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 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 outcome of any existing or future legal action for which the Company or Bank is a defendant;
● 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
Third Quarter 2021 compared to Third Quarter 2020
Third quarter 2021 net income was $10.6 million, or $0.69 per diluted share, compared to $10.4 million, or $0.68 per diluted share in the third quarter of 2020. The Company’s annualized return on average equity was 11.62% and annualized return on average assets was 1.26% for the quarter ended September 30, 2021, compared to 12.34% and 1.34%, respectively, for the same quarter in 2020. The primary drivers behind the variance in third quarter net income are as follows:
● A $0.6 million negative provision for loan and lease losses as compared to a provision for loan and lease losses of $2.4 million in the same quarter in 2020. This favorable impact was attributed to continued improvements in the overall economy and lower uncertainty, a reduction in historical loss rates, a decline in specific reserves on
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impaired loans, net loan recoveries in 2021, and a change in the mix of loans, and lower outstanding balances of net loans and leases.
● Net interest income decreased by $1.4 million mostly due to a 54 bps decline in the yield on earning assets and a shift in mix due to higher levels of average cash invested overnight with the Federal Reserve Bank and lower average loan balances.
● Noninterest income increased $0.4 million or 6% primarily due to increases in checkcard interchange fees from increased usage.
● Noninterest expense increased by $1.6 million, due mostly to a $0.9 million increase in salaries, a $0.4 million increase in deposit servicing costs, and a $0.5 million increase in legal expenses.
Year-to-Date Changes 2021 compared to First Nine-Months of 2020
Net income for the first nine months of 2021 was $33.4 million, or $2.17 per diluted share, compared to $26.5 million, or $1.73 per diluted share for the same period in 2020. The Company’s annualized return on average equity was 12.60% and annualized return on average assets was 1.36% for the nine months ended September 30, 2021, compared to a return on equity of 10.90% and return on assets of 1.26% for the nine months ended September 30, 2020. The primary drivers behind the variance in year-to-date net income are as follows:
● A $2.5 million negative provision for loan and lease losses, relative to $6.4 million provision for loan and lease losses in the first nine months of 2020, for the same reasons outlined above in the quarterly comparison.
● Net interest income increased by $6.5 million or 8% due mostly to higher average loan balances and a continued favorable deposit mix, partially offset by a lower net interest margin.
● Noninterest income increased by $0.9 million, or 4%, due to checkcard interchange fees, increases in BOLI income, and increases in the fair market value of equity securities partially offset by the fact that the third quarter of 2020 had certain nonrecurring gains on the sales of investments, and other assets that did not reoccur in the third quarter of 2021.
● Noninterest expense increased $6.2 million, or 11% due mostly to the increases in salary expense, data processing, checkcard processing costs, and professional services expense, including legal costs.
FINANCIAL CONDITION SUMMARY
September 30, 2021 relative to December 31, 2020
The Company’s assets totaled $3.4 billion at September 30, 2021 relative to $3.2 billion at December 31, 2020. The following provides a summary of key balance sheet changes during the first nine months of 2021:
● Cash and due from banks increased $350.9 million, to $422.4 million during the first nine months of the year due mostly to higher deposit balances coupled with lower loan balances.
● Investment securities increased 35% to $732.3 million from $544.0 million at December 31, 2020, primarily due to bond purchases.
● Gross loans declined $323.3 million due predominantly to a $181.2 million decline in mortgage warehouse line utilization, a $63.0 million decline in real estate loans mostly due to lower commercial real estate and construction loan balances, and a $76.8 million decrease in commercial and industrial loans, which was mostly Small Business Administration Paycheck Protection Program (“SBA PPP”) loan forgiveness.
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● Deposits totaled $2.8 billion at September 30, 2021, representing a year-to-date increase of $196.0 million, or 7%. The growth in deposits came primarily from core transaction and savings accounts, while higher-cost time and wholesale brokered deposits decreased.
● Long-term debt increased to $49.2 million from the issuance of $50 million in ten year 3.25% fixed to floating subordinated notes, net of issuance costs.
● Total shareholders’ equity of $364.5 million at September 30, 2021 reflects an increase of $20.6 million, or 6%, relative to year-end 2020 due to additional capital from the $33.4 million addition of net income, a $3.4 million unfavorable swing in accumulated other comprehensive income/loss, stock options exercised, and restricted stock compensation, net of $9.8 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.
● 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.
● On September 9, 2021, President Biden announced as part of his six-pronged, comprehensive national strategy to combat COVID-19. The “Path out of the Pandemic” includes a rule requiring all employers with 100+ employees to ensure their workforce is fully vaccinated or require any workers who remain unvaccinated to produce a negative test result on at least a weekly basis before coming to work. This Emergency Temporary Standard is currently under White House review. It is anticipated that this rule will become effective in November 2021 with enforcement actions beginning around January 1, 2022. Fines for non-compliance are up to $14,000 per violation.
Impact of COVID-19 on the Company’s Operations
● 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. The Company had $10.4 million in classified assets at September 30, 2021, from loans modified under the CARES Act, as amended, that are either not expected to make all principal and
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interest payments in a timely manner, or will need further modifications or assistance. 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, 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 given pressure on the 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, which the Company uses to price many of its loans. These lower rates impacted our net interest margin. Our net interest margin for the three months ended September 30, 2021, was 3.46%, compared to a net interest margin of 3.98% 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 resulting in $380.0 million in average overnight cash during the third quarter of 2021 and $256.0 in average balances for the year-to-date period ending September 30,2021. This overnight funding earned an average rate of 15 and 13 basis points, respectively, for the third quarter and nine-months ending September 30, 2021. In addition, investment yields have continued to decline given the overall rate environment in 2021. The overall impact of a lower net interest margin was more than offset by higher earning assets in 2021 as compared to 2020 for the year-to-date comparisons. However, for the third quarter of 2021 as compared to the same quarter in 2020, the $267.0 million increase in average interest earning balances did not fully offset the impact of the 54 bps decline in yield.
● The COVID-19 pandemic has not adversely affected our capital or financial resources as of September 30, 2021. During the first nine months of 2021, total shareholders’ equity increased by $20.6 million, or 6%, to $364.5 million. The Company earned $33.4 million in net income in the first nine months of 2021, but had a $3.4 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 $9.8 million during the first nine months of 2021. On October 21, 2021, the Company declared a twenty-two cent per share dividend to be paid on November 11, 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 September 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 nine months of 2021. In the event that we conclude that all or a portion of our goodwill is impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. At September 30, 2021, we had goodwill of $27.4 million which represented 8% of total equity.
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● 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 $0.5 million year-to-date 2021. Most of the staff at these five locations were relocated to existing branches with position vacancies however, four individuals elected to leave the Company. It is projected that closing these five branch locations in June 2021 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.
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NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest income decreased $1.4 million to $26.7 million, for the third quarter of 2021 over the third quarter of 2020 and increased $6.5 million, or 8% to $82.5 million for the first nine months of 2021 in comparison to the first nine months of 2020.
For the third quarter of 2021 as compared to the same quarter in 2020, average loan balances decreased $161.9 million, or 7%, primarily due to $144.6 million, or a 55% decrease in the utilization of mortgage warehouse lines, and a $86.4 million, or 38% decrease in commercial loans, from the forgiveness of SBA PPP loans. These decreases were partially offset by a $75.4 million increase in real estate loan balances, primarily from the purchase of $121.6 million in mortgage loan pools, later in the third quarter of 2021. The average yield on the overall loan portfolio increased 5 basis points, while there was a 2 bps favorable decrease in the cost of interest-bearing liabilities for the third quarter of 2021 as compared to the same quarter in 2020.
For the first nine months of 2021 as compared to the same period in 2020, average loan balances increased $254.3 million or 13%, primarily due to increases in real estate loans of $301.7 million or 20%. The increase in the aforementioned average loan balances were the major driver in the increase in net interest income with a 18 bps decrease in loan yield partially offsetting the increase in volume. There was a 17 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 nine months 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
September 30, 2021
September 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
$
379,597
$
146
0.15%
$
6,942
$
2
0.11%
Taxable
389,524
1,679
1.71%
366,046
1,832
1.99%
Non-taxable
259,996
1,578
3.05%
227,283
1,467
3.25%
Total investments
1,029,117
3,403
1.47%
600,271
3,301
2.45%
Loans and leases: (3)
Real estate
1,775,611
20,805
4.65%
1,700,241
20,467
4.79%
Agricultural
43,243
410
3.76%
47,733
435
3.63%
Commercial
140,105
1,796
5.09%
226,511
2,485
4.36%
Consumer
4,862
205
16.73%
6,226
236
15.08%
Mortgage warehouse lines
118,036
982
3.30%
262,593
2,087
3.16%
Other
1,463
28
7.59%
1,868
32
6.82%
Total loans and leases
2,083,320
24,226
4.61%
2,245,172
25,742
4.56%
Total interest earning assets (4)
3,112,437
27,629
3.58%
2,845,443
29,043
4.12%
Other earning assets
15,713
13,190
Non-earning assets
212,116
215,819
Total assets
$
3,340,266
$
3,074,452
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
$
148,175
$
86
0.23%
$
140,634
$
75
0.21%
NOW
605,620
115
0.08%
516,915
89
0.07%
Savings accounts
443,406
63
0.06%
354,331
51
0.06%
Money market
139,433
26
0.07%
126,567
28
0.09%
Certificates of deposit, under $100,000
70,260
47
0.27%
76,000
65
0.34%
Certificates of deposit, $100,000 or more
223,119
201
0.36%
352,171
318
0.36%
Brokered deposits
72,283
53
0.29%
29,696
15
0.20%
Total interest bearing deposits
1,702,296
591
0.14%
1,596,314
641
0.16%
Borrowed funds:
Federal funds purchased
166
—
0.00%
1,516
1
0.26%
Repurchase agreements
78,965
41
0.21%
39,268
40
0.41%
Short term borrowings
1
—
—
66,812
29
0.17%
Long-term debt
3,812
38
3.95%
—
—
—
Subordinated debentures
35,229
243
2.74%
35,052
258
2.93%
Total borrowed funds
118,173
322
1.08%
142,648
328
0.91%
Total interest bearing liabilities
1,785,240
913
0.20%
1,738,962
969
0.22%
Demand deposits - noninterest bearing
1,104,506
958,233
Other liabilities
53,134
43,521
Shareholders' equity
362,157
333,736
Total liabilities and shareholders' equity
$
3,340,266
$
3,074,452
Interest income/interest earning assets
3.58%
4.12%
Interest expense/interest earning assets
0.12%
0.14%
Net interest income and margin (5)
$
26,716
3.46%
$
28,074
3.98%
(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 $1.3 million for the quarters ended September 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 nine months ended
For the nine months ended
September 30, 2021
September 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
$
255,962
$
250
0.13%
$
32,332
$
155
0.64%
Taxable
351,109
4,835
1.84%
392,617
6,542
2.23%
Non-taxable
241,866
4,539
3.18%
213,294
4,246
3.36%
Total investments
848,937
9,624
1.71%
638,243
10,943
2.53%
Loans and leases: (3)
Real estate
1,826,476
63,211
4.63%
1,524,821
57,544
5.04%
Agricultural
44,441
1,237
3.72%
48,022
1,470
4.09%
Commercial
165,916
6,371
5.13%
168,574
4,661
3.69%
Consumer
5,085
594
15.62%
6,822
831
16.27%
Mortgage warehouse lines
167,293
4,061
3.25%
204,839
4,884
3.18%
Other
1,503
81
7.21%
3,302
148
5.99%
Total loans and leases
2,210,714
75,555
4.57%
1,956,380
69,538
4.75%
Total interest earning assets (4)
3,059,651
85,179
3.77%
2,594,623
80,481
4.20%
Other earning assets
14,817
13,074
Non-earning assets
207,523
206,816
Total assets
$
3,281,991
$
2,814,513
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
$
147,000
$
251
0.23%
$
121,246
$
209
0.23%
NOW
592,177
332
0.07%
485,176
295
0.08%
Savings accounts
419,861
175
0.06%
326,730
170
0.07%
Money market
138,408
86
0.08%
123,149
101
0.11%
Certificates of deposit, under $100,000
70,992
145
0.27%
78,239
270
0.46%
Certificates of deposit, $100,000 or more
276,261
653
0.32%
365,532
2,104
0.77%
Brokered deposits
88,132
176
0.27%
30,135
219
0.97%
Total interest bearing deposits
1,732,831
1,818
0.14%
1,530,207
3,368
0.29%
Borrowed funds:
Federal funds purchased
2,032
1
0.07%
511
1
0.26%
Repurchase agreements
61,103
124
0.27%
33,676
101
0.40%
Short term borrowings
4,846
2
0.06%
28,299
43
0.20%
Long-term debt
1,285
38
3.95%
—
—
—
Subordinated debentures
35,186
736
2.80%
35,008
965
3.68%
Total borrowed funds
104,452
901
1.15%
97,494
1,110
1.52%
Total interest bearing liabilities
1,802,097
2,719
0.20%
1,627,701
4,478
0.37%
Demand deposits - noninterest bearing
1,045,179
822,882
Other liabilities
45,191
39,646
Shareholders' equity
354,338
324,284
Total liabilities and shareholders' equity
$
3,281,991
$
2,814,513
Interest income/interest earning assets
3.77%
4.20%
Interest expense/interest earning assets
0.11%
0.23%
Net interest income and margin (5)
$
82,460
3.66%
$
76,003
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 $3.4 million and $0.9 million for the nine months ended September 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 September 30,
Nine months ended September 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
$
107
$
37
$
144
$
1,072
$
(977)
$
95
Taxable
118
(271)
(153)
(692)
(1,015)
(1,707)
Non-taxable
211
(100)
111
569
(276)
293
Total investments (1)
436
(334)
102
949
(2,268)
(1,319)
Loans and leases:
Real estate
907
(569)
338
11,384
(5,717)
5,667
Agricultural
(41)
16
(25)
(110)
(123)
(233)
Commercial
(948)
259
(689)
(73)
1,783
1,710
Consumer
(52)
21
(31)
(212)
(25)
(237)
Mortgage warehouse
(1,149)
44
(1,105)
(895)
72
(823)
Other
(7)
3
(4)
(81)
14
(67)
Total loans and leases (1)
(1,290)
(226)
(1,516)
10,013
(3,996)
6,017
Total interest earning assets (1)
$
(854)
$
(560)
$
(1,414)
$
10,962
$
(6,264)
$
4,698
Liabilities
Interest bearing deposits:
Demand deposits
$
4
7
$
11
$
44
$
(2)
$
42
NOW
15
11
26
65
(28)
37
Savings accounts
13
(1)
12
48
(43)
5
Money market
3
(5)
(2)
13
(28)
(15)
Certificates of deposit, under $100,000
(5)
(13)
(18)
(25)
(100)
(125)
Certificates of deposit, $100,000 or more
(117)
—
(117)
(514)
(937)
(1,451)
Brokered deposits
22
16
38
421
(464)
(43)
Total interest bearing deposits (1)
(65)
15
(50)
52
(1,602)
(1,550)
Borrowed funds:
Federal funds purchased
(1)
—
(1)
3
(3)
—
Repurchase agreements
40
(39)
1
82
(59)
23
Short term borrowings
(29)
—
(29)
(36)
(5)
(41)
Long-term debt
—
38
38
—
38
38
Subordinated debt
1
(16)
(15)
5
(234)
(229)
Total borrowed funds (1)
11
(17)
(6)
54
(263)
(209)
Total interest bearing liabilities (1)
(54)
(2)
(56)
106
(1,865)
(1,759)
Net interest income (1)
$
(800)
$
(558)
$
(1,358)
$
10,856
$
(4,399)
$
6,457
(1) Subtotals are a sum of the categories above and are not recalculated on the portfolio totals.
The volume variance calculated for the third quarter of 2021 relative to the third quarter of 2020 was an unfavorable $0.8 million due to lower average balances of interest earning assets, resulting from a decrease in mortgage warehouse line utilization coupled with a decrease in commercial loans, mostly from the forgiveness of SBA PPP loans, partially offset by an increase in real estate loans. There was an unfavorable rate variance of $0.6 million for the comparative quarters
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since the weighted average yield on interest earning assets fell by 54 basis points and the weighted average cost of interest-bearing liabil ities decreased by 2 basis points. The rate variance was negatively impacted by the following factors: high average balances of cash and due from banks earning on average 15 bps, new loans and investments having lower yields overall, including low-yielding 1-4 SFD mortgage loans and SBA PPP loans. These negative factors were slightly offset by an increase in lower costs of time-deposits and other interest-bearing liabilities. The average fees on the SBA PPP loans was approximately 5.5%. These fees, net of loan costs, are being accreted over the stated life of the loan (generally two years 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 more than the net volume/rate decrease in interest bearing liabilities and resulted in an unfavorable $1.4 million net volume/rate difference. The Company’s net interest margin for the third quarter of 2021 was 3.46%, as compared to 3.98% for the third quarter of 2020.
The volume variance calculated for the first nine months of 2021 relative to the first nine months of 2020 reflects a favorable volume variance of $10.9 million and an unfavorable rate variance of $4.4 million, resulting from organic growth in commercial real estate loans. The growth in interest earning assets was partially offset by the 43 basis point decrease in yield while interest bearing liabilities increased $174.4 million with a 17 basis point drop in cost. Since the volume variances outweighed the declines in yield there was a favorable $6.5 million net volume/rate difference. The Company’s net interest margin for the first nine months of 2021 was 3.66%, as compared to 3.97% in the first nine months of 2020.
As described above, a lower rate environment precipitated by two interest rate cuts by the Federal Open Market Committee totaling 150 bps in March 2020 and other economic uncertainty negatively impacted our yield on existing adjustable and variable rate portfolio loans and created a lower initial interest rate for new loan volumes. At September 30, 2021, approximately 9% of our total portfolio, or $192.7 million, consists of variable rate loans. Of these variable rate loans, approximately $69.9 million have floors that limited the overall reduction in rates. At September 30, 2021, our outstanding fixed rate loans represented 22% of our loan portfolio. The remaining 69% of our loan portfolio at September 30, 2021 consists of adjustable-rate loans; 60% of these loans (approximately $883 million) will not begin adjusting for at least another 3 years, but up to 10 years. These loans are typically adjustable every five years after the initial adjustment. Approximately $54.3 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 $379.6 million, an increase of $372.7 million for the third quarter of 2021 as compared to the third quarter of 2020 and was $256.0 million, an increase of $223.6 million for the first nine months of 2021 as compared to the same period in 2020.
Overall average investment securities increased by $56.2 million for the third quarter of September 30, 2021 as compared to September 30, 2020 and decreased by $12.9 million for the first nine months of 2021 as compared to the same period in 2020. For the quarter ending September 30, 2021 over the same period for 2020, average non-taxable securities increased $32.7 million and taxable securities increased $23.5 million. For the first nine months of 2021 over the same period for 2020, average non-taxable securities increased $28.6 million and taxable securities decreased $41.5 million due mostly to prepayments on mortgage-backed securities. Partially offsetting the decrease to taxable securities were purchases of subordinated debentures of bank holding companies and collateralized loan obligations. The overall investment portfolio had a tax-equivalent yield of 2.44% at September 30, 2021, with an average life of 4.9 years.
Interest expense was $0.9 million in the third quarter of 2021, a decline of $0.1 million, or 6%, compared to the third quarter of 2020 and was $2.7 million in the first nine-months of 2021, a decline of $1.8 million or 39%. The decline in interest expense for both the quarter and the nine months is attributable to a favorable shift in deposit mix as average total time deposits declined by $134.8 million, or 31%, in the third quarter of 2021 as compared to the same quarter in 2020 and by $96.5 million, or 22% for the first nine months of 2021 as compared to the same period in 2020. The average cost of interest-bearing deposits declined by 2 basis points to 14 basis points for the third quarter of 2021
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compared to the third quarter of 2020, and by 15 basis points to 14 basis points for the first nine-months of 2021 as compared to the same period in 2020. Non-interest bearing demand deposits increased $146.3 million or 15% for the third quarter of 2021 as compared to the third quarter of 2020 and increased $222.3 million or 27% for the first nine-months of 2021 as compared to the same period in 2020.
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 $0.6 million in the third quarter of 2021 relative to a provision of $2.4 million in the third quarter of 2020, and a year-to-date net benefit for loan and lease loss provision of $2.5 million in 2021 as compared to $6.4 million loan and lease loss provision expense for the same period in 2020. The Company's $3.0 million, or 126%, favorable decline in provision for loan and lease losses in the third quarter of 2021 as compared to the third quarter of 2020, and the $8.8 million favorable decrease, or 139% in the first nine months of 2021 compared to the same period in 2020 is due mostly to lower historical loan loss rates, a decline in outstanding balances on loans, a change in the mix of loans, and net year-to-date 2021 recoveries of previously charged-off loan balances. During the first nine months of 2021, 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, 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 in the first quarter of 2020 of the Current Expected Credit Loss ("CECL") accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326). Prior to the close of the first quarter of 2020, the Company elected under Section 4014 of the Coronavirus Aid, Relief, and Economic Security (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. Later in 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’s decision to defer the adoption of CECL was done primarily to provide additional time to better assess the impact of the COVID-19 pandemic on the expected lifetime credit losses. 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. Further, the Company has taken actions to serve our communities during the pandemic, including permitting short-term payment deferrals to current customers, as well as originating bridge loans and SBA PPP loans. Upon the adoption of CECL on January 1, 2022, the Company is expected to record the anticipated increase in the allowance for credit losses as an adjustment to equity, net of deferred taxes.
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 September, 30, 2021, the Company had $10.4 million in remaining loan modifications; all loans are fully secured by real estate. 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 continued performance on these loans after the end of the deferral period could impact future provision.
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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 charge-offs of $0.2 million in the third quarter of 2021 as compared to $0.3 million for the comparative period of 2020. For the first nine months of 2021, the Company recorded net recoveries of $0.3 million as compared to net charge-offs of $0.7 million 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.
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.
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NONINTEREST INCOME AND NONINTEREST EXPENSE
The following table provides details on the Company’s noninterest income and noninterest expense for the three and nine month periods ended September 30, 2021 and 2020:
Noninterest Income/Expense
(dollars in thousands, unaudited)
For the three months ended September 30,
For the nine months ended September 30,
Noninterest income:
2021
2020
2021
2020
Service charges on deposit accounts
$
3,186
$
2,950
$
8,677
$
8,752
Other service charges and fees
2,900
2,511
8,511
7,418
Net gains on sale of securities available-for-sale
11
—
11
390
Bank-owned life insurance
1,048
1,310
2,445
1,997
Other
390
334
1,333
1,555
Total noninterest income
$
7,535
$
7,105
$
20,977
$
20,112
As a % of average interest earning assets (1)
0.96%
0.99%
0.92%
1.04%
Noninterest expense:
Salaries and employee benefits
$
10,618
$
9,698
$
32,194
$
29,136
Occupancy costs
Furniture & equipment
406
498
1,312
1,581
Premises
1,953
2,061
6,160
5,809
Advertising and marketing costs
370
324
982
1,350
Data processing costs
1,470
1,177
4,409
3,365
Deposit services costs
2,402
2,236
6,752
6,261
Loan services costs
Loan processing
109
289
343
652
Foreclosed assets
(19)
355
78
423
Other operating costs
Telephone & data communications
534
485
1,582
1,319
Postage & mail
60
90
253
264
Other
470
338
1,269
1,090
Professional services costs
Legal & accounting
966
317
2,091
1,002
Other professional service
1,320
1,223
3,219
2,171
Stationery & supply costs
107
95
259
341
Sundry & tellers
109
117
478
392
Total noninterest expense
$
20,875
$
19,303
$
61,381
$
55,156
As a % of average interest earning assets (1)
2.66%
2.70%
2.68%
2.85%
Efficiency ratio (2)(3)
59.75%
53.74%
58.30%
56.64%
(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 increases of $0.4 million, or 6%, for the quarter ended September 30, 2021 as compared to the same quarter in 2020, and $0.9 million, or 4% for the year-to-date period ended September 30, 2021 as compared to the same period in 2020.
Service charges on deposit accounts increased by $0.2 million or 8%, for the quarterly comparison and decreased $0.1 million or 1%, for the year-to-date comparison. The variances for both periods were due to increases and decreases, respectively in overdraft fees, due to volume fluctuations.
Other service charges and fees increased $0.4 million or 15% for the third quarter of 2021 and $1.1 million or 15% for the first nine months of 2021 as compared to the same period in 2020. For both the quarter and the year-to-date comparisons 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. The same gain in 2021 was very minor, thus resulting in a negative variance of $0.4 million for the first nine months of 2021 as compared to the same period in 2020.
BOLI income decreased by $0.3 million as compared to the third quarter of 2021 and increased $0.4 million for the first nine months 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 and year-to-date values in BOLI policies are offset by higher deferred compensation expense reflected primarily in director fees expense. At September 30, 2021, there was $44.0 million in BOLI policies and $11.0 million in separate account BOLI policies associated with the deferred compensation plans.
In the “other” category of noninterest income the Company reflected a $0.1 million increase in the third quarter of 2021 as compared to the third quarter of 2020 and a $0.2 million decrease in the first nine months of 2021 as compared to the same period in 2020. The quarterly comparison includes a $0.8 million non-recurring gain resulting from the wrap-up of a low-income housing tax credit fund investment in the third quarter of 2020, partially offset by a $0.6 million favorable change in costs of the same low-income housing tax credit fund investment. A recovery of legal expenses from a prior year for $0.2 million also was recorded in the third quarter of 2021. The year-to-date comparisons were impacted by a $0.6 million favorable variance in low-income housing tax credit fund investments offset by $1.5 million in non-recurring gains in the first nine months of 2020 from the wrap up of low-income housing tax credit fund investments. The year-to-date comparison was also favorably impacted by a $0.4 million increase in the valuation of the Company’s equity investment in Pacific Coast Bankers’ Bank.
Noninterest Expense:
Total noninterest expense increased by $1.6 million, or 8%, in the third quarter of 2021 relative to the third quarter of 2020, and by $6.2 million, or 11%, in the first nine months of 2021 as compared to the same period in 2020. Noninterest expense dropped to 2.66% of average earning assets in the third quarter of 2021 down from 2.70% for the third quarter of 2020 and was 2.67% of average earning assets for the first nine months of 2021 relative to 2.85% for the same period in 2020. The tax-equivalent efficiency ratio was 59.75% in the third quarter of 2021 as compared to 53.74% in the same quarter of 2020 and was 58.30% for the first nine months of 2021 as compared to 56.64% 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, and noninterest income enhancements, however challenges in net interest income from softening loan demand make it difficult to predict further improvements of the efficiency ratio.
Salaries and Benefits were $0.9 million, or 9%, higher in the third quarter of 2021 as compared to the third quarter of 2020 and $3.1 million, or 10%, higher for the first nine months of 2021 compared to the same period in 2020. Salary
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expense deferrals related to the decrease in loan originations were primarily responsible for the negative variance; there was a decrease in salary deferrals of $0.5 million for the quarterly comparison and $2.2 million for the year-to-date comparison. There were 482 full-time equivalent employees at September 30, 2021 as compared to 491 at September 30, 2020.
Occupancy expenses were $0.2 million lower for the third quarter of 2021 as compared to the same quarter in 2020 and $0.1 million higher for the first nine months of 2021 as compared to the same period in 2020. The primary reason for decrease in the quarterly comparison was the closure of five branch facilities earlier in the year, which included the early termination of two leases immediately. The acceleration of leasehold improvements was responsible for the slight increase in the year-to-date comparison.
Other noninterest expense increased $0.9 million, or 12% for the third quarter 2021 as compared to the third quarter in 2020, and increased $3.1 million, or 17% for the first nine months of 2021 as compared to the same period in 2020. The variance for the third quarter of 2021 compared to the same period in 2020 was primarily driven by an increase of $0.6 million in legal and accounting costs due mostly to an increase in litigation costs. Additionally, there were increases of $0.3 million in data processing costs resulting from increases in core banking system expenses, and $0.4 million in increase in checkcard processing costs due to higher debit card usage. These higher costs were partially offset by a $0.4 million decrease in foreclosed assets costs, due to the sale of all but two bank owned properties. For the year-over-year comparison the categories of increase were the same as with the quarterly comparison, along with a $0.3 million increase in FDIC assessments and a $0.3 million increase in deferred compensation expense for directors, which is linked to the changes in BOLI income.
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 24.1% of pre-tax income in the third quarter of 2021 relative to 23.4% in the third quarter of 2020, and 25.0% of pre-tax income for the first nine months of 2021 relative to 23.5% for the same period in 2020. The increase in effective tax rate in the third quarter of 2021 is due to tax credits and tax-exempt income representing a smaller percentage of total taxable income.
BALANCE SHEET ANALYSIS
EARNING ASSETS
The Company’s interest earning assets are comprised of 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 $732.3 million, or 21% of total assets at September 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 $356.2 million of surplus interest earning balances in our Federal Reserve Bank account at September 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 4.9 years and their average effective duration was 3.2 years at September 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)
September 30, 2021
December 31, 2020
Amortized
Fair Market
Amortized
Fair Market
Cost
Value
Cost
Value
Available for Sale
U.S. government agencies
$
1,644
$
1,693
$
1,725
$
1,800
Mortgage-backed securities
320,919
327,645
304,108
314,435
State and political subdivisions
277,690
292,079
212,011
227,739
Corporate bonds
16,195
16,307
—
—
Collateralized loan obligations
94,591
94,588
—
—
Total securities
$
711,039
$
732,312
$
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 $21.3 million at September 30, 2021, a $4.9 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 40% of our total securities portfolio (fair value) at September 30, 2021, and 42% at December 31, 2020. Municipal bonds purchased have strong underlying ratings, and we review all municipal bonds in our portfolio every quarter for potential impairment.
The corporate bonds purchased in 2021 are exclusively subordinated debentures of bank holding companies. These bonds were subject to a credit review by the credit administration department prior to their purchase and are subject to quarterly potential impairment reviews.
The purchases of collateralized loan obligations (“CLOs”) in the third quarter of 2021 is were exclusively AAA and AA rated tranches. Each purchase is subject to a credit and structure review by the credit administration department prior to their purchase and are subject to quarterly potential impairment reviews. The AAA and AA-rated CLO purchases were primarily a balance sheet diversification strategy as management continues to utilize available liquidity. In addition to
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providing asset class diversification given the high level of real estate backed earning assets on the balance sheet, these floating rate CLOs are more asset sensitive which complements the longer-term fixed-rate earning assets.
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 $148.2 million at September 30, 2021 and $232.0 million at December 31, 2020, leaving $584.1 million in unpledged debt securities at September 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 $43.2 million at September 30, 2021 and $52.9 million at December 31, 2020.
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)
September 30, 2021
December 31, 2020
Real estate:
1-4 family residential construction
$
34,720
$
48,565
Other construction/land
25,512
71,980
1-4 family - closed-end
220,240
139,836
Equity lines
31,341
38,075
Multi-family residential
55,628
61,865
Commercial real estate - owner occupied
345,116
343,199
Commercial real estate - non-owner occupied
995,921
1,062,498
Farmland
124,446
129,905
Total real estate
1,832,924
1,895,923
Agricultural
43,296
44,872
Commercial and industrial
132,292
209,048
Mortgage warehouse lines
126,486
307,679
Consumer loans
4,828
5,589
Total loans and leases
$
2,139,826
$
2,463,111
Percentage of Total Loans and Leases
Real estate:
1-4 family residential construction
1.62%
1.97%
Other construction/land
1.19%
2.92%
1-4 family - closed-end
10.29%
5.68%
Equity lines
1.46%
1.55%
Multi-family residential
2.60%
2.51%
Commercial real estate - owner occupied
16.13%
13.93%
Commercial real estate - non-owner occupied
46.54%
43.14%
Farmland
5.82%
5.27%
Total real estate
85.65%
76.97%
Agricultural
2.03%
1.82%
Commercial and industrial
6.18%
8.49%
Mortgage warehouse lines
5.91%
12.49%
Consumer loans
0.23%
0.23%
Total loans and leases
100.00%
100.00%
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Gross loans and leases at $2.1 billion, reflected a decrease of $323.3 million, or 13%, at September 30, 2021 from $2.5 billion at December 31, 2020 due mostly to declines in commercial real estate and construction loan balances, outstanding balances on mortgage warehouse lines, as well as the forgiveness of SBA PPP loans.
Balances on mortgage warehouse lines were down $181.2 million or 59% during the first nine months of 2021. Mortgage warehouse utilization was 33% at September 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.
There was a net decrease of $63.0 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 308% at September 30, 2021, although it is expected to moderately increase this concentration ratio during the fourth quarter of 2021 and into 2022. At September 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 overall decline in real estate secured loans during 2021 was partially offset by an increase of $80.4 million in 1-4 family residential real estate loans due to the $121.6 million purchase of high quality jumbo mortgage loans during the third quarter of 2021. These loan purchases were designed as a bridge to organic loan growth as the Bank’s core loan pipeline continues to improve and the hiring of one or more loan teams that is expected to occur during the fourth quarter of 2021. If successfully hired, the loan teams are anticipated to further diversify the loan portfolio by specializing in various categories of commercial and industrial loans.
The 37% decrease in Commercial and Industrial loans from $209.0 million at December 31, 2020 to $132.3 million at September 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 642 loans for $50.7 million outstanding at September 30, 2021, compared to 1,274 loans for $117.2 million at December 31, 2020. During the first nine months of 2021, the SBA forgave $117.9 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)
September 30, 2021
December 31, 2020
September 30, 2020
NON-ACCRUAL LOANS:
Real estate:
Other construction/land
$
—
$
—
$
—
1-4 family - closed-end
1,418
1,193
975
Equity lines
1,962
2,403
1,537
Commercial real estate - owner occupied
1,251
1,678
2,364
Commercial real estate - non-owner occupied
—
582
602
Farmland
419
442
464
TOTAL REAL ESTATE
5,050
6,298
5,942
Agriculture
471
250
250
Commercial and industrial
1,245
1,026
988
Consumer loans
22
24
6
TOTAL NONPERFORMING LOANS
6,788
7,598
7,186
Foreclosed assets
93
971
2,970
Total nonperforming assets
$
6,881
$
8,569
$
10,156
Performing TDRs (1)
$
5,509
$
11,382
$
7,708
Nonperforming loans as a % of total gross loans and leases
0.32%
0.31%
0.30%
Nonperforming assets as a % of total gross loans and leases and foreclosed assets
0.32%
0.35%
0.43%
(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 $1.7 million, or 20%, to $6.9 million during the first nine months of 2021. The Company's ratio of nonperforming loans to gross loans increased to 0.32% at September 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 $0.8 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 $5.5 million in loans classified as performing TDRs on which we were still accruing interest as of September 30, 2021, a decrease of $5.9 million, or 52%, relative to December 31, 2020.
Foreclosed assets had a carrying value of $0.1 million at September 30, 2021 comprised of 2 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 $1.3 million in loans past due 30-59 days at September 30, 2021. This is a decrease of $0.8 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.
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As described above, the Company is providing loan modifications to certain customers and taking advantage of either Section 4013 of the CARES Act or the April 7, 2020 Interagency Statement, which provides that such modifications do not result in treatment of such loan as a TDR. Since April 2020, the Company modified approximately $426 million of its loans under this guidance. For the Company, these modifications typically provided a deferral of both principal and interest for 180 days. Interest continues to accrue during the deferral period. 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 September 30, 2021, the Company had $10.4 million for one customer relationship remaining in loan modifications under Section 4013 of the CARES Act. The $10.4 million remaining on deferral is 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 September 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 $15.6 million at September 30, 2021, a decrease of $2.1 million, or 12%, relative to December 31, 2020 resulting from a $2.5 million loan loss benefit recorded during the first nine months of 2021, plus a $0.3 million in net recoveries during the same period. The loan loss benefit in the first nine 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 decrease in the provision for loan and lease losses during the first nine months of 2021, please see the discussion above under Provision for Loan and Lease Losses.
The allowance for loan and lease losses was 0.73% of total loans at September 30, 2021, 0.72% at December 31, 2020 and 0.65% at September 30, 2020. The ratio of the allowance for loan and lease losses to nonperforming loans was 230.1% at September 30, 2021, relative to 233.5% at December 31, 2020 and 216.9% for September 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 September 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 September 30, 2021, as compared to $0.3 million at December 31, 2020 and September 30, 2020.
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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 nine
months ended
For the nine
months ended
For the year ended
September 30,
September 30,
September 30,
September 30,
December 31,
Balances:
2021
2020
2021
2020
2020
Average gross loans and leases outstanding during period (1)
$
2,083,320
$
2,245,172
$
2,210,714
$
1,956,380
$
2,068,690
Gross loans and leases outstanding at end of period
$
2,139,826
$
2,380,300
$
2,139,826
$
2,380,300
$
2,463,111
Allowance for loan and lease losses:
Balance at beginning of period
$
16,421
$
13,560
$
17,738
$
9,923
$
9,923
Provision charged to expense
(600)
2,350
(2,450)
6,350
8,550
Charge-offs
Real estate
1-4 family residential construction
—
—
—
—
—
Other construction/land
—
—
—
—
—
1-4 family - closed-end
—
—
—
—
—
Equity lines
—
—
12
—
—
Multi-family residential
—
—
—
—
—
Commercial real estate- owner occupied
—
—
233
—
—
Commercial real estate- non-owner occupied
—
—
—
—
—
Farmland
—
—
—
—
—
Total real estate
—
—
245
—
—
Agricultural
—
—
50
—
—
Commercial and industrial
52
327
129
419
436
Consumer loans
274
234
606
1,137
1,397
Total
$
326
$
561
$
1,030
$
1,556
$
1,833
Recoveries
Real estate
1-4 family residential construction
—
—
—
—
—
Other construction/land
—
1
328
35
40
1-4 family - closed-end
(84)
3
(78)
9
13
Equity lines
25
—
25
34
34
Multi-family residential
—
—
—
—
—
Commercial real estate- owner occupied
—
—
233
—
—
Commercial real estate- non-owner occupied
—
—
82
—
—
Farmland
—
—
—
—
—
Total real estate
(59)
4
590
78
87
Agricultural
—
—
—
—
—
Commercial and industrial
11
35
203
83
129
Consumer loans
170
198
566
708
882
Total
$
122
$
237
$
1,359
$
869
$
1,098
Net loan (recoveries) charge offs
$
204
$
324
$
(329)
$
687
$
735
Balance at end of period
$
15,617
$
15,586
$
15,617
$
15,586
$
17,738
RATIOS
Net (recoveries) charge-offs to average loans and leases (annualized)
0.04%
0.06%
(0.02)%
0.05%
0.04%
Allowance for loan losses to gross loans and leases at end of period
0.73%
0.65%
0.73%
0.65%
0.72%
Allowance for loan losses to nonperforming loans
230.07%
216.89%
230.07%
216.89%
233.46%
Net loan (recoveries) charge-offs to allowance for loan losses at end of period
1.31%
2.08%
(2.11)%
4.41%
4.14%
Net loan (recoveries) charge-offs to provision for loan losses
(34.00)%
13.79%
13.43%
10.82%
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 September 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
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conditions, updated accounting or regulatory requirements, and/or other factors could induce us to augment or reduce the allowance.
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 $540.0 million at September 30, 2021 and $449.9 million at December 31, 2020, representing approximately 25% of gross loans outstanding at September 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 September 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 which totaled $76.2 million at September 30, 2021. 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 investments or loans, subject to the bank’s risk tolerances. The Company’s balance of non-earning cash and due from banks was $66.2 million at September 30, 2021 relative to $67.9 million at December 31, 2020.
Foreclosed assets are discussed above in the section titled “Nonperforming Assets.” Net premises and equipment decreased by $3.0 million during the first nine months of 2021, to $24.5 million. This decline was primarily a result of the closure of five branch locations in the second quarter of 2021. Goodwill was $27 million at September 30, 2021, unchanged during the first nine 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 nine months 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 $55.0 million at September 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
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to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity accounts such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts. Information concerning average balances and rates paid by deposit type is included in the Average Balances and Rates tables appearing above, in the section titled “Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits by type, showing the period-end balance and percentage of total deposits, is presented as of the dates indicated in the following table.
Deposit Distribution
(dollars in thousands, unaudited)
September 30, 2021
December 31, 2020
Noninterest bearing demand deposits
$
1,111,411
$
943,664
Interest bearing demand deposits
154,773
109,938
NOW
611,050
558,407
Savings
451,248
368,420
Money market
141,348
131,232
Time
290,816
412,945
Brokered deposits
60,000
100,000
Total deposits
$
2,820,646
$
2,624,606
Percentage of Total Deposits
Noninterest bearing demand deposits
39.40%
35.95%
Interest bearing demand deposits
5.49%
4.19%
NOW
21.66%
21.28%
Savings
16.00%
14.04%
Money market
5.01%
5.00%
Time
10.31%
15.73%
Brokered deposits
2.13%
3.81%
Total
100.00%
100.00%
Deposit balances reflect net growth of $196.0 million, or 7%, during the first nine months of 2021. Time deposits were $290.8 million at September 30, 2021 as compared to $412.9 million at December 31, 2020. Brokered deposits decreased $40.0 million at September 30, 2021 to $60.0 million as compared to $100.0 million at December 31, 2020. Time deposits declined $122.1 million for the first nine months of 2021 due mostly to the non-renewal of $120.0 million in public time deposits. Non-maturity deposit growth of $358.2 million for the first nine 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 39.4% at September 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 $40.1 million, or 18%, during the first nine months of 2021 primarily due to a decrease in federal funds purchased and borrowings from the FHLB. Repurchase agreements totaled $92.6 million at September 30, 2021 relative to a balance of $39.1 million at year-end 2020. Repurchase agreements
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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.
Long term debt increased to $49.2 million from the issuance of $50 million in 3.25% fixed – floating subordinated debt with a ten-year maturity in the third quarter of 2021. The Company’s Board approved a $25 million contribution of additional capital to the Bank in the fourth quarter of 2021. The Company plans to utilize the remainder of the funds for general corporate purposes, which may include repurchasing shares, among other things.
The Company had junior subordinated debentures totaling $35.3 million and $35.1 million at September 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 $80.6 million at September 30, 2021 as compared to $35.1 million at December 31, 2020. The $45.5 million increase in the first nine months of 2021 was attributed to a forward settling investment securities accrual.
LIQUIDITY AND MARKET RISK MANAGEMENT
LIQUIDITY
Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by Management on a monthly basis, with various stress scenarios applied to assess our ability to meet liquidity needs under unusual or adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored, and we are committed to maintaining adequate liquidity resources to draw upon should unexpected needs arise.
The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet these short-term needs, we can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.
At September 30, 2021 and December 31, 2020, the Company had the following sources of primary and secondary liquidity ($ in thousands):
Primary and secondary liquidity sources
September 30, 2021
December 31, 2020
Cash and cash equivalents
$
422,350
$
71,417
Unpledged investment securities
584,066
311,983
Excess pledged securities
43,246
52,892
FHLB borrowing availability
773,125
535,404
Unsecured lines of credit
305,000
230,000
Funds available through fed discount window
61,867
58,127
Totals
$
2,189,654
$
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
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come from a combination of new loans, including loan purchases, and new investment purchases. In addition, it is possible that a portion of the deposits built-up during the COVID-19 pandemic could be withdrawn by customers. When looking to reduce these low-yielding cash balances with earning assets, 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 September 30, 2021 and December 31, 2020. Other sources of liquidity include 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 62.08% and 28.57%, respectively, at September 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 September 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 and subordinated debt, shareholder dividends, and share repurchases. Its primary source of funds is dividends from the Bank, since the holding company does not conduct regular banking operations, however the holding company did raise $50 million in cash from the issuance of subordinated debt in the third quarter of 2021. As of September 30, 2021, the holding company maintained a cash balance of $53.7 million, but expects to contribute $25.0 million in capital to the Bank in the fourth quarter of 2021. Management anticipates that with the available cash on hand remaining after the capital infusion to the Bank, the holding company still 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).
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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.
The Company had the following estimated net interest income sensitivity profiles over one-year, without factoring in any potential negative impact on spreads resulting from competitive pressures or credit quality deterioration:
September 30, 2021
September 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
16.1%
$
17,379
(0.4)%
$
(367)
+300
13.2%
$
14,317
0.1%
$
131
+200
9.8%
$
10,592
0.7%
$
677
+100
5.7%
$
6,188
0.9%
$
968
Base
-100
(11.0)%
$
(11,936)
(5.8)%
$
(5,948)
For the period ended September 30, 2021, management believes that the Company was asset sensitive, with net income increasing in a rising rate environment in all scenarios but declining considerably in the down shocks. For period ended September 30, 2020, management believed that the Company was generally asset sensitive, with overall sensitivity declining with larger rate shocks and declining overall in the down shock and up 400 basis point shock. The change in the magnitude of the Company’s asset sensitivity based on its interest rate risk model at September 30, 2021 as compared to September 30, 2020, is due mostly to the level of overnight cash held as an interest bearing deposit at the Federal Reserve Bank. At September 30, 2021, the Company had $356.2 million in overnight cash with the Federal Reserve Bank compared to $3.5 million at September 30, 2020. As this cash is held overnight, any change in interest rate in the model would increase the yield on such overnight cash immediately, therefore, increasing the Company’s asset sensitivity.
The simulation for the period ending September 30, 2021 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. As described above, the rate of increase is significantly greater than the September 30, 2020 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 $17.4 million, or 16%, to $125.5 million at September 30, 2021 compared to a 0.4% decrease or $0.4 million for the same period in 2020. The reason that the modeled asset level of asset sensitivity declined at September 30, 2020 with each increase in the parallel rate shock is because of the level of overnight borrowing at such date. With each subsequently larger rate shock, the cost of overnight borrowing increased more than the modeled increase in earning asset rates which caused the level of sensitivity to decline as the rate shocks increased in magnitude at September 30, 2020.
Over the next twelve months, surplus cash is projected to decline due to expected earning asset purchases and core loan growth as our pipelines begin to increase. Further, a portion of the significant increase in deposits during the COVID-19 pandemic could be withdrawn by customers. These expected changes in earnings assets, including overnight cash, are not modeled in the immediate rate shock model described above. 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.
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If there was an immediate downward adjustment, it is anticipated that interest income would decline. The reason for the drop in net interest income is because 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 where we model 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 $13.4 million lower than in our standard simulation.
The modeled 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 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 September 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 and deposit growth. The tables below show estimated changes in the Company’s EVE as modeled under different interest rate scenarios relative to a base case of current interest rates:
September 30, 2021
September 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
38.1%
$
218,354
33.5%
$
175,998
+300
35.7%
$
204,153
30.1%
$
158,018
+200
29.9%
$
171,390
24.2%
$
127,038
+100
17.6%
$
100,607
14.4%
$
75,619
Base
-100
(23.1)%
$
(132,270)
(7.9)%
$
(41,602)
The table shows that our EVE is modeled to 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
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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 $364.5 million at September 30, 2021, comprised of $114.1 million in common stock, $3.7 million in additional paid-in capital, $231.7 million in retained earnings, and accumulated other comprehensive income of $15.0 million. At the end of 2020, total shareholders’ equity was $343.9 million. The increase during the first nine months of 2021 is due to the addition of capital from net income, stock options exercised and restricted stock accrued. These positive changes were partially offset by a $3.4 million unfavorable swing in accumulated other comprehensive income, net and the impact of cash dividends paid. The Company approved a new share repurchase program (the 2021 Share Repurchase Plan) on October 21, 2021 and authorized one million shares to be repurchased under this plan. The previous 2003 Share Repurchase Plan was cancelled and the 268,301 shares remaining in that plan were incorporated into the 2021 Share Repurchase Plan. No shares have been repurchased year-to-date under either plan.
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. 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
September 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")
10.66
%
10.12
%
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 September 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.
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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.”
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.