Carter Bankshares, Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS limitation, adverse effects on the ability of the Company's borrowers to satisfy their obligations to the Company, on the value of collateral securing loans, on the demand for the Company's loans or its other products and services, on incidents of cyberattacks and fraud, on the Company’s liquidity or capital positions, on risks posed by reliance on third-party service providers, on other aspects of the Company's business operations and on financial markets and economic growth; the effect of steps the Company takes or has taken in response to the COVID-19 pandemic, the severity and duration of the pandemic, the uncertainty regarding new variants of COVID-19 that have emerged, the speed and efficacy of vaccine and treatment developments, the impact of loosening or tightening of government restrictions, the pace of economic recovery when the pandemic subsides and the impact it has on exacerbation of many of the risks described herein and in our Annual Report on Form 10-K for the year ended December 31, 2020, as supplemented by the risk factor disclosed in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2021; legislative or regulatory changes and requirements, including the impact of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), as amended by the Consolidated Appropriations Act, 2021 (the “CAA”), and other legislative and regulatory reactions to the COVID-19 pandemic; potential claims, damages, and fines related to litigation or government actions, including litigation or actions arising from the Company’s participation in and administration of programs related to the COVID-19 pandemic, including, among other things, under the CARES Act, as amended by the CAA; sensitivity to the interest rate environment including a prolonged period of low interest rates, a rapid increase in interest rates or a change in the shape of the yield curve; a change in spreads on interest-earning assets and interest-bearing liabilities; regulatory supervision and oversight; legislation affecting the financial services industry as a whole, and the Company, in particular; the outcome of pending and future litigation and governmental proceedings; increasing price and product/service competition; the ability to continue to introduce competitive new products and services on a timely, cost-effective basis; the Company’s strategic branch network optimization plan; managing our internal growth and acquisitions; the possibility that the anticipated benefits from acquisitions cannot be fully realized in a timely manner or at all, or that integrating the acquired operations will be more difficult, disruptive or more costly than anticipated; containing costs and expenses; reliance on significant customer relationships; credit losses; general economic or business conditions; deterioration of the housing market and reduced demand for mortgages; deterioration in the overall macroeconomic conditions or the state of the banking industry that could impact the re-emergence of turbulence in significant portions of the global financial and real estate markets that could impact our performance, both directly, by affecting our revenues and the value of our assets and liabilities, and indirectly, by affecting the economy generally and access to capital in the amounts, at the times and on the terms required to support our future businesses. Many of these factors, as well as other factors, are described throughout this Quarterly Report, including and in Part I, Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2020 and our subsequent filings with the Securities and Exchange Commission (“SEC”). Forward-looking statements are based on beliefs and assumptions using information available at the time the statements are made. We caution you not to unduly rely on forward-looking statements because the assumptions, beliefs, expectations and projections about future events may, and often do, differ materially from actual results. Any forward-looking statement speaks only as to the date on which it is made, and we undertake no obligation to update, revise or clarify any forward-looking statement to reflect developments occurring after the statement is made. Critical Accounting Policies and Estimates Our critical accounting policies involving significant judgments and assumptions used in the preparation of the Consolidated Financial Statements as of September 30, 2021 have remained unchanged from the disclosures presented in our Annual Report on Form 10-K for the year ended December 31, 2020 under the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” except we have updated our allowance for credit losses (“ACL”) policy and included required disclosures in response to the adoption of ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. Please refer to the CECL disclosure contained in Notes 1 and 5 to the consolidated financial statements included in this Quarterly Report on Form 10-Q. Overview Carter Bankshares, Inc. (the “Company”) is a bank holding company headquartered in Martinsville, Virginia with assets of $4.1 billion at September 30, 2021. The Company is the parent company of its wholly owned subsidiary, Carter Bank & Trust (the “Bank”). The Bank is an insured, Virginia state-chartered bank, which operates branches in Virginia and North Carolina. The Company provides a full range of financial services with retail, and commercial banking products and insurance. Our common stock trades on the Nasdaq Global Select Market under the ticker symbol “CARE.” The Company earns revenue primarily from interest on loans, securities and fees charged for financial services provided to our customers. The Company incurs expenses for the cost of deposits, provision for credit losses and other operating costs such as salaries and employee benefits, data processing, occupancy and tax expense. 38 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) Our mission is that the Company strives to be the preferred lifetime financial partner for our customers and shareholders, and the employer of choice in the communities the Company is privileged to serve. Our strategic plan focuses on restructuring the balance sheet to provide more diversification and higher yielding assets to increase the net interest margin. Another area of focus is the transformation of the infrastructure of the Company to provide a foundation for operational efficiency and provide new products and services for our customers that will ultimately increase noninterest income. Our focus continues to be on loan and deposit growth with a shift in the composition of deposits to more low cost core deposits with less dependence in higher cost certificates of deposits (“CDs”), as well as, implementing opportunities to increase fee income while closely monitoring our operating expenses. We continuously work to maintain and improve credit quality and the reduction of problem assets. We are focused on executing our strategy to successfully build our brand and grow our business in our markets. COVID-19 In response to the COVID-19 pandemic, the CARES Act was signed into law on March 27, 2020. The CARES Act is an emergency stimulus measure providing assistance and relief in a variety of ways to certain individuals, businesses, and industries. The CARES Act established a $2 trillion economic stimulus package, including cash payments to individuals, supplemental unemployment insurance benefits and a $349 billion loan program administered through the Small Business Administration (“SBA”), referred to as the Paycheck Protection Program (“PPP”). In addition to the general impact that the COVID-19 pandemic has had on the Company, certain provisions of the CARES Act, as well as other legislative and regulatory relief efforts, may have a material impact on our operations. The full extent of these impacts at the date of this filing is unknown; however, we have disclosed the material items of which we are aware. Many of the CARES Act’s programs are dependent upon the direct involvement of U.S. financial institutions, implemented through rules and guidance adopted by federal agencies, including the U.S. Department of the Treasury, the Federal Deposit Insurance Corporation (“FDIC”), the Board of Governors of the Federal Reserve System (“FRB” or “Federal Reserve”) and other federal bank regulatory authorities, including those with direct supervisory jurisdiction over the Company and the Bank. Set forth below is a brief overview of certain provisions of the CARES Act and certain other regulations and supervisory guidance related to the COVID-19 pandemic that are applicable to the operations and activities of the Company. The following description is qualified in its entirety by reference to the full text of the CARES Act and the statutes, regulations, and policies described herein. Such statutes, regulations, and policies are subject to ongoing review by U.S. Congress and federal regulatory authorities. Future amendments to the provisions of the CARES Act or changes to any of the statutes, regulations, or regulatory policies applicable to the Bank could have a material effect on the Bank. The Bank will continue to assess the impact of the CARES Act and other statutes, regulations and supervisory guidance related to the COVID-19 pandemic. FRB Reserve Programs and Initiatives The CARES Act encourages the FRB, in coordination with the Secretary of the Treasury, to establish or implement various programs to help midsize businesses, nonprofits, and municipalities, including (i) a Midsize Business/Nonprofit Organization Program to provide financing to banks and other lenders to make direct loans to eligible businesses and nonprofit organizations with between 500 and 10,000 employees and (ii) the Municipal Liquidity Facility, provide liquidity to the financial system that supports states and municipalities. On April 9, 2020, the FRB announced and solicited comments regarding the Main Street Lending Program, which would implement certain of these recommendations. Separately, and in response to the COVID-19 pandemic, the FRB’s Federal Open Market Committee (the “FOMC”) has set the federal funds target rate – i.e., the interest rate at which depository institutions such as the Company lend reserve balances to other depository institutions overnight on an uncollateralized basis – to a historic low. On March 16, 2020, the FOMC set the federal funds target rate at 0-0.25%. Consistent with FRB policy, the FRB has committed to the use of overnight reverse repurchase agreements as a supplementary policy tool, as necessary, to help control the federal funds rate and keep it in the target range set by the FOMC. In addition, the FRB expanded the size and scope of three existing programs to mitigate the economic impact of the COVID-19 pandemic: (i) the Primary Market Corporate Credit Facility; (ii) the Secondary Market Corporate Credit Facility; and (iii) the Term Asset-Backed Securities Loan Facility. The FRB also established two new program facilities – the Money Market Mutual 39 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) Fund Liquidity Facility and the Commercial Paper Funding Facility – to broaden its support for the flow of credit to households and businesses during the COVID-19 pandemic. Temporary Bank Secrecy Act (“BSA”) Reporting Relief The U.S. Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) has provided targeted relief from certain BSA reporting requirements and have provided updated guidance to financial institutions on complying with such requirements during the COVID-19 pandemic. Specifically, FinCEN has (i) granted targeted relief to financial institutions participating in the PPP, stating that PPP loans to existing customers will not require reverification under applicable BSA requirements, unless reverification is otherwise required under the financial institution’s risk-based BSA compliance program, (ii) acknowledged that there may be “reasonable delays in compliance” due to the COVID-19 pandemic, and (iii) temporarily suspended implementation of its February 2020 ruling, which would have entailed significant changes to currency transaction reporting filing requirements for transactions involving sole proprietorships and entities operating under a “doing business as” or other assumed name. The Company’s Response to COVID-19 Lending Operations The Company elected to take advantage of Section 4014 of the CARES Act provision to temporarily delay adoption of the CECL methodology. The Company was subject to the adoption of the CECL accounting method under the FASB ASU 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) on January 1, 2020 and has since implemented CECL January 1, 2021. Refer to Note 1, Basis of Presentation and Note 5 Allowance for Credit Losses, of the Notes to Unaudited Consolidated Financial statements for additional disclosures related to CECL. The Company quickly responded to the pandemic and the CARES Act, offering the option of payment deferrals, participation in the PPP, fee waivers and other relief actions to customers. Since April 28, 2021, all of the Company’s branch lobbies are open. We continue to take precautions to protect both customers and employees through enhanced cleaning services, social distancing and personal protective equipment requirements for both. A portion of the Company’s workforce continues to work remotely. Under the CARES Act, the PPP is an amendment to a program administered as part of the SBA 7-A loan program. The Bank became an approved SBA 7-A lender in November 2019. The PPP is a guaranteed, unsecured loan program created to fund certain payroll and operating costs of eligible businesses, organizations and self-employed persons during the COVID-19 pandemic. Initially, $349 billion was approved and designated for the PPP in order for the SBA to guarantee 100% of collective loans made under the program to eligible small businesses, nonprofits, veteran’s organizations, and tribal businesses. The Company participated in the initial round of funding through a referral relationship with a third-party, non-bank lender. When an additional $310 billion in funds were approved and designated for the PPP, we opted to set up an internal, automated loan process utilizing our core system provider. The FRB implemented a liquidity facility available to financial institutions participating in the PPP. However, we opted to fund all PPP loans through our internal liquidity sources. These loans are fully guaranteed by the SBA and do not represent a credit risk. We expect the vast majority of these PPP loans will be forgiven based upon a preliminary review of the loans. The Bank provided deferrals to customers under Section 4013 of the CARES Act and regulatory interagency statements on loan modifications. The Bank launched successive deferral programs with short-term expirations. The Part I program was launched in March 2020 and expired at the end of August 2020. The deferrals in Part I typically provided deferral of both principal and interest through the expiry. The Part II program was launched in July 2020 and expired at the end of December 2020. The deferrals in this program were needs based and required the collection of updated financial information and in certain situations, the validation of liquidity to support the business. Prior to the extension of the CARES Act, the Bank launched the Part III program that offered borrowers in the Part II program an extension of deferrals through June 2021. Borrowers who opted into the Part III program were required to provide monthly financial statements and remit payments on a quarterly basis based on excess cash flows (“recapture payment”). In the quarter ended March 31, 2021, recapture payments due from deferral clients totaled $2.8 million and of this the Bank received $2.0 million. A number of customers opted out of the deferral program after the first quarter. As a result, the second quarter 2021 recapture payments due from deferral clients totaled $1.2 million and of this the Bank received $0.8 million. Following the expiration of the deferral programs on June 30, 2021, for term loans 40 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) payments will be applied to accrued interest first and after accrued interest is current, payments will be applied to principal. Deferred principal will be due at maturity. For interest only loans, such as lines of credit, deferred interest will be due at maturity. As of September 30, 2021 all but $6.5 million of loans resumed regularly scheduled payments. Cumulative deferred interest totaled $11.0 million as of June 30, 2021 but has been reduced to $2.8 million as of September 30, 2021. Through the first two rounds of PPP, we had approved 515 loan applications totaling $39.9 million through our internal lending program, of which 498 loans totaling $38.5 million have been fully forgiven by the SBA as of September 30, 2021. The $39.9 million in PPP loans originated during the first two rounds of PPP generated $1.5 million in fees, which will be recognized in income as loans are forgiven, or over the remaining life of the loan for any portion that is not forgiven. We had an additional 451 loans approved that were referred to an online small business lender, totaling $17.9 million during the first two rounds of PPP. On December 22, 2020 Congress passed legislation that was signed into law on December 27, 2020, making available a third round of PPP funding. We provided access to the program through our internal lending program for our current business customers. As of September 30, 2021, we had approved 136 loan applications totaling $11.1 million, of which 87 loans totaling $6.4 million have been fully forgiven by the SBA. Our interest income could be reduced due to the COVID-19 pandemic. In keeping with guidance from regulators, we are actively working with borrowers affected by the COVID-19 pandemic to defer their payments, interest, and fees. Interest and fees will still accrue to income through normal GAAP accounting. Should eventual credit losses on these deferred payments emerge, interest income and fees accrued would need to be reversed. In such a scenario, interest income in future periods could be negatively impacted. At this time, we are unable to project the significance of such an impact, but recognize the breadth of the economic impact may affect our borrowers’ ability to repay in future periods. Our exposure to the hospitality industry at September 30, 2021 equated to approximately $451.4 million, or 15.6% of total portfolio loans. These were mostly loans secured by upscale or top tier flagged hotels, which have historically exhibited low leverage and strong operating cash flows. However, we anticipate that a significant portion of our borrowers in the hotel industry will continue to operate at occupancy levels at or below breakeven which has caused, or will cause, them to draw on their existing lines of credit with other financial institutions or other sources of liquidity and may adversely affect their ability to repay existing indebtedness. These developments, together with the current economic conditions generally, may adversely impact the value of real estate collateral in hospitality and other commercial real estate exposure. These risk considerations were factored into qualitative adjustments included in the ACL. As a result, we anticipate that our financial condition, capital levels and results of operations could be adversely affected. Retail Operations The Company continues to promote digital banking options through our website. Customers are encouraged to utilize online and mobile banking tools and our customer contact center for personal and automated telephone banking services. Retail branches are staffed and available to assist customers by offering lobby appointments, drive-up and virtual servicing. In March 2020, we closed all branch lobbies to customer activity, offering drive-up and appointment only services due to the COVID-19 pandemic. Since April 28, 2021, all of our branch lobbies have been open. Retail leadership continues to monitor branch traffic and local conditions daily and makes adjustments as needed. All branches are equipped with video conferencing and online tools that enable virtual servicing. We continue to pay all employees according to their normal work schedule, even if their hours were reduced and no employees were furloughed. Employees whose job responsibilities can be effectively carried out remotely are working from home. Employees whose critical duties require their continued presence on-site are utilizing personal protection equipment and observing social distancing and cleaning protocols. Our fee income for 2020 was negatively impacted due to COVID-19 by approximately $1.5 million. Beginning on July 20, 2020, certain account fees were reinstated. In keeping with guidance from regulators, we actively worked with customers affected by the COVID-19 pandemic to waive fees from a variety of sources, such as, but not limited to, insufficient funds and overdraft fees and account maintenance fees. As of September 30, 2021 we had no fee waivers specific to the COVID-19 pandemic. We believe these reductions in fees were temporary. Capital Resources and Liquidity As of September 30, 2021, all of the Company’s capital ratios were in excess of all regulatory requirements. The economic recession brought about by the COVID-19 pandemic has improved during the nine months ended September 30, 2021. 41 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) We maintain access to multiple sources of liquidity. Funding sources accessible to the Company include borrowing availability at the Federal Home Loan Bank (“FHLB”), equal to 25.0% of the Company’s assets approximating $1.0 billion, subject to the amount of eligible collateral pledged, and of which $555.9 million remains available at September 30, 2021, federal funds unsecured lines with six other correspondent financial institutions in the amount of $145.0 million and access to the institutional CD market through brokered CDs. In addition to the above resources, the Company also has $724.7 million of unpledged available-for-sale securities as an additional source of liquidity at September 30, 2021. If an extended recession caused large numbers of our deposit customers to withdraw their funds, we might become more reliant on volatile or more expensive sources of funding. The Company is monitoring and will continue to monitor the impact of the COVID-19 pandemic and has taken and will continue to take steps to mitigate the potential risks and impact on our liquidity and capital resources. Due to the economic uncertainty, we are taking a prudent approach to capital management and have established access to the FRB’s PPP Lending Facility. Earnings Summary Net income increased $68.9 million and $74.8 million for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. Net income for the three and nine months ended September 30, 2021 was $11.2 million and $26.0 million, or $0.42 and $0.98 per diluted share, respectively, compared to net losses of $57.7 million and $48.8 million, or $2.19 and $1.85 per share, respectively, for the same periods in 2020. The net loss was recognized during the third quarter of 2020 related to a one-time charge resulting from goodwill impairment. This impairment charge reduced net income by $62.2 million resulting in the net loss for the period. The increase in net income for the three and nine months ended September 30, 2021 of $68.9 million and $74.8 million was mainly due to the above mentioned goodwill impairment, as well as, lower provision for credit losses for both periods. The total provision for credit losses decreased $3.4 million and $11.7 million for the three and nine months ended September 30, 2021, respectively compared to the same periods in 2020. Included in the total provision for credit losses for the three and nine months ended September 30, 2021 was the release of $0.1 million and $0.9 million for the provision for unfunded commitments, which was included in other expense prior to the January 1, 2021 adoption of CECL. Net interest income increased $4.0 million, or 15.6%, to $29.4 million and increased $4.2 million, or 5.3%, to $83.1 million for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. Net interest margin increased 31 basis points and three basis points to 2.92% and 2.80% for the three and nine months ended September 30, 2021, respectively, compared to 2.61% and 2.77% for the same periods in 2020. These impacts were primarily due to higher yields on interest-earning assets due to the positive impact of significant late fees and enhanced pricing on restructured loans related to one large credit relationship during the period and a decline in the cost of interest-bearing liabilities. Net interest margin, on a fully taxable equivalent (“FTE”) basis (non-GAAP), increased 29 and one basis points to 2.96% and 2.84% for the three and nine months ended September 30, 2021 compared to 2.67% and 2.83% for the same periods in 2020. The decreases in short-term interest rates had a negative impact on both net interest income and the net interest margin, but continues to be offset by lower cost of funds. The yield on interest-earning assets decreased four and 39 basis points for the three and nine months ended September 30, 2021, respectively, partially offset by a 41 and 48 basis points reduction in funding costs compared to the same periods in 2020. Net interest margin is reconciled to net interest income adjusted to an FTE basis in the “Net Interest Income” section of the “Results of Operations - Three and Nine Months Ended September 30, 2021 Compared to Three and Nine Months Ended September 30, 2020” in this MD&A. Also refer to the “Explanation of Use of Non-GAAP Financial Measures” for additional discussion of the non-GAAP measures. The provision for credit losses, excluding unfunded, decreased $3.3 million and $10.8 million to $(0.4) million and $2.4 million for the three and nine months ended September 30, 2021, respectively, compared to $2.9 million and $13.2 million for the same periods in 2020. Provision for credit losses during the three months ended September 30, 2021 was primarily driven by the release of $3.1 million to the ACL due to the sale of two relationships that included nine loans during the third quarter of 2021 with an aggregate unpaid principal balance of $50.2 million that were previously reserved. This decrease was offset by the increase of $1.6 million of special qualitative reserves in connection with increased uncertainty in credit quality with respect to two loans with an aggregate unpaid balance of $12.0 million in the commercial real estate loan segment. During the three and nine months ended September 30, 2021, management observed that $62.0 million of loans that were previously in the deferral program were recovering at rates much lower than peers. Accordingly, management sold $50.2 million of these loans during the three months ended September 30, 2021 and has developed a workout strategy with the remaining two loans with an aggregate 42 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) unpaid balance of $12.0 million. The qualitative reserves were established given the uncertainty of the future performance of these borrowers. Prior to the adoption of CECL at January 1, 2021, the life-of-loss reserves on unfunded commitments was a component of noninterest expense and has not been reclassified for comparable periods. The life-of-loss reserves on unfunded commitments totaled $2.1 million at September 30, 2021. Net charge-offs were $9.6 million and $18.8 million for the three and nine months ended September 30, 2021, respectively, compared to $0.4 million and $2.0 million for the same periods in 2020. The increase in net charge-offs in the third quarter of 2021 was primarily due to $9.2 million charge-offs related to the aforementioned sale of two relationships that included nine loans that had been previously reserved. As a percentage of average portfolio loans, on an annualized basis, net charge-offs were 1.30% and 0.85% for the three and nine months ended September 30, 2021, respectively, compared to 0.05% and 0.09% for the same periods in 2020. At September 30, 2021, we had low nonperforming loans, with such nonperforming loans decreasing $23.1 million to $8.9 million, compared to $32.0 million at December 31, 2020. The decline is due to the aforementioned resolution of our two largest nonperforming relationships during the second quarter of 2021 which resulted in net charge-offs of $6.3 million and $1.9 million, respectively, of which $13.1 million was previously reserved. Nonperforming loans as a percentage of total portfolio loans were 0.31%, 1.09% and 1.35% as of September 30, 2021, December 31, 2020 and September 30, 2020, respectively. Total noninterest income decreased $1.1 million and increased $2.1 million to $6.9 million and $23.1 million for the three and nine months ended September 30, 2021, respectively, compared to $8.0 million and $21.0 million for the same periods in 2020. The decrease of $1.1 million for the three months ended September 30, 2021 compared to the same period in 2020 was primarily the result of declines in net security gains of $1.0 million and lower commercial loan swap fee income of $0.5 million. The fluctuations of commercial loan swap fee income were due to the timing and demand for this product in the current low interest rate environment. The increase of $2.1 million in total noninterest income for the nine months ended September 30, 2021 compared to the same period in 2020 was driven by service charges on deposit accounts increasing $1.9 million, debit card interchange fees increased $1.2 million, higher net security gains of $0.5 million and a year-to-date gain of $0.5 million on the sale of four bank branches included in other income. Offsetting these increases were lower commercial loan swap fee income of $1.1 million and lower insurance commissions of $1.0 million compared to the prior year period. The fluctuations in security gains is due to the Company taking advantage of market opportunities, and repositioning and diversifying holdings in its securities portfolio. Total noninterest expense decreased $62.6 million and $58.9 million to $24.7 million and $76.0 million for the three and nine months ended September 30, 2021, respectively, compared to $87.3 million and $134.9 million for the same periods in 2020. The most significant decrease for both the three and nine month periods was driven by the one-time charge resulting from goodwill impairment of $62.2 million recorded in the third quarter of 2020. Also impacting the variances for both the three and nine months ended September 30, 2021 compared to the same periods in 2020 were the nonrecurring write-downs for closed bank branches and unfunded loan commitment expense. Losses on sales and write-downs of Other Real Estate Owned (“OREO”), net decreased $0.7 million and increased $2.1 million for the three and nine months ended September 30, 2021. The $0.7 million decrease for the three-month period included a $0.6 million loss on the sale of OREO on 13 properties during the third quarter of 2021. For the nine-months ended September 30, 2021, the increase of $2.1 million in losses on sales and write-downs of OREO was related to the nonrecurring write-down of $3.0 million for closed bank branches that were closed in the second quarter of 2021, transferred to OREO and marketed for sale resulting in the nonrecurring write-down. These write-downs were offset by $0.4 million in gains associated with the sale of four of the OREO properties. The $0.3 million increase for the three-month period of 2021 and the $0.3 million decline in the nine-month period of 2021, in unfunded loan commitment expense compared to the same periods in 2020, is a result of the adoption of CECL as unfunded loan commitment expense is now recorded as part of provision for credit losses instead of noninterest expense. Along with the above mentioned variances, total noninterest expense increases during the nine months ended September 30, 2021 included $1.0 million higher data processing expenses due to an increase in customer accounts and new modules added to our core processor, $0.6 million higher professional and legal fees, $0.5 million increase in the amortization of tax credits, $0.3 million in FDIC insurance expense and $0.2 million in occupancy expenses. These increases were offset by a decrease of $0.8 million in advertising expenses due to the sunset of our deposit acquisition strategy in the fourth quarter of 2020. 43 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) The provision for income taxes increased $0.1 million and $2.1 million to $0.9 million and $2.7 million for the three and nine months ended September 30, 2021, respectively, compared to $0.9 million and $0.6 million for the same periods in 2020. Pre-tax income increased $68.9 million and $76.9 million for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. A full goodwill impairment charge in the amount of $62.2 million was recorded in the third quarter of 2020. Our effective tax rate was 7.7% and 9.5% for the three and nine months ended September 30, 2021, respectively, compared to negative 1.5% and negative 1.3% for the same periods in 2020. The nondeductible goodwill impairment charge was the reason for the decreased effective tax rate for the three and nine period ended September 30, 2020. The Company ordinarily generates an annual effective tax rate that is less than the statutory rate of 21% due to benefits resulting from tax-exempt interest income, tax credit projects and Bank Owned Life Insurance (“BOLI”), which are relatively consistent regardless of the level of pre-tax income. Explanation of Use of Non-GAAP Financial Measures In addition to the results of operations presented in accordance with generally accepted accounting principles (“GAAP”) in the United States, management uses, and this quarterly report references, net interest income and net interest margin, each on a fully taxable equivalent, or FTE, basis, which are non-GAAP financial measures. Management believes net interest income and net interest margin on an FTE basis provide information useful to investors in understanding our underlying business, operational performance and performance trends as they facilitate comparisons with the performance of other companies in the financial services industry. Although management believes that these non-GAAP financial measures enhance investors’ understanding of our business and performance, these non-GAAP financial measures should not be considered alternatives to GAAP or considered to be more important than financial results determined in accordance with GAAP, nor are they necessarily comparable with non-GAAP measures which may be presented by other companies. Management believes the presentation of net interest income on an FTE basis (non-GAAP) ensures the comparability of net interest income arising from both taxable and tax-exempt sources and we believe is consistent with industry practice. Net interest income is reconciled to net interest income adjusted to an FTE basis (non-GAAP) in the Net Interest Income section of the "Results of Operations – Three and Nine Months Ended September 30, 2021 Compared to Three and Nine Months Ended September 30, 2020." RESULTS OF OPERATIONS Three and Nine Months Ended September 30, 2021 Compared to Three and Nine Months Ended September 30, 2020 Net Interest Income Our principal source of revenue is net interest income. Net interest income represents the difference between the interest and fees earned on interest-earning assets and the interest paid on interest-bearing liabilities. Net interest income is affected by changes in the average balance of interest-earning assets and interest-bearing liabilities and changes in interest rates and spreads. The level and mix of interest-earning assets and interest-bearing liabilities is managed by our Asset and Liability Committee (“ALCO”), in order to mitigate interest rate and liquidity risks of the balance sheet. A variety of ALCO strategies were implemented, within prescribed ALCO risk parameters, to produce what the Company believes is an acceptable level of net interest income. Net interest income and the net interest margin are presented on an FTE basis. The FTE basis (non-GAAP) adjusts net interest income and net interest margin for the tax benefit of income on certain tax-exempt loans and securities using the applicable federal statutory tax rate for each period (which was 21% for the periods presented) and the dividend-received deduction for equity securities. The Company believes this FTE basis presentation provides a relevant comparison between taxable and non-taxable sources of interest income. Refer to the “Explanation of Use of Non-GAAP Financial Measures” above for additional discussion of non-GAAP measures. Total net interest income increased $4.0 million, or 15.6%, to $29.4 million, and $4.2 million, or 5.3%, to $83.1 million, for the three and nine months ended September 30, 2021, respectively, compared to $25.4 million and $79.0 million for the same periods in 2020. These increases were primarily due to the increase in the volume of interest-earning assets, enhanced pricing on restructured loans related to one large credit relationship, offset by the decline in the interest rate environment. Net interest income, on an FTE basis (non-GAAP), increased $3.7 million, or 14.2%, to $29.7 million and $3.5 million, or 4.4%, to $84.3 44 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) million for the three and nine months ended September 30, 2021, respectively, compared to $26.0 million and $80.8 million for the same periods in 2020. For the three months ended September 30, 2021, the increase in net interest income, on an FTE basis (non-GAAP), was driven by higher interest income of $0.7 million and lower interest expense of $3.0 million compared to the same period in 2020. For the nine months ended September 30, 2021 the increase in net interest income, on a FTE basis (non-GAAP), was due to lower interest income of $7.1 million, offset by a decrease of $10.6 million in interest expense compared to the same periods in 2020. Net interest margin increased 31 basis point and three basis points to 2.92% and 2.80% for the three and nine months ended September 30, 2021, respectively, compared to 2.61% and 2.77% for the same periods in 2020. These impacts were primarily due to the lower yields on interest-earning assets, offset by the aforementioned enhanced pricing on restructured loans and a decline in the cost of interest-bearing liabilities. The net interest margin, on an FTE basis (non-GAAP), increased 29 basis points and one basis point to 2.96% and 2.84% for the three and nine months ended September 30, 2021, respectively, compared to 2.67% and 2.83% for the same periods in 2020, primarily due to the lower interest rate environment. The lower interest rate environment and the intentional runoff of higher cost CDs has significantly contributed to lower the overall cost of funds. The following table reconciles net interest income per the Consolidated Statements of Income to net interest income on an FTE basis, and net interest margin to net interest margin on an FTE basis (non-GAAP), for the periods presented: Three Months Ended September 30, Nine Months Ended September 30, (Dollars in Thousands) 2021 2020 2021 2020 Total Interest Income $ 34,913 $ 33,986 $ 100,964 $ 107,439 Total Interest Expense 5,512 8,550 17,831 28,477 Net Interest Income per Consolidated Statements of Net Income (Loss) 29,401 25,436 83,133 78,962 Adjustment to FTE Basis 330 599 1,178 1,826 Net Interest Income (FTE)(non-GAAP) $ 29,731 $ 26,035 $ 84,311 $ 80,788 Net Interest Margin 2.92 % 2.61 % 2.80 % 2.77 % Adjustment to FTE Basis 0.04 % 0.06 % 0.04 % 0.06 % Net Interest Margin (FTE)(non-GAAP) 2.96 % 2.67 % 2.84 % 2.83 % 45 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) Average Balance Sheet and Net Interest Income Analysis (FTE) The following table provides information regarding the average balances, interest and rates earned on interest-earning assets and the average balances, interest and rates paid on interest-bearing liabilities for the periods presented: Three Months Ended September 30, 2021 Three Months Ended September 30, 2020 (Dollars in Thousands) Average Balance Income/ Expense Rate Average Balance Income/ Expense Rate ASSETS Interest-Bearing Deposits with Banks $ 191,047 $ 76 0.16 % $ 124,886 $ 32 0.10 % Tax-Free Investment Securities (2) 26,849 221 3.27 % 54,541 456 3.33 % Taxable Investment Securities 836,957 3,163 1.50 % 693,330 3,150 1.81 % Total Securities 863,806 3,384 1.55 % 747,871 3,606 1.92 % Tax-Free Loans (1)(2) 174,680 1,350 3.07 % 302,351 2,397 3.15 % Taxable Loans (1) 2,755,595 30,403 4.38 % 2,694,747 28,511 4.21 % Total Loans 2,930,275 31,753 4.30 % 2,997,098 30,908 4.10 % Federal Home Loan Bank Stock 3,215 30 3.70 % 5,093 39 3.05 % Total Interest-Earning Assets 3,988,343 $ 35,243 3.51 % 3,874,948 $ 34,585 3.55 % Noninterest Earning Assets 169,554 299,992 Total Assets $ 4,157,897 $ 4,174,940 LIABILITIES AND SHAREHOLDERS' EQUITY Interest-Bearing Demand $ 424,517 $ 278 0.26 % $ 330,402 $ 238 0.29 % Money Market 420,946 307 0.29 % 200,303 211 0.42 % Savings 668,436 176 0.10 % 616,414 168 0.11 % Certificates of Deposit 1,435,716 4,623 1.28 % 1,801,535 7,815 1.73 % Total Interest-Bearing Deposits $ 2,949,615 $ 5,384 0.72 % $ 2,948,654 $ 8,432 1.14 % Federal Home Loan Bank Borrowings 30,000 89 1.18 % 35,000 101 1.15 % Other Borrowings 3,437 39 4.50 % 1,183 17 5.72 % Total Borrowings 33,437 128 1.52 % 36,183 118 1.30 % Total Interest-Bearing Liabilities 2,983,052 5,512 0.73 % 2,984,837 8,550 1.14 % Noninterest-Bearing Liabilities 769,871 696,273 Shareholders' Equity 404,974 493,830 Total Liabilities and Shareholders' Equity $ 4,157,897 $ 4,174,940 Net Interest Income (2) $ 29,731 $ 26,035 Net Interest Margin (2) 2.96 % 2.67 % (1) Nonaccruing loans are included in the daily average loan amounts outstanding. (2) Tax-exempt income is on an FTE basis (non-GAAP) using the statutory federal corporate income tax rate of 21 percent. 46 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) Nine Months Ended September 30, 2021 Nine Months Ended September 30, 2020 (Dollars in Thousands) Average Balance (3) Income/ Expense Rate Average Balance Income/ Expense Rate ASSETS Interest-Bearing Deposits with Banks $ 185,603 $ 182 0.13 % $ 98,283 $ 268 0.36 % Tax-Free Investment Securities (2) 37,064 906 3.27 % 41,922 1,076 3.43 % Taxable Investment Securities 770,636 9,288 1.61 % 696,954 11,246 2.16 % Total Securities 807,700 10,194 1.69 % 738,876 12,322 2.23 % Tax-Free Loans (1)(2) 198,185 4,703 3.17 % 320,914 7,620 3.17 % Taxable Loans (1) 2,771,860 86,965 4.19 % 2,644,031 88,885 4.49 % Total Loans 2,970,045 91,668 4.13 % 2,964,945 96,505 4.35 % Federal Home Loan Bank Stock 3,739 98 3.50 % 4,869 170 4.66 % Total Interest-Earning Assets 3,967,087 $ 102,142 3.44 % 3,806,973 $ 109,265 3.83 % Noninterest Earning Assets 174,194 289,672 Total Assets $ 4,141,281 $ 4,096,645 LIABILITIES AND SHAREHOLDERS' EQUITY Interest-Bearing Demand $ 402,663 $ 727 0.24 % $ 308,617 $ 926 0.40 % Money Market 361,204 877 0.32 % 179,546 692 0.51 % Savings 657,101 507 0.10 % 590,534 470 0.11 % Certificates of Deposit 1,522,384 15,328 1.35 % 1,855,027 26,076 1.88 % Total Interest-Bearing Deposits $ 2,943,352 $ 17,439 0.79 % $ 2,933,724 $ 28,164 1.28 % Federal Funds Purchased — — — % 73 1 1.83 % Federal Home Loan Bank Borrowings 31,282 276 1.18 % 29,161 260 1.19 % Other Borrowings 3,090 116 5.02 % 1,303 52 5.33 % Total Borrowings 34,372 392 1.52 % 30,537 313 1.37 % Total Interest-Bearing Liabilities 2,977,724 17,831 0.80 % 2,964,261 28,477 1.28 % Noninterest-Bearing Liabilities 767,207 646,924 Shareholders' Equity 396,350 485,460 Total Liabilities and Shareholders' Equity $ 4,141,281 $ 4,096,645 Net Interest Income (2) $ 84,311 $ 80,788 Net Interest Margin (2) 2.84 % 2.83 % (1) Nonaccruing loans are included in the daily average loan amounts outstanding. (2) Tax-exempt income is on an FTE basis (non-GAAP) using the statutory federal corporate income tax rate of 21 percent. (3) Loan and deposit balances include held-for-assumption transactions in connection with sale of Bank branches. Interest income increased $0.9 million, or 2.7% and decreased $6.5 million, or 6.0%, for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. Interest income, on an FTE basis (non-GAAP), increased $0.7 million, or 1.9% and decreased $7.1 million, or 6.5%, for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. We are currently maintaining higher liquidity levels as a result of COVID-19 and resulting government stimulus programs. The change was primarily due to increases in average interest-earning assets of $113.4 million and $160.1 million for the three and nine months ended September 30, 2021, respectively, offset by lower short-term interest rates compared to the same periods in 2020. Average interest-bearing deposits with banks increased $87.3 million for the nine months ended September 30, 2021, and the average rate earned decreased 23 basis points for the nine months ended September 30, 2021 compared to the same period in 2020. Average loan balances decreased $66.8 million, due to the loan sale, and increased $5.1 million for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020, which included PPP loan production that began in the second quarter of 2020. Average PPP loans totaled $24.5 million through September 30, 2021. The average rate earned on loans decreased 20 and 22 basis points for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020 primarily due to lower short-term interest rates. Average investment securities increased $115.9 million and $68.8 million and the average rate earned decreased 37 and 54 basis points for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. The change in investment securities is the result of active balance sheet management as our portfolio has been diversified as to bond types, maturities, and interest rate structures. Interest expense decreased $3.0 million and $10.6 million for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. The decrease was primarily due to lower short-term interest rates in 2021 as compared to 2020 as well as the intentional runoff of higher cost certificates of deposit (“CDs”). Interest expense on deposits decreased $3.0 million and $10.7 million for the three and nine months ended September 30, 2021, respectively, compared to 47 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) the same periods in 2020 primarily due to the decline in the average balance of CDs. The decrease of $365.8 million or 20.3% and $332.6 million or 17.9% in the average balance of CDs for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020 was primarily due to the intentional runoff of these higher cost CDs. Interest-bearing demand accounts increased $94.1 million and $94.0 million for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. The average rate paid on interest-bearing deposits decreased 42 and 49 basis points for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020 primarily due to lower short-term interest rates. Overall, the cost of interest-bearing liabilities decreased 41 and 48 basis points for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. The following table sets forth for the periods presented a summary of the changes in interest earned and interest paid resulting from changes in volume and changes in rates: Three Month Ended September 30, 2021 Compared to September 30, 2020 Nine Months Ended September 30, 2021 Compared to September 30, 2020 (Dollars in Thousands) Volume (3) Rate (3) Increase/ (Decrease) Volume (3) Rate (3) Increase/ (Decrease) Interest Earned on: Interest-Bearing Deposits with Banks $ 20 $ 24 $ 44 $ 149 $ (235) $ (86) Tax-free Investment Securities (2) (227) (8) (235) (121) (49) (170) Taxable Investment Securities 596 (583) 13 1,098 (3,056) (1,958) Total Securities 369 (591) (222) 977 (3,105) (2,128) Tax-free Loans (1)(2) (982) (65) (1,047) (2,919) 2 (2,917) Taxable Loans (1) 683 1,209 1,892 4,143 (6,063) (1,920) Total Loans (299) 1,144 845 1,224 (6,061) (4,837) Federal Home Loan Bank Stock (16) 7 (9) (35) (37) (72) Total Interest-Earning Assets $ 74 $ 584 $ 658 $ 2,315 $ (9,438) $ (7,123) Interest Paid on: Interest-Bearing Demand $ 64 $ (24) $ 40 $ 233 $ (432) $ (199) Money Market 172 (76) 96 510 (325) 185 Savings 18 (10) 8 68 (31) 37 Certificates of Deposit (1,418) (1,774) (3,192) (4,168) (6,580) (10,748) Total Interest-Bearing Deposits (1,164) (1,884) (3,048) (3,357) (7,368) (10,725) Federal Funds Purchased — — — (1) — (1) Federal Home Loan Bank Borrowings (15) 3 (12) 19 (3) 16 Other Borrowings 26 (4) 22 67 (3) 64 Total Borrowings 11 (1) 10 85 (6) 79 Total Interest-Bearing Liabilities $ (1,153) $ (1,885) $ (3,038) $ (3,272) $ (7,374) $ (10,646) Change in Net Interest Margin $ 1,227 $ 2,469 $ 3,696 $ 5,587 $ (2,064) $ 3,523 (1) Nonaccruing loans are included in the daily average loan amounts outstanding. (2) Tax-exempt income is on an FTE basis (non-GAAP) using the statutory federal corporate income tax rate of 21 percent. (3) Changes to rate/volume are allocated to both rate and volume on a proportionate dollar basis. Provision for Credit Losses The provision for credit losses, which includes a provision for losses on unfunded commitments, is the amount to be added to the ACL, after considering loan charge-offs and recoveries, to bring the ACL to a level determined to be appropriate in management's judgment to absorb expected losses inherent in the loan portfolio. The Company elected to defer its adoption of CECL in accordance with relief provided under the CARES Act effective January 1, 2021. At January 1, 2021, we increased the ACL by $64.5 million for the Day 1 CECL adjustment which includes $61.6 million to the ACL and $2.9 million related to the life-of-loss reserve on unfunded loan commitments. The provision for credit losses decreased $3.3 million to $(0.4) million and $10.8 million to $2.4 million for the three and nine months ended September 30, 2021, respectively, compared to $2.9 million and $13.2 million for the same periods in 2020. The provision for unfunded commitments included a release of $0.1 million and a release of $0.9 million for the three and nine months ended September 30, 2021. For the three months ended September 30, 2021, the decrease in the provision for credit 48 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) losses was primarily driven by the release of $3.1 million to the ACL due to nine loans within two performing relationships. These loans were included in the commercial real estate loan segment, during the third quarter of 2021 with an aggregate unpaid principal balance of $50.2 million that were previously reserved. This decrease was offset by the increase of $1.6 million of special qualitative reserves in connection with increased uncertainty in credit quality with respect to two loans with an aggregate unpaid balance of $12.0 million in the commercial real estate loan segment. During the three and nine months ended September 30, 2021, management observed that $62.0 million of loans that were previously in the deferral program were recovering at rates much lower than peers. Accordingly, management sold $50.2 million of these loans during the three months ended September 30, 2021 and has developed a workout strategy with the remaining two loans with an aggregate unpaid balance of $12.0 million. The qualitative reserves were established given the uncertainty of the future performance of these borrowers. Adjustments to the CECL model were made to account for additional potential deterioration in credit quality with respect to certain loans on deferral. Management reviewed and analyzed the monthly operating statements of commercial clients in the Part III deferral program. The deferral program expired June 30, 2021. The majority of our clients in the deferral program experienced recoveries starting in the spring of 2021. Based on the ongoing review of operating statements, management identified a lag in recovery with respect to loans with an aggregate principal balance of $62.0 million. These loans were addressed throughout the nine months ended September 30, 2021 as additional information was received and analyzed as follows. The Day 1 model recognized the deterioration of loans with an aggregate principal balance of $42.8 million which resulted in current expected losses of $10.2 million. In the quarter ended March 31, 2021 the model recognized the deterioration of a loan with a principal balance of $8.1 million which resulted in current expected losses of $1.5 million and an additional $0.6 million standard qualitative general reserve. In the third quarter ended September 30, 2021, the Bank sold these loans with an unpaid principal balance of $50.2 million which resulted in charge-offs totaling $9.2 million and a net release of reserves of $3.1 million. Additionally, in the third quarter ended September 30, 2021, the model recognized the deterioration of loans with an aggregate principal balance of $12.0 million, which resulted in current expected losses of $1.6 million. In summary, out of the $398.5 million in the deferral program as of June 30, 2021, only $12.0 million of these loans remain a concern for the quarter ended September 30, 2021 and have been adequately reserved. Net charge-offs were $9.6 million and $18.8 million for the three and nine months ended September 30, 2021, respectively, compared to $0.4 million and $2.0 million for the same periods in 2020. During the three months ended September 30, 2021, the increase in net charge-offs was primarily due to $9.2 million in charge-offs related to the aforementioned sale of two relationships that included nine loans that had been previously reserved. As a percentage of average portfolio loans, on an annualized basis, net charge-offs were 1.30% and 0.85% for the three and nine months ended September 30, 2021, respectively, compared to 0.05% and 0.09% for the same periods in 2020. At September 30, 2021, we had low nonperforming loans, with such nonperforming loans decreasing $23.1 million to $8.9 million, compared to $32.0 million at December 31, 2020. The decline is due to the aforementioned resolution of our two largest nonperforming relationships during the second quarter of 2021 which resulted in net charge-offs of $6.3 million and $1.9 million, respectively, of which $13.1 million was previously reserved. Nonperforming loans as a percentage of total portfolio loans were 0.31%, 1.09% and 1.35% as of September 30, 2021, December 31, 2020 and September 30, 2020, respectively. At September 30, 2021, the adoption of Topic 326 and subsequent measurement under this standard, resulted in an increase to our ACL of $45.2 million, to $99.3 million compared to $54.1 million at December 31, 2020. The ACL as a percentage of total portfolio loans was 3.44% at September 30, 2021 and 1.83% at December 31, 2020. 49 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) Noninterest Income Three Months Ended September 30, Nine Months Ended September 30, (Dollars in Thousands) 2021 2020 $ Change % Change 2021 2020 $ Change % Change Gain on Sales of Securities, net $ 1,341 $ 2,388 $ (1,047) (43.8) % $ 6,450 $ 5,923 $ 527 8.9 % Service Charges, Commissions and Fees 1,660 1,205 455 37.8 % 4,958 3,045 1,913 62.8 % Debit Card Interchange Fees 1,751 1,559 192 12.3 % 5,456 4,270 1,186 27.8 % Insurance Commissions 427 482 (55) (11.4) % 1,099 2,123 (1,024) (48.2) % Bank Owned Life Insurance Income 349 351 (2) (0.6) % 1,031 1,054 (23) (2.2) % Other Real Estate Owned Income 7 58 (51) (87.9) % 82 279 (197) (70.6) % Commercial Loan Swap Fee Income 1,096 1,572 (476) (30.3) % 2,057 3,120 (1,063) (34.1) % Other 284 360 (76) (21.1) % 1,972 1,177 795 67.5 % Total Noninterest Income $ 6,915 $ 7,975 $ (1,060) (13.3) % $ 23,105 $ 20,991 $ 2,114 10.1 % Total noninterest income decreased $1.1 million, or 13.3%, to $6.9 million for the three months ended September 30, 2021 and increased $2.1 million, or 10.1%, to $23.1 million for the nine months ended September 30, 2021 compared to the same periods in 2020. The decrease of $1.1 million for the three months ended September 30, 2021 compared to the same period in 2020 was related to declines in net security gains of $1.0 million and lower commercial loan swap fee income of $0.5 million due to the timing and demand for this product in the current low interest rate environment. These decreases were offset by increases of $0.5 million in service charges on deposit accounts due to reinstating fees that we previously waived during 2020 for customers affected by the COVID-19 pandemic and higher debit card interchange fees of $0.2 million due to usage. For the nine months ended September 30, 2021 compared to the same period in 2020, the increase of $2.1 million in total noninterest income was driven by increases in service charges on deposit accounts of $1.9 million, debit card interchange fees of $1.2 million, a year-to-date gain of $0.5 million on the sale of four bank branches included in other income and higher net security gains of $0.5 million. The increase in security gains of $0.5 million for the nine months ended September 30, 2021, to $6.5 million compared to $5.9 million for the same period in 2020 was due to the Company taking advantage of market opportunities, and repositioning and diversifying holdings in its securities portfolio. The above increases were offset by lower commercial loan swap fee income of $1.1 million, a decline in insurance commissions of $1.0 million and lower OREO income of $0.2 million. Noninterest Expense Three Months Ended September 30, Nine Months Ended September 30, (Dollars in Thousands) 2021 2020 $ Change % Change 2021 2020 $ Change % Change Salaries and Employee Benefits $ 12,816 $ 13,036 $ (220) (1.7) % $ 39,084 $ 39,106 $ (22) (0.1) % Occupancy Expense, net 3,333 3,413 (80) (2.3) % 10,298 10,077 221 2.2 % FDIC Insurance Expense 582 547 35 6.4 % 1,882 1,628 254 15.6 % Other Taxes 825 809 16 2.0 % 2,305 2,343 (38) (1.6) % Advertising Expense 196 404 (208) (51.5) % 586 1,410 (824) (58.4) % Telephone Expense 519 578 (59) (10.2) % 1,707 1,725 (18) (1.0) % Professional and Legal Fees 1,244 1,474 (230) (15.6) % 3,908 3,310 598 18.1 % Data Processing 1,018 836 182 21.8 % 2,893 1,917 976 50.9 % Losses on Sales and Write-downs of Other Real Estate Owned, net 608 1,305 (697) (53.4) % 3,423 1,357 2,066 152.2 % Losses on Sales and Write-downs on Bank Premises, net 7 17 (10) (58.8) % 114 88 26 29.5 % Debit Card Expense 700 764 (64) (8.4) % 2,045 1,989 56 2.8 % Tax Credit Amortization 427 272 155 57.0 % 1,281 816 465 57.0 % Unfunded Loan Commitment Expense — (348) 348 (100.0) % — 251 (251) (100.0) % Other Real Estate Owned Expense 84 94 (10) (10.6) % 280 411 (131) (31.9) % Goodwill Impairment Expense — 62,192 (62,192) (100.0) % — 62,192 (62,192) (100.0) % Other 2,326 1,907 419 22.0 % 6,243 6,314 (71) (1.1) % Total Noninterest Expense $ 24,685 $ 87,300 $ (62,615) (71.7) % $ 76,049 $ 134,934 $ (58,885) (43.6) % 50 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) Total noninterest expense decreased $62.6 million, or 71.7%, for the three months ended September 30, 2021 and decreased $58.9 million, or 43.6%, for the nine months ended September 30, 2021 compared to the same periods in 2020. The most significant decrease for both the three and nine month periods was driven by a one-time charge resulting from goodwill impairment of $62.2 million recorded in the third quarter of 2020. Also impacting the decrease for the three months ended September 30, 2021 was $0.7 million lower losses on sales and write-downs of OREO, net, a decrease in professional and legal fees of $0.2 million, lower salaries and employee benefits of $0.2 million and lower advertising expenses of $0.2 million. Offsetting these decreases were increases of $0.4 million in other noninterest expense, which included a finder’s fee for the sale of the two credit relationships, $0.3 million increase in unfunded loan commitment expense related to the reclass to the provision for credit losses as a result of the adoption of Topic 326, a $0.2 million increase in data processing expense and $0.2 million in tax credit amortization. Along with the above mentioned one-time goodwill impairment charge of $62.2 million, the decrease in total noninterest expense for the nine months ended September 30, 2021 included an increase for a nonrecurring write-down of $3.0 million for closed bank branches included in losses on sales and write-downs of OREO, net. These branches were closed in the second quarter of 2021, transferred to OREO and marketed for sale resulting in the $3.0 million nonrecurring write-down. Also decreasing for the period was $0.8 million in in advertising expenses due to the sunset of our deposit acquisition strategy in the fourth quarter of 2020, $0.3 million lower unfunded loan commitment expense and $0.1 million lower OREO expenses. Offsetting these decreases for the nine months ended September 30, 2021 were increases of $1.0 million in data processing expenses due to an increase in customer accounts and new modules added to our core processor, $0.6 million higher professional and legal fees, $0.5 million increase in the amortization of tax credits, $0.3 million in higher FDIC insurance expenses and a $0.2 million increase in occupancy expenses. Provision for Income Taxes The provision for income taxes increased $0.1 million and $2.1 million to $0.9 million and $2.7 million for the three and nine months ended September 30, 2021, respectively, compared to $0.9 million and $0.6 million for the same periods in 2020. Pre-tax income increased $68.9 million and $76.9 million for the three and nine months ended September 30, 2021, respectively, compared to the same periods in 2020. A full goodwill impairment charge in the amount of $62.2 million was recorded in the third quarter of 2020. Our effective tax rate was 7.7% and 9.5% for the three and nine months ended September 30, 2021, respectively, compared to negative 1.5% and negative 1.3% for the same periods in 2020. The increase in the effective tax rate is primarily due to a higher level of pre-tax income and a lower level of tax-exempt interest income. The nondeductible goodwill impairment charge was the reason for the decreased effective tax rate for the three and nine period ended September 30, 2020. The Company ordinarily generates an annual effective tax rate that is less than the statutory rate of 21% due to benefits resulting from tax-exempt interest income, tax credit projects and BOLI, which are relatively consistent regardless of the level of pre-tax income. Financial Condition September 30, 2021 Total assets decreased $45.1 million, to $4.1 billion at September 30, 2021 compared to $4.2 billion at December 31, 2020. Federal Reserve Bank excess reserves decreased $42.2 million to $121.3 million at September 30, 2021 from $163.5 million at December 31, 2020 due to active balance sheet management. Total portfolio loans decreased $63.0 million, or 2.9% on an annualized basis, to $2.9 billion at September 30, 2021 compared to December 31, 2020 primarily due to several large commercial loan payoffs. The variances in loan segments for portfolio loans is primarily related to the adoption of Topic 326. We made changes to our loan portfolio segments to align with the methodology applied in determining the allowance under CECL. The new segmentation breaks out an Other category from the original loan categories, which applies only to the current year 2021 and was not applied to periods during 2020 and prior years, therefore showing fluctuations in all categories. At March 31, 2021, the initial break-out of Other loans related to the adoption of Topic 326 totaled $373.4 million consisting of $136.3 million of Commercial Real Estate, (“CRE”), $77.8 million of Commercial and Industrial (“C&I”), $49.6 million of Residential Mortgages and $109.7 million of Construction. This segment of loans has unique risk attributes considered inconsistent with current underwriting standards. The analysis applied to this segment resulted in an increase in reserves of $51.3 million. OREO decreased $2.5 million at September 30, 2021 compared to December 31, 2020 due to 20 branch closures that were completed and 13 of those that were sold as part of our branch network optimization project that aligns with our strategic goals 51 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) to enhance franchise value and improve operating efficiency. Closed retail bank offices increased $0.3 million and have a remaining book value of $2.8 million at September 30, 2021 compared to $2.5 million at December 31, 2020. The securities portfolio increased $118.8 million and is currently 21.7% of total assets at September 30, 2021 compared to 18.6% of total assets at December 31, 2020. The increase is a result of active balance sheet management. We have further diversified the securities portfolio as to bond types, maturities and interest rate structures. Total deposits decreased $18.2 million to $3.7 billion at September 30, 2021 as compared to December 31, 2020. The decline from December 31, 2020 was due to the intentional runoff of $211.8 million of higher cost CDs and $84.7 million of deposits held-for-assumption in connection with the sale of four bank branches, which were completed during the second quarter of 2021. Offsetting these decreases was an increase of $278.3 million, or 14.0% in core deposits, which includes noninterest-bearing and interest-bearing demand deposits, money market accounts and savings accounts. At September 30, 2021, noninterest-bearing deposits comprised 19.7% compared to 19.0% of total deposits at December 31, 2020, respectively. CDs comprised 38.3% and 43.8% of total deposits at September 30, 2021 and December 31, 2020, respectively. Total capital decreased by $34.3 million to $405.9 million at September 30, 2021 compared to $440.2 million at December 31, 2020. The decrease in equity was primarily due to the $50.7 million cumulative-effect adjustment related to the adoption of Topic 326, a $10.3 million, net of tax, decrease in other comprehensive loss due to changes in the fair value of available-for-sale securities partially offset by net income of $26.0 million for the nine months ended September 30, 2021. The remaining difference of $0.7 million is related to stock-based compensation during the nine months ended September 30, 2021. The ACL was 3.44% of total portfolio loans at September 30, 2021 compared to an allowance for loan losses of 1.83% as of December 31, 2020. General reserves as a percentage of total portfolio loans were 3.35% at September 30, 2021 compared to 1.32% at December 31, 2020. Management believes, the ACL is adequate to absorb expected losses inherent in the loan portfolio. The Company remains well capitalized. Our Tier 1 capital ratio increased to 13.85% at September 30, 2021 compared to 13.08% at December 31, 2020. Our leverage ratio was 10.48% at September 30, 2021, compared to 10.26% at December 31, 2020 and total risk-based capital ratio was 15.11% at September 30, 2021 compared to 14.33% at December 31, 2020. We adopted CECL effective January 1, 2021 and elected to implement the regulatory agencies’ capital transition relief over the permissible three-year period. Securities Activity The following table presents the composition of available-for-sale securities: (Dollars in Thousands) September 30, 2021 December 31, 2020 $ Change U.S. Treasury Securities $ 4,419 $ — $ 4,419 U.S. Government Agency Securities 3,478 — 3,478 Residential Mortgage-Backed Securities 83,898 44,724 39,174 Commercial Mortgage-Backed Securities 4,222 5,447 (1,225) Asset Backed Securities 140,202 133,557 6,645 Collateralized Mortgage Obligations 272,976 218,359 54,617 Small Business Administration 108,378 99,145 9,233 States and Political Subdivisions 231,907 252,622 (20,715) Corporate Notes 48,066 24,825 23,241 Total Debt Securities $ 897,546 $ 778,679 $ 118,867 The Company invests in various securities in order to maintain a source of liquidity, to satisfy various pledging requirements, to increase net interest income and as a tool of the ALCO to diversify and reposition the balance sheet for interest rate risk purposes. Securities are subject to market risks that could negatively affect the level of liquidity available to us. Security purchases are subject to our investment policy that is approved annually by our Board and administered through ALCO and our treasury function. The securities portfolio increased by $118.8 million to $897.5 million at September 30, 2021 as compared to $778.7 million at December 31, 2020. Securities comprise 21.7% of total assets at September 30, 2021 as compared to 18.6% at December 31, 52 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) 2020. The increase is a result of active balance sheet management. We have further diversified the securities portfolio as to bond types, maturities and interest rate structures. At September 30, 2021 total gross unrealized gains in the available-for-sale portfolio were $12.0 million, offset by $5.2 million of gross unrealized losses. At December 31, 2020, total gross unrealized gains in the available-for-sale portfolio were $22.6 million offset by $2.7 million of gross unrealized losses. Management evaluates the securities portfolio for other-than-temporary impairment (“OTTI”) on a quarterly basis. At September 30, 2021 and December 31, 2020, the Company did not record any OTTI. The performance of the debt and equity securities markets could generate impairments in future periods requiring realized losses to be reported. Loan Composition The following table summarizes our loan portfolio for the periods presented: (Dollars in Thousands) September 30, 2021 December 31, 2020 Commercial Commercial Real Estate $ 1,346,953 $ 1,453,799 Commercial and Industrial 387,402 557,164 Total Commercial Loans 1,734,355 2,010,963 Consumer Residential Mortgages 449,118 472,170 Other Consumer 44,953 57,647 Total Consumer Loans 494,071 529,817 Construction 297,337 406,390 Other 358,394 — Total Portfolio Loans 2,884,157 2,947,170 Loans Held-for-Sale 4,889 25,437 Loans Held-for-Sale in Connection with Sale of Bank Branches, at the lower of cost or fair value — 9,835 Total Loans $ 2,889,046 $ 2,982,442 Our loan portfolio represents our most significant source of interest income. The risk that borrowers will be unable to pay such obligations is inherent in the loan portfolio. Other conditions such as downturns in the borrower's industry or the overall economic climate can significantly impact the borrower’s ability to pay. For a discussion of the risk factors relevant to our business and operations, please refer to Part I, Item 1A, “Risk Factors,” contained in our Annual Report on Form 10-K for the year ended December 31, 2020, as supplemented by the risk factor disclosed in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2021. Total portfolio loans decreased $63.0 million, or 2.1%, to $2.9 billion at September 30, 2021 compared to December 31, 2020. The variances in loan segments for portfolio loans is primarily related to the adoption of Topic 326. We made changes to our loan portfolio segments to align with the methodology applied in determining the allowance under CECL. The new segmentation breaks out an Other category from the original loan categories, which applies only to the current year 2021 and was not adjusted to the comparable period, therefore showing fluctuations in all categories. At March 31, 2021 the initial break-out of Other loans related to the adoption of Topic 326 totaled $373.4 million consisting of $136.3 million of CRE, $77.8 million of C&I, $49.6 million of Residential Mortgages and $109.7 million of Construction. This segment of loans includes unique risk attributes considered inconsistent with current underwriting standards. The analysis applied to this segment resulted in an increase in reserves of $51.3 million. Nonperforming loans decreased $23.1 million, or 72.3%, to $8.9 million at September 30, 2021 compared to $32.0 million at December 31, 2020. The decline from December 31, 2020 is due to the resolution of our two largest nonperforming credits during the second quarter of 2021. OREO decreased $2.5 million at September 30, 2021 compared to December 31, 2020 due to 20 branches that were closed during the second quarter of 2021, and moved to OREO and marketed for sale resulting in a $3.0 million one-time write-down. During the first nine months of 2021, 20 branch closures were completed and 13 were sold as part of our branch network optimization project that aligns with our strategic goals to enhance franchise value and improve operating efficiency. Closed retail bank offices increased $0.3 million and have a remaining book value of $2.8 million at September 30, 2021 compared to $2.5 million at December 31, 2020. 53 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) The commercial portfolio is monitored for potential concentrations of credit risk by market, property type and tenant concentrations. Our exposure to the hospitality industry at September 30, 2021 equated to approximately $451.4 million, or 15.6% of total portfolio loans. These were mostly loans secured by upscale or top tier flagged hotels, which have historically exhibited low leverage and strong operating cash flows. Starting in the second quarter of 2021, we have observed improvements in occupancy and the average daily rates for our hotel clients following sharp declines through the pandemic. However our clients are now facing enormous challenges when it comes to attracting labor, which impedes their ability to turnover rooms resulting in occupancy constraints. This has caused, or may cause, them to operate with lower levels of liquidity and an inability to reserve for capital improvements forcing them to draw on their existing lines of credit with other financial institutions or other sources of liquidity and may adversely affect their ability to pay property expenses, capital improvements and/or repay existing indebtedness. These developments, together with the current economic conditions generally, may adversely impact the value of real estate collateral in hospitality and other commercial real estate exposure. As a result, our financial condition, capital levels and results of operations could be adversely affected. Aggregate commitments to our top 10 credit relationships were $747.0 million at September 30, 2021. The Other segment represents 47.4% of the top 10 credit relationships. The following table summarizes our top 10 relationships and a description of industries represented for the periods presented: Dollars in Thousands For the Periods Ending Change 9/30/2021 % of Gross Loans 9/30/2021 % of RBC September 30, 2021 December 31, 2020 1. Hospitality, agriculture & energy $354,240 $375,990 ($21,750) 12.26 % 74.07 % 2. Hospitality 63,855 61,691 2,164 2.21 % 13.35 % 3. Retail real estate & food services 56,258 55,373 885 1.95 % 11.76 % 4. Industrial & retail real estate 47,425 41,439 5,986 1.64 % 9.92 % 5. Multifamily, lumber & retail 44,008 35,322 8,686 1.52 % 9.20 % 6. Hospitality 37,584 37,435 149 1.30 % 7.86 % 7. Multifamily development 36,720 40,874 (4,154) 1.27 % 7.68 % 8. Retail real estate 36,619 35,388 1,231 1.27 % 7.66 % 9. Multifamily & student housing 35,749 38,787 (3,038) 1.24 % 7.47 % 10. Hospitality 34,591 36,086 (1,495) 1.20 % 7.23 % Top Ten (10) Relationships 747,049 758,385 (11,336) 25.86 % 156.20 % Total Gross Loans 2,889,046 2,982,442 (93,396) % of Total Gross Loans 25.86 % 25.43 % 12.14 % Concentration (25% of RBC) $119,565 $116,300 Line utilization, unused commitments, excluding consumer overdraft lines, were $394.4 million at September 30, 2021 as compared to $410.7 million at December 31, 2020. The majority of unused commitments are for construction projects that will be drawn as the construction completes. Total utilization, excluding consumer overdraft lines, was 55.4% at September 30, 2021, as compared to 52.2% at December 31, 2020. Commercial line utilization was 55.6% at September 30, 2021, as compared to 51.7% at December 31, 2020. From time to time, we have mortgage loans held-for-sale derived from two sources. First, we purchase mortgage loans on a short-term basis from a partner financial institution that have fully executed sales contracts to end investors. Secondly, we originate and close mortgages with fully executed contracts with investors to purchase shortly after closing. We then hold these mortgage loans from both sources until funded by the investor, typically a two-week period. Mortgage loans held-for-sale were $4.9 million and $25.4 million at September 30, 2021 and December 31, 2020, respectively. In addition to mortgage loans held-for-sale, the Company had $9.8 million in loans held-for-sale in connection with sale of Bank branches at December 31, 2020 that all closed during the second quarter of 2021. 54 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) Credit Quality On a monthly basis, a criticized asset committee meets to review all special mention and substandard loans within prescribed policy thresholds. These loans typically represent the highest risk of loss to the Company. Action plans are established and these loans are monitored through regular contact with the borrower and loan officer, review of current financial information and other documentation, review of all loan or potential loan restructures or modifications and the regular re-evaluation of assets held as collateral. We attempt to limit our exposure to credit risk by diversifying our loan portfolio by segment, geography, collateral and industry and actively managing concentrations. When concentrations exist in certain segments, we mitigate this risk by reviewing the relevant economic indicators and interest risk rating trends and through stress testing of the loans in these segments. The Company has specific loan segment limits in its loan policy. Total commercial real estate balances should not exceed the combination of 300% of total risk based capital and growth in excess of 50% over the previous thirty-six months and construction loan balances should not exceed 100% of total risk based capital. Investment real estate property types and purchased loan programs have individual dollar limits that should not be exceeded in the portfolio. In addition, there are specific limits in place for various categories of real estate loans with regards to loan-to-value ratios, loan terms, and amortization periods. We also have policy limits on loan-to-cost for construction projects. Unsecured loans pose a higher risk for the Company due to the lack of a well-defined secondary source of repayment. Commercial unsecured loans are reserved for the best quality customers with well-established businesses that operate with low financial and operating leverage and demonstrate an ability to clear the outstanding balance on lines of credit for at least thirty consecutive days annually. The repayment capacity of the borrower should exceed all policy and guidelines for secured loans. On a quarterly basis, the Credit Risk Committee of the Board meets to review our loan portfolio metrics, segmentation guidelines, and loan review findings from the previous quarter. Annually, this same committee reviews credit related policies and policy enhancements as they become available. Additional credit risk management practices include periodic review and update of our lending policies and procedures to support sound underwriting practices and portfolio management through portfolio stress testing. Our loan review serves as a mechanism to individually monitor credit quality and assess the effectiveness of credit risk management practices to provide oversight of all lending activities. The loan review function has the primary responsibility for assessing commercial credit administration and credit decision functions of consumer and mortgage underwriting, as well as providing input to the loan risk rating process. Our policy is to place loans in all categories in nonaccrual status when collection of interest or principal is doubtful, or generally when interest or principal payments are 90 days or more past due based on contractual terms. The Company has a loan review policy and annual scope report that details the level of loan review for commercial loans in a given year. Primary objectives of loan reviews include the identification of emerging risks and patterns that might influence potential future losses. In concert with significant enhancements to the underwriting process, the scope of loan review has been broadened since 2019 to include assurance testing with respect to the accuracy of the underwriting function. Since 2020 and continuing into 2021, the Company used a four step approach for loan review in the following categories: • A review of the largest twenty pass-rated loan relationships, which represents approximately a quarter of total loans; • A sampling of new loans originated to include an examination of the evidence of appropriate approval, adherence to loan policy and the completeness and accuracy of the analysis contained in the approval document; • A sampling of large loan relationships which are defined as loan relationships with aggregate exposure of at least $2.0 million that are not part of the top 20 review; and • Concentration focus reviews of identified segments that represent concentration risk, represented by collateral types including but not limited to hospitality, multifamily and retail with the goal of examining patterns of loss history, document exceptions, policy exceptions and emerging trends in risk characteristics. The Company does not typically structure these with a 30-day cleanout feature since that is difficult to measure and enforce. Instead we usually set higher debt service standards and underwrite to the ability to amortize the loan on unsecured terms. 55 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) Allowance for Credit Losses The ACL represents an amount which, in management's judgment, is adequate to absorb current expected credit losses on outstanding loans at the balance sheet date based on the evaluation of the size and current risk characteristics of the loan portfolio, past events, current conditions, reasonable and supportable forecasts of future economic conditions and prepayment experience. The ACL is measured and recorded upon the initial recognition of a financial asset. The ACL is reduced by charge-offs previously reserved for, net of recoveries of previous losses, and is increased or decreased by a provision for credit losses, which is recorded as a current period operating expense. Determination of an appropriate ACL is inherently complex and requires the use of significant and highly subjective estimates. The reasonableness of the ACL is reviewed quarterly by management. Management believes it uses relevant information available to make determinations about the ACL and that it has established the existing allowance in accordance with GAAP. However, the determination of the ACL requires significant judgment, and estimates of expected losses in the loan portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize expected losses, future additions to the ACL may be necessary based on changes in the loans comprising the portfolio, changes in the current and forecasted economic conditions, changes to the interest rate environment which may directly impact prepayment and curtailment rate assumptions, and changes in the financial condition of borrowers. The adoption of CECL guidance did not result in a significant change to any other credit risk management and monitoring processes, including identification of past due or delinquent borrowers, nonaccrual practices, assessment of troubled debt restructurings or charge-off policy. The Company’s methodology for estimating the ACL includes: Segmentation. The Company’s loan portfolio is segmented by homogeneous loan types that behave similarly to economic cycles. Specific Analysis. A specific reserve analysis is applied to certain individually evaluated loans. These loans are evaluated quarterly generally based on collateral value, observable market value or the present value of expected future cash flows. A specific reserve is established if the fair value is less than the loan balance. A charge-off is recognized when the loss is quantifiable. Individually evaluated loans not specifically analyzed reside in the Quantitative Analysis. Quantitative Analysis. The Company elected to use Discounted Cash Flow (“DCF”), which calculates a net present value of expected future cash flows, adjusted for the expected life of the portfolio. Economic forecasts include but are not limited to unemployment, the Consumer Price Index, the Housing Price Index and Gross Domestic Product. These forecasts are assumed to revert to the long-term average and utilized in the model to estimate the probability of default and loss given default through regression. Model assumptions include, but are not limited to the discount rate, prepayments and curtailments. The product of the probability of default and the loss given default is the estimated loss rate, which varies over time. The estimated loss rate is applied within the appropriate periods in the cash flow model to determine the net present value. Net present value is also impacted by assumptions related to the duration between default and recovery. Economic forecasts spanning four quarters are utilized and then reverted to the long-term average to form the estimation of expected future cash flows. The reserve is based on the difference between the summation of the principal balances taking amortized costs into consideration and the summation of the net present values. Qualitative Analysis. Based on management’s review and analysis of internal, external and model risks, management may adjust the model output. Management reviews the peaks and troughs of the model’s calibration, taking into account economic forecasts to develop guardrails that serve as the basis for determining the reasonableness of the model’s output, analyzes the forecast inputs in relation to the model’s calibration and makes adjustments as necessary. This process challenges unexpected variability resulting from outputs beyond the model’s calibration that appear to be unreasonable. Additionally, management may adjust the economic forecast if it is incompatible with known market conditions based on management’s experience and perspective. The Day 1 CECL model and the model ended September 30, 2021, recognized the deterioration of loans with an aggregate principal balance of $42.8 million, which resulted in current expected losses of $10.2 million. In the quarter ended March 31, 2021 the model recognized the deterioration of a loan with a principal balance of $8.1 million which resulted in current expected losses of $1.5 million and an additional $0.6 million standard qualitative general reserve. In the third quarter 56 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) ended September 30, 2021, the bank sold these loans with an unpaid principal balance of $50.2 million, which resulted in charge-offs totaling $9.2 million and a net release of reserves of $3.1 million. Additionally, in the third quarter ended September 30, 2021, the model recognized the deterioration of loans with an aggregate principal balance of $12.0 million, which resulted in current expected losses of $1.6 million. Certain loans exhibit more than expected deterioration and the risk rating has been downgraded to non-pass to reflect the increased risk. Management elected to create reserves with the adoption of the CECL model. These reserves were developed in addition to the model’s methodology. The model introduced a segmented portfolio of loans for discrete analysis. This segmented pool has unique risk attributes considered inconsistent with current underwriting standards. “Other” Segmented Pool CECL provides for the flexibility to model loans differently compared to the incurred loss model. With the adoption of CECL, management elected to separately evaluate certain loans from the Quantitative Analysis based on shared but unique risk attributes. These loans are included in the Other segment of the model. These loans were underwritten and approved based on standards that are inconsistent with our current underwriting standards, which have been enhanced by current management. These inconsistencies may include, but are not limited to i) transaction and/or relationship sizes that exceed limits established in 2018, ii) overreliance on secondary, tertiary or guarantor cash flow, and iii) land acquisition loans without a defined source of amortization. A general reserve of $56.0 million, which is an increase from the $4.7 million under the probable incurred loss model, was established based on the discounted cash flow method with a discount rate, which was quantitatively adjusted. The following tables summarize activity in the ACL during the period presented and present supplemental asset quality information as of the dates presented. Three Months Ended September 30, 2021 (Dollars in Thousands) Commercial Real Estate Commercial and Industrial Residential Mortgage Other Consumer Construction Other (1) Total Allowance for Credit Losses on Loans: Balance at Beginning of Period $ 28,141 $ 4,714 $ 5,367 $ 1,221 $ 8,145 $ 61,731 $ 109,319 Provision for Credit Losses on Loans (304) 4 266 410 (789) — (413) Charge-offs (9,187) (188) (56) (424) — — (9,855) Recoveries 9 3 1 198 32 — 243 Net (Charge-offs) / Recoveries (9,178) (185) (55) (226) 32 — (9,612) Balance at End of Period $ 18,659 $ 4,533 $ 5,578 $ 1,405 $ 7,388 $ 61,731 $ 99,294 (1) In connection with our adoption of Topic 326, we made changes to our loan portfolio segments to align with the methodology applied in determining the allowance under CECL. Our new segmentation breaks out Other loans from our original loan segments: CRE, C&I, residential mortgages and construction. The allowance balance at the beginning of period were reclassified to Other from their original loan segments: CRE, C&I, residential mortgages and construction to conform to current presentation. Nine Months Ended September 30, 2021 (Dollars in Thousands) Commercial Real Estate Commercial and Industrial Residential Mortgage Other Consumer Construction Other (1) Total Allowance for Credit Losses on Loans: Balance at Beginning of Period $ 34,871 $ 3,643 $ 2,000 $ 2,479 $ 6,357 $ 4,724 $ 54,074 Impact of CECL Adoption 6,587 1,379 3,356 (877) (80) 51,277 61,642 Provision for Credit Losses on Loans (5,523) (298) 327 1,157 1,018 5,730 2,411 Charge-offs (17,425) (196) (273) (1,833) — — (19,727) Recoveries 149 5 168 479 93 — 894 Net (Charge-offs) / Recoveries (17,276) (191) (105) (1,354) 93 — (18,833) Balance at End of Period $ 18,659 $ 4,533 $ 5,578 $ 1,405 $ 7,388 $ 61,731 $ 99,294 (1) In connection with our adoption of Topic 326, we made changes to our loan portfolio segments to align with the methodology applied in determining the allowance under CECL. Our new segmentation breaks out Other loans from our original loan segments: CRE, C&I, residential mortgages and construction. The allowance balance at the beginning of period were reclassified to Other from their original loan segments: CRE, C&I, residential mortgages and construction to conform to current presentation. 57 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) September 30, 2021 December 31, 2020 Net Charge-offs to Average Portfolio Loans 0.85 % * 0.09 % Allowance for Credit Losses to Total Portfolio Loans 3.44 % 1.83 % Annualized The adoption of Topic 326 resulted in an increase to our ACL of $61.6 million on January 1, 2021. The Day 1 model introduced a segmented portfolio of loans for discrete analysis. This segmented pool had an aggregate principal balance of $380.0 million at adoption and includes unique risk attributes considered inconsistent with current underwriting standards. These inconsistencies may include, but are not limited to i) transaction and/or relationship sizes that exceed limits established in 2018, ii) overreliance on secondary, tertiary or guarantor cash flow, and iii) land acquisition loans without a defined source of amortization. Management continuously assesses underwriting standards but significantly enhanced these standards in 2018. The analysis applied to this pool resulted in expected credit losses of $51.3 million, at adoption and is disclosed in the Other segment item in the table above. At December 31, 2020, the aforementioned Other segment within the probable incurred loss model included $102.5 million of impaired loans and the remaining $270.9 million were not impaired and remained in their respective segments. Based on the fair value of collateral, the specific reserves on the impaired loans totaled zero and the general reserves for the remainder of these loans totaled $4.7 million at December 31, 2020. As of January 1, 2021, our CECL methodology introduced a modified discounted cash flow methodology based on expected cash flow changes in the future for the Other segment. This methodology produced a significantly higher level of reserves from the incurred loss model. Certain portions of the CECL model are inherently subjective and include, but are not limited to estimates with respect to: prepayment speeds, the timing of prepayments, potential losses given default, discount rates and the timing of future cash flows. Management utilizes widely published economic forecasts as the basis for the regression analysis used to estimate the probability of default in the baseline model. The peaks and troughs of these forecasts serve as guardrails for potential subjective adjustments. In addition to considering the outcomes based on the range of forecasts, management recognizes that the assumptions used in economic forecasts may not perfectly align with our market area, risk profile or unique attributes of our portfolio along with other important considerations. Severe changes in forecasts can also create significant variability and management must assess not only the absolute balance of reserves but also consider the appropriateness of the velocity of change. Therefore, management developed a framework to assess the tolerance and reasonableness of the CECL modeling process by challenging certain elements of the forecasts, when appropriate. These outcomes, known as “challenger models” provide opportunities to examine and subjectively adjust the CECL model output and are designed to be countercyclical, thereby reducing variability. This methodology resulted in an increase in other reserves totaling $51.3 million. The ACL increased $45.2 million to $99.3 million at September 30, 2021 as compared to an allowance for loan losses of $54.1 million at December 31, 2020 primarily due to the Day 1 adoption of CECL of $61.6 million. During the nine months of 2021 adjustments to the CECL model were made to account for additional potential deterioration in credit quality with respect to certain loans on deferral. The decrease in the provision for credit losses was primarily driven by a decrease of $3.1 million to the ACL due to the sale of two performing relationships that included nine loans during the third quarter of 2021 with an aggregate unpaid principal balance of $50.2 million that were previously reserved. The nine loans were comprised of six loans, a resort loan and other commercial assets. This decrease was offset by the increase of $1.6 million of special qualitative reserves in connection with increased uncertainty in credit quality with respect to two loans with an aggregate unpaid balance of $12.0 million in the commercial real estate loan segment. Management monitored loans in the deferral program monthly. The deferral program expired as of June 30, 2021. During the three months ended September 30, 2021, management observed that $62.0 million of loans in the deferral program were recovering at rates much lower than peers. Accordingly, management sold $50.2 million of these loans in the third quarter of 2021 and has developed a workout strategy with the remaining two loans with an aggregate unpaid balance of $12.0 million. The qualitative reserves were established given the uncertainty of the future performance of these borrowers. The ACL was $99.3 million, or 3.44%, of total portfolio loans at September 30, 2021, as compared to an allowance for loan losses of $54.1 million, or 1.83% of total portfolio loans at December 31, 2020. Net charge-offs were $9.6 million and $18.8 million for the three and nine months ended September 30, 2021, respectively, compared to $0.4 million and $2.0 million for the same periods in 2020. During the third quarter of 2021, nine loans within two performing relationships were sold with an aggregate unpaid principal balance of $50.0 million that were previously reserved. This sale resulted in charge-offs of $9.2 million during the third quarter of 2021 and was previously reserved. As a percentage 58 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) of average portfolio loans, on an annualized basis, net charge-offs were 0.85% and 0.09% for the nine months ended September 30, 2021 and year ended December 31, 2020, respectively. Nonperforming loans decreased $23.1 million, or 72.3%, to $8.9 million at September 30, 2021 compared to $32.0 million at December 31, 2020. Nonperforming loans as a percentage of total portfolio loans were 0.31%, 1.09% and 1.35% as of September 30, 2021, December 31, 2020 and September 30, 2020, respectively. Loans that amortize monthly, such as closed-end installment loans and amortizing loans secured by real estate are reported past due when the borrower is in arrears two or more monthly payments. Loans that amortize on a schedule other than monthly and interest only loans are reported past due when one scheduled payment is due and unpaid for 30 days or more. We monitor delinquency on a monthly basis for early identification of potential problem loans. Troubled debt restructurings (“TDRs”) are loans that we, for economic or legal reasons related to a borrower’s financial difficulties, grant a concession to the borrower that we would not otherwise grant. The Company strives to identify borrowers in financial difficulty early and work with them to modify the terms before their loan reaches nonaccrual status. These modified terms generally include extension of maturity dates at a stated interest rate lower than the current market rate for a new loan with similar characteristics, reductions in contractual interest rates or principal deferment. While unusual, there may be instances of principal forgiveness. Modifications structured with deferments for significant periods are generally considered TDRs. However, related to the COVID-19 pandemic, we have modified certain loans since March 2020 without considering them TDRs if consistent with the CARES Act and guidance issued by the federal bank regulatory agencies. Generally, modifications that have not been considered a TDR are relatively short-term in nature. An accruing loan that is modified and determined to be a TDR can remain in accrual status if, based on a current credit analysis, collection of principal and interest in accordance with the modified terms is reasonably assured, and the borrower has demonstrated sustained historical performance for a reasonable period before the modification. TDRs are considered impaired loans and reported as a TDR in the calendar year in which they are determined. The Company individually evaluates all impaired loans, which includes TDRs, greater than or equal to $1.0 million as individually evaluated loans unless otherwise accounted for in the CECL model. Nonaccrual TDRs can be returned to accrual status if the ultimate collectability of all contractual amounts due, according to the restructured agreement, is not in doubt and there is a period of a minimum of six months of satisfactory payment performance by the borrower subsequent to the restructuring. As an example, consider a substandard commercial construction loan that is currently 90 days past due where the loan is restructured to extend the maturity date for a period longer than would be considered an insignificant period of time. The post-modification interest rate given to the borrower is considered to be lower than the current market rate for new debt with similar risk and all other terms remain the same according to the original loan agreement. This loan will be considered a TDR as the borrower is experiencing financial difficulty and a concession has been granted due to the long extension, resulting in payment delay as well as the rate being lower than current market rate for new debt with similar risk. The loan will be reported as a nonaccrual TDR and an individually evaluated loan if the principal balance is equal to or greater than $1.0 million. In addition, the loan could be charged down to the fair value of the collateral if a confirmed loss exists. If the loan subsequently performs, by means of making on-time principal and interest payments according to the newly restructured terms for a period of six months, and it is expected that all remaining principal and interest will be collected according to the terms of the restructured agreement, the loan will be returned to accrual status and reported as an accruing TDR. For the loan’s remaining life, it will continue to be individually evaluated because the interest rate was not adjusted to be equal to or greater than the rate that would be accepted at the time of the restructuring for a new loan with comparable risk. TDRs increased $45.0 million, or 33.5% to $179.2 million at September 30, 2021 compared to $134.2 million at December 31, 2020. The Company had $78.0 million new additions offset by $24.8 million of principal pay-downs and $8.2 million in charge-offs for the resolution of our two largest nonperforming credits during the nine months ended September 30, 2021. During the three and nine months ended September 30, 2021, the Company had five loans that were modified totaling $78.0 million. These loans were included in the Other category and restructured with enhanced pricing and collateral position of the relationships, during the third quarter of 2021. TDRs of $3.2 million and $25.0 million as of September 30, 2021 and December 31, 2020, respectively, were loans modified as TDRs that experienced a payment default subsequent to the rework date and were classified as nonperforming. Our charge-off policy for commercial loans requires that loans and other obligations that are not collectible be promptly charged-off when the loss becomes quantifiable, regardless of the delinquency status of the loan. The Company may elect to recognize a partial charge-off when management has determined that the value of collateral is less than the remaining 59 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) investment in the loan. A loan or obligation does not need to be charged-off, regardless of delinquency status, if (i) management has determined there exists sufficient collateral to protect the remaining loan balance and (ii) there exists a strategy to liquidate the collateral. Management may also consider a number of other factors to determine when a charge-off is appropriate. These factors may include, but are not limited to: • The status of a bankruptcy proceeding; • The value of collateral and probability of successful liquidation; and/or; • The status of adverse proceedings or litigation that may result in collection. Consumer unsecured loans and secured loans are evaluated for charge-off after the loan becomes 90 days past due. Unsecured loans are fully charged-off and secured loans are charged-off to the estimated fair value of the collateral less the cost to sell. Our policy is to place loans in all categories in nonaccrual status when collection of interest or principal is doubtful, or generally when interest or principal payments are 90 days or more past due. Nonperforming assets consist of nonaccrual loans, nonaccrual TDRs and OREO. The following table summarizes nonperforming assets for the dates presented: (Dollars in Thousands) September 30, 2021 December 31, 2020 $ Change Nonperforming Loans Commercial Real Estate $ 606 $ 224 $ 382 Commercial and Industrial 547 456 91 Construction 1,920 2,012 (92) Residential Mortgages 2,500 4,135 (1,635) Other Consumer 77 191 (114) Other — — — Total Nonperforming Loans 5,650 7,018 (1,368) Nonperforming Troubled Debt Restructurings Commercial Real Estate 146 21,667 (21,521) Commercial and Industrial — — — Construction 3,071 3,319 (248) Residential Mortgages — — — Other Consumer — — — Other — — — Total Nonperforming Troubled Debt Restructurings 3,217 24,986 (21,769) Total Nonperforming Loans and Troubled Debt Restructurings 8,867 32,004 (23,137) Other Real Estate Owned 13,265 15,722 (2,457) Total Nonperforming Assets $ 22,132 $ 47,726 $ (25,594) September 30, 2021 December 31, 2020 Nonperforming Loans and Troubled Debt Restructurings to Total Portfolio Loans 0.31 % 1.09 % Nonperforming Assets to Total Portfolio Loans plus Other Real Estate Owned 0.76 % 1.61 % Nonperforming assets decreased $25.6 million to $22.1 million at September 30, 2021 compared to $47.7 million at December 31, 2020. The decrease was primarily related to the resolution of our two largest nonperforming relationships, offset by a $2.5 million decrease in OREO. The decrease in OREO, from December 31, 2021, was primarily due to the sale of the closed retail offices during the second quarter of 2021. Closed retail bank offices have a remaining book value of $2.8 million at September 30, 2021 and $2.5 million at December 31, 2020. The gross amount of interest that would have been recorded under original terms had these loans not been placed on nonaccrual status was $0.8 million and $1.9 million during the three 60 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) and nine months ended September 30, 2021, respectively. There were $7 thousand nonaccrual loans related to loans held-for-sale at December 31, 2020. The CARES Act permits banks to suspend requirements under GAAP for loan modifications to borrowers affected by the COVID-19 pandemic that would otherwise be characterized as TDRs and suspend any determination related thereto if (i) the loan modification is made between March 1, 2020 and the earlier of December 31, 2020 or 60 days after the end of the COVID-19 emergency declaration and (ii) the applicable loan was not more than 30 days past due as of December 31, 2019. The provisions of the CARES Act dealing with temporary relief related to TDRs was extended pursuant to the CAA, which was signed into law on December 27, 2020. This amendment extended the “applicable” period to the earlier of January 1, 2022 or 60 days after the date on which the national emergency concerning the COVID-19 pandemic terminates. The federal banking agencies also issued guidance to encourage banks to make loan modifications for borrowers affected by COVID-19 and to assure banks that they will not be criticized by examiners for doing so. We are currently applying this guidance to qualifying loan modifications. At this time, it is uncertain what future impact loan and lease modifications related to COVID-19 will have on our financial condition, results of operations and ACL. The following table summarizes portfolio loans past due 30-89 days for the periods presented: (Dollars in Thousands) September 30, 2021 December 31, 2020 Loans 30 to 89 Days Past Due Commercial Commercial Real Estate $ 6,861 $ 3,816 Commercial and Industrial 1,308 384 Total Commercial Loans 8,169 4,200 Consumer Residential Mortgages 376 1,347 Other Consumer 291 573 Total Consumer Loans 667 1,920 Construction — 284 Other — — Total Loans 30 to 89 Days Past Due $ 8,836 $ 6,404 Portfolio loans past due 30 to 89 days or more and still accruing increased $2.4 million to $8.8 million at September 30, 2021 compared to $6.4 million at December 31, 2020. The variances in loan segments for past due 30 to 89 days is primarily related to the adoption of Topic 326. We made changes to our loan portfolio segments to align with the methodology applied in determining the allowance under CECL. The new segmentation breaks out an Other category from the original loan categories, which applies only to the current year 2021 and was not adjusted to the comparable period, therefore showing fluctuations in all categories. 61 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) Deposits The following table presents the composition of deposits for the periods presented: (Dollars in Thousands) September 30, 2021 December 31, 2020 $ Change % Change Noninterest-Bearing Demand $ 722,145 $ 699,229 $ 22,916 3.3 % Interest-Bearing Demand 433,144 366,201 66,943 18.3 % Money Market 432,167 294,229 137,938 46.9 % Savings 676,035 625,482 50,553 8.1 % Certificate of Deposits 1,402,982 1,614,770 (211,788) (13.1) % Deposits Held for Assumption in Connection with Sale of Bank Branches — 84,717 (84,717) (100.0) % Total Deposits $ 3,666,473 $ 3,684,628 $ (18,155) (0.5) % Deposits are our primary source of funds. We believe that our deposit base is stable and that we have the ability to attract new depositors while diversifying the deposit composition. Total deposits at September 30, 2021 decreased $18.2 million, or 0.5%, from December 31, 2020. The decrease in deposits primarily related to the $211.8 million, or 13.1%, decline in CDs at September 30, 2021 compared to December 31, 2020 due to the intentional runoff of higher cost CDs, and $84.7 million of deposits held-for-assumption, at December 31, 2020, in connection with the sale of four bank branches which were sold during the second quarter of 2021. These decreases were offset by increases in our core deposits, including $137.9 million in money market accounts due to our deposit acquisition strategy, a $66.9 million increase in interest-bearing demand deposits, a $50.6 million increase in savings accounts due to promotions and an increase of $22.9 million in noninterest-bearing demand accounts. Noninterest-bearing deposits comprised 19.7% and 19.0% of total deposits at September 30, 2021 and December 31, 2020, respectively. Federal Home Loan Bank Borrowings (“FHLB”) Borrowings are an additional source of liquidity for the Company. FHLB borrowings were $30.0 million and $35.0 million at September 30, 2021 and December 31, 2020, respectively. FHLB borrowings are fixed rate advances for various terms and are secured by a blanket lien on select residential mortgages, select multifamily loans, and select commercial real estate loans at September 30, 2021 and December 31, 2020. Total loans pledged as collateral were $908.7 million and $804.2 million at September 30, 2021 and December 31, 2020, respectively. There were no securities available-for-sale pledged as collateral at both September 30, 2021 and December 31, 2020. The Company continues to methodically pledge additional eligible loans and expect continued progress in additional pledging throughout the year. The Bank is eligible to borrow up to an additional $555.9 million based upon current qualifying collateral and has a maximum borrowing capacity of approximately $1.0 billion, or 25.0% of the Company’s assets, as of September 30, 2021. The Company had the capacity to borrow up to an additional $510.5 million from the FHLB at December 31, 2020. Information pertaining to long-term FHLB borrowings is summarized in the following table: (Dollars in Thousands) September 30, 2021 December 31, 2020 Balance at Period End $ 30,000 $ 35,000 Average Balance during the Period $ 31,282 $ 30,628 Average Interest Rate during the Period 1.18 % 1.18 % Maximum Month-end Balance during the Period $ 35,000 $ 35,000 Average Interest Rate at Period End 1.15 % 1.13 % The Company held FHLB Atlanta stock of $3.2 million and $5.1 million at September 30, 2021 and December 31, 2020, respectively. Dividends recorded on this restricted stock were $30 thousand and $98 thousand for the three and nine months ended September 30, 2021, respectively. Dividends recorded on this restricted stock were $39 thousand and $170 thousand for the three and nine months ended September 30, 2020, respectively. The investment is carried at cost and evaluated for impairment based on the ultimate recoverability of the par value. We hold FHLB stock because we are a member of the FHLB of Atlanta. The FHLB requires members to purchase and hold a specified level of FHLB stock based upon the members’ asset values, level of borrowings and participation in other programs offered. Stock in the FHLB is non-marketable and is redeemable at the discretion of the FHLB. Members do not purchase stock in the FHLB for the same reasons that traditional 62 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) equity investors acquire stock in an investor-owned enterprise. Rather, members purchase stock to obtain access to the products and services offered by the FHLB. Unlike equity securities of traditional for-profit enterprises, the stock of the FHLB does not provide its holders with an opportunity for capital appreciation because, by regulation, FHLB stock can only be purchased, redeemed and transferred at par value. Liquidity and Capital Resources Liquidity is defined as a financial institution’s ability to meet its cash and collateral obligations at a reasonable cost. This includes the ability to satisfy the financial needs of depositors who want to withdraw funds or of borrowers needing to access funds to meet their credit needs. In order to manage liquidity risk the Company’s Board has delegated authority to the ALCO for formulation, implementation and oversight of liquidity risk management for the Company. The ALCO’s goal is to maintain adequate levels of liquidity at a reasonable cost to meet funding needs in both a normal operating environment and for potential liquidity stress events. The ALCO monitors and manages liquidity through various ratios, reviewing cash flow projections, performing stress tests and by having a detailed contingency funding plan. The ALCO policy guidelines define graduated risk tolerance levels. If our liquidity position moves to a level that has been defined as high risk, specific actions are required, such as increased monitoring or the development of an action plan to reduce the risk position. Our primary funding and liquidity source is a stable customer deposit base. Management believes that we have the ability to retain existing deposits and attract new deposits, mitigating any funding dependency on other more volatile sources. Although deposits are the primary source of funds, the Company has identified various other funding sources that can be used as part of our normal funding program when either a structure or cost efficiency has been identified. Additional funding sources accessible to the Company include borrowing availability at the FHLB, equal to 25.0% of the Company’s assets approximating $1.0 billion, subject to the amount of eligible collateral pledged, federal funds lines with six other correspondent financial institutions in the amount of $145.0 million, access to the institutional CD market, and the brokered deposit market. In addition to the lines referenced above, the Company also has $724.7 million of unpledged available-for-sale investment securities as an additional source of liquidity. An important component of our ability to effectively respond to potential liquidity stress events is maintaining a cushion of highly liquid assets. Highly liquid assets are those that can be converted to cash quickly, with little or no loss in value, to meet financial obligations. ALCO policy guidelines define a ratio of highly liquid assets to total assets by graduated risk tolerance levels of minimal, moderate and high. At September 30, 2021, the Bank had $912.3 million in highly liquid assets, which consisted of $61.4 million in interest-bearing deposits in other financial institutions, $121.3 million in FRB Excess Reserves, $724.7 million in unpledged securities and $4.9 million in mortgage loans held-for-sale. This resulted in a highly liquid assets to total assets ratio of 22.1% at September 30, 2021. If an extended recession caused large numbers of our deposit customers to withdraw their funds, we might become more reliant on volatile or more expensive sources of funding. The following table provides detail of liquidity sources as of the periods presented: (Dollars in Thousands) September 30, 2021 December 31, 2020 Cash and Due From Banks $ 43,061 $ 38,535 Interest-bearing Deposits in Other Financial Institutions 61,435 39,954 Federal Reserve Bank Excess Reserves 121,300 163,453 Unpledged Investment Securities 724,670 632,724 Excess Pledged Securities 41,623 7,857 FHLB Borrowing Availability 555,866 510,533 Unsecured Lines of Credit 145,000 145,000 Total Liquidity Sources $ 1,692,955 $ 1,538,056 Regulatory Capital Requirements Total shareholders’ equity decreased by $34.3 million to $405.9 million at September 30, 2021 compared to $440.2 million at December 31, 2020. The decrease was primarily due to the $50.7 million cumulative-effect adjustment related to the adoption of Topic 326, a $10.3 million, net of tax, decrease in other comprehensive loss due to changes in the fair value of available-for- 63 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) sale securities partially offset by net income of $26.0 million. The remaining difference of $0.7 million is related to stock-based compensation during the nine months ended September 30, 2021. The Company and the Bank are subject to various capital requirements administered by the federal banking regulators. Failure to meet the minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Quantitative measures established by regulations to ensure capital adequacy require us to maintain minimum amounts and ratios as shown in the following table. Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At September 30, 2021 and December 31, 2020, the most recent regulatory notifications categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution’s category. At September 30, 2021, the Bank continues to maintain its capital position with a leverage ratio of 10.45% as compared to the regulatory guideline of 5.00% to be well-capitalized and a risk-based Common Equity Tier 1 ratio of 13.82% compared to the regulatory guideline of 6.50% to be well-capitalized. The Bank’s risk-based Tier 1 and Total Capital ratios were 13.82% and 15.08%, respectively, which places the Bank above the federal bank regulatory agencies’ well-capitalized guidelines of 8.00% and 10.00%, respectively. We believe that we have the ability to raise additional capital, if necessary. The final rules implementing Basel Committee on Banking Supervision’s capital guidelines for U.S. Banks (“Basel III rules”) became effective on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Under the Basel III rules, we must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer was phased in at the rate of 0.625% per year and was 2.5% on January 1, 2019. Management believes as of September 30, 2021 and December 31, 2020, the Company and the Bank met all capital adequacy requirements to which we are subject and satisfied the applicable capital conservation buffer requirements. The following table summarizes risk-based capital amounts and ratios for the Company and the Bank for the dates presented: (Dollars in Thousands) Adequately Capitalized Well Capitalized (1) September 30, 2021 December 31, 2020 Amount Ratio Amount Ratio Carter Bankshares, Inc. Leverage Ratio 4.00 % NA $ 438,524 10.48 % $ 424,453 10.26 % Common Equity Tier 1 (to Risk-weighted Assets) 4.50 % NA 438,524 13.85 % 424,453 13.08 % Tier 1 Capital (to Risk-weighted Assets) 6.00 % NA 438,524 13.85 % 424,453 13.08 % Total Capital (to Risk-weighted Assets) 8.00 % NA 478,261 15.11 % 465,198 14.33 % Carter Bank & Trust Leverage Ratio 4.00 % 5.00 % $ 437,496 10.45 % $ 423,832 10.24 % Common Equity Tier 1 (to Risk-weighted Assets) 4.50 % 6.50 % 437,496 13.82 % 423,832 13.06 % Tier 1 Capital (to Risk-weighted Assets) 6.00 % 8.00 % 437,496 13.82 % 423,832 13.06 % Total Capital (to Risk-weighted Assets) 8.00 % 10.00 % 477,229 15.08 % 464,578 14.31 % (1) To be “well capitalized” under the prompt corrective action provisions in the Basel III framework. “Well capitalized” applies to the Bank only. The Company was incorporated on October 7, 2020, by and at the direction of the Board of Directors of the Bank, for the sole purpose of acquiring the Bank and serving as the Bank’s parent bank holding company pursuant to a corporate reorganization transaction (the “Reorganization”). The Reorganization was completed on November 20, 2020 pursuant to an Agreement and Plan of Reorganization among the Bank, the Company and CBT Merger Sub, Inc., and the Bank survived the Reorganization as 64 Table of Contents CARTER BANKSHARES, INC. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (continued) a wholly-owned subsidiary of the Company. In the Reorganization, each of the outstanding shares of the Bank’s common stock was converted into and exchanged for one newly issued share of the Company’s common stock. In December 2018, the Office of the Comptroller of the Currency, (the “OCC”), the FRB, and the FDIC approved a final rule to address changes to credit loss accounting under GAAP, including banking organizations’ implementation of CECL. The final rule provides banking organizations the option to phase in over a three-year period the day one adverse effects on regulatory capital that may result from the adoption of the new accounting standard. On March 27, 2020, the regulators issued interim final rule (“IFR”), “Regulatory Capital Rule: Revised Transition of the Current Expected Credit Losses Methodology for Allowances” in response to the disrupted economic activity from the spread of COVID-19. The IFR maintains the three-year transition option in the previous rule and provides banks the option to delay for two years an estimate of CECL’s effect on regulatory capital, relative to the incurred loss methodology’s effect on regulatory capital, followed by a three-year transition period (five-year transition option). We adopted CECL effective January 1, 2021 and elected to implement the capital transition relief over the permissible three-year period. Contractual Obligations As of September 30, 2021, there have been no material changes outside the ordinary course of business to the contractual obligations disclosed in Part II, Item 7, “Management's Discussion and Analysis," under the heading “Contractual Obligations” in the Company's Annual Report on Form 10-K for the year ended December 31, 2020. Off-Balance Sheet Arrangements As of September 30, 2021, there have been no material changes to the off-balance sheet arrangements disclosed in Part II, Item 7, "Management's Discussion and Analysis," under the heading "Off-Balance Sheet Arrangements" in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2020. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market Risk Market risk is defined as the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a financial institution’s earnings or capital. For financial institutions, market risk primarily reflects exposures to changes in interest rates. Interest rate fluctuations affect earnings by changing net interest income and other interest-sensitive income and expense levels. Interest rate changes affect capital by changing the net present value of a financial institution’s future cash flows, and the cash flows themselves, as rates change. Accepting this risk is a normal part of banking and can be an important source of profitability and enhancement of shareholder value. However, excessive interest rate risk can threaten a financial institution’s earnings, capital, liquidity and solvency. Our sensitivity to changes in interest rate movements is continually monitored by the ALCO. The ALCO utilizes an asset liability model (“ALM”) to monitor and manage market risk through net interest income simulation for various rate shock scenarios and economic value of equity (“EVE”), simulation for various rate shock scenarios. The rate shock scenarios used in the ALM span over multiple time horizons and yield curve shapes and include parallel and non-parallel shifts to ensure the ALCO can mitigate future earnings and market value fluctuations due to changes in market interest rates. Within the context of the ALM, net interest income rate shock simulations explicitly measure the exposure to earnings from changes in market rates of interest over a defined time horizon. These robust simulations include assumptions of how the balance sheet will react in different rate environments including loan pre-payment speeds, average life of non-maturing deposits, and how sensitive each interest-earning asset and interest-bearing liability is to changes in market rates (betas). Under simulation analysis, our current financial position is combined with assumptions regarding future business to calculate net interest income under various hypothetical rate scenarios. Reviewing these various measures provides us with a more comprehensive view of our interest rate risk profile. Net interest income rate shock simulation results are compared to a base case to provide an estimate of the impact that market rate changes may have on 12 months and 24 months of pretax net interest income. The base case and rate shock analyses are performed on a static and growth balance sheet. A static balance sheet is a no growth balance sheet in which all maturing and/or 65 Table of Contents CARTER BANKSHARES, INC.