Covered Assets and FDIC Loss-sharing Asset

Covered Assets

Covered assets consist of loans and OREO acquired in FDIC-assisted acquisitions during 2010 and 2011, for which the Bank entered into loss-sharing agreements, whereby the FDIC will cover a substantial portion of any future losses on loans (and related unfunded loan commitments), OREO and certain accrued interest on loans. Under the terms of the loss-sharing agreements, the FDIC will absorb 80% of losses and share in 80% of loss recoveries up to specified amounts and, with respect to loss-sharing agreements for two acquisitions completed in 2010, will absorb 95% of losses and share in 95% of loss recoveries thereafter. The loss-sharing provisions of the agreements for commercial and single-family mortgage loans are in effect for five and ten years, respectively, from the acquisition dates and the loss recovery provisions are in effect for eight and ten years, respectively, from the acquisition dates.

Ten years and forty-five days after the acquisition dates, the Bank shall pay to the FDIC a clawback in the event the losses from the acquisitions fail to reach stated levels. This clawback shall be in the amount of 50% of the excess, if any, of 20% of the stated threshold amounts, less the sum of 25% of the asset premium (discount), 20% or 25% of the cumulative loss-sharing payments (depending on the particular agreement), and the cumulative servicing amount. As of December 31, 2011 and 2010, the net present value of the Bank’s estimated clawback liability is $3.7 million and $0, respectively, which is included in other liabilities on the Consolidated Balance Sheet.

The following is an analysis of our covered loans, net of related allowance for losses on covered loans as of December 31, 2011 and 2010:



	December 31, 2011					December 31, 2010
	Covered Loans		Weighted- Average Risk Rating	Allowance for Loan Losses		Covered Loans		Weighted- Average Risk Rating	Allowance for Loan Losses
	(dollars in thousands)
Commercial business	$	195,737	6.05	$	977	$	165,255	5.74	$	2,903
Real estate:
One-to-four family residential	79,328		5.32	678		68,700		4.77	1,013
Commercial and multifamily residential	311,308		5.65	2,683		341,063		5.70	821
Total real estate	390,636			3,361		409,763			1,834
Real estate construction:
One-to-four family residential	54,402		7.32	136		39,754		7.29	98
Commercial and multifamily residential	23,661		7.32	86		41,624		6.79	469
Total real estate construction	78,063			222		81,378			567
Consumer	56,877		4.84	384		58,337		4.49	751
Subtotal of covered loans	721,313			$	4,944	714,733			$	6,055
Less:
Valuation discount resulting from acquisition accounting	184,440					191,617
Allowance for loan losses	4,944					6,055
Covered loans, net of valuation discounts and allowance for loan losses	$	531,929				$	517,061

Certain acquired loans are accounted for under ASC 310-30 and initially measured at fair value based on expected future cash flows over the life of the loans. Acquired loans that have common risk characteristics are aggregated into pools. The Company re-measures contractual and expected cash flows, at the pool-level, on a quarterly basis.

Contractual cash flows are calculated based upon the loan pool terms after applying a prepayment factor. Calculation of the applied prepayment factor for contractual cash flows is the same as described below for expected cash flows.

Inputs to the determination of expected cash flows include cumulative default and prepayment data as well as loss severity and recovery lag information. Cumulative default and prepayment data are calculated via a transition matrix. The transition matrix is a matrix of probability values that specifies the probability of a loan pool transitioning into a particular delinquency state (e.g. 0-30 days past due, 31 to 60 days, etc.) given its delinquency state at the re-measurement date. Loss severity factors are based upon actual charge-off data within the loan pools and recovery lags are based upon experience with the collateral within the loan pools.

Acquired loans are also subject to the Company’s internal and external credit review and are risk rated using the same criteria as loans originated by the Company. However, risk ratings are not a clear indicator of losses on acquired loans as a majority of the losses are recoverable from the FDIC under the loss-sharing agreements.

Draws on acquired loans, advanced subsequent to the loan acquisition date, are accounted for under ASC 450-20 and those amounts are also subject to the Company’s internal and external credit review. An allowance for loan losses is estimated in a similar manner as the originated loan portfolio, and a provision for loan losses is charged to earnings as necessary.

The excess of cash flows expected to be collected over the initial fair value of acquired impaired loans is referred to as the accretable yield and is accreted into interest income over the estimated life of the acquired loans using the effective yield method. Other adjustments to the accretable yield include changes in the estimated remaining life of the acquired loans, changes in expected cash flows and changes of indices for acquired loans with variable interest rates.

The following table shows the changes in accretable yield for acquired loans for the years ended December 31, 2011 and 2010:



	Years Ended December 31,
	2011			2010
	(in thousands)
Balance at beginning of period	$	256,572		$	—
Additions resulting from acquisitions	59,810			122,705
Accretion	(90,378		)	(45,956		)
Disposals	(31,483		)	(9,014		)
Reclassifications from nonaccretable difference	65,148			188,837
Balance at end of period	$	259,669		$	256,572

During the year ended December 31, 2011, the Company recorded a provision recapture for losses on covered loans of $1.6 million. Of this amount, $589 thousand was impairment recapture calculated in accordance with ASC 310-30 and $1.0 million was a provision recapture to adjust the allowance for loss calculated under ASC 450-20 for draws on acquired loans. The impact to earnings of the $1.6 million of provision recapture for covered loans was partially offset through noninterest income by a decrease in the FDIC loss-sharing asset. For the year ended December 31, 2010, the Company recorded a provision for loan losses of $6.1 million which was partially offset by an increase to the FDIC loss-sharing asset. The Company did not have covered loans in 2009.

The 2011 and 2010 changes in the ALLL for covered loans are summarized as follows:



	Years Ended December 31,
	2011			2010
	(in thousands)
Balance at beginning of year	$	6,055		$	—
Loans charged off	(1,488		)	—
Recoveries	2,025			—
Provision charged to expense	(1,648		)	6,055
Balance at end of year	$	4,944		$	6,055

The following table shows loans acquired during 2011 and 2010 for which it was probable at acquisition that all contractually required payments would not be collected:



	First Heritage Bank			Summit Bank			American Marine Bank			Columbia River Bank
	May 27, 2011			May 20, 2011			January 29, 2010			January 22, 2010
	(in thousands)
Contractually required payments of interest and principal	$	151,611		$	127,823		$	263,371		$	799,244
Nonaccretable difference	(34,052		)	(34,301		)	(65,470		)	(217,856		)
Cash flows expected to be collected(1)	117,559			93,522			197,901			581,388
Accretable yield	(36,071		)	(23,739		)	(21,623		)	(101,082		)
Carrying value of acquired loans	$	81,488		$	69,783		$	176,278		$	480,306

_________

(1) Represents undiscounted expected principal and interest cash flows

The following table sets forth activity in covered OREO at carrying value for the years ended December 31, 2011 and 2010:



	December 31, 2011			December 31, 2010
	(in thousands)
Covered OREO:
Balance, beginning of period	$	14,443		$	—
Established through acquisitions	10,387			17,394
Transfers in, net of write-downs ($2,564 and $2,087, respectively)	15,522			10,858
OREO improvements	5			85
Additional OREO write-downs	(666		)	(1,182		)
Proceeds from sale of OREO property	(20,619		)	(17,890		)
Gain on sale of OREO	9,054			5,178
Total covered OREO, end of period	$	28,126		$	14,443

The covered OREO is covered by loss-sharing agreements with the FDIC in which the FDIC will assume 80% of additional write-downs and losses on covered OREO sales, or 95%, if applicable, of additional write-downs and losses on covered OREO sales if the minimum loss share thresholds are met.

FDIC Loss-sharing Asset

At December 31, 2011 and 2010, the FDIC loss-sharing asset is comprised of an FDIC indemnification asset of $157.5 million and $170.7 million, respectively, and an FDIC receivable of $17.6 million and $35.3 million, respectively. The indemnification represents the cash flows the Company expects to collect from the FDIC under the loss-sharing agreements and the FDIC receivable represents the reimbursable amounts from the FDIC that have not yet been received.

For covered loans, the Company re-measures contractual and expected cash flows on a quarterly basis. When the quarterly re-measurement process results in a decrease in expected cash flows due to an increase in expected credit losses, impairment is recorded. As a result of this impairment, the indemnification asset is increased to reflect anticipated future cash to be received from the FDIC. Consistent with the loss-sharing agreements between the Company and the FDIC, the amount of the increase to the indemnification asset is measured as 80% of the resulting impairment.

Alternatively, when the quarterly re-measurement results in an increase in expected future cash flows due to a decrease in expected credit losses, the nonaccretable difference decreases and the effective yield of the related loan portfolio is increased. As a result of the improved expected cash flows, the indemnification asset would be reduced first by the amount of any impairment previously recorded and, second, by increased amortization over the remaining life of the related loan pool.

The following table shows a detailed analysis of the FDIC-loss sharing asset for the years ending December 31, 2011 and 2010:



	2011			2010
	(in thousands)
Balance at beginning of period	$	205,991		$	—
Adjustments not reflected in income:
Established through acquisitions	68,734			210,405
Cash received from the FDIC	(54,200		)	(11,198		)
FDIC reimbursable losses, net	4,042			1,876
Adjustments reflected in income:
Amortization, net	(46,049		)	1,139
Impairment	(1,318		)	4,844
Sale of other real estate	(4,346		)	(1,148		)
Other	2,217			73
Balance at end of period	$	175,071		$	205,991