Item 2. Management’s Discussion and Analysis
ITEM 2
MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This Form 10- Q includes forward-looking statements that involve inherent risks and uncertainties. These forward-looking statements are within the meaning of Section 27A of the Securities Act of 1933 (“1933 Act”), as amended and Section 21E of the Securities Exchange Act of 1934 (“1934 Act”), as amended. Those sections of the 1933 Act and 1934 Act provide a “safe harbor” for forward-looking statements in order to encourage companies to provide prospective information about their financial performance as long as important factors that could cause actual results to differ significantly from projected results are identified with meaningful cautionary statements. Words such as “expects”, “anticipates”, “believes”, “projects”, “intends”, and “estimates” or variations of such words and similar expressions, as well as future or conditional verbs preceded by “will”, “would”, “should”, “could” or “may” are intended to identify forward-looking statements. These forward-looking 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.
These statements are based on management’s current expectations regarding economic, legislative, regulatory and other environmental issues that may affect our earnings in future periods. Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.
A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the Company’s potential future financial performance. They include, but are not limited to:
● the risk of unfavorable economic conditions in the Company’s market areas;
● risks associated with the current national emergency with respect to COVID-19 and its variants, including the impact that national, state, and local responses, including limitations on business and personal activity as well as any stimulus or relief efforts, have on customers’ continued ability to repay loans or to resume normal payments following the end of COVID-19 related deferrals granted by the Bank;
● the Company’s delayed implementation of CECL;
● risks associated with fluctuations in interest rates or a sustained low interest rate environment;
● liquidity risks, including the ability to effectively manage the additional liquidity from the significant increase in deposits during the COVID-19 pandemic including managing the potential loss of a portion of such deposits;
● increases in nonperforming assets and credit losses that could occur, particularly in times of weak economic conditions or rising interest rates;
● reductions in the market value of available-for-sale securities that could result if interest rates increase substantially or an issuer has real or perceived financial difficulties;
● the Company’s ability to diversify and grow its loan portfolio;
● the Company’s ability to attract and retain skilled employees;
● the Company’s ability to successfully deploy new technology;
● 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;
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● the success of acquisitions or branch expansions, closures or consolidations; and
● risks associated with the multitude of current and prospective laws and regulations to which the Company is and will be subject.
Risk factors that could cause actual results to differ materially from results that might be implied by forward-looking statements include the risk factors detailed in the Company’s Form 10-K for the fiscal year ended December 31, 2020 and in Item 1A, herein. We do not update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.
CRITICAL ACCOUNTING POLICIES
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and incorporate various assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.
Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas:
● the establishment of the allowance for loan and lease losses, as explained in detail in Note 11 to the consolidated financial statements and in the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis;
● the valuation of impaired loans and foreclosed assets, as discussed in Note 11 to the consolidated financial statements;
● 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 regarding those areas.
OVERVIEW OF THE RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
RESULTS OF OPERATIONS SUMMARY
Second Quarter 2021 compared to Second Quarter 2020
Second quarter 2021 net income was $11.7 million, or $0.76 per diluted share, compared to $8.3 million, or $0.54 per diluted share in the second quarter of 2020. The Company’s annualized return on average equity was 13.29% and annualized return on average assets was 1.42% for the quarter ended June 30, 2021, compared to 10.30% and 1.19%, respectively, for the same quarter in 2020. The primary drivers behind the variance in second quarter net income are as follows:
● A $2.1 million negative provision for loan and lease losses. This favorable impact was precipitated by continued improvements in the overall economy, lower historical loss rates, net recoveries during the past two quarters, and a $272.7 million decrease in average balances of net loan and leases.
● The $3.0 million, or 13%, increase in net interest income is due to a $3.6 million increase in interest income resulting primarily from higher real estate secured loan volumes as compared to June 30, 2020, partially offset
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by lower rates on interest earning assets. In addition, there was a favorable decline in interest expense due to a higher mix of noninterest bearing deposits and lower rates on the interest bearing deposits and borrowed funds.
● An increase of $2.2 million, or 12% in noninterest expense partially offset the positive variances mentioned above. The increase was due mostly due a $1.2 increase in salaries and benefits, $0.5 million increase in data processing, and $0.4 million increase in legal expenses.
First Half 2021 compared to First Half 2020
Net income for the first half of 2021 was $22.8 million, or $1.48 per diluted share, compared to $16.1 million, or $1.05 per diluted share for the same period in 2020. The Company’s annualized return on average equity was 13.11% and annualized return on average assets was 1.41% for the six months ended June 30, 2021, compared to a return on equity of 10.14% and return on assets of 1.21% for the six months ended June 30, 2020. The primary drivers behind the variance in year-to-date net income are as follows:
● A $1.9 million negative provision for loan and lease losses, relative to $4.0 million provision for loan and lease losses in the first half of 2020, for the same reasons outlined above in the quarterly comparison.
● Net interest income increased by $7.8 million or 16% as declines in loan yields were offset by higher balances and lower interest expense.
● The above year-to-date increases were partially offset by an increase in noninterest expense of $4.7 million, or 13%, due mostly to a $2.1 million increase in salaries and benefits, $1.4 million increase in professional services, and $0.8 million increase in data processing expense.
FINANCIAL CONDITION SUMMARY
June 30, 2021 relative to December 31, 2020
The Company’s assets totaled $3.3 billion at June 30, 2021 relative to $3.2 billion at December 31, 2020. The following provides a summary of key balance sheet changes during the first six months of 2021:
● The Company’s balance of cash and cash equivalents was up by $302.5 million, or 424% 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 half 2021.
● Securities available-for-sale were $607.5 million at June 30, 2021, an increase of $63.5 million, or 12% from December 31, 2020. The Company purchased $119.3 million in various government agency sponsored mortgage-backed securities, municipal securities, and corporate bonds.
● The year-to-date 2021 loan balance decline of $318.3 million, or 13%, was mostly due to declines in outstanding balances on mortgage warehouse lines of $157.3 million, as well as a $100.0 million decline in real estate loans, mostly in commercial real estate (CRE) loan balances, and a $49.0 million decline in SBA Paycheck Protection Program (PPP) loans. During the second quarter of 2021 the Bank had $16.1 million in SBA PPP loan originations, but overall SBA PPP loan balances declined due to SBA forgiveness of $45.5 million in PPP loans during the same period. During the first half of 2021, the Company changed its strategic loan origination focus to better diversify our portfolio by adding commercial & industrial loans, including owner-occupied CRE loans and small business lending. Most of the decline in CRE loan balances were from construction loan balance declines. The Company’s regulatory commercial real estate concentration ratio decreased to 335% at June 30, 2021 as compared to 378% at December 31, 2020 and remains well within our acceptable risk tolerance for CRE concentration.
● Deposits increased by $151.3 million, or 6%, in the first half of 2021. The growth in deposits came primarily from noninterest bearing or low-cost transaction, and savings accounts, while higher-cost time deposits
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decreased as the Company chose not to renew certain time-deposits or to seek alternative time-deposits for those that matured.
● All short-term borrowings paid off in full, resulting in a decrease of $142.9 million during the first half of 2021. This included fed funds purchased, Federal Home Loan Bank (FHLB) overnight, and term borrowings and was a direct result of an increase in deposit balances combined by softened loan demand. Customer repurchase agreements increased $31.4 million to $70.5 million.
● Total shareholders’ equity of $357.7 million at June 30, 2021 reflects an increase of $13.8 million, or 4%, relative to year-end 2020 due to additional capital from the $22.8 million addition of net income, a $3.0 million unfavorable swing in accumulated other comprehensive income/loss, stock options exercised, restricted stock compensation, net of $6.5 million in dividends paid.
IMPACT OF CORONAVIRUS DISEASE 2019 (COVID-19) PANDEMIC ON THE COMPANY’S OPERATIONS
Overview
On January 31, 2020, the United States Department of Health and Human Services declared a public health emergency with respect to the Coronavirus Disease 2019 (COVID-19). Subsequent to this date, federal, state, and local governmental agencies, regulatory agencies, and the Federal Reserve Board took actions impacting the Company including these more significant items:
● On March 3, 2020, the Federal Open Market Committee (FOMC) of the Federal Reserve Board lowered the federal funds rate by 50 basis points in its first emergency move since October 2008.
● On March 4, 2020, the Governor of the state of California declared a state of emergency to help make additional resources available and formalize emergency actions to address COVID-19.
● On March 6, 2020, the Federal Financial Institutions Examination Council (FFIEC) issued guidance to financial institutions reminding them to include pandemic planning in business continuity plans.
● Starting on March 9, 2020, the Board of Governors of the Federal Reserve System, Consumer Financial Protection Bureau, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, and Conference of State Bank Supervisors began issuing various Interagency Guidance Statements to encourage financial institutions to meet the financial needs of customers affected by the Coronavirus.
● On March 11, 2020, the World Health Organization declared COVID-19 a pandemic.
● On March 15, 2020, the FOMC of the Federal Reserve Board lowered the federal funds rate by 100 basis points in its second emergency move in two weeks, this time on a Sunday. In addition, the FOMC announced that it would let banks borrow from the discount window for up to 90 days, reduced the reserve requirement ratios to zero percent, united with five other central banks to ensure dollars are available via swap lines, and increased bond holdings by at least $700 billion.
● Effective March 20, 2020, the state of California ordered the closure of all non-essential workplaces, restricting non-essential travel, and ordering a state-wide shelter-in-place order. 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. Effective August 31, 2020, a new simplified, four-tier guideline was implemented for counties to reopen. However, most counties remained in partially or fully closed states through
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June 2021. On June 15, 2021, the state of California effectively removed most remaining restrictions for fully vaccinated individuals.
● On March 22, 2020, the federal financial institution regulatory agencies (the agencies) issued guidance to financial institutions to suspend the requirements to classify certain loan modifications as troubled debt restructurings (TDRs). The guidance was subsequently modified on April 7, 2020 to conform with Section 4013 of the Coronavirus Aid, Relief and Economic Security (CARES) Act. Further interagency guidance for financial institutions was issued in June, August, and September 2020.
● On March 27, 2020, the CARES Act was enacted by Congress and signed into law by the President to address the impact of the COVID-19 on the economy. Among other things, the CARES Act provided banking institutions with the option of deferring the implementation of the Current Expected Credit Loss (“CECL”) accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-13 and related amendments, Financial Instruments – Credit Losses (Topic 326) until later in 2020; confirmed that certain loan modifications would not be treated as a TDR; authorized the Small Business Administration to create the Paycheck Protection Program (PPP) which allows banking institutions to offer a certain amount of forgivable loans to primarily assist with funding payroll for small businesses; 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 were met regarding equitable vaccine availability and a consistently low burden of disease.
● On June 15, 2021, the Governor of California terminated the executive orders that put into place the Stay Home Order and the Blueprint for a Safer Economy. He also phased out the vast majority of executive actions put in place since March 2020 as part of the pandemic response, leaving a subset of provisions that facilitate the ongoing recovery.
Impact of COVID-19 on the Company’s Operations
● The Company had $10.4 million in classified assets at June 30, 2021, from loans modified under the 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.
● The uncertainty of national and local economic conditions had an impact on our provision for loan and lease losses in 2020 and early 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. 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,
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beginning after the national emergency terminates or January 1, 2022. The Company’s decision to defer the adoption of CECL was done primarily to provide additional time to assess better the impact of the COVID-19 pandemic on the expected lifetime credit losses in our loan and lease portfolio. At the time the decision was made, there was a significant change in economic uncertainty on the local, regional, and national levels as a result of local and state stay-at-home orders, as well as relief measures provided at a national, state, and local level.
● 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 June 30, 2021, was 3.60%, compared to a net interest margin of 3.81% for the same period in 2020. Additional liquidity from significant deposit growth in 2021 coupled with lower loan balances has negatively impacted our net interest margin. This additional liquidity was mostly deployed in overnight funding at an average rate of 11 basis points for the second quarter and six-months ending June 30, 2021. In addition, investment and new loan yields have continued to decline given the overall rate environment in 2021.
● The COVID-19 pandemic has not adversely affected our capital or financial resources as of June 30, 2021. During the first half of 2021, total shareholders’ equity increased by $13.8 million, or 4%, to $357.7 million. The Company earned $22.8 million in net income in the first half of 2021, but had a $3.0 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 $6.5 million during the first half of 2021. On July 15, 2021, the Company declared a twenty-two cent per share dividend to be paid on August 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. With respect to liquidity, the Company maintains strong primary and secondary liquidity sources as further described under “Liquidity and Market Risk Management” below.
● We do not expect COVID-19 to affect our ability to account timely for the assets on our balance sheet. Certain valuation assumptions and judgments continue to change to account for pandemic-related circumstances such as widening credit spreads. 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 June 30, 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 half 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 June 30, 2021, we had goodwill of $27.4 million which represented 8% of total equity.
● The Company continues to serve its customers. Several of our branch locations, were closed due to the pandemic, however all of our branch lobbies are now fully open, with the exception of five branch locations that the Company decided to permanently close in June 2021. This decision to close these branches was made as a result of a change in customer behaviors brought about by the COVID-19 pandemic along with an efficiency review. All of the five closed locations were located outside of Tulare County, the Bank’s primary market area. 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. Overall deposits at these five closed branches increased during the period of time from announcement to closure and consolidation into a nearby branch. The acceleration of amortization of leasehold improvements for these locations increased depreciation expense by $0.4 million in the second quarter of 2021 and by $0.5 million year-to-date 2021. Most of the staff at these five locations were relocated to existing branches with position vacancies however, four
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individuals elected to leave the Company. It is projected that closing these five branch locations will result in annual noninterest expense savings of between $0.8 and $1.0 million.
● All of our back office and corporate office staff have returned to normal work arrangements, although remote and hybrid work provisions are now defined as “normal” work arrangements for certain corporate and back office employees, depending on the nature of the position. In addition, none of our internal controls have changed or are expected to change as a result of these work arrangements other than the use of remote approvals.
● To date, the Company did not experience any challenges in implementing its business continuity plans. The Company’s Risk Management team began preparing in early 2020, with ordering of supplies such as hand sanitizer, masks 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, albeit at a much slower pace than in 2020. In addition, mortgage warehouse utilization that resulted from the low rate environment is expected to remain at a lower level than 2020. Further, it is expected that SBA PPP loans will continue to be forgiven, with most expected to be forgiven in 2021. 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 and may not outpace overall paydowns or line utilization reductions in 2021.
● The Company loosened its vacation and sick-time policies to accommodate our employees who were affected by COVID-19. The Company hired an additional 28 temporary employees throughout the pandemic related to higher demand for loan processing and forgiveness, and to provide enhanced customer service. Those temporary assignments ended in the second quarter of 2021, although many of those employees have been redeployed within other areas of the Company.
EARNINGS PERFORMANCE
The Company earns income from two primary sources. 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 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 $3.0 million to $27.2 million, for the second quarter of 2021 over the second quarter of 2020 and increased $7.8 million, or 16% to $55.7 million for the first six months of 2021 in comparison to the first six months of 2020.
For the second quarter of 2021 as compared to the same quarter in 2020, average loan balances increased $272.7 million, or 14%, primarily due to increases in real estate loans of $348.2 million, or 24%, offset by a $64.3 million, or 31%, decrease in the utilization of mortgage warehouse lines. The increase in average commercial real estate loan balances was the primary contributor to the $3.2 million increase in loan interest income, as the average yield on the overall loan portfolio was relatively flat. There was a 11 bps favorable decrease in the cost of interest-bearing liabilities for the second quarter of 2021 as compared to the same quarter in 2020.
For the first half of 2021 as compared to the same period in 2020, average loan balances increased $465.1 million or 26%, primarily due to increases in real estate loans of $416.2 million or 29%, $100.4 million in SBA PPP loans and $16.7 million in mortgage warehouse line utilization. The increase in the aforementioned average loan balances were the
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major driver in the increase in net interest income with a 31 bps decrease in loan yield partially offsetting the increase in volume. There was a 25 bps favorable decrease in the yield on interest bearing liabilities driven by an increase in lower or no cost core deposits and a decrease in higher cost time deposits for the first half of 2021 as compared to the same period in 2020.
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.
The following tables show average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for the noted periods. The tables also display calculated yields on each major component of the Company’s investment and loan portfolios, average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods .
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Average Balances and Rates
(dollars in thousands, unaudited)
For the three months ended
For the three months ended
June 30, 2021
June 30, 2020
Assets
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Investments:
Interest-earning due from banks
$
308,453
$
85
0.11%
$
53,209
$
12
0.09%
Taxable
340,690
1,573
1.85%
403,517
2,250
2.24%
Non-taxable
243,461
1,517
3.16%
216,746
1,440
3.38%
Total investments
892,604
3,175
1.61%
673,472
3,702
2.44%
Loans and leases: (3)
Real estate
1,825,600
21,015
4.62%
1,477,380
18,355
5.00%
Agricultural
43,959
408
3.72%
47,806
452
3.80%
Commercial
166,554
2,124
5.12%
170,876
1,080
2.54%
Consumer
4,978
193
15.55%
6,667
225
13.57%
Mortgage warehouse lines
142,348
1,151
3.24%
206,669
1,532
2.98%
Other
1,460
26
7.14%
2,811
39
5.58%
Total loans and leases
2,184,899
24,917
4.57%
1,912,209
21,683
4.56%
Total interest earning assets (4)
3,077,503
28,092
3.71%
2,585,681
25,385
4.01%
Other earning assets
15,438
13,190
Non-earning assets
209,218
207,623
Total assets
$
3,302,159
$
2,806,494
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
$
161,871
$
91
0.23%
$
134,159
$
71
0.21%
NOW
601,339
116
0.08%
481,679
83
0.07%
Savings accounts
424,512
59
0.06%
327,833
46
0.06%
Money market
139,336
30
0.09%
125,594
31
0.10%
Certificates of deposit, under $100,000
70,589
48
0.27%
77,888
71
0.37%
Certificates of deposit, $100,000 or more
266,681
214
0.32%
364,874
554
0.61%
Brokered deposits
92,418
61
0.26%
19,890
37
0.75%
Total interest bearing deposits
1,756,746
619
0.14%
1,531,917
893
0.23%
Borrowed funds:
Federal funds purchased
168
—
0.00%
3
—
—
Repurchase agreements
57,885
39
0.27%
34,217
34
0.40%
Short term borrowings
3,133
—
0.00%
11,716
5
0.17%
TRUPS
35,185
245
2.79%
35,009
311
3.57%
Total borrowed funds
96,371
284
1.18%
80,945
350
1.74%
Total interest bearing liabilities
1,853,117
903
0.20%
1,612,862
1,243
0.31%
Demand deposits - noninterest bearing
1,052,494
830,333
Other liabilities
43,095
39,155
Shareholders' equity
353,453
324,144
Total liabilities and shareholders' equity
$
3,302,159
$
2,806,494
Interest income/interest earning assets
3.71%
4.01%
Interest expense/interest earning assets
0.11%
0.20%
Net interest income and margin (5)
$
27,189
3.60%
$
24,142
3.81%
(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 $1.0 million and $(0.2) million for the quarters ended June 30, 2021 and 2020, 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.
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Average Balances and Rates
(Dollars in Thousands, Unaudited)
For the six months ended
For the six months ended
June 30, 2021
June 30, 2020
Assets
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Investments:
Interest-earning due from banks
$
193,120
$
104
0.11%
$
45,166
$
153
0.68%
Taxable
329,029
3,150
1.93%
406,054
4,710
2.33%
Non-taxable
235,204
2,967
3.22%
206,218
2,778
3.42%
Total investments
757,353
6,221
1.87%
657,438
7,641
2.56%
Loans and leases: (3)
Real estate
1,852,330
42,407
4.62%
1,436,145
37,079
5.19%
Agricultural
45,050
827
3.70%
48,169
1,035
4.32%
Commercial
179,036
4,575
5.15%
139,287
2,176
3.14%
Consumer
5,199
389
15.09%
7,124
593
16.74%
Mortgage warehouse lines
192,329
3,078
3.23%
175,645
2,797
3.20%
Other
1,523
53
7.02%
4,027
116
5.79%
Total loans and leases
2,275,467
51,329
4.55%
1,810,397
43,796
4.86%
Total interest earning assets (4)
3,032,820
57,550
3.88%
2,467,835
51,437
4.25%
Other earning assets
14,363
13,015
Non-earning assets
205,187
202,265
Total assets
$
3,252,370
$
2,683,115
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
$
146,403
$
164
0.23%
$
111,445
$
134
0.24%
NOW
585,344
217
0.07%
469,133
205
0.09%
Savings accounts
407,894
112
0.06%
312,777
119
0.08%
Money market
137,887
60
0.09%
121,421
74
0.12%
Certificates of deposit, under $100,000
71,364
99
0.28%
79,370
205
0.52%
Certificates of deposit, $100,000 or more
303,272
452
0.30%
372,286
1,786
0.96%
Brokered deposits
96,188
123
0.26%
30,357
204
1.35%
Total interest bearing deposits
1,748,352
1,227
0.14%
1,496,789
2,727
0.37%
Borrowed funds:
Federal funds purchased
2,980
1
0.07%
3
—
—
Repurchase agreements
52,024
83
0.32%
30,850
61
0.40%
Short term borrowings
7,308
2
0.06%
8,831
14
0.32%
TRUPS
35,164
493
2.83%
34,986
706
4.06%
Total borrowed funds
97,476
579
1.20%
74,670
781
2.10%
Total interest bearing liabilities
1,845,828
1,806
0.20%
1,571,459
3,508
0.45%
Demand deposits - noninterest bearing
1,015,023
754,463
Other liabilities
41,156
37,687
Shareholders' equity
350,363
319,506
Total liabilities and shareholders' equity
$
3,252,370
$
2,683,115
Interest income/interest earning assets
3.88%
4.25%
Interest expense/interest earning assets
0.12%
0.28%
Net interest income and margin (5)
$
55,744
3.76%
$
47,929
3.97%
(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 $2.4 million and $(0.4) million for the six months ended June 30, 2021 and 2020, 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.
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The Volume and Rate Variances table below sets forth the dollar difference for the comparative periods in interest earned or paid for each major category of interest earning assets and interest-bearing liabilities, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates, and rate variances are equal to the change in rates multiplied by prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the rate variance.
Volume & Rate Variances
(dollars in thousands, unaudited)
Three months ended June 30,
Six months ended June 30,
2021 over 2020
2021 over 2020
Increase (decrease) due to
Increase (decrease) due to
Assets:
Volume
Rate
Net
Volume
Rate
Net
Investments:
Federal funds sold/due from time
$
58
$
15
$
73
$
501
$
(550)
$
(49)
Taxable
(350)
(327)
(677)
(893)
(667)
(1,560)
Non-taxable
177
(100)
77
390
(201)
189
Total investments (1)
(115)
(412)
(527)
(2)
(1,418)
(1,420)
Loans and leases:
Real estate
4,326
(1,666)
2,660
10,745
(5,417)
5,328
Agricultural
(36)
(8)
(44)
(67)
(141)
(208)
Commercial
(27)
1,071
1,044
621
1,778
2,399
Consumer
(57)
25
(32)
(160)
(44)
(204)
Mortgage warehouse
(477)
96
(381)
266
15
281
Other
(19)
6
(13)
(72)
9
(63)
Total loans and leases (1)
3,710
(476)
3,234
11,333
(3,800)
7,533
Total interest earning assets (1)
$
3,595
$
(888)
$
2,707
$
11,331
$
(5,218)
$
6,113
Liabilities
Interest bearing deposits:
Demand deposits
$
15
5
$
20
$
42
$
(12)
$
30
NOW
21
12
33
51
(39)
12
Savings accounts
14
(1)
13
36
(43)
(7)
Money market
3
(4)
(1)
10
(24)
(14)
Certificates of deposit, under $100,000
(7)
(16)
(23)
(21)
(85)
(106)
Certificates of deposit, $100,000 or more
(149)
(191)
(340)
(331)
(1,003)
(1,334)
Brokered deposits
135
(111)
24
442
(523)
(81)
Total interest bearing deposits (1)
32
(306)
(274)
229
(1,729)
(1,500)
Borrowed funds:
Repurchase agreements
24
(19)
5
42
(20)
22
Short term borrowings
(4)
(1)
(5)
(2)
(10)
(12)
TRUPS
2
(68)
(66)
4
(217)
(213)
Total borrowed funds (1)
22
(88)
(66)
44
(246)
(202)
Total interest bearing liabilities (1)
54
(394)
(340)
273
(1,975)
(1,702)
Net interest income (1)
$
3,541
$
(494)
$
3,047
$
11,058
$
(3,243)
$
7,815
(1) Subtotals are a sum of the categories above and are not recalculated on the portfolio totals.
The volume variance calculated for the second quarter of 2021 relative to the second quarter of 2020 was a favorable $3.5 million due to higher average balances of interest earning assets, resulting from organic growth in commercial real estate loans. There was an unfavorable rate variance of $0.5 million for the comparative quarters since the weighted average yield on interest earning assets fell by 30 basis points and the weighted average cost of interest-bearing liabil ities decreased by 11 basis points. The rate variance was negatively impacted by the following factors: high average balances of cash and due from banks earning on average 11 bps, new loans and investments having lower yields overall, including low-yielding SBA PPP loans. These negative factors were partially offset by an increase in loans 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
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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. During this period, payments are not due on the loan. 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 decrease in rate on interest earning assets was less than the net volume/rate decrease in interest bearing liabilities and resulted in a favorable $3.0 million net volume/rate difference. The Company’s net interest margin for the second quarter of 2021 was 3.60%, as compared to 3.81% for the second quarter of 2020.
The volume variance calculated for the first six months of 2021 relative to the first six months of 2020 reflects a favorable variance of $11.1 million and an unfavorable rate variance of $3.2 million, 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. The growth in interest earning assets was more than offset by the 37 basis point decrease in yield while interest bearing liabilities increased $274.4 million with a 25 basis point drop in cost. Since the volume variances outweighed the declines in yield there was a favorable $7.8 million net volume/rate difference. The Company’s net interest margin for the first half of 2021 was 3.76%, as compared to 3.97% in the first half 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 June 30, 2021, approximately 9% of our total portfolio, or $199.3 million, consists of variable rate loans. Of these variable rate loans, approximately $74 million have floors that limited the overall reduction in rates. At June 30, 2021, our outstanding fixed rate loans represented 19% of our loan portfolio. The remaining 71% of our loan portfolio at June 30, 2021 consists of adjustable rate loans. However, the majority of these loans (approximately $1.3 billion) will not begin adjusting for at least another 3 years, but up to 10 years. Approximately $66.0 million of these adjustable rate loans have the ability to reprice next quarter.
Cash balances for the quarter and year to date comparisons continue to increase and have a negative impact on our net interest margin since cash balances earn considerably lower yields than other earning assets. Average cash and due from banks was $308.4 million, an increase of $255.2 million or 480% for the second quarter of 2021 as compared to the second quarter of 2020 and was $148.0 million or 328% higher for the first half of 2021 as compared to the same period in 2020.
Overall average investment securities decreased by $36.1 million for the second quarter of June 30, 2021 as compared to June 30, 2020 and decreased by $48.0 million for the first half of 2021 as compared to the same period in 2020. For the quarter ending June 30, 2021 over the same period for 2020, average non-taxable securities increased $26.7 million and taxable securities decreased $62.8 million. For the first half of 2021 over the same period for 2020, average non-taxable securities increased $29.0 million and taxable securities decreased $77.0 million. The overall investment portfolio had a tax-equivalent yield of 2.49% at June 30, 2021, with an average life of 4.6 years.
Interest expense was $0.9 million in the second quarter of 2021, a decline of $0.3 million, or 27%, compared to the second quarter of 2020 and was $1.8 million in the first six-months of 2021, a decline of $1.7 million or 49%. The decline in interest expense for both the quarter and the half is attributable to a favorable shift in deposit mix as average total time deposits declined by $33.0 million in the second quarter of 2020 as compared to the same quarter in 2019 and by $11.2 million for the first half of 2021 as compared to the same period in 2020. The average cost of interest-bearing deposits declined by 9 basis points to 14 basis points for the second quarter of 2021 compared to the second quarter of 2020, and by 23 basis points for the first six-months of 2021 as compared to the same period in 2020. Non-interest bearing demand deposits increased $222.2 million or 27% for the second quarter of 2021 as compared to the second quarter of 2020 and increased $260.6 million or 35% for the first six-months of 2021 as compared to the same period in 2020.
.
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PROVISION FOR LOAN AND LEASE LOSSES
Credit risk is inherent in the business of making loans. 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 net benefit related to loan and lease loss provision of $2.1 million in the second quarter of 2021 relative to a loan and lease loss provision expense of $2.2 million in the second quarter of 2020, and a year-to-date net benefit for loan and lease loss provision of $1.9 million in 2021 as compared to $4.0 million loan and lease loss provision expense for the same period in 2020. The Company's $4.3 million, or 195%, favorable decline in provision for loan and lease losses in the second quarter of 2021 as compared to the second quarter of 2020, and the $5.9 million favorable decrease, or 146% in the first six months of 2021 compared to the same period in 2020 is due mostly to lower historical loan loss rates, lower average balances on loans, net recoveries of previously charged-off loan balances, and changes to qualitative factors. Management adjusted its qualitative risk factors under our current incurred loss model for improved economic conditions, improvements in the severity and volume of past due loans, enhancements in the quality of the Company’s loan review system, and a reduction in the level of concentrations of credit in non-owner occupied real estate loans.
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.
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. 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. The impact of adoption of CECL has not yet been definitively determined, due in part to changing economic forecasts and further to evaluate model inputs in advance of our planned implementation on January 1, 2022. This adjustment, however, is not expected to immediately impact our regulatory capital ratios given the Interagency Guidance to phase-in the CECL adjustment as adopted in 2020. Even if the entire adjustment immediately impacted regulatory capital ratios, the Company would have a regulatory leverage ratio in excess of 9% as required by the community bank leverage ratio framework.
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 June 30, 2021, the Company had $10.4 million in remaining loan modifications; all 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 $0.2 million in the second quarter of 2021 as compared to net charge-offs of $0.1 million for the comparative period of 2020. For the first six months of 2021, net recoveries were $0.5 million as compared to $0.4 million in net charge-offs for the same 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.
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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 six month periods ended June 30, 2021 and 2020:
Noninterest Income/Expense
(dollars in thousands, unaudited)
For the three months ended June 30,
For the six months ended June 30,
Noninterest income:
2021
2020
2021
2020
Service charges on deposit accounts
$
2,725
$
2,618
$
5,491
$
5,802
Other service charges and fees
3,050
2,503
5,611
4,907
Net gains on sale of securities available-for-sale
—
390
—
390
Bank-owned life insurance
814
649
1,397
687
Other
23
740
943
1,221
Total noninterest income
$
6,612
$
6,900
$
13,442
$
13,007
As a % of average interest earning assets (1)
0.86%
1.07%
0.89%
1.06%
Noninterest expense:
Salaries and employee benefits
$
10,425
$
9,266
$
21,576
$
19,438
Occupancy costs
Furniture & equipment
453
619
905
1,084
Premises
2,173
1,885
4,207
3,748
Advertising and marketing costs
292
425
612
1,026
Data processing costs
1,513
1,045
2,939
2,187
Deposit services costs
2,282
2,229
4,350
4,025
Loan services costs
Loan processing
65
191
234
362
Foreclosed assets
(10)
62
98
68
Other operating costs
Telephone & data communications
668
467
1,048
835
Postage & mail
109
106
193
174
Other
337
365
799
751
Professional services costs
Legal & accounting
682
357
1,125
685
Other professional service
1,004
701
1,899
947
Stationery & supply costs
73
131
151
246
Sundry & tellers
169
184
370
275
Total noninterest expense
$
20,235
$
18,033
$
40,506
$
35,851
As a % of average interest earning assets (1)
2.64%
2.80%
2.68%
2.92%
Efficiency ratio (2)(3)
58.79%
57.78%
57.58%
58.33%
(1) Annualized
(2) Tax equivalent
(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.
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Noninterest Income:
Total noninterest income reflects a decrease of $0.3 million, or 4%, for the quarterly comparison and reflects a $0.4 million increase, or 3% for the year-to-date comparison.
Service charges on deposit accounts increased by $0.1 million or 4%, for the quarterly comparison and decreased $0.3 million or 5%, for the year to date comparison. The positive and negative variances were mostly in returned items on overdrafts for both periods under comparison.
Other service charges and fees increased $0.5 million or 22% for the second quarter of 2021 $0.7 million or 14% for the first half of 2021 as compared to the same periods in 2020. For both the quarter and the half the positive variance was due to increased check-card interchange fees due to increased usage of customer debit cards.
The Company recognized a $0.4 million gain from the sale of debt securities in the second quarter of 2020, with no corresponding like sales in 2021 thus resulting in a negative variance of $0.4 million for both the second quarter and first half of 2021 as compared to the same periods in 2020.
BOLI income increased by $0.2 million as compared to the second quarter of 2021 and $0.7 million for the first half of 2021 as compared to the same period in 2020. 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 values in BOLI policies are offset by higher deferred compensation expense reflected primarily in director fees expense. At June 30, 2021, there was $43.7 million in BOLI policies associated with the deferred compensation plans and $10.2 million in separate account BOLI policies.
In the “other” category of noninterest income the Company reflected a $0.7 million decrease in the second quarter of 2021 as compared to the second quarter of 2020 and a $0.3 million decrease in the first half of 2021 as compared to the same period in 2020. The quarterly and year-to-date comparison includes a $0.7 million non-recurring gain resulting from the wrap-up of a low-income housing tax credit fund investment and a $0.4 million gain from the sale of debt securities which occurred in the second quarter of 2020. Additionally in the “other” category of noninterest income for the 2021 year-to-date comparison over the same period in 2020, the Company reflected a $0.4 million increase in the valuation of restricted stock held by the Company as required under FASB ASU 2016-01. 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.
Noninterest Expense:
Total noninterest expense increased by $2.2 million, or 12%, in the second quarter of 2021 relative to the second quarter of 2020, and increased $4.7 million or 13% in the first half of 2021 as compared to the same period in 2020. Noninterest expense dropped to 2.6% of average earning assets in the second quarter of 2021 from 2.8% for the second quarter of 2020 and was 2.68% of average earning assets for the first six months of 2021 relative to 2.92% for the same period in 2020. The tax-equivalent efficiency ratio was 58.79% in the second quarter of 2021 as compared to 57.78% in the same quarter of 2020 but improved to 57.58% for the first half of 2021 as compared to 58.33% for the same period in 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. 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 $1.2 million, or 13%, higher in the second quarter of 2021 as compared to the second quarter of 2020 and $2.1 million, or 11% higher for the first six months of 2021 compared to the same period in 2020. The reason for this increase is primarily due to lower salary expense deferrals related to the decrease in loan originations for both the quarterly and year-to-date comparisons.
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Occupancy expenses were $0.1 million higher for the second quarter of 2021 as compared to the same quarter in 2020 and $0.3 million higher for the first half of 2021 as compared to the same period in 2020. The primary reason for this increase was an acceleration of leasehold improvement amortization for two leased branch facilities that were closed during the second quarter of 2021. See the discussion of branch closures below.
Other noninterest expense increased $0.9 million, or 15% for the second quarter 2021 as compared to the second quarter in 2020, and increased $2.2 million, or 19% for the first half of 2021 as compared to the same period in 2020. The negative variance for second quarter of 2021 compared to the same period in 2020 was primarily driven by an increase of $0.5 million or 45% in data processing costs, most of which was due mostly to increases in core processor costs, price increases in loan processing software and additional software to compliment the Company’s digital strategy. We also had a $0.2 million increase in data communication costs, a $0.3 million increase in legal costs and a $0.3 million increase in other professional services costs. Other professional services variances include a $0.1 million increase in FDIC assessments, and a $0.1 million increase in deferred compensation expense for directors, which is linked to the changes in BOLI income. For the year-over-year comparison the categories of increase were the same as with the quarterly comparison, along with a $0.4 million increase in check-card processing costs.
As previously mentioned, the Company decided to permanently close five branch locations in June 2021, as a result of a change in customer behaviors brought about by the COVID-19 pandemic along with an efficiency review. The acceleration of amortization of leasehold improvements for these locations increased depreciation expense by $0.4 million in the second quarter of 2021 and by $0.5 million year-to-date 2021. It is projected that closing these five branch locations will result in annual noninterest expense savings of between $0.8 and $1.0 million.
PROVISION FOR INCOME TAXES
The Company sets aside a provision for income taxes on a monthly basis. The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits. Permanent differences include but are not limited to tax-exempt interest income, BOLI income, and certain book expenses that are not allowed as tax deductions. 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 25.3% of pre-tax income in the second quarter of 2021 relative to 23.2% in the second quarter of 2020, and 25.4% of pre-tax income for the first half of 2021, relative to 23.6% for the same period in 2020. The increases in the effective tax rates for the second quarter and first half of 2021 were 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 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.
INVESTMENTS
The Company’s investments may at any given time consist of debt securities and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest earning balances in our
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Federal Reserve Bank account, and overnight fed funds sold. The Company’s investments can serve several purposes, including the following: 1) they can provide liquidity for potential funding needs; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with structural characteristics that can be changed more readily than loan or deposit portfolios, as might be required for interest rate risk management purposes; 4) they are another interest earning option for the placement of surplus funds when loan demand is light; and 5) they can provide partially tax exempt income.
The investment portfolio is reflected on the balance sheet as investment securities and totaled $607.5 million, or 19% of total assets at June 30, 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 $294.1 million of surplus interest earning balances in our Federal Reserve Bank account at June 30, 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.
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 4.6 years and their average effective duration was 3.1 years at June 30, 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:
Investment Portfolio
(dollars in thousands, unaudited)
June 30, 2021
December 31, 2020
Amortized
Fair Market
Amortized
Fair Market
Cost
Value
Cost
Value
Available for Sale
U.S. government agencies
$
1,645
$
1,702
$
1,725
$
1,800
Mortgage-backed securities
330,883
337,760
304,108
314,435
State and political subdivisions
242,383
257,336
212,011
227,739
Corporate bonds
10,703
10,676
—
—
Total securities
$
585,614
$
607,474
$
517,844
$
543,974
The net unrealized gain on our investment portfolio, or the amount by which aggregate fair market values exceeded amortized cost, was $21.9 million at June 30, 2021, a $4.2 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 June 30, 2021, and December 31, 2020. Municipal bonds purchased have strong underlying ratings, and we review all municipal bonds in our portfolio every quarter for potential impairment. In addition, the newly purchased corporate bonds are exclusively subordinated debentures of bank holding companies. These purchases were underwritten by the credit administration department prior to acquisition and will be subject to quarterly potential impairment reviews similar to municipal bonds.
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 $125.4 million at June 30, 2021 and $232.0 million at December 31, 2020, leaving $482.1 million in unpledged debt securities at June 30, 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 $44.3 million at June 30, 2021 and $52.9 million at December 31, 2020.
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LOAN AND LEASE PORTFOLIO
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. The balances in the table are before deferred or unamortized loan origination, extension, or commitment fees, and deferred origination costs. While not reflected in the loan totals and not currently comprising a material segment of our lending activities, the Company also occasionally originates and sells, or participates out portions of, loans to non-affiliated investors.
Loan and Lease Distribution
(dollars in thousands, unaudited)
June 30, 2021
December 31, 2020
Real estate:
1-4 family residential construction
$
37,165
$
48,565
Other construction/land
27,682
71,980
1-4 family - closed-end
106,599
139,836
Equity lines
33,334
38,075
Multi-family residential
58,230
61,865
Commercial real estate - owner occupied
359,021
343,199
Commercial real estate - non-owner occupied
1,048,153
1,062,498
Farmland
125,783
129,905
Total real estate
1,795,967
1,895,923
Agricultural
42,952
44,872
Commercial and industrial
150,632
209,048
Mortgage warehouse lines
150,351
307,679
Consumer loans
4,894
5,589
Total loans and leases
$
2,144,796
$
2,463,111
Percentage of Total Loans and Leases
Real estate:
1-4 family residential construction
1.73%
1.97%
Other construction/land
1.29%
2.92%
1-4 family - closed-end
4.97%
5.68%
Equity lines
1.55%
1.55%
Multi-family residential
2.71%
2.51%
Commercial real estate - owner occupied
16.75%
13.93%
Commercial real estate - non-owner occupied
48.88%
43.14%
Farmland
5.86%
5.27%
Total real estate
83.74%
76.97%
Agricultural
2.00%
1.82%
Commercial and industrial
7.02%
8.49%
Mortgage warehouse lines
7.01%
12.49%
Consumer loans
0.23%
0.23%
Total loans and leases
100.00%
100.00%
Gross loans and leases at $2.1 billion, reflected a decrease of $318.3 million, or 13%, at June 30, 2021 from $2.5 billion at December 31, 2020 due mostly to declines in commercial real estate loan balances, outstanding balances on mortgage warehouse lines, as well as the forgiveness of SBA PPP loans.
Balances on mortgage warehouse lines were down $157.3 million or 51% during the first half of 2021. Mortgage warehouse utilization was 43% at June 30, 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, seasonality, and other factors affecting home purchasing or refinancing demand including economic uncertainty.
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There was a net decrease of $100.0 million in real estate secured loans, primarily from construction and other commercial real estate loans as the Company strategically lowered its regulatory commercial real estate concentration ratio from 378% at December 31, 2020 to 335% at June 30, 2021. Management believes that a regulatory commercial real estate loan ratio of 335% is well within its overall risk appetite given that the Company 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 June 30, 2021 we have concluded that we have an acceptable and well-managed concentration in CRE lending as defined in the Interagency Guidance dated December 12, 2006.
The 28% decrease in Commercial and Industrial loans from $209.0 million at December 31, 2020 to $150.6 million at June 30, 2021 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. There were 943 loans for $68.0 million outstanding at June 30, 2021, compared to 1,274 loans for $117.2 million at December 31, 2020. During the first half of 2021, the Bank originated, and the SBA approved, funding for $49.3 million in PPP loans while the SBA forgave $98.3 million of PPP loans. The Company is working to buildout a more robust Commercial and Industrial loan origination group and platform, including small business loans, in order to complement its commitment to serving its commercial real estate customers.
NONPERFORMING ASSETS
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 4013 of the CARES Act or the April 7, 2020 Interagency Statement. TDRs may be classified as either nonperforming or performing loans depending on their underlying characteristics and
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circumstances. The following table presents comparative data for the Company’s nonperforming assets and performing TDRs as of the dates noted:
Nonperforming assets and performing troubled debt restructurings
(dollars in thousands, unaudited)
June 30, 2021
December 31, 2020
June 30, 2020
NON-ACCRUAL LOANS:
Real estate:
Other construction/land
$
—
$
—
$
4
1-4 family - closed-end
1,473
1,193
843
Equity lines
2,138
2,403
626
Commercial real estate - owner occupied
1,278
1,678
1,909
Commercial real estate - non-owner occupied
—
582
627
Farmland
427
442
702
TOTAL REAL ESTATE
5,316
6,298
4,711
Agriculture
517
250
—
Commercial and industrial
1,423
1,026
1,086
Consumer loans
20
24
11
TOTAL NONPERFORMING LOANS
7,276
7,598
5,808
Foreclosed assets
774
971
2,893
Total nonperforming assets
$
8,050
$
8,569
$
8,701
Performing TDRs (1)
$
10,774
$
11,382
$
9,192
Nonperforming loans as a % of total gross loans and leases
0.34%
0.31%
0.26%
Nonperforming assets as a % of total gross loans and leases and foreclosed assets
0.38%
0.35%
0.39%
(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 decreased by $0.5 million, or 6%, during the first six months of 2021. The Company's ratio of nonperforming loans to gross loans increased to 0.34% at June 30, 2021 from 0.31% at December 31, 2020; this was due to a decrease in the gross loan and lease portfolio, since nonperforming loans decreased $0.3 million during the same period. 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 $10.8 million in loans classified as performing TDRs on which we were still accruing interest as of June 30, 2021, a decrease of $0.6 million, or 5%, relative to December 31, 2020.
Foreclosed assets had a carrying value of $0.8 million at June 30, 2021 comprised of 6 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.
An action plan is in place for each of our non-accruing loans and foreclosed assets and they are all being actively managed. 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 $3.2 million in loans past due 30-59 days at June 30, 2021. This is an increase of $1.1 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 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
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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. At the end of the deferral period, for term loans, payments will be applied to accrued interest first and after the accrued interest is paid in full, the loan will be re-amortized with the maturity extended. 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 June 30, 2021, the Company had $10.4 million remaining in loan modification under Section 4013 of the CARES Act. All loans are fully secured by real estate collateral. 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 some 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 June 30, 2021, all of the $10.4 million in outstanding modifications already are internally graded as classified assets.
ALLOWANCE FOR LOAN AND LEASE LOSSES
The allowance for loan and lease losses, a contra-asset, is established through periodic provisions for loan and lease losses. It is maintained at a level that is considered adequate to absorb probable losses on specifically identified impaired loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; 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 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 $16.4 million at June 30, 2021, a decrease of $1.3 million, or 7%, relative to December 31, 2020 resulting from a $1.9 million loan loss benefit recorded during the first six months of 2021, plus a $0.5 million in net recoveries during the same period. The loan loss benefit in the first six months of 2021 was precipitated primarily by the decrease in loan balances, the impact of loan recoveries and improved historical loan loss rates.
No allowance for loan and lease losses was considered necessary for the SBA PPP loans as those loans carry a 100% 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 half of 2021, please see the discussion above under Provision for Loan and Lease Losses.
The allowance for loan and lease losses was 0.77% of total loans at June 30, 2021, 0.72% at December 31, 2020 and 0.61% at June 30, 2020. The ratio of the allowance for loan and lease losses to nonperforming loans was 225.7% at June 30, 2021, relative to 233.5% at December 31, 2020 and 233.5% for June 30, 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 June 30, 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 $0.2 million for potential losses inherent in unused commitments is included in other liabilities at June 30, 2021.
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The following table summarizes activity in the allowance for loan and lease losses for the noted periods:
Allowance for Loan and Lease Losses
(dollars in thousands, unaudited)
For the three
months ended
For the three
months ended
For the six
months ended
For the six
months ended
For the year ended
June 30,
June 30,
June 30,
June 30,
December 31,
Balances:
2021
2020
2021
2020
2020
Average gross loans and leases outstanding during period (1)
$
2,184,899
$
1,912,209
$
2,275,467
$
1,810,397
$
2,068,690
Gross loans and leases outstanding at end of period
$
2,144,796
$
2,212,097
$
2,144,796
$
2,212,097
$
2,463,111
Allowance for loan and lease losses:
Balance at beginning of period
$
18,319
$
11,453
$
17,738
$
9,923
$
9,923
Provision charged to expense
(2,100)
2,200
(1,850)
4,000
8,550
Charge-offs
Real estate
1-4 family residential construction
—
—
—
—
—
Other construction/land
—
—
—
—
—
1-4 family - closed-end
—
—
—
—
—
Equity lines
11
—
12
—
—
Multi-family residential
—
—
—
—
—
Commercial real estate- owner occupied
—
—
233
—
—
Commercial real estate- non-owner occupied
—
—
—
—
—
Farmland
—
—
—
—
—
Total real estate
11
—
245
—
—
Agricultural
50
—
50
—
—
Commercial and industrial
25
67
77
92
436
Consumer loans
169
286
331
903
1,397
Total
$
255
$
353
$
703
$
995
$
1,833
Recoveries
Real estate
1-4 family residential construction
—
—
—
—
—
Other construction/land
110
—
328
34
40
1-4 family - closed-end
3
3
5
6
13
Equity lines
—
—
—
34
34
Multi-family residential
—
—
—
—
—
Commercial real estate- owner occupied
—
—
233
—
—
Commercial real estate- non-owner occupied
82
—
82
—
—
Farmland
—
—
—
—
—
Total real estate
195
3
648
74
87
Agricultural
—
—
—
—
—
Commercial and industrial
82
20
192
48
129
Consumer loans
180
237
396
510
882
Total
$
457
$
260
$
1,236
$
632
$
1,098
Net loan (recoveries) charge offs
$
(202)
$
93
$
(533)
$
363
$
735
Balance at end of period
$
16,421
$
13,560
$
16,421
$
13,560
$
17,738
RATIOS
Net (recoveries) charge-offs to average loans and leases (annualized)
(0.04)%
0.02%
(0.05)%
0.04%
0.04%
Allowance for loan losses to gross loans and leases at end of period
0.77%
0.61%
0.77%
0.61%
0.72%
Allowance for loan losses to nonperforming loans
225.69%
233.47%
225.69%
233.47%
233.46%
Net loan (recoveries) charge-offs to allowance for loan losses at end of period
(1.23)%
0.69%
(3.25)%
2.68%
4.14%
Net loan (recoveries) charge-offs to provision for loan losses
9.62%
4.23%
28.81%
9.08%
8.60%
(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 June 30, 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.
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OFF-BALANCE SHEET ARRANGEMENTS
The Company maintains commitments to extend credit in the normal course of business, as long as there are no violations of conditions established in the outstanding contractual arrangements. It is unlikely that all unused commitments will ultimately be drawn down. Unused commitments to extend credit, which included standby letters of credit, totaled $488.6 million at June 30, 2021 and $449.9 million at December 31, 2020, representing approximately 23% of gross loans outstanding at June 30, 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 FHLB letters of credit issued to customers totaling $4.9 million at both June 30, 2021 and 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 $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. For more information on the Company’s off-balance sheet arrangements, see Note 7 to the consolidated financial statements located elsewhere herein.
OTHER ASSETS
Interest earning cash balances were discussed above in the “Investments” section, but the Company also maintains a certain level of cash on hand in the normal course of business as well as non-earning deposits at other financial institutions. Our balance of cash and due from banks depends on the timing of collection of outstanding cash items (checks), the amount of cash held at our branches, and our reserve requirement among other things, and it is subject to significant fluctuations in the normal course of business. While cash flows are normally predictable within limits, those limits are fairly broad and the Company manages its short-term cash position through the utilization of overnight loans to, and borrowings from, correspondent banks, including the Federal Reserve Bank and the Federal Home Loan Bank. Should a large “short” overnight position persist for any length of time, the Company typically raises money through focused retail deposit gathering efforts or by adding brokered time deposits. 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 $78.7 million at June 30, 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 fully reopening of all branches in the second quarter 2021 and to meet customer needs for higher amounts of cash.
Foreclosed assets are discussed above in the section titled “Nonperforming Assets.” Net premises and equipment decreased by $1.6 million during the first six months of 2021, to $25.9 million. Goodwill was $27 million at June 30, 2021, unchanged during the first six 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 half 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. Bank-owned life insurance, with a balance of $54.0 million at June 30, 2021, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.
DEPOSITS AND INTEREST BEARING LIABILITIES
DEPOSITS
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. 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
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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.
Deposit Distribution
(dollars in thousands, unaudited)
June 30, 2021
December 31, 2020
Noninterest bearing demand deposits
$
1,073,833
$
943,664
Interest bearing demand deposits
155,749
109,938
NOW
596,388
558,407
Savings
435,076
368,420
Money market
133,977
131,232
Time
295,891
412,945
Brokered deposits
85,000
100,000
Total deposits
$
2,775,914
$
2,624,606
Percentage of Total Deposits
Noninterest bearing demand deposits
38.69%
35.95%
Interest bearing demand deposits
5.61%
4.19%
NOW
21.48%
21.28%
Savings
15.67%
14.04%
Money market
4.83%
5.00%
Time
10.66%
15.73%
Brokered deposits
3.06%
3.81%
Total
100.00%
100.00%
Deposit balances reflect net growth of $151.3 million, or 6%, during the first half of 2021. Time deposits were $380.9 million at June 30, 2021 as compared to $512.9 million at December 31, 2020. Brokered deposits decreased $15.0 million at June 30, 2021 to $85.0 million as compared to $100.0 million at December 31, 2020. Time deposits declined $117.1 million for the first six months of 2021 due mostly to the non-renewal of $120.0 million in public time deposits. Non-maturity deposit growth of $283.4 million for the first six months of 2021 was primarily the result of increases in balances of existing customers as the total number of customers was relatively unchanged.
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 38.7% at June 30, 2021 as compared to 36.0% at December 31, 2020.
OTHER INTEREST-BEARING LIABILITIES
The Company’s non-deposit borrowings may, at any given time, include fed funds purchased from correspondent banks, borrowings from the Federal Home Loan Bank, advances from the Federal Reserve Bank, securities sold under agreements to repurchase, and/or junior subordinated debentures. The Company uses short-term FHLB advances and fed funds purchased on uncommitted lines to support liquidity needs created by seasonal deposit flows, to temporarily satisfy funding needs from increased loan demand, and for other short-term purposes. The FHLB line is committed, but the amount of available credit depends on the level of pledged collateral.
Total non-deposit interest-bearing liabilities decreased by $111.5 million, or 51%, during the first six months of 2021 primarily due to a decrease in federal funds purchased and borrowings from the FHLB. Repurchase agreements totaled $70.5 million at June 30, 2021 relative to a balance of $39.1 million at year-end 2020. Repurchase agreements represent “sweep accounts”, where certain customers have elected to have their commercial deposit balances above a specified threshold transferred at the close of each business day into non-deposit investments accounts. The balance in the investment account is used to have the customer purchase securities or a perfected interest in specifically identified pledged securities from the bank, which are then repurchased by the bank from the customer the next business day.
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The Company had junior subordinated debentures totaling $35.2 million and $35.1 million at June 30, 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 $32.7 million at June 30, 2021 as compared to $35.1 million at December 31, 2020.
LIQUIDITY AND MARKET RISK MANAGEMENT
LIQUIDITY
Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by Management on a monthly basis, with various stress scenarios applied to assess our ability to meet liquidity needs under unusual or adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored, and we are committed to maintaining adequate liquidity resources to draw upon should unexpected needs arise.
The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet these short-term needs, we can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.
At June 30, 2021 and December 31, 2020, the Company had the following sources of primary and secondary liquidity ($ in thousands):
Primary and secondary liquidity sources
June 30, 2021
December 31, 2020
Cash and cash equivalents
$
373,902
$
71,417
Unpledged investment securities
482,039
311,983
Excess pledged securities
44,262
52,892
FHLB borrowing availability
662,641
535,404
Unsecured lines of credit
305,000
230,000
Funds available through fed discount window
62,897
58,127
Totals
$
1,930,741
$
1,259,823
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.
The significant increase in cash and cash equivalents during 2021 is due mostly to continued deposit growth coupled with decreases in loans, but partially offset by increases in investments. Utilization of this excess liquidity is expected to come from a combination of new loans, including potential loan purchases; new investment purchases; and anticipated declines in a portion of the deposits built-up during the COVID-19 pandemic. When looking to reduce these low-yielding cash balances with earning assets other than loans, management considers interest rate risk, including duration and extension risk; credit risk; and the liquidity risk of such alternative assets.
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 $100 million at June 30, 2021 and December
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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 65.4% and 25.1%, respectively, at June 30, 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 June 30, 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.
The holding company’s primary uses of funds include operating expenses incurred in the normal course of business, interest on trust preferred securities, shareholder dividends, and stock repurchases. Its primary source of funds is dividends from the Bank, since the holding company does not conduct regular banking operations. As of June 30, 2021, the holding company maintained a cash balance of $8.7 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. Both the holding company and the Bank are subject to legal and regulatory limitations on dividend payments, as outlined in Item 5(c) Dividends in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020 which was filed with the SEC.
INTEREST RATE RISK MANAGEMENT
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company does not engage in the trading of financial instruments, nor does it have exposure to currency exchange rates. Our market risk exposure is primarily that of interest rate risk, and we have established policies and procedures to monitor and limit our earnings and balance sheet exposure to changes in interest rates. The principal objective of interest rate risk management is to manage the financial components of the Company’s balance sheet in a manner that will optimize the risk/reward equation for earnings and capital under a variety of interest rate scenarios.
To identify areas of potential exposure to interest rate changes, we utilize commercially available modeling software to perform monthly earnings simulations and calculate the Company’s market value of portfolio equity under varying interest rate scenarios. The model imports relevant information for the Company’s financial instruments and incorporates Management’s assumptions on pricing, duration, and optionality for anticipated new volumes. Various rate scenarios consisting of key rate and yield curve projections are then applied in order to calculate the expected effect of a given interest rate change on interest income, interest expense, and the value of the Company’s financial instruments. The rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels).
In addition to a stable rate scenario, which presumes that there are no changes in interest rates, we typically use at least eight other interest rate scenarios in conducting our rolling 12-month net interest income simulations: upward shocks of 100, 200, 300, and 400 basis points, and downward shocks of 100, 200, and 300 basis points. Those scenarios may be supplemented, reduced in number, or otherwise adjusted as determined by Management to provide the most meaningful simulations considering economic conditions and expectations at the time. Given the current near zero interest rate environment it is unlikely that rates could decline much further beyond the downward shock of 100 basis points, therefore the downward shock scenarios of 200,300, and 400 basis points are temporarily being suspended after concurrence by the Company’s Board of Directors. 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.
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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:
June 30, 2021
June 30, 2020
Immediate change in Interest Rates (basis points)
% Change in Net Interest Income
$ Change in Net Interest Income
% Change in Net Interest Income
$ Change in Net Interest Income
+400
11.3%
$
11,645
5.4%
$
5,373
+300
9.1%
$
9,384
4.5%
$
4,477
+200
6.9%
$
7,072
3.5%
$
3,529
+100
4.1%
$
4,226
2.3%
$
2,308
Base
-100
(8.1)%
$
(8,306)
(6.3)%
$
(6,235)
For the periods ended June 30, 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 June 30, 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 June 30, 2021 scenario due to considerably more cash on hand, and to a lesser extent the impact of interest rate increases on loans with variable and adjustable rate characteristics. In the up 400 basis point shock scenario, expected net interest income over the next twelve months increases $11.6 million, or 11%, to $114.8 million at June 30, 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 decline due to asset purchases; core loan growth as mortgage warehouse utilization stabilized and our pipelines begin to increase; and expected declines in a portion of the build-up in deposits during the COVID-19 pandemic. Although the cost of interest-bearing liabilities will also increase in a rate shock, the deposit betas utilized in the interest rate 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 $4.2 million, or 4%, 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 $8.3 million or a negative variance of 8%. The reason for the drop in net interest income is, most deposit products are at or below their modeled floors of 0.10% and cannot be re-priced lower, while non-floored interest earning assets such as loans and securities can theoretically still be re-priced lower in a falling rate environment. Due to the historically low current rate environment, we view any material interest rate reductions as unlikely in the near term. However, 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 if deemed appropriate.
If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $8.3 million or a negative variance of 8%. The reason for the drop in net interest income is, most deposit products are at their floors of 0.10% and cannot be re-priced lower, while non-floored interest earning assets such as loans and securities can theoretically still be re-priced lower in a falling rate environment. Due to the historically low current rate environment, we view any material interest rate reductions as unlikely in the near term. However, 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 if 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 $5 million lower than in our standard simulation.
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. The difference between the projected fair value of the Company’s financial assets and the fair value of its financial liabilities is referred to as the economic value of equity (“EVE”), and changes in EVE under different interest rate scenarios are effectively a gauge of the Company’s longer-term exposure to interest
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rate fluctuations. 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 substantially over time, as is evident in the tables below for the periods ending June 30, 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. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. 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 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:
June 30, 2021
June 30, 2020
Immediate change in Interest Rates (basis points)
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
+400
35.6%
$
202,631
36.5%
$
195,263
+300
31.8%
$
181,010
32.1%
$
171,790
+200
25.9%
$
147,560
25.2%
$
134,702
+100
15.7%
$
89,293
14.5%
$
77,398
Base
-100
(21.3)%
$
(120,991)
(11.1)%
$
(59,340)
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. This increase in sensitivity is caused by the increase in gross deposits, namely, an increase in noninterest bearing deposits. We also run stress scenarios for the unconsolidated Bank’s EVE to simulate the possibility of adverse movement in loan prepayment rates, unfavorable changes in deposit rates, and higher deposit decay rates. Model results are highly sensitive to changes in assumed decay rates for non-maturity deposits, in particular, with material unfavorable variances occurring relative to the standard simulations shown above as decay rates are increased. Furthermore, while not as extreme as the variances produced by increasing non-maturity deposit decay rates, EVE also displays a relatively high level of sensitivity to unfavorable changes in deposit rate betas in rising interest rate scenarios.
CAPITAL RESOURCES
The Company had total shareholders’ equity of $357.7 million at June 30, 2021, comprised of $113.5 million in common stock, $4.2 million in additional paid-in capital, $224.7 million in retained earnings, and accumulated other comprehensive income of $15.4 million. At the end of 2020, total shareholders’ equity was $343.9 million. The increase during the first half 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 $3.0 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. The Company suspended its stock repurchase program on March 16, 2020 and continues to evaluate when or if we will restart repurchasing shares.
The Company uses a variety of measures to evaluate its capital adequacy, including the leverage ratio which is calculated separately for the Company and the Bank. Management reviews these capital measurements on a quarterly basis and takes appropriate action to help ensure that they meet or surpass established internal and external guidelines.
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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 Bank’s regulatory capital ratios as of the dates indicated.
Regulatory Capital Ratios
Minimum
Minimum
Requirement
Required
June 30,
December 31,
to be
Community Bank
2021
2020
Well Capitalized (2)
Leverage Ratio (1) (3)
Bank of the Sierra
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio")
10.43
%
10.50
%
5.00
%
8.50
%
(1) The minimum required Community Bank Leverage Ratio is 9.00%, but the CARES Act temporarily lowers this to 8.5% as described below.
(2) The Company was subject to these minimum requirements under the regulatory framework for Prompt Corrective Action at December 31, 2019.
(3) If the subsidiary bank’s Leverage Ratio exceeds the minimum ratio under the Community Bank Leverage Ratio Framework, it is deemed to be “well capitalized” under all other regulatory capital requirements. The Company may revert back to the regulatory framework for Prompt Corrective Action if the subsidiary bank’s Leverage Ratio falls below the minimum under the Community Bank Leverage Ratio Framework.
The federal banking agencies published a final rule on November 13, 2019, that provided a simplified measure of capital adequacy for qualifying community banking organizations. A qualifying community banking organization that opts into the community bank leverage ratio framework and maintains a leverage ratio greater than 9 percent will be considered to have met the minimum capital requirements, the capital ratio requirements for the well capitalized category under the Prompt Corrective Action framework, and any other capital or leverage requirements to which the qualifying banking organization is subject. A qualifying community banking organization with a leverage ratio of greater than 9 percent may opt into the community bank leverage ratio framework if has average consolidated total assets of less than $10 billion, has off-balance-sheet exposures of 25% or less of total consolidated assets, and has total trading assets and trading liabilities of 5 percent or less of total consolidated assets. Further, the bank must not be an advance approaches banking organization.
The final rule became effective January 1, 2020 and banks that meet the qualifying criteria can elect to use the community bank leverage framework starting with the quarter ended March 31, 2020. 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 1, 2022. The federal bank regulatory agencies adopted an interim final rule to implement this change from the CARES Act. At June 30, 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
ITEM 3
QUALITATIVE & QUANTITATIVE DISCLOSURES
ABOUT MARKET RISK
The information concerning quantitative and qualitative disclosures about market risk is included in Part I, Item 2 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Market Risk Management.”
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PART I – FINANCIAL INFORMATION
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.