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First Texas BHC, Inc. and Subsidiaries

Condensed Consolidated Financial Statements (Unaudited)
June 30, 2017

Contents

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To the Board of Directors and Stockholders
of First Texas BHC, Inc. and Subsidiaries

We have reviewed the condensed consolidated financial statements of First Texas BHC, Inc. and Subsidiaries (Company), which comprise the balance sheet as of June 30, 2017, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for the six-month periods ended June 30, 2017 and 2016.

Management’s Responsibility for the Financial Information

The Company’s management is responsible for the preparation and fair presentation of the condensed consolidated financial information in accordance with accounting principles generally accepted in the United States of America; this responsibility includes the design, implementation, and maintenance of internal control sufficient to provide a reasonable basis for the preparation and fair presentation of interim financial information in accordance with accounting principles generally accepted in the United States of America.

Auditor’s Responsibility

Our responsibility is to conduct our reviews in accordance with auditing standards generally accepted in the United States of America applicable to reviews of interim financial information. A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial information. Accordingly, we do not express such an opinion.

Conclusion

Based on our review, we are not aware of any material modifications that should be made to the condensed financial information referred to above for it to be in accordance with accounting principles generally accepted in the United States of America.

Report on Condensed Consolidated Balance Sheet as of December 31, 2016

We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet as of December 31, 2016, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the year then ended (not presented herein); and we expressed an unmodified audit opinion on those audited consolidated financial statements in our report dated March 13, 2017. In our opinion, the accompanying condensed consolidated balance sheet of First Texas BHC, Inc. and Subsidiaries as of December 31, 2016, is consistent, in all material respects, with the audited consolidated financial statements from which it has been derived.

August 3, 2017

5952 Royal Lane • Suite 158 • Dallas, TX 75230 •214 / 363-9927• Fax 214 / 363-9980

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FIRST TEXAS BHC, INC. AND SUBSIDIARIES
   
Condensed Consolidated Balance Sheets
June 30, 2017 and December 31, 2016
(In thousands of dollars except share amounts)

See accompanying notes to condensed consolidated financial statements and independent auditor’s review report.

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FIRST TEXAS BHC, INC. AND SUBSIDIARIES
   
Condensed Consolidated Statements of Income
Six Months Ended June 30, 2017 and 2016
(Unaudited)
(In thousands of dollars, except per share amounts)

See accompanying notes to condensed consolidated financial statements and independent auditor’s review report.

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FIRST TEXAS BHC, INC. AND SUBSIDIARIES
   
Condensed Consolidated Statements of Comprehensive Income
Six Months Ended June 30, 2017 and 2016
(Unaudited)
(In thousands of dollars)

See accompanying notes to condensed consolidated financial statements and independent auditor’s review report.

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FIRST TEXAS BHC, INC. AND SUBSIDIARIES
   
Condensed Consolidated Statements of Changes in Shareholders’ Equity
Six Months Ended June 30, 2017
(Unaudited)
(In thousands of dollars)

See accompanying notes to condensed consolidated financial statements and independent auditor’s review report.

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FIRST TEXAS BHC, INC. AND SUBSIDIARIES
   
Condensed Consolidated Statements of Cash Flows
Six Months Ended June 30, 2017 and 2016
(Unaudited)
(In thousands of dollars)

See accompanying notes to condensed consolidated financial statements and independent auditor’s review report.

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FIRST TEXAS BHC, INC. AND SUBSIDIARIES
   
Notes to Condensed Consolidated Financial Statements
June 30, 2017

1.   Nature of Operations and Summary of Significant Accounting Policies

Pending Acquisition of First Texas BHC, Inc. by Simmons First National Corporation

On January 23, 2017, First Texas BHC, Inc. (First Texas) entered into an agreement and plan of merger (merger agreement) with Simmons First National Corporation (Simmons).

Under the terms of the agreement Simmons will acquire all of the outstanding common stock of First Texas for approximately $462,000,000 (based on Simmons common stock closing price as of January 20, 2017). More specifically, First Texas shareholders and other equity right holders will receive, in the aggregate, 6,500,000 shares of Simmons common stock and $70,000,000 in cash, all subject to certain conditions and potential adjustments. The transaction is expected to close during the fourth quarter of 2017.

The merger agreement contains both customary and specific representations, warranties, and covenants for each of the parties. Also the merger agreement contains certain termination rights for both Simmons and First Texas and further provides that a termination fee of  $18,000,000 will be payable by First Texas to Simmons upon termination of the agreement under certain specified circumstances.

The completion of the acquisition is subject to various customary closing and other conditions, including but not limited to, the approval of the merger agreement by each party’s shareholders and the receipt of required regulatory approvals.

The foregoing limited description of the transaction and merger agreement does not purport to be complete and is qualified in its entirety by reference to the merger agreement.

Basis of Presentation

The condensed consolidated financial statements include the accounts of First Texas BHC, Inc. (Parent) (a Texas Corporation), and its wholly-owned subsidiaries, SWB Recovery Corp. and Southwest Bank (Bank) and the Bank’s wholly-owned subsidiary, Harob, (collectively referred to as the Company). The Parent owns the outstanding common stock of First Texas BHC Statutory Trust II (Trust II), which was formed for the purpose of issuing company-obligated, mandatorily-redeemable preferred securities.

Certain prior period amounts have been reclassified to conform to current period classification. The condensed consolidated balance sheet of the Company as of December 31, 2016, has been derived from the audited consolidated financial statements of the Company as of December 31, 2016. The results of operations for the period are not necessarily indicative of the results to be expected for the full year.

Certain information and note disclosures normally included in the Company’s annual audited financial statements prepared in with accounting principles generally accepted in the United States of America and the prevailing practices within the banking industry have been condensed or omitted. These condensed consolidated financial statements do not represent complete financial statements and should be read in conjunction with the Company’s audited consolidated financial statements as of and for the year ended December 31, 2016 and notes thereto.

The Subsidiary entities are included in the accompanying financial statements from their dates of acquisition. All significant intercompany accounts and transactions have been eliminated in consolidation.

Nature of Operations

The Company is principally engaged in traditional community banking activities provided through its banking offices in Fort Worth, Dallas, Saginaw, Mansfield, Burleson, Grapevine, and Arlington. Community banking activities include the Company’s commercial and retail lending, deposit gathering, investment, and treasury management activities. Mortgage banking activities are provided through offices in Fort Worth, Dallas, and Austin.

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Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses for the reporting period. Actual results could differ from those estimates. The allowance for possible loan losses, valuation of other real estate owned and goodwill, the fair value of stock-based compensation awards, and the fair values of financial instruments are particularly subject to change.

Subsequent Events

The Company has evaluated subsequent events for recognition and disclosure through August 3, 2017, the date on which the condensed consolidated financial statements were available to be issued.

Cash and Cash Equivalents

For the purposes of reporting cash flows, cash and cash equivalents include cash on hand, deposits with other financial institutions, and federal funds sold. All highly liquid investments with an initial maturity of less than ninety days are considered to be cash equivalents. Cash flows from loans and deposits are reported net. The Company maintains deposits with other financial institutions. Furthermore, federal funds sold are essentially uncollateralized loans to other financial institutions. Management regularly evaluates the credit risk associated with the counterparties to these transactions and believes that the Company is not exposed to any significant credit risks on cash and cash equivalents.

The Company was not required to have funds on hand or on deposit at June 30, 2017 and December 31, 2016 with the Federal Reserve Bank to meet regulatory reserve and clearing requirements.

Securities

Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they may be used as part of the Company’s asset/liability strategy and may be sold prior to maturity in response to changes in interest rate risk, prepayment risk, or other similar economic factors. Securities available for sale are carried at fair value, with unrealized holding gains and losses, net of tax, reported in other comprehensive income. Management determines the appropriate classification of securities at the time of purchase. As of June 30, 2017 and December 31, 2016, all securities were classified as available for sale.

The amortization of premiums and accretion of discounts, computed by the interest method over their contractual lives, are recognized in interest income. Gains and losses on sales are based on the amortized cost of the security sold.

Declines in the fair value of individual securities below their cost that are considered other than temporary result in write downs of the individual securities to their fair value. The related write downs, if any, are included in earnings as realized losses.

Other equity investments such as stock in the Federal Home Loan Bank, Federal Reserve Bank, and Independent Bankers Financial Corporation are carried at cost.

Loans Held for Sale

Loans originated or purchased and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by aggregate outstanding commitments from investors or current investor yield requirements. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans.

Loans

Loans are reported at the principal balance outstanding, less the allowance for loan losses, net of unamortized premium, net deferred loan fees, net deferred loan costs, and net non-accrual interest paid. Interest is accrued daily on the outstanding balances. Loan origination and commitment fees, as well as

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certain direct origination costs, are deferred and amortized as a yield adjustment over the lives of the related loans. Further information regarding the Company’s accounting policy related to past due loans, nonaccrual loans, impaired loans, and troubled-debt restructuring is presented in Note 3 — Loans and Allowance for Loan Losses.

Allowance for Loan Losses

The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated losses inherent in the loan portfolio. For further information regarding the Company’s policies and methodology used to estimate the allowance for loan losses is presented in Note 3 — Loans and Allowance for Loan Losses.

Loan Servicing and Sales

In the normal course of business, the Company sells the guaranteed portion of certain loans originated with the partial guarantee of the Small Business Administration (SBA) or U.S. Department of Agriculture (USDA). At the time of these sales, the Company retains servicing rights and interest-only strips on those loans. Gain or loss on sale of the receivables depends in part on the previous carrying amount of the financial assets involved in the transfer, allocated between the assets sold and the retained interests based on their relative fair values at the date of transfer. To obtain fair values, quoted market prices are used if available. However, quotes are generally not available for retained interests, so the Company generally estimates fair value based on the present value of future expected cash flows. Future expected cash flows are estimated by management based on key assumptions such as credit losses, prepayment speeds, forward yield curves, and discount rates commensurate with the risks involved.

The related servicing rights represent the estimated present values of future cash flows related to rights to service SBA and USDA loans for other investors. Loan servicing rights are amortized against loan servicing fee income on an accelerated basis in proportion to, and over the period of, estimated net future loan servicing fee income. Service fee income is recognized as the related loan payments are collected. At June 30, 2017 and December 31, 2016, the Company had capitalized loan servicing rights of approximately $220,000 and $274,000, respectively, included in other assets in the accompanying financial statements.

Capitalized interest-only strip receivables represent contractual rights to receive the rate differential between the interest rate sold to investors and the rate retained by the Company. Capitalized interest-only strip receivables are amortized against interest income as an adjustment to yield in proportion to, and over the period of, estimated net future loan servicing fee income. At June 30, 2017 and December 31, 2016, the Company had capitalized interest-only strip receivables of approximately $147,000 and $183,000, respectively, included in other assets in the accompanying financial statements.

Deferred gain on sale of loans represents the relative value of the loan sale proceeds of the retained, unguaranteed portion of the loan retained, net of amounts capitalized and the gain immediately recognized. Deferred gain is recognized into income in proportion to, and over the period of, estimated net future loan servicing fee income. At June 30, 2017 and December 31, 2016, the Company had deferred gains of approximately $547,000 and $684,000, respectively, included in other liabilities in the accompanying financial statements.

Management periodically evaluates both servicing rights and interest-only strip receivables for impairment, and, if necessary, writes such assets down to their estimated fair values. At June 30, 2017 and December 31, 2016, management has determined that the carrying amounts of servicing assets and interest-only strip receivables approximate their estimated fair values.

Premises and Equipment

Land is carried at cost. Building and improvements, and furniture and equipment are stated at cost less accumulated depreciation, computed on a straight-line basis over the estimated useful lives of the assets ranging from 3 to 40 years. Leasehold improvements are generally depreciated over the term of the respective leases. The related cost and accumulated depreciation are removed from the accounts at the time an asset is sold or retired, and any resulting gain or loss is recognized in income. Maintenance and repairs are charged to operating expenses as incurred.

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Other Real Estate Owned

Other real estate owned is initially recorded at fair value less the estimated costs to sell the asset. Write downs of carrying value required at the time of foreclosure are recorded as a charge to the allowance for loan losses. Costs related to the development of such real estate are capitalized, whereas those related to holding the property are expensed. Foreclosed property is subject to periodic reevaluation based upon estimates of fair value. In determining the valuation of other real estate owned, management obtains independent appraisals for significant properties. Valuation adjustments are provided, as necessary, by charges to operations.

Goodwill

Goodwill represents the excess of the cost of business acquired over the fair value of the net assets acquired. Goodwill is assessed, at least annually, for impairment, as well as when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. The Company bases its evaluation on such impairment factors as the nature of the assets, the future economic benefit of the assets, any historical or future profitability measurements, and other market conditions or factors that may be present.

Intangibles and Other Long-Lived Assets

Intangible assets are acquired assets that lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset, or liability. The Company’s intangible assets relate to core deposits. Intangible assets with definite useful lives are amortized on a straight-line basis over their estimated useful life. Intangible assets, premises and equipment and other long-lived assets are tested for impairment whenever events or changes in circumstances indicate the carrying amount of the assets may not be recoverable from future cash flows. If impaired, the assets are recorded at fair value and an impairment loss is recognized.

Stock-Based Compensation

The Company accounts for stock-based employee compensation plans in accordance with accounting rules, which require companies to expense the fair value of employee stock options and other forms of stock-based employee compensation in the financial statements over the period that an employee provides service in exchange for the award. Under these rules, the Company measures compensation cost related to stock options based on the grant-date fair value of the award using the Black-Scholes option-pricing model and recognizes it ratably, less estimated forfeitures, over the vesting term of the award.

Income Taxes

Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities (excluding deferred tax assets and liabilities related to components of other comprehensive income). Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and the tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the expected amount most likely to be realized. Realization of deferred tax assets is dependent upon the generation of a sufficient level of future taxable income and recoverable taxes paid in prior years. Although realization is not assured, management believes it is more-likely-than-not that all of the deferred tax assets will be realized.

The Company files a consolidated income tax return with its subsidiaries. Federal income tax expense or benefit has been allocated to subsidiaries on a separate return basis. The open tax years are 2013 through 2017. When and if applicable, potential interest and penalty costs are accrued as incurred, with expenses recognized in selling, general and administrative, expenses in the statements of operations.

For the year ended December 31, 2016, management has determined there are no uncertain tax positions.

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Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are not reported as a separate component in the consolidated statement of income, such items are components of comprehensive income. Gains and losses on available for sale securities are reclassified to net income as the gains or losses are realized upon sale of the securities. Other than temporary impairment charges are reclassified to net income at the time of the charge.

Fair Values of Financial Instruments

ASC Topic 820, Fair Value Measurements and Disclosures, defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and requires certain disclosures about fair value measurements (see Note 6 — Fair Values of Financial Instruments). In general, fair values of financial instruments are based upon quoted market prices, where available. If such quoted market prices are not available, a fair value is based upon models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such validation adjustments are applied consistently over time.

Transfers of Financial Assets

Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (i) the assets have been isolated from the Company, (ii) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (iii) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Dividend Restriction

Banking regulations require the maintenance of certain capital and net income levels that may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of the Bank to fall below specified minimum levels. Regulatory capital requirements are more fully disclosed in Note 5 — Regulatory Matters.

Earnings per Share

Basic earnings per share represent income available to shareholders divided by the weighted average number of shares outstanding during each period. Diluted earnings per share reflect additional potential shares that would have been outstanding if dilutive potential shares had been issued. Potential shares that may be issued by the Company relate to stock options, stock appreciation rights, and restricted stock units.

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Earnings per share (EPS) were computed as follows for the three month periods ended June 30:

2.   Securities Available for Sale

Securities available for sale consisted of the following at June 30, 2017 and December 31, 2016 (in thousands):

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Securities with a fair value of approximately $58,131,000 and $59,523,000 at June 30, 2017 and December 31, 2016, respectively, were sold under agreements to repurchase or were pledged to secure public fund deposits, long term borrowings, or lines of credit, as required or permitted by law.

Unrealized losses and fair value, aggregated by length of time that individual securities have been in a continuous unrealized loss position, as of June 30, 2017 and December 31, 2016, are summarized as follows (in thousands):

Unrealized losses relate principally to current interest rates for similar types of securities. In analyzing an issuer’s financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. The Company does not intend to sell these securities and it is more-likely-than-not that the Company will not be required to sell prior to recovery.

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to sell or whether it would be more-likely-than-not required to sell its investments in the issuer for a period of time sufficient to allow for any anticipated recovery. As of June 30, 2017 and December 31, 2016, no investment securities were other-than-temporarily impaired.

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The amortized cost and estimated fair value of securities at June 30, 2017, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Mortgage-backed securities are shown separately since they are not due at a single maturity date (in thousands):

3.   Loans and Allowance for Loan Losses

Risk By Loan Category

To determine an appropriate allowance for loan losses, management separates loans into separate categories based on similar risk characteristics. These categories and their risk characteristics are described below:

Construction and Land Development — This category consists of loans secured by vacant land, which includes developed commercial land, undeveloped commercial land, rural land, single family residential lots, lot development loans, and interim construction for both 1 – 4 family and commercial developments. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, government regulation of real property, general economic conditions and the availability of long-term financing.

Commercial Real Estate — This category consists of loans secured by both owner-occupied and non-owner occupied commercial real estate properties and represents the largest category of the Company’s total loan portfolio. A majority of the loans in this category are secured by non-owner occupied commercial properties. The remainder of this segment is secured by owner occupied properties. The non-owner occupied portion of this category presents a higher risk profile given the reliance on third-party rental income and the successful operation of the property to service the regular payment, but overall credit risk is low. A substantial majority of these loans have adequate secondary sources of repayment through financially strong guarantors that are well known to the Company. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s portfolio are diverse in terms of type and geographic location. Loan losses in this category have been minimal.

Residential Real Estate — This category consists of loans secured by some form of both owner-occupied and non-owner-occupied residential real estate. The category includes loans for home improvement, home equity lines of credit and close-end financing for 1 – 4 family properties. Mortgage loans held for sale on the secondary market are excluded from this category. Generally, the overall credit risk in this segment of the loan portfolio is low given the nature of the collateral and the Company’s strict underwriting standards for this type of financing. The Company does not originate sub-prime mortgage loans. The higher risk area of this category is the “non-owner-occupied” portion of these loans which are often reliant on rental income as the primary source of repayment.

Commercial, Industrial and Agricultural — This category consists of all business loans secured by assets other than commercial real estate. It also includes loans for agriculture production. A substantial majority of these loans are secured by equipment, accounts receivable and inventory. The loss history in this segment of the portfolio is very low due to sufficient collateralization. The primary risk involved with this

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category is that the loans are typically secured by depreciable assets that may not provide an adequate source of repayment if the loan goes into default.

Loans to Nondepository Financial Institutions — This category consists of all loans to mortgage companies that specialize in mortgage loan originations and mortgage warehouse loans. It also includes loans to real estate investment trusts.

Consumer and Other — This category of loans consists of all other forms of consumer debt, including automobiles, recreational vehicles, debt consolidation, household or personal use, education, taxes, mobile homes, personal lines of credit, loans to mortgage originators, loans to non-profits and overdrafts. Overdrafts are deposit accounts that become unsecured loans when overdrawn by the deposit customer. Overdrafts are monitored by account officers on a daily basis and are often cleared within a very short period of time. It is bank policy to charge off any overdrafts that remain outstanding for more than 60 days.

Loans consisted of the following at June 30, 2017 and December 31, 2016 (in thousands):

At June 30, 2017 and December 31, 2016, the Bank had total commercial real estate loans and construction and land development loans of  $1,273,827,000 and $1,091,879,000, respectively. The Bank had construction, land development, and other loans representing 117% and 115%, respectively, of total risk based capital at June 30, 2017 and December 31, 2016. The Bank had non-owner-occupied commercial real estate loans representing 375% and 379%, respectively, of total risk based capital at June 30, 2017 and December 31, 2016. Sound risk management practices and appropriate levels of capital are essential elements of a sound commercial real estate lending program (CRE). Concentrations of CRE exposures add a dimension of risk that compounds the risk inherent in individual loans. Interagency guidance on CRE concentrations describe sound risk management practices which include board and management oversight, portfolio management, management information systems, market analysis, portfolio stress testing and sensitivity analysis, credit underwriting standards, and credit risk review functions. Management believes it has implemented these practices in order to monitor its CRE. An institution which has reported loans for construction, land development, and other land loans representing 100% or more of total risk-based capital, or total non-owner occupied commercial real estate loans representing 300% or more of the institution’s total risk-based capital and the outstanding balance of commercial real estate loan portfolio has increased by 50% or more during the prior 36 months, may be identified for further supervisory analysis by regulators to assess the nature and risk posed by the concentration.

At June 30, 2017 and December 31, 2016, the Bank had approximately $27,546,000 and $27,435,000, respectively, of energy loans included in commercial and industrial loans. These energy loans represent approximately 9% and 11%, respectively, of total risk based capital at June 30, 2017 and December 31, 2016. Management believes it has implemented appropriate practices for sound underwriting and the monitoring of these loans. However, the weakening of prices within the energy industry over a prolonged period may have an adverse effect on the Company’s profitability and asset quality.

The Company extends commercial and consumer credit primarily to customers in the State of Texas. At June 30, 2017 and December 31, 2016, the majority of the Company’s loans were collateralized with real

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estate. The real estate collateral provides an alternate source of repayment in the event of default by the borrower, and may deteriorate in value during the time the credit is extended. The weakening of real estate markets may have an adverse effect on the Company’s profitability and asset quality. If the Company was required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, earnings and capital could be adversely affected. Additionally, the Company has loans secured by inventory, accounts receivable, equipment, marketable securities, or other assets. The debtors’ ability to honor their contracts on all loans is substantially dependent upon the general economic conditions of the region.

Nonaccrual and Past Due Loans

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. Loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Nonaccrual loans, segregated by class of loans, at June 30, 2017 and December 31, 2016, were as follows (in thousands):

An age analysis of past due loans (including both accruing and nonaccruing loans), segregated by class of loans, as of June 30, 2017 and December 31, 2016, is as follows (in thousands):

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Impaired Loans

A loan is considered impaired when it is probable, based on current information and events, the Company will be unable to collect all contractual principal and interest payments due in accordance with the terms of the loan agreement. Impaired loans are measured on an individual basis based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. The amount of impairment, if any, and any subsequent changes are included in the allowance for loan losses.

Impaired loans as of June 30, 2017 and December 31, 2016 are set forth in the following table (in thousands):

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Troubled Debt Restructurings

The restructuring of a loan is considered a “troubled debt restructuring” if both the borrower is experiencing financial difficulties and the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. The Company had no troubled debt restructurings at June 30, 2017 and December 31, 2016.

Credit Quality Indicators

As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, management tracks certain quality indicators including trends related to the risk grade of loans, the level of classified loans, the delinquency status of loans, net charge-offs, non-performing loans, and the general economic conditions in the state of Texas.

The Company utilizes a risk-grading definition system to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 9. A description of the general characteristics of the 9 risk grades is as follows:

Grade 1 — This grade includes loans with little or no risk of loss. Interest payments are protected by a large or exceptionally stable margin and principal is secured. These borrowers have a strong positive consistent cash flow, stable earnings and growth, significant net worth and sufficient liquidity to fully repay the debt.

Grades 2 and 3 — These grades include loans to borrowers of solid credit quality with moderate risk. Borrowers in these grades are differentiated from higher grades on the basis of leverage, asset quality, and the stability of the industry or market area.

Grade 4 — This grade is for “satisfactory” loans. These borrowers have acceptable financial condition and stability but are more susceptible to economic changes and greater concentration of business risk either by product or market, however borrowers demonstrate consistent profitability or strong historical cash flow; competent management but may not have been tested by cyclical market conditions.

Grade 5 — This grade includes loans on management’s “Pass/Watch list”. Pass/Watch assets are neither criticized nor classified credits. These assets have the potential for future deterioration. This grade is intended to be utilized on a temporary basis.

Grade 6 — This grade is for “Special Mention” loans. Special mention loans are considered criticized assets. These assets have the potential for future deterioration. Such loans are differentiated from a Grade 5 in terms of a higher sensitivity to severity and imminence of the potential weakness(es). If left uncorrected, these potential weakness(es) may at some future date result in the deterioration of the repayment prospects for the loan.

Grade 7 — This grade is for “Substandard” loans. Substandard loans have defined weakness(es) which make payment default or principal exposure likely but not yet certain. These loans are inappropriately protected by the current net worth and paying capacity of the borrower or the collateral pledged. Although loss may not be imminent, if the weakness(es) is not corrected, there is a distinct possibility that the Company will sustain some loss. If the likelihood of full collection of principal and interest may be in doubt these loans are placed on nonaccrual.

Grade 8 — This grade includes “Doubtful” loans. Such loans are differentiated from a Grade 7 in terms that the weakness(es) makes collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Loans in this grade are carried on nonaccrual.

Grade 9 — This grade includes “Loss” loans. Such loans are considered uncollectible and of such little value that their continuance as assets is not warranted. Loss is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.

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The following table presents the risk category of loans by grade as of June 30, 2017 and December 31, 2016 (in thousands):

Allowance for Loan Losses

The allowance is an amount that management believes will be adequate to absorb estimated losses relating to specifically identified loans, as well as probable credit losses inherent in the balance of the loan portfolio, based on an evaluation of the collectability of existing loans and prior loss experience. This evaluation also takes into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers’ ability to pay. This evaluation does not include the effects of expected losses on specific loans or groups of loans that are related to future events or expected changes in economic conditions. While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses, and may require the Company to make changes to the allowance based on their judgment about information available to them at the time of their examinations.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired for which an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers nonimpaired loans and is based on historical loss experience adjusted for qualitative factors.

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The following table presents the activity in the allowance for loan losses by portfolio segment for the years ended June 30, 2017 and December 31, 2016 (in thousands):