Item 2. Management’s Discussion and Analysis
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
Certain matters discussed in this report contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 and the Company intends that these forward-looking statements be covered by the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of forward-looking words or phrases such as “anticipate,” “believe,” “could,” “expect,” “estimates”, “intend,” “may,” “preliminary,” “planned,” “potential,” “should,” “will,” “would,” or the negative of those terms or other words of similar meaning. Similarly, statements that describe the Company’s future plans, objectives or goals are also forward-looking statements. Such forward-looking statements are inherently subject to many uncertainties in the Company’s operations and business environment.
Factors that could affect actual results or outcomes include the matters described under the caption “Risk Factors” in Item 1A of our annual report on Form 10-K for the year ended December 31, 2019, filed with the SEC on March 10, 2020 (“2019 10-K”), the matters described in “Risk Factors” in Item 1A of our Form 10-Q for the quarters ended March 31, 2020, June 30, 2020 and in Item 1A of this Form 10-Q, and the following:
• conditions in the financial markets and economic conditions generally;
• adverse impacts to the Company or Bank arising from the COVID-19 pandemic;
• the possibility of a deterioration in the residential real estate markets;
• interest rate risk;
• lending risk;
• the sufficiency of loan allowances;
• changes in the fair value or ratings downgrades of our securities;
• competitive pressures among depository and other financial institutions;
• our ability to maintain our reputation;
• our ability to realize the benefits of net deferred tax assets;
• our ability to maintain or increase our market share;
• acts of terrorism and political or military actions by the United States or other governments;
• legislative or regulatory changes or actions, or significant litigation, adversely affecting the Company or Bank;
• increases in FDIC insurance premiums or special assessments by the FDIC;
• disintermediation risk;
• our inability to obtain needed liquidity;
• risks related to the ongoing integration of F&M into the Company’s operations;
• our ability to successfully execute our acquisition growth strategy;
• risks posed by acquisitions and other expansion opportunities, including difficulties and delays in integrating the acquired business operations or fully realizing the cost savings and other benefits;
• our ability to raise capital needed to fund growth or meet regulatory requirements;
• the possibility that our internal controls and procedures could fail or be circumvented;
• our ability to attract and retain key personnel;
• our ability to keep pace with technological change;
• cybersecurity risks;
• changes in federal or state tax laws;
• changes in accounting principles, policies or guidelines and their impact on financial performance;
• restrictions on our ability to pay dividends; and
• the potential volatility of our stock price.
Stockholders, potential investors and other readers are urged to consider these factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements made herein are only made as of the date of this filing and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances occurring after the date of this report.
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GENERAL
The following discussion sets forth management’s discussion and analysis of our consolidated financial condition as of September 30, 2020, and our consolidated results of operations for the three and nine months ended September 30, 2020, compared to the same period in the prior fiscal year for the three and nine months ended September 30, 2019. This discussion should be read in conjunction with the interim consolidated financial statements and the condensed notes thereto included with this report and with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the financial statements and notes related thereto included in our 2019 10-K. Unless otherwise stated, all monetary amounts in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, other than share, per share and capital ratio amounts, are stated in thousands.
CRITICAL ACCOUNTING ESTIMATES
Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events, and apply judgments that affect the reported amount of assets, liabilities, revenue, expenses and their related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that our management believes to be relevant at the time our consolidated financial statements are prepared. Some of these estimates are more critical than others. In addition to the policies included in Note 1, “Nature of Business and Summary of Significant Accounting Policies,” to the Consolidated Financial Statements included as an exhibit in our annual report on our 2019 10-K, our critical accounting estimates are as follows:
Allowance for Loan Losses.
We maintain an allowance for loan losses to absorb probable and inherent losses in our loan portfolio. The allowance is based on ongoing, quarterly assessments of the estimated probable incurred losses in our loan portfolio. In evaluating the level of the allowance for loan loss, we consider the types of loans and the amount of loans in our loan portfolio, historical loss experience, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, prevailing economic conditions and other relevant factors determined by management. We follow all applicable regulatory guidance, including the “Interagency Policy Statement on the Allowance for Loan and Lease Losses,” issued by the Federal Financial Institutions Examination Council (FFIEC). We believe that the Bank’s Allowance for Loan Losses Policy conforms to all applicable regulatory requirements. However, based on periodic examinations by regulators, the amount of the allowance for loan losses recorded during a particular period may be adjusted.
Our determination of the allowance for loan losses is based on (1) specific allowances for specifically identified and evaluated impaired loans and their corresponding estimated loss based on likelihood of default, payment history, and net realizable value of underlying collateral. Specific allocations for collateral dependent loans are based on fair value of the underlying collateral relative to the unpaid principal balance of individually impaired loans. For loans that are not collateral dependent, the specific allocation is based on the present value of expected future cash flows discounted at the loan’s original effective interest rate through the repayment period; and (2) a general allowance on loans not specifically identified in (1) above, based on historical loss ratios, which are adjusted for qualitative and general economic factors. We continue to refine our allowance for loan losses methodology, with an increased emphasis on historical performance adjusted for applicable economic and qualitative factors.
Assessing the allowance for loan losses is inherently subjective as it requires making material estimates, including the amount and timing of future cash flows expected to be received on impaired loans, any of which estimates may be susceptible to significant change. In our opinion, the allowance, when taken as a whole, reflects estimated probable loan losses in our loan portfolio.
Goodwill.
We account for goodwill and other intangible assets in accordance with ASC Topic 350, “Intangibles - Goodwill and Other.” The Company records the excess of the cost of acquired entities over the fair value of identifiable tangible and intangible assets acquired, less liabilities assumed, as goodwill. The Company amortizes acquired intangible assets with definite useful economic lives over their useful economic lives utilizing the straight-line method. On a periodic basis, management assesses whether events or changes in circumstances indicate that the carrying amounts of the intangible assets may be impaired. The Company does not amortize goodwill and any acquired intangible asset with an indefinite useful economic life, but reviews them for impairment at a reporting unit level on an annual basis, or when events or changes in circumstances indicate that the carrying amounts may be impaired. A reporting unit is defined as any distinct, separately
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identifiable component of the Company’s one operating segment for which complete, discrete financial information is available and reviewed regularly by the segment’s management. The Company has one reporting unit as of September 30, 2020 which is related to its banking activities. The Company performed the required goodwill impairment test and determined that goodwill was not impaired as of December 31, 2019. The Company performed a goodwill impairment analysis as of September 30, 2020, due to triggering events being identified, and determined that goodwill was not impaired.
Fair Value Measurements and Valuation Methodologies.
We apply various valuation methodologies to assets and liabilities which often involve a significant degree of judgment, particularly when liquid markets do not exist for the particular items being valued. Quoted market prices are referred to when estimating fair values for certain assets, such as most investment securities. However, for those items for which an observable liquid market does not exist, management utilizes significant estimates and assumptions to value such items. Examples of these items include loans, deposits, borrowings, goodwill, core deposit intangible assets, other assets and liabilities obtained or assumed in business combinations, and certain other financial instruments. These valuations require the use of various assumptions, including, among others, discount rates, rates of return on assets, repayment rates, cash flows, default rates, and liquidation values. The use of different assumptions could produce significantly different results, which could have material positive or negative effects on the Company’s results of operations, financial condition or disclosures of fair value information.
In addition to valuation, the Company must assess whether there are any declines in value below the carrying value of assets that should be considered other than temporary or otherwise require an adjustment in carrying value and recognition of a loss in the consolidated statement of income. Examples include but are not limited to; loans, investment securities, goodwill, core deposit intangible assets and deferred tax assets, among others. Specific assumptions, estimates and judgments utilized by management are discussed in detail herein in management’s discussion and analysis of financial condition and results of operations and in notes 1, 2, 3, 4 and 10 of Condensed Notes to Consolidated Financial Statements.
Income Taxes.
Amounts provided for income tax expenses are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred income tax assets and liabilities, which arise principally from temporary differences between the amounts reported in the financial statements and the tax basis of certain assets and liabilities, are included in the amounts provided for income taxes. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and tax planning strategies which will create taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and if necessary, tax planning strategies in making this assessment.
The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and application of specific provisions of federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be material to our consolidated results of our operations and reported earnings. We believe that the deferred tax assets and liabilities are adequate and properly recorded in the accompanying consolidated financial statements. As of September 30, 2020, management does not believe a valuation allowance related to the realizability of its deferred tax assets is necessary.
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STATEMENT OF OPERATIONS ANALYSIS
Net Interest Income. Net interest income represents the difference between the dollar amount of interest earned on interest-bearing assets and the dollar amount of interest paid on interest-bearing liabilities. The interest income and expense of financial institutions (including those of the Bank) are significantly affected by general economic conditions, competition, policies of regulatory authorities and other factors.
Interest rate spread and net interest margin are used to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest earning assets and the rate paid for interest-bearing liabilities that fund those assets. Net interest margin is expressed as the percentage of net interest income to average interest earning assets. Net interest margin currently exceeds interest rate spread because non-interest-bearing sources of funds (“net free funds”), principally demand deposits and stockholders’ equity, also support interest earning assets. The narrative below discusses net interest income, interest rate spread, and net interest margin for the three and nine-month periods ended September 30, 2020 and September 30, 2019, respectively.
Net interest income was $11.9 million for the three months ended September 30, 2020 and $36.9 million for the nine months ended September 30, 2020, compared to $11.6 million for the three months ended September 30, 2019 and $31.7 million of the nine months ended September 30, 2019. For the three months ended September 30, 2020, net interest income benefited from the origination of $139 million of SBA Paycheck Protection Program (“PPP”) loans and organic loan growth partially offset by a decrease in net interest margin percentage.
The net interest margin for the three-month period ended September 30, 2020 was 3.11%, compared to 3.34% for the three-month period ended September, 2019. The decrease in net interest margin was largely due to: (1) the impact of the Federal Reserve actions to offset the impact of the pandemic in March 2020, during which it lowered overnight interest rates by 125 basis points in 12 days and (2) market reactions to decreasing longer-term interest rates on loans, investments and cash and cash equivalents security yields; partially offset by lower deposit rates due to management action to reduce interest rates. The impact of higher cash and cash equivalents balances decreased the interest margin percentage by two basis points as the rate impact is covered above. Higher non-accretable difference accretion of two basis points offset the negative impact of higher cash balances above.
The net interest margin for the nine-months ended September 30, 2020 was 3.36%, compared to 3.35% for the nine-month period ended September 30, 2019. The modest increase in net interest margin was due to the increase in the accretion of purchased credit impaired discounts, which increased net interest margin by 11 basis points. Other factors affecting the net interest margin for the nine month periods of 2020 to 2019 are similar to those discussed above, with a two basis point decrease in net interest margin due to the impact of higher cash and cash equivalent balances as the rate impact is discussed above.
Average Balances, Net Interest Income, Yields Earned and Rates Paid. The following net interest income analysis table presents interest income from average interest earning assets, expressed in dollars and yields, and interest expense on average interest-bearing liabilities, expressed in dollars and rates on a tax equivalent basis. Shown below is the weighted average tax equivalent yield on interest earning assets, rates paid on interest-bearing liabilities and the resultant spread at or during the three and nine-month periods ended September 30, 2020, and for the three and nine-month periods ended September 30, 2019. Non-accruing loans have been included in the table as loans carrying a zero yield.
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NET INTEREST INCOME ANALYSIS ON A TAX EQUIVALENT BASIS
(Dollar amounts in thousands)
Three months ended September 30, 2020 compared to the three months ended September 30, 2019:
Three months ended September 30, 2020 Three months ended September 30, 2019
Average
Balance Interest
Income/
Expense Average
Yield/
Rate (1) Average
Balance Interest
Income/
Expense Average
Yield/
Rate (1)
Average interest earning assets:
Cash and cash equivalents $ 77,774 $ 18 0.09 % $ 32,376 $ 203 2.49 %
Loans 1,258,224 14,154 4.48 % 1,143,252 14,646 5.08 %
Interest-bearing deposits 3,752 23 2.44 % 5,577 34 2.42 %
Investment securities (1) 166,622 846 2.02 % 185,921 1,174 2.56 %
Other investments 15,145 177 4.65 % 13,072 166 5.04 %
Total interest earning assets (1) $ 1,521,517 $ 15,218 3.98 % $ 1,380,198 $ 16,223 4.67 %
Average interest-bearing liabilities:
Savings accounts $ 183,381 $ 98 0.21 % $ 158,967 $ 155 0.39 %
Demand deposits 285,993 231 0.32 % 219,955 550 0.99 %
Money market 255,160 280 0.44 % 200,647 593 1.17 %
CD’s 297,691 1,469 1.96 % 381,331 1,870 1.95 %
IRA’s 41,852 177 1.68 % 44,184 203 1.82 %
Total deposits $ 1,064,077 $ 2,255 0.84 % $ 1,005,084 $ 3,371 1.33 %
FHLB Advances and other borrowings 173,758 1,054 2.41 % 169,908 1,259 2.94 %
Total interest-bearing liabilities $ 1,237,835 $ 3,309 1.06 % $ 1,174,992 $ 4,630 1.56 %
Net interest income $ 11,909 $ 11,593
Interest rate spread 2.92 % 3.11 %
Net interest margin (1) 3.11 % 3.34 %
Average interest earning assets to average interest-bearing liabilities 1.23 1.17
(1) Fully taxable equivalent (FTE). The average yield on tax exempt securities is computed on a tax equivalent basis using a tax rate of 21.0% for the quarters ended September 30, 2020 and September 30, 2019. The FTE adjustment to net interest income included in the rate calculations totaled $0 and $27 thousand for the three months ended September 30, 2020 and September 30, 2019, respectively.
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NET INTEREST INCOME ANALYSIS ON A TAX EQUIVALENT BASIS
(Dollar amounts in thousands)
Nine months ended September 30, 2020 compared to the nine months ended September 30, 2019:
Nine months ended September 30, 2020 Nine months ended September 30, 2019
Average
Balance Interest
Income/
Expense Average
Yield/
Rate (1) Average
Balance Interest
Income/
Expense Average
Yield/
Rate (1)
Average interest earning assets:
Cash and cash equivalents $ 42,946 $ 141 0.44 % $ 29,489 $ 542 2.46 %
Loans 1,232,678 44,300 4.8 % 1,054,492 40,036 5.08 %
Interest-bearing deposits 3,967 73 2.46 % 6,153 107 2.33 %
Investment securities (1) 173,595 2,965 2.28 % 167,023 3,119 2.58 %
Other investments 15,104 533 4.71 % 11,853 473 5.34 %
Total interest earning assets (1) $ 1,468,290 $ 48,012 4.37 % $ 1,269,010 $ 44,277 4.68 %
Average interest-bearing liabilities:
Savings accounts $ 169,754 $ 348 0.27 % $ 156,851 $ 479 0.41 %
Demand deposits 262,748 865 0.44 % 200,387 1,288 0.86 %
Money market 244,965 1,240 0.68 % 172,671 1,423 1.10 %
CD’s 326,776 5,021 2.05 % 348,139 5,163 1.98 %
IRA’s 42,221 568 1.80 % 41,576 537 1.73 %
Total deposits $ 1,046,464 $ 8,042 1.03 % $ 919,624 $ 8,890 1.29 %
FHLB Advances and other borrowings 185,256 3,087 2.23 % 153,960 3649 3.17 %
Total interest-bearing liabilities $ 1,231,720 $ 11,129 1.21 % $ 1,073,584 $ 12,539 1.56 %
Net interest income $ 36,883 $ 31,738
Interest rate spread 3.16 % 3.12 %
Net interest margin (1) 3.36 % 3.35 %
Average interest earning assets to average interest-bearing liabilities 1.19 1.18
(1) Fully taxable equivalent (FTE). The average yield on tax exempt securities is computed on a tax equivalent basis using a tax rate of 21.0% for the nine months ended September 30, 2020 and September 30, 2019. The FTE adjustment to net interest income included in the rate calculations totaled $1 thousand and $103 thousand for the nine months ended September 30, 2020 and September 30, 2019, respectively.
Rate/Volume Analysis. The following table presents the dollar amount of changes in interest income and interest expense for the components of interest earning assets and interest-bearing liabilities that are presented in the preceding table. For each category of interest earning assets and interest-bearing liabilities, information is provided on changes attributable to: (1) changes in volume, which are changes in the average outstanding balances multiplied by the prior period rate (i.e. holding the initial rate constant); and (2) changes in rate, which are changes in average interest rates multiplied by the prior period volume (i.e. holding the initial balance constant). Rate changes have been discussed previously. For the three months ended September 30, 2020, compared to the three months ended September 30, 2019, the loan volume increase is primarily due to SBA PPP originations, and the impact of organic growth since October 1, 2019. The decrease in certificate volumes is due to planned runoff of brokered CD’s and to a lesser extent, retail CD’s, partially offset by growth in non-maturity deposits. Volume change factors for the nine month period are similar to the three month period, along with the impact of having nine months of F&M balances in 2020 compared to only three months in the comparable 2019 period, as the F&M acquisition closed July 1, 2019.
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RATE / VOLUME ANALYSIS
(Dollar amounts in thousands)
Three months ended September 30, 2020 compared to the three months ended September 30, 2019.
Increase (decrease) due to
Volume Rate Net
Interest income:
Cash and cash equivalents $ 181 $ (366) $ (185)
Loans 1,393 (1,885) (492)
Interest-bearing deposits (11) — (11)
Investment securities (115) (213) (328)
Other investments 25 (14) 11
Total interest earning assets 1,473 (2,478) (1,005)
Interest expense:
Savings accounts 21 (78) (57)
Demand deposits 136 (455) (319)
Money market accounts 135 (448) (313)
CD’s (413) 12 (401)
IRA’s (10) (16) (26)
Total deposits (131) (985) (1,116)
FHLB Advances and other borrowings 28 (233) (205)
Total interest bearing liabilities (103) (1,218) (1,321)
Net interest income $ 1,576 $ (1,260) $ 316
Nine months ended September 30, 2020 compared to the nine months ended September 30, 2019.
Increase (decrease) due to
Volume Rate Net
Interest income:
Cash and cash equivalents $ 191 $ (592) $ (401)
Loans 6,504 (2,240) 4,264
Interest-bearing deposits (40) 6 (34)
Investment securities 123 (277) (154)
Other investments 120 (60) 60
Total interest earning assets 6,898 (3,163) 3,735
Interest expense:
Savings accounts 37 (168) (131)
Demand deposits 337 (760) (423)
Money market accounts 497 (680) (183)
CD’s (324) 182 (142)
IRA’s 8 23 31
Total deposits 555 (1,403) (848)
FHLB Advances and other borrowings 662 (1,224) (562)
Total interest bearing liabilities 1,217 (2,627) (1,410)
Net interest income $ 5,681 $ (536) $ 5,145
Provision for Loan Losses. We determine our provision for loan losses (“provision”) based on our desire to provide an adequate allowance for loan losses (“ALL”) to reflect probable and inherent credit losses in our loan portfolio. We continue to monitor adverse general economic conditions that could affect our commercial and agricultural portfolios in the future.
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Total provision for loan losses expense for the three and nine months ended September 30, 2020 was $1,500 and $5,250, respectively. The provision for loan losses was impacted by loan growth, net loan charge offs, increases in unallocated, increases in specific reserves on impaired loans and continued anticipation of pandemic-related adverse economic impacts, including various “Stay-at-Home Orders” which continued to result in temporary business closures, reduced operating capacity and uncertainty regarding potential future revenue and cash flows for certain businesses, including bank borrowers.
Management believes that the provision taken for the current year three-month period is adequate in view of the present condition of our loan portfolio and the sufficiency of collateral supporting our non-performing loans. We continually monitor non-performing loan relationships and will adjust our provision, as necessary, if changing facts and circumstances require a change in the ALL. In addition, a decline in the quality of our loan portfolio as a result of general economic conditions, factors affecting particular borrowers or our market areas, or otherwise, could all affect the adequacy of our ALL. If there are significant charge-offs against the ALL, or we otherwise determine that the ALL is inadequate, we will need to record an additional provision in the future.
Non-interest Income . The following table reflects the various components of non-interest income for the three and nine month periods ended September 30, 2020 and 2019, respectively.
Three months ended September 30, Nine months ended September 30,
2020 2019 % Change 2020 2019 % Change
Non-interest Income:
Service charges on deposit accounts $ 431 $ 625 (31.04) % $ 1,336 $ 1,756 (23.92) %
Interchange income 556 476 16.81 % 1,509 1,267 19.10 %
Loan servicing income 1,144 714 60.22 % 3,144 1,902 65.30 %
Gain on sale of loans 1,987 679 192.64 % 4,585 1,560 193.91 %
Loan fees and service charges 320 471 (32.06) % 1,041 860 21.05 %
Insurance commission income — 197 (100.00) % 475 573 (17.10) %
Net gains on investment securities ( 1 ) 96 (101.04) % 97 151 (35.76) %
Net gain on sale of branch — — N/M — 2,295 N/M
Net gain on sale of acquired business lines 180 — N/M 432 — N/M
Settlement proceeds — — N/M 131 — N/M
Other 445 363 22.59 % 928 827 12.21 %
Total non-interest income $ 5,062 $ 3,621 39.80 % $ 13,678 $ 11,191 22.22 %
The growth in most line items, for the nine months ended September 30, are due to the impact of the F&M acquisition on July 1, 2019.
Service charges on deposit accounts decreased to $431 and $1,336 for the three and nine months ended September 30, 2020, from $625 and $1,756 in the comparable prior year periods. This decrease was due to lower retail customer activity and due to higher balances of retail checking accounts, primarily in the three months ended September 30, 2020.
Loan servicing income increased largely due to increased capitalized mortgage servicing rights due to higher mortgage loan origination fees in both the current three and nine-month periods.
Gain on sale of loans increased in both the current three and nine-month periods due to higher mortgage loan origination sold volumes.
The change in loan fees and service charges for the three and nine months ended September 30, 2020, is largely due to changes in commercial loan customer activity, which was significantly higher in the first quarter of 2020
The Company recognized a gain on sale of its Michigan branch of $2,295 in the second quarter of 2019.
In the quarter ended September 30, 2020, the Bank’s acquired wealth management business partner exercised their contractual call originated prior to the acquisition, resulting in the sale of the wealth management business. The sale resulted in a $180 gain, Also, the Company sold the Wells Insurance Agency in June 2020, realizing a net gain of $252.
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During the quarter ended June 30, 2020, the Company recognized $131 of non-interest income related to a private mortgage-backed security claim. This distribution represents a supplement to the proceeds received in March 2017 from this private mortgage-backed security, previously owned by the Bank, and sold in 2011.
Non-interest Expense. The following table reflects the various components of non-interest expense for the three and nine month periods ended September 30, 2020 and 2019, respectively.
Three months ended September 30, Nine months ended September 30,
2020 2019 % Change 2020 2019 % Change
Non-interest Expense:
Compensation and related benefits $ 5,538 $ 5,295 4.59 % $ 16,881 $ 14,605 15.58 %
Occupancy 993 905 9.72 % 2,898 2,725 6.35 %
Office 532 599 (11.19) % 1,650 1,649 0.06 %
Data processing 1,145 1,092 4.85 % 3,165 2,953 7.18 %
Amortization of intangible assets 399 412 (3.16) % 1,223 1,085 12.72 %
Mortgage servicing rights expense 603 325 85.54 % 2,330 822 183.45 %
Advertising, marketing and public relations 260 315 (17.46) % 802 974 (17.66) %
FDIC premium assessment 188 78 141.03 % 436 318 37.11 %
Professional services 434 561 (22.64) % 1,391 1,961 (29.07) %
Gains on repossessed assets, net ( 105 ) (16) (556.25) % (195) (143) (36.36) %
Other 737 3,409 (78.38) % 2,266 5,309 (57.32) %
Total non-interest expense $ 10,724 $ 12,975 (17.35) % $ 32,847 $ 32,258 1.83 %
Non-interest expense (annualized) / Average assets 2.62 % 3.54 % (25.95) % 2.78 % 3.15 % (11.88) %
The growth in most line items for the nine months September 30 are due to the impact of the F&M acquisition on July 1, 2019.
Compensation expense, for the nine-month period ended September 30, 2020 was higher than the comparable prior year period due primarily to the impact of the F&M acquisition, and to a lesser extent, higher variable mortgage production compensation related to higher mortgage loan origination activity, primarily in the second and third quarter of 2020. Compensation expense for three months ended September 30, 2020 compared to September 30, 2019 was higher largely due to higher variable mortgage production compensation related to higher mortgage loan activity.
Data processing expense increases were due primarily to higher loan origination activity and larger deposit balances.
Mortgage servicing rights expense increased during the three and nine months ended September 30, 2020 by $278 and $1,508 respectively, compared to the comparable prior year periods. The Company recognized related impairment charges of $250 and $1,422 respectively in the three and nine-month periods ended September 30, 2020 compared to $100 and $210 for the three and nine months ended September 30, 2019, largely due to the impact of higher actual and forecasted prepayment rates. The remaining increase is due to higher amortization based on the current interest rate environment.
Professional services expenses were lower during the three months ended September 30, 2020 compared to the prior period due to merger costs in third quarter 2019. For the nine months ended September 30, 2020 compared to the comparable prior year periods, professional service expenses were lower primarily due to lower audit costs and third quarter 2019 acquisition costs. Higher 2019 audit costs were largely due to the transition period audit required due to the change in the Company’s fiscal year-end.
Other expenses for the three and nine-month period ended September 30, 2020 decreased compared to September 30, 2019, largely due to lower merger-related expenses.
Income Taxes. Income tax expense was $1,267 and $3,309 for the three and nine months ended September 30, 2020 compared to $430 and $2,252 for the three and nine months ended September 30, 2019. The impact of higher non-taxable municipal income in 2019 was offset by higher non-deductible merger costs, netting to approximately the same effective tax rates in both periods.
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BALANCE SHEET ANALYSIS
Cash and Cash Equivalents. Cash and cash equivalents increased to $115.5 million at September 30, 2020 from $55.8 million at December 31, 2019. Deposit levels remain robust, while the Bank experienced loan growth primarily due to SBA PPP loan originations and chose to modestly shrink the investment portfolio due to current low yielding investment options. As such, the Company has chosen to maintain a higher level of liquidity.
Investment Securities. We manage our securities portfolio to provide liquidity and enhance income. Our investment portfolio is comprised of securities available for sale and securities held to maturity. In the first quarter, the Bank sold approximately $10.7 million of fixed-rate mortgage-backed certificates, (“MBS”) and these were replaced with similar, lower premium MBS.
Securities available for sale, which represent the majority of our investment portfolio, were $150.9 million at September 30, 2020, compared with $180.1 million at December 31, 2019. The reduction in the AFS portfolio is due to maturities and calls of U.S government agency obligations. The maturities and calls in the corporate asset-based securities in 2020 were replaced with bank holding company issued subordinated debt of which the Bank purchased $7.3 million in the third quarter.
Securities held to maturity increased to $16.9 million at September 30, 2020, compared to $2.9 million at December 31, 2019. This increase was due to the purchase of agency mortgage-backed securities in the first quarter and third quarter of 2020.
The amortized cost and market values of our available for sale securities by asset categories as of the dates indicated below were as follows:
Securities available for sale Amortized
Cost Fair
Value
September 30, 2020
U.S. government agency obligations $ 34,059 $ 34,379
Obligations of states and political subdivisions 140 140
Mortgage-backed securities 49,870 51,758
Corporate debt securities 15,211 15,364
Corporate asset-based securities 36,443 35,543
Trust preferred securities 13,938 13,724
Totals $ 149,661 $ 150,908
December 31, 2019
U.S. government agency obligations $ 52,020 $ 51,805
Obligations of states and political subdivisions 281 281
Mortgage backed securities 70,806 71,331
Corporate debt securities 18,776 18,725
Corporate asset-based securities 27,718 26,854
Trust preferred securities 11,167 11,123
Totals $ 180,768 $ 180,119
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The amortized cost and fair value of our held to maturity securities by asset categories as of the dates noted below were as follows:
Securities held to maturity Amortized
Cost Fair
Value
September 30, 2020
Obligations of states and political subdivisions $ 300 $ 300
Mortgage-backed securities 16,627 16,933
Totals $ 16,927 $ 17,233
December 31, 2019
Obligations of states and political subdivisions $ 300 $ 302
Mortgage-backed securities 2,551 2,655
Totals $ 2,851 $ 2,957
The composition of our available for sale portfolios by credit rating as of the dates indicated below was as follows:
September 30, 2020 December 31, 2019
Available for sale securities Amortized
Cost Fair
Value Amortized
Cost Fair
Value
Agency $ 83,929 $ 86,135 $ 122,826 $ 123,136
AAA 11,185 10,885 4,383 4,245
AA 25,398 24,798 23,475 22,749
A 6,909 7,019 18,776 18,725
BBB 22,240 22,071 11,167 11,123
Non-rated — — 141 141
Total available for sale securities $ 149,661 $ 150,908 $ 180,768 $ 180,119
The composition of our held to maturity portfolio by credit rating as of the dates indicated was as follows:
September 30, 2020 December 31, 2019
Securities held to maturity Amortized
Cost Fair
Value Amortized
Cost Fair
Value
U.S. government agency $ 16,627 $ 16,933 $ 2,551 $ 2,655
AA 125 125 125 126
Non-rated 175 175 175 176
Total $ 16,927 $ 17,233 $ 2,851 $ 2,957
At September 30, 2020, securities with a market value of $1.3 million were pledged against a line of credit with the Federal Reserve Bank of Minneapolis. As of September 30, 2020, this line of credit had a zero-outstanding balance. At September 30, 2020, the Bank has pledged mortgage-backed securities with a market value of $3.9 million and U.S. government agency securities with a market value of $0.6 million as collateral against municipal deposits. At September 30, 2020, the Bank also has mortgage-backed securities with a carrying value of $0.5 million pledged as collateral to the Federal Home Loan Bank of Des Moines.
Loans. Total loans outstanding, net of deferred loan fees and costs and unamortized discount on acquired loans, increased by $53 million, to $1.23 billion as of September 30, 2020, from $1.18 billion at December 31, 2019. This growth was due to the impact of the growth in the SBA PPP origination of $139.2 million, partially offset by the net remaining deferred origination fees of $4.0 million. This growth was partially offset by a reduction in acquired commercial loans and originated loan portfolio. In addition, residential mortgage loans and indirect consumer loans of $36.4 million and $11.0 million, respectively, decreased. The following table reflects the composition, or mix of our loan portfolio at September 30, 2020 and December 31, 2019:
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September 30, 2020 December 31, 2019
Amount Amount
Real estate loans:
Commercial/agricultural real estate
Commercial real estate $ 500,673 $ 514,459
Agricultural real estate 73,143 85,363
Multi-family real estate 109,668 87,008
Construction and land development 89,338 86,410
Residential mortgage
Residential mortgage 141,854 176,332
Purchased HELOC loans 6,547 8,407
Total real estate loans 921,223 957,979
C&I/Agricultural operating and Consumer Installment Loans:
C&I/Agricultural operating
Commercial and industrial (“C&I”) 104,372 133,734
Agricultural operating 33,958 37,780
Consumer installment
Originated indirect paper 28,535 39,585
Other Consumer 14,630 18,186
Total C&I/Agricultural operating and Consumer installment Loans 181,495 229,285
Gross loans before C&I SBA PPP loans 1,102,718 1,187,264
SBA PPP loans 139,166 —
Gross loans $ 1,241,884 $ 1,187,264
Unearned net deferred fees and costs and loans in process (5,033) (393)
Unamortized discount on acquired loans (6,712) (9,491)
Total loans (net of unearned income and deferred expense) 1,230,139 1,177,380
Allowance for loan losses (14,836) (10,320)
Total loans receivable, net $ 1,215,303 $ 1,167,060
Allowance for Loan Losses. The loan portfolio is our primary asset subject to credit risk. To address this credit risk, we maintain an ALL for probable and inherent credit losses through periodic charges to our earnings. These charges are shown in our consolidated statements of operations as PLL. See “Provision for Loan Losses” earlier in this quarterly report. We attempt to control, monitor and minimize credit risk through the use of prudent lending standards, a thorough review of potential borrowers prior to lending and ongoing and timely review of payment performance. Asset quality administration, including early identification of loans performing in a substandard manner, as well as timely and active resolution of problems, further enhances management of credit risk and minimization of loan losses. Any losses that occur and that are charged off against the ALL are periodically reviewed with specific efforts focused on achieving maximum recovery of both principal and interest.
At least quarterly, we review the adequacy of the ALL. Based on an estimate computed pursuant to the requirements of ASC 450-10, “Accounting for Contingencies ” and ASC 310-10, “Accounting by Creditors for Impairment of a Loan ” , the analysis of the ALL consists of three components: (i) specific credit allocation established for expected losses relating to specific impaired loans for which the recorded investment in the loan exceeds its fair value; (ii) general portfolio allocation based on historical loan loss experience for significant loan categories; and (iii) general portfolio allocation based on qualitative factors such as economic conditions and other relevant factors specific to the markets in which we operate. We continue to refine our ALL methodology by introducing a greater level of granularity to our loan portfolio. We currently segregate loans into pools based on common risk characteristics for purposes of determining the ALL. The additional segmentation of the portfolio is intended to provide a more effective basis for the determination of qualitative factors affecting our ALL. In addition, management continually evaluates our ALL methodology to assess whether modifications in our methodology are appropriate in light of underwriting practices, market conditions, identifiable trends, regulatory pronouncements or other factors. We
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believe that any modifications or changes to the ALL methodology would be to enhance the ALL. However, any such modifications could result in materially different ALL levels in future periods.
The specific credit allocation for the ALL is based on a regular analysis of all loans that are considered impaired. In compliance with ASC 310-10, the fair value of the loan is determined based on either the present value of expected cash flows discounted at the loan’s effective interest rate, the market price of the loan, or, if the loan is collateral dependent, the fair value of the underlying collateral less the expected cost of sale for such collateral. At September 30, 2020, the Company had identified impaired loans of $51.7 million, consisting of $19.8 million TDR loans, the carrying amount of purchased credit impaired loans of $23.4 million and $8.5 million of substandard non-TDR loans. The $51.7 million total of impaired loans includes $12.6 million of performing TDR loans. At December 31, 2019, the Company had identified impaired loans of $63.2 million, consisting of $12.6 million TDR loans, the carrying amount of purchased credit impaired loans of $32.0 million and $18.6 million of substandard non-TDR loans. The $63.2 million total of impaired loans includes $5.4 million of performing TDR loans. At September 30, 2020 and December 31, 2019, we had 342 and 389 such impaired loans, respectively, all secured by real estate or personal property. Of the impaired loans, there were 19 individual loans where estimated fair value was less than their book value (i.e. we deemed impairment to exist) totaling $5.3 million for which $1.2 million in specific ALL was recorded as of September 30, 2020.
The allowance for loan and losses increased to $14.8 million at September 30, 2020 representing 1.21% of loans receivable, less the 100% SBA guaranteed PPP loans. A significant portion of the current loan portfolio includes loans purchased through whole bank acquisitions in recent years resulting in purchased credit impairments which are not included in the allowance for loan losses. The Allowance for loan losses was $10.3 million at December 31, 2019, representing 0.88% of loans receivable. The increase in the allowance was due to loan growth, increases in unallocated, increases in specific reserves on impaired loans and continued anticipation of pandemic-related adverse economic impacts, including various “Stay-at-Home Orders” which continued to result in temporary business closures, reduced operating capacity and uncertainty regarding potential future revenue and cash flows for certain businesses, including bank borrowers.
Allowance for Loan Losses to Loans, net of SBA PPP Loans
(in thousands, except ratios)
September 30,
2020 June 30,
2020 December 31,
2019 September 30, 2019
Loans, end of period $ 1,230,139 $ 1,281,175 $ 1,177,380 $ 1,134,708
SBA PPP loans, net of deferred fees (135,177) (132,800) — —
Loans, net of SBA PPP loans and deferred fees $ 1,094,962 $ 1,148,375 $ 1,177,380 $ 1,134,708
Allowance for loan losses $ 14,836 $ 13,373 $ 10,320 $ 9,177
ALL to loans net of SBA PPP loans and deferred fees 1.35 % 1.16 % 0.88 % 0.81 %
ALL to loans, end of period 1.21 % 1.04 % 0.88 % 0.81 %
All of the nine factors identified in the FFIEC’s Interagency Policy Statement on the Allowance for Loan and Lease Losses are taken into account in determining the ALL. The impact of the factors in general categories are subject to change; thus, the allocations are management’s estimate of the loan loss categories in which the probable and inherent loss has occurred as of the date of our assessment. Of the nine factors, we believe the following have the greatest impact on our customers’ ability to repay loans and our ability to recover potential losses through collateral sales: (1) lending policies and procedures; (2) economic and business conditions; and (3) the value of the underlying collateral. As loan balances and estimated losses in a particular loan type decrease or increase and as the factors and resulting allocations are monitored by management, changes in the risk profile of the various parts of the loan portfolio may be reflected in the allocated allowance. The general component covers non-impaired loans and is based on historical loss experience adjusted for these and other qualitative factors. In addition, management continues to refine the ALL estimation process as new information becomes available. These refinements could also cause increases or decreases in the ALL. See Provision for loan losses in the Consolidated Statements of Operations (unaudited) for further details. The unallocated portion of the ALL is intended to account for imprecision in the estimation process or relevant current information that may not have been considered in the process.
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Nonperforming Loans, Potential Problem Loans and Foreclosed Properties. We practice early identification of nonaccrual and problem loans in order to minimize the Bank’s risk of loss. Nonperforming loans are defined as nonaccrual loans and restructured loans that were 90 days or more past due at the time of their restructure, or when management determines that such classification is warranted. The accrual of interest income is discontinued on our loans according to the following schedule:
• Commercial/agricultural real estate loans, past due 90 days or more;
• C&I/Agricultural operating loans, past due 90 days or more;
• Closed ended consumer installment loans past due 120 days or more; and
• Residential mortgage loans and open-ended consumer installment loans past due 180 days or more.
When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on non-accrual loans are used to reduce principal rather than being recorded as interest income. A TDR typically involves the granting of some concession to the borrower involving a loan modification, such as modifying the payment schedule or making interest rate changes. TDR loans may involve loans that have had a charge-off taken against the loan to reduce the carrying amount of the loan to fair market value as determined pursuant to ASC 310-10.
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The following table identifies the various components of nonperforming assets and other balance sheet information as of the dates indicated below and changes in the ALL for the periods then ended:
September 30, 2020 and Nine Months Then Ended December 31, 2019 and Twelve Months Then Ended
Nonperforming assets:
Nonaccrual loans
Commercial real estate $ 2,762 $ 5,705
Agricultural real estate 5,252 7,568
Commercial and industrial 853 1,850
Agricultural operating 1,651 1,702
Residential mortgage 2,536 2,063
Consumer installment 100 168
Total nonaccrual loans $ 13,154 $ 19,056
Accruing loans past due 90 days or more 950 1,104
Total nonperforming loans (“NPLs”) 14,104 20,160
Other real estate owned 756 1,429
Other collateral owned 56 31
Total nonperforming assets (“NPAs”) $ 14,916 $ 21,620
Troubled Debt Restructurings (“TDRs”) $ 19,778 $ 12,594
Accruing TDR's $ 12,579 $ 5,396
Nonaccrual TDRs $ 7,199 $ 7,198
Average outstanding loan balance $ 1,232,678 $ 1,074,952
Loans, end of period $ 1,230,139 $ 1,177,380
Total assets, end of period $ 1,622,593 $ 1,531,249
ALL, at beginning of period $ 10,320 $ 7,604
Loans charged off:
Commercial/Agricultural real estate — (381)
C&I/Agricultural operating (791) —
Residential mortgage (78) (239)
Consumer installment (126) (291)
Total loans charged off (995) (911)
Recoveries of loans previously charged off:
Commercial/Agricultural real estate 149 3
C&I/Agricultural operating 33 1
Residential mortgage 20 5
Consumer installment 59 93
Total recoveries of loans previously charged off: 261 102
Net loans charged off (“NCOs”) (734) (809)
Additions to ALL via provision for loan losses charged to operations 5,250 3,525
ALL, at end of period $ 14,836 $ 10,320
Ratios:
ALL to NCOs (annualized) 1,515.94 % 1,275.65 %
NCOs (annualized) to average loans 0.08 % 0.08 %
ALL to total loans 1.21 % 0.88 %
NPLs to total loans 1.15 % 1.71 %
NPAs to total assets 0.92 % 1.41 %
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The following table shows the detail of non-performing assets by originated and acquired portfolios.
Nonperforming Originated / Acquired Assets
(in thousands, except ratios)
September 30, 2020 and Three Months Ended December 31, 2019 and Three Months Ended September 30, 2019 and Three Months Ended
Nonperforming assets:
Originated nonperforming assets:
Nonaccrual loans $ 3,255 $ 4,285 $ 4,816
Accruing loans past due 90 days or more 698 946 842
Total originated nonperforming loans (“NPL”) 3,953 5,231 5,658
Other real estate owned (“OREO”) 352 441 195
Other collateral owned 56 28 25
Total originated nonperforming assets (“NPAs”) $ 4,361 $ 5,700 $ 5,878
Acquired nonperforming assets:
Nonaccrual loans $ 9,899 $ 14,771 $ 14,206
Accruing loans past due 90 days or more 252 158 257
Total acquired nonperforming loans (“NPL”) 10,151 14,929 14,463
Other real estate owned (“OREO”) 404 988 1,153
Other collateral owned — 3 —
Total acquired nonperforming assets (“NPAs”) $ 10,555 $ 15,920 $ 15,616
Total nonperforming assets (“NPAs”) $ 14,916 $ 21,620 $ 21,494
Loans, end of period $ 1,230,139 $ 1,177,380 $ 1,124,378
Total assets, end of period $ 1,622,593 $ 1,531,249 $ 1,475,364
Ratios:
Originated NPLs to total loans 0.32 % 0.44 % 0.50 %
Acquired NPLs to total loans 0.83 % 1.27 % 1.29 %
Originated NPAs to total assets 0.27 % 0.37 % 0.40 %
Acquired NPAs to total assets 0.65 % 1.04 % 1.06 %
Nonperforming assets decreased by $6.7 million to $14.9 million at September 30, 2020 from December 31, 2019. This decrease is largely due to reductions in acquired non-performing loans. Part of this reduction, included the return to accrual status of nonaccrual acquired loans totaling $1.7 million in the second quarter of 2020, based on their current payment status and history and in accordance with the Bank’s policy. Refer to the “Allowance for Loan Losses” and “Nonperforming Loans, Potential Problem Loans and Foreclosed Properties” sections below for more information related to nonperforming loans.
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Nonaccrual Loans Roll forward:
Quarter Ended
September 30, 2020 June 30, 2020 March 31, 2020 December 31, 2019 September 30, 2019
Balance, beginning of period $ 14,787 $ 16,090 $ 19,056 $ 19,022 $ 13,612
Additions 716 1,907 1,811 2,641 1,493
Acquired nonaccrual loans — — — — 5,898
Charge offs (141) (175) (452) (198) (134)
Transfers to OREO (172) — (1,100) (425) (209)
Return to accrual status (165) (1,702) (120) (14) (53)
Payments received (1,744) (1,292) (2,887) (1,957) (1,539)
Other, net (127) (41) (218) (13) (46)
Balance, end of period $ 13,154 $ 14,787 $ 16,090 $ 19,056 $ 19,022
Nonaccrual TDR loans remained at $7.2 million at both September 30, 2020 and December 31, 2019.
September 30, 2020 December 31, 2019 September 30, 2019
Number of
Modifications Recorded
Investment Number of
Modifications Recorded
Investment Number of
Modifications Recorded
Investment
Troubled debt restructurings: Accrual Status
Commercial/Agricultural real estate 19 $ 5,480 14 $ 1,730 14 $ 2,202
C&I/Agricultural operating 5 3,868 2 366 4 478
Residential mortgage 42 3,178 40 3,233 39 3,137
Consumer installment 7 53 7 67 11 82
Total loans 73 $ 12,579 63 $ 5,396 68 $ 5,899
Classified assets decreased to $32.9 million at September 30, 2020, from $39.9 million at December 31, 2019 largely due to the reduction in nonperforming assets discussed above, with a modest increase in newly classified assets. Nonperforming assets decreased to $14.9 million or 0.92% of total assets at September 30, 2020 compared to $21.6 million or 1.41% of total assets at December 31, 2019. Included in nonperforming assets at September 30, 2020 are $10.6 million of nonperforming assets acquired during recent whole-bank acquisitions.
The table below shows a summary of the decrease in substandard loans by quarter since the first impact of the F&M acquisition on September 30, 2019 levels. While special mention loans increased in the first quarter of 2020 and more modestly in the second quarter of 2020, the balances decreased in the third quarter of 2020 due to resolution. See Note 3, “Loans, Allowance for Loan Losses and Impaired Loans” for additional information.
(in thousands)
September 30,
2020 June 30,
2020 March 31,
2020 December 31,
2019 September 30, 2019
Special mention loan balances $ 7,777 $ 19,958 $ 19,387 $ 10,856 $ 12,959
Substandard loan balances 32,922 35,911 38,393 39,892 38,527
Criticized loans, end of period $ 40,699 $ 55,869 $ 57,780 $ 50,748 $ 51,486
Hotels and restaurants represent our portfolio’s two industry sectors most directly and adversely affected by the recent pandemic and related government actions. These sector loans totaled approximately $102 million and $39 million, respectively at September 30, 2020. The weighted-average loan-to-value percentage and debt service coverage ratio on these hotel industry sector loans was 58% and 2.2 times. Approximately $18 million of restaurant sector loans are to franchise quick-service restaurants.
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As of September 30, 2020, the Bank had $126.7 million of loan modifications remaining due to pandemic-related borrower requests. Approximately $50 million of modifications are scheduled to resume their regular principal and interest payments in the fourth quarter. Hotel industry sector loans represent approximately $70 million of the approved deferrals projected at December 31, 2020. Of these, $48 million represent a second deferral under the CARES ACT, with the customer making an interest only payment and the Bank generally receives the reserve accounts pledge. While the Company has no indication that any of the modified credits are specifically impaired, additional risk and uncertainty inherent in the current pandemic-affected environment has been considered. See “Allowance for Loan Losses” section above for discussion of pandemic-related qualitative factor, and related provision for loan losses.
The table below shows the changes in the Bank’s non-accretable difference on purchased credit impaired loans. Payoffs of purchased credit impaired loans, including selected nonaccrual loans discussed above resulted in associated non-accretable differences being realized as interest income as shown below. The Bank has transferred non-accretable difference on purchased credit impaired loans to accretable loan discount as collateral coverage improved sufficiently, due to a combination of principal paydowns and/or improving collateral positions. This transferred accretion is accreted over the remaining contractual term of the loan or until payoff, whichever is shorter.
Non-accretable Difference:
(in thousands)
September 30,
2020 June 30,
2020 March 31,
2020 December 31,
2019 September 30, 2019
Non-accretable difference, beginning of period $ 3,355 $ 4,327 $ 6,290 $ 6,737 $ 3,889
Additions to non-accretable difference for acquired purchased credit impaired loans — — — (170) 2,898
Non-accretable difference realized as interest from payoffs of purchased credit impaired loans (130) (196) (1,043) (271) (50)
Transfers from non-accretable difference to accretable discount. (1,294) (741) (669) — —
Non-accretable difference used to reduce loan principal balance (270) (35) — — —
Non-accretable difference transferred to OREO due to loan foreclosure — — (251) (6) —
Non-accretable difference, end of period $ 1,661 $ 3,355 $ 4,327 $ 6,290 $ 6,737
Mortgage Servicing Rights. Mortgage servicing rights (“MSR”) assets are initially measured at fair value; assessed at least quarterly for impairment; carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value. MSR assets are amortized in proportion to and over the period of estimated net servicing income, with the amortization recorded in non-interest expense in the consolidated statement of operations. The valuation of MSRs and related amortization thereon are based on numerous factors, assumptions and judgments, such as those for: changes in the mix of loans, interest rates, prepayment speeds, and default rates. Changes in these factors, assumptions and judgments may have a material effect on the valuation and amortization of MSRs. Although management believes that the assumptions used to evaluate the MSRs for impairment are reasonable, future adjustment may be necessary if future economic conditions differ substantially from the economic assumptions used to determine the value of MSRs.
The fair market value of the Company’s MSR asset decreased from $4.3 million at December 31, 2019 to $3.5 million at September 30, 2020, primarily due to $1.4 million of impairment recorded on the MSR asset due to the impact of higher prepayment activity and partially offset by increased capitalized servicing on newly sold mortgage originations. The unpaid balances of one- to four-family residential real estate loans serviced for others as of September 30, 2020 and December 31, 2019 were $555.7 million and $524.7 million, respectively. The fair market value of the Company’s MSR asset as a percentage of its servicing portfolio at September 30, 2020 and December 31, 2019 was 0.63% and 0.82%, respectively.
Deposits. Deposits increased $75.0 million to $1.271 billion at September 30, 2020, from $1.196 billion at December 31, 2019. The strong non-maturity deposit growth allowed the Company to reduce reliance on higher cost brokered and institutional deposits. This planned reduction in brokered and institutional deposits resulted in a reduction to $3.3 million at September 30, 2020 from $50.4 million at December 31, 2019. Additionally, retail certificates of deposit decreased by $28 million as the Company chose not to match higher rate local retail certificate competition.
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The following is a summary of deposits by type at September 30, 2020 and December 31, 2019, respectively:
September 30, 2020 December 31, 2019
Non-interest bearing demand deposits $ 229,217 $ 168,157
Interest bearing demand deposits 279,648 223,102
Savings accounts 191,511 156,599
Money market accounts 246,651 246,430
Certificate accounts 323,751 401,414
Total deposits $ 1,270,778 $ 1,195,702
Federal Home Loan Bank (FHLB) advances (borrowings) and Other Borrowings. FHLB advances were $124.5 million as of September 30, 2020 and $131.0 million as of December 31, 2019, as we continue to utilize these advances, as necessary, to supplement core deposits to meet our funding and liquidity needs, and as we evaluate all options to manage the Bank’s cost of funds. The Bank has an irrevocable Standby Letter of Credit Master Reimbursement Agreement with the Federal Home Loan Bank. This irrevocable standby letter of credit (“LOC”) is supported by loan collateral as an alternative to directly pledging investment securities on behalf of a municipal customer as collateral for their interest-bearing deposit balances. The Bank’s current unused borrowing capacity, supported by loan collateral as of September 30, 2020 is approximately $105.9 million.
In the quarter ended June 30, the Bank’s origination of SBA PPP loans allowed the Bank to gain access to the Federal Reserve Bank Paycheck Protection Program Liquidity Facility (“PPPLF”), whereby the Bank can pledged SBA PPP loans, by day of origination, up to the contractual maturity of the Bank’s SBA PPP loans with no collateral haircut. The Bank borrowed twice under this facility in the second quarter of 2020. Due to the strong growth in non-maturity deposits discussed above, the Bank had no outstanding borrowings under this facility at June 30, 2020 or at any time during the quarter ending September 30, 2020. The Bank could borrow $139.2 million under this facility in 2020.
During the first quarter of 2020, the Bank added $12.5 million of 10-year maturity advances that can be called or replaced by the FHLB on a quarterly basis, beginning approximately three months from the initial advance. At September 30, 2020 and December 31, 2019, the Bank had $55 million and $42.5 million, respectively, of these 10-year, three-month callable advances.
In the first quarter of 2020, the Bank extended overnight advances with $5 million maturing in each quarter of 2023 and 2024, and $5 million maturing in the first quarter of 2025. See Note 7, “Federal Home Loan Bank and Federal Reserve Bank Advances and Other Borrowings” for more information.
At September 30, 2020, the Bank has pledged $682.0 million of loans to secure the current FHLB outstanding advances, letters of credit and to provide the unused borrowing capacity compared to $792.9 million of loans pledged at December 31, 2019.
In August 2020, the Company issued ten-year, 6% fixed to floating subordinated notes totaling $15 million. The notes have a five-year non-call feature.
Stockholders’ Equity. Total stockholders’ equity increased to $157.3 million at September 30, 2020 from $150.6 million at December 31, 2019, largely due to net income of $9.2 million. This increase was offset by the annual cash dividend paid to common stockholders of $2.4 million during the first quarter of 2020. Additionally, during the first quarter, the Company repurchased 156,000 shares of its common stock at a cost of $1.8 million under the Company’s stock buyback authorization. On March 20, 2020, the Company announced the Board of Directors had suspended this stock buyback authorization and on July 27, 2020, the Board of Directors terminated the stock buyback authorization, which was previously scheduled to expire on September 30, 2020.
Liquidity and Asset / Liability Management . Our primary sources of funds are deposits; amortization, prepayments and maturities of outstanding loans; short-term investments; and borrowings. We use our sources of funds primarily to meet ongoing commitments, to pay non-renewing, maturing certificates of deposit and savings withdrawals, and to fund loan commitments. We have enhanced our liquidity monitoring and updated what we consider to be sources of on-balance sheet cash. We consider our interest-bearing cash and unpledged investment securities to be our sources of on-balance sheet liquidity. At September 30, 2020, our on-balance sheet liquidity ratio was 16.2%. While scheduled payments from the amortization of loans and maturing short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are influenced by factors partially outside of the Bank’s control, including general interest rates, economic conditions and competition. Although $216.9 million of our $323.8 million (67%) CD portfolio as of September 30, 2020 will mature within the next 12 months, we have historically retained a majority of our maturing CD’s. However, due to strategic pricing decisions
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regarding rate matching and branch closures, our retention rate may decrease in the future. Through new deposit product offerings to our branch and commercial customers, we are currently attempting to strengthen customer relationships to attract additional non-rate sensitive deposits. In our present interest rate environment, and based on maturing yields, this is intended to also reduce our cost of funds.
We maintain access to additional sources of funds including FHLB borrowings and lines of credit with the Federal Reserve Bank and correspondent banks We utilize FHLB borrowings to leverage our capital base, to provide funds for our lending and investment activities, and to manage our interest rate risk. Our borrowing arrangement with the FHLB calls for pledging certain qualified real estate loans and borrowing up to 75% of the value of those loans, not to exceed 35% of the Bank’s total assets. As of September 30, 2020, we had approximately $105.9 million available under this arrangement, supported by loan collateral, as compared to $203.9 million at December 31, 2019. In the quarter ended June 30, 2020, the Bank’s origination of SBA PPP loans allowed the Bank to gain access to the Federal Reserve’s PPPLF facility, whereby the Bank can pledge SBA PPP loans, by day of origination, up to the contractual maturity of the Bank’s SBA PPP loans with no collateral haircut. Due to the strong growth in non-maturity deposits discussed above, the Bank had no outstanding borrowing under this facility at June 30, 2020 or at any time during the quarter ended September 30, 2020. The Bank could borrow $139.2 million under this facility at September 30, 2020. As the SBA PPP loans are forgiven, the collateral will reduce and our borrowing capacity under this facility will be reduced.
We maintain a line of credit with the Federal Reserve Bank which has a $1.0 million capacity, based on our current pledged collateral position. Additionally, we have $25.0 million of uncommitted federal funds purchased lines of credit, as well as a $5.0 million revolving line of credit which is available as needed for general liquidity purposes.
In reviewing our adequacy of liquidity, we review and evaluate historical financial information, including information regarding general economic conditions, current ratios, management goals and the resources available to meet our anticipated liquidity needs. Management believes that our liquidity is adequate, and, to management’s knowledge, there are no known events or uncertainties that will result or are likely to reasonably result in a material increase or decrease in our liquidity.
Off-Balance Sheet Liabilities . Some of our financial instruments have off-balance sheet risk. These instruments include unused commitments for lines of credit, overdraft protection lines of credit and home equity lines of credit, as well as commitments to extend credit. As of September 30, 2020, the Company had $260.8 million in unused commitments, compared to $246.7 million in unused commitments as of December 31, 2019.
Capital Resources. As of September 30, 2020, as shown in the table below, the Bank’s Tier 1 and Risk-based capital levels exceeded levels necessary to be considered “Well Capitalized” under Prompt Corrective Action provisions.
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Below are the amounts and ratios for our capital levels as of the dates noted below for the Bank.
Actual For Capital Adequacy
Purposes To Be Well Capitalized
Under Prompt Corrective
Action Provisions
Amount Ratio Amount Ratio Amount Ratio
As of September 30, 2020 (Unaudited)
Total capital (to risk weighted assets) $ 170,610 15.0 % $ 91,021 > = 8.0 % $ 113,776 > = 10.0 %
Tier 1 capital (to risk weighted assets) 156,388 13.7 % 68,266 > = 6.0 % 91,021 > = 8.0 %
Common equity tier 1 capital (to risk weighted assets) 156,388 13.7 % 51,199 > = 4.5 % 73,955 > = 6.5 %
Tier 1 leverage ratio (to adjusted total assets) 156,388 9.9 % 63,465 > = 4.0 % 79,331 > = 5.0 %
As of December 31, 2019 (Audited)
Total capital (to risk weighted assets) $ 160,302 13.1 % $ 98,174 > = 8.0 % $ 122,718 > = 10.0 %
Tier 1 capital (to risk weighted assets) 149,982 12.2 % 73,631 > = 6.0 % 98,174 > = 8.0 %
Common equity tier 1 capital (to risk weighted assets) 149,982 12.2 % 55,223 > = 4.5 % 79,767 > = 6.5 %
Tier 1 leverage ratio (to adjusted total assets) 149,982 10.4 % 57,834 > = 4.0 % 72,293 > = 5.0 %
At September 30, 2020, the Bank was categorized as “Well Capitalized” under Prompt Corrective Action Provisions, as determined by the OCC, our primary regulator.
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Below are the amounts and ratios for our capital levels as of the dates noted below for the Company.
Actual For Capital Adequacy
Purposes To Be Well Capitalized
Under Prompt Corrective
Action Provisions
Amount Ratio Amount Ratio Amount Ratio
As of September 30, 2020 (Unaudited)
Total capital (to risk weighted assets) $ 163,250 14.3 % $ 91,021 > = 8.0 % N/A N/A
Tier 1 capital (to risk weighted assets) 119,028 10.5 % 68,266 > = 6.0 % N/A N/A
Common equity tier 1 capital (to risk weighted assets) 119,028 10.5 % 51,199 > = 4.5 % N/A N/A
Tier 1 leverage ratio (to adjusted total assets) 119,028 7.5 % 63,465 > = 4.0 % N/A N/A
As of December 31, 2019 (Audited)
Total capital (to risk weighted assets) $ 137,259 11.2 % $ 98,174 > = 8.0 % N/A N/A
Tier 1 capital (to risk weighted assets) 111,939 9.1 % 73,631 > = 6.0 % N/A N/A
Common equity tier 1 capital (to risk weighted assets) 111,939 9.1 % 55,223 > = 4.5 % N/A N/A
Tier 1 leverage ratio (to adjusted total assets) 111,939 7.7 % 57,834 > = 4.0 % N/A N/A
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.