AUBURN NATIONAL BANCORPORATION, INC 10-K

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is a discussion of our financial condition at December 31, 2021 and 2020 and our results of operations for the years ended December 31, 2021 and 2020. The purpose of this discussion is to provide information about our financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included elsewhere herein. In addition, this discussion and analysis contains forward-looking statements, so you should refer to Item 1A, “Risk Factors” and “Special Cautionary Notice Regarding Forward-Looking Statements”. OVERVIEW The Company was incorporated in 1990 under the laws of the State of Delaware and became a bank holding company after it acquired its Alabama predecessor, which was a bank holding company established in 1984. The Bank, the Company's principal subsidiary, is an Alabama state-chartered bank that is a member of the Federal Reserve System and has operated continuously since 1907. Both the Company and the Bank are headquartered in Auburn, Alabama. The Bank conducts its business primarily in East Alabama, including Lee County and surrounding areas. The Bank operates full-service branches in Auburn, Opelika, Notasulga and Valley, Alabama. The Bank also operates loan production offices in Auburn and Phenix City, Alabama. Table of Contents 46 Summary of Results of Operations Year ended December 31 (Dollars in thousands, except per share data) 2021 2020 Net interest income (a) $ 24,460 $ 24,830 Less: tax-equivalent adjustment 470 492 Net interest income (GAAP) 23,990 24,338 Noninterest income 4,288 5,375 Total revenue 28,278 29,713 Provision for loan losses (600) 1,100 Noninterest expense 19,433 19,554 Income tax expense 1,406 1,605 Net earnings $ 8,039 $ 7,454 Basic and diluted net earnings per share $ 2.27 $ 2.09 (a) Tax-equivalent. See "Table 1 - Explanation of Non-GAAP Financial Measures". Financial Summary The Company’s net earnings were $8.0 million for the full year 2021, compared to $7.5 million for the full year 2020. Basic and diluted net earnings per share were $2.27 per share for the full year 2021, compared to $2.09 per share for the full year 2020. Net interest income (tax-equivalent) was $24.5 million in 2021, a 1% decrease compared to $24.8 million in 2020. This decrease was primarily due to net interest margin compression , partially offset by balance sheet growth. Net interest margin (tax-equivalent) decreased to 2.55% in 2021, compared to 2.92% in 2020, primarily due to the lower interest rate environment and changes in our asset mix resulting from the significant increase in deposits from government stimulus and relief programs and customers’ increased savings. At December 31, 2021, the Company’s allowance for loan losses was $4.9 million, or 1.08% of total loans, compared to $5.6 million, or 1.22% of total loans, at December 31, 2020. Excluding Paycheck Protection Program (“PPP”) loans, which are guaranteed by the SBA, the Company’s allowance for loan losses was 1.10% and 1.27% of total loans at December 31, 2021 and 2020, respectively . The Company recorded a negative provision for loan losses of $0.6 million in 2021 compared to a charge of $1.1 million during 2020. The negative provision for loan losses was primarily related to improvements in economic conditions in our primary market area, and related improvements in our asset quality. The provision for loan losses is based upon various estimates and judgements, including the absolute level of loans, loan growth, credit quality and the amount of net charge-offs. Net charge-offs as a percent of average loans were 0.02% in 2021 , compared to net recoveries as a percent of average loans of 0.03% in 2020. Noninterest income was $4.3 million in 2021 compared to $5.4 million in 2020. The decrease was primarily due to a $0.8 million decrease in mortgage lending income in 2021 as refinance activity declined in our primary market area and a $0.3 million non-taxable death benefit from bank-owned life insurance received in 2020. Noninterest expense was $19.4 million in 2021 compared to $19.6 million in 2020. The decrease was primarily due to a reduction of $0.8 million in various expenses related to the redevelopment of the Company’s headquarters in downtown Auburn. This decrease was mostly offset by increases in salaries and benefits expe nse of $0.4 million and a $0.2 million increase in FDIC and other regulatory assessments during 2021. Income tax expense was $1.4 million in 2021 and $1.6 million in 2020 reflecting an effective tax rate of 14.89 % and 17.72%, respectively. This decrease was primarily due to an income tax benefit related to a New Markets Tax Credit investment funded in the fourth quarter of 2021. The Company’s effective income tax rate is principally impacted by tax- exempt earnings from the Company’s investments in municipal securities, bank-owned life insurance, and New Markets Tax Credits. Table of Contents 47 The Company paid cash dividends of $1.04 per share in 2021, an increase of 2% from 2020. At December 31, 2021, the Bank’s regulatory capital ratios were well above the minimum amounts required to be “well capitalized” under current regulatory standards with a total risk-based capital ratio of 17.06%, a tier 1 leverage ratio of 9.35% and common equity tier 1 (“CET1”) of 16.23% at December 31, 2021. COVID-19 Impact Assessment The COVID-19 pandemic has occurred in waves of different variants since the first quarter of 2020. Vaccines to protect against and/or reduce the severity of COVID-19 were widely introduced at the beginning of 2021. At times, the pandemic has severely restricted the level of economic activity in our markets. In response to the COVID -19 pandemic, the State of Alabama, and most other states, have taken preventative or protective actions to prevent the spread of the virus, including imposing restrictions on travel and business operations and a statewide mask mandate, advising or requiring individuals to limit or forego their time outside of their homes, limitations on gathering of people and social distancing, and causing temporary closures of businesses that have been deemed to be non-essential. Though certain of these measures have been relaxed or eliminated, especially as vaccination levels increased, such measures could be reestablished in cases of new waves, especially a wave of a COVID-19 variant that is more resistant to existing vaccines. COVID-19 has significantly affected local state, national and global health and economic activity and its future effects are uncertain and will depend on various factors, including, among others, the duration and scope of the pandemic, especially new variants of the virus, effective vaccines and drug treatments, together with governmental, regulatory and private sector responses. COVID-19 has had continuing significant effects on the economy, financial markets and our employees, customers and vendors. Our business, financial condition and results of operations generally rely upon the ability of our borrowers to make deposits and repay their loans, the value of collateral underlying our secured loans, market value, stability and liquidity and demand for loans and other products and services we offer, all of which are affected by the pandemic. We have implemented a number of procedures in response to the pandemic to support the safety and well-being of our employees, customers and shareholders. • We believe our business continuity plan has worked to provide essential banking services to our communities and customers, while protecting our employees’ health. As part of our efforts to exercise social distancing in accordance with the guidelines of the Centers for Disease Control and the Governor of the State of Alabama, starting March 23, 2020, we limited branch lobby service to appointment only while continuing to operate our branch drive-thru facilities and ATMs. As permitted by state public health guidelines, on June 1, 2020, we re- opened some of our branch lobbies. In 2021, we opened our remaining branch lobbies. We continue to provide services through our online and other electronic channels. In addition, we maintain remote work access to help employees stay at home while providing continuity of service. • We are focused on servicing the financial needs of our commercial and consumer clients with extensions and deferrals to loan customers effected by COVID-19, provided such customers were not more than 30 days past due at the time of the request; and • We were an active PPP lender. PPP loans were forgivable, in whole or in part, if the proceeds are used for payroll and other permitted purposes in accordance with the requirements of the PPP. These loans carry a fixed rate of 1.00% and a term of two years (loans made before June 5, 2020) or five years (loans made on or after June 5, 2020), if not forgiven, in whole or in part. Payments are deferred until either the date on which the Small Business Administration (“SBA”) remits the amount of forgiveness proceeds to the lender or the date that is 10 months after the last day of the covered period if the borrower does not apply for forgiveness within that 10-month period. We believe these loans and our participation in the program helped our customers and the communities we serve. COVID-19 has also had various economic effects, generally. These include supply chain disruptions and manufacturing delays, shortages of certain goods and services, reduced consumer expenditure on hospitality and travel, and migration from larger urban centers to less populated areas and remote work. The demand for single family housing has exceeded existing supplies. When coupled with construction delays attributable to supply chain disruptions and worker shortages, these factors have caused housing prices and apartment rents to increase, generally. Stimulative monetary and fiscal policy, along with shortages of certain goods and services, and rising petroleum and food prices have led to the highest inflation in decades. Although fiscal stimulus remains under consideration by the President and Congress, the Federal Reserve is considering increasing its target interest rates and reducing its holding of securities to stem inflation. Table of Contents 48 A summary of PPP loans extended during 2020 follows: (Dollars in thousands) # of SBA Approved Mix $ of SBA Approved Mix SBA Tier: $2 million to $10 million — — % $ — — % $350,000 to less than $2 million 23 5 14,691 40 Up to $350,000 400 95 21,784 60 Total 423 100 % $ 36,475 100 % We collected approximately $1.5 million in fees related to our PPP loans during 2020. Through December 31, 2021, we have recognized all of these fees, net of related costs. As of December 31, 2021, we had received payments and forgiveness on all PPP loans extended during 2020. On December 27, 2020, the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the “Economic Aid Act”) was signed into law. The Economic Aid Act provides a second $900 billion stimulus package, including $325 billion in additional PPP loans. The Economic Aid Act also permits the collection of a higher amount of PPP loan fees by participating banks. A summary of PPP loans extended during 2021 under the Economic Aid Act follows: (Dollars in thousands) # of SBA Approved Mix $ of SBA Approved Mix SBA Tier: $2 million to $10 million — — % $ — — % $350,000 to less than $2 million 12 5 6,494 32 Up to $350,000 242 95 13,757 68 Total 254 100 % $ 20,251 100 % We collected approximately $1.0 million in fees related to PPP loans under the Economic Aid Act. Through December 31, 2021, we have recognized $0.7 million of these fees, net of related costs. As of December 31, 2021, we have received payments and forgiveness on 116 PPP loans under the Economic Aid Act, totaling $12.1 million. The outstanding balance for the remaining 138 PPP loans under the Economic Aid Act was approximately $8.1 million at December 31, 2021. We continue to closely monitor this pandemic, and are working to continue our services during the pandemic and to address developments as those occur. Our results of operations for year ended December 31, 2021, and our financial condition at that date reflect only the ongoing effects of the pandemic, and may not be indicative of future results or financial conditions, including possible changes in monetary or fiscal stimulus, and the possible effects of the expiration or extension of temporary accounting and bank regulatory relief measures in response to the COVID-19 pandemic. As of December 31, 2021, all of our capital ratios were in excess of all regulatory requirements to be well capitalized. The effects of the COVID-19 pandemic on our borrowers could result in adverse changes to credit quality and our regulatory capital ratios. We continue to closely monitor this pandemic, and are working to continue our services during the pandemic and to address developments as those occur. CRITICAL ACCOUNTING POLICIES The accounting and financial reporting policies of the Company conform with U.S. generally accepted accounting principles and with general practices within the banking industry. In connection with the application of those principles, we have made judgments and estimates which, in the case of the determination of our allowance for loan losses, our assessment of other-than-temporary impairment, recurring and non-recurring fair value measurements, the valuation of other real estate owned, and the valuation of deferred tax assets, were critical to the determination of our financial position and results of operations. Other policies also require subjective judgment and assumptions and may accordingly impact our financial position and results of operations. Table of Contents 49 Allowance for Loan Losses The Company assesses the adequacy of its allowance for loan losses prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect a borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates and other pertinent factors, including regulatory recommendations. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. Loans are charged off, in whole or in part, when management believes that the full collectability of the loan is unlikely. A loan may be partially charged-off after a “confirming event” has occurred which serves to validate that full repayment pursuant to the terms of the loan is unlikely. The Company deems loans impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Collection of all amounts due according to the contractual terms means that both the interest and principal payments of a loan will be collected as scheduled in the loan agreement. An impairment allowance is recognized if the fair value of the loan is less than the recorded investment in the loan. The impairment is recognized through the allowance. Loans that are impaired are recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate, or if the loan is collateral dependent, impairment measurement is based on the fair value of the collateral, less estimated disposal costs. The level of allowance maintained is believed by management to be adequate to absorb probable losses inherent in the portfolio at the balance sheet date. The allowance is increased by provisions charged to expense and decreased by charge- offs, net of recoveries of amounts previously charged-off. In assessing the adequacy of the allowance, the Company also considers the results of its ongoing internal, independent loan review process. The Company’s loan review process assists in determining whether there are loans in the portfolio whose credit quality has weakened over time and evaluating the risk characteristics of the entire loan portfolio. The Company’s loan review process includes the judgment of management, the input from our independent loan reviewers, and reviews that may have been conducted by bank regulatory agencies as part of their examination process. The Company incorporates loan review results in the determination of whether or not it is probable that it will be able to collect all amounts due according to the contractual terms of a loan. As part of the Company’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial and industrial, construction and land development, commercial real estate, residential real estate, and consumer installment loans. The Company analyzes each segment and estimates an allowance allocation for each loan segment. The allocation of the allowance for loan losses begins with a process of estimating the probable losses inherent for these types of loans. The estimates for these loans are established by category and based on the Company’s internal system of credit risk ratings and historical loss data. The estimated loan loss allocation rate for the Company’s internal system of credit risk grades is based on its experience with similarly graded loans. For loan segments where the Company believes it does not have sufficient historical loss data, the Company may make adjustments based, in part, on loss rates of peer bank groups. At December 31, 2021 and 2020, and for the years then ended, the Company adjusted its historical loss rates for the commercial real estate portfolio segment based, in part, on loss rates of peer bank groups. The estimated loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several “qualitative and environmental” factors. The allocation for qualitative and environmental factors is particularly subjective and does not lend itself to exact mathematical calculation. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and are based upon quarterly trend assessments in delinquent and nonaccrual loans, credit concentration changes, prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures and other influencing factors. These qualitative and environmental factors are considered for each of the five loan segments and the allowance allocation, as determined by the processes noted above, is increased or decreased based on the incremental assessment of these factors. Table of Contents 50 The Company regularly re-evaluates its practices in determining the allowance for loan losses. Since the fourth quarter of 2016, the Company has increased its look-back period each quarter to incorporate the effects of at least one economic downturn in its loss history. The Company believes the extension of its look-back period is appropriate due to the risks inherent in the loan portfolio. Absent this extension, the early cycle periods in which the Company experienced significant losses would be excluded from the determination of the allowance for loan losses and its balance would decrease. For the year ended December 31, 2021, the Company increased its look-back period to 51 quarters to continue to include losses incurred by the Company beginning with the first quarter of 2009. The Company will likely continue to increase its look- back period to incorporate the effects of at least one economic downturn in its loss history. During 2020, the Company adjusted certain qualitative and economic factors related to changes in economic conditions driven by the impact of the COVID-19 pandemic and resulting adverse economic conditions, including higher unemployment in our primary market area. During 2021, the Company adjusted certain qualitative and economic factors to reflect improvements in economic conditions in our primary market area. Further adjustments may be made in the future as a result of the ongoing COVID-19 pandemic. Assessment for Other-Than-Temporary Impairment of Securities On a quarterly basis, management makes an assessment to determine whether there have been events or economic circumstances to indicate that a security on which there is an unrealized loss is other-than-temporarily impaired. For debt securities with an unrealized loss, an other-than-temporary impairment write-down is triggered when (1) the Company has the intent to sell a debt security, (2) it is more likely than not that the Company will be required to sell the debt security before recovery of its amortized cost basis, or (3) the Company does not expect to recover the entire amortized cost basis of the debt security. If the Company has the intent to sell a debt security or if it is more likely than not that it will be required to sell the debt security before recovery, the other-than-temporary write-down is equal to the entire difference between the debt security’s amortized cost and its fair value. If the Company does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the other-than-temporary impairment write- down is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and is recognized in other comprehensive income, net of applicable taxes. The Company is required to own certain stock as a condition of membership, such as Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”). These non-marketable equity securities are accounted for at cost which equals par or redemption value. These securities do not have a readily determinable fair value as their ownership is restricted and there is no market for these securities. The Company records these non-marketable equity securities as a component of other assets, which are periodically evaluated for impairment. Management considers these non-marketable equity securities to be long-term investments. Accordingly, when evaluating these securities for impairment, management considers the ultimate recoverability of the par value rather than by recognizing temporary declines in value. Fair Value Determination U.S. GAAP requires management to value and disclose certain of the Company’s assets and liabilities at fair value, including investments classified as available-for-sale and derivatives. ASC 820, Fair Value Measurements and Disclosures , which defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP and expands disclosures about fair value measurements. For more information regarding fair value measurements and disclosures, please refer to Note 14, Fair Value, of the consolidated financial statements that accompany this report. Fair values are based on active market prices of identical assets or liabilities when available. Comparable assets or liabilities or a composite of comparable assets in active markets are used when identical assets or liabilities do not have readily available active market pricing. However, some of the Company’s assets or liabilities lack an available or comparable trading market characterized by frequent transactions between willing buyers and sellers. In these cases, fair value is estimated using pricing models that use discounted cash flows and other pricing techniques. Pricing models and their underlying assumptions are based upon management’s best estimates for appropriate discount rates, default rates, prepayments, market volatility and other factors, taking into account current observable market data and experience. These assumptions may have a significant effect on the reported fair values of assets and liabilities and the related income and expense. As such, the use of different models and assumptions, as well as changes in market conditions, could result in materially different net earnings and retained earnings results. Table of Contents 51 Other Real Estate Owned Other real estate owned (“OREO”), consists of properties obtained through foreclosure or in satisfaction of loans and is reported at the lower of cost or fair value, less estimated costs to sell at the date acquired with any loss recognized as a charge-off through the allowance for loan losses. Additional OREO losses for subsequent valuation adjustments are determined on a specific property basis and are included as a component of other noninterest expense along with holding costs. Any gains or losses on disposal of OREO are also reflected in noninterest expense. Significant judgments and complex estimates are required in estimating the fair value of OREO, and the period of time within which such estimates can be considered current is significantly shortened during periods of market volatility. As a result, the net proceeds realized from sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of OREO. Deferred Tax Asset Valuation A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely- than-not that some portion or the entire deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of taxable income over the last three years and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that we will realize the benefits of these deductible differences at December 31, 2021. The amount of the deferred tax assets considered realizable, however, could be reduced if estimates of future taxable income are reduced. Average Balance Sheet and Interest Rates Year ended December 31 2021 2020 Average Yield/ Average Yield/ (Dollars in thousands) Balance Rate Balance Rate Loans and loans held for sale $ 459,712 4.45% $ 465,378 4.74% Securities - taxable 320,766 1.28% 234,420 1.68% Securities - tax-exempt (a) 62,736 3.57% 63,029 3.72% Total securities 383,502 1.66% 297,449 2.11% Federal funds sold 38,659 0.15% 30,977 0.41% Interest bearing bank deposits 77,220 0.13% 56,104 0.41% Total interest-earning assets 959,093 2.81% 849,908 3.38% Deposits: NOW 178,197 0.12% 154,431 0.34% Savings and money market 296,708 0.22% 242,485 0.44% Certificates of deposits 159,111 1.03% 165,120 1.36% Total interest-bearing deposits 634,016 0.39% 562,036 0.68% Short-term borrowings 3,349 0.51% 1,864 0.48% Total interest-bearing liabilities 637,365 0.39% 563,900 0.68% Net interest income and margin (a) $ 24,460 2.55% $ 24,830 2.92% (a) Tax-equivalent. See "Table 1 - Explanation of Non-GAAP Financial Measures". RESULTS OF OPERATIONS Net Interest Income and Margin Net interest income (tax-equivalent) was $24.5 million in 2021, compared to $24.8 million in 2020. This decrease was due to a decline in the Company’s net interest margin (tax-equivalent), partially offset by balance sheet growth. Table of Contents 52 The tax-equivalent yield on total interest-earning assets decreased by 57 basis points in 2021 from 2020 to 2.81%. This decrease was primarily due to the lower rate environment and changes in our asset mix from the significant increase in deposits from government stimulus and relief programs and customers’ increased savings. The cost of total interest-bearing liabilities decreased 29 basis points to 0.39% in 2021 compared to 0.68 in 2020. The net decrease in our funding costs was primarily due to lower prevailing market interest rates. Our funding costs declined less than the rates earned on our interest earning assets. The Company continues to deploy various asset liability management strategies to manage its risk to interest rate fluctuations. The Company’s net interest margin could experience pressure due to reduced earning asset yields and increased competition for quality loan opportunities. Provision for Loan Losses The provision for loan losses represents a charge to earnings necessary to provide an allowance for loan losses that management believes, based on its processes and estimates, should be adequate to provide for the probable losses on outstanding loans. The Company recorded a negative provision for loan losses of $0.6 million during 2021, compared to $1.1 million in provision for loan losses during 2020. The negative provision for loan losses was primarily related to improvements in economic conditions in our primary market area. The provision for loan losses is based upon various factors, including the absolute level of loans, loan growth, the credit quality, and the amount of net charge-offs or recoveries. Based upon its assessment of the loan portfolio, management adjusts the allowance for loan losses to an amount it believes should be appropriate to adequately cover its estimate of probable losses in the loan portfolio. The Company’s allowance for loan losses as a percentage of total loans was 1.08% at December 31, 2021, compared to 1.22% at December 31, 2020. Excluding PPP loans, which are guaranteed by the SBA, the Company’s allowance for loan losses was 1.10% and 1.27% of total loans at December 31, 2021 and 2020, respectively. While the policies and procedures used to estimate the allowance for loan losses, as well as the resulting provision for loan losses charged to operations, are considered adequate by management and are reviewed from time to time by our regulators, they are based on estimates and judgments and are therefore approximate and imprecise. Factors beyond our control (such as conditions in the local and national economy, local real estate markets, or industries) may have a material adverse effect on our asset quality and the adequacy of our allowance for loan losses resulting in significant increases in the provision for loan losses. Noninterest Income Year ended December 31 (Dollars in thousands) 2021 2020 Service charges on deposit accounts $ 566 $ 585 Mortgage lending 1,547 2,319 Bank-owned life insurance 403 724 Securities gains, net 15 103 Other 1,757 1,644 Total noninterest income $ 4,288 $ 5,375 The decrease in service charges on deposit accounts was primarily driven by a decline in consumer spending activity as a result of the COVID-19 pandemic. The Company’s income from mortgage lending is primarily attributable to the (1) origination and sale of new mortgage loans and (2) servicing of mortgage loans. Origination income, net, is comprised of gains or losses from the sale of the mortgage loans originated, origination fees, underwriting fees and other fees associated with the origination of loans, which are netted against the commission expense associated with these originations. The Company’s normal practice is to originate mortgage loans for sale in the secondary market and to either sell or retain the MSRs when the loan is sold. MSRs are recognized based on the fair value of the servicing right on the date the corresponding mortgage loan is sold. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Servicing fee income is reported net of any related amortization expense. Table of Contents 53 The Company evaluates MSRs for impairment on a quarterly basis. Impairment is determined by grouping MSRs by common predominant characteristics, such as interest rate and loan type. If the aggregate carrying amount of a particular group of MSRs exceeds the group’s aggregate fair value, a valuation allowance for that group is established. The valuation allowance is adjusted as the fair value changes. An increase in mortgage interest rates typically results in an increase in the fair value of the MSRs while a decrease in mortgage interest rates typically results in a decrease in the fair value of MSRs. The following table presents a breakdown of the Company’s mortgage lending income for 2021 and 2020. Year ended December 31 (Dollars in thousands) 2021 2020 Origination income $ 1,417 $ 2,300 Servicing fees, net 130 19 Total mortgage lending income $ 1,547 $ 2,319 The Company’s income from mortgage lending typically fluctuates as mortgage interest rates change and is primarily attributable to the origination and sale of new mortgage loans. Origination income decreased in 2021 compared to 2020 due to a decrease in refinance activity in our primary market. The decrease in origination income was partially offset by an increase in servicing fees, net of related amortization expense as prepayment speeds slowed during 2021, resulting in decreased amortization expense. Income from bank-owned life insurance decreased primarily due to $0.3 million in non-taxable death benefits received in 2020. The assets that support these policies are administered by the life insurance carriers and the income we receive (i.e., increases or decreases in the cash surrender value of the policies and death benefits received) on these policies is dependent upon the returns the insurance carriers are able to earn on the underlying investments that support these policies. Earnings on these policies are generally not taxable. Noninterest Expense Year ended December 31 (Dollars in thousands) 2021 2020 Salaries and benefits $ 11,710 $ 11,316 Net occupancy and equipment 1,743 2,511 Professional fees 995 1,052 FDIC and other regulatory assessments 426 256 Other 4,559 4,419 Total noninterest expense $ 19,433 $ 19,554 The increase in salaries and benefits expense was primarily due to a decrease in deferred costs related to the PPP loan program, routine annual wage and benefit increases, and management increasing the minimum hourly wage for banking positions to $15. The decrease in net occupancy and equipment was primarily due to a reduction of various expenses related to the redevelopment of the Company’s headquarters in downtown Auburn. This amount includes revised depreciation estimates and other temporary relocation costs. For more information regarding changes in accounting estimates, please refer to Note 1, Summary of Significant Accounting Policies, of the consolidated financial statements that accompany this report. The increase in FDIC and other regulatory assessments was primarily due to the expiration of FDIC assessment credits during 2020 and an increased assessment base during 2021. Income Tax Expense Income tax expense was $1.4 million in 2021 and $1.6 million in 2020. The Company’s effective income tax rate was 14.89% in 2021, compared to 17.72% in 2020. This change was primarily due to an income tax benefit related to a New Markets Tax Credit investment funded in the fourth quarter of 2021. The Company’s effective income tax rate is principally impacted by tax-exempt earnings from the Company’s investments in municipal securities, bank-owned life insurance, and New Markets Tax Credits. Table of Contents 54 BALANCE SHEET ANALYSIS Securities Securities available-for-sale were $421.9 million at December 31, 2021, compared to $335.2 million at December 31, 2020. This increase reflects an increase in the amortized cost basis of securities available-for-sale of $95.7 million, and a decrease of $9.0 million in the fair value of securities available-for-sale. The increase in the amortized cost basis of securities available-for-sale was primarily attributable to management allocating more funding to the investment portfolio following the significant increases in customer deposits. The decrease in the fair value of securities was primarily due to an increase in long-term interest rates. The average annualized tax-equivalent yields earned on total securities were 1.66% in 2021 and 2.11% in 2020. The following table shows the carrying value and weighted average yield of securities available -for-sale as of December 31, 2021 according to contractual maturity. Actual maturities may differ from contractual maturities of mortgage-backed securities (“MBS”) because the mortgages underlying the securities may be called or prepaid with or without penalty. December 31, 2021 1 year 1 to 5 5 to 10 After 10 Total (Dollars in thousands) or less years years years Fair Value Agency obligations $ 5,007 49,604 69,802 — 124,413 Agency MBS — 680 35,855 186,836 223,371 State and political subdivisions 170 647 15,743 57,547 74,107 Total available-for-sale $ 5,177 50,931 121,400 244,383 421,891 Weighted average yield (1): Agency obligations 2.00% 1.36% 1.31% — 1.36% Agency MBS — 3.42% 1.48% 1.34% 1.37% State and political subdivisions 4.25% 2.85% 2.18% 2.77% 2.64% Total available-for-sale 2.07% 1.40% 1.47% 1.68% 1.59% (1) Yields are calculated based on amortized cost. Loans December 31 (In thousands) 2021 2020 Commercial and industrial $ 83,977 82,585 Construction and land development 32,432 33,514 Commercial real estate 258,371 255,136 Residential real estate 77,661 84,154 Consumer installment 6,682 7,099 Total loans 459,123 462,488 Less: unearned income (759) (788) Loans, net of unearned income $ 458,364 461,700 Total loans, net of unearned income, were $458.4 million at December 31, 2021, and $461.7 million at December 31, 2020. Excluding PPP loans, total loans, net of unearned income, were $450.5 million, an increase of $7.5 million, or 2% from December 31, 2020. This increase was primarily due to an increase in commercial and industrial loans , net of PPP, of $12.2 million, partially offset by a decrease in residential real estate loans of $6.5 million, as lower rates increased refinance activity and payoffs for consumer mortgage loans. Four loan categories represented the majority of the loan portfolio at December 31, 2021: commercial real estate (56%), residential real estate (17%), commercial and industrial (18%) and construction and land development (7%). Approximately 25% of the Company’s commercial real estate loans were classified as owner-occupied at December 31, 2021. Table of Contents 55 Within the residential real estate portfolio segment, the Company had junior lien mortgages of approximately $7.2 million, or 2%, and $8.7 million, or 2%, of total loans, net of unearned income at December 31, 2021 and 2020, respectively. For residential real estate mortgage loans with a consumer purpose, the Company had no loans that required interest only payments at December 31, 2021 and 2020. The Company’s residential real estate mortgage portfolio does not include any option ARM loans, subprime loans, or any material amount of other high-risk consumer mortgage products. The average yield earned on loans and loans held for sale was 4.45% in 2021 and 4.74% in 2020. The specific economic and credit risks associated with our loan portfolio include, but are not limited to, the effects of current economic conditions, including the COVID-19 pandemic’s effects, on our borrowers’ cash flows, real estate market sales volumes, valuations, availability and cost of financing properties, real estate industry concentrations, competitive pressures from a wide range of other lenders, deterioration in certain credits, interest rate fluctuations, reduced collateral values or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and any violation of applicable laws and regulations. The Company attempts to reduce these economic and credit risks through its loan-to-value guidelines for collateralized loans, investigating the creditworthiness of borrowers and monitoring borrowers’ financial position. Also, we have established and periodically review, lending policies and procedures. Banking regulations limit a bank’s credit exposure by prohibiting unsecured loan relationships that exceed 10% of its capital; or 20% of capital, if loans in excess of 10% of capital are fully secured. Under these regulations, we are prohibited from having secured loan relationships in excess of approximately $21.0 million. Furthermore, we have an internal limit for aggregate credit exposure (loans outstanding plus unfunded commitments) to a single borrower of $18.9 million. Our loan policy requires that the Loan Committee of the Board of Directors approve any loan relationships that exceed this internal limit. At December 31, 2021, the Bank had no relationships exceeding these limits. We periodically analyze our commercial loan portfolio to determine if a concentration of credit risk exists in any one or more industries. We use classification systems broadly accepted by the financial services industry in order to categorize our commercial borrowers. Loan concentrations to borrowers in the following classes exceeded 25% of the Bank’s total risk- based capital at December 31, 2021 (and related balances at December 31, 2020). December 31 (In thousands) 2021 2020 Lessors of 1-4 family residential properties $ 47,880 $ 49,127 Hotel/motel 43,856 42,900 Multi-family residential properties 42,587 40,203 Shopping centers 29,574 30,000 In light of disruptions in economic conditions caused by COVID-19, the financial regulators have issued guidance encouraging banks to work constructively with borrowers affected by the virus in our community. This guidance, including the Interagency Statement on COVID-19 Loan Modifications and the Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions, provides that the agencies will not criticize financial institutions that mitigate credit risk through prudent actions consistent with safe and sound practices. Specifically, examiners will not criticize institutions for working with borrowers as part of a risk mitigation strategy intended to improve existing loans, even if the restructured loans have or develop weaknesses that ultimately result in adverse credit classification. Upon demonstrating the need for payment relief, the bank will work with qualified borrowers that were otherwise current before the pandemic to determine the most appropriate deferral option. For residential mortgage and consumer loans the borrower may elect to defer payments for up to three months. Interest continues to accrue and the amount due at maturity increases. Commercial real estate, commercial, and small business borrowers may elect to defer payments for up to three months or pay scheduled interest payments for a six-month period. The bank recognizes that a combination of the payment relief options may be prudent dependent on a borrower’s business type. As of December 31, 2021, we had one COVID-19 loan deferral totaling $0.1 million, compared to $32.3 million, or 7% of total loans at December 31, 2020. Table of Contents 56 The tables below provide information concerning the composition of these COVID-19 modifications as of December 31, 2021 and 2020. COVID-19 Modifications Modification Types (Dollars in thousands) # of Loans Modified Balance % of Portfolio Modified Interest Only Payment P&I Payments Deferred December 31, 2021: Residential real estate 1 $ 59 — — 100 % Total 1 $ 59 — % — % 100 % December 31, 2020: Commercial and industrial 2 $ 741 — % 100 % — % Commercial real estate 12 31,399 7 100 — Residential real estate 2 133 — — 100 Total 16 $ 32,273 7 % 99 % 1 % COVID-19 Modifications within Commercial Real Estate Segment (Dollars in thousands) # of Loans Modified Balance of Loans Modified % of Total Loan Class December 31, 2020: Hotel/motel 10 $ 26,427 49 % Multifamily 1 3,530 9 Restaurants 1 1,442 10 There were no COVID-19 modifications within the commercial real estate segment at December 31, 2021. Section 4013 of the CARES Act provides that a qualified loan modification is exempt by law from classification as a TDR pursuant to GAAP. In addition, the Interagency Statement on COVID-19 Loan Modifications provides circumstances in which a loan modification is not subject to classification as a TDR if such loan is not eligible for modification under Section 4013. Allowance for Loan Losses The Company maintains the allowance for loan losses at a level that management believes appropriate to adequately cover the Company’s estimate of probable losses inherent in the loan portfolio. The allowance for loan losses was $4.9 million at December 31, 2021 compared to $5.6 million at December 31, 2020, which management believed to be adequate at each of the respective dates. The judgments and estimates associated with the determination of the allowance for loan losses are described under “Critical Accounting Policies.” Table of Contents 57 A summary of the changes in the allowance for loan losses and certain asset quality ratios for the years ended December 31, 2021 and 2020 are presented below. Year ended December 31 (Dollars in thousands) 2021 2020 Allowance for loan losses: Balance at beginning of period $ 5,618 4,386 Charge-offs: Commercial and industrial — (7) Commercial real estate (254) — Residential real estate (3) — Consumer installment (37) (38) Total charge -offs (294) (45) Recoveries: Commercial and industrial 140 94 Residential real estate 55 63 Consumer installment 20 20 Total recoveries 215 177 Net (charge-offs) recoveries (79) 132 Provision for loan losses (600) 1,100 Ending balance $ 4,939 5,618 as a % of loans 1.08 % 1.22 as a % of nonperforming loans 1,112 % 1,052 Net charge-offs (recoveries) as a % of average loans 0.02 % (0.03) As described under “Critical Accounting Policies”, management assesses the adequacy of the allowance prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolios, past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates, and other pertinent factors. This evaluation is inherently subjective as it requires various material estimates and judgments including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The ratio of our allowance for loan losses to total loans outstanding was 1.08% at December 31, 2021, compared to 1.22% at December 31, 2020. Excluding PPP loans, which are guaranteed by the SBA, the Company’s allowance for loan losses was 1.10% and 1.27% of total loans at December 31, 2021 and 2020, respectively. In the future, the allowance to total loans outstanding ratio will increase or decrease to the extent the factors that influence our quarterly allowance assessment, including the duration and magnitude of COVID-19 effects, in their entirety either improve or weaken. In addition our regulators, as an integral part of their examination process, will periodically review the Company’s allowance for loan losses, and may require the Company to make additional provisions to the allowance for loan losses based on their judgment about information available to them at the time of their examinations. Nonperforming Assets At December 31, 2021 the Company had $0.8 million in nonperforming assets compared to $0.5 million at December 31, 2020. Table of Contents 58 The table below provides information concerning total nonperforming assets and certain asset quality ratios. December 31 (Dollars in thousands) 2021 2020 Nonperforming assets: Nonperforming (nonaccrual) loans $ 444 534 Other real estate owned 374 — Total nonperforming assets $ 818 534 as a % of loans and other real estate owned 0.18 % 0.12 as a % of total assets 0.07 % 0.06 Nonperforming loans as a % of total loans 0.10 % 0.12 Accruing loans 90 days or more past due $ — 141 The table below provides information concerning the composition of nonaccrual loans at December 31, 2021 and 2020, respectively. December 31 (In thousands) 2021 2020 Nonaccrual loans: Commercial real estate $ 187 212 Residential real estate 257 322 Total nonaccrual loans / nonperforming loans $ 444 534 The Company discontinues the accrual of interest income when (1) there is a significant deterioration in the financial condition of the borrower and full repayment of principal and interest is not expected or (2) the principal or interest is more than 90 days past due, unless the loan is both well-secured and in the process of collection. At December 31, 2021 and 2020, respectively, the Company had $0.4 million and $0.5 million in loans on nonaccrual. At December 31, 2021 there were no loans 90 days past due and still accruing interest, compared to $0.1 million at December 31, 2020. The table below provides information concerning the composition of OREO at December 31, 2021 and 2020, respectively. December 31 (In thousands) 2021 2020 Other real estate owned: Commercial real estate $ 374 — Total other real estate owned $ 374 — Potential Problem Loans Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the Federal Reserve, the Company’s primary regulator, for loans classified as substandard, excluding nonaccrual loans. Potential problem loans, which are not included in nonperforming assets, amounted to $2.4 million, or 0.5% of total loans at December 31, 2021, compared to $2.9 million, or 1.0% of total loans at December 31, 2020. Table of Contents 59 The table below provides information concerning the composition of potential problem loans at December 31, 2021 and 2020, respectively. December 31 (In thousands) 2021 2020 Potential problem loans: Commercial and industrial $ 226 218 Construction and land development 218 254 Commercial real estate 156 188 Residential real estate 1,748 2,229 Consumer installment 12 23 Total potential problem loans $ 2,360 2,912 At December 31, 2021, approximately $0.3 million or 14.2% of total potential problem loans were past due at least 30 but less than 90 days. The following table is a summary of the Company’s performing loans that were past due at least 30 days but less than 90 days as of December 31, 2021 and 2020, respectively. December 31 (In thousands) 2021 2020 Performing loans past due 30 to 89 days: Commercial and industrial $ 3 230 Construction and land development 204 61 Commercial real estate — 29 Residential real estate 516 1,509 Consumer installment 25 29 Total performing loans past due 30 to 89 days $ 748 1,858 Deposits December 31 (In thousands) 2021 2020 Noninterest bearing demand $ 316,132 245,398 NOW 183,021 155,870 Money market 244,195 199,937 Savings 91,245 78,187 Certificates of deposit under $250,000 101,660 105,357 Certificates of deposit and other time deposits of $250,000 or more 57,990 55,044 Total deposits $ 994,243 839,793 Total deposits increased $154.5 million, or 18%, to $994.2 million at December 31, 2021, compared to $839.8 million at December 31, 2020. Noninterest-bearing deposits were $316.1 million, or 32% of total deposits, at December 31, 2021, compared to $245.4 million, or 29% of total deposits at December 31, 2020. These increases reflect deposits from customers who received PPP loans, the impact of government stimulus checks, and reduced customer spending during the COVID-19 pandemic. Estimated uninsured deposits totaled $420.8 million and $315.2 million at December 31, 2021 and 2020, respectively. Uninsured amounts are estimated based on the portion of account balances in excess of FDIC insurance limits. The average rates paid on total interest-bearing deposits were 0.39% in 2021 and 0.68% in 2020. Table of Contents 60 Other Borrowings Other borrowings generally consist of short-term borrowings and long-term debt. Short-term borrowings generally consist of federal funds purchased and securities sold under agreements to repurchase with an original maturity of one year or less. The Bank had available federal fund lines totaling $41.0 million with none outstanding at December 31, 2021 and 2020, respectively. Securities sold under agreements to repurchase totaled $3.4 million and $2.4 million at December 31, 2021 and 2020, respectively. The average rates paid on short-term borrowings were 0.51% and 0.48% in 2021 and 2020, respectively. The Company had no long-term debt outstanding at December 31, 2021 and 2020, respectively. CAPITAL ADEQUACY The Company's consolidated stockholders' equity was $103.7 million and $107.7 million as of December 31, 2021 and 2020, respectively. The decrease from December 31, 2020 was primarily driven by an other comprehensive loss due to the change in unrealized gains on securities available-for-sale, net of tax, of $6.7 million, cash dividends paid of $3.7 million and stock repurchases of $1.6 million, representing 45,946 shares, which was partially offset by net earnings of $8.0 million. On January 1, 2015, the Company and Bank became subject to the rules of the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act changes. The rules included the implementation of a capital conservation buffer that is added to the minimum requirements for capital adequacy purposes. The capital conservation buffer was subject to a three year phase-in period that began on January 1, 2016 and was fully phased-in on January 1, 2019 at 2.5%. A banking organization with a conservation buffer of less than the required amount will be subject to limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. At December 31, 2021, the Bank’s ratio was sufficient to meet the fully phased-in conservation buffer. Effective March 20, 2020, the Federal Reserve and the other federal banking regulators adopted an interim final rule that amended the capital conservation buffer. The interim final rule was adopted as a final rule on August 26, 2020. The new rule revises the definition of “eligible retained income” for purposes of the maximum payout ratio to allow banking organizations to more freely use their capital buffers to promote lending and other financial intermediation activities, by making the limitations on capital distributions more gradual. The eligible retained income is now the greater of (i) net income for the four preceding quarters, net of distributions and associated tax effects not reflected in net income; and (ii) the average of all net income over the preceding four quarters. The interim final rule only affects the capital buffers, and banking organizations were encouraged to make prudent capital distribution decisions. The Federal Reserve has treated us as a “small bank holding company’ under the Federal Reserve’s policy. Accordingly, our capital adequacy is evaluated at the Bank level, and not for the Company and its consolidated subsidiaries. The Bank’s tier 1 leverage ratio was 9.35%, CET1 risk-based capital ratio was 16.23%, tier 1 risk-based capital ratio was 16.23%, and total risk-based capital ratio was 17.06% at December 31, 2021. These ratios exceed the minimum regulatory capital percentages of 5.0% for tier 1 leverage ratio, 6.5% for CET1 risk-based capital ratio, 8.0% for tier 1 risk-based capital ratio, and 10.0% for total risk-based capital ratio to be considered “well capitalized.” The Bank’s capital conservation buffer was 9.06% at December 31, 2021. Table of Contents 61 MARKET AND LIQUIDITY RISK MANAGEMENT Management’s objective is to manage assets and liabilities to provide a satisfactory, consistent level of profitability within the framework of established liquidity, loan, investment, borrowing, and capital policies. The Bank’s Asset Liability Management Committee (“ALCO”) is charged with the responsibility of monitoring these policies, which are designed to ensure an acceptable asset/liability composition. Two critical areas of focus for ALCO are interest rate risk and liquidity risk management. Interest Rate Risk Management In the normal course of business, the Company is exposed to market risk arising from fluctuations in interest rates because assets and liabilities may mature or reprice at different times. For example, if liabilities reprice faster than assets, and interest rates are generally rising, earnings will initially decline. In addition, assets and liabilities may reprice at the same time but by different amounts. For example, when the general level of interest rates is rising, the Company may increase rates paid on interest bearing demand deposit accounts and savings deposit accounts by an amount that is less than the general increase in market interest rates. Also, short-term and long-term market interest rates may change by different amounts. For example, a flattening yield curve may reduce the interest spread between new loan yields and funding costs. Further, the remaining maturity of various assets and liabilities may shorten or lengthen as interest rates change. For example, if long-term mortgage interest rates decline sharply, mortgage-backed securities in the securities portfolio may prepay earlier than anticipated, which could reduce earnings. Interest rates may also have a direct or indirect effect on loan demand, loan losses, mortgage origination volume, the fair value of MSRs and other items affecting earnings. ALCO measures and evaluates the interest rate risk so that we can meet customer demands for various types of loans and deposits. ALCO determines the most appropriate amounts of on-balance sheet and off-balance sheet items. Measurements used to help manage interest rate sensitivity include an earnings simulation and an economic value of equity model. Earnings simulation . Management believes that interest rate risk is best estimated by our earnings simulation modeling. On at least a quarterly basis, the following 12 month time period is simulated to determine a baseline net interest income forecast and the sensitivity of this forecast to changes in interest rates. The baseline forecast assumes an unchanged or flat interest rate environment. Forecasted levels of earning assets, interest-bearing liabilities, and off-balance sheet financial instruments are combined with ALCO forecasts of market interest rates for the next 12 months and other factors in order to produce various earnings simulations and estimates. To help limit interest rate risk, we have guidelines for earnings at risk which seek to limit the variance of net interest income from gradual changes in interest rates. For changes up or down in rates from management’s flat interest rate forecast over the next 12 months, policy limits for net interest income variances are as follows: +/- 20% for a gradual change of 400 basis points +/- 15% for a gradual change of 300 basis points +/- 10% for a gradual change of 200 basis points +/- 5% for a gradual change of 100 basis points Table of Contents 62 The following table reports the variance of net interest income over the next 12 months assuming a gradual change in interest rates up or down when compared to the baseline net interest income forecast at December 31, 2021. Changes in Interest Rates Net Interest Income % Variance 400 basis points 7.92 % 300 basis points 5.61 200 basis points 3.59 100 basis points 1.54 (100) basis points (0.44) (200) basis points NM (300) basis points NM (400) basis points NM NM=not meaningful At December 31, 2021, our earnings simulation model indicated that we were in compliance with the policy guidelines noted above. Economic Value of Equity Economic value of equity (“EVE”) measures the extent that estimated econom ic values of our assets, liabilities and off- balance sheet items will change as a result of interest rate changes. Economic values are estimated by discounting expected cash flows from assets, liabilities and off-balance sheet items, which establishes a base case EVE. In contrast with our earnings simulation model which evaluates interest rate risk over a 12 month timeframe, EVE uses a terminal horizon which allows for the re-pricing of all assets, liabilities, and off-balance sheet items. Further, EVE is measured using values as of a point in time and does not reflect any actions that ALCO might take in responding to or anticipating changes in interest rates, or market and competitive conditions. To help limit interest rate risk, we have stated policy guidelines for an instantaneous basis point change in interest rates, such that our EVE should not decrease from our base case by more than the following: 45% for an instantaneous change of +/- 400 basis points 35% for an instantaneous change of +/- 300 basis points 25% for an instantaneous change of +/- 200 basis points 15% for an instantaneous change of +/- 100 basis points The following table reports the variance of EVE assuming an immediate change in interest rates up or down when compared to the baseline EVE at December 31, 2021. Changes in Interest Rates EVE % Variance 400 basis points (20.53) % 300 basis points (14.14) 200 basis points (8.35) 100 basis points (3.23) (100) basis points 0.91 (200) basis points NM (300) basis points NM (400) basis points NM NM=not meaningful At December 31, 2021, our EVE model indicated that we were in compliance with the policy guidelines noted above. Table of Contents 63 Each of the above analyses may not, on its own, be an accurate indicator of how our net interest income will be affected by changes in interest rates. Income associated with interest-earning assets and costs associated with interest-bearing liabilities may not be affected uniformly by changes in interest rates. In addition, the magnitude and duration of changes in interest rates may have a significant impact on net interest income. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates, and other economic and market factors, including market perceptions. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types of assets and liabilities may lag behind changes in general market rates. In addition, certain assets, such as adjustable rate mortgage loans, have features (generally referred to as “interest rate caps and floors”) which limit changes in interest rates. Prepayment and early withdrawal levels also could deviate significantly from those assumed in calculating the maturity of certain instruments. The ability of many borrowers to service their debts also may decrease during periods of rising interest rates or economic stress, which may differ across industries and economic sectors. ALCO reviews each of the above interest rate sensitivity analyses along with several different interest rate scenarios in seeking satisfactory, consistent levels of profitability within the framework of the Company’s established liquidity, loan, investment, borrowing, and capital policies. The Company may also use derivative financial instruments to improve the balance between interest-sensitive assets and interest-sensitive liabilities and as one tool to manage interest rate sensitivity while continuing to meet the credit and deposit needs of our customers. From time to time, the Company may enter into interest rate swaps (“swaps”) to facilitate customer transactions and meet their financing needs. These swaps qualify as derivatives, but are not designated as hedging instruments. At December 31, 2021 and 2020, the Company had no derivative contracts to assist in managing interest rate sensitivity. Liquidity Risk Management Liquidity is the Company’s ability to convert assets into cash equivalents in order to meet daily cash flow requirements, primarily for deposit withdrawals, loan demand and maturing obligations. Without proper management of its liquidity, the Company could experience higher costs of obtaining funds due to insufficient liquidity, while excessive liquidity can lead to a decline in earnings due to the cost of foregoing alternative higher-yielding investment opportunities. Liquidity is managed at two levels. The first is the liquidity of the Company. The second is the liquidity of the Bank. The management of liquidity at both levels is essential, because the Company and the Bank are separate and distinct legal entities with different funding needs and sources, and each are subject to regulatory guidelines and requirements. The Company depends upon dividends from the Bank for liquidity to pay its operating expenses, debt obligations and dividends. The Bank’s payment of dividends depends on its earnings, liquidity, capital and the absence of any regulatory restrictions. The primary source of funding and liquidity for the Company has been dividends received from the Bank. If needed, the Company could also issue common stock or other securities. Primary uses of funds by the Company include dividends paid to stockholders and stock repurchases. Primary sources of funding for the Bank include customer deposits, other borrowings, repayment and maturity of securities, and sale and repayment of loans. The Bank has access to federal funds lines from various banks and borrowings from the Federal Reserve discount window. In addition to these sources, the Bank has participated in the FHLB's advance program to obtain funding for its growth. Advances include both fixed and variable terms and are taken out with varying maturities. As of December 31, 2021, the Bank had a remaining available line of credit with the FHLB totaling $319.6 million. As of December 31, 2021, the Bank also had $41.0 million of federal funds lines, with none outstanding. Primary uses of funds include repayment of maturing obligations and growing the loan portfolio. Table of Contents 64 The following table presents additional information about our contractual obligations as of December 31, 2021, which by their terms had contractual maturity and termination dates subsequent to December 31, 2021: Payments due by period 1 year 1 to 3 3 to 5 More than (Dollars in thousands) Total or less years years 5 years Contractual obligations: Deposit maturities (1) $ 994,243 948,364 37,905 7,785 189 Operating lease obligations 610 120 239 141 110 Total $ 994,853 948,484 38,144 7,926 299 (1) Deposits with no stated maturity (demand, NOW, money market, and savings deposits) are presented in the "1 year or less" column Management believes that the Company and the Bank have adequate sources of liquidity to meet all known contractual obligations and unfunded commitments, including loan commitments and reasonable borrower, depositor, and creditor requirements over the next 12 months. Off-Balance Sheet Arrangements At December 31, 2021, the Bank had outstanding standby letters of credit of $1. 4 million and unfunded loan commitments outstanding of $71.0 million. Because these commitments generally have fixed expiration dates and many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements. If needed to fund these outstanding commitments, the Bank has the ability to liquidate federal funds sold or securities available-for-sale, or on a short-term basis to borrow and purchase federal funds from other financial institutions. Residential mortgage lending and servicing activities We primarily sell conforming residential mortgage loans in the secondary market to Fannie Mae while retaining the servicing of these loans. The sale agreements for these residential mortgage loans with Fannie Mae and other investors include various representations and warranties regarding the origination and characteristics of the residential mortgage loans. Although the representations and warranties vary among investors, they typically cover ownership of the loan, validity of the lien securing the loan, the absence of delinquent taxes or liens against the property securing the loan, compliance with loan criteria set forth in the applicable agreement, compliance with applicable federal, state, and local laws, among other matters. As of December 31, 2021, the unpaid principal balance of residential mortgage loans, which we have originated and sold, but retained the servicing rights was $252.7 million. Although these loans are generally sold on a non-recourse basis, except for breaches of customary seller representations and warranties, we may have to repurchase residential mortgage loans in cases where we breach such representations or warranties or the other terms of the sale, such as where we fail to deliver required documents or the documents we deliver are defective. Investors also may require the repurchase of a mortgage loan when an early payment default underwriting review reveals significant underwriting deficiencies, even if the mortgage loan has subsequently been brought current. Repurchase demands are typically reviewed on an individual loan by loan basis to validate the claims made by the investor and to determine if a contractually required repurchase event has occurred. We seek to reduce and manage the risks of potential repurchases or other claims by mortgage loan investors through our underwriting, quality assurance and servicing practices, including good communications with our residential mortgage investors. The Company was not required to repurchase any loans during 2021 and 2020 as a result of representation and warranty provisions contained in the Company’s sale agreements with Fannie Mae, and had no pending repurchase or make-whole requests at December 31, 2021. We service all residential mortgage loans originated and sold by us to Fannie Mae. As servicer, our primary duties are to: (1) collect payments due from borrowers; (2) advance certain delinquent payments of principal and interest; (3) maintain and administer any hazard, title, or primary mortgage insurance policies relating to the mortgage loans; (4) maintain any required escrow accounts for payment of taxes and insurance and administer escrow payments; and (5) foreclose on defaulted mortgage loans or take other actions to mitigate the potential losses to investors consistent with the agreements governing our rights and duties as servicer. Table of Contents 65 The agreement under which we act as servicer generally specifies a standard of responsibility for actions taken by us in such capacity and provides protection against expenses and liabilities incurred by us when acting in compliance with the respective servicing agreements. However, if we commit a material breach of our obligations as servicer, we may be subject to termination if the breach is not cured within a specified period following notice. The standards governing servicing and the possible remedies for violations of such standards are determined by servicing guides issued by Fannie Mae as well as the contract provisions established between Fannie Mae and the Bank. Remedies could include repurchase of an affected loan. Although to date repurchase requests related to representation and warranty provisions, and servicing activities have been limited, it is possible that requests to repurchase mortgage loans may increase in frequency if investors more aggressively pursue all means of recovering losses on their purchased loans. As of December 31, 2021, we believe that this exposure is not material due to the historical level of repurchase requests and loss trends, the results of our quality control reviews, and the fact that 99% of our residential mortgage loans serviced for Fannie Mae were current as of such date. We maintain ongoing communications with our investors and will continue to evaluate this exposure by monitoring the level and number of repurchase requests as well as the delinquency rates in our investor portfolios. Section 4021 of the CARES Act allows borrowers under 1-to-4 family residential mortgage loans sold to Fannie Mae to request forbearance to the servicer after affirming that such borrower is experiencing financial hardships during the COVID-19 emergency. Except for vacant or abandoned properties, Fannie Mae servicers may not initiate foreclosures on similar procedures or related evictions or sales until December 31, 2020. The forbearance period was extended, generally, to March 31, 2021. The Bank sells mortgage loans to Fannie Mae and services these on an actual/actual basis. As a result, the Bank is not obligated to make any advances to Fannie Mae on principal and interest on such mortgage loans where the borrower is entitled to forbearance. Effects of Inflation and Changing Prices The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with GAAP and practices within the banking industry which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Table of Contents 66 CURRENT ACCOUNTING DEVELOPMENTS The following ASU has been issued by the FASB but is not yet effective. ● ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments; Information about this pronouncement is described in more detail below. ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): - Measurement of Credit Losses on Financial Instruments , amends guidance on reporting credit losses for assets held at amortized cost basis and available for sale debt securities. For assets held at amortized cost basis, the new standard eliminates the probable initial recognition threshold in current GAAP and, instead, requires an entity to reflect its current estimate of all expected credit losses using a broader range of information regarding past events, current conditions and forecasts assessing the collectability of cash flows. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected. For available for sale debt securities, credit losses should be measured in a manner similar to current GAAP, however the new standard will require that credit losses be presented as an allowance rather than as a write-down. The new guidance affects entities holding financial assets and net investment in leases that are not accounted for at fair value through net income. The amendments affect loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. For public business entities, the new guidance was originally effective for annual and interim periods in fiscal years beginning after December 15, 2019. The Company has developed an implementation team that is following a general timeline. The team has been working with an advisory consultant, with whom a third-party software license has been purchased. The Company’s preliminary evaluation indicates the provisions of ASU No. 2016-13 are expected to impact the Company’s consolidated financial statements, in particular the level of the reserve for credit losses. The Company is continuing to evaluate the extent of the potential impact and expects that portfolio composition and economic conditions at the time of adoption will be a factor. On October 16, 2019, the FASB approved a previously issued proposal granting smaller reporting companies a postponement of the required implementation date for ASU 2016-13. The Company will now be required to implement the new standard in January 2023, with early adoption permitted in any period prior to that date. Table of Contents 67 Table 1 – Explanation of Non-GAAP Financial Measures In addition to results presented in accordance with GAAP, this annual report on Form 10-K includes certain designated net interest income amounts presented on a tax-equivalent basis, a non-GAAP financial measure, including the presentation of total revenue and the calculation of the efficiency ratio. The Company believes the presentation of net interest income on a tax-equivalent basis provides comparability of net interest income from both taxable and tax-exempt sources and facilitates comparability within the industry. Although the Company believes these non-GAAP financial measures enhance investors’ understanding of its business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP. The reconciliation of these non- GAAP financial measures from GAAP to non-GAAP is presented below. Year ended December 31 (In thousands) 2021 2020 2019 2018 2017 Net interest income (GAAP) $ 23,990 24,338 26,064 25,570 24,526 Tax-equivalent adjustment 470 492 557 613 1,205 Net interest income (Tax-equivalent) $ 24,460 24,830 26,621 26,183 25,731 Table of Contents 68 Table 2 - Selected Financial Data Year ended December 31 (Dollars in thousands, except per share amounts) 2021 2020 2019 2018 2017 Income statement Tax-equivalent interest income (a) $ 26,977 28,686 30,804 29,859 29,325 Total interest expense 2,517 3,856 4,183 3,676 3,594 Tax equivalent net interest income (a) 24,460 24,830 26,621 26,183 25,731 Provision for loan losses (600) 1,100 (250) — (300) Total noninterest income 4,288 5,375 5,494 3,325 3,441 Total noninterest expense 19,433 19,554 19,697 17,874 16,784 Net earnings before income taxes and tax-equivalent adjustment 9,915 9,551 12,668 11,634 12,688 Tax-equivalent adjustment 470 492 557 613 1,205 Income tax expense 1,406 1,605 2,370 2,187 3,637 Net earnings $ 8,039 7,454 9,741 8,834 7,846 Per share data: Basic and diluted net earnings $ 2.27 2.09 2.72 2.42 2.15 Cash dividends declared $ 1.04 1.02 1.00 0.96 0.92 Weighted average shares outstanding Basic and diluted 3,545,310 3,566,207 3,581,476 3,643,780 3,643,616 Shares outstanding 3,520,485 3,566,276 3,566,146 3,643,868 3,643,668 Book value $ 29.46 30.20 27.57 24.44 23.85 Common stock price High $ 48.00 63.40 53.90 53.50 40.25 Low 31.32 24.11 30.61 28.88 30.75 Period-end $ 32.30 42.29 53.00 31.66 38.90 To earnings ratio 14.23 x 20.23 19.49 13.08 18.09 To book value 110 % 140 192 130 163 Performance ratios: Return on average equity 7.54 % 7.12 10.35 10.14 9.17 Return on average assets 0.78 % 0.83 1.18 1.08 0.94 Dividend payout ratio 45.81 % 48.80 36.76 39.67 42.79 Average equity to average assets 10.39 % 11.63 11.39 10.63 10.30 Asset Quality: Allowance for loan losses as a % of: Loans 1.08 % 1.22 0.95 1.00 1.05 Nonperforming loans 1,112 % 1,052 2,345 2,691 160 Nonperforming assets as a % of: Loans and other real estate owned 0.18 % 0.12 0.04 0.07 0.66 Total assets 0.07 % 0.06 0.02 0.04 0.35 Nonperforming loans as % of loans 0.10 % 0.12 0.04 0.04 0.66 Net charge-offs (recoveries) as a % of average loans 0.02 % (0.03) 0.03 (0.01) (0.09) Capital Adequacy (c): CET 1 risk-based capital ratio 16.23 % 17.27 17.28 16.49 16.42 Tier 1 risk-based capital ratio 16.23 % 17.27 17.28 16.49 16.98 Total risk-based capital ratio 17.06 % 18.31 18.12 17.38 17.91 Tier 1 leverage ratio 9.35 % 10.32 11.23 11.33 10.95 Other financial data: Net interest margin (a) 2.55 % 2.92 3.43 3.40 3.29 Effective income tax rate 14.89 % 17.72 19.57 19.84 31.67 Efficiency ratio (b) 67.60 % 64.74 61.33 60.57 57.53 Selected period end balances: Securities $ 421,891 335,177 235,902 239,801 257,697 Loans, net of unearned income 458,364 461,700 460,901 476,908 453,651 Allowance for loan losses 4,939 5,618 4,386 4,790 4,757 Total assets 1,105,150 956,597 828,570 818,077 853,381 Total deposits 994,243 839,792 724,152 724,193 757,659 Long-term debt — — — — 3,217 Total stockholders’ equity 103,726 107,689 98,328 89,055 86,906 (a) Tax-equivalent. See "Table 1 - Explanation of Non-GAAP Financial Measures". (b) Efficiency ratio is the result of noninterest expense divided by the sum of noninterest income and tax-equivalent net interest income. (c) Regulatory capital ratios presented are for the Company's wholly-owned subsidiary, AuburnBank. Table of Contents 69 Table 3 - Average Balance and Net Interest Income Analysis Year ended December 31 2021 2020 Interest Interest Average Income/ Yield/ Average Income/ Yield/ (Dollars in thousands) Balance Expense Rate Balance Expense Rate Interest-earning assets: Loans and loans held for sale (1) $ 459,712 $ 20,473 4.45% $ 465,378 $ 22,055 4.74% Securities - taxable 320,766 4,107 1.28% 234,420 3,932 1.68% Securities - tax-exempt (2) 62,736 2,242 3.57% 63,029 2,343 3.72% Total securities 383,502 6,349 1.66% 297,449 6,275 2.11% Federal funds sold 38,659 55 0.15% 30,977 125 0.41% Interest bearing bank deposits 77,220 100 0.13% 56,104 231 0.41% Total interest-earning assets 959,093 26,977 2.81% 849,908 28,686 3.38% Cash and due from banks 14,591 13,727 Other assets 51,664 37,010 Total assets $ 1,025,348 $ 900,645 Interest-bearing liabilities: Deposits: NOW $ 178,197 212 0.12% $ 154,431 523 0.34% Savings and money market 296,708 655 0.22% 242,485 1,071 0.44% Certificates of deposits 159,111 1,633 1.03% 165,120 2,253 1.36% Total interest-bearing deposits 634,016 2,500 0.39% 562,036 3,847 0.68% Short-term borrowings 3,349 17 0.51% 1,864 9 0.48% Total interest-bearing liabilities 637,365 2,517 0.39% 563,900 3,856 0.68% Noninterest-bearing deposits 278,013 227,127 Other liabilities 3,392 4,884 Stockholders' equity 106,578 104,734 Total liabilities and and stockholders' equity $ 1,025,348 $ 900,645 Net interest income and margin $ 24,460 2.55% $ 24,830 2.92% (1) Average loan balances are shown net of unearned income and loans on nonaccrual status have been included in the computation of average balances. (2) Yields on tax-exempt securities have been computed on a tax-equivalent basis using an income tax rate of 21%. Table of Contents 70 Table 4 - Volume and Rate Variance Analysis Years ended December 31, 2021 vs. 2020 Years ended December 31, 2020 vs. 2019 Net Due to change in Net Due to change in (Dollars in thousands) Change Rate (2) Volume (2) Change Rate (2) Volume (2) Interest income: Loans and loans held for sale $ (1,582) (1,333) (249) $ (875) (455) (420) Securities - taxable 175 (933) 1,108 (68) (1,010) 942 Securities - tax-exempt (1) (101) (91) (10) (313) (180) (133) Total securities 74 (1,024) 1,098 (381) (1,190) 809 Federal funds sold (70) (81) 11 (298) (342) 44 Interest bearing bank deposits (131) (159) 28 (564) (645) 81 Total interest income $ (1,709) (2,597) 888 $ (2,118) (2,632) 514 Interest expense: Deposits: NOW $ (311) (340) 29 $ (187) (255) 68 Savings and money market (416) (537) 121 102 (3) 105 Certificates of deposits (620) (560) (60) (244) (166) (78) Total interest-bearing deposits (1,347) (1,437) 90 (329) (424) 95 Short-term borrowings 8 — 8 2 — 2 Total interest expense (1,339) (1,437) 98 (327) (424) 97 Net interest income $ (370) (1,160) 790 $ (1,791) (2,208) 417 (1) Yields on tax-exempt securities have been computed on a tax-equivalent basis using an income tax rate of 21%. (2) Changes that are not solely a result of volume or rate have been allocated to volume. Table of Contents 71 Table 5 - Net Charge-Offs (Recoveries) to Average Loans 2021 2020 Net Net Net charge-off Net (recovery) charge-offs Average (recovery) (recoveries) Average charge-off (Dollars in thousands) (recoveries) Loans (2) ratio charge-offs Loans (2) ratio Commercial and industrial (1) $ (140) 64,618 (0.22) % $ (87) 56,836 (0.15) % Construction and land development — 33,945 — — 32,721 — Commercial real estate 254 253,113 0.10 — 256,444 — Residential real estate (52) 81,526 (0.06) (63) 87,888 (0.07) Consumer installment 17 6,975 0.24 18 8,096 0.22 Total $ 79 440,177 0.02 % $ (132) 441,985 (0.03) % (1) Excludes PPP loans, which are guaranteed by the SBA. (2) Gross loan balances. Table of Contents 72 Table 6 - Loan Maturities December 31, 2021 1 year 1 to 5 5 to 15 After 15 (Dollars in thousands) or less years years years Total Commercial and industrial $ 26,593 17,474 38,125 1,785 83,977 Construction and land development 26,346 5,191 849 46 32,432 Commercial real estate 31,406 85,149 137,411 4,405 258,371 Residential real estate 3,832 21,919 31,227 20,683 77,661 Consumer installment 2,215 4,111 356 — 6,682 Total loans $ 90,392 133,844 207,968 26,919 459,123 Table of Contents 73 Table 7 - Sensitivities to Changes in Interest Rates on Loans Maturing in More Than One Year December 31, 2021 Variable Fixed (Dollars in thousands) Rate Rate Total Commercial and industrial $ 268 57,116 57,384 Construction and land development 1,934 4,152 6,086 Commercial real estate 8,220 218,745 226,965 Residential real estate 24,058 49,771 73,829 Consumer installment 38 4,429 4,467 Total loans $ 34,518 334,213 368,731 Table of Contents 74 Table 8 - Allocation of Allowance for Loan Losses 2021 2020 (Dollars in thousands) Amount %* Amount %* Commercial and industrial $ 857 18.3% $ 807 17.9% Construction and land development 518 7.1% 594 7.2% Commercial real estate 2,739 56.2% 3169 55.2% Residential real estate 739 16.9% 944 18.2% Consumer installment 86 1.5% 104 1.5% Total allowance for loan losses $ 4,939 $ 5,618 * Loan balance in each category expressed as a percentage of total loans. Table of Contents 75 Table 9 - Estimated Uninsured Time Deposits by Maturity (Dollars in thousands) December 31, 2021 Maturity of: 3 months or less $ 2,079 Over 3 months through 6 months 1,747 Over 6 months through 12 months 31,159 Over 12 months 6,505 Total estimated uninsured time deposits $ 41,490 Table of Contents 76 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information called for by ITEM 7A is set forth in ITEM 7 under the caption “Market and Liquidity Risk Management” and is incorporated herein by reference.