AUBURN NATIONAL BANCORPORATION, INC 10-Q

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is designed to provide a better understanding of various factors related to the results of operations and financial condition of the Company and the Bank. This discussion is intended to supplement and highlight information contained in the accompanying unaudited condensed consolidated financial statements and related notes for the quarters ended March 31, 2022 and 2021, as well as the information contained in our Annual Report on Form 10-K for the year ended December 31, 2021. Special Notice Regarding Forward-Looking Statements Various of the statements made herein under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Quantitative and Qualitative Disclosures about Market Risk”, “Risk Factors” and elsewhere, are “forward-looking statements” within the meaning and protections of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause the actual results, performance, achievements or financial condition of the Company to be materially different from future results, performance, achievements or financial condition expressed or implied by such forward-looking statements. You should not expect us to update any forward-looking statements. All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “project,” “could,” “intend,” “target” and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation: ● the effects of future economic, business and market conditions and changes, foreign, domestic and locally, including inflation, seasonality, natural disasters or climate change, such as rising sea and water levels, hurricanes and tornados, COVID-19 or other epidemics or pandemics; ● the effects of war or other conflicts, acts of terrorism, or other events that may affect general economic conditions; ● governmental monetary and fiscal policies, including the continuing effects of COVID-19 fiscal and monetary stimulus, and changes in monetary policies in response to inflations; ● legislative and regulatory changes, including changes in banking, securities and tax laws, regulations and rules and their application by our regulators, including capital and liquidity requirements, and changes in the scope and cost of FDIC insurance; ● the failure of assumptions and estimates, as well as differences in, and changes to, economic, market and credit conditions, including changes in borrowers’ credit risks and payment behaviors from those used in our loan portfolio reviews; ● the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand and mortgage loan originations, and the values and liquidity of loan collateral, securities, and interest-sensitive assets and liabilities, and the risks and uncertainty of the amounts realizable; ● changes in borrower credit risks, and savings payment behaviors; ● changes in the availability and cost of credit and capital in the financial markets, and the types of instruments that may be included as capital for regulatory purposes; ● changes in the prices, values and sales volumes of residential and commercial real estate; Table of Contents 29 ● the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services, including the disruption effects of financial technology and other competitors who are not subject to the same regulations as the Company and the Bank; ● the failure of assumptions and estimates underlying the establishment of allowances for possible loan losses and other asset impairments, losses valuations of assets and liabilities and other estimates; ● the costs of redeveloping our headquarters and the timing and amount of rental income upon completion of the project; ● the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions; ● changes in technology or products that may be more difficult, costly, or less effective than anticipated; ● cyber-attacks and data breaches that may compromise our systems, our vendor systems or customers’ information; ● the risks that our deferred tax assets (“DTAs”), if any, could be reduced if estimates of future taxable income from our operations and tax planning strategies are less than currently estimated, and sales of our capital stock could trigger a reduction in the amount of net operating loss carry-forwards that we may be able to utilize for income tax purposes; and ● other factors and information in this report and other filings that we make with the SEC under the Exchange Act, including our Annual Report on Form 10-K for the year ended December 31, 2021 and subsequent quarterly and current reports. See Part II, Item 1A. “RISK FACTORS”. All written or oral forward-looking statements that are made by us or are attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made. ITEM 1. BUSINESS Auburn National Bancorporation, Inc. (the “Company”) is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Company was incorporated in Delaware in 1990, and in 1994 it succeeded its Alabama predecessor as the bank holding company controlling AuburnBank, an Alabama state member bank with its principal office in Auburn, Alabama (the “Bank”). The Company and its predecessor have controlled the Bank since 1984. As a bank holding company, the Company may diversify into a broader range of financial services and other business activities than currently are permitted to the Bank under applicable laws and regulations. The holding company structure also provides greater financial and operating flexibility than is presently permitted to the Bank. The Bank has operated continuously since 1907 and currently conducts its business primarily in East Alabama, including Lee County and surrounding areas. The Bank has been a member of the Federal Reserve System since April 1995. The Bank’s primary regulators are the Federal Reserve and the Alabama Superintendent of Banks (the “Alabama Superintendent”). The Bank has been a member of the Federal Home Loan Bank of Atlanta (the “FHLB”) since 1991. Certain of the statements made in this discussion and analysis and elsewhere, including information incorporated herein by reference to other documents, are “forward-looking statements” within the meaning of, and subject to, the protections of Section 27A of the Securities Act. Table of Contents 30 Summary of Results of Operations Quarter ended March 31, (Dollars in thousands, except per share data) 2022 2021 Net interest income (a) $ 6,190 $ 6,057 Less: tax-equivalent adjustment 112 120 Net interest income (GAAP) 6,078 5,937 Noninterest income 908 1,182 Total revenue 6,986 7,119 Provision for loan losses (250) — Noninterest expense 4,901 4,690 Income tax expense 254 423 Net earnings $ 2,081 $ 2,006 Basic and diluted earnings per share $ 0.59 $ 0.56 (a) Tax-equivalent. See "Table 1 - Explanation of Non-GAAP Financial Measures." Financial Summary The Company’s net earnings were $2.1 million for the first quarter of 2022, compared to $2.0 million for the first quarter of 2021. Basic and diluted earnings per share were $0.59 per share for the first quarter of 2022, compared to $0.56 per share for the first quarter of 2021. Net interest income (tax-equivalent) was $6.2 million for the first quarter of 2022, a 2% increase compared to $6.1 million for the first quarter of 2021. This increase was primarily due to balance sheet growth, partially offset by a decrease in the Company’s net interest margin (tax-equivalent). Net interest margin (tax-equivalent) declined to 2.43% in the first quarter of 2022, compared to 2.66% for the first quarter of 2021 due to the continued lower interest rate environment and changes in our asset mix resulting from the continuing elevated levels of customer deposits . Net interest income (tax-equivalent) included $0.1 million in PPP loan fees, net of related costs for the first quarter of 2022, compared to $0. 2 million for the first quarter of 2021. At March 31, 2022, the Company’s allowance for loan losses was $4.7 million, or 1.09% of total loans, compared to $4.9 million, or 1.08% of total loans, at December 31, 2021, and $5.7 million, or 1.23% of total loans, at March 31, 2021. The Company recorded a negative provision for loan losses of $0.3 million during the first quarter of 2022, compared to no provision for loan losses during the first quarter of 2021. The negative provision for loan losses was primarily related to a decrease in total loans, excluding PPP, during the first quarter of 2022. Total loans, excluding PPP, were $424.3 million at March 31, 2022, a decrease of $25.9 million, or 6%, compared to December 31, 2021. This decline was primarily due to decreases in multi-family loans of $17.3 million and hotel loans of $6.5 million due to payoffs. The provision for loan losses is based upon various estimates and judgments, including the absolute level of loans, economic conditions, credit quality and the amount of net charge-offs. Noninterest income was $0.9 million for the first quarter of 2022 compared to $1.2 million for the first quarter of 2021. The decrease in noninterest income was primarily due to a decrease in mortgage lending income of $0.3 million as refinance activity slowed in our primary market area, as market interest rates on mortgage loans increased. Noninterest expense was $4.9 million for the first quarter of 2022 compared to $4.7 million for the first quarter of 2021. The increase in noninterest expense was due to increases in salaries and benefits expense and other noninterest expense. Income tax expense was $0.3 million for the first quarter of 2022 compared to $0.4 million during the first quarter of 2021. The Company’s effective tax rate for the first quarter of 2022 was 10.88%, compared to 17.41% in the first quarter of 2021. The 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 31 The Company paid cash dividends of $0.265 per share in the first quarter of 2022, an increase of 2% from the same period of 2021. The Company’s share repurchases of $0.1 million since December 31, 2021 resulted in 3,559 fewer outstanding common shares at March 31, 2022. At March 31, 2022, 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 18.08%, a tier 1 leverage ratio of 9.09% and a common equity tier 1 (“CET1”) ratio of 17.26% at March 31, 2022. 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 and newly developed treatments. 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 during outbreaks of COVID-19 variants. ● We serviced 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. Table of Contents 32 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 disrupti ons and worker shortages, these factors have caused housing prices and apartment rents to increase, generally. Stimulative monetary and fiscal policies, 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 has begun increasing its target interest rates and is considering reducing its holdings of securities to counteract inflation. 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 from the SBA 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 from the SBA related to PPP loans under the Economic Aid Act. Through March 31, 2022, we have recognized $0.8 million of these fees, net of related costs. As of March 31, 2022, we have received payments and forgiveness on 172 PPP loans under the Economic Aid Act, totaling $16.1 million. The outstanding balance for the remaining 82 PPP loans under the Economic Aid Act was approximately $4.1 million at March 31, 2022. We continue to closely monitor this pandemic, and are working to continue our services and to address developments as those occur. Our results of operations for quarter ended March 31, 2022, 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 March 31, 2022, all of our capital ratios were in excess of all regulatory requirements to be well capitalized. The continuing effects of the COVID-19 pandemic could result in adverse changes to credit quality and our regulatory capital ratios, and inflation will affect our costs, interest rates and the values of our assets and liabilities, customer behaviors and economic activity. Continuing supply chain and supply disruptions also adversely affect the levels and costs of economic activities. We continue to closely monitor this pandemic, and are working to continue our services during the pandemic and to address developments as those occur. Table of Contents 33 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. 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 and by releases from the allowance when determined to be appropriate to the levels of loans and probable loan losses in such loans.. 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 March 31, 2022 and December 31, 2021, and for the periods 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. Table of Contents 34 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. The Company regularly re-evaluates its practices in determining the allowance for loan losses. The Company’s look-back period each quarter incorporates the effects of at least one economic downturn in its loss history. The Company believes this look-back period is appropriate due to the risks inherent in the loan portfolio. Absent this look-back period, 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 quarter ended March 31, 2022, the Company increased its look-back period to 52 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 the quarter ended June 30, 2021, the Company adjusted certain qualitative and economic factors, previously downgraded as a result of the COVID-19 pandemic, to reflect improvements in economic conditions in our primary market area. Further adjustments may be made from time to time in the future as a result of the COVID-19 pandemic and other economic changes. 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 7, Fair Value, of the consolidated financial statements that accompany this report. Table of Contents 35 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. 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 March 31, 2022. The amount of the deferred tax assets considered realizable, however, could be reduced if estimates of future taxable income are reduced. Table of Contents 36 RESULTS OF OPERATIONS Average Balance Sheet and Interest Rates Quarter ended March 31, 2022 2021 Average Yield/ Average Yield/ (Dollars in thousands) Balance Rate Balance Rate Loans and loans held for sale $ 440,608 4.46% $ 466,368 4.50% Securities - taxable 374,825 1.45% 289,981 1.33% Securities - tax-exempt 60,272 3.57% 63,050 3.68% Total securities 435,097 1.74% 353,031 1.75% Federal funds sold 73,575 0.17% 32,809 0.15% Interest bearing bank deposits 83,161 0.16% 70,350 0.09% Total interest-earning assets 1,032,441 2.66% 922,558 2.96% Deposits: NOW 200,907 0.12% 172,055 0.16% Savings and money market 345,549 0.20% 281,844 0.25% Time Deposits 159,785 0.90% 159,466 1.09% Total interest-bearing deposits 706,241 0.34% 613,365 0.44% Short-term borrowings 3,943 0.50% 3,161 0.50% Total interest-bearing liabilities 710,184 0.34% 616,526 0.44% Net interest income and margin (tax-equivalent) $ 6,190 2.43% $ 6,057 2.66% Net Interest Income and Margin Net interest income (tax-equivalent) was $6.2 million for the first quarter of 2022 , a 2% increase compared to $6.1 million for the first quarter of 2021. This increase was primarily due to balance sheet growth, partially offset by a decrease in the Company’s net interest margin (tax-equivalent). The tax-equivalent yield on total interest-earning assets decreased by 30 basis points to 2.66% in the first quarter of 2022 compared to 2.96% in the first quarter of 2021. This decrease was primarily due to the lower interest environment and changes in our asset mix resulting from the significant increase in customer deposits. The cost of total interest-bearing liabilities decreased by 10 basis points to 0.34% in the first quarter of 2022 compared to 0.44% in the first quarter of 2021, even as interest bearing deposits increased. 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 continue to 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 $0.3 million for the first quarter of 2022, compared to no charge to provision for loan losses for the first quarter of 2021. The negative provision for loan losses was primarily related to a decrease in total loans, excluding PPP, during the first quarter of 2022. Total loans, excluding PPP, were $424.3 million at March 31, 2022, a decrease of $25.9 million, or 6%, compared to December 31, 2021. This decline was primarily due to decreases in multi-family loans of $17.3 million and hotel loans of $6.5 million due to payoffs. The provision for loan losses is based upon various factors, including the absolute level of loans, economic conditions, credit quality, and the amount of net charge-offs. Table of Contents 37 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 1.09% at March 31, 2022, compared to 1.08% at December 31, 2021. 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 Quarter ended March 31, (Dollars in thousands) 2022 2021 Service charges on deposit accounts $ 142 $ 132 Mortgage lending income 253 549 Bank-owned life insurance 99 103 Other 414 398 Total noninterest income $ 908 $ 1,182 The Company’s income from mortgage lending was primarily attributable to the (1) origination and sale of 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 associated 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. 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. Quarter ended March 31, (Dollars in thousands) 2022 2021 Origination income, net $ 229 $ 537 Servicing fees, net 24 12 Total mortgage lending income $ 253 $ 549 The Company’s income from mortgage lending typically fluctuates as mortgage interest rates change and is primarily attributable to the origination and sale of mortgage loans. Origination income decreased in in the first quarter of 2022 compared to the first quarter of 2021 due to a decrease in refinance activity in our primary market area, as market interest rates on mortgage loans increased. The decrease in origination income was partially offset by an increase in servicing fees, net of related amortization expense as prepayment speeds slowed during the first quarter of 2022, resulting in decreased amortization expense. Table of Contents 38 Noninterest Expense Quarter ended March 31, (Dollars in thousands) 2022 2021 Salaries and benefits $ 2,950 $ 2,851 Net occupancy and equipment 434 438 Professional fees 230 256 Other 1,287 1,145 Total noninterest expense $ 4,901 $ 4,690 The increase in salaries and benefits was primarily due to a decrease in deferred costs related to the PPP loan program, and routine annual wage and benefit increases. The increase in other noninterest expense was due to a variety of miscellaneous items including: increased marketing costs, ATM and checkcard expenses, and stationary and supplies. Income Tax Expense Income tax expense was $0.3 million for the first quarter of 2022 compared to $0.4 million for the first quarter of 2021. The Company’s effective income tax rate for the first quarter of 2022 was 10.88%, compared to 17.41% in the first quarter of 2021. The 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. BALANCE SHEET ANALYSIS Securities Securities available-for-sale were $417.5 million at March 31, 2022 compared to $421.9 million at December 31, 2021. This increase reflects an increase in the amortized cost basis of securities available-for-sale of $20.1 million, and a decrease of $24.5 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 increase in customer deposits. The decrease in the fair value of securities was primarily due to an increase in long-term market interest rates. The average annualized tax-equivalent yields earned on total securities were 1.74% in the first quarter of 2022 and 1.75% in the first quarter of 2021. Loans 2022 2021 First Fourth Third Second First (In thousands) Quarter Quarter Quarter Quarter Quarter Commercial and industrial $ 73,297 83,977 79,202 87,933 88,687 Construction and land development 33,058 32,432 34,890 37,477 30,332 Commercial real estate 235,062 258,371 252,798 242,845 254,731 Residential real estate 79,102 77,661 80,205 82,164 82,848 Consumer installment 8,412 6,682 7,060 7,762 6,524 Total loans 428,931 459,123 454,155 458,181 463,122 Less: unearned income (514) (759) (923) (1,197) (1,243) Loans, net of unearned income $ 428,417 458,364 453,232 456,984 461,879 Total loans, net of unearned income, were $428.4 million at March 31, 2022, and $458.4 million at December 31, 2021. Excluding PPP loans, total loans, net of unearned income, were $424.3 million, a decrease of $25.9 million, or 6% from December 31, 2021. This decline was primarily due to decreases in multi-family loans of $17.3 million and hotel loans of $6.5 million. Four loan categories represented the majority of the loan portfolio at March 31, 2022: commercial real estate (55%), residential real estate (18%), commercial and industrial (17%) and construction and land development (8%). Approximately 25% of the Company’s commercial real estate loans were classified as owner-occupied at March 31, 2022. Table of Contents 39 Within the residential real estate portfolio segment, the Company had junior lien mortgages of approximately $7.1 million, or 2%, and $7.2 million, or 2%, of total loans, net of unearned income at March 31, 2022 and December 31, 2021, respectively. For residential real estate mortgage loans with a consumer purpose, the Company had no loans that required interest only payments at March 31, 2022 and December 31, 2021. 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 4.46% in the first quarter of 2022 and 4.50% in the first quarter of 2021. 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 continuing effects from the COVID-19 pandemic, 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 $21.2 million. Furthermore, we have an internal limit for aggregate credit exposure (loans outstanding plus unfunded commitments) to a single borrower of $19.1 million. Our loan policy requires that the Loan Committee of the Board of Directors approve any loan relationships that exceed this internal limit. At March 31, 2022, the Bank had no relationships exceeding these limits. We periodically analyze our commercial and industrial and commercial real estate loan portfolios 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 March 31, 2022 and December 31, 2021. March 31, December 31, (Dollars in thousands) 2022 2021 Lessors of 1-4 family residential properties $ 48,920 $ 47,880 Hotel/motel 37,377 43,856 Shopping centers 29,147 29,574 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 March 31, 2022, we had no COVID-19 loan deferrals, compared to one COVID-19 loan deferral totaling $0.1 million 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. Table of Contents 40 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 $4.7 million at March 31, 2022 compared to $4.9 million at December 31, 2021, 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.” A summary of the changes in the allowance for loan losses and certain asset quality ratios for the first quarter of 2022 and the previous four quarters is presented below. 2022 2021 First Fourth Third Second First (Dollars in thousands) Quarter Quarter Quarter Quarter Quarter Balance at beginning of period $ 4,939 5,119 5,107 5,682 5,618 Charge-offs: Commercial real estate — (254) — — — Residential real estate — (2) — (1) — Consumer installment (48) (32) — — (5) Total charge -offs (48) (288) — (1) (5) Recoveries 17 108 12 26 69 Net (charge-offs) recoveries (31) (180) 12 25 64 Provision for loan losses (250) — — (600) — Ending balance $ 4,658 4,939 5,119 5,107 5,682 as a % of loans 1.09 % 1.08 1.13 1.12 1.23 as a % of nonperforming loans 1,256 % 1,112 1,053 813 726 Net charge-offs (recoveries) as % of average loans (a) 0.03 % 0.16 (0.01) (0.02) (0.06) (a) Net (charge-offs) recoveries are annualized. 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 1.09% at March 31, 2022, compared to 1.08% at December 31, 2021. Excluding PPP loans, which are guaranteed by the SBA, the Company’s allowance for loan losses was 1.10% of total loans at both March 31, 2022 and December 31, 2021. 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 March 31, 2022 the Company had $0.7 million in nonperforming assets compared to $0.8 million at December 31, 2021. Table of Contents 41 The table below provides information concerning total nonperforming assets and certain asset quality ratios for the first quarter of 2022 and the previous four quarters. 2022 2021 First Fourth Third Second First (Dollars in thousands) Quarter Quarter Quarter Quarter Quarter Nonperforming assets: Nonaccrual loans $ 371 444 486 628 783 Other real estate owned 374 374 — — — Total nonperforming assets $ 745 818 486 628 783 as a % of loans and other real estate owned 0.17 % 0.18 0.11 0.14 0.17 as a % of total assets 0.07 % 0.07 0.05 0.06 0.08 Nonperforming loans as a % of total loans 0.09 % 0.10 0.11 0.14 0.17 Accruing loans 90 days or more past due $ — — 69 — — The table below provides information concerning the composition of nonaccrual loans for the first quarter of 2022 and the previous four quarters. 2022 2021 First Fourth Third Second First (In thousands) Quarter Quarter Quarter Quarter Quarter Nonaccrual loans: Commercial real estate $ 182 187 193 199 206 Residential real estate 189 257 293 429 577 Total nonaccrual loans $ 371 444 486 628 783 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 90 days or more past due, unless the loan is both well-secured and in the process of collection . The Company had $0.4 million in loans on nonaccrual status at March 31, 2022 and December 31, 2021, respectively. The Company had no loans 90 days or more past due and still accruing at March 31, 2022 and December 31, 2021, respectively. The table below provides information concerning the composition of OREO for the first quarter of 2022 and the previous four quarters. 2022 2021 First Fourth Third Second First (In thousands) Quarter Quarter Quarter Quarter Quarter Other real estate owned: Commercial real estate $ 374 374 — — — Total other real estate owned $ 374 374 — — — Potential Problem Loans Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of a borrower 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 $2.0 million, or 0.5% of total loans at March 31, 2022, and $2.4 million, or 0.5% of total loans at December 31, 2021. Table of Contents 42 The table below provides information concerning the composition of potential problem loans for the first quarter of 2022 and the previous four quarters. 2022 2021 First Fourth Third Second First (In thousands) Quarter Quarter Quarter Quarter Quarter Potential problem loans: Commercial and industrial $ 215 226 274 291 299 Construction and land development 13 218 231 239 247 Commercial real estate 150 156 172 178 173 Residential real estate 1,592 1,748 1,848 2,096 2,092 Consumer installment 8 12 19 7 9 Total potential problem loans $ 1,978 2,360 2,544 2,811 2,820 At March 31, 2022, approximately $0.2 million or 8% of total potential problem loans were past due at least 30 days, 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, for the first quarter of 2022 and the previous four quarters. 2022 2021 First Fourth Third Second First (In thousands) Quarter Quarter Quarter Quarter Quarter Performing loans past due 30 to 89 days: Commercial and industrial $ 7 3 68 1 42 Construction and land development 1 204 — 204 10 Commercial real estate — — — 205 180 Residential real estate 496 516 409 68 399 Consumer installment 15 25 25 7 36 Total $ 519 748 502 485 667 Deposits Total deposits increased $23.5 million, or 2%, to $1.0 billion at March 31, 2022, compared to $994.2 million at December 31, 2021. Noninterest-bearing deposits were $308.3 million, or 30% of total deposits, at March 31, 2022, compared to $316.1 million, or 32% of total deposits at December 31, 2021. Estimated uninsured deposits totaled $427.3 million and $420.8 million at March 31, 2022 and December 31, 2021, respectively. Uninsured amounts are estimated based on the portion of account balances in excess of FDIC insurance limits. The average rate paid on total interest-bearing deposits was 0.34% in the first quarter of 2022 compared to 0.44% in the first quarter of 2021. Other Borrowings Other borrowings 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 funds lines totaling $51.0 million and $41.0 million with none outstanding at March 31, 2022, and December 31, 2021, respectively. Securities sold under agreements to repurchase totaled $4.0 million and $3.4 million at March 31, 2022 and December 31, 2021, respectively. The average rate paid on short-term borrowings was 0.50% in the first quarter of 2022 and 2021, respectively. The Company had no long-term debt at March 31, 2022 and December 31, 2021. Table of Contents 43 CAPITAL ADEQUACY The Company’s consolidated stockholders’ equity was $86.4 million and $103.7 million as of March 31, 2022 and December 31, 2021, respectively. The decrease from December 31, 2021 was primarily driven by an other comprehensive loss due to the change in unrealized losses on securities available-for-sale, net of tax of $18.3 million. The increase in the unrealized loss on securities was primarily due to an increase in long-term market interest rates. These unrealized losses do not affect the Bank’s capital for regulatory capital purposes. The Company paid cash dividends of $0.265 per share in the first quarter of 2022, an increase of 2% from the same period in 2021. The Company’s share repurchases of $0.1 million since December 31, 2021 resulted in 3,559 fewer outstanding common shares at March 31, 2022. 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 March 31, 2022, 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 9.09%, CET1 risk-based capital ratio was 17.26%, tier 1 risk-based capital ratio was 17.26%, and total risk-based capital ratio was 18.08% at March 31, 2022. 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 10.08% at March 31, 2022. 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. ALCO measures and evaluates interest rate risk so that the Bank can meet customer demands for various types of loans and deposits. Measurements used to help manage interest rate sensitivity include an earnings simulation model and an economic value of equity (“EVE”) model. Table of Contents 44 Earnings simulation . Management believes that interest rate risk is best estimated by our earnings simulation modeling. 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 At March 31, 2022, our earnings simulation model indicated that we were in compliance with the policy guidelines noted above. Economic Value of Equity . EVE measures the extent that the estimated economic 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 At March 31, 2022, our EVE model indicated that we were in compliance with our policy guidelines. 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. Prepayments 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 a tool to manage interest rate sensitivity while continuing to meet the credit and deposit needs of our customers. From time to time, the Company also may enter into back-to-back interest rate swaps to facilitate customer transactions and meet their financing needs. These interest rate swaps qualify as derivatives, but are not designated as hedging instruments. At March 31, 2022 and December 31, 2021, the Company had no derivative contracts designated as part of a hedging relationship to assist in managing its interest rate sensitivity. Table of Contents 45 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 could lead to lower earnings due to the cost of foregoing alternative higher-yield market 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 regulatory restrictions on such dividends. The primary source of funding and liquidity for the Company has been dividends received from the Bank. If needed, the Company could also borrow money, or issue common stock or other securities. Primary uses of funds by the Company include dividends paid to stockholders, Company stock repurchases, and payment of Company expenses. Primary sources of funding for the Bank include customer deposits, other borrowings, repayment and maturity of securities, sales of securities, and the 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 may participate in the FHLB’s advance program to obtain funding for its growth. Advances include both fixed and variable terms and may be taken out with varying maturities. At March 31, 2022, the Bank had a remaining available line of credit with the FHLB of $331.4 million. At March 31, 2022, the Bank also had $51.0 million of available federal funds lines with no borrowings outstanding. Primary uses of funds include repayment of maturing obligations and growing the loan portfolio. Management believes that the Company and the Bank have adequate sources of liquidity to meet all their respective known contractual obligations and unfunded commitments, including loan commitments and reasonable borrower, depositor, and creditor requirements over the next twelve months. Off-Balance Sheet Arrangements, Commitments, Contingencies and Contractual Obligations At March 31, 2022, the Bank had outstanding standby letters of credit of $1.4 million and unfunded loan commitments outstanding of $53.7 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 could liquidate federal funds sold or a portion of our securities available- for-sale, or draw on its available credit facilities. Mortgage lending activities We primarily sell 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 March 31, 2022, the unpaid principal balance of residential mortgage loans, which we have originated and sold, but retained the servicing rights, was $250.3 million. Although these loans are generally sold on a non-recourse basis, we may be obligated to repurchase residential mortgage loans or reimburse investors for losses incurred (make whole requests) if a loan review reveals a potential breach of seller representations and warranties. Upon receipt of a repurchase or make whole request, we work with investors to arrive at a mutually agreeable resolution. Repurchase and make whole requests 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 or make whole event has occurred. We seek to reduce and manage the risks of potential repurchases, make whole requests, or other claims by mortgage loan investors through our underwriting and quality assurance practices and by servicing mortgage loans to meet investor and secondary market standards. Table of Contents 46 The Company was not required to repurchase any loans during the first quarter of 2022 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 March 31, 2022. 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. The agreement under which we act as servicer generally specifies standards 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 repurchase and make whole requests related to representation and warranty provisions and servicing activities have been limited to date, it is possible that requests to repurchase mortgage loans or reimburse investors for losses incurred (make whole requests) may increase in frequency if investors more aggressively pursue all means of recovering losses on their purchased loans. As of March 31, 2022, we do not believe that this exposure is material due to the historical level of repurchase requests and loss trends, in addition to 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. CURRENT ACCOUNTING DEVELOPMENTS The following ASUs have been issued by the FASB but are not yet effective. ● ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments; Table of Contents 47 Information about these pronouncements 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 48 Table 1 – Explanation of Non-GAAP Financial Measures In addition to results presented in accordance with U.S. generally accepted accounting principles (GAAP), this quarterly report on Form 10-Q includes certain designated net interest income amounts presented on a tax-equivalent basis, a non- GAAP financial measure, including the presentation and 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 reconciliations of these non- GAAP financial measures to their most directly comparable GAAP financial measures are presented below. 2022 2021 First Fourth Third Second First (in thousands) Quarter Quarter Quarter Quarter Quarter Net interest income (GAAP) $ 6,078 6,037 6,041 5,975 5,937 Tax-equivalent adjustment 112 115 117 118 120 Net interest income (Tax -equivalent) $ 6,190 6,152 6,158 6,093 6,057 Table of Contents 49 Table 2 - Selected Quarterly Financial Data 2022 2021 First Fourth Third Second First (Dollars in thousands, except per share amounts) Quarter Quarter Quarter Quarter Quarter Results of Operations Net interest income (a) $ 6,190 6,152 6,158 6,093 6,057 Less: tax-equivalent adjustment 112 115 117 118 120 Net interest income (GAAP) 6,078 6,037 6,041 5,975 5,937 Noninterest income 908 1,019 956 1,131 1,182 Total revenue 6,986 7,056 6,997 7,106 7,119 Provision for loan losses (250) — — (600) — Noninterest expense 4,901 5,092 4,736 4,916 4,690 Income tax expense 254 93 386 504 423 Net earnings $ 2,081 1,871 1,875 2,286 2,006 Per share data: Basic and diluted net earnings $ 0.59 0.53 0.53 0.65 0.56 Cash dividends declared 0.265 0.26 0.26 0.26 0.26 Weighted average shares outstanding: Basic and diluted 3,518,657 3,524,311 3,536,320 3,554,871 3,566,299 Shares outstanding, at period end 3,516,971 3,520,485 3,529,338 3,545,855 3,566,326 Book value $ 24.57 29.46 29.73 29.91 29.06 Common stock price High $ 34.49 34.79 35.36 38.90 48.00 Low 31.75 31.32 33.25 34.50 37.55 Period end: 33.21 32.30 33.80 35.46 38.37 To earnings ratio 14.44 14.23 14.57 15.22 17.85 To book value 135 % 110 114 119 132 Performance ratios: Return on average equity 7.97 % 7.07 7.01 8.74 7.37 Return on average assets 0.75 % 0.70 0.72 0.91 0.82 Dividend payout ratio 44.92 % 49.06 49.06 40.00 46.43 Asset Quality: Allowance for loan losses as a % of: Loans 1.09 % 1.08 1.13 1.12 1.23 Nonperforming loans 1,256 % 1,112 1,053 813 726 Nonperforming assets as a % of: Loans and other real estate owned 0.17 % 0.18 0.11 0.14 0.17 Total assets 0.07 % 0.07 0.05 0.06 0.08 Nonperforming loans as a % of total loans 0.09 % 0.10 0.11 0.14 0.17 Annualized net charge-offs (recoveries) as % of average loans 0.03 % 0.16 (0.01) (0.02) (0.06) Capital Adequacy: (c) CET 1 risk-based capital ratio 17.26 % 16.23 16.82 17.03 17.21 Tier 1 risk-based capital ratio 17.26 % 16.23 16.82 17.03 17.21 Total risk-based capital ratio 18.08 % 17.06 17.72 17.94 18.25 Tier 1 leverage ratio 9.09 % 9.35 9.57 9.81 9.99 Other financial data: Net interest margin (a) 2.43 % 2.45 2.51 2.60 2.66 Effective income tax rate 10.88 % 4.74 17.07 18.06 17.41 Efficiency ratio (b) 69.05 % 71.01 66.57 68.05 64.79 Selected average balances: Securities available-for-sale $ 435,097 414,061 395,529 370,582 353,031 Loans, net of unearned income 439,713 455,726 452,668 460,672 463,424 Total assets 1,114,407 1,073,564 1,040,985 1,005,041 980,884 Total deposits 1,003,394 961,544 927,368 894,757 863,194 Total stockholders’ equity 104,493 105,925 106,936 104,591 108,890 Selected period end balances: Securities available-for-sale $ 417,459 421,891 407,474 384,865 359,630 Loans, net of unearned income 428,417 458,364 453,232 456,984 461,879 Allowance for loan losses 4,658 4,939 5,119 5,107 5,682 Total assets 1,109,664 1,105,150 1,065,871 1,036,232 993,263 Total deposits 1,017,742 994,243 954,971 923,462 880,590 Total stockholders’ equity 86,411 103,726 104,929 106,043 103,639 (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 50 Table 3 - Average Balances and Net Interest Income Analysis Quarter ended March 31, 2022 2021 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) $ 440,608 $ 4,850 4.46% $ 466,368 $ 5,178 4.50% Securities - taxable 374,825 1,336 1.45% 289,981 949 1.33% Securities - tax-exempt (2) 60,272 531 3.57% 63,050 572 3.68% Total securities 435,097 1,867 1.74% 353,031 1,521 1.75% Federal funds sold 73,575 31 0.17% 32,809 12 0.15% Interest bearing bank deposits 83,161 32 0.16% 70,350 16 0.09% Total interest-earning assets 1,032,441 $ 6,780 2.66% 922,558 $ 6,727 2.96% Cash and due from banks 15,105 13,880 Other assets 66,861 44,446 Total assets $ 1,114,407 $ 980,884 Interest-bearing liabilities: Deposits: NOW $ 200,907 $ 57 0.12% $ 172,055 $ 66 0.16% Savings and money market 345,549 172 0.20% 281,844 172 0.25% Time deposits 159,785 356 0.90% 159,466 428 1.09% Total interest-bearing deposits 706,241 585 0.34% 613,365 666 0.44% Short-term borrowings 3,943 5 0.50% 3,161 4 0.50% Total interest-bearing liabilities 710,184 $ 590 0.34% 616,526 $ 670 0.44% Noninterest-bearing deposits 297,153 249,829 Other liabilities 2,577 5,639 Stockholders' equity 104,493 108,890 Total liabilities and stockholders' equity $ 1,114,407 $ 980,884 Net interest income and margin (tax-equivalent) $ 6,190 2.43% $ 6,057 2.66% (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 a federal income tax rate of 21%. Table of Contents 51 Table 4 - Allocation of Allowance for Loan Losses 2022 2021 First Quarter Fourth Quarter Third Quarter Second Quarter First Quarter (Dollars in thousands) Amount %* Amount %* Amount %* Amount %* Amount %* Commercial and industrial $ 774 17.1 $ 857 18.3 $ 816 17.4 $ 829 19.2 $ 828 19.1 Construction and land development 508 7.7 518 7.1 590 7.7 639 8.2 551 6.5 Commercial real estate 2,536 54.8 2,739 56.2 2,823 55.6 2,704 53.0 3,259 55.1 Residential real estate 737 18.4 739 16.9 799 17.7 838 17.9 951 17.9 Consumer installment 103 2.0 86 1.5 91 1.6 97 1.7 93 1.4 Total allowance for loan losses $ 4,658 $ 4,939 $ 5,119 $ 5,107 $ 5,682 * Loan balance in each category expressed as a percentage of total loans. Table of Contents 52 Table 5 – Estimated Uninsured Time Deposits by Maturity (Dollars in thousands) March 31, 2022 Maturity of: 3 months or less $ 1,603 Over 3 months through 6 months 17,746 Over 6 months through 12 months 17,917 Over 12 months 4,185 Total estimated uninsured time deposits $ 41,451 Table of Contents 53 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information called for by ITEM 3 is set forth in ITEM 2 under the caption “MARKET AND LIQUIDITY RISK MANAGEMENT” and is incorporated herein by reference.