Bankwell Financial Group, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section presents management’s perspective on our financial condition and results of operations. The following discussion and analysis should be read in conjunction with the unaudited interim consolidated financial statements and related notes contained elsewhere in this report on Form 10-Q. To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of future financial outcomes. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management’s expectations. Factors that could cause such differences are discussed in the Company’s Form 10-K filed for the year ended December 31, 2019 in the sections titled “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors.” Additionally, the COVID-19 pandemic could adversely affect the Company, its customers, counterparties, employees, and third-party service providers, and the ultimate extent of the impacts on its business, financial position, results of operations, liquidity, and prospects is uncertain. We assume no obligation to update any of these forward-looking statements. General Bankwell Financial Group, Inc. is a bank holding company headquartered in New Canaan, Connecticut. Through our wholly owned subsidiary, Bankwell Bank, or the Bank, we serve small and medium-sized businesses and retail customers in the New York metropolitan area and throughout Connecticut with the majority of our loans in Fairfield and New Haven Counties, Connecticut. We have a history of building long-term customer relationships and attracting new customers through what we believe is our strong customer service and our ability to deliver a diverse product offering. The following discussion and analysis presents our results of operations and financial condition on a consolidated basis. However, because we conduct all of our material business operations through the Bank, the discussion and analysis relates to activities primarily conducted at the Bank. We generate most of our revenue from interest on loans and investments and fee-based revenues. Our primary source of funding for our loans is deposits. Our largest expenses are interest on deposits and salaries and related employee benefits. We measure our performance primarily through our net interest margin, efficiency ratio, ratio of allowance for loan losses to total loans, return on average assets and return on average equity, among other metrics, while maintaining appropriate regulatory leverage and risk-based capital ratios. Executive Overview We are focused on being the “Hometown” bank and the banking provider of choice in our highly attractive market area, and to serve as a locally based alternative to our larger competitors. We aim to do this through: • Responsive, customer-centric products and services and a community focus; • Organic growth and strategic acquisitions when market opportunities present themselves; • Utilization of efficient and scalable infrastructure; and • Disciplined focus on risk management. Impact of COVID-19 The COVID-19 pandemic has resulted in, and is likely to continue to result in, significant economic disruption affecting our business and the clients we serve. A significant degree of uncertainty still exists concerning the duration and magnitude of the COVID-19 pandemic. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the full impact of the COVID-19 outbreak on our business. The extent of such impact will depend on future developments, which are highly uncertain, including when the coronavirus can be controlled and abated. For the nine months ended September 30, 2020, we increased the provision for loan losses and added liquidity to the balance sheet due to the impact of COVID-19, both of which adversely impacted our earnings and performance metrics. 45 Critical Accounting Policies and Estimates The discussion and analysis of our results of operations and financial condition are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires us to make significant estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from our current estimates, as a result of changing conditions and future events. We believe that accounting estimates related to the measurement of the allowance for loan losses, the valuation of derivative instruments, investment securities and deferred income taxes, and the evaluation of investment securities for other than temporary impairment are particularly critical and susceptible to significant near-term change. Earnings and Performance Overview For the three months ended September 30, 2020, we had net interest income of $13.6 million, an increase of $0.6 million or 4.6% when compared to the same period in 2019. The increase in net interest income was due to a decline in interest expense, driven by lower interest rates when compared to the same period in 2019. For the nine months ended September 30, 2020, we had net interest income of $40.5 million, a decrease of $0.3 million, or 0.9%, over the nine months ended September 30, 2019. The decrease in net interest income for the nine months ended September 30, 2020 was attributable to a decline in income from loan prepayments and lower loan yields as loans are re-priced in the current low interest rate environment. The decrease in net interest income was partially offset by a decline in interest expense, driven by lower interest rates when compared to the same period in 2019. Noninterest income decreased $0.9 million to $0.6 million for the three months ended September 30, 2020 compared to the same period in 2019. Noninterest income decreased $1.9 million to $2.3 million for the nine months ended September 30, 2020 compared to the same period in 2019. The decrease in noninterest income for the three and nine months ended September 30, 2020, when compared to the same periods in 2019, was primarily a result of the absence of gains and fees from the sales of SBA loans, and to a lesser degree, a decrease in service charges and fees. Net income available to common shareholders was $3.0 million, or $0.38 per diluted share, and $4.1 million, or $0.52 per diluted share, for the three months ended September 30, 2020 and 2019, respectively. Net income available to common shareholders was $5.6 million, or $0.71 per diluted share, and $14.7 million, or $1.87 per diluted share, for the nine months ended September 30, 2020 and 2019, respectively. The decrease in net income for the three month period ended September 30, 2020 when compared to the same period in 2019 was driven by an increase in noninterest expense. The decrease in net income for the nine months ended September 30, 2020 when compared to the same period in 2019 was due to an increase in the provision for loan losses due to the COVID-19 pandemic and, to a lesser degree, an increase in noninterest expense. The provision for loan losses related to COVID-19 totaled $7.9 million for the nine months ended September 30, 2020. Returns on average stockholders' equity and average assets for the three months ended September 30, 2020 were 6.87% and 0.55%, respectively, compared to 9.12% and 0.87%, respectively, for the three months ended September 30, 2019. Returns on average stockholders' equity and average assets for the nine months ended September 30, 2020 were 4.23% and 0.36%, respectively, compared to 11.06% and 1.05%, respectively, for the nine months ended September 30, 2019. For the nine months ended September 30, 2020, returns were negatively impacted due to the increase in the provision for loan losses. The return on average assets was negatively impacted by higher average asset balances, primarily due to additional liquidity maintained on the balance sheet. Results of Operations Net Interest Income Net interest income is the difference between interest earned on loans and securities and interest paid on deposits and other borrowings, and is the primary source of our operating income. Net interest income is affected by the level of interest rates, changes in interest rates and changes in the amount and composition of interest earning assets and interest bearing liabilities. Included in interest income are certain loan fees, such as deferred origination fees and late charges. We convert tax-exempt income to a fully taxable equivalent ("FTE") basis using the statutory federal income tax rate adjusted for applicable state income taxes net of the related federal tax benefit. The average balances are principally daily averages. Interest income on loans includes the effect of deferred loan fees and costs accounted for as yield adjustments. Premium amortization and discount accretion are included in the respective interest income and interest expense amounts. 46 FTE net interest income for the three months ended September 30, 2020 and 2019 was $13.7 million and $13.1 million, respectively. FTE interest income for the three months ended September 30, 2020 decreased by $1.6 million, or 7.7%, to $19.0 million, compared to FTE interest income for the three months ended September 30, 2019. The decrease in net interest income was primarily a result of lower loan yields as loans are re-priced in the current low interest rate environment. The decrease in net interest income was partially offset by a decrease in interest expense driven by lower interest rates on deposits. FTE net interest income for the nine months ended September 30, 2020 and 2019 was $40.7 million and $41.1 million, respectively. FTE interest income for the nine months ended September 30, 2020 decreased by $4.7 million, or 7.5%, to 58.5 million, compared to FTE interest income for the nine months ended September 30, 2019 The decrease in net interest income was primarily a result of a decline in income from loan prepayments and lower loan yields as loans are re-priced in the current low interest rate environment. The decrease in net interest income was partially offset by a decrease in interest expense driven by lower interest rates on deposits. The net interest margin decreased by 29 basis points to 2.67% for the three months ended September 30, 2020, compared to the three months ended September 30, 2019 and the net interest margin decreased by 26 basis points to 2.81% for the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019. The decline in the net interest margin was primarily due to excess cash held at low interest rates to maintain a higher level of liquidity during the COVID-19 pandemic. Interest expense for the three months ended September 30, 2020 decreased by $2.2 million, or 29.0%, compared to interest expense for the three months ended September 30, 2019. Interest expense for the nine months ended September 30, 2020 decreased by $4.3 million, or 19.5%, compared to interest expense for the nine months ended September 30, 2019. This decrease is due to lower interest rates on deposits for the three and nine months ended September 30, 2020 when compared to the same periods in 2019. 47 Distribution of Assets, Liabilities and Stockholders’ Equity; Interest Rates and Interest Differential The following tables present the average balances and yields earned on interest earning assets and average balances and weighted average rates paid on our funding liabilities for the three and nine months ended September 30, 2020 and 2019. Three Months Ended September 30, 2020 2019 (Dollars in thousands) Average Balance Interest Yield / Rate (5) Average Balance Interest Yield / Rate (5) Assets: Cash and Fed funds sold $ 312,078 $ 96 0.12 % $ 86,967 $ 535 2.44 % Securities (1) 96,448 776 3.22 109,247 845 3.09 Loans: Commercial real estate 1,087,765 12,570 4.52 1,066,256 12,590 4.62 Residential real estate 125,069 1,097 3.51 161,312 1,559 3.87 Construction (2) 94,984 1,029 4.24 86,342 1,141 5.17 Commercial business 322,066 3,329 4.04 248,116 3,761 5.93 Consumer 121 2 7.37 229 4 6.93 Total loans 1,630,005 18,027 4.33 1,562,255 19,055 4.77 Federal Home Loan Bank stock 7,835 77 3.91 7,474 113 6.02 Total earning assets 2,046,366 $ 18,976 3.63 % 1,765,943 $ 20,548 4.55 % Other assets 132,617 103,742 Total assets $ 2,178,983 $ 1,869,685 Liabilities and shareholders' equity: Interest bearing liabilities: NOW $ 87,890 $ 40 0.18 % $ 62,444 $ 26 0.17 % Money market 517,638 859 0.66 423,638 1,739 1.63 Savings 163,135 237 0.58 174,587 740 1.68 Time 757,176 2,968 1.56 644,536 3,826 2.36 Total interest bearing deposits 1,525,839 4,104 1.07 1,305,205 6,331 1.92 Borrowed money 200,237 1,210 2.36 175,185 1,151 2.57 Total interest bearing liabilities 1,726,076 $ 5,314 1.22 % 1,480,390 $ 7,482 2.01 % Noninterest bearing deposits 226,473 177,922 Other liabilities 53,272 33,457 Total Liabilities 2,005,821 1,691,769 Shareholders' equity 173,162 177,916 Total liabilities and shareholders' equity $ 2,178,983 $ 1,869,685 Net interest income (3) $ 13,662 $ 13,066 Interest rate spread 2.41 % 2.54 % Net interest margin (4) 2.67 % 2.96 % (1) Average balances and yields for securities are based on amortized cost. (2) Includes commercial and residential real estate construction. (3) The adjustment for securities and loans taxable equivalency amounted to $54 thousand and $55 thousand for the three months ended September 30, 2020 and 2019, respectively. (4) Annualized net interest income as a percentage of earning assets. (5) Yields are calculated using the contractual day count convention for each respective product type. 48 Nine Months Ended September 30, 2020 2019 (Dollars in thousands) Average Balance Interest Yield / Rate (5) Average Balance Interest Yield / Rate (5) Assets: Cash and Fed funds sold $ 207,058 $ 468 0.30 % $ 84,212 $ 1,432 2.27 % Securities (1) 96,761 2,289 3.15 115,586 2,722 3.14 Loans: Commercial real estate 1,094,956 38,460 4.61 1,061,536 38,176 4.74 Residential real estate 134,369 3,636 3.61 169,297 4,892 3.85 Construction (2) 98,539 3,350 4.47 84,487 3,412 5.33 Commercial business 289,959 10,017 4.54 259,154 12,198 6.21 Consumer 130 8 8.15 274 13 6.60 Total loans 1,617,953 55,471 4.50 1,574,748 58,691 4.91 Federal Home Loan Bank stock 7,547 272 4.81 7,512 365 6.49 Total earning assets 1,929,319 $ 58,500 3.98 % 1,782,058 $ 63,210 4.68 % Other assets 125,957 89,332 Total assets $ 2,055,276 $ 1,871,390 Liabilities and shareholders' equity: Interest bearing liabilities: NOW $ 76,661 $ 99 0.17 % $ 61,872 $ 101 0.22 % Money market 473,485 3,213 0.91 447,008 5,567 1.67 Savings 170,262 1,204 0.94 176,491 2,252 1.71 Time 721,051 10,107 1.87 638,978 10,830 2.27 Total interest bearing deposits 1,441,459 14,623 1.36 1,324,349 18,750 1.89 Borrowed money 187,177 3,187 2.24 175,290 3,386 2.55 Total interest bearing liabilities 1,628,636 $ 17,810 1.46 % 1,499,639 $ 22,136 1.97 % Noninterest bearing deposits 201,384 166,864 Other liabilities 49,418 26,650 Total Liabilities $ 1,879,438 1,693,153 Shareholders' equity 175,838 178,237 Total liabilities and shareholders' equity $ 2,055,276 $ 1,871,390 Net interest income (3) $ 40,690 $ 41,074 Interest rate spread 2.52 % 2.71 % Net interest margin (4) 2.81 % 3.07 % (1) Average balances and yields for securities are based on amortized cost. (2) Includes commercial and residential real estate construction. (3) The adjustment for securities and loans taxable equivalency amounted to $159 thousand and $195 thousand for the nine months ended September 30, 2020 and 2019, respectively. (4) Annualized net interest income as a percentage of earning assets. (5) Yields are calculated using the contractual day count convention for each respective product type. 49 Effect of changes in interest rates and volume of average earning assets and average interest bearing liabilities The following table shows the extent to which changes in interest rates and changes in the volume of average earning assets and average interest bearing liabilities have affected net interest income. For each category of earning assets and interest bearing liabilities, information is provided relating to: changes in volume (changes in average balances multiplied by the prior year’s average interest rates); changes in rates (changes in average interest rates multiplied by the prior year’s average balances); and the total change. Changes attributable to both volume and rate have been allocated proportionately based on the relationship of the absolute dollar amount of change in each. Three Months Ended September 30, 2020 vs 2019 Increase (Decrease) Nine Months Ended September 30, 2020 vs 2019 Increase (Decrease) (In thousands) Volume Rate Total Volume Rate Total Interest and dividend income: Cash and Fed funds sold $ 424 $ (863) $ (439) $ 952 $ (1,916) $ (964) Securities (102) 33 (69) (445) 12 (433) Loans: Commercial real estate 251 (271) (20) 1,184 (900) 284 Residential real estate (327) (135) (462) (960) (296) (1,256) Construction 107 (219) (112) 522 (584) (62) Commercial business 952 (1,384) (432) 1,332 (3,513) (2,181) Consumer (2) — (2) (8) 3 (5) Total loans 981 (2,009) (1,028) 2,070 (5,290) (3,220) Federal Home Loan Bank stock 5 (41) (36) 2 (95) (93) Total change in interest and dividend income 1,308 (2,880) (1,572) 2,579 (7,289) (4,710) Interest expense: Deposits: NOW 12 2 14 22 (24) (2) Money market 323 (1,203) (880) 313 (2,667) (2,354) Savings (46) (457) (503) (77) (971) (1,048) Time 592 (1,450) (858) 1,288 (2,011) (723) Total deposits 881 (3,108) (2,227) 1,546 (5,673) (4,127) Borrowed money 156 (97) 59 220 (419) (199) Total change in interest expense 1,037 (3,205) (2,168) 1,766 (6,092) (4,326) Change in net interest income $ 271 $ 325 $ 596 $ 813 $ (1,197) $ (384) Provision for Loan Losses The provision for loan losses is based on management’s periodic assessment of the adequacy of our allowance for loan losses which, in turn, is based on interrelated factors such as the composition of our loan portfolio and its inherent risk characteristics, the level of nonperforming loans and net charge-offs, both current and historic, local economic and credit conditions, the direction of real estate values, and regulatory guidelines. The provision for loan losses is charged against earnings in order to maintain our allowance for loan losses and reflects management’s best estimate of probable losses inherent in our loan portfolio as of the balance sheet date. The provision for loan losses for the three months ended September 30, 2020 was $0.7 million compared to a provision for loan losses of $0.8 million for the three months ended September 30, 2019. The provision for loan losses for the nine months ended September 30, 2020 was $6.9 million compared to a provision for loan losses of $0.1 million for the nine months ended September 30, 2019. The increase in the provision for loan losses for the nine months ended September 30, 2020, was due to management’s assessment of increased credit risk relating to economic disruption and uncertainty caused by the COVID-19 pandemic. For further information, see sections titled Asset Quality and Allowance for Loan Losses. 50 Noninterest Income Noninterest income is a component of our revenue and is comprised primarily of fees generated from loan and deposit relationships with our customers, fees generated from sales and referrals of loans, income earned on bank-owned life insurance and gains on sales of investment securities. The following tables compare noninterest income for the three and nine months ended September 30, 2020 and 2019: Three Months Ended September 30, Change (Dollars in thousands) 2020 2019 $ % Bank-owned life insurance $ 242 $ 255 $ (13) (5.1) % Service charges and fees 190 264 (74) (28.0) Gains and fees from sales of loans 27 703 (676) (96.2) Gain (loss) on sale of other real estate owned, net 19 (102) 121 (118.6) Other 136 432 (296) (68.5) Total noninterest income $ 614 $ 1,552 $ (938) (60.4) % Nine Months Ended September 30, Change (Dollars in thousands) 2020 2019 $ % Bank-owned life insurance $ 726 $ 758 $ (32) (4.2) % Service charges and fees 578 776 (198) (25.5) Gains and fees from sales of loans 27 1,409 (1,382) (98.1) Gain (loss) on sale of other real estate owned, net 19 (102) 121 (118.6) Net gain on sale of available for sale securities — 76 (76) (100.0) Other 913 1,279 (366) (28.6) Total noninterest income $ 2,263 $ 4,196 $ (1,933) (46.1) % Noninterest income decreased by $0.9 million, or 60%, to $0.6 million for the three months ended September 30, 2020 compared to the three months ended September 30, 2019. Noninterest income decreased by $1.9 million, or 46%, to $2.3 million for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019. The decrease in noninterest income was primarily a result of the absence of gains and fees from the sales of SBA loans for the three and nine months ended September 30, 2020 compared to the same periods in 2019. To a lesser degree, the decrease in noninterest income was also driven by certain waived service charges and fees on depository accounts as a courtesy to customers during the COVID-19 pandemic. The decrease in other noninterest income was primarily a result of loan related interest rate swap fees recognized in 2019. 51 Noninterest Expense The following tables compare noninterest expense for the three and nine months ended September 30, 2020 and 2019: Three Months Ended September 30, Change (Dollars in thousands) 2020 2019 $ % Salaries and employee benefits $ 5,295 $ 4,881 $ 414 8.5 % Occupancy and equipment 2,266 1,946 320 16.4 Data processing 529 505 24 4.8 Professional services 374 346 28 8.1 Director fees 301 235 66 28.1 FDIC insurance 176 (125) 301 (240.8) Marketing 151 210 (59) (28.1) Amortization of intangibles 18 19 (1) (5.3) Other 619 655 (36) (5.5) Total noninterest expense $ 9,729 $ 8,672 $ 1,057 12.2 % Nine Months Ended September 30, Change (Dollars in thousands) 2020 2019 $ % Salaries and employee benefits $ 15,902 $ 14,272 $ 1,630 11.4 % Occupancy and equipment 6,410 5,666 744 13.1 Data processing 1,558 1,568 (10) (0.6) Professional services 1,519 1,455 64 4.4 Director fees 883 639 244 38.2 FDIC insurance 529 74 455 614.9 Marketing 512 751 (239) (31.8) Amortization of intangibles 54 57 (3) (5.3) Other 1,743 1,920 (177) (9.2) Total noninterest expense $ 29,110 $ 26,402 $ 2,708 10.3 % Noninterest expense increased by $1.1 million, or 12.2%, to $9.7 million for the three months ended September 30, 2020 compared to the three months ended September 30, 2019. Noninterest expense increased by $2.7 million or 10.3%, to $29.1 million for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019. The increase in noninterest expense was primarily driven by an increase in salaries and employee benefits, occupancy and equipment expense and FDIC insurance expense. Salaries and employee benefits totaled $5.3 million for the three months ended September 30, 2020, an increase of $0.4 million when compared to the same period in 2019. Salaries and employee benefits totaled $15.9 million for the nine months ended September 30, 2020, an increase of $1.6 million when compared to the same period in 2019. The increase in salaries and employee benefits was primarily driven by normal annual salary increases, additional hires in support of growth initiatives and expanded employee benefits to assist employees impacted by the COVID-19 pandemic. Occupancy and equipment expense totaled $2.3 million for the three months ended September 30, 2020, an increase of $0.3 million when compared to the same period in 2019. Occupancy and equipment expense totaled $6.4 million for the nine months ended September 30, 2020, an increase of $0.7 million when compared to the same period in 2019. The increase in occupancy and equipment expense was primarily due to additional cleaning costs associated with precautions taken to prevent the spread of COVID-19. FDIC insurance expense totaled $0.2 million for the three months ended September 30, 2020, an increase of $0.3 million when compared to the same period in 2019. FDIC insurance expense totaled $0.5 million for the nine months ended September 30, 52 2020, an increase of $0.5 million when compared to the same period in 2019. The increase in FDIC insurance expense was primarily driven by a credit received during the three months ended September 30, 2019, that was not repeated during the three months ended September 30, 2020. Income Taxes Income tax expense for the three months ended September 30, 2020 and 2019 totaled $0.8 million and $1.0 million, respectively. The effective tax rates for the three months ended September 30, 2020 and 2019 were 20.9% and 20.1%, respectively. Income tax expense for the nine months ended September 30, 2020 and 2019 totaled $1.2 million and $3.8 million, respectively. The effective tax rates for the nine months ended September 30, 2020 and 2019 were 18.0% and 20.5%, respectively. For the nine months ended September 30, 2020, the decline in the effective tax rate was primarily attributable to a discrete benefit recognized in the first quarter of 2020, and to a lesser extent, other permanent differences. The impact of these items on the effective tax rate varies with changes in pre-tax income. Financial Condition Summary At September 30, 2020 total assets were $2.2 billion, a $310.8 million, or a 16.5%, increase compared to December 31, 2019. The increase in assets is primarily driven by an increase in cash and cash equivalents in order to maintain a higher level of liquidity during the COVID-19 pandemic. Gross loans totaled $1.6 billion at September 30, 2020, an increase of $20.2 million compared to December 31, 2019. Excluding PPP loans, gross loans decreased by $36.5 million at September 30, 2020 when compared to December 31, 2019. Deposits totaled $1.8 billion at September 30, 2020, compared to $1.5 billion at December 31, 2019. The increase in deposits was a result of successful commercial core deposit gathering efforts, as well as a temporary increase in short term time deposits to expand on-balance sheet liquidity during the COVID-19 pandemic. Total shareholders’ equity at September 30, 2020 and December 31, 2019 was $174.3 million and $182.4 million, respectively. The decrease in shareholders' equity was primarily driven by a $10.7 million unfavorable impact to accumulated other comprehensive loss, driven by fair value marks related to hedge positions involving interest rate swaps, as well as $3.3 million in dividends paid and common stock repurchases of $1.0 million. The decrease was partially offset by net income for the nine months ended September 30, 2020 of $5.6 million. The marks on the interest rate swaps are driven by lower long term market interest rates in 2020 when compared to 2019. The Company's interest rate swaps are used to hedge interest rate risk. The Company's current interest rate swap positions will cause a decrease to other comprehensive income in a falling interest rate environment and an increase in a rising interest rate environment. Tangible book value was $22.20 per share outstanding at September 30, 2020 compared to $23.15 per share outstanding at December 31, 2019. Loan Portfolio We originate commercial real estate loans, including construction loans, commercial business loans and other consumer loans. Lending activities are conducted principally in the New York metropolitan area and throughout Connecticut, with the majority in Fairfield and New Haven Counties of Connecticut. Our loan portfolio is the largest category of our earning assets. Total loans before deferred loan fees and the allowance for loan losses were $1.62 billion at September 30, 2020 and $1.60 billion at December 31, 2019. Total gross loans increased $20.2 million as of September 30, 2020 compared to the year ended December 31, 2019. 53 The following table compares the composition of our loan portfolio for the dates indicated: (In thousands) At September 30, 2020 At December 31, 2019 Change Real estate loans: Residential $ 120,531 $ 147,109 $ (26,578) Commercial 1,105,862 1,128,614 (22,752) Construction 96,508 98,583 (2,075) 1,322,901 1,374,306 (51,405) Commercial business 301,747 230,028 71,719 Consumer 78 150 (72) Total loans $ 1,624,726 $ 1,604,484 $ 20,242 Asset Quality We actively manage asset quality through our underwriting practices and collection operations. Our Board of Directors monitors credit risk management through two committees, the Directors Loan Committee ("DLC") and the Audit Committee. The DLC has primary oversight responsibility for the credit granting function including approval authority for credit granting policies, review of management’s credit granting activities and approval of large exposure credit requests. The Audit Committee oversees management’s systems and procedures to monitor the credit quality of our loan portfolio and the loan review program. These committees report the results of their respective oversight functions to our Board of Directors. In addition, our Board of Directors receives information concerning asset quality measurements and trends on a monthly basis. While we continue to adhere to prudent underwriting standards, our loan portfolio is not immune to potential negative consequences as a result of general economic weakness, such as a prolonged downturn in the housing market on a national scale. Decreases in real estate values could adversely affect the value of property used as collateral for loans. In addition, adverse changes in the economy could have a negative effect on the ability of borrowers to make scheduled loan payments, which would likely have an adverse impact on earnings. The Company has established credit policies applicable to each type of lending activity in which it engages. The Company evaluates the creditworthiness of each customer and extends credit of up to 80% of the market value of the collateral, depending on the borrower's creditworthiness and the type of collateral. The borrower’s ability to service the debt is monitored on an ongoing basis. Real estate is the primary form of collateral. Other important forms of collateral are business assets, time deposits and marketable securities. While collateral provides assurance as a secondary source of repayment, the Company ordinarily requires the primary source of repayment for commercial loans, to be based on the borrower’s ability to generate continuing cash flows. In the fourth quarter of 2017 management made the strategic decision to no longer originate residential mortgage loans. As of the beginning of the third quarter of 2019, the Company no longer offered home equity loans or lines of credit. The Company’s policy for residential lending generally required that the amount of the loan may not exceed 80% of the original appraised value of the property. In certain situations, the amount may have exceeded 80% LTV either with private mortgage insurance being required for that portion of the residential loan in excess of 80% of the appraised value of the property or where secondary financing is provided by a housing authority program second mortgage, a community’s low/moderate income housing program, or a religious or civic organization. Credit risk management involves a partnership between our relationship managers and our credit approval, portfolio management, credit administration and collections personnel. Disciplined underwriting, portfolio monitoring and early problem recognition are important aspects of maintaining our high credit quality standards and low levels of nonperforming assets since our inception in 2002. 54 Nonperforming assets . Nonperforming assets include nonaccrual loans and property acquired through foreclosures or repossession. The following table presents nonperforming assets and additional asset quality data for the dates indicated: (In thousands) At September 30, 2020 At December 31, 2019 Nonaccrual loans: Real estate loans: Residential $ 1,596 $ 1,560 Commercial 4,812 5,222 Commercial business 3,760 3,806 Total nonaccrual loans 10,168 10,588 Other real estate owned — — Total nonperforming assets $ 10,168 $ 10,588 Nonperforming assets to total assets 0.46 % 0.56 % Nonaccrual loans to total gross loans 0.63 % 0.66 % Total past due loans to total gross loans 0.46 % 0.77 % Nonperforming assets totaled $10.2 million and represented 0.46% of total assets at September 30, 2020, compared to $10.6 million and 0.56% of total assets at December 31, 2019. Nonaccrual loans totaled $10.2 million at September 30, 2020, of which $4.5 million is guaranteed by the Small Business Administration (SBA). There was no other real estate owned at September 30, 2020 or December 31, 2019. Allowance for Loan Losses We evaluate the adequacy of the allowance for loan losses at least quarterly, and in determining our allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of our allowance for loan losses is based on internally assigned risk classifications of loans, the Bank’s and peer banks’ historical loss experience, changes in the nature of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. Our general practice is to identify problem credits early and recognize full or partial charge-offs as promptly as practicable when it is determined that it is probable that the loan will not be repaid according to its original contractual terms, including principal and interest. Full or partial charge-offs on collateral dependent impaired loans are recognized when the collateral is deemed to be insufficient to support the carrying value of the loan. We do not recognize a recovery when an updated appraisal indicates a subsequent increase in value of the collateral. Our charge-off policies, which comply with standards established by our banking regulators, are consistently applied from period to period. Charge-offs are recorded on a monthly basis, as incurred. Partially charged-off loans continue to be evaluated on a monthly basis and additional charge-offs or loan loss provisions may be recorded on the remaining loan balance based on the same criteria. 55 The following table presents the activity in our allowance for loan losses and related ratios for the dates indicated: Three Months Ended September 30, Nine Months Ended September 30, (Dollars in thousands) 2020 2019 2020 2019 Balance at beginning of period $ 19,662 $ 13,890 $ 13,509 $ 15,462 Charge-offs: Residential real estate — (78) — (875) Commercial real estate — (594) — (594) Commercial business — (748) (7) (884) Consumer (4) (57) (29) (70) Total charge-offs (4) (1,477) (36) (2,423) Recoveries: Commercial business — 2 1 18 Consumer 2 24 2 28 Total recoveries 2 26 3 46 Net charge-offs (2) (1,451) (33) (2,377) Provision charged to earnings 712 773 6,896 127 Balance at end of period $ 20,372 $ 13,212 $ 20,372 $ 13,212 Net charge-offs to average loans — % 0.09 % — % 0.15 % Allowance for loan losses to total gross loans 1.25 % 0.84 % 1.25 % 0.84 % At September 30, 2020, our allowance for loan losses was $20.4 million and represented 1.25% of total gross loans, compared to $13.5 million, or 0.84% of total gross loans, at December 31, 2019. The $6.9 million increase in the allowance for loan losses at September 30, 2020 when compared to December 31, 2019 was primarily due to incremental loan loss reserves recognized for increased credit risk relating to economic disruption and uncertainty caused by the COVID-19 pandemic. The following table presents the allocation of the allowance for loan losses and the percentage of these loans to total loans for the dates indicated: At September 30, 2020 At December 31, 2019 (Dollars in thousands) Amount Percent of Loan Portfolio Amount Percent of Loan Portfolio Residential real estate $ 714 7.42 % $ 730 9.17 % Commercial real estate 14,900 68.06 10,551 70.34 Construction 434 5.94 324 6.14 Commercial business 4,324 18.57 1,903 14.34 Consumer — 0.01 1 0.01 Total allowance for loan losses $ 20,372 100.00 % $ 13,509 100.00 % The allocation of the allowance for loan losses at September 30, 2020 reflects our assessment of credit risk and probable loss within each portfolio. We believe that the level of the allowance for loan losses at September 30, 2020 is appropriate to cover probable losses. Section 4013 of the CARES Act allows financial institutions to grant short term payment relief to borrowers impacted by COVID-19 and permits a financial institution to elect to suspend troubled debt restructuring accounting for relief granted under the Act. As of September 30, 2020, the Company has active COVID-19 related deferrals on 12 loans (excluding SBA loans, which are paid for 6 months by the SBA on behalf of borrowers) totaling $32.7 million. In addition, the Company was evaluating 10 loans, totaling $31.3 million, for a second COVID-19 deferral term. The Company has thoroughly evaluated these deferral requests, granting initial three month payment deferral periods and, in some instances, a second three month payment deferral period. This excludes SBA loans, which are mandated to receive an automatic six month deferral. These deferrals are not considered troubled debt restructurings based on Section 4013 of the CARES Act and interagency guidance issued in March of 2020. Also, the FASB has determined that the TDR guidance in the interagency statement is an appropriate 56 application of ASC 310-40. As such, all of the Company’s deferrals under the CARES Act are also considered in conformity with US GAAP as to their non-TDR classification. The following table details these deferral by loan category and type as of September 30, 2020: At September 30, 2020 (Dollars in thousands) Amount Number Commercial real estate $ 23,207 8 Construction 8,997 2 Commercial business 481 2 Total $ 32,685 12 Reserve for Unfunded Commitments The reserve for unfunded commitments provides for probable losses inherent with funding the unused portion of legal commitments to lend. The unfunded reserve calculation is primarily based on our allowance for loan loss methodology for funded loans, adjusted for utilization expectations. The reserve for unfunded credit commitments is included within other liabilities in the accompanying Consolidated Balance Sheets. Changes in the reserve are reported as a component of other noninterest expense in the accompanying Consolidated Statements of Income. Investment Securities At September 30, 2020, the carrying value of our investment securities portfolio totaled $108.9 million and represented 5.0% of total assets, compared to $100.9 million, or 5.4% of total assets, at December 31, 2019. The net unrealized gain position on our investment portfolio at September 30, 2020 was $7.5 million and included no gross unrealized losses. The net unrealized gain position on our investment portfolio at December 31, 2019 was $3.2 million and included gross unrealized losses of $2.0 thousand. Deposit Activities and Other Sources of Funds Nine Months Ended September 30, 2020 Twelve Months Ended December 31, 2019 (Dollars in thousands) Amount Percent Weighted Average Rate Amount Percent Weighted Average Rate Noninterest bearing demand $ 234,848 13.29 % — % $ 191,518 12.84 % — % NOW 90,776 5.14 0.17 70,020 4.69 0.21 Money market 561,101 31.74 0.91 419,495 28.12 1.62 Savings 164,590 9.31 0.94 183,729 12.31 1.67 Time 716,213 40.52 1.87 627,141 42.04 2.27 Total deposits $ 1,767,528 100.00 % 1.36 % $ 1,491,903 100.00 % 1.87 % Total deposits were $1.8 billion at September 30, 2020, an increase of $275.6 million, from the balance at December 31, 2019. The increase in total deposits was a result of successful commercial core deposit gathering efforts, as well as a temporary increase in short term time deposits to expand on-balance sheet liquidity during the COVID-19 pandemic. Brokered certificates of deposits totaled $296.0 million and $179.8 million at September 30, 2020 and December 31, 2019, respectively. Brokered money market accounts totaled $28.7 million and $39.9 million at September 30, 2020 and December 31, 2019, respectively. Brokered deposits represent brokered certificates of deposit, brokered money market accounts and one way buy Certificate of Deposit Account Registry Service (CDARS), and one way buy Insured Cash Sweep (ICS). Brokered deposits are utilized as an additional source of funding. 57 At September 30, 2020 and December 31, 2019, time deposits with a denomination of $100 thousand or more, including CDARS and brokered deposits, totaled $601.6 million and $502.8 million, respectively, maturing during the periods indicated in the table below: (Dollars in thousands) September 30, 2020 December 31, 2019 Maturing: Within 3 months $ 155,675 $ 114,636 After 3 but within 6 months 89,654 139,852 After 6 months but within 1 year 143,522 104,355 After 1 year 212,768 143,907 Total $ 601,619 $ 502,750 We utilize advances from the Federal Home Loan Bank of Boston, or FHLB, as part of our overall funding strategy and to meet short-term liquidity needs, and to a lesser degree, manage interest rate risk arising from the difference in asset and liability maturities. Total FHLB advances were $175.0 million and $150.0 million at September 30, 2020 and December 31, 2019, respectively. The increase of $25.0 million, or 16.7%, reflects normal operating fluctuation in our borrowings. The Bank has additional borrowing capacity at the FHLB up to a certain percentage of the value of qualified collateral. In accordance with agreements with the FHLB, the qualified collateral must be free and clear of liens, pledges and encumbrances. At September 30, 2020, the Bank had pledged $858.7 million of eligible loans as collateral to support borrowing capacity at the FHLB of Boston. As of September 30, 2020, the Bank had immediate availability to borrow an additional $355.8 million based on qualified collateral. Liquidity and Capital Resources Liquidity Management Liquidity is defined as the ability to generate sufficient cash flows to meet all present and future funding requirements at reasonable costs. Our primary source of liquidity is deposits. While our generally preferred funding strategy is to attract and retain low cost deposits, our ability to do so is affected by competitive interest rates and terms in the marketplace. Other sources of funding include discretionary use of purchased liabilities (e.g., FHLB term advances and other borrowings), cash flows from our investment securities portfolios, loan sales, loan repayments and earnings. Investment securities designated as available for sale may also be sold in response to short-term or long-term liquidity needs. The Bank’s liquidity positions are monitored daily by management. The Asset Liability Committee ("ALCO") establishes guidelines to ensure maintenance of prudent levels of liquidity. ALCO reports to the Company’s Board of Directors. The Bank has a detailed liquidity funding policy and a contingency funding plan that provide for the prompt and comprehensive response to unexpected demands for liquidity. We employ a stress testing methodology to estimate needs for contingent funding that could result from unexpected outflows of funds in excess of “business as usual” cash flows. The Bank has established unsecured borrowing capacity with the Atlantic Community Bankers Bank ("ACBB") (formerly Bankers’ Bank Northeast), Zion’s Bank and Texas Capital Bank and also maintains additional collateralized borrowing capacity with the FHLB in excess of levels used in the ordinary course of business. Our sources of liquidity include cash, unpledged investment securities, borrowings from the FHLB, lines of credit from ACBB, Zion’s Bank and Texas Capital Bank, the brokered deposit market and national CD listing services. The Company anticipates that it will have sufficient funds available to meet its current loan and other commitments. As of September 30, 2020, the Company had cash and cash equivalents of $339.5 million and available-for-sale securities of $90.6 million. At September 30, 2020, outstanding commitments to originate loans totaled $23.3 million and undisbursed funds from approved lines of credit, home equity lines of credit and secured commercial lines of credit totaled $153.2 million. Capital Resources Shareholders’ equity totaled $174.3 million as of September 30, 2020, a decrease of $8.1 million compared to December 31, 2019, primarily a result of an $10.7 million unfavorable impact to accumulated other comprehensive loss driven by fair value marks related to hedge positions involving interest rate swaps, as well as $3.3 million in dividends paid and common stock 58 repurchases of $1.0 million. The decrease was partially offset by net income for the nine months ended September 30, 2020 of $5.6 million. The marks on the interest rate swaps are driven by lower long term market interest rates in 2020 when compared to 2019. The Company's interest rate swaps are used to hedge interest rate risk. The Company's current interest rate swap positions will cause a decrease to other comprehensive income in a falling interest rate environment and an increase in a rising interest rate environment. As of September 30, 2020, the tangible common equity ratio and tangible book value per share were 7.83% and $22.20, respectively. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. At September 30, 2020, the Bank met all capital adequacy requirements to which it was subject and exceeded the regulatory minimum capital levels to be considered well-capitalized under the regulatory framework for prompt corrective action. At September 30, 2020, the Bank’s ratio of Common Equity Tier 1 capital to risk-weighted assets was 12.36%, total capital to risk-weighted assets was 13.57%, Tier 1 capital to risk-weighted assets was 12.36% and Tier 1 capital to average assets was 9.58%. In July 2013, the Federal Reserve published Basel III rules establishing a new comprehensive capital framework of U.S. banking organizations. Under the rules, effective January 1, 2015 for the Company and Bank, the minimum capital ratios became a) 4.5% Common Equity Tier 1 to risk-weighted assets, b) 6.0% Tier 1 capital to risk weighted assets and c) 8.0% total capital to risk-weighted assets. In addition, the new regulations imposed certain limitations on dividends, share buy-backs, discretionary payments on Tier 1 instruments and discretionary bonuses to executive officers if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of common equity to risk weighted assets, in addition to the amounts necessary to meet the minimum risk-based capital requirements described above. As of January 1, 2019, the “capital conservation buffer” increased from 1.875% to 2.5%. As of September 30, 2020, the capital conservation buffer was 5.6% and 5.3% at the Bank and the Company, respectively. Asset/Liability Management and Interest Rate Risk We measure interest rate risk using simulation analysis to calculate earnings and equity at risk. These risk measures are quantified using simulation software from one of the leading firms in the field of asset/liability modeling. Key assumptions relate to the behavior of interest rates and spreads, prepayment speeds and the run-off of deposits. From such simulations, interest rate risk, or IRR, is quantified and appropriate strategies are formulated and implemented. We model IRR by using two primary risk measurement techniques: simulation of net interest income and simulation of economic value of equity. These two measurements are complementary and provide both short-term and long-term risk profiles for the Company. Because both baseline simulations assume that our balance sheet will remain static over the simulation horizon, the results do not reflect adjustments in strategy that ALCO could implement in response to rate shifts. The simulation analyses are updated quarterly. We use a net interest income at risk simulation to measure the sensitivity of net interest income to changes in market rates. This simulation captures underlying product behaviors, such as asset and liability repricing dates, balloon dates, interest rate indices and spreads, rate caps and floors, as well as other behavioral attributes. The simulation of net interest income also requires a number of key assumptions such as: (i) prepayment projections for loans and securities that are projected under each interest rate scenario using internal and external mortgage analytics; (ii) new business loan rates that are based on recent new business origination experience; and (iii) deposit pricing assumptions for non-maturity deposits reflecting the Bank’s limited history, management judgment and core deposit studies. Combined, these assumptions can be inherently uncertain, and as a result, actual results may differ from simulation forecasts due to the timing, magnitude and frequency of interest rate changes, future business conditions, as well as unanticipated changes in management strategies. We use two sets of standard scenarios to measure net interest income at risk. For the Parallel Ramp Scenarios, rate changes are ramped over a twelve-month horizon based upon a parallel yield curve shift and then maintained at those levels over the remainder of the simulation horizon. Parallel Shock Scenarios assume instantaneous parallel movements in the yield curve compared to a flat yield curve scenario. Simulation analysis involves projecting a future balance sheet structure and interest income and expense under the various rate scenarios. Internal policy regarding internal rate risk simulations currently specifies that for instantaneous parallel shifts of the yield curve, estimated net interest income at risk for the subsequent one-year period should not decline by more than: 6% for a 100 basis point shift; 12% for a 200 basis point shift; and 18% for a 300 basis point shift. Per Company policy, the Bank should not be outside these limits for twelve consecutive months unless the Bank's forecasted capital ratios are considered to be "well capitalized". As of September 30, 2020, the Bank has met all minimum regulatory capital requirements to be considered "well capitalized", reference footnote 7 to the consolidated financial statements for more detail. 59 The following tables set forth the estimated percentage change in our net interest income at risk over one-year simulation periods beginning September 30, 2020 and December 31, 2019: Parallel Ramp Estimated Percent Change in Net Interest Income Rate Changes (basis points) September 30, 2020 December 31, 2019 -100 0.30 % 3.00 % +200 (1.50) (6.80) Parallel Shock Estimated Percent Change in Net Interest Income Rate Changes (basis points) September 30, 2020 December 31, 2019 -100 — % 5.00 % +100 (1.00) (6.20) +200 (1.70) (12.90) +300 (2.00) (19.50) The net interest income at risk simulation results indicate that, as of September 30, 2020, we remain liability sensitive. The liability sensitivity is due to the fact that there are more liabilities than assets subject to repricing as market rates change. We conduct an economic value of equity at risk simulation in tandem with net interest income simulations, to ascertain a longer term view of our interest rate risk position by capturing longer-term repricing risk and options risk embedded in the balance sheet. It measures the sensitivity of economic value of equity to changes in interest rates. The economic value of equity at risk simulation values only the current balance sheet and does not incorporate the growth assumptions used in one of the income simulations. As with the net interest income simulation, this simulation captures product characteristics such as loan resets, repricing terms, maturity dates, rate caps and floors. Key assumptions include loan prepayment speeds, deposit pricing elasticity and non-maturity deposit attrition rates. These assumptions can have significant impacts on valuation results as the assumptions remain in effect for the entire life of each asset and liability. All key assumptions are subject to a periodic review. Base case economic value of equity at risk is calculated by estimating the net present value of all future cash flows from existing assets and liabilities using current interest rates. The base case scenario assumes that future interest rates remain unchanged. The following table sets forth the estimated percentage change in our economic value of equity at risk, assuming various shifts in interest rates: Estimated Percent Change in Economic Value of Equity Rate Changes (basis points) September 30, 2020 December 31, 2019 -100 (41.90) % (2.00) % +100 7.40 (6.50) +200 10.30 (17.20) +300 13.40 (25.50) While ALCO reviews and updates simulation assumptions and also periodically back-tests the simulation results to ensure that the assumptions are reasonable and current, income simulation may not always prove to be an accurate indicator of interest rate risk or future net interest margin. Over time, the repricing, maturity and prepayment characteristics of financial instruments and the composition of our balance sheet may change to a different degree than estimated. ALCO recognizes that deposit balances could shift into higher yielding alternatives as market rates change. ALCO has modeled increased costs of deposits in the rising rate simulation scenarios presented above. 60 It should be noted that the static balance sheet assumption does not necessarily reflect our expectation for future balance sheet growth, which is a function of the business environment and customer behavior. Another significant simulation assumption is the sensitivity of core deposits to fluctuations in interest rates. Income simulation results assume that changes in both core savings deposit rates and balances are related to changes in short-term interest rates. Lastly, mortgage-backed securities and mortgage loans involve a level of risk that unforeseen changes in prepayment speeds may cause related cash flows to vary significantly in differing rate environments. Such changes could affect the level of reinvestment risk associated with cash flow from these instruments, as well as their market value. Changes in prepayment speeds could also increase or decrease the amortization of premium or accretion of discounts related to such instruments, thereby affecting interest income. 61