment (OTTI) for the collateralized debt obligation (CDO) trust preferred security including review of trustee reports, monitoring of break in yield tests, analysis of current defaults and deferrals and the expectation for future defaults and deferrals. The Company reviews the key financial characteristics for individual issuers (commercial banks or thrifts) in the CDO trust preferred security and considers capital ratios, leverage ratios, nonperforming loan and nonperforming asset ratios, in addition to the credit ratings. The credit ratings of the Companys CDO trust preferred security were Ca (Moodys) and C (Fitch) as of September 30, 2011 and December 31, 2010.
The Company uses cash flow projections for the purpose of assessing OTTI on the CDO trust preferred security which incorporate certain credit events in the underlying collaterals and prepayment assumptions. The projected issuer default rates are assumed at a rate equivalent to 150 basis points applied annually and have a 0% recovery factor after the initial default date. The principal is assumed to be prepaying at 1% annually and at 100% at maturity.
Based on the results from the cash flow model, the CDO trust preferred security did not experience an adverse change in its cash flow status. As such, based on all of these factors, the Company determined that there was no OTTI adjustment required for the securities that have been in a continuous unrealized loss position as of September 30, 2011. The risk of future OTTI will be highly dependent upon the performance of the underlying issuers. The Company does not have the intention to sell and does not believe it will be required to sell the CDO trust preferred security until maturity.
The following table summarizes, as of September 30, 2011, the maturity characteristics of the investment portfolio by investment category. Expected remaining maturities may differ from remaining contractual maturities because obligors may have the right to prepay certain obligations with or without penalties.
7. NON-COVERED LOANS AND ALLOWANCE FOR LOAN AND LEASE LOSSES
On April 16, 2010, the California Department of Financial Institution (the DFI) closed Innovative Bank, Oakland, California, and appointed the FDIC as its receiver. On the same date, Center Bank assumed the banking operations of Innovative Bank from the FDIC under a purchase and assumption agreement with loss sharing. Non-covered loans refer to loans not covered by the FDIC loss sharing agreement. Loans acquired in an FDIC-assisted acquisition that are subject to a loss sharing agreement are referred to as covered loans and reported separately in the interim consolidated statements of financial condition.
Non-covered loans, segregated by class of loans, as of September 30, 2011 and December 31, 2010 consist of the following:
The activity in the allowance for loan losses on total loans (including non-covered loans and covered loans and excluding loans held for sale), segregated by portfolio segment, as of and for the three and nine months ended September 30, 2011 and the year ended December 31, 2010 is as follows:
Loans are considered impaired when it is probable that the Company will be unable to collect all amounts due as scheduled according to the contractual terms of the loan agreement, including contractual interest and principal payments. Impaired loans are measured for impairment based on the present value of expected future cash flows discounted at the loans effective interest rate or, alternatively, at the loans observable market price or the fair value of the collateral if the loan is collateralized, less costs to sell. Loans are identified for specific allowances from information provided by several sources including asset classification, third party reviews, delinquency reports, periodic updates to financial statements, public records, and industry reports. All loan types are subject to impairment evaluation for a specific allowance once identified as impaired.
The Bank generally writes down nonperforming collateral dependent impaired loans to the value of the underlying collateral. The collateral value is generally updated every six months and the impairment amount is generally charged off during the quarter in which collateral value is updated. The performing impaired loans, such as performing TDRs, are allocated with specific reserve and are not generally charged off. The performing impaired loans typically continue to make contractual payments according to their restructured terms and conditions.
Non-covered nonperforming loans, net of SBA guarantees totaled $29.0 million as of September 30, 2011, a decrease of $13.2 million as compared to $42.2 million as of December 31, 2010. Non-covered nonperforming loans, net of SBA guarantees as a percentage of total non-covered loans decreased to 1.98% as of September 30, 2011 as compared to 2.76% as of December 31, 2010. Gross interest income of approximately $308,000 and $657,000 would have been additionally recorded for the three and nine months ended September 30, 2011, respectively, compared to $373,000 and $1.6 million for the same periods in 2010, respectively, if these loans had been paid in accordance with their original terms and had been outstanding throughout the applicable period then ended or, if not outstanding throughout the applicable period then ended, since origination.
As of September 30, 2011, the Company held non-covered TDRs of $46.3 million, representing an increase of $7.2 million, or 18.4%, as compared to $39.1 million as of December 31, 2010. The increase in the non-covered TDRs was mainly result of one commercial business loan relationship for $8.0 million that became a TDR during the third quarter of 2011. The debtor has been making loan payments according to its restructured terms and conditions since July 2011.
A TDR is a debt restructuring in which a bank, for economic or legal reasons related to a borrowers financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs may include, but are not necessarily limited to, one or a combination of the following:
3. Modification of terms of a debt, such as one or a combination of any of the following:
A TDR that has been formally restructured so as to be reasonably assured of repayment and of performance according to its modified terms need not be maintained in a non-accrual or nonperforming status, provided the TDR is supported by a current well documented credit evaluation and positive prospects of repayment under the revised terms. If these conditions can not be met, the Company will classify the TDR as non-accrual or nonperforming.
The TDRs are monitored on a monthly basis to review the performance of the restructured term. When it is determined that the future performance of TDR is uncertain of repayment in accordance with the new restructured term, the loan is placed on non-accrual. The TDRs are usually analyzed for impairment evaluation for a specific allowance when outstanding balance is $100,000 or more. The fair value of the collateral is used for nonperforming TDR and present value of expected future cash flow is used for performing TDR.
As a result of adopting the amendments in ASU 2011-02, the Company reassessed all restructurings that occurred on or after January 1, 2011 for identification as a TDR. The Company usually identified as TDRs certain receivables for which the ALLL had previously been measured under a general ALLL methodology. Upon identifying those receivables as TDRs, the Company identified them as impaired under the guidance in ASC 310-10-35. The amendments in ASU 2011-02 require prospective application of the impairment measurement guidance in ASC 310-10-35 for those receivables newly identified as impaired. At September 30, 2011, the recorded investment in receivables for which the ALLL was previously measured under a general ALLL methodology and are now considered as the TDRs under ASC 310-10-35 was $21.4 million, and the ALLL associated with those receivables, on the basis of current evaluation of loss, was $3.3 million.
92% of the TDRs as of September 30, 2011 are impaired, and $12.1 million were on non-accrual status. The remaining $34.2 million of the Companys TDRs meet the conditions that qualify these loans as performing as of September 30, 2011.
The following table provides the information of the Companys TDRs as of September 30, 2011:
The most of common types of modification that the Company provided for commercial real estate loans and commercial loans are interest rate reductions and loan payment adjustments. The loan payment adjustment typically involves deferment of principal payment for significant delay that increases uncertainty factor for full repayment of the loans. Generally, a nonaccrual loan that is restructured remains on nonaccrual for a period of six months to demonstrate that the borrower can meet the restructured terms. The subsequent default generally occurs when the borrowers performance under the restructuring is not reasonably assured, and the loan is classified as a nonaccrual loan. The subsequent defaulted TDR is measured for impairment and subject to a specific or formula allowance.
The following table provides information on non-covered impaired loans, segregated by class of loans, as of and for the three and nine months ended September 30, 2011 and the year ended December 31, 2010, respectively:
The following table provides aging information on non-covered past due loans inclusive of loans held for sale, segregated by class of loans, as of September 30, 2011 and December 31, 2010, respectively:
The Company utilizes a risk grading matrix to assign a risk grade to its loan portfolio. The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. Loans, excluding homogeneous loans, are individually analyzed by classifying loans as to credit risk and are graded on a scale of 1 to 7 at least on a quarterly basis. A description of the general characteristics of the seven risk grades is as follows:
Grade 1 - This grade includes loans secured by cash or listed securities. The borrowers generally have significant capital strength with unquestionable ability to service the debt.
Grades 2 and 3 - These grades include pass grade loans to borrowers of solid or acceptable credit quality and risk. The borrowers generally have sufficient capital strength with highly reliable or adequate primary source of repayment.
Grade 3A - This grade includes loans on managements watch list and is intended to be utilized on a temporary basis for pass grade borrowers. The borrowers generally experiencing a temporary setback and may have weakening primary source of repayment.
Grade 4 - This grade is for Special Mention in accordance with regulatory guidelines. This grade includes borrowers that require close credit monitoring. The borrowers generally have inconclusive earnings histories and access to alternate sources of financing are limited.
Grade 5 - This grade includes Substandard loans in accordance with regulatory guidelines. The borrowers typically have well-defined weaknesses with possibility of payment default or some loss if the weakness is not corrected.
Grade 6 - This grade includes Doubtful loans in accordance with regulatory guidelines. Such loans are placed on non-accrual status and the liquidation of collateral in full is highly questionable or improbable.
Grade 7 - This grade includes Loss loans in accordance with regulatory guidelines. Such loans are deemed uncollectible and are to be charged off or charged down. This classification is not intended to imply that the loan or some portion of it will never be paid.
The following table presents the credit risk profile of non-covered loans exclusive of loans held for sale, segregated by class of loans, as of September 30, 2011 and December 31, 2010, respectively:
The Companys allowance for loan loss methodologies incorporate a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Companys historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers sensitivity to interest rate movements and to quantifiable external factors including commodity and finished good prices as well as acts of nature (earthquakes, floods, fires, etc.) that occur in a particular period. Qualitative factors include the general economic environment in the Companys markets and, in particular, the state of certain industries. Size and complexity of individual credits, loan structure, extent and nature of waivers of existing loan policies and pace of portfolio growth are other qualitative factors that are considered in its methodologies. As the Company adds new products, increases the complexity of the loan portfolio, and expands its geographic coverage, the Company will enhance the methodologies to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have significant impact to the allowance for loan loss calculation. The Company believes that its methodologies continue to be appropriate given its size and level of complexity.
The allowance for loan losses reflects managements judgment of the level of allowance adequate to provide for probable losses inherent in the loan portfolio as of the date of the consolidated statements of financial condition. On a quarterly basis, the Company assesses the overall adequacy of the allowance for loan losses, utilizing a disciplined and systematic approach which includes the application of a specific allowance for identified problem loans, a formula allowance for identified graded loans and an allocated allowance for large groups of smaller balance homogenous loans.
Allowance for Specifically Identified Problem Loans. A specific allowance is established for impaired loans. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The specific allowance is determined based on the present value of expected future cash flows discounted at the loans effective interest rate, except that as a practical expedient, the Company may measure impairment based on a loans observable market price, or the fair value of the collateral if the loan is collateral dependent. The Company measures impairment based on the fair value of the collateral, adjusted for the cost related to liquidation of the collateral.
Formula Allowance for Identified Graded Loans. Non-homogenous loans such as commercial real estate, construction, commercial business, trade finance and SBA loans that are not subject to the allowance for specifically identified loans discussed above are not reviewed individually and are subject to a formula allowance. The formula allowance is calculated by applying loss factors to outstanding Pass, Special Mention, Substandard and Doubtful loans. The evaluation of the inherent loss for these loans involves a high degree of uncertainty, subjectivity and judgment because probable loan losses are not identified with a specific loan. In determining the formula allowance, the Company relies on a mathematical calculation that incorporates a six-quarter rolling average of historical losses, which has been adjusted from the twelve quarter analysis used historically. The Company started using the six-quarter rolling average beginning in the fourth quarter of 2008 instead of the twelve-quarter rolling average that the Company had historically been applying. Current quarter losses are measured against previous quarter loan balances to develop the loss factor. Loans risk rated Pass, Special Mention and Substandard for the most recent three quarters are adjusted to an annual basis as follows:
The formula allowance may be further adjusted to account for the following qualitative factors:
Allowance for Large Groups of Smaller Balance Homogenous Loans. The portion of the allowance allocated to large groups of smaller balance homogenous loans is focused on loss experience for the pool rather than on an analysis of individual loans. Large groups of smaller balance homogenous loans mainly consist of consumer loans to individuals. The allowance for groups of performing loans is based on historical losses over a six-quarter period. In determining the level of allowance for delinquent groups of loans, the Company classifies groups of homogenous loans based on the number of days delinquent and other qualitative factors and trends.
Allowance for Loans held for sale. No allowance is established for loans held for sale.
8. NON-COVERED OTHER REAL ESTATE OWNED (OREO)
The Company had three non-covered OREO properties valued at $947,000 as of September 30, 2011. The changes in non-covered other real estate owned for the three and nine months ended September 30, 2011 and 2010 are as follows:
9. COVERED ASSETS AND FDIC LOSS SHARE RECEIVABLE
Loans acquired in an FDIC-assisted acquisition that are subject to a loss sharing agreement are referred to as covered loans and reported separately in the interim consolidated statements of financial condition. Covered loans are reported exclusive of the expected cash flow reimbursements expected from the FDIC.
Acquired loans are valued as of the acquisition date in accordance with FASB ASC 805, Business Combinations. Loans purchased with evidence of credit deterioration since origination for which it is probable that all contractually required payments will not be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. In addition, because of the significant discounts associated with the acquired portfolios, the Company elected to account for all of the acquired loans, with the exception of a small population of loans, under ASC 310-30 in the amount of $125.2 million at acquisition. Certain cash secured loans and overdrafts in the amount of $0.9 million were not accounted for under ASC 310-30. Under ASC 805 and ASC 310-30, loans are recorded at fair value at the acquisition date, factoring in credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for loan losses is not carried over or recorded as of the acquisition date.
If credit deterioration is experienced subsequent to the initial acquisition fair value amount, such deterioration of the expected cash flows will be measured, and a provision for loan losses will be charged to earnings. The effect of the provision for loan losses on covered loans will be offset, to the extent of the 80% loss share, by an increase to the FDIC loss share receivable. Any increase in the FDIC loss share receivable will be recognized in non-interest income. During the nine months ended September 30, 2011, no additional provision for loan losses has been required related to the covered loan portfolio.
The outstanding principal balance of covered loans, excluding fair value adjustments, as of September 30, 2011 and December 31, 2010 was $117.7 million and $147.6 million, respectively. The following table presents covered loans inclusive of fair value adjustment, segregated by class of loans, as of September 30, 2011 and December 31, 2010:
The following table presents the outstanding principal balance and related fair value adjustments of covered loans, segregated by class of loans, as of September 30, 2011 and December 31, 2010:
In estimating the fair value of the covered loans at the acquisition date, the Company (i) calculated the contractual amount and timing of undiscounted principal and interest payments and (ii) estimated the amount and timing of undiscounted expected principal and interest payments. The difference between these two amounts represents the nonaccretable difference.
On the acquisition date, the amount by which the undiscounted expected cash flows exceed the estimated fair value of the acquired loans is the accretable yield. The accretable yield is then measured at each financial reporting date and represents the difference between the remaining undiscounted expected cash flows and the current carrying value of the loans. The accretable yield will change from period to period due to the followings:
During the first nine months of 2011, there was no change in the estimate of contractual principal and interest that will ultimately be collectible.
The following table presents the carrying amounts for the covered loans as of September 30, 2011 and December 31, 2010, respectively:
Changes in the carrying amount of covered loans and the accretable yield were as follows for the three and nine months ended September 30, 2011 and 2010:
Net payment received includes all cash receipts related to the covered loans, net of the disbursements that are required to repurchase the participation sold portion of the SBA loans prior to collecting this guaranteed balance from the SBA.
Credit Quality IndicatorsThe covered loans acquired are and will continue to be subject to the Banks internal and external credit review and monitoring. The covered loans have the same credit quality indicators as the non-covered loans, to enable the monitoring of the borrowers credit and the likelihood of repayment.
Loans are risk rated based on analysis of the current state of the borrowers credit quality. The analysis of credit quality includes review of all sources of repayment, the borrowers current financial and liquidity status and all other relevant information. The Company utilizes a seven-grade risk rating system, where a higher grade represents a higher level of credit risk. The seven-grade risk rating system can be generally classified by the following categories: Pass or Watch (Grade 1-3A), Special Mention (Grade 4), Substandard (Grade 5), Doubtful and Loss (Grade 6-7). The risk ratings reflect the relative strength of the sources of repayment. A detailed description of this risk grading matrix is included in Note 7 above concerning non-covered loans.
The following table presents the credit risk profile of covered loans, by class of loans, as of dates indicated: