Item 2. Management’s Discussion and Analysis
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following presents management’s discussion and analysis of the financial condition and results of operations of Live Oak Bancshares, Inc. (individually, “Bancshares” and collectively with its subsidiaries including Live Oak Banking Company, the “Company”). This discussion should be read in conjunction with the unaudited condensed consolidated financial statements and related notes included elsewhere in this quarterly report on Form 10-Q and with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022 (the “2022 Form 10-K”). Results of operations for the periods included in this quarterly report on Form 10-Q are not necessarily indicative of results to be obtained during any future period.
Important Note Regarding Forward-Looking Statements
This quarterly report on Form 10-Q contains statements that management believes are forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995.
These statements generally relate to the financial condition, results of operations, plans, objectives, future performance or business of Live Oak Bancshares, Inc. (the “Company”). They usually can be identified by the use of forward-looking terminology, such as “believes,” “expects,” or “are expected to,” “plans,” “projects,” “goals,” “estimates,” “will,” “may,” “should,” “could,” “would,” “continues,” “intends to,” “outlook” or “anticipates,” or variations of these and similar words, or by discussions of strategies that involve risks and uncertainties. You should not place undue reliance on these statements, as they are subject to risks and uncertainties, including but not limited to, those described in this Report. When considering these forward-looking statements, you should keep in mind these risks and uncertainties, as well as any cautionary statements management may make. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information actually known to the Company at the time. Management undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements contained in this Report are based on current expectations, estimates and projections about the Company’s business, management’s beliefs and assumptions made by management. These statements are not guarantees of the Company’s future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in the forward-looking statements. These risks, uncertainties and assumptions include, without limitation:
• deterioration in the financial condition of borrowers resulting in significant increases in the Company’s loan and lease losses and provisions for those losses and other adverse impacts to results of operations and financial condition;
• changes in Small Business Administration (“SBA”) rules, regulations and loan products, including specifically the Section 7(a) program, changes in SBA standard operating procedures or changes to the status of Live Oak Banking Company (the “Bank”) as an SBA Preferred Lender;
• changes in rules, regulations or procedures for other government loan programs, including those of the United States Department of Agriculture (“USDA”);
• changes in interest rates that affect the level and composition of deposits, loan demand and the values of loan collateral, securities, and interest sensitive assets and liabilities;
• the failure of assumptions underlying the establishment of reserves for possible loan and lease losses;
• changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments;
• recent adverse developments in the banking industry highlighted by high-profile bank failures and the potential impact of such developments on customer confidence, liquidity, and regulatory responses to these developments;
• the impacts of global health crises and pandemics, such as the Coronavirus Disease 2019 (“COVID-19”) pandemic, on trade (including supply chains and export levels), travel, employee productivity and other economic activities that may have a destabilizing and negative effect on financial markets, economic activity and customer behavior;
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• a reduction in or the termination of the Company’s ability to use the technology-based platform that is critical to the success of the Company’s business model or to develop a next-generation banking platform, including a failure in or a breach of the Company’s operational or security systems or those of its third party service providers;
• changes in financial market conditions, either internationally, nationally or locally in areas in which the Company conducts operations, including reductions in rates of business formation and growth, demand for the Company’s products and services, commercial and residential real estate development and prices, premiums paid in the secondary market for the sale of loans, and valuation of servicing rights;
• changes in accounting principles, policies, and guidelines applicable to bank holding companies and banking;
• fluctuations in markets for equity, fixed-income, commercial paper and other securities, which could affect availability, market liquidity levels, and pricing;
• the effects of competition from other commercial banks, non-bank lenders, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and mutual funds, and other financial institutions operating in the Company’s market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone and the Internet;
• the Company's ability to attract and retain key personnel;
• changes in governmental monetary and fiscal policies as well as other legislative and regulatory changes, including with respect to SBA or USDA lending programs and investment tax credits;
• a deterioration of the credit rating for U.S. long-term sovereign debt, actions that the U.S. government may take to avoid exceeding the debt ceiling, and uncertainties surrounding the debt ceiling and the federal budget;
• changes in political and economic conditions;
• the impact of heightened regulatory scrutiny of financial products and services, primarily led by the Consumer Financial Protection Bureau and various state agencies;
• the Company's ability to comply with any requirements imposed on it by regulators, and the potential negative consequences that may result;
• operational, compliance and other factors, including conditions in local areas in which the Company conducts business such as inclement weather or a reduction in the availability of services or products for which loan proceeds will be used, that could prevent or delay closing and funding loans before they can be sold in the secondary market;
• the effect of any mergers, acquisitions or other transactions, to which the Company or the Bank may from time to time be a party, including management’s ability to successfully integrate any businesses acquired;
• adverse results, including related fees and expenses, from pending or future lawsuits, government investigations or private actions;
• other risk factors listed from time to time in reports that the Company files with the SEC, including those described under “Risk Factors” in this Report; and
• the Company’s success at managing the risks involved in the foregoing.
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Except as otherwise disclosed, forward-looking statements do not reflect: (i) the effect of any acquisitions, divestitures or similar transactions that have not been previously disclosed; (ii) any changes in laws, regulations or regulatory interpretations; or (iii) any change in current dividend or repurchase strategies, in each case after the date as of which such statements are made. All forward-looking statements speak only as of the date on which such statements are made, and the Company undertakes no obligation to update any statement, to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.
Amounts in all tables in Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) have been presented in thousands, except percentage, time period, stock option, share and per share data or where otherwise indicated.
Nature of Operations
Bancshares is a financial holding company and a bank holding company headquartered in Wilmington, North Carolina incorporated under the laws of the state of North Carolina in December 2008. The Company conducts business operations primarily through its commercial bank subsidiary, Live Oak Banking Company (the “Bank”). The Bank was incorporated in February 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending and deposit related services to small businesses nationwide. A significant portion of the loans originated by the Bank are guaranteed by the SBA under the 7(a) Loan Program and the U.S. Department of Agriculture’s (“USDA”) Rural Energy for America Program (“REAP”), Water and Environmental Program (“WEP”), Business & Industry (“B&I”) and Community Facilities loan programs. These loans are to small businesses and professionals with what the Bank believes are lower risk characteristics. Industries, or “verticals,” on which the Bank focuses its lending efforts are carefully selected. The Bank also lends more broadly to select borrowers outside of those verticals.
The Company’s wholly owned material subsidiaries are the Bank, Government Loan Solutions (“GLS”), Live Oak Grove, LLC (“Grove”), Live Oak Ventures, Inc. (“Live Oak Ventures”) and Canapi Advisors, LLC (“Canapi Advisors”). GLS is a management and technology consulting firm that advises and offers solutions and services to participants in the government guaranteed lending sector. GLS primarily provides services in connection with the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan programs and USDA guaranteed loans. The Grove provides Company employees and business visitors an on-site restaurant location. Live Oak Ventures’ purpose is investing in businesses that align with the Company's strategic initiative to be a leader in financial technology. Canapi Advisors provides investment advisory services to a series of funds (the “Canapi Funds”) focused on providing venture capital to new and emerging financial technology companies.
The Bank’s wholly owned subsidiaries are Live Oak Number One, Inc., Live Oak Clean Energy Financing LLC (“LOCEF”), Live Oak Private Wealth, LLC (“Live Oak Private Wealth”) and Tiburon Land Holdings, LLC (“TLH”). Live Oak Number One, Inc. holds properties foreclosed on by the Bank. LOCEF provides financing to entities for renewable energy applications. Live Oak Private Wealth provides high-net-worth individuals and families with strategic wealth and investment management services. During the first quarter of 2022, Jolley Asset Management, LLC (“JAM”) was merged into Live Oak Private Wealth. JAM was previously a wholly owned subsidiary of Live Oak Private Wealth. TLH was formed in the third quarter of 2022 to hold land adjacent to the Bank's headquarters consisting of wetlands and other protected property for the use and enjoyment of the Bank's employees and customers.
The Company generates revenue primarily from net interest income and secondarily through origination and sale of government guaranteed loans. Income from the retention of loans is comprised principally of interest income. Income from the sale of loans is comprised of loan servicing revenue and revaluation of related servicing assets along with net gains on sales of loans. Offsetting these revenues are the cost of funding sources, provision for loan and lease credit losses, any costs related to foreclosed assets and other operating costs such as salaries and employee benefits, travel, professional services, advertising and marketing and tax expense. The Company also has less routinely generated gains and losses arising from its financial technology investments predominantly in its fintech segment, as discussed more fully later in this section under the caption “Results of Segment Operations.”
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Results of Operations
Performance Summary
Three months ended June 30, 2023 compared with three months ended June 30, 2022
For the three months ended June 30, 2023, the Company reported net income of $17.5 million, or $0.39 per diluted share, compared to net income of $97.0 million, or $2.16 per diluted share, for the second quarter of 2022.
The decrease in net income was largely due to the following items:
• Decrease in equity method investment income of $121.1 million, largely driven by the second quarter of 2022 gain of $120.5 million related to the Company's sale of its investment in Finxact, Inc. (“Finxact”); and
• Provision for loan and lease credit losses increased by $7.8 million to $13.0 million, compared to $5.3 million for the second quarter of 2022. The level of provision expense in the second quarter of 2023 was primarily the result of continued growth of the loan and lease portfolio combined with portfolio trends largely comprised of specific reserve increases in two impaired loans.
Key factors partially offsetting the decrease in net income for the second quarter of 2023 were:
• Increase in net interest income of $4.4 million, or 5.5%, predominately from increases in variable interest-earning assets following the first quarter of 2023 Federal Reserve rate increases combined with increased levels of cash, investments and the total loan and lease portfolio, partially mitigated by a decrease in the net interest margin arising from an increase in interest-bearing liabilities combined with average cost of funds outpacing the average yield on interest-earning assets;
• The net loss on loan servicing asset revaluation decreased $5.8 million, or 67.3%, to $2.8 million compared to a net loss of $8.7 million in the second quarter of 2022;
• Increased net gains on sales of loans of $5.2 million, or 91.9%, principally the result of a higher volume of loan sales in the second quarter of 2023;
• The net gain on loans accounted for under the fair value option of $1.7 million, improved by $6.2 million, from a net loss of $4.5 million in the second quarter of 2022;
• Decreased contributions and donations expense of $5.5 million, principally related to a special 2022 charitable donation of $5.0 million made in connection with the above discussed Finxact gain; and
• Decreased income tax expense of $23.8 million, or 94.3%, principally related to above discussed decrease in net income.
Six months ended June 30, 2023 compared with six months ended June 30, 2022
For the six months ended June 30, 2023, the Company reported net income of $17.9 million, or $0.40 per diluted share, compared to net income of $131.5 million, or $2.92 per diluted share, for the first half of 2022.
The decrease in net income was largely due to the following items:
• Decrease in equity method investment income of $121.9 million, principally a product of the above discussed Finxact gain of $120.5 million in the second quarter of 2022;
• Provision for loan and lease credit losses increased by $24.9 million, to $32.0 million, compared to $7.1 million for the first half of 2022. The level of provision expense in the first half of 2023 was primarily the result of continued growth of the loan and lease portfolio combined with portfolio trends and changes in the macroeconomic outlook;
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• Decreased net gains on sales of loans of $5.6 million, or 21.2%, principally the result of comparatively negative market premiums in the first half of 2023; and
• Increased FDIC insurance expense of $4.3 million, or 104.6%, largely a product of rate increases effective in 2023 combined with the ongoing growth of Live Oak Banking Company.
Key factors partially offsetting the decrease in net income for the first half of 2023 were:
• Increase in net interest income of $8.6 million, or 5.5%, principally the result of the above discussed drivers of the quarter over quarter increase;
• A net loss on loan servicing asset revaluation of $2.5 million compared to a net loss of $10.2 million in the first half of 2022, resulting in a positive change of $7.8 million, or 75.8%;
• Decreased contributions and donations expense of $6.2 million, principally related to a special 2022 charitable donation of $5.0 million discussed above related to the 2022 Finxact gain; and
• Decreased income tax expense of $29.0 million, or 86.2%, principally related to above discussed decrease in net income.
Net Interest Income and Margin
Net interest income represents the difference between the income that the Company earns on interest-earning assets and the cost of interest-bearing liabilities. The Company’s net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates that the Company earns or pays on them, respectively. Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume changes.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as “rate changes.” As a bank without a branch network, the Bank gathers deposits over the Internet and in the community in which it is headquartered. Due to the nature of a branchless bank and the relatively low overhead required for deposit gathering, the rates that the Bank offers are generally above the industry average.
Three months ended June 30, 2023 compared with three months ended June 30, 2022
For the three months ended June 30, 2023, net interest income increased $4.4 million, or 5.5%, to $84.3 million compared to $79.9 million for the three months ended June 30, 2022. This increase was principally due to the growth in the held for investment loan and lease portfolio outpacing growth in interest-bearing liabilities offset by an increase in average cost of funds which exceeded the increase in average yield on interest-earning assets. Excluding PPP loan impacts, comprised of amortization of net deferred fees combined with a 1% annualized interest rate less the related interest expense from funding activity, net interest income increased by $5.5 million. Average interest-earning assets increased by $2.03 billion, or 24.6%, to $10.27 billion for the second quarter of 2023, compared to $8.25 billion for the second quarter of 2022, while the yield on average interest-earning assets increased one hundred-eighty basis points to 6.63%. The cost of funds on interest-bearing liabilities for the second quarter of 2023 increased two hundred-sixty basis points to 3.59%, and the average balance of interest-bearing liabilities increased by $1.69 billion, or 21.6%, over the second quarter of 2022.
The increase in average interest-bearing liabilities was largely driven by funding for significant loan originations and growth as well as maintenance of the Company's target liquidity profile. This increase was muted by a $95.0 million reduction in average borrowings largely related to Paycheck Protection Program Liquidity Facility, or PPPLF, repayments in 2022. As indicated in the rate/volume table below, the overall increase discussed above is reflected in increased interest income of $70.5 million outpacing growth in interest expense of $66.1 million for the second quarter of 2023 compared to the second quarter of 2022. The net interest margin decreased from 3.89% for the second quarter of 2022 to 3.29% for the second quarter of 2023.
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Six months ended June 30, 2023 compared with six months ended June 30, 2022
For the six months ended June 30, 2023, net interest income increased $8.6 million, or 5.5%, to $166.3 million compared to $157.7 million for the six months ended June 30, 2022. This increase was principally due to the growth in the held for investment loan and lease portfolio outpacing growth in interest-bearing liabilities offset by an increase in average cost of funds which exceeded the increase in average yield on interest-earning assets. Excluding PPP loan impacts, comprised of amortization of net deferred fees combined with a 1% annualized interest rate less the related interest expense from funding activity, net interest income increased by $13.8 million. Average interest-earning assets increased by $1.94 billion, or 24.1%, to $9.99 billion for the first half of 2023, compared to $8.05 billion for the first half of 2022, while the yield on average interest-earning assets increased one hundred-sixty-seven basis points to 6.48%. The cost of funds on interest-bearing liabilities for the first half of 2023 increased two hundred-forty-six basis points to 3.36%, and the average balance of interest-bearing liabilities increased by $1.61 billion, or 21.0%, over the first half of 2022.
The increase in average interest-bearing liabilities was largely driven by funding for significant loan originations and growth as well as maintenance of the Company's target liquidity profile. This increase was muted by a $99.4 million reduction in average borrowings largely related to Paycheck Protection Program Liquidity Facility, or PPPLF, repayments in 2022. As indicated in the rate/volume table below, the overall increase discussed above is reflected in increased interest income of $129.1 million outpacing growth in interest expense of $120.5 million for the first half of 2023 compared to the first half of 2022. The net interest margin decreased from 3.95% for the first half of 2022 to 3.36% for the first half of 2023.
During the first half of 2023, the Federal Reserve increased the federal funds upper target rate by 75 basis points. Subsequently, on July 26, 2023 the Federal Reserve further increased the federal funds upper target rate by 25 basis points, to 5.50%. In June 2023, the Federal Reserve released its most current federal funds target rate midpoint projections which implied an increase of the median Federal Funds rate to 5.6% by the end of 2023 and a decrease of approximately 100 basis points to 4.6% by the end of 2024. There can be no assurance that any further increases in the Federal Funds rate will occur, and if they do, the amount and timing of actual increases are subject to change. See Item 3. Quantitative and Qualitative Disclosures About Market Risk for information about the Company’s sensitivity to interest rates.
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Average Balances and Yields. The following table presents information regarding average balances for assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amount of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing the income or expense by the average balances for assets or liabilities, respectively, for the periods presented and annualizing that result. Loan fees are included in interest income on loans.
Three Months Ended June 30,
2023 2022
Average
Balance Interest Average
Yield/Rate Average
Balance
Interest Average
Yield/Rate
Interest-earning assets:
Interest-earning balances in other banks $ 731,427 $ 8,847 4.85 % $ 328,014 $ 848 1.04 %
Federal funds sold — — — 78,216 196 1.01
Investment securities 1,252,320 8,503 2.72 915,106 4,046 1.77
Loans held for sale 516,378 12,153 9.44 1,119,094 15,969 5.72
Loans and leases held for investment (1)
7,773,816 140,209 7.23 5,805,907 78,188 5.40
Total interest-earning assets 10,273,941 169,712 6.63 8,246,337 99,247 4.83
Less: Allowance for credit losses on loans and leases
(108,552) (62,566)
Noninterest-earning assets 499,661 644,495
Total assets $ 10,665,050 $ 8,828,266
Interest-bearing liabilities:
Interest-bearing checking $ 300,046 $ 3,968 5.30 % $ — $ — — %
Savings 4,277,850 41,930 3.93 3,894,177 7,538 0.78
Money market accounts 121,382 184 0.61 93,072 56 0.24
Certificates of deposit 4,792,289 38,921 3.26 3,714,882 11,183 1.21
Total deposits 9,491,567 85,003 3.59 7,702,131 18,777 0.98
Borrowings 37,997 407 4.30 132,969 536 1.62
Total interest-bearing liabilities 9,529,564 85,410 3.59 7,835,100 19,313 0.99
Noninterest-bearing deposits 205,741 96,123
Noninterest-bearing liabilities 80,427 55,725
Shareholders' equity 849,318 841,318
Total liabilities and shareholders' equity
$ 10,665,050 $ 8,828,266
Net interest income and interest rate spread
$ 84,302 3.04 % $ 79,934 3.84 %
Net interest margin 3.29 % 3.89 %
Ratio of average interest-earning assets to average interest-bearing liabilities
107.81 % 105.25 %
(1) Average loan and lease balances include non-accruing loans and leases.
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Six Months Ended June 30,
2023 2022
Average
Balance
Interest Average
Yield/Rate
Average
Balance
Interest Average
Yield/Rate
Interest-earning assets:
Interest-earning balances in other banks $ 530,205 $ 12,040 4.58 % $ 276,114 $ 1,027 0.75 %
Federal funds sold 69,629 1,624 4.70 43,897 202 0.93
Investment securities 1,220,028 16,050 2.65 905,403 7,445 1.66
Loans held for sale 538,385 24,139 9.04 1,117,360 31,152 5.62
Loans and leases held for investment (1)
7,636,343 267,275 7.06 5,708,084 152,203 5.38
Total interest-earning assets 9,994,590 321,128 6.48 8,050,858 192,029 4.81
Less: Allowance for credit losses on loans and leases
(101,457) (62,649)
Noninterest-earning assets 496,925 616,486
Total assets $ 10,390,058 $ 8,604,695
Interest-bearing liabilities:
Interest-bearing checking $ 161,626 $ 4,239 5.29 % $ — $ — — %
Savings 4,242,763 78,181 3.72 3,750,838 12,378 0.67
Money market accounts 117,753 321 0.55 92,272 110 0.24
Certificates of deposit 4,664,536 69,857 3.02 3,633,547 20,637 1.15
Total deposits 9,186,678 152,598 3.35 7,476,657 33,125 0.89
Borrowings 97,920 2,211 4.55 197,369 1,191 1.22
Total interest-bearing liabilities 9,284,598 154,809 3.36 7,674,026 34,316 0.90
Noninterest-bearing deposits 191,489 91,373
Noninterest-bearing liabilities 72,467 53,841
Shareholders' equity 841,504 785,455
Total liabilities and shareholders' equity
$ 10,390,058 $ 8,604,695
Net interest income and interest rate spread
$ 166,319 3.12 % $ 157,713 3.91 %
Net interest margin 3.36 % 3.95 %
Ratio of average interest-earning assets to average interest-bearing liabilities
107.65 % 104.91 %
(1) Average loan and lease balances include non-accruing loans and leases.
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Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The total column represents the sum of the prior columns. For purposes of this table, increases or decreases attributable to changes in both rate and volume that cannot be segregated have been allocated proportionally based on the changes due to rate and the changes due to volume.
Three Months Ended June 30, Six Months Ended June 30,
2023 vs. 2022 2023 vs. 2022
Increase (Decrease) Due to Increase (Decrease) Due to
Rate Volume Total Rate Volume Total
Interest income:
Interest-earning balances in other banks $ 5,038 $ 2,961 $ 7,999 $ 7,655 $ 3,358 $ 11,013
Federal funds sold — (196) (196) 1,063 359 1,422
Investment securities 2,567 1,890 4,457 5,242 3,363 8,605
Loans held for sale 7,577 (11,393) (3,816) 14,037 (21,050) (7,013)
Loans and leases held for investment 31,023 30,998 62,021 55,619 59,453 115,072
Total interest income 46,205 24,260 70,465 83,616 45,483 129,099
Interest expense:
Interest-bearing checking — 3,968 3,968 — 4,239 4,239
Savings 32,140 2,252 34,392 60,459 5,344 65,803
Money market accounts 98 30 128 161 50 211
Certificates of deposit 21,741 5,997 27,738 38,572 10,648 49,220
Borrowings 571 (700) (129) 2,443 (1,423) 1,020
Total interest expense 54,550 11,547 66,097 101,635 18,858 120,493
Net interest income $ (8,345) $ 12,713 $ 4,368 $ (18,019) $ 26,625 $ 8,606
Provision for Loan and Lease Credit Losses
The provision for loan and lease credit losses represents the amount necessary to be charged against the current period’s earnings to maintain the allowance for credit losses (“ACL”) on loans and leases at a level that the Company believes is appropriate in relation to the estimated losses inherent in the loan and lease portfolio.
Losses inherent in loan relationships are mitigated if a portion of the loan is guaranteed by the SBA or USDA. Typical SBA 7(a) and USDA guarantees range from 50% to 90% depending on loan size and type, which serve to reduce the risk profile of these loans. The Company believes that its focus on compliance with regulations and guidance from the SBA and USDA are key factors to managing this risk.
For the second quarter of 2023, there was a provision for loan and lease credit losses of $13.0 million compared to $5.3 million for the same period in 2022, an increase of $7.8 million. For the first six months of 2023, there was a provision for loan and lease credit losses of $32.0 million compared to $7.1 million for the same period in 2022, an increase of $24.9 million. The increase in provision expense as compared to the second quarter of 2022 and first six months of 2022 was primarily the result of loan growth, combined with portfolio trends and changes in the macroeconomic outlook.
Loans and leases held for investment at historical cost were $7.39 billion as of June 30, 2023, increasing by $2.07 billion, or 38.7%, compared to June 30, 2022.
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Net charge-offs for loans and leases carried at historical cost were $1.2 million, or 0.06% of average quarterly loans and leases held for investment, carried at historical cost, on an annualized basis, for the three months ended June 30, 2023, compared to net charge-offs of $2.5 million, or 0.19%, for the three months ended June 30, 2022. For the six months ended June 30, 2023 , net charge-offs totaled $7.8 million compared to $4.8 million for the six months ended June 30, 2022 , an increase of $3.0 million, or 62.2%. The increase in net charge-offs for the first half of 2023 was primarily isolated to two relationships. Net charge-offs are a key element of historical experience in the Company's estimation of the allowance for credit losses on loans and leases.
In addition, nonperforming loans and leases not guaranteed by the SBA or USDA, excluding $8.6 million and $3.6 million accounted for under the fair value option at June 30, 2023 and 2022, respectively, totaled $44.9 million, which was 0.61% of the held for investment loan and lease portfolio carried at historical cost at June 30, 2023, compared to $12.0 million, or 0.22% of loans and leases held for investment carried at historical cost at June 30, 2022. The increase in total nonperforming loans and leases not guaranteed and carried at historical cost was principally isolated to two large relationships.
Noninterest Income
Noninterest income is principally comprised of net gains from the sale of SBA and USDA-guaranteed loans along with loan servicing revenue and related revaluation of the servicing asset. Revenue from the sale of loans depends upon the volume, maturity structure and rates of underlying loans as well as the pricing and availability of funds in the secondary markets prevailing in the period between completed loan funding and closing of sale. In addition, the loan servicing revaluation is significantly impacted by changes in market rates and other underlying assumptions such as prepayment speeds and default rates. Net gain (loss) on loans accounted for under the fair value option is also significantly impacted by changes in market rates, prepayment speeds and inherent credit risk. Other less consistent elements of noninterest income include gains and losses on investments.
The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.
Three Months Ended June 30, 2023/2022 Increase (Decrease)
2023 2022 Amount Percent
Noninterest income
Loan servicing revenue $ 6,687 $ 6,477 $ 210 3.2 %
Loan servicing asset revaluation (2,831) (8,668) 5,837 67.3
Net gains on sales of loans 10,804 5,630 5,174 91.9
Net gain (loss) on loans accounted for under the fair value option 1,728 (4,461) 6,189 138.7
Equity method investments (loss) income (2,055) 119,056 (121,111) (101.7)
Equity security investments gains (losses), net 121 1,655 (1,534) (92.7)
Lease income 2,535 2,510 25 1.0
Management fee income 3,266 2,558 708 27.7
Other noninterest income 3,901 3,772 129 3.4
Total noninterest income $ 24,156 $ 128,529 $ (104,373) (81.2) %
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Six Months Ended June 30, 2023/2022 Increase (Decrease)
2023 2022 Amount Percent
Noninterest income
Loan servicing revenue $ 13,067 $ 12,833 $ 234 1.8 %
Loan servicing asset revaluation (2,475) (10,237) 7,762 75.8
Net gains on sales of loans 20,979 26,607 (5,628) (21.2)
Net gain (loss) on loans accounted for under the fair value option (2,801) (3,945) 1,144 29.0
Equity method investments (loss) income (5,007) 116,932 (121,939) (104.3)
Equity security investments gains (losses), net 198 1,611 (1,413) (87.7)
Lease income 5,070 5,013 57 1.1
Management fee income 6,738 4,046 2,692 66.5
Other noninterest income 7,966 8,337 (371) (4.5)
Total noninterest income $ 43,735 $ 161,197 $ (117,462) (72.9) %
For the three months ended June 30, 2023, noninterest income decreased by $104.4 million, or 81.2%, compared to the three months ended June 30, 2022. The decrease over the prior year is primarily a result of the $120.5 million Finxact gain included in equity method investment income in the second quarter of 2022. Partially offsetting the decrease over the second quarter of 2022 was lower losses of $5.8 million related to the servicing asset revaluation, an increase in net gains on sales of loans of $5.2 million, combined with an incremental $6.2 million net gain on loans accounted for under the fair value option.
For the six months ended June 30, 2023, noninterest income decreased by $117.5 million, or 72.9%, compared to the six months ended June 30, 2022. The decrease over the prior year is primarily a result of the above mentioned Finxact gain in the second quarter of 2022 combined with a decrease in net gains on sales of loans of $5.6 million. Partially offsetting the decrease over the prior year to date period was lower losses of $7.8 million related to the servicing asset revaluation combined with a $2.7 million increase in management fee income generated by Canapi Advisors. Canapi Advisors is included in the Company's Fintech segment.
The following table reflects loan and lease production, sales of guaranteed loans and the aggregate balance in guaranteed loans sold. These components are key drivers of the Company's noninterest income.
Three months ended June 30, Three months ended March 31,
2023 2022 2023 2022
Amount of loans and leases originated $ 861,033 $ 959,635 $ 1,030,882 $ 865,063
Guaranteed portions of loans sold 245,074 68,818 167,826 219,703
Outstanding balance of guaranteed loans sold (1)
2,808,200 2,681,079 2,695,757 2,786,403
Six Months Ended June 30, For years ended December 31,
2023 2022 2022 2021 2020 2019
Amount of loans and leases originated
$ 1,891,915 $ 1,824,698 $ 4,007,621 $ 4,480,725 $ 4,450,198 $ 2,001,886
Guaranteed portions of loans sold
412,900 288,521 580,889 668,462 542,596 340,374
Outstanding balance of guaranteed loans sold (1)
2,808,200 2,681,079 2,668,110 2,756,915 2,819,625 2,746,480
(1) This represents the outstanding principal balance of guaranteed loans serviced, as of the last day of the applicable period, which have been sold into the secondary market.
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Changes in various components of noninterest income are discussed in more detail below.
Loan Servicing Asset Revaluation: The Company revalues its serviced loan portfolio at least quarterly. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as adequate compensation for servicing, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses, with the prepayment speed being one of the most sensitive assumptions. For the three months ended June 30, 2023, there was a net loss on loan servicing asset revaluation of $2.8 million, compared to a net loss of $8.7 million for the three months ended June 30, 2022, resulting in a positive comparative quarter change of $5.8 million, or 67.3%. For the six months ended June 30, 2023, there was a net loss on loan servicing asset revaluation of $2.5 million compared to $10.2 million for the six months ended June 30, 2022, resulting in a positive change of $7.8 million, or 75.8%. The increase in the valuation of the servicing asset compared to the second quarter and first half of 2022 was principally the result of negative market trends in 2022 outpacing those experienced in 2023.
Net Gains on Sales of Loans: For the three months ended June 30, 2023, net gains on sales of loans increased $5.2 million, or 91.9%, compared to the three months ended June 30, 2022. The volume of guaranteed loans sold increased $176.3 million, or 256.1%, for the three months ended June 30, 2023 to $245.1 million from $68.8 million in the three months ended June 30, 2022. For the six months ended June 30, 2023, net gains on sales of loans decreased $5.6 million, or 21.2%, compared to the six months ended June 30, 2022. For the six months ended June 30, 2023, the volume of guaranteed loans sold increased $124.4 million, or 43.1%, to $412.9 million from $288.5 million for the six months ended June 30, 2022. The average net gain on loan sale premium decreased from 108% to 105% in the second quarters of 2022 and 2023, respectively, and decreased from 109% to 106% in the first halves of 2022 and 2023, respectively. The increase in net gains on sales of loans over the second quarter of 2022 was principally the result of higher loan sale volume while the decrease over the first half of 2022 was principally related to the effect of weaker premiums outpacing heightened levels of sales volume.
Net Gain (Loss) on Loans Accounted for Under the Fair Value Option : For the three months ended June 30, 2023, the Company had a net gain on loans accounted for under the fair value option of $1.7 million compared to a net loss of $4.5 million for the second quarter of 2022, a positive change of $6.2 million, or 138.7%. For the six months ended June 30, 2023 , the Company had a net loss on loans accounted for under the fair value option of $2.8 million compared to a net loss of $3.9 million for the same period of 2022 , a positive change of $1.1 million, or 29.0%. The carrying amount of loans accounted for under the fair value option at June 30, 2023 and 2022 was $441.8 million (all classified as held for investment) and $554.1 million ($23.5 million classified as held for sale and $530.6 million classified as held for investment), respectively, a decrease of $112.3 million, or 20.3% . The incremental net gain on loans accounted for under the fair value option compared to both prior periods was largely the result of moderating interest rate impacts in 2023 combined with a continued decline in the size of the underlying principal balance of the portfolio.
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Noninterest Expense
Noninterest expense comprises all operating costs of the Company, such as employee related costs, travel, professional services, advertising and marketing expenses, exclusive of interest and income tax expense.
The following table shows the components of noninterest expense and the related dollar and percentage changes for the periods presented.
Three Months Ended June 30, 2023/2022 Increase (Decrease)
2023 2022 Amount Percent
Noninterest expense
Salaries and employee benefits $ 43,066 $ 46,276 $ (3,210) (6.9) %
Non-employee expenses:
Travel expense 2,770 2,358 412 17.5
Professional services expense 1,996 3,988 (1,992) (49.9)
Advertising and marketing expense 3,009 2,301 708 30.8
Occupancy expense 2,205 2,773 (568) (20.5)
Technology expense 8,005 5,762 2,243 38.9
Equipment expense 4,023 3,784 239 6.3
Other loan origination and maintenance expense 3,442 3,022 420 13.9
Renewable energy tax credit investment impairment — 50 (50) (100.0)
FDIC insurance 5,061 2,164 2,897 133.9
Contributions and donations — 5,515 (5,515) (100.0)
Other expense 2,880 2,886 (6) (0.2)
Total non-employee expenses 33,391 34,603 (1,212) (3.5)
Total noninterest expense $ 76,457 $ 80,879 $ (4,422) (5.5) %
Six Months Ended June 30, 2023/2022 Increase (Decrease)
2023 2022 Amount Percent
Noninterest expense
Salaries and employee benefits $ 87,831 $ 84,783 $ 3,048 3.6 %
Non-employee expenses:
Travel expense 5,181 4,255 926 21.8
Professional services expense 2,923 6,779 (3,856) (56.9)
Advertising and marketing expense 6,612 4,030 2,582 64.1
Occupancy expense 4,130 5,100 (970) (19.0)
Technology expense 15,734 11,815 3,919 33.2
Equipment expense 7,841 7,600 241 3.2
Other loan origination and maintenance expense 7,369 6,135 1,234 20.1
Renewable energy tax credit investment impairment 69 50 19 38.0
FDIC insurance 8,464 4,136 4,328 104.6
Contributions and donations — 6,238 (6,238) (100.0)
Other expense 9,265 5,672 3,593 63.3
Total non-employee expenses 67,588 61,810 5,778 9.3
Total noninterest expense $ 155,419 $ 146,593 $ 8,826 6.0 %
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Total noninterest expense for the three and six months ended June 30, 2023, decreased $4.4 million, or 5.5%, and increased $8.8 million, or 6.0%, respectively, compared to the same periods in 2022. The changes in noninterest expense for the comparable three and six month period was largely driven by various components, as discussed below.
Salaries and employee benefits : Total personnel expense for the three and six months ended June 30, 2023 decreased by $3.2 million, or 6.9%, and increased $3.0 million, or 3.6%, respectively, compared to the same periods in 2022. The decrease in salaries and employee benefits over the second quarter of 2022 was largely the product of lower levels in bonus accruals while the increase over the first half of 2022 is principally related to continued investment in human resources to support strategic and growth initiatives. Total full-time equivalent employees increased from 891 at June 30, 2022, to 984 at June 30, 2023 . Salaries and employee benefits expense included $6.3 million and $12.5 million of stock-based compensation for the three and six months ended June 30, 2023, respectively, compared to $5.1 million and $10.0 million for the three and six months ended June, 30, 2022, respectively. Expenses related to the employee stock purchase program, stock grants, stock option compensation and restricted stock expense are all considered stock-based compensation.
Professional services expense: For the three and six months ended June 30, 2023, professional services expense decreased $2.0 million, or 49.9%, and $3.9 million, or 56.9%, respectively, compared to the same periods in 2022 . The decrease compared to the prior periods was due to lower levels of legal fees combined with an insurance recovery of $1.3 million in the first quarter of 2023 related to previously expensed legal fees.
Advertising and marketing expense : For the six months ended June 30, 2023, advertising and marketing expense increased $2.6 million, or 64.1%, compared to the same period in 2022. The increase over the first half of 2022 was largely driven by continued investment in the Company’s lending and deposit market growth.
Technology expense : For the three and six months ended June 30, 2023, technology expense increased $2.2 million, or 38.9%, and $3.9 million, or 33.2%, respectively, compared to the same periods in 2022. This increase was primarily related to enhanced investments in the Company’s technology resources.
FDIC insurance: For the three and six months ended June 30, 2023, FDIC insurance increased $2.9 million, or 133.9%, and $4.3 million, or 104.6%, respectively, compared to the same periods in 2022. This increase is largely the result of rate increases effective in 2023 combined with the ongoing growth of Live Oak Banking Company.
Contributions and donations: For the three and six months ended June 30, 2023, contributions and donations decreased $5.5 million, and $6.2 million, respectively, compared to the same periods in 2022. The decrease is principally related to a special charitable donation during the second quarter of 2022 of $5.0 million made in connection with the earlier discussed Finxact gain.
Other expense: For the six months ended June 30, 2023, other expense increased $3.6 million, or 63.3%, compared to the same period in 2022, largely related to $2.9 million in increased levels of reserves on unfunded commitments. This increase in the reserve for unfunded commitments was largely a result of refinements to the estimation assumptions in the first quarter of 2023.
Income Tax Expense
For the three months ended June 30, 2023, income tax expense was $1.4 million compared to $25.3 million for the second quarter of 2022, and the Company’s effective tax rates were 7.5% and 20.7%, respectively. For the six months ended June 30, 2023, income tax expense was $4.6 million compared to $33.7 million for the first half of 2022, and the Company’s effective tax rates were 20.6% and 20.4%, respectively. The lower level of income tax expense for the second quarter and the first half of 2023 as compared to the same periods in 2022 was principally the result of decreased pretax income combined with increased tax credits.
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Results of Segment Operations
The Company’s operations are managed along two primary operating segments Banking and Fintech. A description of each segment and the methodologies used to measure financial performance is described in Note 11. Segments in the accompanying Notes to the Unaudited Condensed Consolidated Financial Statements. Net income (loss) by operating segment is presented below:
Three Months Ended June 30, Six Months Ended June 30,
2023 2022 2023 2022
Banking $ 19,623 $ 3,755 $ 22,011 $ 41,595
Fintech (727) 94,683 (1,088) 92,934
Other (1,352) (1,399) (2,981) (2,981)
Consolidated net income $ 17,544 $ 97,039 $ 17,942 $ 131,548
Banking
For the three and six months ended June 30, 2023, net income increased $15.9 million and decreased $19.6 million, respectively, compared to the same periods of 2022. Key factors influencing these changes are discussed below.
For the three and six months ended June 30, 2023, net interest income increased $4.1 million, or 5.1%, and $8.1 million, or 5.1%, respectively, compared to the same periods of 2022. See above section captioned “Net Interest Income and Margin” as it is principally related to the Banking segment.
The provision for loan and lease credit losses for the three and six months ended June 30, 2023, increased $7.8 million and $24.9 million, respectively, compared to the same periods of 2022. See the analysis of provision for loan and lease credit losses included in the above section captioned “Provision for Loan and Lease Credit Losses” as it is entirely related to the Banking segment.
For the three and six months ended June 30, 2023, noninterest income increased $16.3 million and $1.4 million, respectively, compared to the same periods of 2022. The increase for the three month comparative period was principally driven by lower losses related to the loan servicing asset revaluation, increased net gains on sales of loans and an incremental gain on loans accounted for under the fair value option. See the analysis of these categories of noninterest income included in the above section captioned “Noninterest Income” for additional discussion.
For the three and six months ended June 30, 2023, noninterest expense decreased $4.9 million, or 6.3%, and increased $8.2 million, or 5.9%, respectively, compared to same periods of 2022. See the analysis of these categories of noninterest expense included in the above section captioned “Noninterest Expense” for additional discussion.
For the three and six months ended June 30, 2023, income tax expense increased $1.7 million and decreased $4.1 million, respectively, compared to the same periods of 2022. The decrease compared to the six months ended June 30, 2022 is principally due to lower levels of pretax income.
Fintech
For the three and six months ended June 30, 2023, net income decreased by $95.4 million and $94.0 million, respectively, compared to same periods of 2022. The primary factor influencing this decrease compared to both prior periods is the $120.5 million Finxact gain included in equity method investment income in the second quarter of 2022. Partially offsetting the decrease over the first half of 2022 was a $2.7 million increase in management fee income earned by Canapi Advisors combined with lower levels of income tax expense as a result decreased pretax income in 2023.
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Discussion and Analysis of Financial Condition
June 30, 2023 vs. December 31, 2022
Total assets at June 30, 2023 were $10.82 billion, an increase of $963.7 million, or 9.8%, compared to total assets of $9.86 billion at December 31, 2022. The growth in total assets was principally driven by the following:
• Cash and cash equivalents, comprised of cash and due from banks and federal funds sold, combined with investment securities available-for-sale was $1.94 billion at June 30, 2023, an increase of $509.9 million, or 35.6%, compared to $1.43 billion at December 31, 2022. This increase reflects growing deposit levels combined with strategic maintenance of the Company's liquidity profile.
• Growth in total loans and leases held for investment and held for sale of $461.4 million resulting from strong origination activity in the first six months of 2023 and holding loans available for sale for longer periods of time before sale, as discussed more fully below. Total originations during the first half of 2023 were $1.89 billion.
Loans held for sale decreased $30.8 million, or 5.6%, during the first six months of 2023, from $554.6 million at December 31, 2022, to $523.8 million at June 30, 2023. The decrease in loans held for sale was principally due to the impact of market conditions in a rising rate environment which has influenced management's intent to hold a greater portion of loans as held for investment combined with higher levels of loan sales in the first half of 2023.
Loans and leases held for investment increased $492.2 million, or 6.7%, during the first six months of 2023, from $7.34 billion at December 31, 2022, to $7.84 billion at June 30, 2023. The increase was primarily the result of the above-mentioned loan originations in 2023 combined with increased levels of loans retained as held for investment.
Total deposits were $9.88 billion at June 30, 2023, an increase of $994.2 million, or 11.2%, from $8.88 billion at December 31, 2022. The increase in total deposits from the prior period was to support growth in the loan and lease portfolio combined with strong deposit inflows. At June 30, 2023, the Bank’s total uninsured deposits were approximately $1.4 billion, or 14.3%, of total deposits.
Borrowings decreased to $28.3 million at June 30, 2023, from $83.2 million at December 31, 2022. This decrease was principally due to paying off the Company’s Fed Funds line of credit in the first quarter of 2023. See Note 8. Borrowings in the accompanying Notes to Unaudited Condensed Consolidated Financial Statements for a discussion of current sources of available debt capacity.
Regulatory Impact of Asset Growth
General. In the first quarter of 2023, the Company and the Bank each first exceeded $10 billion in total assets. As of June 30, 2023, the Company and the Bank each had total assets of $10.82 billion and $10.72 billion, respectively. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and its implementing regulations impose various additional requirements on bank holding companies and banks with $10 billion or more in total consolidated assets. As a general matter, the Company and the Bank are not immediately subject to these additional requirements when they exceed $10 billion in assets; instead, the Company and the Bank will be subject to these various requirements over various dates, as described below.
Consumer Financial Laws. Under the Dodd-Frank Act, the Consumer Financial Protection Bureau (CFPB) has near-exclusive supervision authority, including examination authority, to assess compliance with federal consumer financial laws for a bank and its affiliates if the bank has total assets of more than $10 billion. This provision becomes applicable to a bank following the fourth consecutive quarter where the total assets of the bank, as reported in its quarterly Call Report, exceed $10 billion and afterwards remains applicable to the bank unless the bank has reported total assets of $10 billion or less in its quarterly Call Report for four consecutive quarters.
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Deposit Insurance Assessments. Also under the Dodd-Frank Act, the minimum ratio of net worth to insured deposits of the federal Deposit Insurance Fund administered by the FDIC was increased from 1.15 percent to 1.35 percent and the FDIC is required, in setting deposit insurance assessments, to offset the effect of the increase on institutions with assets of less than $10 billion, which results in institutions with assets greater than $10 billion paying higher assessments. In addition, following the fourth consecutive quarter where the total assets of a bank exceeds $10 billion, as reported in its quarterly Call Report, the FDIC utilizes a different method for determining deposit insurance assessments. This large bank method is based on a bank’s ability to withstand asset- and funding-related stress, its regulatory ratings, and potential losses to the FDIC in the event of the bank’s failure, subject to discretionary adjustments by the FDIC.
Volcker Rule. Under provisions of the Dodd-Frank Act referred to as the “Volcker Rule,” certain limitations are placed on the ability of insured depository institutions and their affiliates to engage in sponsoring, investing in and transacting with certain investment funds, known as “covered funds” under the rule. There are a number of exclusions from the definition of “covered funds,” including for investments in Small Business Investment Companies, or SBICs, and certain qualifying venture capital funds. The Volcker Rule also places restrictions on proprietary trading, which could impact certain hedging activities.
Limits on Interchange Fees. The Bank also may be affected by the Durbin Amendment to the Dodd-Frank Act regarding limits on debit card interchange fees. The Durbin Amendment gave the Federal Reserve Board the authority to establish rules regarding interchange fees charged for electronic debit transactions by a payment card issuer that, together with its affiliates, has assets of $10 billion or more, as of December 31 of the preceding calendar year, and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer. The Federal Reserve Board has adopted rules under this provision that limit the swipe fees that a debit card issuer can charge a merchant for a transaction to the sum of 21 cents and five basis points times the value of the transaction, plus up to one cent for fraud prevention costs.
Asset Quality
Management considers asset quality to be of primary importance. A formal loan review function, independent of loan origination, is used to identify and monitor problem loans. This function reports directly to the Audit & Risk Committee of the Board of Directors.
Nonperforming Assets
The Bank places loans and leases on nonaccrual status when they become 90 days past due as to principal or interest payments, or prior to that if management has determined based upon current information available to them that the timely collection of principal or interest is not probable. When a loan or lease is placed on nonaccrual status, any interest previously accrued as income but not actually collected is reversed and recorded as a reduction of loan or lease interest and fee income. Typically, collections of interest and principal received on a nonaccrual loan or lease are applied to the outstanding principal as determined at the time of collection of the loan or lease. In respect to the Company's adoption of ASU No. 2022-02 on January 1, 2023, as described more fully in Note 2 in the accompanying Unaudited Condensed Consolidated Financial Statements, the prior period discussed below has been adjusted to exclude previously disclosed troubled debt restructurings for comparative purposes.
Nonperforming assets, excluding loans measured at fair value, at June 30, 2023 were $111.2 million, which represented a $37.8 million, or 51.5%, increase from December 31, 2022. These nonperforming assets at June 30, 2023 were all nonaccrual loans and leases. At June 30, 2023, there were no foreclosed assets. Of the $111.2 million of nonperforming assets, $66.3 million carried a government guarantee, leaving an unguaranteed exposure of $44.9 million in total nonperforming assets at June 30, 2023. This represents an increase of $26.1 million, or 139.0%, from an unguaranteed exposure of $18.8 million at December 31, 2022.
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The following table provides information with respect to nonperforming assets, excluding loans measured at fair value, at the dates indicated.
June 30, 2023 (1)
December 31, 2022 (1)
Nonaccrual loans and leases:
Total nonperforming loans and leases (all on nonaccrual) $ 111,221 $ 73,392
Foreclosed assets — —
Total nonperforming assets $ 111,221 $ 73,392
Allowance for credit losses on loans and leases $ 120,116 $ 96,566
Total nonperforming loans and leases to total loans and leases held for investment 1.50 % 1.07 %
Total nonperforming loans and leases to total assets 1.07 % 0.78 %
Allowance for credit losses on loans and leases to loans and leases held for investment 1.62 % 1.41 %
Allowance for credit losses on loans and leases to total nonperforming loans and leases 108.00 % 131.58 %
(1) Excludes loans measured at fair value.
June 30, 2023 (1)
December 31, 2022 (1)
Nonaccrual loans and leases guaranteed by U.S. government:
Total nonperforming loans and leases guaranteed by the U.S government (all on nonaccrual) $ 66,322 $ 54,608
Foreclosed assets guaranteed by the U.S. government — —
Total nonperforming assets guaranteed by the U.S. government $ 66,322 $ 54,608
Allowance for credit losses on loans and leases $ 120,116 $ 96,566
Total nonperforming loans and leases not guaranteed by the U.S. government to total held for investment loans and leases 0.61 % 0.27 %
Total nonperforming loans and leases not guaranteed by the U.S. government to total assets 0.43 % 0.20 %
Allowance for credit losses on loans and leases to total nonperforming loans and leases not guaranteed by the U.S. government 267.52 % 514.09 %
(1) Excludes loans measured at fair value.
Total nonperforming assets, including loans measured at fair value, at June 30, 2023 were $168.8 million, which represented a $48.4 million, or 40.2%, increase from December 31, 2022. Of the $168.8 million of nonperforming assets, $113.2 million carried a government guarantee, leaving an unguaranteed exposure of $55.6 million in total nonperforming assets at June 30, 2023. This represents an increase of $29.5 million, or 113.4%, from an unguaranteed exposure of $26.0 million at December 31, 2022.
See the below discussion related to the change in potential problem and impaired loans and leases for management’s overall observations regarding growth in total nonperforming loans and leases.
As a percentage of the Bank’s total capital, nonperforming loans and leases, excluding loans measured at fair value, represented 12.8% at June 30, 2023, compared to 9.0% at December 31, 2022. Adjusting the ratio to include only the unguaranteed portion of nonperforming loans and leases at historical cost to reflect management’s belief that the greater magnitude of risk resides in this portion, the ratios at both June 30, 2023 and December 31, 2022 were 5.2% and 2.3%, respectively.
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As of June 30, 2023, and December 31, 2022, potential problem (also referred to as criticized) and classified loans and leases, excluding loans measured at fair value, totaled $556.6 million and $424.7 million, respectively. The following is a discussion of these loans and leases. Risk Grades 5 through 8 represent the spectrum of criticized and classified loans and leases. For a complete description of the risk grading system, see Note 3. Loans and Leases Held for Investment and Credit Quality in the Company’s 2022 Form 10-K. At June 30, 2023 , the portion of criticized and classified loans and leases guaranteed by the SBA or USDA totaled $227.1 million and total portfolio unguaranteed exposure risk was $329.5 million, or 7.0% of total held for investment unguaranteed exposure carried at historical cost. This compares to the December 31, 2022 portion of criticized and classified loans and leases guaranteed by the SBA or USDA which totaled $195.8 million and total portfolio unguaranteed exposure risk was $228.9 million, or 5.5% of total held for investment unguaranteed exposure carried at historical cost. As of June 30, 2023 , loans and leases carried at historical cost within the following verticals comprise the largest portion of the total potential problem and classified loans and leases: Wine and Craft Beverage at 12.3%, Senior Housing at 12.2%, Sponsor Finance at 12.1% (principally related to Search Fund Lending), General Lending at 10.1%, Healthcare at 5.0%, Senior Care at 4.7%, Fitness Centers at 4.6%, Hotels at 4.6%, Venture Banking at 4.4% and Agriculture at 4.0%. As of December 31, 2022 , loans and leases carried at historical cost within the following verticals comprise the largest portion of the total potential problem and classified loans and leases: Wine and Craft Beverage at 11.5%, General Lending at 10.3%, Senior Housing at 10.2%, Sponsor Finance at 7.8%, Healthcare at 6.4%, Hotels at 5.9%, Fitness Centers at 5.1%, Agriculture at 4.5% and Senior Care at 4.0%. Of the above listed verticals, Senior Housing, Sponsor Finance and Venture Banking are within the Company’s Specialty Lending division while Hot els are within the Energy & Infrastructure division, the remainder of the above listed verticals are within the Small Business Banking division. The majority of the $131.9 million increase in potential problem and classified loans and leases in the first six months of 2023 was comprised of several relationships that did not have a government guarantee. The Company believes that its underwriting and credit quality standards have remained high and continues to consider changing economic conditions in a rising interest rate environment.
Loans and leases that experience insignificant payment delays and payment shortfalls are generally not individually evaluated for the purpose of estimating the allowance for credit losses. The Bank generally considers an “insignificant period of time” from payment delays to be a period of 90 days or less. The Bank would consider a modification for a customer experiencing what is expected to be a short-term event that has temporarily impacted cash flow. This could be due, among other reasons, to illness, weather, impact from a one-time expense, slower than expected start-up, construction issues or other short-term issues. Credit personnel will review the request to determine if the customer is stressed and how the event has impacted the ability of the customer to repay the loan or lease long term. At June 30, 2023, the Company had a total of $21.7 million in loans modified in the first half of 2023 to borrowers experiencing financial difficulty, all of which remained current with $4.5 million on principal payment deferral.
Management endeavors to be proactive in its approach to identify and resolve p roblem loans and leases and is focused on working with the borrowers and guarantors of these loans and leases to provide loan and lease modifications when warranted. Management implements a proactive approach to identifying and classifying loans and leases as special mention (also referred to as criticized), Risk Grade 5. At June 30, 2023, and December 31, 2022, Risk Grade 5 loans and leases, excluding lo ans measured at fair value, totaled $404.3 million and $286.5 million, respectively, for a six month increase of $117.8 million. The increase in Risk Grade 5 loans and leases, exclusive of loans measured at fair value, during the first half of 2023 was principally confined to eight verticals: Sponsor Finance ($35.9 million or 30.4%, principally related to Search Fund Lending ), Wine and Craft Beverage ($19.7 million or 16.7%), Venture Banking ($17.1 million or 14.5%), Bioenergy ($13.5 million or 11.4%), Senior Housing ($12.5 million or 10.6%), Conventional Financing ($10.3 million or 8.7%), General Lending ($6.4 million or 5.4%), and Senior Care ($6.1 million or 5.2%). Of the above listed verticals, Sponsor Finance, Senior Housing, Venture Banking and Conventional Financing are within the Company’s Specialty Lending division while Bioenergy is within the Energy & Infrastructure division, the remainder of the above listed verticals are within the Small Business Banking division.
At June 30, 2023, approximately 97.5% of loans and leases classified as Risk Grade 5 are performing with no relationships having payments past due more than 30 days. While the level of nonperforming assets fluctuates in response to changing economic and market conditions, in light of the relative size and composition of the loan and lease portfolio and management’s degree of success in resolving problem assets, management believes that a proactive approach to early identification and intervention is critical to successfully managing a small business loan portfolio. As government payment assistance began to expire toward the end of 2020, borrowers with continuing difficulties arising from the pandemic were provided additional relief through payment deferrals. At June 30, 2023, the Company had $9.5 million in unguaranteed loans on SBA payment assistance. Management monitors these borrowers closely and has observed financial conditions continuing to improve.
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Allowance for Credit Losses on Loans and Leases
The ACL of $96.6 million at December 31, 2022, increased by $23.6 million, or 24.4%, to $120.1 million at June 30, 2023. The ACL as a percentage of loans and leases held for investment at historical cost amounted to 1.4% and 1.6% at December 31, 2022 and June 30, 2023, respectively. The increase in the ACL during the first six months of 2023 was primarily the result of loan growth, combined with portfolio trends and changes in the macroeconomic outlook. See also the above section captioned “Provision for Loan and Lease Credit Losses” in “Results of Operations” for related information.
Actual past due held for investment loans and leases, inclusive of loans measured at fair value, have increased by $40.6 million since December 31, 2022. Total loans and leases 90 or more days past due increased $41.1 million, or 72.7 %, compared to December 31, 2022. This increase was comprised of a $11.5 million increase in unguaranteed exposure combined with a $29.7 million increase in the guaranteed portion of past due loans compared to December 31, 2022. At June 30, 2023 and December 31, 2022, total held for investment unguaranteed loans and leases past due as a percentage of total held for investment unguaranteed loans and leases, inclusive of loans measured at fair value, was 0.9% and 0.7%, respectively. Total unguaranteed loans and leases past due were comprised of $35.8 million carried at historical cost, an increase of $14.6 million, and $11.8 million measured at fair value, an increase of $2.2 million, as of June 30, 2023 compared to December 31, 2022. Management continues to actively monitor and work to improve asset quality. Management believes the ACL of $120.1 million at June 30, 2023 is appropriate in light of the risk inherent in the loan and lease portfolio. Management’s judgments are based on numerous assumptions about current and expected events that it believes to be reasonable, but which may or may not be valid. Accordingly, no assurance can be given that management’s ongoing evaluation of the loan and lease portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the ACL, thus adversely affecting the Company’s operating results. Additional information on the ACL is presented in Note 5. Loans and Leases Held for Investment and Credit Quality of the Unaudited Condensed Consolidated Financial Statements in this report.
Liquidity Management
Liquidity management refers to the ability to meet day-to-day cash flow requirements based primarily on activity in loan and deposit accounts of the Company’s customers. Liquidity is immediately available from four major sources: (a) cash on hand and on deposit at other banks; (b) the outstanding balance of federal funds sold; (c) the market value of unpledged investment securities; and (d) availability under lines of credit. At June 30, 2023, the total amount of these four items was $4.59 billion, or 42.4% of total assets compared to 40.7% of total assets, at December 31, 2022.
Loans and other assets are funded by loan sales, wholesale deposits and core deposits. To date, an increasing retail deposit base and a stable amount of brokered deposits have been adequate to meet loan obligations, while maintaining the desired level of immediate liquidity. The Company maintains an investment securities portfolio that is available for both immediate and secondary contingent liquidity purposes, whether via pledging to the Federal Home Loan Bank, Federal Reserve Bank Term Funding Program or through liquidation. Additionally, the Company maintains a guaranteed loan portfolio that is also a contingent liquidity source, whether via pledging to the Federal Reserve Discount Window or through liquidation.
At June 30, 2023, none of the investment securities portfolio was pledged to secure public deposits or pledged to retail repurchase agreements, leaving $1.13 billion available to pledge as collateral.
Contractual Obligations
The Company has entered into significant fixed and determinable contractual obligations for future payments. Other than normal changes in the ordinary course of the Company’s operations, there have been no significant changes in the types of contractual obligations or amounts due since December 31, 2022. See the section titled “Liquidity Management” in Part II, Item 7 of the Company’s 2022 Form 10-K for additional discussion of contractual obligations.
Off-Balance Sheet Arrangements
In the normal course of operations, the Company engages in a variety of financial transactions that, in accordance with GAAP, are not recorded in the consolidated financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of commitments to extend credit and standby letters of credit. For more information, see Note 10. Commitments and Contingencies in the accompanying notes to Unaudited Condensed Consolidated Financial Statements.
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Asset/Liability Management and Interest Rate Sensitivity
One of the primary objectives of asset/liability management is to maximize the net interest margin while minimizing the earnings risk associated with changes in interest rates. One method used to manage interest rate sensitivity is to measure, over various time periods, the interest rate sensitivity positions, or gaps. As of June 30, 2023, the balance sheet’s total cumulative gap position was 5.0%. For further information, see Item 3. Quantitative and Qualitative Disclosures About Market Risk.
The interest rate gap method, however, addresses only the magnitude of asset and liability repricing timing differences as of the report date and does not address earnings, market value, changes in account behaviors based on the interest rate environment, or growth. Therefore, management also uses an earnings simulation model to prepare, on a regular basis, earnings projections based on a range of instantaneous parallel interest rate shocks applied to a static balance sheet and non-parallel interest rate shocks applied to a dynamic balance sheet to measure interest rate risk. As of June 30, 2023, the Company’s interest rate risk profile under the instantaneous parallel interest rate shock scenarios applied to a static balance sheet is slightly asset-sensitive. For more information, see Item 3. Quantitative and Qualitative Disclosures About Market Risk.
An asset-sensitive position means that net interest income will generally move in the same direction as interest rates. For instance, if interest rates increase, net interest income can be expected to increase, and if interest rates decrease, net interest income can be expected to decrease. The Company attempts to mitigate interest rate risk by match funding assets and liabilities with similar rate instruments. Asset/liability sensitivity is primarily derived from the prime-based loans that adjust as the prime interest rate changes, rates on cash accounts that adjusts as the federal funds rate changes and the longer duration of indeterminate term deposits. Note that the Company regularly models various forecasted rate projections with non-parallel shifts that are reflective of potential current rate environment outcomes. Under these scenarios, the Company’s interest rate risk profile may increase in asset sensitivity, decrease in asset sensitivity, or depending on the scenario and timing of anticipated rate changes, may transition to a liability-sensitive interest rate risk profile. The Company believes that regular modeling of various interest rate outcomes allows it to assess and manage potential risks from various rate shifts.
Capital
The maintenance of appropriate levels of capital is a management priority and is monitored on a regular basis. The Company’s principal goals related to the maintenance of capital are the following: to provide adequate capital to support the Company’s risk profile consistent with the risk appetite approved by the Board of Directors; to provide financial flexibility to support future growth and client needs; to comply with relevant laws, regulations, and supervisory guidance; to achieve optimal ratings for the Company and its subsidiaries; and to provide a competitive return to shareholders. Management regularly monitors the capital position of the Company on both a consolidated and bank level basis. In this regard, management’s goal is to maintain capital at levels that are in excess of the regulatory “well capitalized” levels. Risk-based capital ratios, which include Tier 1 Capital, Total Capital and Common Equity Tier 1 Capital, are calculated based on regulatory guidance related to the measurement of capital and risk-weighted assets.
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Capital amounts and ratios as of June 30, 2023, and December 31, 2022, are presented in the table below.
Actual Minimum Capital
Requirement Minimum To Be
Well Capitalized
Under Prompt
Corrective Action
Provisions (1)
Amount Ratio Amount Ratio Amount Ratio
Consolidated - June 30, 2023
Common Equity Tier 1 (to Risk-Weighted Assets) $ 911,721 11.55 % $ 355,139 4.50 % N/A N/A
Total Capital (to Risk-Weighted Assets) 1,010,695 12.81 631,358 8.00 N/A N/A
Tier 1 Capital (to Risk-Weighted Assets) 911,721 11.55 473,519 6.00 N/A N/A
Tier 1 Capital (to Average Assets) 911,721 8.46 430,986 4.00 N/A N/A
Bank - June 30, 2023
Common Equity Tier 1 (to Risk-Weighted Assets) $ 770,449 10.14 % $ 342,051 4.50 % $ 494,074 6.50 %
Total Capital (to Risk-Weighted Assets) 865,832 11.39 608,091 8.00 760,113 10.00
Tier 1 Capital (to Risk-Weighted Assets) 770,449 10.14 456,068 6.00 608,091 8.00
Tier 1 Capital (to Average Assets) 770,449 7.23 426,493 4.00 533,116 5.00
Consolidated - December 31, 2022
Common Equity Tier 1 (to Risk-Weighted Assets) $ 888,235 12.47 % $ 320,446 4.50 % N/A N/A
Total Capital (to Risk-Weighted Assets) 977,360 13.73 569,681 8.00 N/A N/A
Tier 1 Capital (to Risk-Weighted Assets) 888,235 12.47 427,261 6.00 N/A N/A
Tier 1 Capital (to Average Assets) 888,235 9.26 383,499 4.00 N/A N/A
Bank - December 31, 2022
Common Equity Tier 1 (to Risk-Weighted Assets) $ 730,092 10.70 % $ 307,179 4.50 % $ 443,703 6.50 %
Total Capital (to Risk-Weighted Assets) 815,577 11.95 546,096 8.00 682,620 10.00
Tier 1 Capital (to Risk-Weighted Assets) 730,092 10.70 409,572 6.00 546,096 8.00
Tier 1 Capital (to Average Assets) 730,092 7.70 379,396 4.00 474,245 5.00
(1) Prompt corrective action provisions are not applicable at the bank holding company level.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in accordance with GAAP requires the Company to make estimates and judgments that affect reported amounts of assets, liabilities, income and expenses and related disclosure of contingent assets and liabilities. The Company bases estimates on historical experience and on various other assumptions that are believed to be reasonable under current circumstances, results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Estimates are evaluated on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.
Accounting policies, as described in detail in the Notes to the Company’s Unaudited Condensed Consolidated Financial Statements in this report and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022, are an integral part of the Company’s consolidated financial statements. A thorough understanding of these accounting policies is essential when reviewing the Company’s reported results of operations and financial position. The Company’s most critical accounting policies and estimates are listed below. These estimates require the Company to make difficult, subjective or complex judgments about matters that are inherently uncertain.
• Allowance for credit losses;
• Valuation of loans accounted for under the fair value option;
• Valuation of servicing assets; and
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• Income taxes
Changes in these estimates, that are likely to occur from period to period, or the use of different estimates that the Company could have reasonably used in the current period, would have a material impact on the Company’s financial position, results of operations or liquidity.