20 Real Estate - Construction & Land  – Real estate construction loans (including land and  development loans) generally possess a higher inherent risk of loss than other real estate  portfolio segments. A major risk arises from the necessity to complete projects within specified  cost and time lines. Trends in the construction industry significantly impact the credit quality  of these loans, as demand drives construction activity. In addition, trends in real estate  values significantly impact the credit quality of these loans, as property values determine the  economic viability of construction projects. Real Estate - Other  – Real estate mortgage loans generally possess a higher inherent risk of  loss than other real estate portfolio segments, except land and construction loans. Adverse  economic developments or an overbuilt market impact commercial real estate projects and  may result in troubled loans. Trends in vacancy rates of commercial and residential properties  impact the credit quality of these loans. High vacancy rates reduce operating revenues and  the ability for properties to produce sufficient cash flow to service debt obligations. Commercial & Industrial  – Commercial loans generally possess a lower inherent risk of loss  than real estate portfolio segments because these loans are generally underwritten to existing  cash flows of operating businesses. Debt coverage is provided by business cash flows and  economic trends influenced by unemployment rates and other key economic indicators are  closely correlated to the credit quality of these loans. The general reserve component of the allowance for loan losses also consists of reserve factors that  are based on management’s assessment of the following for each portfolio segment: (1) inherent  credit risk, (2) historical losses and (3) other qualitative factors. These reserve factors are inherently  subjective and are driven by the repayment risk associated with each portfolio segment described  below. Loss  – Loans classified as loss are considered uncollectible and charged off immediately. Doubtful  –  Loans classified doubtful have all the weaknesses inherent in those classified as  substandard with the added characteristic that the weaknesses make collection or liquidation  in full, on the basis of currently known facts, conditions and values, highly questionable and  improbable. Allowance for Loan Losses (Continued) Substandard  – A substandard loan is not adequately protected by the current sound worth and  paying capacity of the borrower or the value of the collateral pledged, if any. Loans classified  as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation  of the debt. Well defined weaknesses include a project’s lack of marketability, inadequate  cash flow or collateral support, failure to complete construction on time or the project’s failure  to fulfill economic expectations. They are characterized by the distinct possibility that the  Bank will sustain some loss if the deficiencies are not corrected. 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued) NOTES TO FINANCIAL STATEMENTS California Bank of Commerce