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 fluctuations in interest rates;
● 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;
● risks associated with inflation (including efforts by the Board of Governors of the Federal Reserve to control the same);
● 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 or changes to current and prospective laws and regulations, and related interpretations, 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, 2021 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 credit losses, as explained in detail in Note 10 to the consolidated financial statements and in the “Provision for Credit Losses” and “Allowance for Credit Losses” sections of this discussion and analysis;
● the valuation of individually evaluated loans and foreclosed assets, as discussed in Notes 8 and 10 to the consolidated financial statements;
● income taxes and related deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; and
● goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in the “Other Assets” section of this discussion and analysis.
Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations regarding those areas.
OVERVIEW OF THE RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
RESULTS OF OPERATIONS SUMMARY
Second Quarter 2022 compared to Second Quarter 2021
Second quarter 2022 net income was $9.2 million, or $0.61 per diluted share, compared to $11.7 million, or $0.76 per diluted share in the second quarter of 2021. The Company’s annualized return on average equity was 11.68% and annualized return on average assets was 1.07% for the quarter ended June 30, 2022, compared to 13.29% and 1.42%, respectively, for the same quarter in 2021. The primary drivers behind the variance in second quarter net income are as follows:
● Net interest income decreased $0.6 million, or 2%, due primarily to a $0.4 million increase in interest expense from the issuance of subordinated debt during the third quarter of 2021 and higher cost of funds on interest-bearing liabilities due to the recent increases in the prime interest rate.
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● The provision for credit losses on loans and leases was $2.5 million under the new current expected credit losses (“CECL”) methodology, as compared to a $2.1 million benefit under the incurred loss model in the same quarter of 2021, for a net increase of $4.6 million. This is driven primarily from the replacement of allowance due to $4.1 million in net loan charge offs during the second quarter of 2022.
● Noninterest income increased $3.8 million, primarily due to a $3.2 million gain on sale of other assets, $0.4 million in life insurance proceeds, a $0.2 million recovery on an acquired loan, and a $1.0 million recovery of prior year legal expenses, partially offset by a $1.4 million negative variance in Corporate Owned Life Insurance with income linked to the Company’s nonqualified deferred compensation plan.
● Total noninterest expense increased $1.9 million, or 9%, in the second quarter of 2022 as compared to the second quarter of 2021. Higher salaries and benefits costs accounted for $1.3 million of the increase as we added new lending teams, and $0.8 million of the increase was due to higher other expenses, mostly for the accrual of restitution payments to customers charged nonsufficient fund fees for representments in the past five years and $0.3 million in postage and mailing costs associated with new disclosure agreements which detail updated service charges on returned items and overdraft fees.
First Half 2022 compared to First Half 2021
Net income for the first half of 2022 was $16.6 million, or $1.10 per diluted share, compared to $22.8 million, or $1.48 per diluted share for the same period in 2021. The Company’s annualized return on average equity was 10.10% and annualized return on average assets was 0.98% for the six months ended June 30, 2022, compared to a return on equity of 13.11% and return on assets of 1.41% for the six months ended June 30, 2021. The primary drivers behind the variance in year-to-date net income are as follows:
● The provision for credit losses on loans and leases was $3.1 million, an increase of $5.0 million, due to a change from the incurred loss method to the current expected credit loss method, coupled with higher charge-offs in 2022 on two loan relationships.
● Net interest income decreased by $4.4 million, or 8%, due mostly to the change in mix of interest earning assets with average loan balances increasing and investments increasing. In addition, the cost of interest-bearing liabilities was higher due to increases in index rates on certain floating rate liabilities.
● Noninterest income increased $3.1 million, or 23%, for the same reasons as noted above in the quarterly comparison, combined with a $1.0 million gain on the sale of investment securities, and a $2.6 million negative variance in BOLI income tied to our nonqualified deferred compensation plan.
● Noninterest expense increased $1.8 million, or 4% for the same reasons as outlined in the quarterly comparison above.
FINANCIAL CONDITION SUMMARY
June 30, 2022 relative to December 31, 2021
The Company’s assets totaled $3.4 billion at June 30, 2022 unchanged from December 31, 2021. The following provides a summary of key balance sheet changes during the first six months of 2022:
● The Company’s balance of cash and cash equivalents declined by $95.7 million, or 37% from December 31, 2021. The overall increase in cash balances was due primarily to increases in investment securities and loans and leases during the first half 2022.
● Investment securities were $1.0 billion at June 30, 2022, an increase of $52.3 million, or 5% from December 31, 2021. The Company purchased $158.2 million in various government agency sponsored mortgage-backed securities, agency securities, municipal securities, corporate bonds and collateralized mortgage obligations. On April 1, 2022, the Company transferred $162.1 million of “available-for-sale” investment securities to “held-to-maturity”. The securities were transferred at fair market value on the date of transfer. The transfer was initiated to partially insulate other comprehensive income and equity from changes in interest rates. This transfer had no
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impact on net income, and future price changes on these securities due to changes in interest rates will not affect capital.
● Gross loans increased $32.9 million due predominantly to the purchase of high quality jumbo single family mortgage loan pool purchases. This increase was offset by reductions in almost all loan categories as loan maturities and payoffs exceeded the increases in loan production for the first six months of 2022.
● Deposits increased by $69.4 million, or 2%. The growth in deposits came primarily from noninterest-bearing or low-cost transaction and savings accounts, while higher-cost time deposits increased $5.9 million.
Total shareholders’ equity of $299.0 million at June 30, 2022 reflects a decrease of $63.4 million, or 18%, relative to year-end 2021, due to the addition of $16.6 million in net income, offset by a $61.6 million unfavorable swing in accumulated other comprehensive income/loss due principally to changes in investment securities’ fair value, a one-time adjustment from the implementation of CECL on January 1, 2022 for $7.3 million, $4.9 million in share repurchases and net of $7.0 million in dividends paid. The remaining difference is related to stock options exercised and restricted stock compensation recognized during the quarter.
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 many actions impacting the Company. These actions included, among other things, the Federal Open Market Committee (FOMC) reducing the federal funds rate; California issuing a state-wide shelter-in-place order and various other orders at the state and local levels restricting business operations, closing schools, and thereafter prescribing requirements for reopening; and various pieces of federal legislation were passed to attempt to address the impact of COVID-19 on the economy.
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 no loans remaining on deferral, which were modified under the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act, as amended.
● The uncertainty of national and local economic conditions had an impact on our provision for credit losses in early 2022 and on our provision for loan and lease losses in 2021. The Company implemented 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) on January 1, 2022, after having elected under Section 4014 of the CARES Act and the Consolidated Appropriations Act, 2021 to defer earlier implementation.
● The Company expects that net interest income may continue to be adversely impacted given pressure on the net interest margin as a result of the current interest rate environment. Although the FOMC has raised the fed funds rate three times in the first half of 2022; 25 basis points on March 16, 2022, 50 basis points on May 4, 2022 and 75 basis points on June 16, 2022, the overall rate environment is still relatively low. The FOMC has indicated potential future increases to the overnight fed funds rate but uncertainty as to when and at what rate this may occur still remains. These lower rates have impacted our net interest margin. Our net interest margin for the six months ended June 30, 2022, was 3.31%, compared to a net interest margin of 3.76% for the same period in 2021. Additional liquidity from significant deposit growth in 2021 and the first six months of 2022, coupled with lower loan balances has negatively impacted our net interest margin. This additional liquidity was mostly deployed in overnight funding resulting in $170.4 million in average overnight cash during the first half of 2022. This overnight funding earned an average rate of 43 basis points, for the first six months ending June
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30, 2022. In addition, the Company had $1.0 billion in investment securities at average tax effective yield 207 basis points lower than that of current loan yields.
● The COVID-19 pandemic has not adversely affected our capital or financial resources as of June 30, 2022. During the first half of 2022, total shareholders’ equity decreased by $63.4 million, or 18%, to $299.0 million. The Company earned $16.6 million in net income in the first six months of 2022, but had a $61.6 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. If interest rates continue to rise, this component of equity would be expected to further decline. The Company also paid dividends of $7.0 million and repurchased shares of stock for $4.9 million during the first half of 2022. On July 21, 2022, the Company declared a twenty-three cent per share dividend to be paid on August 15, 2022. 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.
● The Company continues to serve its customers. Several of our branch locations were closed during the height of the pandemic, but have since re-opened. Five branch locations were permanently closed 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.
● As a financial institution providing essential services, the Company expects continued demand for loans and deposits. In addition, strong mortgage warehouse utilization that resulted from the low rate refinance environment of 2020 and 2021 is not expected to return in 2022 and hence our loans outstanding in this sector remain at lower levels. Further, it is expected that SBA PPP loans will continue to be forgiven, with the remainder expected to be forgiven in 2022.
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 BOLI and investment gains. The majority of the Company’s noninterest expense is comprised of operating costs that facilitate offering a full range of banking services to our customers.
.
NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest income decreased $0.6 million to $26.6 million, for the second quarter of 2022 over the second quarter of 2021 and decreased $4.4 million, or 8% to $51.3 million for the first six months of 2022 relative to the same period in 2021.
For the second quarter of 2022 as compared to the same quarter in 2021, average loan balances decreased $173.0 million, or 8%, primarily due to decreases in commercial loans of $86.0 million, or 52%, a $13.5 million, or 31% decrease in agricultural production loans, and a $92.5 million, or 65%, decrease in the utilization of mortgage warehouse lines. These decreases were partially offset by an $18.8 million, or 1% increase in real estate loans. The yield on the loan and lease portfolio was 26 basis points lower in the second quarter of 2022 as compared to the same period in 2021. Average investment balances also increased $290.6 million with a 79 basis point increase in yield, mostly due to a $388.9 million increase in average collateralized loan obligation balances which have variable rates, which helped
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alleviate some of the negative pressure on our net interest margin. Adding to the pressure on our net interest margin, was a 13 basis points unfavorable increase in the cost of interest-bearing liabilities in the second quarter of 2022 as compared to the second quarter of 2021.
For the first half of 2022 as compared to the same period in 2021, average loan balances decreased $293.5 million or 13%. All categories of loans decreased with the primary decrease in commercial loans for $90.3 million and a $136.8 million decline in mortgage warehouse line utilization. There was a 24 basis points decrease in loan yield for the first half of 2022 as compared to the same period in 2021. Average investment balances increased $451.0 million yielding 28 basis points higher for the same period, which helped offset the negative loan yield variances. Adding to the unfavorable decrease in yield was an 11 basis point decrease in the yield on interest bearing liabilities, driven by the recent increases in the prime interest rate.
The level of net interest income we recognize in any given period depends on a combination of factors including the average volume and yield for interest earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities.
The following tables show average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for the noted periods. The tables also display calculated yields on each major component of the Company’s investment and loan portfolios, average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods .
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Average Balances and Rates
(dollars in thousands, unaudited)
For the three months ended
For the three months ended
June 30, 2022
June 30, 2021
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
$
146,287
$
270
0.74%
$
308,453
$
85
0.11%
Taxable
752,693
4,477
2.39%
340,690
1,573
1.85%
Non-taxable
284,198
1,854
3.31%
243,461
1,517
3.16%
Total investments
1,183,178
6,601
2.40%
892,604
3,175
1.61%
Loans and leases: (3)
Real estate
1,844,367
19,659
4.28%
1,825,600
21,015
4.62%
Agricultural
30,466
232
3.05%
43,959
408
3.72%
Commercial
80,533
980
4.88%
166,554
2,124
5.12%
Consumer
4,264
207
19.47%
4,978
193
15.55%
Mortgage warehouse lines
49,884
493
3.96%
142,348
1,151
3.24%
Other
2,354
34
5.79%
1,460
26
7.14%
Total loans and leases
2,011,868
21,605
4.31%
2,184,899
24,917
4.57%
Total interest earning assets (4)
3,195,046
28,206
3.60%
3,077,503
28,092
3.71%
Other earning assets
15,628
15,438
Non-earning assets
239,803
209,218
Total assets
$
3,450,477
$
3,302,159
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
$
221,322
$
120
0.22%
$
161,871
$
91
0.23%
NOW
542,915
82
0.06%
601,339
116
0.08%
Savings accounts
480,654
70
0.06%
424,512
59
0.06%
Money market
155,574
23
0.06%
139,336
30
0.09%
Time Deposits
295,850
441
0.60%
337,270
262
0.31%
Brokered deposits
60,000
48
0.32%
92,418
61
0.26%
Total interest bearing deposits
1,756,315
784
0.18%
1,756,746
619
0.14%
Borrowed funds:
Federal funds purchased
168
—
—
168
—
0.00%
Repurchase agreements
112,417
77
0.27%
57,885
39
0.27%
Short term borrowings
1
—
—
3,133
—
0.00%
Long-term debt
49,160
430
3.51%
—
—
Subordinated debentures
35,365
330
3.74%
35,185
245
2.79%
Total borrowed funds
197,111
837
1.70%
96,371
284
1.18%
Total interest bearing liabilities
1,953,426
1,621
0.33%
1,853,117
903
0.20%
Demand deposits - noninterest bearing
1,132,601
1,052,494
Other liabilities
48,458
43,095
Shareholders' equity
315,992
353,453
Total liabilities and shareholders' equity
$
3,450,477
$
3,302,159
Interest income/interest earning assets
3.60%
3.71%
Interest expense/interest earning assets
0.20%
0.12%
Net interest income and margin (5)
$
26,585
3.40%
$
27,189
3.60%
(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 $0.4 million and $1.0 million for the quarters ended June 30, 2022 and 2021, respectively.
(4) Non-accrual loans have been included in total loans for purposes of computing total earning assets.
(5) Net interest margin represents net interest income as a percentage of average interest earning assets.
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Average Balances and Rates
(Dollars in Thousands, Unaudited)
For the six months ended
For the six months ended
June 30, 2022
June 30, 2021
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
$
170,432
$
363
0.43%
$
193,120
$
104
0.11%
Taxable
756,061
7,966
2.12%
329,029
3,150
1.93%
Non-taxable
281,882
3,581
3.24%
235,204
2,967
3.21%
Total investments
1,208,375
11,910
2.15%
757,353
6,221
1.87%
Loans and leases: (3)
Real estate
1,799,132
37,984
4.26%
1,852,330
42,407
4.62%
Agricultural
32,216
534
3.34%
45,050
827
3.70%
Commercial
88,784
2,378
5.40%
179,036
4,575
5.15%
Consumer
4,355
413
19.12%
5,199
389
15.09%
Mortgage warehouse lines
55,538
1,003
3.64%
192,329
3,078
3.23%
Other
1,922
65
6.82%
1,523
53
7.02%
Total loans and leases
1,981,947
42,377
4.31%
2,275,467
51,329
4.55%
Total interest earning assets (4)
3,190,322
54,287
3.49%
3,032,820
57,550
3.88%
Other earning assets
15,654
14,363
Non-earning assets
225,345
205,187
Total assets
$
3,431,321
$
3,252,370
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
$
212,193
$
226
0.21%
$
146,403
$
164
0.23%
NOW
544,589
164
0.06%
585,344
217
0.07%
Savings accounts
474,213
137
0.06%
407,894
112
0.06%
Money market
153,469
46
0.06%
137,887
60
0.09%
Time Deposits
294,773
675
0.46%
374,636
551
0.30%
Brokered deposits
60,000
96
0.32%
96,188
123
0.26%
Total interest bearing deposits
1,739,237
1,344
0.16%
1,748,352
1,227
0.14%
Borrowed funds:
Federal funds purchased
169
1
1.19%
2,980
1
0.07%
Repurchase agreements
108,762
158
0.29%
52,024
83
0.32%
Short term borrowings
1
—
0.00%
7,308
2
0.06%
Long-term debt
49,152
857
3.52%
—
—
—
Subordinated debentures
35,342
585
3.34%
35,164
493
2.83%
Total borrowed funds
193,426
1,601
1.67%
97,476
579
1.20%
Total interest bearing liabilities
1,932,663
2,945
0.31%
1,845,828
1,806
0.20%
Demand deposits - noninterest bearing
1,113,262
1,015,023
Other liabilities
53,712
41,156
Shareholders' equity
331,684
350,363
Total liabilities and shareholders' equity
$
3,431,321
$
3,252,370
Interest income/interest earning assets
3.49%
3.88%
Interest expense/interest earning assets
0.18%
0.12%
Net interest income and margin (5)
$
51,342
3.31%
$
55,744
3.76%
(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 $0.8 million and $2.4 million for the six months ended June 30, 2022 and 2021, respectively.
(4) Non-accrual loans have been included in total loans for purposes of computing total earning assets.
(5) Net interest margin represents net interest income as a percentage of average interest-earning assets.
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The Volume and Rate Variances table below sets forth the dollar difference for the comparative periods in interest earned or paid for each major category of interest earning assets and interest-bearing liabilities, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates, and rate variances are equal to the change in rates multiplied by prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the rate variance.
Volume & Rate Variances
(dollars in thousands, unaudited)
Three months ended June 30,
Six months ended June 30,
2022 over 2021
2022 over 2021
Increase (decrease) due to
Increase (decrease) due to
Assets:
Volume
Rate
Mix
Net
Volume
Rate
Mix
Net
Investments:
Federal funds sold/due from time
$
(45)
$
485
$
(255)
$
185
$
(12)
$
307
$
(36)
$
259
Taxable
1,902
453
548
2,904
4,088
317
411
4,816
Non-taxable
63
72
202
337
589
23
2
614
Total investments (1)
1,920
1,010
495
3,426
4,665
647
377
5,689
Loans and leases:
Real estate
216
(1,556)
(16)
(1,356)
(1,218)
(3,300)
95
(4,423)
Agricultural
(125)
(73)
22
(176)
(236)
(80)
23
(293)
Commercial
(1,097)
(97)
50
(1,144)
(2,306)
220
(111)
(2,197)
Consumer
(28)
49
(7)
14
(63)
104
(17)
24
Mortgage warehouse
(748)
256
(166)
(658)
(2,189)
395
(281)
(2,075)
Other
16
(5)
(3)
8
14
(2)
—
12
Total loans and leases (1)
(1,766)
(1,426)
(120)
(3,312)
(5,998)
(2,663)
(291)
(8,952)
Total interest earning assets (1)
$
154
$
(416)
$
375
$
114
$
(1,333)
$
(2,016)
$
86
$
(3,263)
Liabilities
Interest bearing deposits:
Demand deposits
$
33
(3)
(1)
$
29
$
74
$
(8)
(4)
$
62
NOW
(11)
(25)
2
(34)
(15)
(41)
3
(53)
Savings accounts
8
3
—
11
18
6
1
25
Money market
3
(9)
(1)
(7)
7
(19)
(2)
(14)
Time Deposits
(32)
241
(30)
179
(117)
306
(65)
124
Brokered deposits
(21)
13
(5)
(13)
(46)
31
(12)
(27)
Total interest bearing deposits (1)
(20)
220
(35)
165
(79)
275
(79)
117
Borrowed funds:
Federal funds purchased
—
—
—
—
(1)
17
(16)
—
Repurchase agreements
36
1
1
38
91
(8)
(8)
75
Short term borrowings
—
—
—
—
(2)
(2)
2
(2)
Long-term debt
—
—
430
430
—
—
857
857
Subordinated debt
1
84
—
85
2
90
—
92
Total borrowed funds (1)
37
85
431
553
90
97
835
1,022
Total interest bearing liabilities (1)
17
305
396
718
11
372
756
1,139
Net interest income (1)
$
137
$
(721)
$
(21)
$
(604)
$
(1,344)
$
(2,388)
$
(670)
$
(4,402)
(1) Subtotals are a sum of the categories above and are not recalculated on the portfolio totals.
The volume variance calculated for the second quarter of 2022 relative to the second quarter of 2021 was a favorable $0.1 million; although average balances of interest earning assets were flat, we had an increase in investment securities, offset by a decrease in almost all categories of loans. There was an unfavorable rate variance of $0.7 million for the comparative quarters since the weighted average yield on interest earning assets decreased by 11 basis points and the weighted average cost of interest-bearing liabilities increased by 13 basis points. There was also an unfavorable mix
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variance of $0.02 million primarily from the issuance of variable rate subordinated debentures issued in September of 2021. The $0.7 million negative rate variance was impacted by the following factors: relatively high average balances of cash and due from banks earning on average 74 bps, new loans and investments having lower yields overall, including low-yielding purchased 1-4 SFD mortgage loans. Increased costs on interest bearing liabilities also had a negative impact on the variance primarily from two Federal Reserve fed funds rate increases in the second quarter of 2022 for a total of 125 basis points, and the issuance of subordinated debt mentioned above. The Company’s net interest margin for the second quarter of 2022 was 3.40%, as compared to 3.60% for the second quarter of 2021.
The volume variance calculated for the first six months of 2022 relative to the first six months of 2021 reflects an unfavorable variance of $1.3 million, an unfavorable rate variance of $2.4 million, and an unfavorable mix variance of $0.7 million. There was a decline in loan balances, partially offset by an increase in investment securities. Interest bearing liabilities were relatively flat with an 11 basis point increase in cost, primarily from three Federal Reserve fed funds interest rate increases totaling 150 basis points and the issuance of variable rate subordinated debentures issued in September 2021. The Company’s net interest margin for the first half of 2022 was 3.31%, as compared to 3.76% in the first half of 2021.
At June 30, 2022, approximately 8% of our total portfolio, or $122.7 million, consists of variable rate loans. Of these variable rate loans, approximately $34.0 million have floors. At June 30, 2022, our outstanding fixed rate loans represented 26% of our loan portfolio. The remaining 66% of our loan portfolio at June 30, 2022 consists of adjustable-rate loans; 74% of these loans (approximately $930.9 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, which will have a positive impact on earnings.
Cash balances for the quarter and year-to-date comparisons have decreased and having less of 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 $146.3 million, a decrease of $162.2 million, or 53% for the second quarter of 2022, and was $22.7 million lower, or 12% for the first half of 2022 as compared to the same period in 2021.
Overall average investment securities increased by $452.7 million for the second quarter of June 30, 2022 as compared to June 30, 2021, and increased by $473.7 million for the first half of 2022. For the quarter ending June 30, 2022 over the same period for 2021, average non-taxable securities increased $40.7 million and taxable securities increased $412.0 million. For the first half of 2022 over the same period in 2021, average non-taxable securities increased $46.7 million and taxable securities increased $427.0 million. The overall investment portfolio had a tax-equivalent yield of 2.65% at June 30, 2022, with an average life of 7.55 years.
Interest expense was $1.6 million for the second quarter of 2022, an increase of $0.7 million, or 80%, compared to the second quarter of 2021, and increased $1.1 million or 63% for the first six-months of 2022 as compared to the same period in 2021. The increase in interest expense for the quarter is primarily attributable to the increase in the cost of time deposits tied to prime interest rate increases, while the year-to-date comparison included the increase in the cost of time deposits as well as the issuance of subordinated debentures in September of 2021 at a variable rate. The average cost of interest-bearing deposits increased by 4 basis points to 18 basis points for the second quarter of 2022 compared to the second quarter of 2021, and by 2 basis points to 16 basis points for the first six-months of 2022 as compared to the same period in 2021. The average cost of borrowed funds increased 52 basis points for the second quarter of 2022 as compared to the same period in 2021 and by 47 basis points for the first six-months of 2022 as compared to the first six-months of 2021. Non-interest bearing demand deposits increased $80.1 million or 8% for the second quarter of 2022 as compared to the second quarter of 2021, and increased by $98.2 million or 10% for the first half of 2022 as compared to the first half of 2021.
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PROVISION FOR CREDIT LOSSES ON LOANS AND LEASES
The Company implemented 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) on January 1, 2022 . Upon implementation the Company recorded a $10.4 million increase in the allowance for credit losses, which included a $0.9 million reserve for unfunded commitments as an adjustment to equity, net of deferred taxes.
Credit risk is inherent in the business of making loans. The Company sets aside an allowance for credit losses on loans and leases, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for credit losses on loans and leases. The Company recorded an expense related to a credit loss provision for loans and leases of $2.5 million in the second quarter of 2022 relative to a provision for loan and lease losses benefit of $2.1 million in the second quarter of 2021, and a year-to-date credit loss provision for loans and leases of $3.1 million in 2022 as compared to a $1.9 million loan and lease loss provision benefit in 2021. The higher provision for credit losses in the second quarter of 2022 over the same quarter in 2021, was primarily due to the impact of the change in reserve methodology from the incurred loss method to the current expected credit loss method combined with $2.3 million in net charge-offs in the second quarter of 2022 from a single office building loan relationship that was sold at a discount due to an increased risk of default that would have likely led to a prolonged collection period. For the first six months of 2022 compared to the same period in 2021 the $5.0 million increase in provision for credit losses on loans and leases is due to the change in reserve methodology along with the impact of $4.1 million in net charge offs for the first six months of 2022. The first half of 2022 was not only impacted by the loan relationship as mentioned above in the quarterly discussion but also by a charge-off on a single dairy loan relationship that defaulted in March 2022.
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 $2.3 million in the second quarter of 2022 as compared to net recoveries of $0.2 million for the comparative period of 2021. For the first six months of 2022, net charge-offs were $4.1 million as compared to $0.5 million in net recoveries for the same period of 2021.
The allowance for credit losses on loans and leases is at a level that, in Management’s judgment, is adequate to absorb probable credit losses on loans related to individually identified loans as well as probable incurred credit 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 10 to the consolidated financial statements, and below, under “Allowance for Credit Losses.” The process utilized to establish an appropriate credit allowance for losses on loans and leases can result in a high degree of variability in the Company’s credit 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 six-month periods ended June 30, 2022 and 2021:
Noninterest Income/Expense
(dollars in thousands, unaudited)
For the three months ended June 30,
For the six months ended June 30,
Noninterest income:
2022
2021
2022
2021
Service charges on deposit accounts
$
3,204
$
2,725
$
6,245
$
5,491
Other service charges and fees
2,893
3,050
5,680
5,611
Net gains on sale of securities available-for-sale
—
—
1,032
—
Bank-owned life insurance
(582)
814
(1,228)
1,397
Other
4,924
23
4,773
943
Total noninterest income
$
10,439
$
6,612
$
16,502
$
13,442
As a % of average interest earning assets (1)
1.31%
0.86%
1.04%
0.89%
Noninterest expense:
Salaries and employee benefits
$
11,745
$
10,425
$
23,550
$
21,576
Occupancy costs
Furniture & equipment
511
453
964
905
Premises
1,895
2,173
3,735
4,207
Advertising and marketing costs
449
292
855
612
Data processing costs
1,525
1,513
3,010
2,939
Deposit services costs
2,417
2,282
4,662
4,350
Loan services costs
Loan processing
186
65
297
234
Foreclosed assets
92
(10)
87
98
Other operating costs
Telephone & data communications
377
668
821
1,048
Postage & mail
223
109
279
193
Other
1,447
337
1,868
799
Professional services costs
Legal & accounting
673
682
1,219
1,125
Acquisition costs
—
—
—
—
Other professional service
259
1,004
402
1,899
Stationery & supply costs
116
73
201
151
Sundry & tellers
198
169
336
370
Total noninterest expense
$
22,113
$
20,235
$
42,286
$
40,506
As a % of average interest earning assets (1)
2.78%
2.64%
2.67%
2.68%
Efficiency ratio (2)(3)
59.19%
58.79%
62.70%
57.58%
(1) Annualized
(2) Tax equivalent
(3) The efficiency ratio is a non-GAAP measure and is a calculation of 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 increased by $3.8 million, or 58%, for the quarter ended June 30, 2022 as compared to the same quarter in 2021 and increased $3.1 million, or 23% for the comparable year-to-date periods.
Service charges on customer deposit account income increased by $0.5 million, or 18%, to $3.2 million in the second quarter of 2022 as compared to the second quarter of 2021. This service charge income was $0.8 million higher, or 14% in the first six months of 2022, as compared to the same period in 2021. These increases in the quarterly and year-to-date comparisons are primarily a result of increased analysis fees and overdraft income. Overdraft fees and returned check charges increased $0.2 million to $1.4 million for the second quarter of 2022, and increased $0.4 million to $2.7 million for the first six months of 2022.
Effective in the third quarter of 2022, the Company made several changes to its NSF fees (i.e. returned item) and overdraft fees for customers. In particular, NSF fees will no longer be charged, and overdraft fees will be limited to 4 per day and no continuous overdraft fee will be charged. In addition, the amount of overdraft privilege (i.e. the amount to which the Company will pay overdrafts for customers) was increased by $250. Although the exact impact of these changes is unknown, the combination of eliminating NSF fees and increasing overdraft privilege is not expected to have a material impact on overall overdraft income.
Other service charges and fees decreased $0.2 million or 5% for the second quarter of 2022 as compared to the same period in 2021, and increased $0.1 million for the first half of 2022 as compared to the same periods in 2021. The unfavorable variance for the quarterly comparison is mostly due to lower miscellaneous loan fees while the increase for the year to date comparison is mainly due to an increase in debit card interchange fees from higher usage.
There were no gains of the sales of securities for the second quarter of 2022 or 2021, but there was a $1.0 million gain on the sale of securities for the first half of 2022 with no sales in the comparable year-to-date period of 2021. The sale in the first half of 2022 was a strategic effort to rebalance the portfolio by selling longer duration and higher price volatility securities as a hedge against rising interest rates, due to likely persistent inflationary pressures in the near-intermediate term environment.
BOLI income decreased by $1.4 million for the second quarter of 2022 as compared to the second quarter of 2021. At June 30, 2022, there was $42.9 million in traditional BOLI policies and $9.3 million in separate account corporate owned life insurance policies associated with the deferred compensation plans. Investments in the separate account variable life insurance policies are invested in a similar proportionate mix of asset classes that our deferred compensation participants have elected, with the exception of participant elections in a fixed income account. Such election by plan participants in the fixed income account is ignored which creates greater volatility of the corporate owned life insurance asset value as compared to the related liability balance for deferred compensation. More specifically, the specific account life insurance policies are designed to hold similar assets to the deemed investments in the director and employee deferred compensation plans. Directors and officers are allowed to make a deemed investment in a fixed income account designed to mirror the crediting rate on one of the life insurance policies. However, the amount of deferred compensation elected to attributed to the fixed income account significantly exceeds the amount of life insurance invested in a similar fixed income account. As the life insurance funding does not closely match the deferred compensation deemed investments, fluctuations occur in earnings of the life insurance plan as compared to the related expense of the deferred compensation plan. If earnings on the life insurance plan are negative, it creates a scenario where the negative income is not tax deductible and has an unfavorable impact on the Company’s tax rate. This occurred in 2022 as the lower quarterly values in the life insurance policies were only partially offset by lower deferred compensation expense reflected primarily in director fees expense. For the first half of 2022 as compared to the same period in 2021 life insurance income was $2.6 million lower and the related deferred compensation was $1.8 million lower.
In the “other” category of noninterest income the Company reflected a $4.9 million increase in the second quarter of 2022 as compared to the second quarter of 2021, and a $3.8 million increase in the first half of 2022 as compared to the same period in 2021. The quarterly and year-to-date comparison includes non-recurring gains resulting from the sale of Visa B stock of $2.6 million and a small business investment company fund investment of $0.6 million, as well as $0.4
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million in life insurance proceeds, a $1.0 million recovery of prior year legal expenses, and a $0.2 million gain from a recovery on an acquired loan.
Noninterest Expense:
Total noninterest expense increased by $1.9 million, or 9%, in the second quarter of 2022 relative to the second quarter of 2021, and by $1.8 million, or 4%, in the first six months of 2022 as compared to the first six months of 2021.
The tax-equivalent efficiency ratio was 59.19% in the second quarter of 2022 as compared to 58.79% in the same quarter of 2021, and was 62.70% for the first half of 2022 as compared to 57.58% for the first half of 2021. The efficiency ratio represents total noninterest expense divided by the sum of fully tax-equivalent net interest and noninterest income; the provision for credit losses on loans and leases and investment gains/losses are excluded from the equation.
Salaries and Benefits were $1.3 million, or 13%, higher in the second quarter of 2022 as compared to the second quarter of 2021 and $2.0 million, or 9% higher for the first six months of 2022 compared to the same period in 2021. The reason for this increase is primarily due to increased salary expense due to the strategic hiring of lending and management staff for both the quarterly and year-to-date comparisons. Overall full-time equivalent employees were 504 at June 30, 2022 as compared to 486 at June 30, 2021.
Occupancy expenses were $0.2 million lower for the second quarter of 2022 as compared to the same quarter in 2021 and $0.4 million lower for the first half of 2022 as compared to the first half of 2021. The primary reason for this decrease was from a decrease in premises depreciation due to the sale of a branch building which was closed in the third quarter of 2021.
Other noninterest expense increased $0.8 million, or 11% for the second quarter 2022 as compared to the second quarter in 2021, and increased $0.2 million, or 2% for the first half of 2022 as compared to the same period in 2021. The variance for the second quarter of 2022 compared to the same period in 2021 was driven by a $0.7 million accrual for restitution payments to customers charged nonsufficient fund fees in the past five years for representments. This accrual was established after the FDIC published a change in its position in how such representments are characterized for regulatory purposes. The Company also incurred higher costs of $0.3 million associated with postage and mailing of new account agreements to customers as well as higher professional fees associated with this matter. Beginning in the third quarter of 2022, the Company will no longer charge customers for returned item fees, commonly referred to as nonsufficient fund fees. In addition, the Company increased overdraft privilege for both commercial and consumer customers, but will limit the number of daily overdraft fees to four per day (previously five per day) and will no longer charge a fee for continuous overdrafts (previously a $35 charge after the 10 th consecutive day an account is in an overdraft position). These changes to our nonsufficient fund fees, overdraft fees and overdraft privilege program are not expected to have a material impact on deposit fee income. In addition, there was a $0.4 million increase in recruitment costs associated with new lending teams and management staff. For the quarterly and year-to-date comparisons decreases in deferred compensation expense for directors, which is linked to the changes in life insurance income partially offset the increases.
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 26.3% of pre-tax income in the second quarter of 2022 relative to 25.3% in the second quarter of 2021, and 26.6% of pre-tax income for the first half of 2022 relative to 25.4% for the same period in 2021. The increase in effective tax rate for both the quarterly and year-to-date comparisons is due to the volatility in the Corporate Owned Life Insurance asset value associated with our non-qualified deferred compensation plans. In the
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second quarter and first half of 2022, the investments associated with the non-qualified deferred compensation plans declined in value, resulting in a non-deductible expense as compared to an increase in value generating non-taxable income for the second quarter, and first half of 2021.
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 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 $1.03 billion, or 30% of total assets at June 30, 2022, and $973.3 million, or 29% of total assets at December 31, 2021. The increase was primarily due to purchases of $215.3 million to deploy cash into interest earning assets and to provide Balance Sheet diversification. In addition, within the Cash and Due from Banks account on the balance sheet was $79.8 million of surplus interest earning balances in our Federal Reserve Bank account at June 30, 2022, as compared to $193.2 million at December 31, 2021. 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 “available for sale” investments at their fair market values and “held to maturity” investments at amortized cost. We currently have the intent and ability to hold our investment securities to maturity, but the securities are all marketable. The expected average duration was 3.2 years at June 30, 2022, and at year-end 2021.
In the second quarter of 2022 the Company transferred $162.1 million of “available for sale” investments to “held to maturity”. Those securities were transferred at fair market value on the date of the transfer. The transfer was initiated to reduce the effect of potential future rate increases on the available-for-sale portfolio, mark-to-market, other comprehensive income and equity. See Note 9, Investment Securities for additional information.
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The following table sets forth the carrying amount for available-for-sale securities, at fair value, and held-to-maturity securities, at amortized cost, net of the allowance for credit losses of the Company’s investment portfolio by investment type as of the dates noted:
Investment Portfolio
(dollars in thousands, unaudited)
June 30, 2022
December 31, 2021
Carrying Amount
Percent
Carrying Amount
Percent
Available for sale
U.S. government agencies
$
981
0%
$
1,574
0%
Mortgage-backed securities
181,446
18%
306,727
32%
State and political subdivisions
254,888
25%
304,268
31%
Corporate bonds
46,539
5%
28,529
3%
Collateralized loan obligations
380,324
37%
332,216
34%
Total available for sale
864,178
84%
973,314
100%
Held to maturity
U.S. government agencies
6,762
1%
—
—
Mortgage-backed securities
103,888
10%
—
—
State and political subdivisions
50,749
5%
—
—
Total held to maturity
161,399
16%
—
—
Total securities
$
1,025,577
100%
$
973,314
100%
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 $169.2 million at June 30, 2022 and $167.2 million at December 31, 2021, leaving $842.1 million in unpledged debt securities at June 30, 2022 and $806.1 million at December 31, 2021. Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $38.2 million at June 30, 2022 and $47.0 million at December 31, 2021.
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.
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Loan and Lease Distribution
(dollars in thousands, unaudited)
June 30, 2022
December 31, 2021
Amount
Percent
Amount
Percent
Real estate:
1-4 family residential construction
$
5,542
0.28%
$
21,369
1.08%
Other construction/land
20,758
1.04%
25,299
1.28%
1-4 family - closed-end
430,135
21.52%
289,457
14.65%
Equity lines
25,574
1.28%
26,588
1.35%
Multi-family residential
66,291
3.32%
53,458
2.71%
Commercial real estate - owner occupied
312,089
15.61%
334,446
16.93%
Commercial real estate - non-owner occupied
895,353
44.79%
882,888
44.69%
Farmland
101,761
5.09%
106,706
5.40%
Total real estate
1,857,503
92.93%
1,740,211
88.09%
Agricultural
28,757
1.44%
33,990
1.72%
Commercial and industrial
72,825
3.64%
109,791
5.56%
Mortgage warehouse lines
58,134
2.91%
101,184
5.12%
Consumer loans
4,362
0.22%
4,550
0.23%
Total loans and leases
2,021,581
101.14%
1,989,726
100.72%
Allowance for credit losses on loans
(22,802)
(1.14)%
(14,256)
(0.72)%
Total loans and leases, net
$
1,998,779
100.00%
$
1,975,470
100.00%
Gross loans and leases at $2.0 billion, increased $32.9 million during the first half of 2022 with an overall 2% change. The increase in gross loan balances as compared to December 31, 2021 was primarily a result of an increase in 1-4 family residential real estate loans, mostly from the purchase of $173.1 million in high quality jumbo mortgage loans designed as a bridge to organic growth, and a $12.8 million organic increase in multi-family residential loans. Organic loan production for the first half of 2022 was $142.1 million, a 61% increase, as compared to $88.3 million for the comparative period in 2021, as the new lending teams hired earlier in the year have been gaining traction in our market. Counterbalancing these positive variances were loan paydowns, charge-offs and maturities resulting in net declines in many categories even with higher loan production. In particular, there was a $20.4 million net decrease in construction loans, a $9.9 million net decline in commercial real estate loans, a $37.0 million net reduction in commercial and industrial loans, a $43.0 million unfavorable change in mortgage warehouse line utilization, and a $10.2 million net decline in agricultural loans. Further, SBA PPP loan forgiveness resulted in a $23.6 million decline in loan balances, included in the commercial and industrial variance noted above.
The following table presents a roll forward of the Company’s gross loan balances for each of the periods noted:
LOAN ROLLFORWARD
(Dollars in Thousands, Unaudited)
For the three months ended:
For the six months ended:
June 30, 2022
March 31, 2022
June 30, 2021
June 30, 2022
June 30, 2021
Gross loans beginning balance
$
1,983,331
$
1,989,726
$
2,288,468
$
1,989,726
$
2,463,111
New credit extended
119,553
22,543
21,698
142,096
88,294
Loan purchases
46,364
126,718
—
173,082
—
Changes in line of credit utilization
(17,837)
(19,553)
(17,071)
(37,390)
(39,657)
Change in mortgage warehouse
956
(44,005)
(37,588)
(43,049)
(157,327)
Pay-downs, maturities, charge-offs and amortization (1)
(109,705)
(92,098)
(110,711)
(201,803)
(209,625)
Gross loans ending balance
2,022,662
1,983,331
2,144,796
2,022,662
2,144,796
Deferred costs and (fees), net
(1,081)
(1,200)
(3,835)
(1,081)
(3,835)
Loans, net of deferred costs and (fees)
$
2,021,581
$
1,982,131
$
2,140,961
$
2,021,581
$
2,140,961
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The Company’s regulatory commercial real estate concentration ratio decreased to 238% at June 30, 2022 as compared to 248% at December 31, 2021.
Unused commitments, excluding mortgage warehouse and overdraft lines, were $199.4 million at June 30, 2022, compared to $242.3 million at December 31, 2021. Total line utilization, excluding mortgage warehouse and consumer overdraft lines, was 61.2% at June 30, 2022 and 61.0% at December 31, 2021. Mortgage warehouse utilization declined significantly to 12% at June 30, 2022, as compared to 28% at December 31, 2021. It should be noted that approximately $278.0 million of the mortgage warehouse lines were moved to repurchase agreement lines that provide stronger credit protection to the Company, as well as more favorable regulatory capital treatment as these repurchase lines are not considered off-balance sheet commitments.
As expected, PPP loans continue to decline as borrowers receive forgiveness on these loans. There were 107 loans for $8.2 million outstanding at June 30, 2022, compared to 438 loans for $31.8 million at December 31, 2021.
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 include 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 circumstances. The following table presents comparative data for the Company’s nonperforming assets and performing TDRs as of the dates noted:
Nonperforming assets and performing troubled debt restructurings
(dollars in thousands, unaudited)
June 30, 2022
December 31, 2021
June 30, 2021
NON-ACCRUAL LOANS:
Real estate:
Other construction/land
$
—
$
—
$
—
1-4 family - closed-end
745
1,023
1,473
Equity lines
62
892
2,138
Commercial real estate - owner occupied
379
1,234
1,278
Commercial real estate - non-owner occupied
—
—
—
Farmland
19,301
—
427
TOTAL REAL ESTATE
20,487
3,149
5,316
Agriculture
8,444
378
517
Commercial and industrial
814
973
1,423
Consumer loans
—
22
20
TOTAL NONPERFORMING LOANS
29,745
4,522
7,276
Foreclosed assets
2
93
774
Total nonperforming assets
$
29,747
$
4,615
$
8,050
Performing TDRs (1)
$
4,714
$
4,910
$
10,774
Nonperforming loans as a % of total gross loans and leases
1.47%
0.23%
0.34%
Nonperforming assets as a % of total gross loans and leases and foreclosed assets
1.47%
0.23%
0.38%
(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.
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Total nonperforming assets increased by $25.1 million, to $29.7 million during the first half of 2022, primarily as a result of a downgrade in the first quarter of 2022, consisting of one relationship in the dairy industry comprising four separate loans. These loans were written down by $1.96 million and no further allowance for credit losses was deemed necessary on these loans. The Company's ratio of nonperforming loans to gross loans increased to 1.47% at June 30, 2022 from 0.23% at December 31, 2021. All of the Company's nonperforming 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 $4.7 million in loans classified as performing TDRs on which we were still accruing interest as of June 30, 2022, a decrease of $0.2 million, or 4%, relative to December 31, 2021.
Foreclosed assets had a carrying value of $0.002 million at June 30, 2022 and $0.1 million December 31, 2021 comprised of one property classified as OREO. The property was written down to fair value less disposition costs in the second quarter of 2022 and subsequently sold in the third quarter of 2022. 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 $5.3 million in loans past due 30-59 days at June 30, 2022. This is an increase of $3.1 million over the balance at December 31, 2021. 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.
ALLOWANCE FOR CREDIT LOSSES – LOANS AND LEASES RECEIVABLE
The allowance for credit losses on loans and leases, a contra-asset, is established through periodic provisions for credit losses on loans and leases. It is maintained at a level that is considered adequate to measure expected losses on individually identified loans, as well as expected 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.
After deferring implementation of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) under section 4014 of the CARES Act, the Company implemented CECL on January 1, 2022 . Upon implementation the Company recorded a $10.4 million increase in the allowance for credit losses, which included a $0.9 million reserve for unfunded commitments as an adjustment to equity, net of deferred taxes.
The Company's allowance for credit losses on loans and leases was $22.8 million at June 30, 2022, as compared to $14.3 million at December 31, 2021, and $16.4 million at June 30, 2021. The $8.5 million increase in the allowance for credit losses on loans and leases during the first half of 2022 is due to a $9.5 million one-time adjustment from the implementation of CECL on January 1, 2022, a $3.1 million provision for credit losses on loans and leases, and net loan charge-offs of $4.1 million.
The allowance was 1.13% of gross loans at June 30, 2022, 0.72% of gross loans at December 31, 2021, and 0.77% of total loans at June 30, 2021. Management's detailed analysis indicates that the Company's allowance for credit losses on loans and leases should be sufficient to cover credit losses for the life of the loans and leases outstanding as of June 30, 2022, but no assurance can be given that the Company will not experience substantial future losses relative to the size of the loan and lease loss allowance.
A separate allowance of $0.9 million for potential credit losses inherent in unused commitments is included in other liabilities at June 30, 2022, as compared to $0.2 million at December 31, 2021. As mentioned previously a $0.9 million
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one-time adjustment was recorded to the reserve for unfunded commitments on January 1, 2022 upon the implementation of CECL.
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The following table summarizes activity in the credit allowance for losses on loans and leases for the noted periods:
Allowance for Credit Losses on Loans and Leases
(dollars in thousands, unaudited)
For the three
months ended
For the three
months ended
For the six
months ended
For the six
months ended
For the year ended
June 30,
June 30,
June 30,
June 30,
December 31,
Balances:
2022
2021
2022
2021
2021
Average gross loans and leases outstanding during period (1)
$
2,011,868
$
2,184,899
$
1,981,947
$
2,275,467
$
2,169,582
Gross loans and leases outstanding at end of period
$
2,022,662
$
2,144,796
$
2,022,662
$
2,144,796
$
1,989,726
Allowance for credit losses on loans and leases:
Balance at beginning of period
$
22,530
$
18,319
$
14,256
$
17,738
$
17,738
Adoption of ASC 326
—
—
9,454
—
—
Provision charged to expense
2,548
(2,100)
3,148
(1,850)
(3,650)
Charge-offs
Real estate
1-4 family residential construction
—
—
—
—
—
Other construction/land
—
—
—
—
—
1-4 family - closed-end
—
—
—
—
—
Equity lines
—
11
—
12
12
Multi-family residential
—
—
—
—
—
Commercial real estate- owner occupied
—
—
—
233
233
Commercial real estate- non-owner occupied
1,911
—
1,911
—
—
Farmland
—
—
1,958
—
—
Total real estate
1,911
11
3,869
245
245
Agricultural
212
50
212
50
50
Commercial and industrial
86
25
159
77
159
Consumer loans
314
169
612
331
946
Total
$
2,523
$
255
$
4,852
$
703
$
1,400
Recoveries
Real estate
1-4 family residential construction
—
—
—
—
—
Other construction/land
—
110
259
328
328
1-4 family - closed-end
1
3
86
5
(67)
Equity lines
12
—
12
—
25
Multi-family residential
—
—
—
—
—
Commercial real estate- owner occupied
—
—
—
233
233
Commercial real estate- non-owner occupied
—
82
—
82
82
Farmland
—
—
—
—
—
Total real estate
13
195
357
648
601
Agricultural
—
—
—
—
—
Commercial and industrial
62
82
82
192
223
Consumer loans
172
180
357
396
744
Total
$
247
$
457
$
796
$
1,236
$
1,568
Net loan charge offs (recoveries)
$
2,276
$
(202)
$
4,056
$
(533)
$
(168)
Balance at end of period
$
22,802
$
16,421
$
22,802
$
16,421
$
14,256
RATIOS
Net charge-offs (recoveries) to average loans and leases (annualized)
0.45%
(0.04)%
0.41%
(0.05)%
(0.01)%
Allowance for credit losses on loans and leases to gross loans and leases at end of period
1.13%
0.77%
1.13%
0.77%
0.72%
Allowance for credit losses on loans and leases to nonperforming loans
76.66%
225.69%
76.66%
225.69%
315.26%
Net loan charge-offs (recoveries) to allowance for credit losses on loans and leases at end of period
9.98%
(1.23)%
17.79%
(3.25)%
(1.18)%
Net loan charge-offs (recoveries) to provision for credit losses on loans and leases
89.32%
9.62%
128.84%
28.81%
4.60%
(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 credit allowance for losses on loans and leases at June 30, 2022 represents Management’s best estimate of expected losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance. Furthermore, fluctuations in credit quality, changes in economic conditions, updated accounting or regulatory requirements, and/or other factors could induce us to augment or reduce the allowance.
OFF-BALANCE SHEET ARRANGEMENTS
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 $513 million at June 30, 2022 and $561 million at December 31, 2021, representing approximately 25% of gross loans outstanding at June 30, 2022 and 28% at December 31, 2021. The decrease in unused commitments is due in large part to the decrease in loan balances with unfunded commitments. The Company also had undrawn letters of credit issued to customers totaling $3.6 million at June 30, 2022 and December 31, 2021. The effect on the Company’s
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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 $125 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 $77.5 million at June 30, 2022. 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 $82.1 million at June 30, 2022 relative to $63.1 million at December 31, 2021.
Foreclosed assets are discussed above in the section titled “Nonperforming Assets.”
Net premises and equipment decreased by $0.6 million during the first half of 2022, to $22.9 million. This decline was primarily a result of normal depreciation, net of new purchases.
Goodwill was $27.4 million at June 30, 2022, unchanged during the first half of 2022. Goodwill is tested for impairment annually, unless events and circumstances exist which indicate that an impairment test should be performed. A Goodwill impairment test was last performed during the fourth quarter 2021 and determined that no impairment existed. There have been no triggering events in the first six months of 2022 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 $52.2 million at June 30, 2022, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.
DEPOSITS AND INTEREST BEARING LIABILITIES
DEPOSITS
Deposits represent another key balance sheet category impacting the Company’s net interest income and profitability metrics. Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity accounts such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts. Information concerning average balances and rates paid by deposit type is included in the Average Balances and Rates tables appearing above, in the section titled “Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits by type, showing the period-end balance and percentage of total deposits, is presented as of the dates indicated in the following table.
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Deposit Distribution
(dollars in thousands, unaudited)
June 30, 2022
December 31, 2021
Noninterest bearing demand deposits
$
1,120,413
$
1,084,544
Interest bearing demand deposits
203,032
129,783
NOW
533,002
614,770
Savings
482,140
450,785
Money market
152,596
147,793
Time
299,816
293,897
Brokered deposits
60,000
60,000
Total deposits
$
2,850,999
$
2,781,572
Percentage of Total Deposits
Noninterest bearing demand deposits
39.30%
38.99%
Interest bearing demand deposits
7.12%
4.67%
NOW
18.70%
22.10%
Savings
16.91%
16.21%
Money market
5.35%
5.31%
Time
10.52%
10.57%
Brokered deposits
2.10%
2.16%
Total
100.00%
100.00%
Deposit balances reflect net growth of $69.4 million, or 2%, during the first half of 2022. Time deposits were $299.8 million at June 30, 2022 as compared to $293.9 million at December 31, 2021. Brokered deposits were unchanged at $60.0 million at June 30, 2022 from December 31, 2021. Non-maturity deposit growth of $63.5 million for the first half of 2022 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 39.3% at June 30, 2022 as compared to 39.0% at December 31, 2021.
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 increased by $11.2 million, during the first half of 2022 primarily due to an increase in customer repurchase agreements. Repurchase agreements totaled $118.0 million at June 30, 2022 relative to a balance of $106.9 million at year-end 2021. Repurchase agreements represent “sweep accounts”, where certain customers have elected to have their commercial deposit balances above a specified threshold transferred at the close of each business day into non-deposit investments accounts. The balance in the investment account is used to have the customer purchase securities or a perfected interest in specifically identified pledged securities from the bank, which are then repurchased by the bank from the customer the next business day.
The Company had Long term debt totaling $49.2 million and $49.1 million at June 30, 2022 and December 31, 2021, respectively, in the form of 3.25% fixed – floating subordinated debt with a ten-year maturity and junior subordinated debentures totaling $35.4 million at June 30, 2022 and $35.3 million at December 31, 2021, in the form of long-term borrowings from trust subsidiaries formed specifically to issue trust preferred securities.
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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 $43.1 million at June 30, 2022 as compared to $35.4 million at December 31, 2021, an increase of $7.8 million or 22%. The increase was primarily driven by the Company’s investment commitment in a $2.0 million low income housing tax credit fund and $5.0 million investment commitment in a FinTech Fund.
LIQUIDITY AND MARKET RISK MANAGEMENT
LIQUIDITY
Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by Management on a monthly basis, with various stress scenarios applied to assess our ability to meet liquidity needs under unusual or adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored, and we are committed to maintaining adequate liquidity resources to draw upon should unexpected needs arise.
The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet these short-term needs, we can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.
At June 30, 2022 and December 31, 2021, the Company had the following sources of primary and secondary liquidity (dollars in thousands):
Primary and secondary liquidity sources
June 30, 2022
December 31, 2021
Cash and cash equivalents
$
161,875
$
257,528
Unpledged investment securities
839,833
806,132
Excess pledged securities
38,245
47,024
FHLB borrowing availability
830,615
787,519
Unsecured lines of credit
305,000
305,000
Funds available through fed discount window
32,762
50,608
Totals
$
2,208,330
$
2,253,811
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.
Cash and cash equivalents during the first half of 2022, declined $95.7 million due to increases in investment securities and loans and leases. Utilization of remaining excess liquidity is expected to come from a combination of new organic loan originations, and new investment purchases, mostly in the form of collateralization loan obligations. 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 $125 million at June 30, 2022 and December 31, 2021. 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
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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 primary liquidity ratio and net loans to deposits were 36.56% and 70.11%, respectively, at June 30, 2022, as compared to internal policy guidelines of “greater than 15%” and “less than 95%.” Ratios and sub-limits for the various components comprising wholesale funding, which were all well within policy guidelines at June 30, 2022, are also periodically reviewed by Management and the Board. 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. As of June 30, 2022, the holding company maintained a cash balance of $7.5 million. Management anticipates that the holding company has sufficient liquidity to meet its funding requirements for the foreseeable future. Both the holding company and the Bank are subject to legal and regulatory limitations on dividend payments, as outlined in Item 5(c) Dividends in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021 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.
The Company reclassified $162.1 million of securities that have the highest level of volatility to changes in interest rates from available-for-sale to held-to-maturity to mitigate the impact on tangible capital.
To identify areas of potential exposure to interest rate changes, we utilize commercially available modeling software to perform monthly earnings simulations and calculate the Company’s market value of portfolio equity under varying interest rate scenarios. The model imports relevant information for the Company’s financial instruments and incorporates Management’s assumptions on pricing, duration, and optionality for anticipated new volumes. Various rate scenarios consisting of key rate and yield curve projections are then applied in order to calculate the expected effect of a given interest rate change on interest income, interest expense, and the value of the Company’s financial instruments. The rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels).
In addition to a stable rate scenario, which presumes that there are no changes in interest rates, we typically use at least eight other interest rate scenarios in conducting our rolling 12- month net interest income simulations: upward shocks of 100, 200, 300, and 400 basis points, and downward shocks of 100, 200, and 300 basis points. Those scenarios may be supplemented, reduced in number, or otherwise adjusted as determined by Management to provide the most meaningful simulations considering economic conditions and expectations at the time. The downward shock scenarios of 200 300 and 400 basis points were temporarily suspended in the second quarter of 2020 after concurrence by the Company’s Board of Directors, due to the fact that in these down scenarios, projected interest rates would be near or below zero. At the June 2022 Finance & Sustainability Committee Meeting, Management reinstituted the down 200 scenario, due to the Federal Open Market Committee increasing rates by 150 basis points during the quarter. Pursuant to policy guidelines, we generally attempt to limit the projected decline in net interest income relative to the stable rate scenario to no more than 5% for a 100 basis point (bp) interest rate shock, 10% for a 200 bp shock, 15% for a 300 bp shock, and 20% for a 400 bp shock.
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The Company had the following estimated net interest income sensitivity profiles over one-year, without factoring in any potential negative impact on spreads resulting from competitive pressures or credit quality deterioration:
June 30, 2022
June 30, 2021
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
9.5%
$
11,559
11.3%
$
11,645
+300
7.5%
$
9,053
9.1%
$
9,384
+200
5.6%
$
6,778
6.9%
$
7,072
+100
3.3%
$
3,939
4.1%
$
4,226
Base
-100
(6.9)%
$
(8,316)
(8.1)%
$
(8,306)
-200
(15.9)%
$
(19,279)
N/A
N/A
For the periods ending June 30, 2022 and June 30, 2021, management believes that the Company was asset sensitive, with net income increasing in a rising rate environment in all scenarios but declining in the down shocks. The Company’s asset sensitivity based on its interest rate risk model at June 30, 2022 as compared to June 30, 2021, is similar. In the up 400 basis point shock scenario, expected net interest income over the next twelve months increases $11.6 million, or 10%, to $132.7 million at June 30, 2022 compared to an 11% increase or $11.6 million for the same period in 2021.
The Company reclassified $162.1 million of securities that have the highest level of volatility to changes in interest rates from available-for-sale to held-to-maturity to mitigate the impact on tangible capital.
Over the next twelve months, $161.9 million in surplus cash is projected to decline due to expected core loan growth as our pipelines begin to increase, and a redeployment of excess cash into variable rate investment vehicles such as collateralized loan obligations. 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.
The change in net interest income is similar for the up 100, 200, 300, and 400 basis point scenarios. If there were an immediate and sustained upward adjustment of 100 basis points in interest rates, all else being equal, net interest income over the next 12 months is projected to improve by $3.9 million, or 3%, relative to a stable interest rate scenario, with the favorable variance increasing marginally as interest rates rise higher.
If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $8.3 million or a negative variance of 7%. The change in net interest income in the down 200 basis point scenario is a decrease of $19.3 million or 16%. The reason for the drop in net interest income in the down 200 basis points scenario over the 100 basis point scenario is that many of the deposit products reach their floors and cannot be repriced lower while, non-floored interest earning assets such as loans and securities can theoretically still be re-priced lower in a falling rate environment. The potential percentage drop in net interest income in the “down 200 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. The percentage drop in net interest income exceeding internal policy guidelines will most likely continue until interest rates return to historically higher levels.
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 $8.0 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
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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 June 30, 2022 and 2021, 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 primarily driven by an increase in deposits and an increase in deposit values. The tables below show estimated changes in the Company’s EVE as modeled under different interest rate scenarios relative to the base case:
June 30, 2022
June 30, 2021
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
13.4%
$
95,479
35.6%
$
202,631
+300
10.9%
$
77,821
31.8%
$
181,010
+200
8.2%
$
58,626
25.9%
$
147,560
+100
3.6%
$
25,282
15.7%
$
89,293
Base
-100
(18.9)%
$
(134,337)
(21.3)%
$
(120,991)
-200
(38.6)%
$
(274,465)
N/A
N/A
The table shows that our EVE is modeled to deteriorate in 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 which become more valuable as interest rates rise. We also run stress scenarios for the unconsolidated Bank’s EVE to simulate the possibility of adverse movement in loan prepayment rates, unfavorable changes in deposit rates, and higher deposit decay rates. Model results are highly sensitive to changes in assumed decay rates for non-maturity deposits, in particular, with material unfavorable variances occurring relative to the standard simulations shown above as decay rates are increased. Furthermore, while not as extreme as the variances produced by increasing non-maturity deposit decay rates, EVE also displays a relatively high level of sensitivity to unfavorable changes in deposit rate betas in rising interest rate scenarios.
The potential percentage drop in EVE in the “down 100 and 200 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. The percentage drop in EVE exceeding internal policy guidelines will most likely continue until interest rates and deposit rates return to historically higher levels.
CAPITAL RESOURCES
The Company had total shareholders’ equity of $299.0 million at June 30, 2022, comprised of $111.7 million in common stock, $4.6 million in additional paid-in capital, $233.2 million in retained earnings, and accumulated other
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comprehensive loss of $50.4 million. At the end of 2021, total shareholders’ equity was $362.5 million. The decrease in equity during the first half of 2022 is due to net income of $16.6 million, offset by a $7.0 million dividend paid to shareholders, $4.9 million in share repurchases, a $61.6 million unfavorable swing in other comprehensive income/loss due principally to changes in investment securities' fair value and a $7.3 million decrease in retained earnings due to the cumulative effect of a change in accounting principal from the implementation of CECL, topic 326. The remaining difference is related to stock options exercised and restricted stock compensation recognized during the quarter.
The Company’s strong liquidity position enabled the transfer of $162.1 million of “available-for-sale” investment securities to “held-to-maturity” classification effective April 1, 2022. The transfer was initiated to reduce the effect of future rate increases on the available-for-sale portfolio, mark-to-market adjustments, comprehensive income and equity.
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. There were 182,562 shares repurchased in the first half of 2022, with 630,000 shares remaining to be repurchased under the 2021 Share Repurchase 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
June 30,
December 31,
to be
Community Bank
2022
2021
Well Capitalized (1)
Leverage Ratio (2)
Bank of the Sierra
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio") (3)
11.72
%
11.31
%
5.00
%
9.00
%
Sierra Bancorp
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio") (3)
10.45
%
10.43
%
5.00
%
N/A
(1) The Company was subject to these minimum requirements under the regulatory framework for Prompt Corrective Action at December 31, 2019.
(2) 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.
(3) The Company has elected to phase in the impact of implementing CECL on regulatory capital over a three-year period.
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,
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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.
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.