What changed in this filing

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Item 2. Management’s Discussion and Analysis

2021-05-06 compared with 2020-11-05 · 292 added, 384 removed, 459 unchanged (60% of the section changed)

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Words such as “expects”, “anticipates”, “believes”, “projects”, and “estimates” or variations of such words and similar expressions are intended to identify forward-looking statements.

These statements are based on certain underlying assumptions and are not guarantees of future performance, as they could be impacted by a number of potential risks and developments that cannot be predicted with any degree of certainty.

These statements are based on certain underlying assumptions and are not guarantees of future performance, as they could be impacted by a several potential risks and developments that cannot be predicted with any degree of certainty.

Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.

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risks associated with the current national emergency with respect to COVID-19 including the impact that national, state, and local responses, including shelter-at-home orders and limitations on business and personal activity as well as any stimulus or relief efforts, have on customers’ ability to repay loans or to resume normal payments following the end of COVID-19 related deferrals granted by the Bank;

the Company’s implementation of CECL;

the Company’s delayed implementation of CECL;

the ability for the Company to serve its customers with modified branch operations as well as social distancing guidelines and mandates under state and local stay-at-home orders;

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the Company’s ability to successfully deploy new technology;

the success of acquisitions or branch expansion;

the Company’s ability to receive regulatory approval for acquisitions or branch expansion while having a less than satisfactory rating under the Community Reinvestment Act;

the success of acquisitions or branch expansion, closure or consolidation;

and risks associated with the multitude of current and prospective laws and regulations to which the Company is and will be subject.

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income taxes and related deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis;

and goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in the “Other Assets” section of this discussion and analysis.

Critical accounting areas

are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations with regard to those areas.

and goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment

exists, as discussed in the “Other Assets” section of this discussion and analysis.

Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations regarding those areas.

OVERVIEW OF THE RESULTS OF OPERATIONS

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RESULTS OF OPERATIONS SUMMARY

Third Quarter 2020 compared to Third Quarter 2019

Third quarter 2020 net income was $10.4 million, or $0.68 per diluted share, compared to $9.0 million, or $0.58 per diluted share in the third quarter of 2019.

The Company’s annualized return on average equity was 12.34% and annualized return on average assets was 1.34% for the quarter ended September 30, 2020, compared to 11.78% and 1.36%, respectively, for the same quarter in 2019.

The primary drivers behind the variance in third quarter net income are as follows:

● The $3.7 million increase in net interest income is due to a $1.1 million increase in interest income due mostly to higher loan volumes partially offset by lower rates and lower interest expense, as well as a $2.6 million decrease in interest expense due to an increase in noninterest bearing deposits and lower rates on the remaining deposits.

The provision for loan & lease losses was $1.0 million higher due to the increase in core loan volume and relative uncertainty in the economy.

● The $1.2 million favorable increase in noninterest income is due to a $0.8 million gain from the disposal of a low-income housing tax credit fund investment, and a $0.7 million increase in bank-owned life insurance (BOLI) income.

These increases were partially offset by a $0.3 million decline in customer service charges.

● Noninterest expense increased by $2.2 million, due mostly to a $1.1 million increase in salaries, a $0.4 million increase in foreclosed asset expenses, and a $0.5 million increase in director’s deferred compensation.

Nine months ended 2020 compared to nine months ended 2019

Net income for the first nine months of 2020 was $26.5 million, or $1.73 per diluted share, compared to $26.7 million, or $1.73 per diluted share for the first nine months of 2019.

The Company’s annualized return on average equity was 10.90% and annualized return on average assets was 1.26% for the nine months ended September 30, 2020, compared to a return on equity of 12.33% and return on assets of 1.40% for the nine months ended September 30, 2019.

The primary drivers behind the variance in year-to-date net income are as follows:

● Net interest income was up $3.5 million or 5% due to the increase in volume of interest earning assets and the favorable impact of a 54 basis point decrease in yield on interest bearing liabilities.

● The Company’s provision for loan and lease losses was $6.4 million in the first nine months of 2020 relative to $2.1 million for the first nine months of 2019.

Organic loan growth specifically non-owner occupied commercial real estate combined with the uncertainties surrounding the economy due to the COVID-19 pandemic, necessitated the $4.3 million increase in the comparative periods,.

● Noninterest income increased by $2.5 million, or 14%, due mostly to a $0.4 million increase in BOLI income, a $1.4 million gain from the wrap up of low-income housing tax credit fund investments, a decrease of $0.6 million in low-income housing tax credit fund expenses, an increase of $0.2 million in the valuation gain of restricted equity investments owned by the Company and a $0.4 million gain on the sale of debt securities from the restructuring of the portfolio in the second quarter.

● Noninterest expense increased by $2.6 million or 5% due mostly to the same reasons outlined above in the quarterly comparison.

First Quarter 2021 compared to First Quarter 2020

First quarter 2021 net income was $11.1 million, or $0.72 per diluted share, compared to $7.8 million, or $0.51 per diluted share in the first quarter of 2020.

The Company’s annualized return on average equity was 12.94% and annualized return on average assets was 1.40% for the quarter ended March 31, 2021, compared to 9.97% and 1.23%, respectively, for the same quarter in 2020.

The primary drivers behind the variance in first quarter net income are as follows:

● The $4.8 million, or 20%, increase in net interest income is due mostly to a $3.4 million increase in interest income resulting primarily from higher loan volumes as compared to March 31, 2020, accelerated fee income recognition from the forgiveness of SBA PPP loans, partially offset by lower rates.

In addition, there was a $1.4 million favorable decline in interest expense due to a higher mix of noninterest bearing deposits and lower rates on the remaining deposits and borrowed funds.

The provision for loan & lease losses is $1.6 million lower as a result of higher economic uncertainty as the primary driver for provision, offset by net loan recoveries and lower historical loss rates used in the calculation.

● The $0.7 million, or 12%, favorable increase in noninterest income is due to a $0.4 million favorable change in the annual fair market value adjustment of restricted equity investments, and fluctuations in income on bank- owned life insurance (BOLI) associated with deferred compensation plans.

Customer service charges on deposit accounts were lower in the quarterly comparison, but were partially offset by increases in debit card interchange income.

● The efficiency ratio improved to 56.43% from 58.88%.

Although there was a $2.5 million increase in noninterest expense, net interest income increased $4.8 million as described above.

The largest expense item with an increase was salaries and benefits, with a $1.0 million increase due to lower deferred loan costs and higher bonus expense in the first quarter of 2021 as compared to the same period in 2020.

FINANCIAL CONDITION SUMMARY

September 30, 2020 relative to December 31, 2019

The Company’s assets totaled $3.2 billion at September 30, 2020 relative to $2.6 billion at December 31, 2019.

The following provides a summary of key balance sheet changes during the first nine months of 2020:

● The Company’s balance of cash and cash equivalents was up by $8.9 million, or 11% from December 31, 2019, to support fluctuations in month end mortgage warehouse line utilization.

● Securities available-for-sale were $577.3 million at September 30, 2020, a decrease of $23.5 million, or 4% from December 31, 2019.

The Company sold approximately $20.3 million in certain debt securities during the first half of 2020 as an effort to restructure the portfolio, selling smaller-balance or variable rate SBA and FNMA bonds, as well as certain municipal securities with potential higher credit risk.

Those sales were mostly offset by bond purchases.

During the third quarter of 2020 however, regular principal paydowns were generally not replaced to offset organic growth in the commercial real estate loan portfolio.

● Year-to-date 2020 loan growth of $611.8 million, or 35%, was highlighted by a $435.7 million increase in non-agricultural real estate loans, as well as a $98.4 million increase in mortgage warehouse lines, and $123.6 million of Paycheck Protection Program (PPP) loans.

Foreclosed assets increased $2.2 million, to $3.0 million during the first nine months of 2020.

This increase was mostly due to $2.1 million in one commercial real estate credit.

The single loan which moved to foreclosed assets during the first nine months of 2020, has a pending sale contract, expected to close in the fourth quarter of 2020.

● Deposits increased by $423.3 million, or 20% during 2020.

The growth in deposits came primarily from noninterest bearing or low-cost transaction and savings accounts, while higher-cost time deposits decreased.

● Short-term borrowings increased by $138.0 million to $158.0 million at September 30, 2020.

This increase was due to additional Federal Home Loan Bank (FHLB) overnight borrowings to partially fund loan growth including PPP loans and increased utilization of mortgage warehouse lines at September 30, 2020.

Ten million of these FHLB advances were “interest-free”, given to all member banks as part of the FHLB’s “Zero Interest Recovery Advance” program to provide immediate relief to property owners, businesses, and other customers struggling with the financial impacts of the pandemic.

● Total shareholders’ equity of $336.2 million at September 30, 2020 reflects an increase of $27.0 million, or 9%, relative to year-end 2019 due to capital from the addition of net income, a $11.6 million favorable swing in accumulated other comprehensive income/loss, stock options exercised, net of $9.1 million in dividends paid and $2.6 million in stock repurchases prior to March 15, 2020.

March 31, 2021 relative to December 31, 2020

The Company’s assets totaled $3.3 billion at March 31, 2021 relative to $3.2 billion at December 31, 2020.

The following provides a summary of key balance sheet changes during the first three months of 2021:

● The Company’s balance of cash and cash equivalents was up by $274.8 million, or 385% from December 31, 2020.

The overall increase in cash balances was due primarily to increases in deposit accounts and decreases in loan balances during the first quarter 2021.

● Securities available-for-sale were $552.9 million at March 31, 2021, an increase of $9.0 million, or 2% from December 31, 2020.

The Company purchased $45.2 million in various Government Agency sponsored mortgage-backed securities and municipal securities.

● The year-to-date 2021 loan balance decline of $175.2 million, or 7%, was highlighted by declines in outstanding balances on mortgage warehouse lines of $119.7 million, as well as a $19.3 million decline in SBA Paycheck Protection Program (PPP) loans.

During the first quarter of 2021 the Bank had $33.2 million in SBA PPP loan originations, but overall SBA balances declined due to SBA forgiveness of $52.8 million in PPP loans during the same period.

The remainder of the decline was primarily in real estate secured loans with an increased strategic focus of building our commercial & industrial loans, including owner-occupied CRE loans

and small business lending.

The Company’s regulatory commercial real estate concentration ratio decreased to 352% at March 31, 2021 as compared to 378% at December 31, 2020.

● Deposits increased by $229.3 million, or 9%, in the first quarter of 2021.

The growth in deposits came primarily from noninterest bearing or low-cost transaction, and savings accounts, while higher-cost time deposits decreased slightly.

● Short-term borrowings decreased by $125.5 million during the first quarter of 2021 to $56.5 million at March 31, 2021.

The decrease was due to a decrease in Federal Home Loan Bank (FHLB) overnight borrowings due to an increase in deposit balances.

● Total shareholders’ equity of $348.0 million at March 31, 2021 reflects an increase of $4.1 million, or 1%, relative to year-end 2020 due to capital from the $11.1 million addition of net income, a $4.1 million unfavorable swing in accumulated other comprehensive income/loss, stock options exercised, restricted stock compensation, net of $3.2 million in dividends paid.

IMPACT OF CORONAVIRUS DISEASE 2019 (COVID-19) PANDEMIC ON THE COMPANY’S OPERATIONS

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This was followed by extensions of these orders in April and many local municipalities in which the Company operates issued orders mandating additional requirements to protect their citizens.

Although many counties in California began phased reopening plans, due to recent increases in cases effective July 13, 2020, the Governor ordered that dine-in restaurants, wineries and tasting rooms, movie theaters, family entertainment centers, zoos and museums, and cardrooms immediately close all indoor operations.

Although many counties in California began phased reopening

plans, due to recent increases in cases effective July 13, 2020, the Governor ordered that dine-in restaurants, wineries and tasting rooms, movie theaters, family entertainment centers, zoos and museums, and cardrooms immediately close all indoor operations.

Effective August 31, 2020, a new simplified, four-tier guideline was implemented for counties to reopen.

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and provides a temporary reduction to the minimum ratio under the Community Bank Leverage Ratio framework.

● On December 21, 2020, the Consolidated Appropriation Act, 2021 was enacted by Congress and signed into law by the President on December 27, 2020.

Among other things, this bill provided $600 per person (subject to income limits), included $284 billion in additional forgivable loans via the PPP, extended the suspension of TDR identification, and extended the temporary delay of the implementation of CECL through January 2022.

● On March 10, 2021, the American Rescue Plan Act was enacted by Congress and signed into law by the President on March 11, 2021.

Among other things, this bill provided an additional economic impact payment of $1,400 per-person (subject to income limits), and many other economic incentives and benefits to individuals, businesses, states, municipalities, and tribal governments.

● In 2021, COVID-19 vaccinations began rolling out across the country and in California.

In early April 2021, with over 20 million vaccines administered in California, a Blueprint for a Safer Economy was announced to fully reopen the California economy on June 15, 2021, subject to certain health requirements, if two criteria are met regarding equitable vaccine availability and a consistently low burden of disease.

Impact of COVID-19 on the Company’s Operations

● The Company has had an $8.4 million increase in classified assets, including $2.1 million in non-accrual loans as a result of COVID-19 due to loans modified under the Interagency Guidance that are either not expected to make all principal and interest payments in a timely manner, or will need further modifications or assistance.

Further, we have not experienced any charge-offs as a result of COVID-19.

● The Company had $10.4 million in classified assets at March 31, 2021, from loans modified under the Interagency Guidance or CARES Act, as amended, that are either not expected to make all principal and interest payments in a timely manner, or will need further modifications or assistance.

Starting in April 2020, the Company took actions to mitigate the impact on credit losses including permitting short-term payment deferrals to current customers, as well as providing bridge loans and SBA Paycheck Protection Program (PPP) loans.

For further information on the principal and interest deferrals, please see the “Nonperforming Assets” section below.

However, the uncertainty of national and local economic conditions had a material impact on our

provision for loan and lease losses.

● The uncertainty of national and local economic conditions had an impact on our provision for loan and lease losses in 2020 and continuing into 2021.

The Company elected under Section 4014 of the CARES Act to defer the implementation of CECL until the earlier of when the national emergency related to the outbreak of COVID-19 ends or December 31, 2020.

Although this deferral will still require CECL to be implemented as of January 1, 2020, the Company believes that the deferral will provide time to better assess the impact of the COVID-19 pandemic on the expected lifetime credit losses.

In December 2020, the Consolidated Appropriations Act, 2021, extended the deferral of implementation of CECL from December 31, 2020, to the earlier of the first day of the fiscal year, beginning after the national emergency terminates or January 1, 2022.

Although this deferral will

still require CECL to be implemented as of January 1, 2022, the Company believes that the deferral will provide time to better assess the impact of the COVID-19 pandemic on the expected lifetime credit losses in our loan and lease portfolio.

The most significant unknown factor is how long economic activity will be impacted by COVID-19, and in turn how deeply that will impact the markets in which we operate.

Therefore, more time was needed to assess the impact of this economic uncertainty and related actions taken such as the stimulus provisions of the CARES Act on the Company’s allowance for loan and lease losses under the CECL methodology.

● In addition to the expected increase in provision for loan losses, the Company expects that net interest income could be adversely impacted over time given pressure on net interest margin as a result of the FOMC’s emergency rate cuts in March 2020.

For example, our net interest margin for the nine months ended September 30, 2020, was 3.97%, compared to a net interest margin of 4.20% for the same period in 2019.

New loans booked in 2020 have been at lower rates and although deposit costs have also declined, deposit costs were already low or at their floors prior to these interest rate cuts.

Further, the stay-at-home order and record unemployment resulting from the COVID-19 pandemic has reduced consumer spending which has reduced our fee income, primarily from overdraft activity.

● The COVID-19 pandemic has not adversely affected our capital or financial resources as of September 30, 2020.

During the first nine months of 2020, total shareholders’ equity increased by $27.0 million, or 9%, to $336.2 million.

A large component of this was an $11.6 million increase in accumulated other comprehensive income as a result of increases in the value of our investment portfolio due to lower interest rates.

If interest rates rise, this component of equity would be expected to decline.

In addition, the Company earned $26.5 million in net income in the first nine months of 2020 and paid dividends of $9.1 million.

The Company also declared a twenty cent per share dividend to be paid on November 12, 2020.

● The Company expects that net interest income will continue to be adversely impacted over time given pressure on net interest margin as a result of the current interest rate environment.

As described above, in March 2020, the FOMC cut short-term rates by 150 basis points to near zero.

The uncertainty with COVID-19 and the lower targeted fed funds rates also impacted other rates including the Prime Rate and treasury yields.

These lower rates impacted our net interest margin.

Our net interest margin for the three months ended March 31, 2021, was 3.93%, compared to a net interest margin of 4.13% for the same period in 2020.

New loans booked in 2021 have been at lower rates and although deposit costs have also declined, deposit costs were already low or at their floors.

● The COVID-19 pandemic has not adversely affected our capital or financial resources as of March 31, 2021.

During the first three months of 2021, total shareholders’ equity increased by $4.1 million, or 1%, to $348.0 million.

The Company earned $11.1 million in net income in the first three months of 2021, but had a $4.1 million decrease in accumulated other comprehensive income as a result of decreases in the value of our investment portfolio due to an uptick in interest rates.

The Company also paid dividends of $3.2 million during the first quarter of 2021.

On April 15, 2021, the Company declared a twenty-one cent per share dividend to be paid on May 12, 2021.

Although presently not expected, if the Company were to incur significant credit losses as a result of COVID-19’s impact on our customers’ ability to repay loans, capital could be adversely impacted.

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However, we do not anticipate any significant changes in methodology used to determine the fair value of assets measured in accordance with GAAP.

As of September 30, 2020, our goodwill was not impaired.

The Company performed a qualitative assessment of its goodwill at September 30, 2020 and concluded that it was not more likely than not that a goodwill impairment exists.

The Company will continue to monitor its goodwill recorded on the balance sheet for potential impairment.

As of March 31, 2021, our goodwill was not impaired.

The Company last performed an assessment of potential impairment to its goodwill at December 31, 2020 and concluded that it was not more likely than not that a goodwill impairment exists.

The Company continues to monitor its goodwill recorded on the balance sheet for potential impairment and did not believe there was any event that would trigger a potential impairment in the first quarter of 2021.

In the event that we conclude that all or a portion of our goodwill is impaired, a non-cash charge for the amount of such impairment would be recorded to earnings.

At September 30, 2020, we had goodwill of $27.4 million which represented 8% of total equity.

At March 31, 2021, we had goodwill of $27.4 million which represented 8% of total equity.

● The Company continues to serve its customers.

Out of our 40 branch locations, four are open with limited lobby hours, while 8 branches have limited lobby hours and a drive-up or walk-up facility.

23 branches are open for drive-up or walk-up only and five branches are currently closed except by appointment.

Out of our 40 branch locations, four are open with drive-up only access, and five branches are currently closed except by appointment.

Approximately 45% of our back-office and corporate employees are working remotely and it has not adversely affected our operations.

In addition, none of our internal controls have changed or are expected to change as a result of the remote work arrangements other than the use of remote approvals.

The Company is prepared to continue operating in this manner until it is safe to begin bringing those working remotely back to our corporate offices and branches.

The Company is preparing to bring all the branch locations back to normal operating hours in the next 30 days and is analyzing the return of the corporate office staff over the next 90 days.

As a result of a change in customer behaviors brought about by the COVID-19 pandemic along with an efficiency review, the Company has decided to permanently close five branch locations effective June 18, 2021.

Many of our customers have found an added convenience and ease of transacting business through online and mobile banking services which precipitated our decision to close locations where in-person transaction volumes no longer warranted a traditional brick-and-mortar branch.

The acceleration of leasehold improvements for these locations increased depreciation expense by $0.1 million in the first quarter of 2021 and is expected to increase depreciation expense by an additional $0.4 million in the second quarter of 2021.

Further, it is anticipated that there will be additional amortization expense of $0.2 million related to the

right of use asset from lease cancellations.

It is projected that closing these five branch locations will result in annual noninterest expense savings of between $0.8 and $1.0 million.

● To date, the Company did not experience any challenges in implementing its business continuity plans.

The Company’s Risk Management team began preparing in late January and early February with ordering of supplies such as hand sanitizer, masks and cleaning supplies, as well as laptops for those who did not have one.

The Company’s Risk Management team began preparing in early 2020, with ordering of supplies such as hand sanitizer, masks and cleaning supplies, as well as laptops for those who did not have one.

This enabled the Company to immediately communicate and implement plans to continue operations in our banking facilities while enabling those non-customer facing employees to immediately begin working remotely.

The Company did not face any material resource constraints in implementing these plans.

● As a financial institution providing essential services, the Company expects continued demand for loans and deposits.

As described above, it is expected that certain services may see declines in demand such as debit and credit card interchange given lower consumer spending.

While overall net income is expected to decline, it presently is more a function of the interest rate environment than a change in overall demand for loan and deposit products.

● As a financial institution providing essential services, the Company expects continued demand for loans and deposits, albeit at a much slower pace than in 2020 for mortgage warehouse utilization and SBA PPP loan demand.

In addition, it is expected that the Company’s strategic shift to focus more on loan categories other than non-owner occupied real estate will result in lower overall loan originations in 2021 than in 2020.

It is further expected that certain services may see continued declines in demand for certain deposit services, such as debit and credit card interchange, given lower consumer spending.

● The Company loosened its vacation and sick-time policies to accommodate our employees who were affected by COVID-19.

The Company has not had any temporary or permanent reductions in staff as a result of COVID-19.

The Company has hired an additional 28 temporary employees throughout the pandemic related to higher demand for loan processing and forgiveness, and to provide enhanced customer service.

It is expected that the number of temporary employees will begin to decline through the second and third quarters of 2021.

EARNINGS PERFORMANCE

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The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money.

The second is noninterest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance.

The second is noninterest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance and certain non-debt investments.

The majority of the Company’s noninterest expense is comprised of operating costs that facilitate offering a broad range of banking services to our customers.

NET INTEREST INCOME AND NET INTEREST MARGIN

Net interest income increased $3.7 million to $28.1 million, for the third quarter of 2020 over the third quarter of 2019, and increased $3.5 million to $76.0 million for the first nine months of 2020 relative to the same period in 2019.

For the third quarter of 2020, growth in average interest-earning assets totaled $452.8 million, or 19%, as compared to the third quarter of 2019.

Although the yield on these balances was 56 basis points lower for the same period, the decrease in our cost of interest-bearing liabilities for the same period was 66 basis points resulting in an overall decline in margin of 11 basis points.

Net interest income for the comparative year-to-date periods increased $3.5 million as the increase in volume of interest earning assets and favorable change in our deposit mix more than made up for the decrease in margin.

Net interest income increased $4.8 million to $28.6 million, for the first quarter of 2021 over the first quarter of 2020.

For the first quarter of 2021 as compared to the same quarter in 2020, average loan balances increased $658.5 million, primarily due to increases in real estate loans of $484.4 million, mortgage warehouse lines of $98.2 million and SBA PPP loans of $109.7 million contributing to the $4.3 million increase in loan interest income, however the volume increase was offset by lower yields.

Overall, there was a decline of 68 bps in loan yield for the quarter ending March 31, 2021 as compared to the same period in 2020.

Offsetting declines in yield on earnings assets, there was a 40 bps decrease in the cost of interest-bearing liabilities for the same period.

The level of net interest income we recognize in any given period depends on a combination of factors including the average volume and yield for interest earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities.

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For the three months ended

September 30, 2020

September 30, 2019

Rate/Yield (2)

Federal funds sold/due from time

Total investments

Loans and leases:

Mortgage warehouse lines

Total loans and leases

Total interest earning assets (4)

Other earning assets

Non-earning assets

Liabilities and shareholders' equity

Interest bearing deposits:

Demand deposits

Savings accounts

Certificates of deposit, under $100,000

Certificates of deposit, $100,000 or more

Brokered deposits

Total interest bearing deposits

Borrowed funds:

Federal funds purchased

Repurchase agreements

Short term borrowings

Total borrowed funds

Total interest bearing liabilities

Demand deposits - noninterest bearing

Other liabilities

Shareholders' equity

Total liabilities and shareholders' equity

Interest income/interest earning assets

Interest expense/interest earning assets

Net interest income and margin (5)

(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.

(2) Yields and net interest margin have been computed on a tax equivalent basis utilizing a 21% effective tax rate.

(3) Loans are gross of the allowance for possible loan losses.

Loan fees have been included in the calculation of interest income.

Net loan fees and loan acquisition FMV amortization were $1,302 thousand and $(137) thousand for the quarters ended September 30, 2020 and 2019, respectively.

(4) Non-accrual loans have been included in total loans for purposes of computing total earning assets.

(5) Net interest margin represents net interest income as a percentage of average interest-earning assets.

Average Balances and Rates

(dollars in thousands, unaudited)

For the nine months ended

September 30, 2020

September 30, 2019

March 31, 2021

March 31, 2020

Rate/Yield (2)

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Loan fees have been included in the calculation of interest income.

Net loan fees and loan acquisition FMV amortization were $942 thousand and $(314) thousand for the nine months ended September 30, 2020 and 2019, respectively.

Net loan fees and loan acquisition FMV amortization were $1.4 million and $(0.1) million for the quarters ended March 31, 2021 and 2020, respectively.

(4) Non-accrual loans have been included in total loans for purposes of computing total earning assets.

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(dollars in thousands, unaudited)

Three months ended September 30,

Nine months ended September 30,

2020 over 2019

Three months ended March 31,

2021 over 2020

Increase (decrease) due to

Federal funds sold/due from time

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Net interest income

The volume variance calculated for the third quarter of 2020 relative to the third quarter of 2019 was a favorable $6.0 million due to higher average balances of interest-earning assets, resulting from organic growth in commercial real estate loans, growth in commercial loans due to our participation in the SBA PPP program and higher utilization of mortgage warehouse lines.

Given the low rate environment, loan demand for our mortgage warehouse lines have increased, as demonstrated by the $0.9 million favorable volume variance.

The volume variance calculated for the first three months of 2021 relative to the first three months of 2020 was a favorable $7.6 million due to higher average balances of interest earning assets, resulting from organic growth in commercial real estate loans, growth in commercial loans due to our participation in the SBA PPP program and higher utilization of mortgage warehouse lines.

There was an unfavorable rate variance of $2.9 million for the comparative quarters since the weighted average yield on interest earning assets fell by 47 basis points and the weighted average cost of interest-bearing liabil ities decreased by 40 basis points.

The rate variance was negatively impacted by the following factors:

A shift in our earning asset mix into lower-yielding loans and investments;

line utilization of mortgage warehouse lines, $123.62 million in low-yielding SBA PPP loans;

partially offset by lower costs of time-deposits and other interest-bearing liabilities.

rate cuts by the FOMC in March 2020 and resulting lower rates and yields given the uncertainty of the pandemic, new loans and investments having lower yields overall, including an increase in low-yielding SBA PPP loans.

These negative factors were partially offset by an increase in loans overall as a percent of overall earning assets, as well as lower costs of time-deposits and other interest-bearing liabilities.

The average fees on the SBA PPP loans was approximately 5.5%.

These fees, net of loan costs, are being accreted over the stated life of the loan (generally two years), net of loan costs.

Our customers with an SBA PPP loan are generally eligible to apply for loan forgiveness after 24 weeks, however there is pending legislation regarding the forgiveness process that could impact loans of less than $150,000.

These fees, net of loan costs, are being accreted over the stated life of the loan (generally two years for PPP loans generated in 2020 and 5 years for PPP loans generated in 2021), net of loan costs.

Our customers with an SBA PPP loan are generally eligible to apply for loan forgiveness after 24 weeks.

After the 24-week covered period, PPP borrowers have ten months to apply for forgiveness.

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If a loan is forgiven, upon repayment of principal and interest by the SBA, any unaccreted fee income, net of unamortized costs, would be recognized as interest income at such time.

The volume variance calculated for the first nine months of 2020 relative to the first nine months of 2019 reflects a favorable variance of $9.3 million and an unfavorable rate variance of $5.8 million.

As with the discussion of the volume and rate variances for the quarter, the same is true for the first nine months.

The growth in interest earning assets was offset by the 61 basis point decrease in yield while interest bearing liabilities increased $63.7 million with a 54 basis point drop in cost.

The decrease in rate on interest bearing liabilities more than offset the net volume/rate decrease in interest earning assets and resulted in a favorable $3.5 million net volume/rate difference.

The Company’s net interest margin for the first nine months of 2020 was 3.97%, as compared to 4.20% in the first nine months of 2019.

The FOMC lowered rates by a total of 150 basis points in March 2020 in two separate emergency actions.

These actions have had an unfavorable impact on our net interest margin for the quarter and year to date periods as compared to the same period in 2019, and will most likely have the same unfavorable impact on net interest margin through the end of 2020.

At September 30, 2020, approximately 12% of our total portfolio, or $273.7 million, consists of variable rate loans.

Of these variable rate loans, approximately $93.9 million have floors that limited the overall reduction in rates in the first nine months.

At September 30, 2020, our outstanding fixed rate loans represented 28% of our loan portfolio.

The remaining 60% of our loan portfolio at September 30, 2020 consists of adjustable rate loans.

However, the majority of these loans (approximately $1.1 billion) will not adjust for at least another 3 years.

The decrease in rate on interest earning assets was less than the net volume/rate decrease in interest bearing liabilities and resulted in a favorable $4.8 million net volume/rate difference.

The Company’s net interest margin for the first three months of 2021 was 3.93%, as compared to 4.13% in the first three months of 2020.

As described above, a lower rate environment precipitated by two interest rate cuts by the Federal Open Market Committee totaling 150 bps in March 2020 and other economic uncertainty negatively impacted our yield on existing adjustable and variable rate portfolio loans and created a lower initial interest rate for new loan volumes.

At March 31, 2021, approximately 10% of our total portfolio, or $226.2 million, consists of variable rate loans.

Of these variable rate loans, approximately $84.1 million have floors that limited the overall reduction in rates.

At March 31, 2021, our outstanding fixed rate loans represented 22% of our loan portfolio.

The remaining 68% of our loan portfolio at March 31, 2021 consists of adjustable rate loans.

However, the majority of these loans (approximately $1.2 billion) will not begin adjusting for at least another 3 years.

Approximately $70.1 million of these adjustable rate loans will reprice in the next quarter.

In addition, as described below under Nonperforming Assets, as of September 30, 2020, the Company has modified approximately $405.9 million of loans under either Section 4013 of the CARES Act or the April 7, 2020 Interagency statement that offered some practical expedients for loan modifications.

These modifications generally provide for a six-month deferral of both interest and principal.

As of September 30, 2020, there is approximately $9.0 million of accrued but uncollected interest related to such modifications.

If a portion of this interest is uncollectible, it could be partially or fully written off and could impact interest income recognition in future quarters.

Cash balances were increased on September 30, 2020 in anticipation of mortgage warehouse line utilization.

For the quarterly comparisons, average volumes were lower than the same period in 2019 mitigating the unfavorable net volume and rate variance however, for the year to date comparisons the average volume was higher contributing to the unfavorable net volume rate variance since cash balances earned considerably lower yields than other earning assets.

It is expected that these balances will return to more normalized levels towards the end 2020 when the normal seasonal volatility reduces the utilization on mortgage warehouse lines.

Overall average investment securities decreased by $2.3 million for the quarter ending September 30, 2020 as compared to September 30, 2019 and by $28.5 million for the first nine months of 2020, as compared to the same period in 2019.

Average non-taxable securities increased for both the quarterly and first nine month periods by $58.2 million and $59.5 million respectively.

The overall investment portfolio had a tax-equivalent yield of 2.74% at September 30, 2020, with an average life of 4.2 years.

Interest expense was $1.0 million in the third quarter of 2020, a decline of $2.6 million, or 73%, compared to the third quarter of 2019 and was $4.5 million in the first nine months of 2020, a decline of $6.1 million or 58%, compared to the first nine months of 2019.

The significant decline in interest expense for both the quarter and the first nine months is attributable to a favorable shift in deposit mix as average total time deposits declined by $86.7 million in the third quarter of 2020 as compared to the same quarter in 2019 and by $60.9 million for the first nine months of 2020 as compared to the same period in 2019.

The average cost of interest-bearing deposits declined by 62 basis points, or 79%,

to 16 basis points for the third quarter of 2020 compared to the third quarter of 2019, and by 51 basis points, or 64% to 29 basis points for the first nine months of 2020 as compared to the same period in 2019.

Cash balances have increased on March 31, 2021 as compared to December 31, 2020 due to the increase in deposit balances and lower loan balances in the first quarter of 2021.

For the quarterly comparisons, there was an unfavorable net volume rate variance since cash balances earned considerably lower yields than other earning assets.

Overall average investment securities decreased by $60.2 million for the quarter ending March 31, 2021 as compared to March 31, 2020.

For the three months ending March 31, 2021 over the same period for 2020, average non-taxable securities increased $31.4 million and taxable securities decreased $91.6 million.

The overall investment portfolio had a tax-equivalent yield of 2.66% at March 31, 2021, with an average life of 4.5 years.

Interest expense was $0.9 million in the first quarter of 2021, a decline of $1.4 million, or 60%, compared to the first quarter of 2020.

The significant decline in interest expense for the quarterly comparisons is attributable to a favorable shift in deposit mix as average noninterest bearing demand deposits increased $298.5 million in the first quarter of 2021 as compared to the same quarter in 2020.

Lower cost transaction, savings and money market accounts increased $267.2 million in the first quarter of 2021 as compared to the same quarter in 2020.

The average cost of interest-bearing deposits declined by 36 basis points, or 72%, to 14 basis points for the first quarter of 2021 compared to the first quarter of 2020.

PROVISION FOR LOAN AND LEASE LOSSES

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The Company sets aside an allowance for loan and lease losses, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for loan and lease losses.

The Company recorded a loan loss provision of $2.4 million in the third quarter of 2020 compared to $1.4 million in the third quarter of 2019, and a year-to-date loan loss provision totaling $6.4 million in 2020 as compared to $2.1 million for the comparable period in 2019.

As discussed above, the significant increase in the provision for loan and lease losses is primarily due to organic loan growth in non-owner occupied real estate loans and management’s estimate of the impact of increased economic uncertainty with respect to COVID-19 on our customers’ ability to repay loans.

There was no increase in the provision for loan and lease losses due to the additional $123.6 million in SBA PPP loans as those loans are guaranteed under a new loan program titled the “Paycheck Protection Program” and carry a full guarantee by the SBA, subject to the financial institution meetings its Bank Secrecy Act obligations and other diligence requirements in making such loans.

Management adjusted its qualitative risk factors under our incurred loss model based on information presently available for economic conditions, changes in payment deferral procedures, expected changes in collateral values due to reduced cash flows, and external factors such as government actions.

In particular, the uncertainty regarding our customers’ ability to repay loans could be adversely impacted by COVID-19 given higher unemployment rates, requests for payment deferrals, temporary business shut-downs, and reduced consumer and business spending.

The Company was subject to the adoption of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-13 and related amendments, Financial Instruments – Credit Losses (Topic 326).

The Company recorded a loan loss provision of $0.3 million in the first quarter of 2021 compared to $1.8 million in the first quarter of 2020.

The decrease in provision for loan and lease losses is due to a decrease in loan balances and the receipt of net loan recoveries for the first three months of 2021.

There was no provision for loan and lease losses, or related allowance for loan and leases losses, associated with the SBA PPP loans as those loans carry a full guarantee by the SBA, subject to the financial institution meetings its Bank Secrecy Act obligations and other diligence requirements in making such loans.

Management also evaluated its qualitative risk factors under our current incurred loss model and adjusted for changes as deemed appropriate in the current environment.

These qualitative risk factors accounted for the majority of the provision expense in both the first quarter of 2020 and in the first quarter of 2021.

As described above, the Company was subject to the adoption of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-13 and related amendments, Financial Instruments – Credit Losses (Topic 326).

However, the Company elected under Section 4014 of the CARES Act to defer the implementation of CECL until the earlier of when the national emergency related to the outbreak of COVID-19 ends or December 31, 2020.

Although this deferral will still require CECL to be adopted as of January 1, 2020, the Company believes that the deferral will provide time to better assess the impact of the COVID-19 pandemic on the expected lifetime credit losses.

There is increased uncertainty on the local, regional, and national economy as a result of local and state stay-at-home orders, as well as relief measures provided at a national, state, and local level.

In addition, COVID-19 case rates appear to be increasing throughout the United States, which may trigger a tightening of government restrictions.

Further, the Company has taken actions to mitigate the impact on credit losses including permitting short-term payment deferrals to current customers, as well as providing bridge loans and SBA PPP loans.

More time is needed to assess the impact of this uncertainty and related actions on the Company’s allowance for loan and lease losses under the CECL methodology.

The current estimate is that a one-time adjustment to the allowance will be booked as an adjustment through equity, net of taxes, as previously disclosed in Company’s Form 10-K for the fiscal year ended December 31, 2019, for approximately $12 million.

The impact of COVID-19 on the Company’s allowance for loan and leases losses under the CECL methodology in the third quarter and first nine months of 2020 will remain unknown until more information is available with respect to the impact of the economic uncertainty of the impact of COVID-19, net of actions taken to mitigate such impact.

Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance.

The Company recorded net charge-offs of $0.3 million in the third quarter of 2020 as compared to net charge-offs of less than $0.1 million in the third quarter of 2019.

For the first nine months, net charge-offs were $0.7 million in 2020 and $0.6 million in 2019.

The Consolidated Appropriations Act, 2021 extended the deferral of implementation of CECL to the earlier of the first day of the fiscal year, beginning after the national emergency terminates or January 1, 2022.

The Company has elected this deferral to provide time to better assess the impact of the COVID-19 pandemic and changing economic forecasts on the expected lifetime credit losses.

It is expected that the Company’s Allowance for Credit Loss under CECL will be approximately 50% higher than the current Allowance for Loan and Lease Losses, with the initial adjustment being recorded as an adjustment to equity, as previously disclosed in the Company’s Form 10-K for the fiscal year ended December 31, 2020.

If the CECL adjustment is to increase the current Allowance for Loan and Lease Losses by 50% at 1/1/2022, the adjustment to equity will also be adjusted for income taxes, causing a net decrease to equity of approximately $5.8 million to $6.5 million.

This adjustment is not expected to immediately impact our regulatory capital ratios given the Interagency Guidance to phase-in the CECL adjustment as adopted in 2020.

At this time, the Company is not anticipating any need to raise capital due to the CECL implementation.

The Company has taken actions to mitigate the impact on credit losses including permitting short-term payment deferrals to current customers, as well as providing bridge loans and SBA PPP loans.

As described below under Nonperforming Assets, since April 2020, the Company modified approximately $425.9 million of loans under either Section 4013 of the CARES Act or the April 7, 2020 Interagency statement that offered some practical expedients for loan modifications.

These modifications generally provided for a six-month deferral of both interest and principal and the vast majority of the customers on deferral resumed making scheduled payments upon the expiration of the deferral.

As of March 31, 2021, the Company had $22.4 million in remaining loan modifications;

all but two small balance consumer loans are fully secured by real estate.

The Company expects that all customers show an ability and willingness to pay full principal and interest upon maturity of their deferment period.

These deferrals had an impact on how the Company internally grades its loans and as such had an impact on the overall provision under the incurred loss method.

The performance on these loans after the end of the deferral period could impact future provision.

Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance, with subsequent recoveries reflected as an increase to the allowance.

The Company recorded net recoveries of $0.3 million in the first quarter of 2021 as compared to net charge-offs of $0.3 million for the comparative period of 2020.

The allowance for loan and lease losses is at a level that, in Management’s judgment, is adequate to absorb probable loan losses related to specifically identified impaired loans as well as probable incurred losses in the remaining loan portfolio.

appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan loss provision, and consequently in our net earnings.

The Company’s policies for monitoring the adequacy of the allowance, determining loan balances that should be charged off, and other detailed information with regard to changes in the allowance are discussed in Note 11 to the consolidated financial statements, and below, under “Allowance for Loan and Lease Losses.” The process utilized to establish an appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan loss provision, and consequently in our net earnings.

NONINTEREST INCOME AND NONINTEREST EXPENSE

The following table provides details on the Company’s noninterest income and noninterest expense for the three and nine month periods ended September 30, 2020 and 2019:

The following table provides details on the Company’s noninterest income and noninterest expense for the three periods ended March 31, 2021 and 2020:

Noninterest Income/Expense

(dollars in thousands, unaudited)

For the three months ended September 30,

For the nine months ended September 30,

For the three months ended March 31,

Noninterest income:

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As a % of average interest earning assets (1)

OTHER OPERATING EXPENSE:

Noninterest expense:

Salaries and employee benefits

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(3) Noninterest expense as a percentage of the sum of net interest income and noninterest income excluding net gains (losses) from securities and bank owned life insurance income.

Total noninterest income reflects increases of $1.2 million, or 21%, for the quarterly comparison and $2.5 million, or 14% for the year-to-date comparison.

BOLI income increased by $0.7 million as compared to the third quarter of 2019 and increased $0.4 million for the first nine months of 2020 as compared to the same period in 2019.

These variances are due mostly to fluctuations in underlying values of assets in the specific account BOLI policies that are designed to have similar assets to those in the deferred compensation plans.

Thus, the higher quarterly and year to date values in BOLI policies are offset by higher deferred compensation expense reflected primarily in director fees expense for the first nine months of 2020 compared to 2019.

At September 30, 2020, there was $43.0 million in BOLI policies associated with the deferred compensation plans and $9.1 million in separate account BOLI policies.

Complementing

the change in BOLI income for the quarterly and year to date comparison was a $0.8 and $1.4 million increase respectively, in other noninterest income due to the wrap up of a low- income housing tax credit fund.

We also had a $0.4 million gain in the year to date comparison on the sale of debt securities.

There was a $0.3 million decrease in service charges on deposit accounts mostly from lower returned items and overdraft fees for the quarterly comparison and $0.6 million decrease for the year to date comparison.

The Company expects that service charges on deposit accounts could continue to decline for the remainder of the year based on reduced customer activity.

Additionally in the “other” category of noninterest income the Company reflected a $0.2 million increase in the year to date comparison from the valuation of restricted stock held by the Company as required under FASB ASU 2016-01.

This stock is related to an equity investment in Pacific Coast Bankers’ Bank and is adjusted when financial information becomes available, generally in the late first quarter of each year.

Further, noninterest income includes a valuation adjustment related to investments in low-income housing credit investments.

This valuation adjustment was a reduction of income of $0.7 million in the third quarters of 2020 and 2019, and $1.0 million in the first nine months of 2020 compared to $1.6 million in 2019.

Total noninterest expense increased by $2.2 million, or 13%, in the third quarter of 2020 relative to the third quarter of 2019, and by $2.6 million, or 5%, in the first nine months of 2020 as compared to the first nine months of 2019.

Noninterest expense dropped to 2.7% of average earning assets in the third quarter of 2020 from 2.83% for the third quarter of 2019 and was 2.85% of average earning assets for the first nine months of 2020 relative to 3.01% for the first nine months of 2019.

Salaries and Benefits were $0.9 million, or 10%, higher in the third quarter of 2020 as compared to the third quarter of 2019 and $2.1 million higher for the first nine months of 2020 compared to the same period in 2019.

The reason for this increase is due to several factors, including merit increases for employees due to annual performance evaluations for 2019.

These increases were augmented for the quarterly comparison by the impact of deferred salaries related to loan origination costs, which were $0.1 million lower however, they were $0.4 million higher for the first nine months of 2020 as compared to the same period in 2019 offsetting some of the increase.

There have not been any permanent or temporary reductions in employees as a result of COVID-19.

Occupancy expenses were roughly the same for the respective comparative periods.

Further, other noninterest expense categories as a whole was $1.2 million higher for the third quarter 2020 as compared to the third quarter in 2019 but was $0.4 million higher for the first nine months of 2020 as compared to the same period in 2019.

The variance for the third quarter of 2020 compared to the same period in 2019 was primarily driven by a $0.6 million increase in loan servicing expense, due mostly to write-downs of other real estate owned assets;

a $0.5 million increase in professional services;

partially offset by a $0.3 million decrease in advertising costs.

The $0.5 million change in professional services includes a $0.2 million increase in FDIC assessments due to the Small Bank Assessment credits applied against FDIC deposit insurance costs in the comparative quarter for 2019, a $0.5 million increase in deferred compensation expense for directors, which is linked to the changes in BOLI income, and a $0.2 million reduction in consulting costs.

The Company continues to actively consider a variety of operational efficiency opportunities.

For the first nine months of 2020, the $0.4 million increase in other noninterest expense was driven by a $0.6 million increase in loan services costs (mostly in foreclosed assets), a $0.3 million increase in deposit services costs, a $0.2 million increase in sundry losses, partially offset by a $0.5 million decrease in advertising costs and a $0.2 million decrease in professional services expense.

The Company’s tax-equivalent efficiency ratio was 53.74% in the third quarter 2020 as compared to 55.64% in the same quarter of 2019, and 56.64% for the first nine months of 2020 and 57.51% for the comparative period in 2019.

Noninterest Income:

Total noninterest income reflected an increase of $0.7 million, or 12%, for the quarter ended March 31, 2021 as compared to the same quarter in 2020 due mostly to higher BOLI income and an increase in the other noninterest income category.

BOLI income increased by $0.5 million as compared to the same quarter of 2020.

This BOLI variance was due mostly to fluctuations in underlying values of assets in the specific account BOLI policies that are designed to have similar assets to those in the deferred compensation plans.

Thus, the higher values in BOLI policies are offset by higher deferred compensation expense reflected primarily in director fees expense.

At March 31, 2021, there was $43.5 million in BOLI policies associated with the deferred compensation plans and $9.8 million in separate account BOLI policies.

Additionally, in the “other” category of noninterest income the Company reflected a $0.4 million increase in the first quarter of 2021 as compared to the first quarter of 2020 the valuation of restricted stock held by the Company as required under FASB ASU 2016-01.

This stock is related to an equity investment in Pacific Coast Bankers’ Bank and is adjusted when financial information and an updated valuation report becomes available, generally in the late first quarter of each year.

Offsetting the above increases, there was a $0.4 million decrease in service charges on deposit accounts mostly from lower returned items and overdraft fees for the quarter ending March 31, 2021 over the comparable period in 2020.

Customer spending behaviors have changed since the onset of the COVID-19 pandemic, reducing disbursement activity that creates overdrafts.

It is unknown how long this trend will continue.

Noninterest Expense:

Total noninterest expense increased by $2.5 million, or 14%, in the first quarter of 2021 relative to the first quarter of 2020.

Noninterest expense dropped to 2.8% of average earning assets in the first quarter of 2021 from 3.1% for the first quarter of 2020 and the tax-equivalent efficiency ratio improved to 56.43 % in the first quarter of 2021 as compared to 58.88% in the same quarter of 2020.

The efficiency ratio represents total noninterest expense divided by the sum of fully tax-equivalent net interest and noninterest income;

the provision for loan losses and investment gains/losses are excluded from the equation.

Given the expected decline in net interest income due to the lower rate environment in 2020, it is expected that the efficiency ratio could increase in the remaining months of 2020.

The Company continues to actively consider a wide variety of operational efficiency opportunities, however with softening loan demand and reduced noninterest income further improvement of the efficiency ratio is difficult to predict.

Salaries and Benefits were $1.0 million, or 10%, higher in the first quarter of 2021 as compared to the same quarter in 2020.

The reason for the increase is merit increases for employees due to annual performance evaluations for 2021 and the addition of and a focus on hiring higher-level staff and management.

Salary expense deferrals related to loan originations were $0.4 million lower in the first quarter of 2021 as compared to the same quarter in 2020.

Occupancy expenses were $0.2 million higher for the first quarter of 2021 as compared to the first quarter of 2020.

We experienced higher depreciation expense related to an acceleration of expense associated with the branch closures as described further below.

In addition, we incurred higher janitorial costs due to intermittent COVID-19 sanitization of facilities.

Further, other noninterest expense categories were $1.3 million higher for the first quarter 2021 as compared to the first quarter in 2020.

The Company experienced increases in every expense category except advertising and marketing.

Advertising and marketing declined due to the COVID-19 pandemic as much of our in-person marketing efforts were temporarily suspended.

The principal increases were in data processing for $0.3 million due to increased network security and additional software required for the efficient processing of SBA PPP loans, a $0.3 million increase in debit card processing costs, $0.1 million increase in foreclosed asset expenses, an increase in FDIC assessments for $0.2 million, as the first quarter of 2020 included Small Bank Assessment credits applied against the FDIC deposit insurance assessment, a $0.3 million increase in directors deferred compensation expense, which is linked to changes in BOLI income, a $0.1 million increase in debit card losses, and other costs associated with five branch closures scheduled for June 2021 as discussed in the paragraph below.

As a result of an ongoing COVID-19 pandemic, several of our branch lobbies were closed throughout the pandemic.

Many of these lobbies have reopened, but a few remain closed.

As a result a change in customer behaviors brought about by the COVID-19 pandemic along with an efficiency review, the Company has decided to permanently close five branch locations outside of our primary market area, effective June 18, 2021.

Many of our customers have found an added convenience and ease of transacting business through online and mobile banking services which precipitated our

decision to close locations where in-person transaction volumes no longer warranted a traditional brick-and-mortar branch.

The acceleration of amortization of leasehold improvements for these locations increased depreciation expense by $0.1 million in the first quarter of 2021 and is expected to increase depreciation expense by an additional $0.4 million in the second quarter of 2021.

Further, it is anticipated that there will be additional lease expense of $0.2 million related to right of use asset due to lease cancellations.

It is projected that closing these five branch locations will result in annual noninterest expense savings, realized fully by the end of the fourth quarter 2021, of between $0.8 and $1.0 million.

PROVISION FOR INCOME TAXES

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Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds.

The Company’s provision for income taxes was 23.4% of pre-tax income in the third quarter of 2020 relative to 24.2% in the third quarter of 2019, and 23.5% of pre-tax income for the first nine months of 2020 relative to 24.9% for the same period in 2019.

The decrease for the 2020 quarterly comparison is due primarily to an increase in partially tax exempt municipal bond interest and tax exempt BOLI income.

The comparison for the first nine months of 2020 as compared to the same period in 2019 was positively impacted for the same reasons as the quarterly comparison.

The Company’s provision for income taxes was 25.47% of pre-tax income in the first quarter of 2021 relative to 24.02% in the first quarter of 2020.

The increase in the effective tax rate for the first quarter of 2021 is due to tax credits and tax-exempt income representing a smaller percentage of total taxable income.

BALANCE SHEET ANALYSIS

EARNING ASSETS

The Company’s interest-earning assets are comprised of investments and loans, and the composition, growth characteristics, and credit quality of both of those components are significant determinants of the Company’s financial condition.

The Company’s interest earning assets are comprised of loans and investments, including overnight investments and surplus balances held in interest earning accounts in our Federal Reserve Bank account.

The composition, growth characteristics, and credit quality of both of those components are significant determinants of the Company’s financial condition.

Investments are analyzed in the section immediately below, while the loan and lease portfolio and other factors affecting earning assets are discussed in the sections following investments.

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and 5) they can provide partially tax exempt income.

The investment portfolio is reflected on the balance sheet as investment securities and totaled $552.9 million, or 17% of total assets at March 31, 2021, and $544.0 million, or 17% of total assets at December 31, 2020.

In addition, within the Cash and Due from Banks account on the balance sheet was $268.4 million of surplus interest earning balances in our Federal Reserve Bank account at March 31, 2021, as compared to $3.5 million at December 31, 2020.

Surplus balances in our Federal Reserve Bank account and fed funds sold to correspondent banks typically represent the temporary investment of excess liquidity.

Aggregate investments totaled $581.9 million, or 18% of total assets at September 30, 2020, and $615.3 million, or 24% of total assets at December 31, 2019.

The Company carries investments at their fair market values.

We currently have the intent and ability to hold our investment securities to maturity, but the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management.

The expected average life for bonds in our investment portfolio was 4.2 years and their average effective duration was 2.5 years at September 30, 2020, down from an expected average life of 4.4 years and an average effective duration of 3.2 years at year-end 2019.

The expected average life for bonds in

our investment portfolio was 4.5 years and their average effective duration was 3.0 years at March 31, 2021, up from an expected average life of 4.2 years and an average effective duration of 2.4 years at year-end 2020.

The following table sets forth the amortized cost and fair market value of Company’s investment portfolio by investment type as of the dates noted:

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(dollars in thousands, unaudited)

September 30, 2020

March 31, 2021

December 31, 2020

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Total securities

The net unrealized gain on our investment portfolio, or the amount by which aggregate fair market values exceeded amortized cost, was $24.8 million at September 30, 2020, a $16.4 million increase relative to the net unrealized gain of $8.4 million at December 31, 2019.

The change was caused by declining long-term market interest rates on fixed-rate bond values.

Municipal bond balances comprise 40% of our total securities portfolio at September 30, 2020, as compared to 31% at December 31, 2019.

The net unrealized gain on our investment portfolio, or the amount by which aggregate fair market values exceeded amortized cost, was $20.4 million at March 31, 2021, a $5.7 million decrease relative to the net unrealized gain of $26.1 million at December 31, 2020.

The change was caused by increased long-term market interest rates on fixed-rate bond values.

Municipal bond balances comprise 42% of our total securities portfolio at March 31, 2021, as compared to 42% at December 31, 2020.

Municipal bonds purchased have strong underlying ratings, and we review all municipal bonds in our portfolio every quarter for potential impairment.

Investment securities that were pledged as collateral for borrowings and/or potential borrowings from the Federal Home Loan Bank and the Federal Reserve Bank, repurchase agreements, and other purposes as required or permitted by law totaled $238.2 million at September 30, 2020 and $234.8 million at December 31, 2019, leaving $339.1 million in unpledged debt securities at September 30, 2020 and $366.0 million at December 31, 2019.

Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $61.7 million at September 30, 2020 and $71.0 million at December 31, 2019.

Investment securities that were pledged as collateral for borrowings and/or potential borrowings from the Federal Home Loan Bank and the Federal Reserve Bank, customer repurchase agreements, and other purposes as required or permitted by law totaled $246.7 million at March 31, 2021 and $232.0 million at December 31, 2020, leaving $306.3 million in unpledged debt securities at March 31, 2021 and $312.0 million at December 31, 2020.

Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $53.8 million at March 31, 2021 and $52.9 million at December 31, 2020.

LOAN AND LEASE PORTFOLIO

Gross loans and leases reflect a net increase of $617.7 million, or 35%, growing to $2.380 billion at September 30, 2020 from $1.763 billion at December 31, 2019 due to organic growth in non-owner occupied commercial real estate loans, an increase in commercial and industrial loans from our participation in the SBA PPP program and an increase in outstanding balances on mortgage warehouse lines.

A distribution of the Company’s loans showing the balance and percentage of loans by type is presented for the noted periods in the table below.

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(dollars in thousands, unaudited)

September 30, 2020

March 31, 2021

December 31, 2020

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Total loans and leases

For the first nine months of 2020, gross loans were up by $617.7 million, or 35%, including increases of $98.4 million in mortgage warehouse lines, $437.8 million increase in non-agricultural real estate loans, and a $101.7 million increase in commercial and industrial loans.

Mortgage warehouse loan balances increased due to market factors favorably impacting line utilization due to both mortgage originations and refinancing activity.

Mortgage warehouse utilization was 61.4% at September 30, 2020, as compared to 58.7% at December 31, 2019.

Future utilization of the mortgage warehouse lines could be impacted if the economic impacts of the COVID-19 pandemic reduce the demand for mortgages.

Non-agricultural real estate loan balances increased due to deliberate and concentrated efforts of our Northern and Southern market loan production teams.

The growth in these markets was mostly due to commercial real estate and was the primary driver of our $532.8 million increase in non-owner occupied commercial real estate loans.

Residential real estate loans have been declining since the Company made the deliberate decision to discontinue such lending at the end of 2018, thus maturing balances and prepayments are no longer being replaced.

At September 30, 2020 the Bank’s regulatory credit concentration of commercial real estate loans (CRE), as defined in the Interagency Guidance dated, December 12, 2006, was 364%.

Management employs heightened risk management practices with respect to CRE lending, including board and management oversight, strategic planning, development and

underwriting standards, risk assessment and monitoring through market analysis, and stress testing.

At September 30, 2020 we have concluded that we have an acceptable and well-managed concentration in CRE lending under the foregoing standards, however, given the current level of CRE we are actively monitoring this segment of the loan portfolio.

The 88.0% increase in Commercial and Industrial loans from $115.5 million at December 31, 2019 to $217.2 million was primarily driven by the Company’s participation in the Small Business Administration’s PPP as authorized by the CARES Act.

Gross loans and leases at $2.3 billion, reflected a decrease of $174.6 million, or 7%, at March 31, 2021 from $2.5 billion at December 31, 2020 due mostly to declines in outstanding balances on mortgage warehouse lines, as well as the forgiveness of PPP loans.

Balances on mortgage warehouse lines were down $119.7 million or 39% during the first quarter of 2021, due to seasonal fluctuations and a decline in mortgage refinancing activity.

Mortgage warehouse utilization was 51% at March 31, 2021, as compared to 71% at December 31, 2020.

Utilization of mortgage warehouse lines in the future could be impacted by fluctuations in interest rates and from economic uncertainty including the impact of the COVID-19 pandemic.

Non-agricultural real estate loan balances decreased due to a deliberate decision to supplement the Company’s core commercial real estate franchise with an increased strategic focus of building our commercial and industrial lending, including loans for owner-occupied commercial real estate and small business.

At March 31, 2021 the Bank’s regulatory credit concentration of commercial real estate loans (CRE), as defined in the Interagency Guidance dated, December 12, 2006, was 352%, down from 378% at December 31, 2020.

Management employs heightened risk management practices with respect to CRE lending, including board and management oversight, strategic planning, development and underwriting standards, risk assessment and monitoring through market

analysis, and stress testing.

At March 31, 2021 we have concluded that we have an acceptable and well-managed concentration in CRE lending under the foregoing standards, however, given the current level of CRE, and potential increased regulatory scrutiny it could bring, we are actively monitoring this segment of the loan portfolio.

The 12% decrease in Commercial and Industrial loans from $209.0 million at December 31, 2020 to $183.8 million was primarily driven by loan forgiveness precipitated by the Company’s participation in the Small Business Administration’s PPP as authorized by the CARES Act.

The Company began accepting and funding loans under this program in April 2020.

As of September 30, 2020, the Company obtained approval from the Small Business Administration and has funded PPP loans for approximately 1,334 customers totaling $123.6 million.

The recent growth in loans, in particular, non-owner occupied commercial real estate loans was accomplished without relaxing any of the Company’s credit standards that had been tightened after the great recession.

Instead, the growth came by diversifying geography with new loan teams announced in the first quarter 2020 in our Northern and Southern California markets.

Those loan teams have maintained these enhanced underwriting standards through the pandemic and have not compromised credit quality when sourcing new loans.

However, no assurance can be given as to how these loans will perform over their lifetime.

There were 1,070 loans for $97.3 million outstanding at March 31, 2021, compared to 1,274 loans for $117.2 million at December 31, 2020.

During the first quarter of 2021, the Bank originated, and the SBA approved, funding for $33.2 million in PPP loans while the SBA forgave $52.8 million of PPP loans.

NONPERFORMING ASSETS

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, in addition to foreclosed assets which can include mobile homes and OREO.

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, in addition to foreclosed assets which is primarily OREO, but can included other foreclosed assets.

If the Company grants a concession to a borrower in financial difficulty, the loan falls into the category of a TDR, unless the modification was granted under section 4016 of the CARES Act or the April 7, 2020 Interagency Statement.

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(dollars in thousands, unaudited)

September 30, 2020

March 31, 2021

December 31, 2020

September 30, 2019

March 31, 2020

NON-ACCRUAL LOANS:

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(1) Performing TDRs are not included in nonperforming loans above, nor are they included in the numerators used to calculate the ratios disclosed in this table.

Total nonperforming assets increased by $3.6 million, or 55%, during the first nine months of 2020.

The increase resulted from $2.2 million in new foreclosed assets due to the impact of one commercial real estate credit that went into foreclosure and the downgrade of certain loans deferred due to COVID-19 for which repayment has become uncertain.

The commercial property that went into other real estate owned is under contract and is expected to close escrow in the fourth quarter of 2020.

Total nonperforming assets increased by $1.0 million, or 11%, during the first three months of 2021.

The increase resulted from two loans to one borrower.

None of these increases were due to COVID-19.

As a result of the increase in the gross loan portfolio, the Company’s ratio of nonperforming assets to loans decreased to 0.30% at September 30, 2020, from 0.33% at December 31, 2019.

All of the Company’s impaired assets are periodically reviewed, and are either well-reserved based on current loss expectations, or are carried at the fair value of the underlying collateral net of expected disposition costs.

As shown in the table, we also had $7.7 million in loans classified as performing TDRs on which we were still accruing interest as of September 30, 2020, a decrease of $0.7 million, or 8%, relative to December 31, 2019.

Foreclosed assets had a carrying value of $3.0 million at September 30, 2020, comprised of 9 properties classified as OREO and miscellaneous Ag equipment relative to year-end 2019 when foreclosed assets consisted of 10 properties classified as OREO and two mobile homes.

One property representing 63% of the OREO balance at September 30, 2020 is under contract and is expected to close escrow in the fourth quarter of 2020.

As a result of the decrease in the gross loan portfolio, the Company’s ratio of nonperforming assets to loans increased to 0.42% at March 31, 2021, from 0.35% at December 31, 2020.

All of the Company’s impaired assets are periodically reviewed and are either well-

reserved based on current loss expectations, or are carried at the fair value of the underlying collateral net of expected disposition costs.

As shown in the table, we also had $10.6 million in loans classified as performing TDRs on which we were still accruing interest as of March 31, 2021, a decrease of $0.8 million, or 7%, relative to December 31, 2020.

Foreclosed assets had a carrying value of $0.9 million at March 31, 2021 comprised of 7 properties classified as OREO as compared to 7 properties for $1.0 million at December 31, 2020.

All foreclosed assets are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.

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Collection efforts are continuously pursued for all nonperforming loans, but we cannot provide assurance that they will be resolved in a timely manner or that nonperforming balances will not increase.

The Company had $7.2 million in loans past due 30-59 days at September 30, 2020.

The Company had $4.2 million in loans past due 30-59 days at March 31, 2021.

This is an increase of $2.1 million over the balance at December 31, 2020.

All of these past due loans are under management supervision and every effort is being taken to assist the borrowers in this regard.

90% of the 30-59 day past due balance, totaling $6.5 million returned to current status shortly after September 30, 2020.

The Company is providing deferrals to certain customers and taking advantage of either Section 4013 of the CARES Act or the April 7, 2020 Interagency Statement, which provides that such deferrals do not result in treatment of such loan as a TDR.

These deferrals typically provide deferrals of both principal and interest for 180 days.

All of these past due loans are under management supervision and every effort is being taken to assist the borrowers and manage credit risk in this regard.

As described above, the Company is providing loan modifications to certain customers and taking advantage of either Section 4013 of the CARES Act or the April 7, 2020 Interagency Statement, which provides that such modifications do not result in treatment of such loan as a TDR.

Since April 2020, the Company modified approximately $426 million of its loans under this guidance.

For the Company, these modifications typically provided a deferral of both principal and interest for 180 days.

Interest continues to accrue during the deferral period.

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For lines of credit, the borrower must repay the accrued interest at the end of the deferral period or take out a second credit facility to repay the accrued interest.

As of September 30, 2020, 314 customers, for a total of $424.0 million, had executed a loan modification under Section 4013 of the CARES Act.

Approximately 97% of these loan deferrals were for commercial customers with 39% or $163.8 million of these modifications, in the hospitality industry.

In addition, there were $99.0 million, or 23%, that are lessors of real estate, both commercial and residential;

$52.3 million, or 12%, in the dairy industry;

and $29.5 million, or 7%, related to convenience stores, and $7.0 million, or 2%, in the healthcare industry.

Of the commercial deferrals, there were $9.4 million that were unsecured.

Consumer deferrals totaled $12.8 million, of which $12.6 million were mortgage related.

At September 30, 2020, $15.3 million of these loans were considered classified assets including $2.1 million on non-accrual and $49.0 million considered special mention.

We continue to monitor these loans during the deferral period and if circumstances change, we may downgrade the loan to a criticized asset.

As of March 31, 2021, the Company had $22.4 million remaining in loan modification under Section 4013 of the CARES Act.

All but one small consumer relationship are fully secured by real estate collateral.

We expect all customers to show an ability and willingness to pay full principal and interest upon maturity of their deferment periods.

We monitor these loans during the deferral period and if circumstances change, we may downgrade the loan to a criticized asset.

An additional modification, if necessary, could also result in the loan being treated as a TDR or classified asset.

If a portion of the customers are not able to resume payments after the deferral period, it likely could result in higher classified and/or nonperforming assets, reversals of interest income, and/or higher charge-offs.

The following table summarizes the loans deferred as September 30, 2020:

As of 9-30-20

Are payments expected to resume upon expiration of deferment?

(dollars in thousands)

Deferment Loans

Deferment Balance

Deferment Loans as % of Total Loans in Category

No/Further Review Required

CRE non-owner occupied

Special purpose

CRE owner occupied

Commercial - secured by SFR 1-4 unit

Multi-family residential

Commercial construction

Lots/land and other

Ag farm mortgage and ag production

Consumer SFR 1-4 unit mortgage and consumer other

Commercial and industrial

Total Loan Deferments (1)

(1) Loans with temporary modification agreements remain on deferral status internally until management completes its evaluation of the customer’s potential need for an additional modification.

As of October 31, 2020, the Company had approximately $73.9 million in loans remaining on deferral status, including $18.9 million that have matured but still require further evaluation.

If some portion of the customers are not able to resume payments after the deferral period, it likely could result in higher classified and/or nonperforming assets, reversals of interest income, and/or higher charge-offs.

At March 31, 2020, approximately $10.4 million of the $22.4 million in outstanding modification already are internally graded as a classified asset.

ALLOWANCE FOR LOAN AND LEASE LOSSES

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recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge off.

As described above, the Company elected under Section 4014 of the CARES Act to defer the implementation of CECL until the earlier of when the national emergency related to the outbreak of COVID-19 ends or December 31, 2020.

The Company believes that the deferral will provide time to better assess the impact of the COVID-19 pandemic and related stimulus and relief efforts on the expected lifetime credit losses.

The Company’s allowance for loan and lease losses was $15.6 million at September 30, 2020, an increase of $5.7 million, or 57%, relative to December 31, 2019 resulting from a $6.4 million loan loss provision recorded during the first nine months of 2020, less $0.7 million in net charge-offs during the same period.

The additional loan loss provision in the first nine months of 2020 was precipitated primarily by the increase in non-owner occupied commercial real estate loan balances as well as the impact of qualitative factors associated with economic uncertainty during these unprecedented times.

No additional loan loss was considered necessary for the $123.6 million in SBA PPP loans added during the period ending September 30, 2020, as those loans carry a 100 percent guarantee under the “Paycheck Protection Program”, subject to certain diligence requirements by the issuing financial institution.

For further information regarding the Company's decision to defer the implementation of CECL under Section 4014 of the CARES Act, as well as further detail on the increase in provision during the third quarter of 2020, please see the discussion above under Provision for Loan and Lease Losses.

The allowance was 0.65% of total loans at September 30, 2020, 0.56% at December 31, 2019 and 0.62% at September 30, 2019.

The ratio of the allowance for loan and lease losses to nonperforming loans was 216.89% at September 30, 2020, relative to 172.96% at December 31, 2019 and 166.69% for September 30, 2019.

Management's detailed analysis indicates that the Company's allowance for loan and lease losses should be sufficient to cover credit losses inherent in

loan and lease balances outstanding as of September 30, 2020, but no assurance can be given that the Company will not experience substantial future losses relative to the size of the allowance.

A separate allowance of $0.3 million for potential losses inherent in unused commitments is included in other liabilities at September 30, 2020.

As described above, the Company elected under Section 4014 of the CARES Act to defer the implementation of CECL until January 1, 2022.

The Company made this election as it believed that the deferral provided additional time to better assess the impact of the COVID-19 pandemic and related stimulus and relief efforts on the expected lifetime credit losses.

The Company’s allowance for loan and lease losses was $18.3 million at March 31,2021, an increase of $0.6 million, or 3%, relative to December 31, 2020 resulting from a $0.3 million loan loss provision recorded during the first three months of 2021, plus a $0.3 million in net recoveries during the same period.

The loan loss provision in the first three months of 2021 was precipitated primarily by the decrease in loan balances as well as the impact of loan recoveries.

No allowance for loan and lease losses was considered necessary for the SBA PPP loans as those loans carry a 100 percent guarantee under the “Paycheck Protection Program”, subject to certain diligence requirements by the issuing financial institution.

For further information regarding the Company's decision to defer the implementation of CECL under Section 4014 of the CARES Act, as well as further detail on the increase in provision during the first quarter of 2021, please see the discussion above under Provision for Loan and Lease Losses.

The allowance for loan and lease losses was 0.80% of total loans at March 31, 2021, 0.72% at December 31, 2020 and 0.64% at March 31, 2020.

The ratio of the allowance for loan and lease losses to nonperforming loans was 213.0% at March 31, 2021, relative to 233.5% at December 31, 2020 and 155.8% for March 31, 2020.

Management's detailed analysis indicates that the Company's allowance for loan and lease losses should be sufficient to cover credit losses inherent in loan and lease balances outstanding as of March 31, 2021, but no assurance can be given that the Company will not experience substantial future losses relative to the size of the allowance.

A separate allowance of $0.3 million for potential losses inherent in unused commitments is included in other liabilities at March 31, 2021.

The following table summarizes activity in the allowance for loan and lease losses for the noted periods:

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For the year ended

September 30,

Average gross loans and leases outstanding during period (1)

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Consumer loans

Net loan charge offs

Net loan (recoveries) charge offs

Balance at end of period

Net charge-offs to average loans and leases (annualized)

Net (recoveries) charge-offs to average loans and leases (annualized)

Allowance for loan losses to gross loans and leases at end of period

Allowance for loan losses to nonperforming loans

Net loan charge-offs to allowance for loan losses at end of period

Net loan charge-offs to provision for loan losses

Net loan (recoveries) charge-offs to allowance for loan losses at end of period

Net loan (recoveries) charge-offs to provision for loan losses

(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.

The Company’s allowance for loan and lease losses at September 30, 2020 represents Management’s best estimate of probable losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance.

Furthermore, fluctuations in credit quality, changes in economic

conditions, updated accounting or regulatory requirements, and/or other factors could induce us to augment or reduce the allowance.

The Company’s allowance for loan and lease losses at March 31, 2021 represents Management’s best estimate of probable losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance.

Furthermore, fluctuations in credit quality, changes in economic conditions, updated accounting or regulatory requirements, and/or other factors could induce us to augment or reduce the allowance.

OFF-BALANCE SHEET ARRANGEMENTS

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It is unlikely that all unused commitments will ultimately be drawn down.

Unused commitments to extend credit totaled $541.4 million at September 30, 2020 and $492.0 million at December 31, 2019, representing approximately 23% of gross loans outstanding at September 30, 2020 and 28% at December 31, 2019.

Unused commitments to extend credit, which included standby letters of credit, totaled $485.3 million at March 31, 2021 and $449.9 million at December 31, 2020, representing approximately 21% of gross loans outstanding at March 31, 2021 and 18% at December 31, 2020.

The increase in unused commitments is due in large part to the increase in unfunded commitments on mortgage warehouse lines.

The Company also had undrawn letters of credit issued to customers totaling $8.8 million at September 30, 2020 and $8.6 million at December 31, 2019.

The Company also had undrawn letters of credit issued to customers totaling $8.4 million at March 31, 2021 and $8.1 million at December 31, 2020.

The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of commitments to provide credit cannot be reasonably predicted because there is no guarantee that the lines of credit will ever be used.

However, the “Liquidity” section in this Form 10-Q outlines resources available to draw upon should we be required to fund a significant portion of unused commitments.

In addition to unused commitments to provide credit, the Company is utilizing a $105 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits and to facilitate certain credit arrangements with the Company’s customers.

In addition to unused commitments to provide credit, the Company is utilizing a $100 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain local agency deposits.

That letter of credit is backed by loans that are pledged to the FHLB by the Company.

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If a “long” position is prevalent, we could let brokered deposits or other wholesale borrowings roll off as they mature, or we might invest excess liquidity into longer-term, higher-yielding bonds.

The Company’s balance of non-earning cash and due from banks was $84.3 million at September 30, 2020 relative to $65.6 million at December 31, 2019.

The increase is primarily due to maintaining higher amounts of cash on hand due to lack of certainty from our armored cash delivery vendor during the COVID-19 pandemic due to potential staffing issues and governmental stay-at-home orders.

Foreclosed assets are discussed above in the section titled “Nonperforming Assets.” Net premises and equipment decreased by $0.2 million during the first nine months of 2020.

Goodwill was $27 million at September 30, 2020, unchanged during the first nine months of 2020.

As mentioned above, the Company performed a qualitative assessment of goodwill impairment during the third quarter 2020 and determined that a quantitative analysis was not required at this time.

The Company will continue to monitor its Goodwill for potential impairment given the COVID-19 pandemic.

Bank-owned life insurance, with a balance of $52.1 million at September 30, 2020, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.

The Company’s balance of non-earning cash and due from banks was $77.8 million at March 31, 2021 relative to $67.9 million at December 31, 2020.

The increase is primarily due to maintaining higher amounts of cash on hand due to the COVID-19 pandemic specifically government stimulus payments and customer needs for higher amounts of cash.

Foreclosed assets are discussed above in the section titled “Nonperforming Assets.” Net premises and equipment decreased by $0.7 million during the first three months of 2021, to $26.8 million.

Goodwill was $27 million at March 31, 2021, unchanged during the first three months of 2021.

As mentioned above, the Company performed a qualitative assessment of goodwill impairment during the fourth quarter 2020 and determined that a quantitative analysis was not required.

There have been no triggering events in the first quarter of 2021 that would require The Company to perform a Goodwill impairment test, however the Company will continue to monitor its Goodwill for potential impairment given the COVID-19 pandemic.

Bank-owned life insurance, with a balance of $53.3 million at March 31, 2021, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.

DEPOSITS AND INTEREST BEARING LIABILITIES

Deposits represent another key balance sheet category impacting the Company’s net interest income and profitability metrics.

Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent

that growth in deposits is concentrated in less volatile and typically less costly non-maturity accounts such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts.

Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity accounts such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts.

Information concerning average balances and rates paid by deposit type is included in the Average Balances and Rates tables appearing above, in the section titled “Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits by type, showing the period-end balance and percentage of total deposits, is presented as of the dates indicated in the following table.

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(dollars in thousands, unaudited)

September 30, 2020

March 31, 2021

December 31, 2020

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Brokered deposits

Deposit balances reflect net growth of $423.3 million, or 20%, during the first nine months of 2020.

Time deposits were $470.3 million at September 30, 2020 as compared to $514.4 million at December 31, 2019.

The $44.1 million decline in time-deposits was a result of a reduction in customer time deposits as brokered deposits were flat for the same period.

All of our non-maturity deposit growth was organic in nature.

Deposit balances reflect net growth of $229.3 million, or 9%, during the first three months of 2021.

Time deposits were $511.4 million at March 31, 2021 as compared to $512.9 million at December 31, 2020.

Brokered deposits were flat for the same period.

Non-maturity deposit growth of $230.8 million for the first three months of 2021was primarily the result of increases in balances of existing customers as the total number of customers increased by less than 1%.

Management is of the opinion that a relatively high level of core customer deposits is one of the Company’s key strengths, and we continue to strive for core deposit retention and growth.

In particular, the Company’s ratio of noninterest-bearing deposits to total deposits was 37.7% at September 30, 2020 as compared to 31.9% at December 31, 2019.

In particular, the Company’s ratio of noninterest-bearing deposits to total deposits was 35.8% at March 31, 2021 as compared to 36.0% at December 31, 2020.

OTHER INTEREST-BEARING LIABILITIES

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The FHLB line is committed, but the amount of available credit depends on the level of pledged collateral.

Total non-deposit interest-bearing liabilities increased by $149.1 million, or 185%, during the first nine months of 2020 primarily due to an increase in borrowings from the FHLB primarily to support organic growth in non-owner occupied commercial real estate loans, PPP loans, and to fund increased temporary utilization of mortgage warehouse lines.

Repurchase agreements totaled $36.7 million at September 30, 2020 relative to a balance of $25.7 million at year-end 2019.

Total non-deposit interest-bearing liabilities decreased by $125.5 million, or 58%, during the first three months of 2021 primarily due to a decrease in federal funds purchased and borrowings from the FHLB, due to the increase in deposits.

Repurchase agreements totaled $51.5 million at March 31, 2021 relative to a balance of $39.1 million at year-end 2020.

Repurchase agreements represent “sweep accounts”, where commercial deposit balances above a specified threshold are transferred at the close of each business day into non-deposit accounts secured by investment securities.

The Company had junior subordinated debentures totaling $35.0 million at both September 30, 2020 and December 31, 2019, in the form of long-term borrowings from trust subsidiaries formed specifically to issue trust preferred securities.

The Company had junior subordinated debentures totaling $35.2 million and $35.1 million at March 31, 2021 and December 31, 2020, respectively, in the form of long-term borrowings from trust subsidiaries formed specifically to issue trust preferred securities.

OTHER NONINTEREST BEARING LIABILITIES

Other liabilities are principally comprised of operating lease right-of-use liabilities, accrued interest payable, other accrued but unpaid expenses, and certain clearing amounts.

The Company’s balance of other liabilities was $41.9 million at September 30, 2020 as compared to $35.5 million at December 31, 2019.

The Company’s balance of other liabilities was $32.5 million at March 31, 2021 as compared to $35.1 million at December 31, 2020.

LIQUIDITY AND MARKET RISK MANAGEMENT

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To meet these short-term needs, we can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.

At September 30, 2020 and December 31, 2019, the Company had the following sources of primary and secondary liquidity ($ in thousands):

At March 31, 2021 and December 31, 2020, the Company had the following sources of primary and secondary liquidity ($ in thousands):

Primary and Secondary Liquidity Sources

September 30, 2020

March 31, 2021

December 31, 2020

Cash and Due From Banks

Cash and Cash Equivalents

Unpledged Investment Securities

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In addition to the above sources, the Company could obtain brokered deposits, obtain deposits via deposit listing services, or offer higher rate time deposits within our market.

At September 30, 2020, the Company had previously applied for and received approval to borrow $126.8 million from the Federal Reserve Bank for a Paycheck Protection Program Lending Facility (PPPLF) through December 31, 2020.

At March 31, 2021, the Company had previously applied for and received approval to borrow $99.8 million from the Federal Reserve Bank for a Paycheck Protection Program Lending Facility (PPPLF) through June 30, 2021.

The PPPLF provides the Company with the ability to pledge any PPP loan to the Federal Reserve Bank and obtain funding at 35 basis points.

Further, any loans pledged to the PPPLF will be excluded from the regulatory leverage capital ratio.

Due to the Company’s liquidity throughout the first nine months of 2020 it elected not to utilize the PPPLF during the quarter.

The Company will continue to evaluate whether it should utilize the PPPLF in the fourth quarter 2020.

Due to the Company’s liquidity throughout the first three months of 2021 it elected not to utilize the PPPLF during the quarter.

The Company will continue to evaluate whether it should utilize the PPPLF in the second quarter 2021.

The Company performs regular stress tests on its liquidity and at this time, believes that we have sufficient primary and secondary liquidity sources for operations.

The Company has a higher level of actual balance sheet liquidity than might otherwise be the case, since we utilize a letter of credit from the FHLB rather than investment securities for certain pledging requirements.

That letter of credit, which is backed by loans pledged to the FHLB by the Company, totaled $105 million at September 30, 2020 and December 31, 2019.

That letter of credit, which is backed by loans pledged to the FHLB by the Company, totaled $100 million at March 31, 2021 and December 31, 2020.

Other sources of liquidity included the brokered deposit market, deposit listing services, and the ability to offer local time-deposit campaigns.

Management is of the opinion that available investments and other

potentially liquid assets, along with standby funding sources it has arranged, are more than sufficient to meet the Company’s current and anticipated short-term liquidity needs and that its liquidity has not been adversely impacted by COVID-19.

The Company’s net loans to assets and available investments to assets ratios were 74.3% and 12.7%, respectively, at September 30, 2020, as compared to internal policy guidelines of “less than 78%” and “greater than 3%.” Other liquidity ratios reviewed periodically by Management and the Board include net loans to total deposits and wholesale funding to total assets, including ratios and sub-limits for the various components comprising wholesale funding, which were all well within policy guidelines at September 30, 2020.

Management is of the opinion that available investments and other potentially liquid assets, along with standby funding sources it has arranged, are more than sufficient to meet the Company’s current and anticipated short-term liquidity needs and that its liquidity has not been adversely impacted by COVID-19.

The Company’s net loans to assets and available investments to assets ratios were 68.7% and 18.9%, respectively, at March 31, 2021, as compared to internal policy guidelines of “less than 78%” and “greater than 3%.” Other liquidity ratios reviewed periodically by Management and the Board include net loans to total deposits and wholesale funding to total assets, including ratios and sub-limits for the various components comprising wholesale funding, which were all well within policy guidelines at March 31, 2021.

The Company has been able to maintain a robust liquidity position in recent periods, but no assurance can be provided that our liquidity position will continue at current strong levels.

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Its primary source of funds is dividends from the Bank, since the holding company does not conduct regular banking operations.

As of September 30, 2020, the holding company maintained a cash balance of $11.9 million.

As of March 31, 2021, the holding company maintained a cash balance of $12.4 million.

Management anticipates that with the available cash and the continued ability for the Bank to provide dividends to the holding company, that the holding company has sufficient liquidity to meet its funding requirements for the foreseeable future.

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We currently utilize an additional upward rate shock scenario of 400 basis points.

Pursuant to policy guidelines, we generally attempt to limit the projected decline in net interest income relative to the stable rate scenario to no more than 5% for a 100 basis point (bp) interest rate shock, 10% for a 200 bp shock, 15% for a 300 bp shock, and 20% for a 400 bp shock.

Pursuant to policy guidelines, we generally attempt to limit the projected decline in net interest income relative to the

stable rate scenario to no more than 5% for a 100 basis point (bp) interest rate shock, 10% for a 200 bp shock, 15% for a 300 bp shock, and 20% for a 400 bp shock.

The Company had the following estimated net interest income sensitivity profiles over one-year, without factoring in any potential negative impact on spreads resulting from competitive pressures or credit quality deterioration:

September 30, 2020

September 30, 2019

March 31, 2021

March 31, 2020

Immediate change in Interest Rates (basis points)

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$ Change in Net Interest Income

In the stable rate environment, expected net interest income over twelve months increased $8.1 million, or 9%, to $103.3 million for the first nine months of 2020 compared to $95.2 million for the same period in 2019.

The primary reason for the increase in expected net interest income despite a lower rate environment was the increase in loan balances, primarily in commercial real estate.

Further, the loan-to-deposit ratio increased from 82% at September 30, 2019 to over 91% at September 30, 2020 which demonstrates a greater level of high-earning assets at September 30, 2020.

Therefore, even though the rate shocks are not as significant at September 30, 2020 as compared to September 30, 2019, overall projected net interest income remains higher in all scenarios at September 30, 2020.

The simulation for the period ending September 30, 2020 indicates that the Company’s net interest income will increase over the next 12 months in a rising rate environment, however the increase will diminish as rates rise from +100 bps to +300 bps, with a decrease in net interest income in the +400 bps scenario.

The decrease in net income in the +400 bps scenario is primarily due to the Company’s current $148.0 million overnight borrowing position which will immediately reprice.

The immediately repricing of liabilities in each progressively larger rate positive rate shock is more significant than the corresponding gradual increase in asset repricing over the same period given the growth assumption utilized in the model.

A drop in interest rates could have a substantial negative impact as is reflected in the down 100 bps simulation resulting in a decrease of 5.8% in net income.

For the period ended September 30, 2019, the Company was asset sensitive, with net income increasing in a rising rate environment in all scenarios but declining considerably in the down shocks.

Given the 150-basis point decrease in the target federal funds rate in March 2020 and the drop in the 10-year Treasury yields in the first nine months of 2020, it is unlikely to see dramatic rate decreases unless rates go negative.

If there were an immediate and sustained upward adjustment of 100 basis points in interest rates, all else being equal, net interest income over the next 12 months is projected to improve by $1.0 million, or 0.9%, for the period ending September 30, 2020 and $1.0 million, or 1.1%, for the period ended September 30, 2019, relative to a stable interest rate scenario, with the favorable variance decreasing as interest rates rise for the September 30, 2020 and increasing as interest rates rise for the period ending September 30, 2019.

If interest rates were to decline by 100 basis points, however, net interest income would likely be $5.9 million lower or 5.8% for the period ended September 30, 2020, and $4.3 million lower or 4.6% for the period ended September 30, 2019, than in a stable interest rate scenario.

The unfavorable variance increases when rates drop are due to the fact that certain deposit rates are already relatively low (on NOW accounts and savings accounts for example) and will hit a natural floor of close to zero while non-floored variable-rate loan yields continue to drop.

This effect is exacerbated by accelerated prepayments on fixed-rate loans and mortgage-backed securities when rates decline, although rate floors on some of our variable-rate loans partially offset other negative pressures.

While we view material interest rate reductions as unlikely in the near term, the potential percentage decline in net interest income in the “down 100 basis points” interest rate scenario exceeds our internal policy guidelines for the period ended September 30, 2020, but the risk has been accepted with no immediate plans to address this scenario.

For the periods ended March 31, 2021 and 2020, the Company was asset sensitive, with net income increasing in a rising rate environment in all scenarios but declining considerably in the down shocks.

The simulation for the period ending March 31, 2020 indicates that the Company’s net interest income will increase over the next 12 months in a rising rate environment in all scenarios, but a continued drop in interest rates could have a substantial negative impact.

However the rate of increase is not as pronounced as in the March 31, 2021 scenario due to considerably less cash on hand and the impact of interest rate reductions and balance sheet changes including an increase in loans with variable rate characteristics (mortgage warehouse loans), the runoff of loans which had rates fixed for periods in excess of a year, and a projected slight shift in our deposit mix toward time deposits over time.

In the up 400 basis point shock scenario, expected net interest income over the next twelve months increases $7.7 million, or 7%, to $115.7 million at March 31, 2021 compared to a 5% increase or $5.0 million for the same period in 2020.

The primary reason for the increase in expected net interest income despite a lower rate environment, was the increase in surplus interest-bearing cash in other banks.

In an instantaneous parallel rate shock the entire balance of surplus cash would reprice immediately.

Over the next twelve months, surplus cash is projected to remain at higher levels than prior years as the Company shifts from non-owner occupied commercial real estate to other types of lending.

Although the cost of interest-bearing liabilities will also increase, the deposit betas utilized in the model mitigate the magnitude of a deposit rate increase.

The change in net interest income is similar for the up 100, 200, and 300 basis point scenarios.

If there were an immediate and sustained upward adjustment of 100 basis points in interest rates, all else being equal, net interest income over the next 12 months is projected to improve by $2.4 million, or 2.40%, relative to a stable interest rate scenario, with the favorable variance increasing marginally as interest rates rise higher.

If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $8.2 million or a negative variance of 8%.

Since many of deposit products are at their natural floors as reflected in our current cost of deposits of.14% for the first quarter of 2021, the unfavorable variances increase as interest rates decline because non-floored variable-rate loans continue to drop.

This effect is further exacerbated by accelerated prepayments on fixed-rate loans and mortgage- backed securities when rates decline.

While we view material interest rate reductions as unlikely in the near term, the potential percentage drop in net interest income in the “down 100 basis points” interest rate scenario exceeds our internal policy guidelines and we will continue to monitor our interest rate risk profile and implement remedial changes as deemed appropriate.

In addition to the net interest income simulations shown above, we run stress scenarios for the unconsolidated Bank modeling the possibility of no balance sheet growth, the potential runoff of “surge” core deposits which flowed into the Bank in the most recent economic cycle, and unfavorable movement in deposit rates relative to yields on earning assets (i.e., higher deposit betas).

When a static balance sheet and a stable interest rate environment are assumed, projected annual net interest income is more than $3 million lower than in our standard simulation.

However, the stressed

simulations reveal that the Company’s greatest potential pressure on net interest income would result from excessive non-maturity deposit runoff and/or unfavorable deposit rate changes in rising rate scenarios.

The economic value (or “fair value”) of financial instruments on the Company’s balance sheet will also vary under the interest rate scenarios previously discussed.

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Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at anticipated replacement interest rates for each account type, while the fair value of non-financial accounts is assumed to equal their book value for all rate scenarios.

An economic value simulation is a static measure utilizing balance sheet accounts at a given point in time, and the measurement can change sub stantially over time, as is evident in the tables below for the periods ending September 30, 2020 and 2019, respectively, as the Company’s balance sheet evolves and interest rate and yield curve assumptions are updated.

An economic value simulation is a static measure utilizing balance sheet accounts at a given point in time, and the measurement can change substantially over time, as is evident in the tables below for the periods ending March 31, 2021 and 2020, respectively, as the Company’s balance sheet evolves and interest rate and yield curve assumptions are updated.

The change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including stated interest rates or spreads relative to current or projected market-level interest rates or spreads, the likelihood of principal prepayments, whether contractual interest rates are fixed or floating, and the average remaining time to maturity.

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In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical patterns and Management’s best estimates.

Our EVE had been increasing due to asset growth and rising discount rates, which result in a larger benefit assessed to non-maturity deposits, but that trend reversed in the second quarter of 2019 as loan growth slowed and interest rates started to fall.

Our EVE increased in the past twelve months due to asset growth, but that trend slowed in the first quarter of 2021 as loan growth decelerated.

The tables below show estimated changes in the Company’s EVE, under different interest rate scenarios relative to a base case of current interest rates:

September 30, 2020

September 30, 2019

March 31, 2021

March 31, 2020

Immediate change in Interest Rates (basis points)

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$ Change in Fair Value of Equity

The table shows that our EVE will generally deteriorate in moderate declining rate scenarios but should benefit from a paral lel shift upward in the yield curve.

The table shows that our EVE will deteriorate in moderate declining rate scenarios but should benefit from a parallel shift upward in the yield curve.

The rate of increase in EVE accelerates the higher interest rates rise.

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CAPITAL RESOURCES

The Company had total shareholders’ equity of $336.2 million at September 30, 2020, comprised of $112.6 million in common stock, $3.6 million in additional paid-in capital, $202.5 million in retained earnings, and accumulated other comprehensive income of $17.5 million.

The Company had total shareholders’ equity of $348.0 million at March 31, 2021, comprised of $113.5 million in common stock, $4.0 million in additional paid-in capital, $216.2 million in retained earnings, and accumulated other comprehensive income of $14.3 million.

At the end of 2020, total shareholders’ equity was $343.9 million.

The increase during the first nine months of 2020 is due to the addition of capital from net income and stock options exercised as well as a $11.6 million favorable swing in accumulated other comprehensive income, net of the impact of cash dividends paid and share repurchases.

There were repurchases totaling 112,050 shares at a weighted average cost

of $22.86 per share executed by the Company during the first quarter of 2020.

The increase during the first three months of 2021 is due to the addition of capital from net income, stock options exercised and restricted stock accrued.

These positive changes were partially offset by a $4.1 million unfavorable swing in accumulated other comprehensive income, net and the impact of cash dividends paid.

The Company has 268,301 shares authorized to repurchase under the current repurchase program.

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As permitted by the regulators for financial institutions that are not deemed to be “advanced approaches” institutions, the Company has elected to opt out of the Basel III requirement to include accumulated other comprehensive income in risk-based capital.

The following table sets forth the consolidated Company’s and the Bank’s regulatory capital ratios as of the dates indicated.

The following table sets forth the Bank’s regulatory capital ratios as of the dates indicated.

Regulatory Capital Ratios

September 30,

Community Bank

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Leverage Ratio (2) (4)

Sierra Bancorp

Common Equity Tier 1 Capital to Risk-Weighted Assets (1)

Tier 1 Capital to Risk-weighted Assets (1)

Total Capital to Risk-weighted Assets (1)

Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio") (1)

Bank of the Sierra

Common Equity Tier 1 Capital to Risk-Weighted Assets (1)

Tier 1 Capital to Risk-weighted Assets (1)

Total Capital to Risk-weighted Assets (1)

Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio")

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The CARES Act reduced the required community bank leverage ratio to 8% until the earlier of December 31, 2020, or the national emergency is declared over.

Beginning in 2021 the CBLR was increased to 8.5% for the calendar year with the CBLR increasing to 9% on January 31, 2022.

The federal bank regulatory agencies adopted an interim final rule to implement this change from the CARES Act.

The Company and the Bank meet the criteria outlined in the final rule and the interim final rule and have adopted the community bank leverage ratio framework in the first quarter 2020.

At March 31, 2021, the Company and the Bank met the criteria outlined in the final rule and the interim final rule and elected to measure capital adequacy under the CBLR framework.

PART I – FINANCIAL INFORMATION

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 2. Management’s Discussion and Analysis