Item 2. Management’s Discussion and Analysis
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
INTRODUCTION
The following discussion and analysis is intended as a review of material changes in and significant factors affecting the financial condition and results of operations of First United Corporation and its consolidated subsidiaries for the periods indicated. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and the notes thereto contained in Item 1 of Part I of this report, as well as the audited consolidated financial statements and related notes included in First United Corporation’s Annual Report on Form 10-K for the year ended December 31, 2022.
Unless the context clearly suggests otherwise, references in this report to “us”, “we”, “our”, and “the Corporation” are to First United Corporation and its consolidated subsidiaries.
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FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Forward-looking statements do not represent historical facts, but are statements about management’s beliefs, plans and objectives about the future, as well as its assumptions and judgments concerning such beliefs, plans and objectives. These statements are evidenced by terms such as "anticipate," "estimate," "should," "expect," "believe," "intend," and similar expressions. Although these statements reflect management’s good faith beliefs and projections, they are not guarantees of future performance and they may not prove true. The beliefs, plans and objectives on which forward-looking statements are based involve risks and uncertainties that could cause actual results to differ materially from those addressed in the forward-looking statements. For a discussion of these risks and uncertainties, see the section of the periodic reports that First United Corporation files with the Securities and Exchange Commission entitled "Risk Factors".
FIRST UNITED CORPORATION
First United Corporation is a Maryland corporation chartered in 1985 and a financial holding company registered with the Board of Governors of the Federal Reserve System (the “FRB”) under the Bank Holding Company Act of 1956, as amended, that elected financial holding company status in 2021. The Corporation’s primary business is serving as the parent company of First United Bank & Trust, a Maryland trust company (the “Bank”), First United Statutory Trust I (“Trust I”) and First United Statutory Trust II (“Trust II” and together with Trust I, “the Trusts”), both Connecticut statutory business trusts, and First United Legacy Advisors, LLC, a Maryland limited liability company (“FULA”). The Trusts were formed for the purpose of selling trust preferred securities that qualified as Tier 1 capital. FULA was formed to provide investment advice and related services, but it is not yet active. The Bank has two consumer finance company subsidiaries- OakFirst Loan Center, Inc., a West Virginia corporation, and OakFirst Loan Center, LLC, a Maryland limited liability company – and two subsidiaries that it uses to hold real estate acquired through foreclosure or by deed in lieu of foreclosure – First OREO Trust, a Maryland statutory trust, and FUBT OREO I, LLC, a Maryland limited liability company. In addition, the Bank owns 99.9% of the limited partnership interests in Liberty Mews Limited Partnership, a Maryland limited partnership formed for the purpose of acquiring, developing and operating low-income housing units in Garrett County, Maryland (“Limited Mews”), and a 99.9% non-voting membership interest in MCC FUBT Fund, LLC, an Ohio limited liability company formed for the purpose of acquiring, developing and operating low-income housing units in Allegany County, Maryland (the “MCC Fund”).
At March 31, 2023, the Corporation’s total assets were $1.9 billion, net loans were $1.3 billion, and deposits were $1.6 billion. Shareholders’ equity at March 31, 2023 was $152.9 million.
The Corporation maintains an Internet site at www.mybank.com on which it makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.
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SELECTED FINANCIAL DATA
The following table sets forth certain selected financial data for the three month periods ended March 31, 2023 and 2022 and is qualified in its entirety by the detailed information and unaudited financial statements, including the notes thereto, included elsewhere in this quarterly report.
As of the three months ended
March 31,
2023
2022
Per Share Data
Basic net income per common share
$
0.66
$
0.86
Diluted net income per common share
$
0.65
$
0.86
Basic book value per common share
$
22.85
$
20.22
Diluted book value per common share
$
22.81
$
20.19
Significant Ratios:
Return on Average Assets (a)
0.94
%
1.31
%
Return on Average Equity (a)
11.87
%
16.49
%
Average Equity to Average Assets
7.90
%
7.94
%
Capital Ratios:
Consolidated Total Capital (to risk weighted assets)
16.15
%
15.67
%
Consolidated Tier 1 Capital (to risk weighted assets)
14.90
%
14.52
%
Consolidated Common Equity Tier 1 Capital (to risk weighted assets)
12.82
%
12.42
%
Consolidated Tier 1 Capital (to average assets)
11.47
%
10.94
%
RESULTS OF OPERATIONS
Overview
Consolidated net income was $4.4 million for the first quarter of 2023 compared to $5.7 million for the first quarter of 2022 and $7.0 million for the fourth quarter of 2022. Basic net income was $0.66 per share and diluted net income was $0.65 per share for the first quarter of 2023, compared to basic and diluted net income per share of $0.86 for the first quarter of 2022.
The decrease in net income year-over-year was primarily driven by a $1.3 million increase in salaries and employee benefits due to an increase in health insurance costs related to increased claims, as well as increased salary expense for new hires, merit increases effective April 1, 2022, and increased incentive compensation. Provision for credit losses increased by $1.0 million due to increased qualitative factors related to the potential impact of inflation and rising rates on the cash flows of borrowers. Data processing expenses increased by $0.1 million, equipment and occupancy expenses increased by $0.1 million and miscellaneous expenses increased by $0.5 million primarily due to increased pension costs. These increases were partially offset by an increase in net interest income of $1.2 million and a decrease in income tax expense of $0.5 million.
Other operating income, including gains, for the first quarter of 2023 was stable when compared to the same period of 2022. Increases in service charges and debit card income were offset by a decrease in wealth management income attributable to the decline in market values of assets under management.
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Operating expenses increased by $2.1 million when comparing the first quarter of 2023 to the first quarter of 2022. This increase was driven largely by a $1.3 million increase in salaries and employee benefits attributable to increased salary expense related to new hires and merit increases effective April 1, 2022, increased health insurance costs associated with unusually high claims and increased incentive payouts. Occupancy, equipment and data processing expenses increased $0.3 million. Other miscellaneous expenses increased $0.5 million due to increases in charitable contributions, consulting fees, Visa processing fees, continuing education fees, mileage reimbursements, fraud related expense, and pension costs, offset by slight reductions in contract labor, legal and professional, telephone expense, investor relations, debit card expense, and miscellaneous loan fees.
The effective income tax rates as a percentage of income for the three-month period ended March 31, 2023 and March 31, 2022 were 23.6% and 25.0%, respectively. The decrease in the tax rate for the period was primarily related to a new low-income housing tax credit investment in 2022 that began generating tax credits during the fourth quarter of 2022 and will continue to generate tax credits in 2023 and future years.
Net Interest Income
Net interest income is our largest source of operating revenue. Net interest income is the difference between the interest that we earn on our interest-earning assets and the interest expense we incur on our interest-bearing liabilities. For analytical and discussion purposes, net interest income is adjusted to a FTE basis to facilitate performance comparisons between taxable and tax-exempt assets by increasing tax-exempt income by an amount equal to the federal income taxes that would have been paid if this income were taxable at the statutorily applicable rate. This is a non-GAAP disclosure and management believes it is not materially different than the corresponding GAAP disclosure.
The tables below summarizes net interest income for the three month periods ended March 31, 2023 and 2022.
Non-GAAP
GAAP
Three Months Ended
Three Months Ended
March 31,
March 31,
(dollars in thousands)
2023
2022
2023
2022
Interest income
$
18,056
$
14,388
$
17,829
$
14,147
Interest expense
3,311
806
3,311
806
Net interest income
$
14,745
$
13,582
$
14,518
$
13,341
Net interest margin %
3.53
%
3.40
%
3.48
%
3.34
%
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The following tables set forth the average balances, net interest income and expense, and average yields and rates of our interest-earning assets and interest-bearing liabilities for the three month period ended March 31 , 2023 and 2022:
Three Months Ended
March 31,
2023
2022
Average
Average
Average
Average
(dollars in thousands)
Balance
Interest
Yield/Rate
Balance
Interest
Yield/Rate
Assets
Loans
$
1,279,547
$
15,457
4.90
%
$
1,168,803
$
12,450
4.32
%
Investment Securities:
Taxable
340,622
1,768
2.11
%
363,155
1,406
1.57
%
Non taxable
26,104
484
7.52
%
28,022
505
7.31
%
Total
366,726
2,252
2.49
%
391,177
1,911
1.98
%
Federal funds sold
40,092
307
3.11
%
53,321
18
0.14
%
Interest-bearing deposits with other banks
5,001
26
2.11
%
5,255
1
0.08
%
Other interest earning assets
1,632
14
3.48
%
1,029
8
3.15
%
Total earning assets
1,692,998
18,056
4.33
%
1,619,585
14,388
3.60
%
Allowance for loan losses
(14,816)
(15,900)
Non-earning assets
213,929
165,549
Total Assets
$
1,892,111
$
1,769,234
Liabilities and Shareholders’ Equity
Interest-bearing demand deposits
$
353,072
$
888
1.02
%
$
284,799
$
89
0.13
%
Interest-bearing money markets
340,128
1,298
1.55
%
295,923
63
0.09
%
Savings deposits
246,708
79
0.13
%
243,919
18
0.03
%
Time deposits - Retail
118,667
281
0.96
%
154,811
305
0.80
%
Time deposits - Brokered
10,180
132
5.26
%
—
—
—
%
Short-term borrowings
57,364
31
0.22
%
59,555
18
0.12
%
Long-term borrowings
43,373
602
5.63
%
30,929
313
4.10
%
Total interest-bearing liabilities
1,169,492
3,311
1.15
%
1,069,936
806
0.31
%
Non-interest-bearing deposits
545,215
530,672
Other liabilities
27,988
28,109
Shareholders’ Equity
149,416
140,517
Total Liabilities and Shareholders’ Equity
$
1,892,111
$
1,769,234
Net interest income and spread
$
14,745
3.18
%
$
13,582
3.29
%
Net interest margin
3.53
%
3.40
%
(1) The above table reflects the average rates earned or paid stated on an FTE basis assuming a 21% tax rate for 2023 and 2022. Non-GAAP interest income on a fully taxable equivalent was $227 and $242, respectively.
(2) Net interest margin is calculated as net interest income divided by average earning assets.
(3) The average yields on investments are based on amortized cost.
Net interest income, on a non-GAAP, FTE basis, increased by $1.2 million for the first quarter of 2023 when compared to the first quarter of 2022. This increase was driven by an increase of $3.7 million in interest income from an overall increase in yield of 73 basis points on interest earning assets and an increase in average balances of $73.4 million. Interest income on loans increased by $3.0 million due to the increase of 58 basis points in overall yield on the loan portfolio as new loans were booked at higher rates as well as adjustable-rate loans repricing in correlation to the rising rate environment and an increase in average balances of $110.7 million. Investment income increased by $0.3 million. The increase of $2.5 million in interest expense was driven by the increase of 82 basis points on interest paid on deposit accounts as well as an increase of $89.3 million in average balances of interest-bearing deposit accounts when compared to 2022. Increased deposit pricing is a result of the continued pressure on deposits as well as a shift of balances from non-interest-bearing deposits to the interest bearing Insured Cash Sweep (“ICS”) product to ensure full FDIC insurance coverage.
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The following table sets forth an analysis of volume and rate changes in interest income and interest expense for our average interest-earning assets and average interest-bearing liabilities for the three month periods ended March 31, 2023 and 2022:
For the Three months ended March 31, 2023
compared to the three months ended March 31, 2022
(in thousands and tax equivalent basis)
Volume
Rate
Net
Interest Income:
Loans
$
1,196
$
1,811
$
3,007
Taxable Investments
(88)
450
362
Non-taxable Investments
(35)
14
(21)
Federal funds sold
(5)
294
289
Interest-bearing deposits
0
25
25
Other interest earning assets
5
1
6
Total interest income
1,073
2,595
3,668
Interest Expense:
Interest-bearing demand deposits
22
777
799
Interest-bearing money markets
10
1,226
1,236
Savings deposits
0
61
61
Time deposits - Retail
(72)
48
(24)
Time deposits - Brokered
0
132
132
Short-term borrowings
(1)
14
13
Long-term borrowings
128
162
290
Total interest expense
87
2,420
2,507
Net interest income
$
986
$
175
$
1,161
(1) The change in interest income/expense due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
Provision for Credit Losses
Specific allocations have been made for loans where management has determined that the collateral supporting the loans is not adequate to cover the loan balance, and the qualitative factors affecting the ACL/ALL have been adjusted based on the current economic environment and the characteristics of the loan portfolio.
Other Income
The composition of other operating income for the three month periods ended March 31, 2023 and 2022 is illustrated in the following table:
Income as % of
Total Other Income
Three Months Ended
March 31,
(in thousands)
2023
2022
Service charges on deposit accounts
$
516
12%
$
465
10%
Other service charges
232
5%
213
5%
Trust department
1,970
46%
2,189
50%
Debit card income
955
22%
886
20%
Bank owned life insurance
305
7%
292
7%
Brokerage commissions
297
7%
220
5%
Other income
64
1%
117
3%
$
4,339
100%
$
4,382
100%
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Other Operating Expenses
The composition of other operating expenses for the three month periods ended March 31, 2023 and 2022 is illustrated in the following table:
Expense as % of
Total Other Operating Expenses
Three Months Ended
March 31,
(in thousands)
2023
2022
Salaries and employee benefits
$
7,290
57%
$
5,968
56%
FDIC premiums
193
2%
174
2%
Equipment
1,092
9%
1,044
10%
Occupancy expense of premises
785
6%
727
7%
Data processing expense
969
8%
821
8%
Marketing expense
117
1%
106
1%
Professional services
518
3%
520
5%
Contract labor
139
1%
165
1%
Telephone
110
1%
114
1%
Other real estate owned
124
1%
95
1%
Investor relations
57
1%
96
1%
Contributions
64
1%
21
0%
Other
1,180
9%
729
7%
$
12,638
100%
$
10,580
100%
Provision for Income Taxes
In reporting interim financial information, income tax provisions should be determined under the procedures set forth in Financial Accounting Standards Board’s Accounting Standards Codification (“ASC”) Topic 740, Income Taxes (Section 740-270-30). This guidance provides that at the end of each interim period, an entity should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year. The rate so determined should be used in providing for income taxes on a current year-to-date basis. The effective tax rate should reflect anticipated investment tax credits, capital gains rates, and other available tax planning alternatives. In arriving at this effective tax rate, however, no effect should be included for the tax related to significant, unusual or extraordinary items that will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year.
FINANCIAL CONDITION
Balance Sheet Overview
Total assets at March 31, 2023 were $1.9 billion, representing a $89.3 million increase since December 31, 2022. During the first quarter of 2023, cash and interest-bearing deposits in other banks increased by $81.6 million as a result of the implementation of the contingency funding plan and obtaining $61.1 million of brokered certificates of deposit and $80.0 million in FHLB borrowings. Implementing the contingency funding plan and the increase in on-balance sheet liquidity was a precautionary move given the market disruptions associated with the volatile banking environment and the near-term uncertainties regarding growth in the deposit portfolio. The investment portfolio decreased by $4.5 million associated with normal principal amortization and gross loans increased by $9.6 million. Other assets, including deferred taxes, premises and equipment, and accrued interest receivable, remained stable.
Total liabilities at March 31, 2023 were $1.8 billion, representing an $88.2 million increase since December 31, 2022. Total deposits increased by $20.6 million since December 31, 2022. The increase in deposits during the first quarter was primarily attributable to $61.1 million in new brokered deposits, which was partially offset by a decrease of approximately $38.1 million in non-interest deposits from a shift to interest bearing accounts, the effects of consumer and commercial spending and the competitive market for deposits. Short term borrowings decreased by $12.5 million since December 31, 2022 due to municipalities in our Treasury management product utilizing cash for normal spending. Long term borrowings increased by $80.0 million in the first
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quarter of 2023 when compared to December 31, 2022 due to the acquisition of $80.0 million in FHLB borrowings related to the implementation of our Contingency Funding Plan.
Loan Portfolio
The following table presents the composition of our loan portfolio at the dates indicated:
(dollars in thousands)
March 31, 2023
December 31, 2022
Commercial real estate
$
453,356
35%
$
458,831
36%
Acquisition and development
76,980
6%
70,596
6%
Commercial and industrial *
241,959
19%
245,396
19%
Residential mortgage
456,198
35%
444,411
35%
Consumer
60,587
5%
60,260
5%
Total Loans
$
1,289,080
100%
$
1,279,494
100%
*Includes $0.3 million of PPP loans at March 31, 2023 and $0.4 million at December 31, 2022
Outstanding loans of $1.3 billion at March 31, 2023 reflected growth of $9.6 million for the first quarter of 2023. Since December 31, 2022, commercial real estate loans decreased by $5.5 million and acquisition and development loans increased by $6.4 million. Commercial and industrial loans decreased by $3.4 million since December 31, 2022, primarily due to seasonal fluctuations of floor plan lending. Residential mortgage loans increased $11.8 million related to management’s strategic decision to book new mortgage loans at higher rates to our in-house portfolio. The consumer loan portfolio increased slightly by $0.3 million.
New commercial loan production for the three months ended March 31, 2023 was approximately $52.8 million. The pipeline of commercial loans as of March 31, 2023 was $42.3 million. At March 31, 2023, unfunded, committed commercial construction loans totaled approximately $42.6 million. Commercial amortization and payoffs were approximately $38.9 million through March 31, 2023 due primarily to pay-offs of short-term commercial loans as well as normal amortizations of the commercial loan portfolio.
New consumer mortgage loan production for the first quarter of 2023 was approximately $19.0 million, with most of this production comprised of in-house mortgages. The pipeline of in-house, portfolio loans as of March 31, 2023, was $20.3 million. The residential mortgage production level normalized in the first quarter of 2023 due to the increasing interest rates that occurred throughout 2022 and 2023.
Non-accrual loans totaled $3.3 million at March 31, 2023 compared to $3.5 million at December 31, 2022. The decrease in non-accrual balances at March 31, 2023 was related to principal reductions. OREO balances decreased by $0.1 million since December 31, 2022 due to sales of OREO properties.
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Risk Elements of Loan Portfolio
The following table presents the risk elements of our loan portfolio at the dates indicated. Management is not aware of any potential problem loans other than those listed in this table or discussed below.
(dollars in thousands)
March 31,
2023
% of
Applicable
Portfolio
December 31,
2022
% of
Applicable
Portfolio
Non-accrual loans:
Commercial real estate
$
85
0.02%
$
145
0.03%
Acquisition and development
135
0.18%
146
0.21%
Residential mortgage
3,016
0.66%
3,204
0.72%
Consumer
22
0.04%
—
0.00%
Total non-accrual loans
$
3,258
0.25%
$
3,495
0.27%
Accruing Loans Past Due 90 days or more:
Residential mortgage
46
282
Consumer
41
25
Total loans past due 90 days or more
$
87
$
307
Total non-accrual and accruing loans past due 90 days or more
$
3,345
$
3,802
Other real estate owned
$
4,598
$
4,733
Total Non-performing assets
$
7,943
$
8,535
Non-accrual loans to total loans (as %)
0.25%
0.27%
Non-performing loans to total loans (as %)
0.26%
0.30%
Non-performing assets to total assets (as %)
0.41%
0.46%
Allowance for credit losses to non-accrual loans (as %)
517.83%
418.77%
Allowance for credit losses to non-performing assets (as %)
212.40%
171.48%
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Allowance for Credit Losses
The ACL represents an amount which, in management’s judgment, is adequate to absorb expected credit losses over the life of outstanding loans as of the balance sheet date based on the evaluation of current risk characteristics of the loan portfolio, past events, current conditions, reasonable and supportable forecasts of future economic conditions and prepayment experience. The ACL is measured and recorded upon the initial recognition of a financial asset. The ACL is reduced by charge-offs, net of recoveries of previous losses, and is increased by a provision or decreased by a recovery for credit losses, which is recorded as a current period operating expense.
Determination of an appropriate ACL is inherently complex and requires the use of highly subjective estimates. The reasonableness of the ACL is reviewed quarterly by management.
Management believes it uses relevant information available to make determination about the ACL and that it has established the existing allowance in accordance with GAAP. However, the determination of the ACL requires significant judgment, and estimates of expected credit losses in the loan portfolio can vary from the amounts actually observed. While management uses available information to recognize expected credit losses, future additions to the ACL may be necessary based on changes in the loans comprising the portfolio, changes in the current and forecasted economic conditions, changes to the interest rate environment which may directly impact prepayment and curtailment rate assumptions, and changes in the financial condition of borrowers.
The ACL “base case” model is derived from various economic forecasts provided by widely recognized sources. Management evaluates the variability of market conditions by examining the peak and trough of economic cycles. These peaks and torughs are used to stress the base case model to develop a range of potential outcomes. Management then determines the appropriate reserve through an evaluation of these various outcomes relative to current economic conditions and known risks in the portfolio.
The following table presents a summary of the activity in the ACL and ALL for the three months ended March 31:
(dollars in thousands)
2023
2022
Balance, January 1
$
14,636
$
15,955
Impact of CECL Adoption
2,066
—
Charge-offs:
Commercial real estate
—
—
Acquisition and development
—
—
Commercial and industrial
—
(48)
Residential mortgage
(6)
(9)
Consumer
(333)
(246)
Total charge-offs
(339)
(303)
Recoveries:
Commercial real estate
5
1
Acquisition and development
5
18
Commercial and industrial
4
3
Residential mortgage
18
15
Consumer
62
22
Total recoveries
94
59
Net losses
(245)
(244)
Credit Loss Expense/(Credit)
414
(419)
Balance at end of period
$
16,871
$
15,292
Allowance for credit/loan losses to gross loans outstanding (as %)
1.31
%
1.29
%
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Net (Charge-offs)/Recoveries as a % of Average Applicable Portfolio
2023
2022
Commercial real estate
0.00%
0.00%
Acquisition and development
0.03%
0.06%
Commercial and industrial
0.01%
(0.10)%
Residential mortgage
0.01%
0.01%
Consumer
(1.79)%
(1.42)%
Investment Securities
At March 31, 2023, the total amortized cost basis of the available-for-sale investment portfolio was $148.2 million, compared to a fair value of $124.0 million. Unrealized gains and losses on securities available-for-sale are reflected in accumulated other comprehensive loss, a component of shareholders’ equity. The amortized cost basis of the held to maturity portfolio was $233.1 million, compared to a fair value of $204.5 million.
The following table presents the composition of our securities portfolio at amortized cost and fair values at the dates indicated:
March 31, 2023
December 31, 2022
Amortized
Fair Value
FV as %
Amortized
Fair Value
FV as %
(dollars in thousands)
Cost
(FV)
of Total
Cost
(FV)
of Total
Securities Available for Sale:
U.S. government agencies
$
11,036
$
9,653
9%
$
11,044
$
9,462
8%
Residential mortgage-backed agencies
44,224
37,281
30%
45,052
37,401
30%
Commercial mortgage-backed agencies
37,151
30,494
25%
37,393
30,732
23%
Collateralized mortgage obligations
25,322
20,977
17%
25,828
21,044
17%
Obligations of state and political subdivisions
10,842
10,629
9%
10,848
10,492
8%
Corporate bonds
1,000
830
1%
1,000
887
1%
Collateralized debt obligations
18,661
14,114
11%
18,664
15,871
13%
Total available for sale
$
148,236
$
123,978
100%
$
149,829
$
125,889
100%
Securities Held to Maturity:
U.S. treasuries
$
37,268
$
36,023
18%
$
37,204
$
35,611
18%
U.S. government agencies
67,803
56,828
28%
67,734
54,473
27%
Residential mortgage-backed agencies
27,624
24,586
13%
28,624
25,122
12%
Commercial mortgage-backed agencies
21,635
17,069
8%
22,389
17,821
9%
Collateralized mortgage obligations
56,128
47,099
23%
57,085
47,084
23%
Obligations of state and political subdivisions
22,625
22,936
10%
22,623
22,969
11%
Total held to maturity
$
233,083
$
204,541
100%
$
235,659
$
203,080
100%
Total fair value of investment securities available for sale decreased by $1.9 million since December 31, 2022 due to principal paydowns of the portfolio in the first quarter of 2023. At March 31, 2023, the securities classified as available-for-sale included a net unrealized loss of $24.3 million, which represents the difference between the fair value and amortized cost of securities in the portfolio.
As discussed in Note 6 to the consolidated financial statements presented elsewhere in this report, the Corporation measures fair market values based on the fair value hierarchy established in ASC Topic 820, Fair Value Measurements and Disclosures . The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Level 3 prices or valuation techniques require inputs that are both significant to the valuation assumptions and are not readily observable in the market (i.e. supported with little or no market activity). These Level 3 instruments are valued based on both observable and unobservable inputs derived from the best available data, some of which is internally developed, and considers risk premiums that a market participant would require.
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Approximately $109.9 million of the available for sale portfolio was valued using Level 2 pricing and had net unrealized losses of $21.1 million at March 31, 2023. The remaining $14.1 million of the securities available for sale represents the entire collateralized debt obligation (“CDO”) portfolio, which was valued using significant unobservable inputs (Level 3 assets). The $4.5 million in net unrealized losses associated with this portfolio relates to nine pooled trust preferred securities that comprise the CDO portfolio. Net unrealized losses of $3.3 million represent non-credit related OTTI charges on seven of the securities, while $1.2 million of unrealized losses relates to two securities which have had no OTTI related charges.
Deposits
The following table presents the composition of our deposits at the dates indicated:
(dollars in thousands)
March 31, 2023
December 31, 2022
Non-interest-bearing demand deposits
$
468,554
30%
$
506,613
32%
Interest-bearing deposits:
Demand
362,585
23%
327,685
21%
Money Market
339,163
21%
365,192
23%
Savings deposits
242,441
15%
250,720
16%
Time deposits- retail
117,461
7%
120,523
8%
Time deposits- brokered
61,081
4%
—
0%
Total Deposits
$
1,591,285
100%
$
1,570,733
100%
Total deposits at March 31, 2023 increased by $20.6 million when compared to December 31, 2022. In 2023, non-interest-bearing deposits decreased by $38.1 million primarily due to the shift of balances into interest bearing accounts to ensure full FDIC coverage through the ICS product, consumer and commercial spending and the competitive deposit market. Interest bearing demand deposits increased by $34.9 million and traditional savings and money market accounts decreased by $34.3 million. Total time deposits increased by $58.0 million. This increase in time deposits was primarily driven by management’s decision to acquire $61.1 million in brokered deposits during the first quarter of 2023 as a result of the market disruption.
The following table summarizes the percentage of deposits that are insured by deposit insurance or otherwise fully collateralized by securities compared to uninsured deposits as of March 31, 2023 and December 31, 2022.
March 31, 2023
December 31, 2022
(dollars in thousands)
Balance
Percent
Balance
Percent
Insured/collateralized deposits
$
1,125,896
71%
$
1,118,190
71%
Uninsured deposits
465,389
29%
452,543
29%
$
1,591,285
100%
$
1,570,733
100%
The following table summarizes the percentage of deposit balances from retail customers compared to business customers as of March 31, 2023 and December 31, 2022.
March 31, 2023
December 31, 2022
(dollars in thousands)
Balance
Percent
Balance
Percent
Retail deposits
$
820,063
52%
855,014
55%
Business deposits
771,222
48%
715,719
45%
$
1,591,285
100%
1,570,733
100%
Deposit outflows experienced in the latter half of 2022 and in January 2023 were due to the competitive pricing landscape and inflationary spending. Changes in deposit levels were not directly related to recent market disruptions.
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Borrowed Funds
The following table presents the composition of our borrowings at the dates indicated:
(in thousands)
March 31,
2023
December 31,
2022
Securities sold under agreements to repurchase
$
52,030
$
64,565
Total short-term borrowings
52,030
64,565
FHLB advances
$
80,000
$
—
Junior subordinated debt
30,929
30,929
Total long-term borrowings
$
110,929
$
30,929
Short term borrowings decreased $12.5 million since December 31, 2022, driven by the utilization of cash by municipalities in our Treasury Management product.
Long-term borrowings increased by $80.0 million due to management’s decision to implement the Contingency Funding plan in regards to the recent market disruption. Two new borrowings totaling $80.0 million in FHLB advances were obtained in the first quarter of 2023.
Liquidity Management
Liquidity is a financial institution’s capability to meet customer demands for deposit withdrawals while funding all credit-worthy loans. The factors that determine the institution’s liquidity are:
● Reliability and stability of core deposits;
● Cash flow structure and pledging status of investments; and
● Potential for unexpected loan demand.
We actively manage our liquidity position through regular meetings of a sub-committee of executive management, known as the Treasury Team, which looks forward 12 months at 30-day intervals. The measurement is based upon the projection of funds sold or purchased position, along with ratios and trends developed to measure dependence on purchased funds and core growth. Monthly reviews by management and quarterly reviews by the Asset and Liability Committee under prescribed policies and procedures are designed to ensure that we will maintain adequate levels of available funds.
It is our policy to manage our affairs so that liquidity needs are fully satisfied through normal Bank operations. That is, the Bank will manage its liquidity to minimize the need to make unplanned sales of assets or to borrow funds under emergency conditions. The Bank will use funding sources where the interest cost is relatively insensitive to market changes in the short run (periods of one year or less) to satisfy operating cash needs. The remaining normal funding will come from interest-sensitive liabilities, either deposits or borrowed funds. When the marginal cost of needed wholesale funding is lower than the cost of raising this funding in the retail markets, the Corporation may supplement retail funding with external funding sources such as:
1. Unsecured Fed Funds lines of credit with upstream correspondent banks (M&T Bank, Pacific Coast Banker’s Bank, PNC Financial Services, Atlantic Community Bankers Bank and Community Bankers Bank).
2. Secured advances with the FHLB, which are collateralized by eligible one to four family residential mortgage loans, home equity lines of credit, commercial real estate loans.
3. Secured line of credit with the Fed Discount Window for use in borrowing funds up to 90 days, using municipal securities as collateral.
4. Brokered deposits, including CDs and money market funds, provide a method to generate deposits quickly. These deposits are strictly rate driven but often provide the most cost-effective means of funding growth.
5. One Way Buy CDARS/ICS funding – a form of brokered deposits that has become a viable supplement to brokered deposits obtained directly.
6. Bank Term Funding Program – A Federal Reserve program collateralized by government agency securities, if needed.
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The following table presents sources of liquidity available to the Company as of March 31, 2023.
(dollars in thousands)
Total Availability
Amount Used
Net Availability
Internal Sources
Excess cash
$
132,928
$
-
$
132,928
Unpledged securities
146,508
-
146,508
External Sources
Federal Reserve (discount window)
9,788
-
9,788
Correspondent unsecured lines of credit
105,000
-
105,000
FHLB
199,327
82,500
116,827
Bank Term Funding Program*
-
-
-
$
593,551
$
82,500
$
511,051
*Bank Term Funding Program ("BTFP") has been established and can be utilized if needed. $122 million available for BTFP included in unpledged above.
Management is not aware of any demands, commitments, events or uncertainties that are likely to materially affect our ability to meet our future capital requirements
Due to the recent market disruption, management implemented the Liquidiity Contingency Plan and believes that we have adequate liquidity available to respond to current and anticipated liquidity demands and is not aware of any trends or demands, commitments, events or uncertainties that are likely to materially affect our ability to maintain liquidity at satisfactory levels.
Market Risk and Interest Sensitivity
Our primary market risk is interest rate fluctuation. Interest rate risk results primarily from the traditional banking activities that we engage in, such as gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates and consumer preferences affect the difference between the interest earned on our assets and the interest paid on our liabilities. Interest rate sensitivity refers to the degree that earnings will be impacted by changes in the prevailing level of interest rates. Interest rate risk arises from mismatches in the repricing or maturity characteristics between interest-bearing assets and liabilities. Management seeks to minimize fluctuating net interest margins, and to enhance consistent growth of net interest income through periods of changing interest rates. Management uses interest sensitivity gap analysis and simulation models to measure and manage these risks. The interest rate sensitivity gap analysis assigns each interest-earning asset and interest-bearing liability to a time frame reflecting its next repricing or maturity date. The differences between total interest-sensitive assets and liabilities at each time interval represent the interest sensitivity gap for that interval. A positive gap generally indicates that rising interest rates during a given interval will increase net interest income, as more assets than liabilities will reprice. A negative gap position would benefit us during a period of declining interest rates.
At March 31, 2023, we were asset sensitive.
Our interest rate risk management goals are:
● Ensure that the Board of Directors and senior management will provide effective oversight and ensure that risks are adequately identified, measured, monitored and controlled;
● Enable dynamic measurement and management of interest rate risk;
● Select strategies that optimize our ability to meet our long-range financial goals while maintaining interest rate risk within policy limits established by the Board of Directors;
● Use both income and market value oriented techniques to select strategies that optimize the relationship between risk and return; and
● Establish interest rate risk exposure limits for fluctuation in net interest income (“NII”), net income and economic value of equity.
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To manage interest sensitivity risk, management formulates guidelines regarding asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These guidelines are based on management’s outlook regarding future interest rate movements, the state of the regional and national economy, and other financial and business risk factors. Management uses computer simulations to measure the effect on net interest income of various interest rate scenarios. Key assumptions used in the computer simulations include cash flows and maturities of interest rate sensitive assets and liabilities, changes in asset volumes and pricing, and management’s capital plans. This modeling reflects interest rate changes and the related impact on net interest income over specified periods.
We evaluate the effect of a change in interest rates of +/-100 basis points to +/-400 basis points on both NII and Net Portfolio Value (“NPV”) / Economic Value of Equity (“EVE”). We concentrate on NII rather than net income as long as NII remains the significant contributor to net income.
NII modeling allows management to view how changes in interest rates will affect the spread between the yield paid on assets and the cost of deposits and borrowed funds. Unlike traditional Gap modeling, NII modeling takes into account the different degree to which installments in the same repricing period will adjust to a change in interest rates. It also allows the use of different assumptions in a falling versus a rising rate environment. The period considered by the NII modeling is the next eight quarters.
NPV / EVE modeling focuses on the change in the market value of equity. NPV / EVE is defined as the market value of assets less the market value of liabilities plus/minus the market value of any off-balance sheet positions. By effectively looking at the present value of all future cash flows on or off the balance sheet, NPV / EVE modeling takes a longer-term view of interest rate risk. This complements the shorter-term view of the NII modeling.
Measures of NII at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value of the institution.
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Based on the simulation analysis performed at March 31, 2023 and December 31, 2022, management estimated the following changes in net interest income, assuming the indicated rate changes:
(Dollars in thousands)
March 31,
2023
December 31,
2022
+400 basis points
$
8,897
$
1,112
+300 basis points
$
5,954
$
225
+200 basis points
$
3,957
$
173
+100 basis points
$
2,004
$
121
-100 basis points
$
(2,248)
$
(776)
-200 basis points
$
(5,144)
$
(3,165)
This estimate is based on assumptions that may be affected by unforeseeable changes in the general interest rate environment and any number of unforeseeable factors. Rates on different assets and liabilities within a single maturity category adjust to changes in interest rates to varying degrees and over varying periods of time. The relationships between lending rates and rates paid on purchased funds are not constant over time. Management can respond to current or anticipated market conditions by lengthening or shortening the Bank’s sensitivity through loan repricings or changing its funding mix. The rate of growth in interest-free sources of funds will influence the level of interest-sensitive funding sources. In addition, the absolute level of interest rates will affect the volume of earning assets and funding sources. As a result of these limitations, the interest-sensitive gap is only one factor to be considered in estimating the net interest margin.
Management believes that no material changes in our market risks, our procedures used to evaluate and mitigate those risks, or our actual or simulated sensitivity positions have occurred since December 31, 2022. Our NII simulation analysis as of December 31, 2022 is included in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2022 under the heading “Market Risk and Interest Sensitivity.
Impact of Inflation – Our assets and liabilities are primarily monetary in nature, and as such, future changes in prices do not affect the obligations to pay or receive fixed and determinable amounts of money. During inflationary periods, monetary assets lose value in terms of purchasing power and monetary liabilities have corresponding purchasing power gains. The concept of purchasing power is not an adequate indicator of the impact of inflation on financial institutions because it does not incorporate changes in our earnings.
Capital Resources
We require capital to fund loans, satisfy our obligations under the Bank’s letters of credit, meet the deposit withdrawal demands of the Bank’s customers, and satisfy our other monetary obligations. To the extent that deposits are not adequate to fund our capital requirements, we can rely on the funding sources identified above under the heading “Liquidity Management”.
In addition to operational requirements, the Bank is subject to risk-based capital regulations, which were adopted and are monitored by federal banking regulators. These regulations are used to evaluate capital adequacy and require an analysis of an institution’s asset risk profile and off-balance sheet exposures, such as unused loan commitments and stand-by letters of credit. Based on capital ratios at March 31, 2023, the Bank was considered to be well-capitalized. We adopted CECL effective January 1, 2023 and elected to implement the regulatory agencies’ capital transition entirely upon implementation.
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The following table presents the Bank’s capital ratios as of the dates indicated:
March 31,
2023
December 31,
2022
Required for
Capital
Adequacy
Purposes
Required
to be Well
Capitalized
Total Capital (to risk-weighted assets)
14.25
%
14.37
%
8.00
%
10.00
%
Tier 1 Capital (to risk-weighted assets)
13.00
%
13.29
%
6.00
%
8.00
%
Common Equity Tier 1 Capital (to risk-weighted assets)
13.00
%
13.29
%
4.50
%
6.50
%
Tier 1 Capital (to average assets)
10.00
%
10.01
%
4.00
%
5.00
%
As of March 31, 2023 and December 31, 2022, the Bank was considered “well capitalized” under the regulatory framework for prompt corrective action. We adopted CECL effective January 1, 2023 and elected not to implement the regulatory agencies’ capital transition and instead opted to record the impact to ouc capital ratios immediately upon implementation.
Effective with the implementation of CECL, a $2.2 million, net of tax, adjustment was made to retained earnings. The adjustment did not have a material impact to our capital ratios.
Contractual Obligations, Commitments and Off-Balance Sheet Arrangements
Contractual Obligations
The Corporation enters into contractual obligations in the normal course of business. Among these obligations are FHLB advances and junior subordinated debentures, operating lease agreements for banking and subsidiaries’ offices and for data processing and telecommunications equipment. Comparing March 31, 2023 to December 31, 2022, short-term borrowings decreased $12.5 million, driven by a the utilization of cash balances by municipalities related to the overnight investments product. Long-term borrowings increased by $80.0 million during the quarter due to management’s decision to obtain $80 million in FHLB advances during the first quarter of 2023.
Commitments
Loan commitments are made to accommodate the financial needs of our customers. Letters of credit commit us to make payments on behalf of customers when certain specified future events occur. The credit risks inherent in loan commitments and letters of credit are essentially the same as those involved in extending loans to customers, and these arrangements are subject to our normal credit policies. We are not a party to any other off-balance sheet arrangements.
Commitments to extend credit in the form of consumer, commercial and business at the dates indicated were as follows:
(in thousands)
March 31,
2023
December 31,
2022
Residential Mortgage - home equity
$
72,623
$
70,845
Residential Mortgage - construction
21,776
25,499
Commercial
172,944
153,235
Consumer - personal credit lines
4,334
4,323
Standby letters of credit
6,979
14,325
Total
$
278,656
$
268,227
The increase of $10.4 million in commitments at March 31, 2023 when compared to December 31, 2022 was due to new business in construction commitments in the commercial portfolio as well as new home equity lines of credit.
Upon adoption of ASC 326 on January 1, 2023, the Company recorded an initial increase to the ACL for off-balance sheet exposures of $0.9 million. Credit loss expense for off-balance sheet credit exposures totaled $0.1 million for the period ending March 31, 2023.
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Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.