FARMERS & MERCHANTS BANCORP 10-Q

Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations The following is management’s discussion and analysis of the major factors that influenced our financial performance for the three and nine months ended September 30, 2020. This analysis should be read in conjunction with our 2019 Annual Report to Shareholders on Form 10-K, and with the unaudited financial statements and notes as set forth in this report. Forward–Looking Statements This Form 10-Q contains various forward-looking statements, usually containing the words “estimate,” “project,” “expect,” “objective,” “goal,” or similar expressions and includes assumptions concerning Farmers & Merchants Bancorp’s (together with its subsidiaries, the “Company” or “we”) operations, future results, and prospects. These forward-looking statements are based upon current expectations and are subject to risks and uncertainties. In connection with the “safe-harbor” provisions of the Private Securities Litigation Reform Act of 1995, the Company provides the following cautionary statement identifying important factors which could cause the actual results of events to differ materially from those set forth in or implied by the forward-looking statements and related assumptions. Such factors include, but are not limited to, the following: (1) economic conditions in the Central Valley of California; (2) significant changes in interest rates and loan prepayment speeds; (3) credit risks of lending and investment activities; (4) changes in federal and state banking laws or regulations; (5) competitive pressure in the banking industry; (6) changes in governmental fiscal or monetary policies; (7) uncertainty regarding the economic outlook resulting from the continuing war on terrorism, as well as actions taken or to be taken by the U.S. or other governments as a result of further acts or threats of terrorism; (8) water management issues in California and the resulting impact on the Company’s agricultural customers; (9) expansion into new geographic markets and new lines of business; (10) the impact of COVID-19 on the Company and its customers (see COVID-19 Disclosure below); and (11) other factors discussed in Item 1A. Risk Factors located in the Company’s 2019 Annual Report on Form 10-K. Readers are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date hereof. The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made. COVID-19 (Coronavirus) Disclosure In an attempt to slow the accelerating spread of COVID-19, on March 16, 2020 the first cities and counties in Northern California were place under “shelter-in-place” orders. By March 19th, the Governor had placed the entire state under these orders. In June 2020 these orders were substantially lifted, but then on July 13, 2020, due to a significant increase in reported COVID-19 cases, the orders were reinstated in most California counties, including those in which the Company operates. The Governor has now developed guidelines as to when a given county can re-open certain business and other activities but all counties in which the Company operates remain under some level of restrictions. Businesses have been designated as “essential” or “non-essential.” Non-essential businesses have either been closed or had the scope of their activities significantly reduced. The economic impact of this situation has already been severe, and continuing restrictions will only exacerbate the situation. The duration of these restrictions is not known at this time nor is the pace of recovery once they are lifted. Designated as an “essential business”, Farmers & Merchants Bank of Central California has kept all branches open and maintained regular business hours during this difficult time. Our staffing levels have remained stable during the COVID-19 crisis. 36 Table of Contents Impact on the Banking Industry On March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) was signed into law by Congress. The primary impact of this legislation, as well as related federal and state regulatory actions, is as follows: • Paycheck Protection Program (“PPP”) … The Small Business Administration (“SBA”) was directed by Congress to provide loans to small businesses with less than 500 employees to assist these businesses in meeting their payroll and other financial obligations over the next several months. These government guaranteed loans are made with an interest rate of 1%, a risk weight of 0% under risk-based capital rules, have a term of 2 years, and under certain conditions the SBA can forgive them after eight weeks. Farmers & Merchants Bank of Central California has actively participated in the PPP, and since April, 2020 we have funded $347.4 million of loans for 1,540 of our small business customers. Although these loans carry a nominal interest rate of 1%, the SBA will pay the banks an origination fee of 1-5% depending on the size of the loan. All fees have been capitalized and are being amortized over the life of the loans. The Company has collected $11.3 million in fees from the SBA, and as of September 30, 2020, $2.1 million of these fees have been accreted into income. Since the current assumption is that these loans will be forgiven beginning in October, the income statement impact to the Company in the fourth quarter of 2020 and early 2021 could be significant. • Main Street Lending Program (“MSLP”) … The Federal Reserve Bank is administering a program to provide up to $600 billion of credit to small and medium-sized eligible businesses that were in sound financial condition before COVID-19 and that were either unable to access the PPP or that require additional financial support after receiving a PPP loan. These loans are not forgivable. The MSLP offers loans up to $300 million for businesses with up to 15,000 employees or $5 billion in annual revenues. Terms are five years, interest rate of LIBOR plus 3%, and deferral of principal for two years and interest for one year. If sold, lenders are required to retain 5% of each loan with the remaining 95% sold to the Federal Reserve Bank. The Company has registered as an eligible lender under the MSLP, but has not yet used the program. • Temporary Relief from Troubled Debt Restructurings … The CARES Act provides financial institutions, under specific circumstances, the opportunity to temporarily suspend certain requirements under generally accepted accounting principles related to troubled debt restructurings (“TDR”) for a limited period of time to account for the effects of COVID-19. Farmers & Merchants Bank of Central California has, and continues to, actively work with existing borrowers to restructure loans, primarily for up to six months, moving to either interest only payments or full deferral of principal and interest payments. After the deferral period ends, any deferred amounts would then be added to the final principal balance. We believe that these actions will assist these borrowers in getting through these difficult times, but no guaranties can be made that at some time in the future these loans will not be required to be accounted for as a TDR. Since April 2020 we have restructured $276.9 million of loans under the CARES Act guidelines. The payment status of these loans as of October 31, 2020 is as follows: – $3.1 million have paid-off or paid-down; – $157.8 million have resumed full principal and interest payments; – $91.9 million are making interest only payments; and – $24.1 million remain in full payment deferral. As of September 30, 2020, accrued interest receivable on these loans totals $3.6 million, with only $505,000 of that amount related to borrowers that remain in full payment deferral. At the current time, the Company believes its accrued interest is collectible, but continues to monitor each borrower. • Foreclosure Actions … The CARES Act restricts the ability of financial institutions to exercise their foreclosure rights on residential and multi-family properties backed by federally guaranteed mortgage loans. The State of California has gone further and temporarily suspended all residential and commercial foreclosures through January 31, 2021. The Company is working with its borrowers when they make requests to defer payments on their mortgage loans. • CECL Implementation Deferral … The Company was originally scheduled to implement ASU 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“CECL”) as of January 1, 2020. The CARES Act provides the election to defer CECL implementation until December 31, 2020 or when the national emergency ends, whichever comes first. In addition, the national banking regulators have issued a joint statement allowing financial institutions to mitigate the effects of CECL in their regulatory capital calculations for up to two years. The Company has elected to delay CECL implementation. • Paycheck Protection Program Liquidity Facility (“PPPLF”) … The Federal Reserve Bank has developed a loan program to neutralize the liquidity impact to financial institutions of funding loans made under the PPP. Banks may pledge their PPP loans on a non-recourse basis and borrow against these loans for a period of up to two years at a fixed rate of .35%. Furthermore, since these FRB borrowings are on a non-recourse basis, the loans will not be counted under the calculation of leverage capital ratios. Since Farmers & Merchants Bank of Central California has significant liquidity at the current time, no borrowings have been made under the PPPLF. The Company has until December 31, 2020 to borrow under this facility. 37 Table of Contents Impact on Farmers & Merchants Bancorp and Farmers & Merchants Bank of Central California The Company is exposed to the following COVID-19 risks and uncertainties: • We may not be able to maintain staff levels in order to operate key activities of our business. • Our earnings may be affected by borrowers that cannot make payments on their loans. We have credit exposure to industries that have been impacted by either: (1) the public’s changing habits in response to the risks of COVID-19 (e.g., hotels, movie theaters, health clubs and restaurants); or (2) continuing levels of “shelter-in-place” orders imposed by local, state and federal officials (e.g., small businesses determined to be “non-essential”). • Our liquidity position may be affected as a result of significant and unusual deposit outflows or loan drawdowns. However, from a financial perspective, as reflected by the following September 30, 2020 measures, we remain in a strong financial position which should continue to assist us in responding to the risks of COVID-19: • Liquidity consisting of $300 million of Fed Funds Sold and $638 million of Investment Securities; • Strong Asset Quality as reflected by only $498,000 of non-performing loans, and a negligible delinquency ratio of .036% of total loans; • Risk Based Capital Ratio of 13.12%; • Allowance for Credit Losses of $56.8 million or 2.05% of total loans and leases (exclusive of government guaranteed SBA PPP loans); and • ROAA of 1.40% and ROAE of 14.40% in third quarter 2020. Our credit exposure to the “Hospitality” (primarily hotels) and “Entertainment” (primarily restaurants, health clubs and movie theaters) industries totals $147.4 million in loans and leases outstanding at September 30, 2020. This represents 4.7% of total loans and leases outstanding and 35.1% of total shareholders’ equity, both measures that are thought to be reasonable when compared to peers. Most of these loans: (1) were underwritten with an original LTV of 50-70% on the underlying real estate, providing us what should be adequate collateral coverage; and (2) have financially strong guarantors with liquidity that provides additional protection. Over and above the impact on the Hospitality and Entertainment industries, there has been a general economic slowdown as a result of the continuing levels of “shelter-in-place” orders. The Central Valley of California may be in a better position than other areas to weather this impact because agricultural activity has substantially continued. We are monitoring the impact on our borrowers, and working closely with them using all of the tools at our disposal, including the SBA PPP program, the FRB Main Street Lending Program and other loan restructuring strategies, to help them move through this period of reduced business activity. Since April 2020, we have restructured $276.9 million of loans under the CARES Act guidelines (primarily payment or interest deferrals up to six months). We believe that these actions will assist these borrowers in getting through these difficult times, but no guaranties can be made that at some time in the future these loans will not be required to be accounted for as a TDR. Although we continue to believe that our 2020 financial performance will, in all likelihood, be negatively impacted over the next three months by sustained low interest rates and the potential for increased borrower stress, the full extent of this impact cannot be determined at this time. Additionally, these negative impacts may be somewhat mitigated by the fees paid by the SBA under the PPP. We believe that we are well positioned to move through this difficult period with sustained profitability. Introduction Farmers & Merchants Bancorp, or the Company, is a bank holding company formed March 10, 1999. Its subsidiary, Farmers & Merchants Bank of Central California, or the Bank, is a California state-chartered bank formed in 1916. Banking services are provided in twenty-nine full-service branches and three stand-alone ATM’s in the Company's service area. The service area includes Sacramento, San Joaquin, Stanislaus, Merced, Contra Costa, Napa, and Solano Counties with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto, Turlock, Hilmar, Merced, Manteca, Riverbank, Napa, Walnut Creek, Concord, Rio Vista, Walnut Grove and Lockeford. 38 Table of Contents As a bank holding company, the Company is subject to regulation and examination by the Board of Governors of the Federal Reserve System (“FRB”). The Bank is a California state-chartered non-FRB member bank subject to the regulation and examination by the Department of Financial Protection and Innovation (“DFPI”) and the Federal Deposit Insurance Corporation (“FDIC”). Overview Although the Company has initiated efforts to expand its geographic footprint into the East Bay area of San Francisco and Napa, California (see Item 1: Business – Service Area located in the Company’s 2019 Annual Report on Form 10-K), the Company’s primary service area remains the mid Central Valley of California. Accordingly, discussion of the Company’s Financial Condition and Results of Operations is influenced by the seasonal banking needs of its agricultural customers (e.g., during the spring and summer customers draw down their deposit balances and increase loan borrowing to fund the purchase of equipment and planting of crops. Correspondingly, deposit balances are replenished and loans repaid in late fall and winter as crops are harvested and sold). The State of California experienced drought conditions from 2013 through most of 2016. Since 2016, reasonable levels of rain and snow have alleviated drought conditions in California. As a result, reservoir levels are normal and the availability of water in our primary service area should not be an issue. However, these recent weather patterns further reinforce the fact that the long-term risks associated with the availability of water are significant. For the three and nine months ended September 30, 2020, Farmers & Merchants Bancorp reported net income of $14,810,000 and $43,241,000, earnings per share of $18.66 and $54.49 and return on average assets of 1.40% and 1.44%, respectively. Return on average shareholders’ equity was 14.40% and 14.54% for the three and nine months ended September 30, 2020. For the three and nine months ended September 30, 2019, Farmers & Merchants Bancorp reported net income of $13,738,000 and $41,392,000, earnings per share of $17.45 and $52.64 and return on average assets of 1.58% and 1.61%, respectively. Return on average shareholders’ equity was 15.76% and 16.52% for the three and nine months ended September 30, 2019. The following is a summary of the financial results for the nine-month period ended September 30, 2020, compared to September 30, 2019: • Net income increased 4.5% to $43.2 million from $41.4 million. • Earnings per share increased 3.5% to $54.49 from $52.64. • Total assets increased 20.5% to $4.3 billion from $3.6 billion. • Total loans & leases increased 18.9% to $3.1 billion from $2.6 billion. • Total deposits increased 21.5% to $3.8 billion from $3.1 billion. The primary reasons for the Company’s $1.8 million or 4.5% increase in net income in the first nine months of 2020 as compared to the same period of 2019 were: • A $3.7 million increase in net interest income related to the growth in earning assets. • A $2.2 million decrease in the legal fees. • A $368,000 decrease in FDIC insurance expense. • A decrease in the tax provision from 25.6% to 24.4%. These positive impacts were partially offset by: • A $1.1 million increase in salaries and employee benefits. • A $787,000 decrease in service charges collected on deposit accounts. • A $1.8 million increase in the provision for credit losses. • A $1.1 million increase in other non-interest expense. 39 Table of Contents Results of Operations Net Interest Income / Net Interest Margin The tables on the following pages reflect the Company's average balance sheets and volume and rate analysis for the three and nine-month periods ended September 30, 2020 and 2019. The average yields on earning assets and average rates paid on interest-bearing liabilities have been computed on an annualized basis for purposes of comparability with full year data. Average balance amounts for assets and liabilities are the computed average of daily balances. Net interest income is the amount by which the interest and fees on loans & leases and other interest-earning assets exceed the interest paid on interest-bearing sources of funds. For the purpose of analysis, the interest earned on tax-exempt investments and municipal loans is adjusted to an amount comparable to interest subject to normal income taxes. This adjustment is referred to as “tax equivalent” adjustment and is noted wherever applicable. The presentation of net interest income and net interest margin on a tax equivalent basis is a common practice within the banking industry. The Volume and Rate Analysis of Net Interest Income summarizes the changes in interest income and interest expense based on changes in average asset and liability balances (volume) and changes in average rates (rate). For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to: (1) changes in volume (change in volume multiplied by initial rate); (2) changes in rate (change in rate multiplied by initial volume); and (3) changes in rate/volume, also called “changes in mix” (allocated in proportion to the respective volume and rate components). The Company’s earning assets and rate sensitive liabilities are subject to repricing at different times, which exposes the Company to income fluctuations when interest rates change. In order to minimize income fluctuations, the Company attempts to match asset and liability maturities. However, some maturity mismatch is inherent in the asset and liability mix. See “Item 3. Quantitative and Qualitative Disclosures about Market Risk – Interest Rate Risk.” 40 Table of Contents Farmers & Merchants Bancorp Quarterly Average Balances and Interest Rates (Interest and Rates on a Taxable Equivalent Basis) (in thousands) Three Months Ended Sept 30, 2020 Three Months Ended Sept 30, 2019 Assets Balance Interest Rate Balance Interest Rate Interest Bearing Deposits with Banks $ 314,049 $ 81 0.10 % $ 255,335 $ 1,396 2.17 % Investment Securities: U.S. Treasuries 27,423 89 1.29 % 21,445 114 2.13 % U.S. Govt SBA 9,167 24 1.05 % 12,665 71 2.24 % Government Agency & Government-Sponsored Entities - - - 2,418 18 2.98 % Municipals - Taxable 19,966 156 3.13 % 6,545 86 5.26 % Obligations of States and Political Subdivisions - Non-Taxable (1) 49,452 521 4.22 % 52,985 484 3.65 % Mortgage Backed Securities 430,145 2,567 2.39 % 282,305 1,832 2.60 % Other 25,477 53 0.83 % 4,726 38 3.22 % Total Investment Securities 561,630 3,410 2.43 % 383,089 2,643 2.76 % Loans & Leases: (2) Real Estate 1,952,892 24,193 4.93 % 1,790,970 23,339 5.17 % Home Equity Lines & Loans 37,815 423 4.45 % 39,820 605 6.03 % Agricultural 263,706 3,365 5.08 % 288,085 4,089 5.63 % Commercial 362,880 4,377 4.80 % 378,210 5,131 5.38 % Consumer 12,261 190 6.16 % 16,284 266 6.48 % Other 348,093 2,415 2.76 % 1,079 7 2.57 % Leases 106,272 1,446 5.41 % 103,247 1,399 5.38 % Total Loans & Leases 3,083,919 36,409 4.70 % 2,617,695 34,836 5.28 % Total Earning Assets 3,959,598 $ 39,900 4.01 % 3,256,119 $ 38,875 4.74 % Unrealized Gain (Loss) on Securities Available-for-Sale 20,960 3,992 Allowance for Credit Losses (55,782 ) (55,045 ) Cash and Due From Banks 61,633 57,094 All Other Assets 244,056 226,769 Total Assets $ 4,230,465 $ 3,488,929 Liabilities & Shareholders' Equity Interest Bearing Deposits: Interest Bearing DDA $ 824,587 $ 383 0.18 % $ 667,687 $ 666 0.40 % Savings and Money Market 1,176,238 594 0.20 % 930,490 886 0.38 % Time Deposits 468,072 1,034 0.88 % 524,076 1,840 1.39 % Total Interest Bearing Deposits 2,468,897 2,011 0.32 % 2,122,253 3,392 0.63 % Subordinated Debentures 10,310 83 3.20 % 10,310 138 5.31 % Total Interest Bearing Liabilities 2,479,207 $ 2,094 0.34 % 2,132,563 $ 3,530 0.66 % Interest Rate Spread (3) 3.67 % 4.08 % Demand Deposits (Non-Interest Bearing) 1,279,142 947,854 All Other Liabilities 60,812 59,765 Total Liabilities 3,819,161 3,140,182 Shareholders' Equity 411,304 348,747 Total Liabilities & Shareholders' Equity $ 4,230,465 $ 3,488,929 Net Interest Income and Margin on Total Earning Assets (4) 37,806 3.80 % 35,345 4.31 % Tax Equivalent Adjustment (108 ) (65 ) Net Interest Income $ 37,699 3.79 % $ 35,280 4.30 % (1) Yields and interest income are calculated on an fully taxable equivalent basis using the current statutory federal tax rate. (2) Average balances on loans & leases outstanding include non-performing loans, if any. The amortized portion of net loan origination fees is included in interest income on loans & leases, representing an adjustment to the yield. (3) Interest rate spread represents the average yield earned on interest-earning assets minus the average rate paid on interest-bearing liabilities. (4) Net interest margin is computed by calculating the difference between interest income and interest expense, divided by the average balance of interest-earning assets. 41 Table of Contents Farmers & Merchants Bancorp Year-to-Date Average Balances and Interest Rates (Interest and Rates on a Taxable Equivalent Basis) (in thousands) Nine Months Ended Sept. 30, 2020 Nine Months Ended Sept. 30, 2019 Assets Balance Interest Rate Balance Interest Rate Interest Bearing Deposits with Banks $ 286,049 $ 1,093 0.51 % $ 212,388 $ 3,682 2.32 % Investment Securities: U.S. Treasuries 19,897 267 1.79 % 30,382 440 1.93 % U.S. Govt SBA 9,799 94 1.28 % 13,995 267 2.54 % Government Agency & Government-Sponsored Entities - - - 2,818 62 2.93 % Municipals - Taxable 11,362 359 4.21 % 6,545 258 5.26 % Obligations of States and Political Subdivisions - Non-Taxable (1) 52,741 1,587 4.01 % 51,474 1,509 3.91 % Mortgage Backed Securities 445,336 8,432 2.52 % 295,524 5,828 2.63 % Other 10,747 64 0.79 % 4,958 148 3.98 % Total Investment Securities 549,882 10,803 2.62 % 405,696 8,512 2.80 % Loans & Leases: (2) Real Estate 1,885,455 71,031 5.03 % 1,777,258 69,588 5.23 % Home Equity Lines & Loans 39,162 1,447 4.94 % 39,810 1,806 6.07 % Agricultural 264,528 10,180 5.14 % 272,498 11,565 5.67 % Commercial 378,272 13,810 4.88 % 365,316 14,679 5.37 % Consumer 13,294 619 6.22 % 17,106 775 6.06 % Other 209,653 3,521 2.24 % 1,079 18 2.23 % Leases 105,880 4,272 5.39 % 105,672 4,297 5.44 % Total Loans & Leases 2,896,244 104,880 4.84 % 2,578,739 102,728 5.33 % Total Earning Assets 3,732,175 $ 116,776 4.18 % 3,196,823 $ 114,922 4.81 % Unrealized Gain (Loss) on Securities Available-for-Sale 16,096 (126 ) Allowance for Credit Losses (55,190 ) (55,113 ) Cash and Due From Banks 61,588 55,897 All Other Assets 238,898 222,670 Total Assets $ 3,993,567 $ 3,420,151 Liabilities & Shareholders' Equity Interest Bearing Deposits: Interest Bearing DDA $ 761,437 $ 1,342 0.24 % $ 661,462 $ 1,792 0.36 % Savings and Money Market 1,091,672 2,280 0.28 % 913,942 2,413 0.35 % Time Deposits 503,319 3,991 1.06 % 518,646 5,120 1.32 % Total Interest Bearing Deposits 2,356,428 7,613 0.43 % 2,094,050 9,325 0.60 % Federal Home Loan Bank Advances 1 - 0.00 % 1 - 0.00 % Subordinated Debentures 10,310 296 3.83 % 10,310 424 5.50 % Total Interest Bearing Liabilities 2,366,739 $ 7,909 0.45 % 2,104,361 $ 9,749 0.62 % Interest Rate Spread (3) 3.73 % 4.19 % Demand Deposits (Non-Interest Bearing) 1,169,333 928,246 All Other Liabilities 61,024 53,380 Total Liabilities 3,597,096 3,085,987 Shareholders' Equity 396,471 334,164 Total Liabilities & Shareholders' Equity $ 3,993,567 $ 3,420,151 Net Interest Income and Margin on Total Earning Assets (4) 108,867 3.90 % 105,173 4.40 % Tax Equivalent Adjustment (327 ) (313 ) Net Interest Income $ 108,540 3.88 % $ 104,860 4.39 % (1) Yields and interest income are calculated on an fully taxable equivalent basis using the current statutory federal tax rate. (2) Average balances on loans & leases outstanding include non-performing loans, if any. The amortized portion of net loan origination fees is included in interest income on loans & leases, representing an adjustment to the yield. (3) Interest rate spread represents the average yield earned on interest-earning assets minus the average rate paid on interest-bearing liabilities. (4) Net interest margin is computed by calculating the difference between interest income and interest expense, divided by the average balance of interest-earning assets. 42 Table of Contents Farmers & Merchants Bancorp Volume and Rate Analysis of Net Interest Revenue (Interest and Rates on a Taxable Equivalent Basis) (in thousands) Three Months Ended Sept. 30, 2020 compared to Sept. 30, 2019 Nine Months Ended Sept. 30, 2020 compared to Sept. 30, 2019 Interest Earning Assets Volume Rate Net Chg. Volume Rate Net Chg. Interest Bearing Deposits with Banks $ 257 $ (1,572 ) $ (1,315 ) $ 976 $ (3,565 ) $ (2,590 ) Investment Securities: U.S. Treasuries 27 (52 ) (25 ) (143 ) (30 ) (172 ) U.S. Govt SBA (17 ) (31 ) (47 ) (65 ) (108 ) (173 ) Government Agency & Government-Sponsored Entities (9 ) (9 ) (18 ) (31 ) (31 ) (62 ) Municipals - Taxable 117 (47 ) 70 160 (59 ) 101 Obligations of States and Political Subdivisions - Non-Taxable (34 ) 72 38 37 41 78 Mortgage Backed Securities 892 (157 ) 735 2,845 (242 ) 2,604 Other 61 (46 ) 15 91 (174 ) (84 ) Total Investment Securities 1,038 (270 ) 768 2,894 (603 ) 2,292 Loans & Leases: Real Estate 1,989 (1,135 ) 854 4,185 (2,742 ) 1,443 Home Equity Lines & Loans (29 ) (153 ) (182 ) (28 ) (330 ) (359 ) Agricultural (334 ) (390 ) (724 ) (328 ) (1,057 ) (1,385 ) Commercial (205 ) (549 ) (754 ) 513 (1,382 ) (869 ) Consumer (63 ) (13 ) (76 ) (177 ) 21 (156 ) Other 2,408 1 2,408 3,503 0 3,503 Leases 38 9 47 9 (34 ) (25 ) Total Loans & Leases 3,804 (2,231 ) 1,573 7,677 (5,525 ) 2,152 Total Earning Assets 5,098 (4,073 ) 1,026 11,547 (9,693 ) 1,854 Interest Bearing Liabilities Interest Bearing Deposits: Interest Bearing DDA 129 (412 ) (283 ) 244 (694 ) (450 ) Savings and Money Market 191 (483 ) (292 ) 425 (557 ) (133 ) Time (181 ) (625 ) (806 ) (147 ) (982 ) (1,129 ) Total Interest Bearing Deposits 139 (1,520 ) (1,381 ) 521 (2,233 ) (1,712 ) Subordinated Debentures - (55 ) (55 ) - (128 ) (128 ) Total Interest Bearing Liabilities 139 (1,575 ) (1,436 ) 521 (2,361 ) (1,840 ) Total Change on a Tax Equivalent Basis $ 4,959 $ (2,497 ) $ 2,462 $ 11,025 $ (7,332 ) $ 3,693 Note: Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total "net change." The above figures have been rounded to the nearest whole number. Third Quarter 2020 vs. Third Quarter 2019 Net interest income for the third quarter of 2020 increased 6.9% or $2.4 million to $37.7 million. On a fully taxable equivalent basis, net interest income increased 7.0% and totaled $37.8 million for the third quarter of 2020. As more fully discussed below, the increase in net interest income was due primarily to a $703.5 million increase in average earning assets offset by a 51 basis point decrease in the net interest margin. Net interest income on a taxable equivalent basis, expressed as a percentage of average total earning assets, is referred to as the net interest margin. For the quarter ended September 30, 2020, the Company’s net interest margin was 3.80% compared to 4.31% for the quarter ended September 30, 2019. This decrease in net interest margin was due primarily to a 73 basis point decrease in yield on earning assets offset somewhat by a 32 basis point decrease in the cost of interest bearing liabilities. Average loans & leases totaled $3.1 billion for the quarter ended September 30, 2020; an increase of $466.2 million compared to the average balance for the quarter ended September 30, 2019. A significant portion of this increase was due to loans funded under the SBA PPP. Since April 2020 we have funded $347.4 million of loans for 1,540 of our small business customers. (See “Management’s Discussion and Analysis - COVID-19 (Coronavirus) Disclosure” for additional information). Loans & leases decreased from 80.4% of average earning assets at September 30, 2019 to 77.9% at September 30, 2020. The annualized yield on the Company’s loan & lease portfolio decreased to 4.70% for the quarter ended September 30, 2020, compared to 5.28% for the quarter ended September 30, 2019. Some of this decrease was due to $347.4 million of PPP loans funded at a rate of 1.00% (plus accreted loan fees) with the remaining decrease due to an overall drop in market interest rates. This lower yield was offset by the positive impact of increased average loan & lease balances resulting in interest revenue from loans & leases to increase by 4.52% to $36.4 million. The Company continues to experience aggressive competitor pricing for loans & leases to which it may need to continue to respond in order to retain key customers. This could place negative pressure on future loan & lease yields and net interest margin. 43 Table of Contents The investment portfolio is the other main component of the Company’s earning assets. Historically, the Company invested primarily in: (1) mortgage-backed securities issued by government-sponsored entities; (2) debt securities issued by the U.S. Treasury, government agencies and government-sponsored entities; and (3) investment grade bank-qualified municipal bonds. However, at certain times the Company has selectively added investment grade corporate securities (floating rate and fixed rate with maturities less than 7 years) to the portfolio in order to obtain yields that exceed government agency securities of equivalent maturity. Since the risk factor for these types of investments is generally lower than that of loans & leases, the yield earned on investments is generally less than that of loans & leases. Average investment securities totaled $561.6 million for the quarter ended September 30, 2020; an increase of $178.5 million compared to the average balance for the quarter ended September 30, 2019. The average investment portfolio yield, on a tax equivalent (TE) basis, was 2.43% for the quarter ended September 30, 2020, compared to 2.76% for the quarter ended September 30, 2019. This overall decrease in yield was caused primarily by a decrease in market interest rates. As a result of the combined impact of mix, balance and yield changes, tax equivalent interest income on securities increased $768,000 to $3.41 million for the quarter ended September 30, 2020, compared to $2.64 million for the quarter ended September 30, 2019. See “Financial Condition – Investment Securities” for a discussion of the Company’s investment strategy in 2020. Net interest income on the Schedule of Year-to-Date Average Balances and Interest Rates is shown on a tax equivalent basis, which is higher than net interest income as reflected on the Consolidated Statements of Income because of adjustments that relate to income on securities that are exempt from federal income taxes. Interest bearing deposits with banks and overnight investments in Federal Funds Sold are additional earning assets available to the Company. Average interest-bearing deposits with banks consisted primarily of FRB deposits. Balances with the FRB earn interest at the Fed Funds rate, which was .10% in September 2020 compared to 1.80% in September 2019. Average interest bearing deposits with banks for the quarter ended September 30, 2020, was $314.0 million, an increase of $58.7 million compared to the average balance for the quarter ended September 30, 2019. Interest income on interest bearing deposits with banks for the quarter ended September 30, 2020, decreased $1.3 million to $81,000 compared to the quarter ended September 30, 2019. Average interest-bearing liabilities increased $346.6 million or 16.3% during the third quarter of 2020. Of that increase: (1) interest-bearing transaction deposits increased $156.9 million; (2) savings and money market deposits increased $245.7 million; (3) time deposits decreased $56.0 million (see “Financial Condition – Deposits”); (4) FHLB advances remained unchanged (see “Financial Condition – Federal Home Loan Bank Advances and Federal Reserve Bank Borrowings”); and (5) subordinated debt remained unchanged (see “Financial Condition – Subordinated Debentures”). A significant portion of this deposit growth was a result of funds from the SBA PPP being deposited into borrower accounts until those funds will be used for operating expenses. Total interest expense on interest bearing deposits was $2.0 million for the third quarter of 2020 as compared to $3.4 million for the third quarter of 2019. The average rate paid on interest-bearing deposits was 0.32% for the third quarter of 2020 compared to 0.63% for the third quarter of 2019. The Company continues to experience aggressive competitor rates on interest bearing deposits which it may need to meet in order to retain key customers. This could place negative pressure on future deposit rates and net interest margin. Nine Months Ended September 30, 2020 vs. Nine Months Ended September 30, 2019 During the first nine months of 2020, net interest income increased 3.51% to $108.5 million, compared to $104.9 million at September 30, 2019. On a fully taxable equivalent basis, net interest income increased 3.51% and totaled $108.9 million at September 30, 2020, compared to $105.2 million at September 30, 2019. The increase in net interest income was primarily due to a $535.4 million increase in average earning assets offset by a 50 basis point decrease in the net interest margin. For the nine months ended September 30, 2020, the Company’s net interest margin was 3.90% compared to 4.40% for the same period in 2019. This decrease in net interest margin was due primarily to a decrease of 0.63% in the yield received on earning assets, offset somewhat by a 17 basis point decrease in the cost of interest bearing liabilities. 44 Table of Contents The average balance of loans & leases increased by $317.5 million for the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019. A significant portion of this increase was due to loans funded under the SBA PPP. Since April 2020 we have funded $347.4 million of loans for 1,540 of our small business customers. (See “Management’s Discussion and Analysis - COVID-19 (Coronavirus) Disclosure” for additional information). The yield on the loan & lease portfolio decreased 49 basis points to 4.84% for the nine months ended September 30, 2020, compared to 5.33% for the nine months ended September 30, 2019. This lower yield offset somewhat the positive impact of increased average loan & lease balances resulting in interest revenue from loans & leases increasing 2.09% or $2.2 million for the first nine months of 2020. Average investment securities were $549.9 million for the nine months ended September 30, 2020, compared to $405.7 million for the same period in 2019. The average tax equivalent yield for the nine months ended September 30, 2020, was 2.62% compared to 2.80% for the nine months ended September 30, 2019. This overall decrease in yield was caused primarily by a decrease in market interest rates. See “Financial Condition – Investment Securities” for a discussion of the Company’s investment strategy in 2020. Net interest income on the Schedule of Year-to-Date Average Balances and Interest Rates is shown on a tax equivalent basis, which is higher than net interest income as reflected on the Consolidated Statements of Income because of adjustments that relate to income on securities that are exempt from federal income taxes. Interest bearing deposits with banks and overnight investments in Federal Funds Sold are additional earning assets available to the Company. Interest bearing deposits with banks consisted primarily of FRB deposits. Balances with the FRB earn interest at the Fed Funds rate, which was .10% in September 2020, compared to 1.80% in September 2019. Average interest bearing deposits with banks for the nine-months ended September 30, 2020, was $286.0 million, an increase of $73.7 million compared to the average balance for the nine-months ended September 30, 2019. Interest income on interest bearing deposits with banks for the nine-months ended September 30, 2020, decreased $2.6 million to $1.1 million compared to the nine-months ended September 30, 2019. Average interest-bearing liabilities increased $262.4 million or 12.5% during the nine months ended September 30, 2020, as compared to the nine months ended September 30, 2019. Of that increase: (1) interest-bearing transaction deposits increased $100 million; (2) savings and money market deposits increased $177.7 million; (3) time deposits decreased $15.3 million (see “Financial Condition – Deposits”); and (4) subordinated debt remained unchanged (see “Financial Condition – Subordinated Debentures”). Total interest expense on interest bearing deposits was $7.6 million for the first nine months of 2020 as compared to $9.3 million for the first nine months of 2019. The average rate paid on interest-bearing deposits was 0.43% in the first nine months of 2020 and 0.60% in the first nine months of 2019. The Company continues to experience aggressive competitor rates on interest bearing deposits, which it may need to meet in order to retain key customers. This could place negative pressure on future deposit rates and net interest margin. Provision and Allowance for Credit Losses As a financial institution that assumes lending and credit risks as a principal element of its business, credit losses will be experienced in the normal course of business. The Company has established credit management policies and procedures that govern both the approval of new loans & leases and the monitoring of the existing portfolio. The Company manages and controls credit risk through comprehensive underwriting and approval standards, dollar limits on loans & leases to one borrower (the term “borrower” is used herein to describe a customer who has entered into either a loan or lease transaction), and by restricting loans & leases made primarily to its principal market area where management believes it is best able to assess the applicable risk. Additionally, management has established guidelines to ensure the diversification of the Company’s credit portfolio such that even within key portfolio sectors such as real estate or agriculture, the portfolio is diversified across factors such as location, building type, crop type, etc. Management reports regularly to the Board of Directors regarding trends and conditions in the loan & lease portfolio and regularly conducts credit reviews of individual loans & leases. Loans & leases that are performing but have shown some signs of weakness are subject to more stringent reporting and oversight. 45 Table of Contents Allowance for Credit Losses The allowance for credit losses is an estimate of probable incurred credit losses inherent in the Company's loan & lease portfolio as of the balance sheet date. The allowance is established through a provision for credit losses, which is charged to expense. Additions to the allowance are expected to maintain the adequacy of the total allowance after credit losses and loan & lease growth. Credit exposures determined to be uncollectible are charged against the allowance. Cash received on previously charged off amounts is recorded as a recovery to the allowance. The overall allowance consists of three primary components: specific reserves related to impaired loans & leases; general reserves for inherent losses related to loans & leases that are not impaired; and an unallocated component that takes into account the imprecision in estimating and allocating allowance balances associated with macro factors. A loan or lease is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the original agreement. Loans & leases determined to be impaired are individually evaluated for impairment. When a loan or lease is impaired, the Company measures impairment based on the present value of expected future cash flows discounted at the loan’s or lease's effective interest rate, except that as a practical expedient, it may measure impairment based on a loan’s or lease's observable market price, or the fair value of the collateral if the loan or lease is collateral dependent. A loan or lease is collateral dependent if the repayment of the loan or lease is expected to be provided solely by the underlying collateral. A restructuring of a loan or lease constitutes a troubled debt restructuring (“TDR”) under ASC 310-40, if the Company for economic or legal reasons related to the borrower's financial difficulties grants a more than insignificant concession to the borrower that it would not otherwise consider. Restructured loans or leases typically present an elevated level of credit risk, as the borrowers are not able to perform according to the original contractual terms. If the restructured loan or lease was current on all payments at the time of restructure and management reasonably expects the borrower will continue to perform after the restructure, management may keep the loan or lease on accrual. Loans & leases that are on nonaccrual status at the time they become TDR, remain on nonaccrual status until the borrower demonstrates a sustained period of performance, which the Company generally believes to be six consecutive months of payments, or equivalent. A loan or lease can be removed from TDR status if it was restructured at a market rate in a prior calendar year and is currently in compliance with its modified terms. However, these loans or leases continue to be classified as impaired and are individually evaluated for impairment. The determination of the general reserve for loans or leases that are collectively evaluated for impairment is based on estimates made by management, to include, but not limited to, consideration of historical losses by portfolio segment, internal asset classifications, and qualitative factors that include economic trends in the Company's service areas, industry experience and trends, geographic concentrations, estimated collateral values, the Company's underwriting policies, the character of the loan & lease portfolio, and probable losses inherent in the portfolio taken as a whole. The Company maintains a separate allowance for each portfolio segment (loan & lease type). These portfolio segments include: (1) commercial real estate; (2) agricultural real estate; (3) real estate construction (including land and development loans); (4) residential 1 st mortgages; (5) home equity lines and loans; (6) agricultural; (7) commercial; (8) consumer & other; and (9) equipment leases. See “Financial Condition – Loans & Leases” for examples of loans & leases made by the Company. The allowance for credit losses attributable to each portfolio segment, which includes both impaired loans & leases and loans & leases that are not impaired, is combined to determine the Company's overall allowance, which is included on the consolidated balance sheet. The Company assigns a risk rating to all loans & leases and periodically performs detailed reviews of all such loans & leases over a certain threshold to identify credit risks and assess overall collectability. For smaller balance loans & leases, such as consumer and residential real estate, a credit grade is established at inception, and then updated only when the loan or lease becomes contractually delinquent or when the borrower requests a modification. For larger balance loans or leases, management monitors and analyzes the financial condition of borrowers and guarantors, trends in the industries in which borrowers operate and the fair values of collateral securing these loans & leases. These credit quality indicators are used to assign a risk rating to each individual loan or lease. These risk ratings are also subject to examination by independent specialists engaged by the Company. The general reserve component of the allowance for credit losses also consists of reserve factors that are based on management’s assessment of the following for each portfolio segment: (1) inherent credit risk; (2) historical losses; and (3) other qualitative factors. These reserve factors are inherently subjective and are driven by the repayment risk associated with each portfolio segment. See “Note 1 Significant Accounting Policies - Allowance for Credit Losses.” In addition, the Company's and Bank's regulators, including the FRB, DFPI and FDIC, as an integral part of their examination process, review the adequacy of the allowance. These regulatory agencies may require additions to the allowance based on their judgment about information available at the time of their examinations. 46 Table of Contents Provision for Credit Losses Changes in the provision for credit losses between years are the result of management’s evaluation, based upon information currently available, of the adequacy of the allowance for credit losses relative to factors such as the credit quality of the loan & lease portfolio, loan & lease growth, current credit losses, and the prevailing economic climate and its effect on borrowers’ ability to repay loans & leases in accordance with the terms of the notes. The State of California experienced drought conditions from 2013 through most of 2016. Since 2016, reasonable levels of rain and snow have alleviated drought conditions in California. As a result, reservoir levels are normal and the availability of water in our primary service area should not be an issue. However, these recent weather patterns further reinforce the fact that the long-term risks associated with the availability of water are significant. The Company made a $2.0 million provision for credit losses during the first nine months of 2020 compared to $200,000 for the same period in 2019. Net charge-offs during the first nine months of 2020 were $214,000 compared to net charge-offs of $512,000 in the first nine months of 2019. See “Overview – Looking Forward: 2020 and Beyond”, “Critical Accounting Policies and Estimates – Allowance for Credit Losses” and “Item 7A. Quantitative and Qualitative Disclosures About Market Risk-Credit Risk” located in the Company’s 2019 Annual Report on Form 10-K. After reviewing all factors above, management concluded that the allowance for credit losses, as of September 30, 2020, and September 30, 2019 were adequate . The table below contains the allowance for credit losses for the three and nine-month periods ended September 2020 and 2019: Three Months Ended September 30, Nine Months Ended September 30, (in thousands) 2020 2019 2020 2019 Balance at Beginning of Period $ 55,058 $ 55,125 $ 55,012 $ 55,266 Charge-Offs (25 ) (235 ) (487 ) (654 ) Recoveries 65 64 273 142 Provision 1,700 - 2,000 200 Balance at End of Period $ 56,798 $ 54,954 $ 56,798 $ 54,954 The table below breaks out current quarter activity by portfolio segment (in thousands): September 30, 2020 Commercial Real Estate Agricultural Real Estate Real Estate Construction Residential 1st Mortgages Home Equity Lines & Loans Agricultural Commercial Consumer & Other Leases Unallocated Total Year-To-Date Allowance for Credit Losses: Beginning Balance- January 1, 2020 $ 11,053 $ 15,128 $ 1,949 $ 855 $ 2,675 $ 8,076 $ 11,466 $ 456 $ 3,162 $ 192 $ 55,012 Charge-Offs - - - - (7 ) - (426 ) (54 ) - - (487 ) Recoveries - - - 49 65 54 80 25 - - 273 Provision 13,236 (6,336 ) (381 ) 45 (617 ) (3,458 ) (1,127 ) (63 ) (248 ) 949 2,000 Ending Balance- September 30, 2020 $ 24,289 $ 8,792 $ 1,568 $ 949 $ 2,116 $ 4,672 $ 9,993 $ 364 $ 2,914 $ 1,141 $ 56,798 Third Quarter Allowance for Credit Losses: Beginning Balance- July 1, 2020 $ 21,423 $ 9,021 $ 1,452 $ 1,771 $ 2,239 $ 4,790 $ 10,043 $ 359 $ 2,800 $ 1,160 $ 55,058 Charge-Offs - - - - - - - (25 ) - - (25 ) Recoveries - - - 3 31 24 - 7 - - 65 Provision 2,866 (229 ) 116 (825 ) (154 ) (142 ) (50 ) 23 114 (19 ) 1,700 Ending Balance- September 30, 2020 $ 24,289 $ 8,792 $ 1,568 $ 949 $ 2,116 $ 4,672 $ 9,993 $ 364 $ 2,914 $ 1,141 $ 56,798 47 Table of Contents The Allowance for Credit Losses at September 30, 2020 increased $1.84 million from September 30, 2019 and increased $1.79 million from December 31, 2019. The Company believes that an allowance of 1.82% of gross loans (2.05% when government guaranteed SBA PPP loans are excluded) provides sufficiently for our exposure at the current time. Changes to the reserve during the first nine months of 2020 are due to changes in the underlying credit quality of the loan portfolio. Overall: (1) reserves for “Agricultural” and “Agricultural Real Estate” loans (which are currently thought to have more limited COVID-19 loss exposure since agricultural activity has substantially continued) have been reduced significantly; (2) reserves for Commercial Real Estate (where our COVID-19 exposure is thought to be greater since many of these borrowers have been impacted by “non-essential” designations and “shelter-in-place” orders) have been increased significantly; and (3) the “Unallocated” reserve has been increased. See “Management’s Discussion and Analysis - COVID-19 (Coronavirus) Disclosure” for additional information of the Company’s COVID-19 exposure. See “Management’s Discussion and Analysis - Financial Condition – Classified Loans & Leases and Non-Performing Assets” for further discussion regarding these loan categories. See “Note 5. Allowance for Credit Losses” for additional details regarding the provision and allowance for credit losses. Non-Interest Income Non-interest income includes: (1) service charges and fees from deposit accounts; (2) net gains and losses from investment securities; (3 ) increases in the cash surrender value of bank owned life insurance; (4) debit card and ATM fees; (5) net gains and losses on non-qualified deferred compensation plans; and (6) fees from other miscellaneous business services. Third Quarter 2020 vs. Third Quarter 2019 Non-interest income increased $565,000 or 14.2% for the three months ended September 30, 2020, compared to the same period of 2019. This increase was primarily due to: (1) a $159,000 increase related Debit Card and ATM fees; and (2) a $815,000 increase in the net gain on deferred compensation investments (Balances in non-qualified deferred compensation plans may be invested in financial instruments whose market value fluctuates based upon trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest income, an offsetting entry is also required to be made to non-interest expense resulting in no effect on the Company’s net income). This increase was partially offset by: (1) a $304,000 decrease in Service Charges on Deposit Accounts; (2) a $64,000 decrease resulting from the net gain on the sale of leases during the third quarter of the prior year (2019); and (3) a decrease of 47,000 in dividends received from the FHLB. Nine Months Ended September 30, 2020 vs. Nine Months Ended September 30, 2019 Non‑interest income decreased $1.9 million or 14.5% for the nine months ended September 30, 2020, compared to the same period of 2019. This decrease was primarily due to: (1) a $787,000 decrease in service charges collected on deposit accounts resulting from the Bank complying with the Governor of California’s request that banks not charge overdraft and other fees during the early stages of the COVID-19 crisis; and (2) a $1.2 million decrease in the net gain on deferred compensation investments (Balances in non-qualified deferred compensation plans may be invested in financial instruments whose market value fluctuates based upon trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest income, an offsetting entry is also required to be made to non-interest expense resulting in no effect on the Company’s net income). Non-Interest Expense Non-interest expense for the Company includes expenses for: (1) salaries and employee benefits; (2) net gains and losses on non-qualified deferred compensation plan investments; (3) occupancy; (4) equipment; (5) supplies; (6) legal fees; (7) professional services; (8) data processing; (9) marketing; (10) deposit insurance; (11) ORE carrying costs and gains/losses on sale; and (12) other miscellaneous expenses. Third Quarter 2020 vs. Third Quarter 2019 Overall, non-interest expense decreased $73,000 or 4.0% for the three months ended September 30, 2020, compared to the same period in 2019. This decrease was primarily comprised of: (1) a $715,000 decrease in salaries and employee benefits; and (2) a $577,000 decrease in legal expenses. These decreases were partially offset by a $815,000 increase in the net gain on deferred compensation investments (Balances in non-qualified deferred compensation plans may be invested in financial instruments whose market value fluctuates based upon trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest income, an offsetting entry is also required to be made to non-interest expense resulting in no effect on the Company’s net income). 48 Table of Contents Nine Months Ended September 30, 2020 vs. Nine Months Ended September 30, 2019 Non-interest expense decreased $1.5 million or 2.4% for the nine months ended September 30, 2020, compared to the same period of 2019. This decrease was primarily comprised of: (1) a $2.2 million decrease in legal expenses; and (2) a $1.2 million decrease in the net gain on deferred compensation investments (Balances in non-qualified deferred compensation plans may be invested in financial instruments whose market value fluctuates based upon trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest income, an offsetting entry is also required to be made to non-interest expense resulting in no effect on the Company’s net income). These decreases were partially offset by; (1) a $1.1 million increase in salaries and employee benefits; and (2) a $453,000 increase in occupancy and equipment. Income Taxes The Bank’s provision for income taxes increased 6.1% to $4.9 million for the third quarter of 2020 compared to the third quarter of 2019. The Company’s effective tax rate for the third quarter of 2020 was 25.03% compared to 25.33% for the third quarter of 2019. The Company’s effective tax rate fluctuates from quarter to quarter due primarily to changes in the mix of taxable and tax-exempt earning sources. The effective rates were lower than the combined Federal and State statutory rate of 30% due primarily to benefits regarding the cash surrender value of life insurance; credits associated with low income housing tax credit investments (LIHTC); and tax-exempt interest income on municipal securities and loans. Financial Condition This section discusses material changes in the Company’s consolidated balance sheet at September 30, 2020, as compared to December 31, 2019, and to September 30, 2019. As previously discussed (see “Overview”), the Company’s consolidated financial condition can be influenced by the seasonal banking needs of its agricultural customers. Investment Securities and Federal Funds Sold The investment portfolio provides the Company with an income alternative to loans & leases. The debt securities in the Company’s investment portfolio have historically been comprised primarily of: (1) mortgage-backed securities issued by federal government-sponsored entities; (2) debt securities issued by US Treasury, government agencies and government-sponsored entities; and (3) investment grade bank-qualified municipal bonds. However, at certain times, the Company has selectively added investment grade corporate securities (floating rate and fixed rate with maturities less than 7 years) to the portfolio in order to obtain yields that exceed government agency securities of equivalent maturity without subjecting the Company to the interest rate risk associated with mortgage-backed securities. The Company’s investment portfolio at September 30, 2020, was $638.4 million compared to $567.6 million at the end of 2019, an increase of $70.8 million or 12.5%. At September 30, 2019, the investment portfolio totaled $553.3 million. The Company uses its investment portfolio to help balance its overall interest rate risk. Accordingly, when market rates are increasing it invests most of its funds in shorter term Treasury and Agency securities or shorter term (10, 15 and 20 year) mortgage backed securities. Conversely, when rates are falling, 30 year mortgage backed securities or longer term Treasury and Agency securities may be increased. The Company's total investment portfolio currently represents 14.8% of the Company’s total assets as compared to 15.3% at December 31, 2019, and 15.5% at September 30, 2019. As of September 30, 2020, the Company held $70 million of municipal investments, all classified as HTM. Of this balance, $26.4 million were bank-qualified municipal bonds, and $43.6 million were private placement municipal bonds, warrants, and CRA qualified investments in our service area. In order to comply with Section 939A of the Dodd-Frank Act, the Company performs its own credit analysis on new purchases of municipal bonds. As of September 30, 2020, the Company’s bank-qualified municipal bond portfolio was rated at either the issue or issuer level, and all of these ratings are “investment grade.” The Company monitors the status of all municipal investments, and at the current time does not believe any of them to be exhibiting financial problems that could result in a loss in any individual security. 49 Table of Contents Not included in the investment portfolio are interest bearing deposits with banks and overnight investments in Federal Funds Sold. Interest bearing deposits with banks consisted of FRB deposits. The FRB currently pays interest on the deposits that banks maintain in their FRB accounts, whereas historically banks had to sell these Federal Funds to other banks in order to earn interest. Since balances at the FRB are effectively risk free, the Company elected to maintain its excess cash at the FRB. Interest bearing deposits with banks totaled $299.6 million at September 30, 2020, $223.2 million at December 31, 2019, and $150.9 million at September 30, 2019. The Company classifies its investments in securities as held-to-maturity ("HTM”), trading, or available-for-sale (“AFS”). Securities are classified as HTM and are carried at amortized cost when the Company has the intent and ability to hold the securities to maturity. Trading securities are securities acquired for short-term appreciation and are carried at fair value, with unrealized gains and losses recorded in non-interest income. As of September 30, 2020, December 31, 2019, and September 30, 2019, there were no securities in the trading portfolio. Securities classified as AFS include securities, which may be sold to effectively manage interest rate risk exposure, prepayment risk, satisfy liquidity demands and other factors. These securities are reported at fair value with aggregate, unrealized gains or losses excluded from income and included as a separate component of shareholders’ equity, net of related income taxes. Loans & Leases Loans & leases can be categorized by borrowing purpose and use of funds. Common examples of loans & leases made by the Company include: Commercial and Agricultural Real Estate - These are loans secured by farmland, commercial real estate, multifamily residential properties, and other non-farm, non-residential properties generally within our market area. Commercial mortgage term loans can be made if the property is either income producing or scheduled to become income producing based upon acceptable pre-leasing, and the income will be the Bank's primary source of repayment for the loan. Loans are made both on owner occupied and investor properties; generally do not exceed 15 years (and may have pricing adjustments on a shorter timeframe); have debt service coverage ratios of 1.00 or better with a target of greater than 1.25; and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk in the loan. Real Estate Construction - These are loans for development and construction (the Company generally requires the borrower to fund the land acquisition) and are secured by commercial or residential real estate. These loans are generally made only to experienced local developers with whom the Bank has a successful track record; for projects in our service area; with Loan To Value (LTV) below 75%; and where the property can be developed and sold within 2 years. Commercial construction loans are made only when there is a written take-out commitment from the Bank or an acceptable financial institution or government agency. Most acquisition, development and construction loans are tied to the prime rate or LIBOR with an appropriate spread based on the amount of perceived risk in the loan. Residential 1 st Mortgages - These are loans primarily made on owner occupied residences; generally underwritten to income and LTV guidelines similar to those used by FNMA and FHLMC; however, we will make loans on rural residential properties up to 40 acres. Most residential loans have terms from ten to twenty years and carry fixed rates priced off of treasury rates. The Company has always underwritten mortgage loans based upon traditional underwriting criteria and does not make loans that are known in the industry as “subprime,” “no or low doc,” or “stated income.” Home Equity Lines and Loans - These are loans made to individuals for home improvements and other personal needs. Generally, amounts do not exceed $250,000; Combined Loan To Value (CLTV) does not exceed 80%; FICO scores are at or above 670; Total Debt Ratios do not exceed 43%; and in some situations the Company is in a 1 st lien position. Agricultural - These are loans and lines of credit made to farmers to finance agricultural production. Lines of credit are extended to finance the seasonal needs of farmers during peak growing periods; are usually established for periods no longer than 12 to 36 months; are often secured by general filing liens on livestock, crops, crop proceeds and equipment; and are most often tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan. Term loans are primarily made for the financing of equipment, expansion or modernization of a processing plant, or orchard/vineyard development; have maturities from five to seven years; and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk in the loan. 50 Table of Contents Commercial - These are loans and lines of credit to businesses that are sole proprietorships, partnerships, LLC’s and corporations. Lines of credit are extended to finance the seasonal working capital needs of customers during peak business periods; are usually established for periods no longer than 12 to 24 months; are often secured by general filing liens on accounts receivable, inventory and equipment; and are most often tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan. Term loans are primarily made for the financing of equipment, expansion or modernization of a plant or purchase of a business; have maturities from five to seven years; and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk in the loan. Consumer - These are loans to individuals for personal use, and primarily include loans to purchase automobiles or recreational vehicles, and unsecured lines of credit. The Company has a very minimal consumer loan portfolio, and loans are primarily made as an accommodation to deposit customers. Leases - These are leases to businesses or individuals, for the purpose of financing the acquisition of equipment. They can be either “finance leases” where the lessee retains the tax benefits of ownership but obtains 100% financing on their equipment purchases; or “true tax leases” where the Company, as lessor, places reliance on equipment residual value and in doing so obtains the tax benefits of ownership. Leases typically have a maturity of three to ten years, and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk. Credit risks are underwritten using the same credit criteria the Company would use when making an equipment term loan. Residual value risk is managed through the use of qualified, independent appraisers that establish the residual values the Company uses in structuring a lease. The Company accounts for leases with Investment Tax Credits (ITC) under the deferred method as established in ASC 740-10. ITC are viewed and accounted for as a reduction of the cost of the related assets and presented as deferred income on the Company’s financial statement. See “Item 3. Quantitative and Qualitative Disclosures About Market Risk-Credit Risk” for a discussion about the credit risks the Company assumes and its overall credit risk management practices. Each loan or lease type involves risks specific to the: (1) borrower; (2) collateral; and (3) loan & lease structure. See “Results of Operations - Provision and Allowance for Credit Losses” for a more detailed discussion of risks by loan & lease type. The Company’s current underwriting policies and standards are designed to mitigate the risks involved in each loan & lease type. The Company’s policies require that loans & leases are approved only to those borrowers exhibiting a clear source of repayment and the ability to service existing and proposed debt. The Company’s underwriting procedures for all loan & lease types require careful consideration of the borrower, the borrower’s financial condition, the borrower’s management capability, the borrower’s industry, and the economic environment affecting the loan or lease. Most loans & leases made by the Company are secured, but collateral is the secondary or tertiary source of repayment; cash flow is our primary source of repayment. The quality and liquidity of collateral are important and must be confirmed before the loan is made. In order to be responsive to borrower needs, the Company prices loans & leases: (1) on both a fixed rate and adjustable rate basis; (2) over different terms; and (3) based upon different rate indices; as long as these structures are consistent with the Company’s interest rate risk management policies and procedures. See “Item 3. Quantitative and Qualitative Disclosures About Market Risk-Interest Rate Risk” for further details. Overall, the Company's loan & lease portfolio at September 30, 2020, totaled $3.1 billion, an increase of $494.8 million or 18.9% over September 30, 2019. This increase has occurred as a result of: (1) the Company’s business development efforts directed toward credit-qualified borrowers; (2) expansion of our service area into the East Bay of San Francisco and Napa; and (3) the origination of $347.4 million of PPP loans (See “Management’s Discussion and Analysis - COVID-19 (Coronavirus) Disclosure” for additional information of the Company’s COVID-19 exposure). No assurances can be made that this growth in the loan & lease portfolio will continue, and it is anticipated that the majority of the PPP loans will be forgiven by the SBA in the fourth quarter of 2020 and early 2021. Loans & leases at September 30, 2020 increased $438.9 million from $2.7 billion at December 31, 2019. 51 Table of Contents The following table sets forth the distribution of the loan & lease portfolio by type and percent as of the periods indicated. Loan & Lease Portfolio September 30, 2020 December 31, 2019 September 30, 2019 (in thousands) $ % $ % $ % Commercial Real Estate $ 887,999 28.4 % $ 846,486 31.6 % $ 824,283 31.5 % Agricultural Real Estate 639,172 20.4 % 625,767 23.3 % 617,310 23.5 % Real Estate Construction 186,623 6.0 % 115,644 4.3 % 98,662 3.8 % Residential 1st Mortgages 293,489 9.4 % 255,253 9.5 % 255,394 9.7 % Home Equity Lines and Loans 35,875 1.1 % 39,270 1.5 % 39,490 1.5 % Agricultural 252,031 8.1 % 292,904 10.9 % 289,182 11.0 % Commercial 367,052 11.7 % 384,795 14.4 % 381,774 14.6 % Consumer & Other (1) 359,697 11.5 % 15,422 0.6 % 16,871 0.6 % Leases 105,511 3.4 % 104,470 3.9 % 100,784 3.8 % Total Gross Loans & Leases 3,127,449 100.0 % 2,680,011 100.0 % 2,623,750 100.0 % Less: Unearned Income 15,518 6,984 6,628 Subtotal 3,111,931 2,673,027 2,617,122 Less: Allowance for Credit Losses 56,798 55,012 54,954 Net Loans & Leases $ 3,055,133 $ 2,618,015 $ 2,562,168 (1) Includes PPP loans. Classified Loans & Leases and Non-Performing Assets All loans & leases are assigned a credit risk grade using grading standards developed by bank regulatory agencies. See “Results of Operations - Provision and Allowance for Credit Losses” for more detail on risk grades. The Company utilizes the services of a third-party independent loan review firm to perform evaluations of individual loans & leases and review the credit risk grades the Company places on loans & leases. Loans & leases that are judged to exhibit a higher risk profile are referred to as “classified” and these loans & leases receive increased management attention. As of September 30, 2020, classified loans totaled $20.8 million compared to $16.2 million at December 31, 2019, and $15.3 million at September 30, 2019. Classified loans & leases with higher levels of credit risk can be further designated as “impaired” loans & leases. A loan or lease is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the original agreement. See “Results of Operations - Provision and Allowance for Credit Losses” for further details. Impaired loans & leases consist of: (1) non-accrual loans & leases; and/or (2) restructured loans & leases that are still performing (i.e., accruing interest). Non-Accrual Loans & leases - Accrual of interest on loans & leases is generally discontinued when a loan or lease becomes contractually past due by 90 days or more with respect to interest or principal. When loans & leases are 90 days past due, but in management's judgment are well secured and in the process of collection, they may not be classified as non-accrual. When a loan or lease is placed on non-accrual status, all interest previously accrued but not collected is reversed. Income on such loans & leases is then recognized only to the extent that cash is received and where the future collection of principal is probable. At September 30, 2020, non-accrual loans & leases totaled $498,000. There were no non-accrual loans & leases at December 31, 2019 or September 30, 2019. Restructured Loans & Leases - A restructuring of a loan or lease constitutes a TDR under ASC 310-40, if the Company for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider. Restructured loans or leases typically present an elevated level of credit risk as the borrowers are not able to perform according to the original contractual terms. If the restructured loan or lease was current on all payments at the time of restructure and management reasonably expects the borrower will continue to perform after the restructure, management may keep the loan or lease on accrual. Loans & leases that are on nonaccrual status at the time they become TDR loans or leases, remain on nonaccrual status until the borrower demonstrates a sustained period of performance, which the Company generally believes to be six consecutive months of payments, or equivalent. A loan or lease can be removed from TDR status if it was restructured at a market rate in a prior calendar year and is currently in compliance with its modified terms. However, these loans or leases continue to be classified as impaired and are individually evaluated for impairment. 52 Table of Contents As of September 30, 2020, restructured loans & leases on accrual totaled $7.9 million as compared to $12.1 million at December 31, 2019, and $12 million at September 30, 2019. Since April 2020, we have restructured $276.9 million of loans under the CARES Act guidelines (primarily payment or interest deferrals up to six months). As of September 30, 2020, $103.8 million of these loans remain in a deferral status, the other loans having returned to making principal and/or interest payments. By October 31, 2020, the loans still in a deferral status had dropped to $24.1 million. We believe that these actions will assist these borrowers in getting through these difficult times, but no guaranties can be made that at some time in the future these loans will not be required to be accounted for as a TDR. Other Real Estate - Loans where the collateral has been repossessed are classified as other real estate ("ORE") or, if the collateral is personal property, the loan is classified as other assets on the Company's financial statements. The following table sets forth the amount of the Company's non-performing loans & leases (defined as non-accrual loans & leases plus accruing loans & leases past due 90 days or more) and ORE as of the dates indicated. Non-Performing Assets (in thousands) September 30, 2020 Dec. 31, 2019 September 30, 2019 Non-Performing Loans & Leases $ 498 $ - $ - Other Real Estate 873 873 873 Total Non-Performing Assets $ 1,371 $ 873 $ 873 Non-Performing Loans & Leases as a % of Total Loans & Leases 0.2 % 0 % 0 % Restructured Loans & Leases (Performing) $ 7,890 $ 12,105 $ 12,010 Although management believes that non-performing loans & leases are generally well-secured and that potential losses are provided for in the Company’s allowance for credit losses, there can be no assurance that future deterioration in economic conditions and/or collateral values will not result in future credit losses. Specific reserves of $92,400, $0, and $0 have been established for non-performing loans & leases at September 30, 2020, December 31, 2019 and September 30, 2019, respectively. Foregone interest income on non-accrual loans & leases, which would have been recognized during the period, if all such loans & leases had been current in accordance with their original terms, totaled $15,530, $0, and $0 at September 30, 2020 , December 31, 2019, and September 30, 2019, respectively . The Company reported $873,000 of ORE at September 30, 2020 , December 31, 2019, and September 30, 2019 . Except for: (i) those classified and non-performing loans & leases discussed above; and (ii) those loans modified under the COVID-19 guidelines of the CARES Act. the Company’s management is not aware of any loans & leases as of September 30, 2020, for which known financial problems of the borrower would cause serious doubts as to the ability of these borrowers to materially comply with their present loan or lease repayment terms, or any known events that would result in the loan or lease being designated as non-performing at some future date. However: • The State of California experienced drought conditions from 2013 through most of 2016. Since 2016, reasonable levels of rain and snow have alleviated drought conditions in California. As a result, reservoir levels are normal and the availability of water in our primary service area should not be an issue. However, these recent weather patterns further reinforce the fact that the long-term risks associated with the availability of water are significant. • The agricultural industry is facing challenges associated with: (1) downward pressures on commodity prices (somewhat offset by higher yields); (2) tight labor markets and higher wages due to legislative changes at the state and federal levels; and (3) proposed changes in immigration policy and the resulting impact on the labor pool. • In an attempt to slow the accelerating spread of COVID-19, on March 16, 2020 the first cities and counties in Northern California were placed under “shelter-in-place” orders. By March 19th, the Governor had placed the entire state under these orders. In June, these orders were substantially lifted, but then on July 13, 2020, due to a significant increase in reported COVID-19 cases, the orders were reinstated in most California counties, including those in which the Company operates. The Governor has now developed guidance as to when a given county can re-open certain business and other activities, but all counties in which the Company operates remain under some level of restriction. Businesses have been designated as “essential” or “non-essential.” Non-essential businesses have either been closed or had the scope of their activities significantly reduced. Unemployment has increased. The economic impact of this situation has already been severe, and continuing restrictions will only exacerbate the situation. The duration of these restrictions is not known at this time nor is the pace of recovery once they are lifted, therefore, the Company cannot determine the ultimate impact on classified and non-performing loans and leases (see “Part I, Item 2. COVID-19 (Coronavirus) Disclosure)”. 53 Table of Contents See “Part I, Item 1A. Risk Factors” in the Company’s 2019 Annual Report on Form 10-K, and “Management’s Discussion and Analysis - COVID-19 (Coronavirus) Disclosure” for additional information of the Company’s COVID-19 exposure. Deposits One of the key sources of funds to support earning assets is the generation of deposits from the Company’s customer base. The ability to grow the customer base, and subsequently deposits, is a significant element in the performance of the Company. The Company's deposit balances at September 30, 2020, have increased $675.4 million or 21.5% compared to September 30, 2019. In addition to the Company’s ongoing business development activities for deposits, the following factors positively impacted year-over-year deposit growth: (1) the Company’s strong financial results and position and F&M Bank’s reputation as one of the most safe and sound banks in its market area; (2) the Company’s expansion of its service area into Walnut Creek, Concord and Napa; and (3) borrowers under the PPP depositing loan proceeds into their deposit accounts until those funds are used for operating expenses. The Company continues to experience significant competitive pressures on deposit rates. The Company remains selective in how they respond to competitor rates, which may impact future deposit growth. Although total deposits have increased 21.5% since September 30, 2019, importantly, low cost transaction accounts have grown at a strong pace as well: • Demand and interest-bearing transaction accounts increased $488.2 million or 29.3% since September 30, 2019. • Savings and money market accounts have increased $253.2 million or 26.7% since September 30, 2019. • Time deposit accounts have decreased $66 million or 12.5% since September 30, 2019. The Company's deposit balances at September 30, 2020, have increased $536.8 million or 16.4% compared to December 31, 2019. Demand and interest-bearing transaction accounts increased by $387.8 million or 22.0%, savings and money market deposits increased 20.8% or $206.6 million while time deposit accounts decreased by $57.6 million or 11.1%. This decrease in time deposit accounts was due to the Company’s decision not to renew $57 million in higher rate public funds time deposit accounts from the State of California. Deposit trends in the first six-to-nine months of the year can be impacted by the seasonal needs of our agricultural customers. Federal Home Loan Bank Advances and Federal Reserve Bank Borrowings Lines of credit with the Federal Reserve Bank and the Federal Home Loan Bank are other key sources of funds to support earning assets. These sources of funds are also used to manage the Company’s interest rate risk exposure, and as opportunities arise, to borrow and invest the proceeds at a positive spread through the investment portfolio. There were no FHLB Advances at September 30, 2020, December 31, 2019, or September 30, 2019. There were no Federal Funds purchased or advances from the FRB at September 30, 2020, December 31, 2019, or September 30, 2019. As of September 30, 2020, the Company has additional borrowing capacity of $613.9 million with the Federal Home Loan Bank and $446.3 million with the Federal Reserve Bank. Any borrowings under these lines would be collateralized with loans that have been accepted for pledging at the FHLB and FRB. 54 Table of Contents Long-Term Subordinated Debentures On December 17, 2003, the Company raised $10 million through an offering of trust-preferred securities (“TPS”). See Note 12 located in “Item 8. Financial Statements and Supplementary Data” of the Company’s 2019 Annual Report on Form 10-K. Although this amount is reflected as subordinated debt on the Company’s balance sheet, under current regulatory guidelines, our TPS will continue to qualify as regulatory capital (See “Capital”). These securities accrue interest at a variable rate based upon 3-month LIBOR plus 2.85%. Interest rates reset quarterly and were 3.10% as of September 30, 2020, 4.75% at December 31, 2019, and 4.99% at September 30, 2019. The average rate paid for these securities for the first nine months of 2020 was 3.83% and 5.50% for the first nine months of 2019. Additionally, if the Company decided to defer interest on the subordinated debentures, the Company would be prohibited from paying cash dividends on the Company’s common stock. Capital The Company relies primarily on capital generated through the retention of earnings to satisfy its capital requirements. The Company engages in an ongoing assessment of its capital needs in order to support business growth and to insure depositor protection. Shareholders’ Equity totaled $416.9 million at September 30, 2020, $369.3 million at December 31, 2019, and $355.7 million at September 30, 2019. The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain actions by regulators that, if undertaken, could have a material effect on the Company and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. The minimum capital level requirements applicable to the Company and the Bank are: (i) a common equity Tier 1 capital ratio of 4.5% of risk-weighted assets (“RWA”); (ii) a Tier 1 capital ratio of 6% of RWA; (iii) a total capital ratio of 8% of RWA; and (iv) a Tier 1 leverage ratio of 4% of total assets. A "capital conservation buffer" of 2.5% above each of the regulatory minimum capital ratios, which would result in the following minimum ratios: (i) a common equity Tier 1 capital ratio of 7.0% of RWA; (ii) a Tier 1 capital ratio of 8.5% of RWA; and (iii) a total capital ratio of 10.5% of RWA. An institution will be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. The Company’s subordinated debentures issued in 2003 continue to be counted as Tier 1 capital. The Company believes that it is currently in compliance with all of these capital requirements and that they did not result in any restrictions on the Company’s business activity. In addition, the most recent notification from the FDIC 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 Bank’s category. (in thousands) Actual Current Regulatory Capital Requirements Well Capitalized Under Prompt Corrective Action The Company: Amount Ratio Amount Ratio Amount Ratio As of September 30, 2020 Total Capital Ratio $ 441,352 13.12 % $ 269,091 8.0 % N/A N/A Common Equity Tier 1 Capital Ratio $ 389,121 11.57 % $ 151,364 4.5 % N/A N/A Tier 1 Capital Ratio $ 399,121 11.87 % $ 201,819 6.0 % N/A N/A Tier 1 Leverage Ratio $ 399,121 9.50 % $ 168,097 4.0 % N/A N/A 55 Table of Contents (in thousands) Actual Current Regulatory Capital Requirements Well Capitalized Under Prompt Corrective Action The Bank: Amount Ratio Amount Ratio Amount Ratio As of September 30, 2020 Total Capital Ratio $ 440,879 13.11 % $ 269,037 8.0 % $ 336,297 10.0 % Common Equity Tier 1 Capital Ratio $ 398,656 11.85 % $ 151,334 4.5 % $ 218,593 6.5 % Tier 1 Capital Ratio $ 398,656 11.85 % $ 201,778 6.0 % $ 269,037 8.0 % Tier 1 Leverage Ratio $ 398,656 9.49 % $ 168,034 4.0 % $ 210,043 5.0 % Loans originated under the SBA’s PPP are assigned a risk-weighting of 0% so they have no impact on the Company’s RBC ratios. However, they are fully includable in the tier 1 leverage capital ratio calculation, which has resulted in a short-term reduction in that ratio (until the PPP loans are forgiven). Had the Company not participated in the PPP program, the net result would have been a 86 basis point improvement to the September 30, 2020 tier 1 leverage capital ratio, increasing the ratio to 10.36%. As previously discussed (see “Long-Term Subordinated Debentures”), in order to supplement its regulatory capital base, during December 2003 the Company issued $10 million of trust preferred securities. On March 1, 2005, the Federal Reserve Board issued its final rule effective April 11, 2005, concerning the regulatory capital treatment of trust preferred securities (“TPS”) by bank holding companies (“BHCs”). Under the final rule BHCs may include TPS in Tier 1 capital in an amount equal to 25% of the sum of core capital net of goodwill. Any portion of trust-preferred securities not qualifying as Tier 1 capital would qualify as Tier 2 capital subject to certain limitations. The Company has received notification from the Federal Reserve Bank of San Francisco that all of the Company’s trust preferred securities currently qualify as Tier 1 capital. The Company is not considered the primary beneficiary of this Trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. In 1998, the Board approved the Company’s first common stock repurchase program. This program has been extended and expanded several times since then, and most recently, on November 6, 2018, the Board of Directors approved an extension of the $20 million stock repurchase program over the three-year period ending December 31, 2021. See “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” of the Company’s 2019 Annual Report on Form 10-K for additional information. There were no stock repurchases during the first nine months of 2020 or 2019. The remaining dollar value of shares that may yet be purchased under the Company’s Common Stock Repurchase Plan is approximately $20 million. On August 5, 2008, the Board of Directors approved a Share Purchase Rights Plan (the “Rights Plan”), pursuant to which the Company entered into a Rights Agreement dated August 5, 2008, with Computershare as Rights Agent. The Rights Plan was set to expire on August 5, 2018. On November 19, 2015, the Board of Directors approved a seven-year extension of the term of the Rights Plan. Pursuant to an Amendment to the Rights Agreement dated February 18, 2016, the term of the Rights Plan was extended from August 5, 2018 to August 5, 2025. The extension of the term of the Rights Plan was intended as a means to continue to guard against abusive takeover tactics and was not in response to any particular proposal. See “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” of the Company’s 2019 Annual Report on Form 10-K for further explanation. During the nine months ended September 30, 2020, the Company issued 523 shares of common stock to the Bank’s non-qualified deferred compensation retirement plans. These shares were issued at a price of $770.00 per share based upon a valuation completed by a nationally recognized bank consulting and advisory firm and in reliance upon the exemption in Section 4(a)(2) of the Securities Act of 1933, as amended, and the regulations promulgated thereunder. The proceeds were contributed to the Bank as equity capital. During the nine months ended September 30, 2019, the Company issued 3,586 shares of common stock to the Bank’s non-qualified defined contribution retirement plans. These shares were issued at a price of $715.00 per share based upon a valuation completed by a nationally recognized bank consulting and advisory firm and in reliance upon the exemption in Section 4(a)(2) of the Securities Act of 1933, as amended, and the regulations promulgated thereunder. The proceeds were contributed to the Bank as equity capital. 56 Table of Contents Critical Accounting Policies and Estimates This “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” is based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. In preparing the Company’s financial statements management makes estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. These judgments govern areas such as the allowance for credit losses, the fair value of financial instruments and accounting for income taxes. For a full discussion of the Company’s critical accounting policies and estimates see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s 2019 Annual Report on Form 10-K. Off Balance Sheet Commitments In the normal course of business, the Company enters into financial instruments with off balance sheet risks in order to meet the financing needs of its customers. These financial instruments consist of commitments to extend credit, letters of credit and other types of financial guarantees. The Company had the following off balance sheet commitments as of the dates indicated. (in thousands) September 30, 2020 December 31, 2019 September 30, 2019 Commitments to Extend Credit $ 969,258 $ 919,982 $ 838,049 Letters of Credit 19,816 20,346 19,960 Performance Guarantees Under Interest Rate Swap Contracts Entered Into Between Our Borrowing Customers and Third Parties 3,797 1,513 2,003 The Company's exposure to credit loss in the event of nonperformance by the other party with regard to standby letters of credit, undisbursed loan commitments, and financial guarantees is represented by the contractual notional amount of those instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. The Company uses the same credit policies in making commitments and conditional obligations as it does for recorded balance sheet items. The Company may or may not require collateral or other security to support financial instruments with credit risk. Evaluations of each customer's creditworthiness are performed on a case-by-case basis. Standby letters of credit are conditional commitments issued by the Company to guarantee performance of or payment for a customer to a third party. Most standby letters of credit are issued for 12 months or less. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Additionally, the Company maintains a reserve for off balance sheet commitments, which totaled $315,000 at September 30, 2020, December 31, 2019, and September 30, 2019. We do not anticipate any material losses as a result of these transactions.