Mechanics Bancorp 10-Q

ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes presented elsewhere in this report and in HomeStreet, Inc.'s 2021 Annual Report on Form 10-K. FORWARD-LOOKING STATEMENTS Statements contained in this Quarterly Report on Form 10-Q that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business or in the markets in which we operate, anticipated completion of loan forbearances with respect to customer loans, our future plans and the credit exposure of certain loan products and other components of our business that could be impacted by the COVID-19 pandemic, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Many forward-looking statements can be identified as using words such as "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "plan," "potential," "should," "will" and "would" and similar expressions (or the negative of these terms). Such statements involve inherent risks and uncertainties, many of which are difficult to predict and are generally beyond the control of the Company and are subject to risks and uncertainties, including, but not limited to, those discussed in our Annual Report on Form 10-K for the year ended December 31, 2021 and the risks and uncertainties discussed below and elsewhere in this Quarterly Report on Form 10-Q that could cause actual results to differ significantly from those projected. In addition, many of the risks and uncertainties are, and will be, exacerbated by the COVID-19 pandemic and any worsening of the global, national, regional and local business and economic environment as a result. Although we believe that expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We undertake no obligation, and expressly disclaim any such obligation to update; or clarify any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to reflect changed assumptions, the occurrence of anticipated or unanticipated events, new information or changes to future results over time or otherwise, except as required by law. Readers are cautioned not to place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. Except as otherwise noted, references to "we," "our," "us" or "the Company" refer to HomeStreet, Inc. and its subsidiaries that are consolidated for financial reporting purposes. Statements of knowledge, intention or belief reflect those characteristics of our executive management team based on current facts and circumstances. You may review a copy of this Quarterly Report on Form 10-Q, including exhibits and any schedule filed therewith on the Securities and Exchange Commission's website (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding registrants, such as HomeStreet, Inc., that file electronically with the Securities and Exchange Commission. Copies of our Securities Exchange Act reports also are available from our investor relations website, http://ir.homestreet.com. Information contained in or linked from our websites is not incorporated into and does not constitute a part of this report. Critical Accounting Estimates We have identified two estimates as being critical because they require management to make particularly difficult, subjective, and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for credit losses (“ACL”) and the valuation of single family mortgage servicing rights (“MSRs"). The ACL is calculated based on quantitative and qualitative factors to estimate credit losses over the life of the loan. The inputs used to determine quantitative factors include estimates based on historical experience of probability of default and losses given default. Inputs used to determine qualitative factors include changes in current portfolio characteristics and operating environments such as current and forecasted unemployment rates, capitalization rates used to value properties securing loans, rental rates and single family pricing indexes. Qualitative factors may also include adjustments to address matters not contemplated by the model and to assumptions used to determine qualitative factors. Although we believe that our methodology for determining an appropriate level for the ACL adequately addresses the various components that could potentially result in credit losses, the processes and their elements include features that may be susceptible to significant change. Any unfavorable 41 differences between the actual outcome of credit-related events and our estimates could require an additional provision for credit losses. For example, if the projected unemployment rate was downgraded one grade for all periods, the amount of the ACL at June 30, 2022 would increase by approximately $12 million. This sensitivity analysis is hypothetical and has been provided only to indicate the potential impact that changes in assumptions may have on the ACL estimate. The valuation of MSRs is based on various assumptions which are set forth in Note 7– Mortgage Banking Operations of the financial statements. Note 7 also provides sensitivity analysis based on the assumptions used. The sensitivity analyses are hypothetical and have been provided to indicate the potential impact that changes in assumptions may have on the estimate of the fair value of MSRs. 42 Summary Financial Data Quarter Ended Six Months Ended June 30, (in thousands, except per share data and FTE data) June 30, 2022 March 31, 2022 2022 2021 Select Income Statement data: Net interest income $ 60,056 $ 54,546 $ 114,602 $ 112,489 Provision for credit losses — (9,000) (9,000) (4,000) Noninterest income 13,013 15,558 28,571 67,057 Noninterest expense 50,637 54,473 105,110 109,423 Net income: Before income taxes 22,432 24,631 47,063 74,123 Total 17,721 19,951 37,672 58,820 Net income per share - diluted 0.94 1.01 1.95 2.72 Select Performance Ratios: Return on average equity - annualized 11.8 % 11.6 % 11.7 % 16.4 % Return on average tangible equity - annualized (1) 12.6 % 12.2 % 12.4 % 17.3 % Return on average assets - annualized 0.89 % 1.10 % 0.99 % 1.62 % Efficiency ratio (1) 68.5 % 77.0 % 72.7 % 61.3 % Net interest margin 3.27 % 3.27 % 3.28 % 3.37 % Other data Full time equivalent employees 956 962 956 997 (1) Return on average tangible equity and the efficiency ratio are non-GAAP financial measures. For a reconciliation of return on average tangible equity to the nearest comparable GAAP financial measure, see “Non-GAAP Financial Measures” elsewhere in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. 43 As of (in thousands, except share and per share data) June 30, 2022 December 31, 2021 Selected Balance Sheet Data Loans held for sale $ 47,314 $ 176,131 Loans held for investment, net 6,722,382 5,495,726 ACL 37,355 47,123 Investment securities 1,237,957 1,006,691 Total assets 8,582,886 7,204,091 Deposits 6,183,299 6,146,509 Borrowings 1,458,000 41,000 Long-term debt 224,227 126,026 Total shareholders' equity 580,767 715,339 Other data: Book value per share $ 31.04 $ 35.61 Tangible book value per share (1) $ 29.37 $ 34.04 Total equity to total assets 6.8 % 9.9 % Tangible common equity to tangible assets (1) 6.4 % 9.5 % Shares outstanding at period end 18,712,789 20,085,336 Loans to deposit ratio 110.1 % 93.0 % Credit Quality: ACL to total loans (2) 0.56 % 0.88 % ACL to nonaccrual loans 411.3 % 386.2 % Nonaccrual loans to total loans 0.13 % 0.22 % Nonperforming assets to total assets 0.13 % 0.18 % Nonperforming assets $ 10,835 $ 12,936 Regulatory Capital Ratios: Bank Tier 1 leverage ratio 9.78 % 10.11 % Total risk-based capital 12.29 % 13.77 % Company Tier 1 leverage ratio 8.38 % 9.94 % Total risk-based capital 11.49 % 12.66 % (1) Tangible book value per share and tangible common equity to tangible assets are non-GAAP financial measures. For a reconciliation to the nearest comparable GAAP financial measure, see “Non-GAAP Financial Measures” elsewhere in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. (2) This ratio excludes balances insured by the FHA or guaranteed by the VA or SBA. 44 Current Developments As part of our business strategy, we are focusing on growing our loan portfolio and leveraging our existing operating expense infrastructure. Increases in our loan portfolio will have the effect of increasing our level of net interest income in future periods, a more stable source of revenues as compared to gain on loan origination and sale activities. As part of this strategy, we did not sell any multifamily portfolio loans in the first six months of 2022. In July 2022, we closed a sale of five retail deposit branches in eastern Washington, including the branches' lending businesses and employees. This sale allows us to focus our retail banking branch strategy on the larger metropolitan markets in the western United States. Management's Overview of the Second Quarter 2022 Financial Performance Second Quarter of 2022 Compared to the First Quarter of 2022 General: Our net income and income before taxes were $17.7 million and $22.4 million, respectively, in the second quarter of 2022, as compared to $20.0 million and $24.6 million, respectively, in the first quarter of 2022. The $2.2 million decrease in income before taxes was due to lower recovery of our allowance for credit losses and lower noninterest income, partially offset by higher net interest income and lower noninterest expense. Income Taxes: Our effective tax rate was 21.0% in the second quarter of 2022 as compared to 19.0% in first quarter of 2022 and a statutory rate of 23.9%. Our effective tax rate was lower than our statutory rate due to the benefits of tax advantaged investments. Additionally, our effective tax rate in the first quarter of 2022 was lower than the second quarter of 2022 due to reductions in taxes on income related to excess tax benefits resulting from the vesting of stock awards during the first quarter. 45 Net Interest Income: The following tables set forth, for the periods indicated, information regarding (i) the total dollar amount of interest income from interest-earning assets and the resultant average yields on those assets; (ii) the total dollar amount of interest expense and the average rate of interest on our interest-bearing liabilities; (iii) net interest income; (iv) net interest rate spread; and (v) net interest margin: Quarter Ended June 30, 2022 March 31, 2022 (in thousands) Average Balance Interest Average Yield/Cost Average Balance Interest Average Yield/Cost Assets: Interest-earning assets: Loans (1) $ 6,231,081 $ 60,008 3.82 % $ 5,691,316 $ 53,135 3.74 % Investment securities (1) 1,134,929 8,415 2.97 % 1,028,971 6,671 2.59 % FHLB Stock, Fed Funds and other 80,998 487 2.38 % 65,918 108 0.65 % Total interest-earning assets 7,447,008 68,910 3.68 % 6,786,205 59,914 3.54 % Noninterest-earning assets 498,290 577,384 Total assets $ 7,945,298 $ 7,363,589 Liabilities and shareholders' equity: Interest-bearing deposits: (2) Demand deposits $ 552,749 $ 177 0.13 % $ 525,608 $ 143 0.11 % Money market and savings 3,050,173 1,615 0.21 % 3,101,607 1,121 0.15 % Certificates of deposit 961,052 1,101 0.46 % 886,416 1,020 0.47 % Total 4,563,974 2,893 0.25 % 4,513,631 2,284 0.21 % Borrowings: Borrowings 761,606 2,338 1.21 % 64,557 91 0.56 % Long-term debt 224,167 2,404 4.28 % 204,553 2,107 4.12 % Total interest-bearing liabilities 5,549,747 7,635 0.55 % 4,782,741 4,482 0.38 % Noninterest-bearing liabilities: Demand deposits (2) 1,668,631 1,744,202 Other liabilities 123,256 138,048 Total liabilities 7,341,634 6,664,991 Shareholders' equity 603,664 698,598 Total liabilities and shareholders' equity $ 7,945,298 $ 7,363,589 Net interest income $ 61,275 $ 55,432 Net interest rate spread 3.13 % 3.16 % Net interest margin 3.27 % 3.27 % (1) Includes taxable-equivalent adjustments primarily related to tax-exempt income on certain loans and securities of $1.2 million and $0.9 million for the quarters ended June 30, 2022 and March 31, 2022. The estimated federal statutory tax rate was 21% for the periods presented. (2) Cost of all deposits, including noninterest-bearing demand deposits was 0.19% and 0.15% for the quarters ended June 30, 2022 and March 31, 2022, respectively. Net interest income was $5.5 million higher in the second quarter of 2022 as compared to the first quarter of 2022 due to a 10% increase in average interest earning assets. The increase in the average balance of interest-earning assets was due to the high level of loan originations and purchases of investment securities during the second quarter. Our net interest margin stayed constant at 3.27% as a 14 basis point increase in the yield on interest-earning assets was offset by a 17 basis point increase in the cost of interest-bearing liabilities. Yields on interest-earning assets increased as the rates on loan originations and investment securities purchased during the second quarter were higher than the rates of our existing portfolios of loans and investment securities, respectively. Our cost of borrowings increased 65 basis points during the second quarter while the cost of deposits increased 4 basis points. Additionally, our average borrowings increased by $697 million to fund the growth of our interest-earning assets. The increases in yields on interest-earning assets and the rates paid on interest-bearing liabilities was due to the significant increase in market interest rates during the first half of 2022. 46 Provision for Credit Losses: No provision for credit losses was recorded during the second quarter of 2022 as the benefits of the continuing favorable performance of our loan portfolio was used to offset any required ACL resulting from the significant growth in our loan portfolio. As a result of the favorable performance of our loan portfolio during the first quarter, a stable low level of nonperforming assets and an improved outlook of the estimated impact of COVID-19 on our loan portfolio, we recorded a $9 million recovery of our allowance for credit losses in the first quarter of 2022. Noninterest Income consisted of the following: Quarter Ended (in thousands) June 30, 2022 March 31, 2022 Noninterest income Gain on loan origination and sale activities (1) Single family $ 3,949 $ 6,169 CRE, multifamily and SBA 1,343 2,105 Loan servicing income 3,661 3,304 Deposit fees 2,218 2,075 Other 1,842 1,905 Total noninterest income $ 13,013 $ 15,558 (1) May include loans originated as held for investment. Loan servicing income, a component of noninterest income, consisted of the following: Quarter Ended (in thousands) June 30, 2022 March 31, 2022 Single family servicing income, net Servicing fees and other $ 3,952 $ 3,871 Changes - amortization (1) (2,515) (3,425) Net 1,437 446 Risk management, single family MSRs: Changes in fair value due to assumptions (2) 4,323 10,303 Net gain (loss) from economic hedging (5,317) (10,183) Subtotal (994) 120 Single Family servicing income (loss) 443 566 Commercial loan servicing income: Servicing fees and other 5,555 4,450 Amortization of capitalized MSRs (2,337) (1,712) Total 3,218 2,738 Total loan servicing income $ 3,661 $ 3,304 (1) Represents changes due to collection/realization of expected cash flows and curtailments. (2) Principally reflects changes in model assumptions, including prepayment speed assumptions, which are primarily affected by changes in mortgage interest rates. The decrease in noninterest income in the second quarter of 2022 as compared to the first quarter of 2022 was due to a $3.0 million decrease in gain on loan origination and sale activities due primarily to a $2.2 million decrease in single family gain on loan origination and sale activities. The decrease in single family gain on loan origination and sale activities was due to a decrease in rate lock volume as a result of the effects of increasing interest rates. 47 Noninterest Expense consisted of the following: Quarter Ended (in thousands) June 30, 2022 March 31, 2022 Noninterest expense Compensation and benefits $ 30,191 $ 32,031 Information services 7,780 7,062 Occupancy 5,898 6,365 General, administrative and other 6,768 9,015 Total noninterest expense $ 50,637 $ 54,473 The $3.8 million decrease in noninterest expense in the second quarter of 2022 as compared to the first quarter of 2022 was primarily due to lower compensation and benefits and general, administrative and other costs, partially offset by higher information services costs. The decrease in compensation costs was due to the seasonality of certain employee benefit costs, such as employer taxes, 401k match and vacation accruals, which are higher in the first quarter of the year, and the deferred cost benefit resulting from the significantly higher level of originations in the second quarter. The increase in information services costs was due to the implementation of new systems in the second quarter and higher activity levels. Legal costs, which are included in general, administrative and other costs, were $1.7 million lower in the second quarter of 2022 as compared to first quarter of 2022 due to nonrecurring costs expended on litigation activities and legal matters in the first quarter. Six Months Ended June 30, 2022 Compared to Six Months Ended June 30, 2021 General: Our net income and income before taxes were $37.7 million and $47.1 million, respectively, in the six months ended June 30, 2022, as compared to $58.8 million and $74.1 million, respectively, in the six months ended June 30, 2021. The $27.1 million decrease in income before taxes was due to lower noninterest income, partially offset by higher net interest income, a larger recovery of our allowance for credit losses in 2022 and lower noninterest expense. Income Taxes: Our effective tax rate during six months ended June 30, 2022 was 20.0% as compared to 20.6% in the six months ended June 30, 2021 and a statutory rate of 23.9%. Our effective tax rate for both periods was lower than our statutory rate due to the benefits of tax advantaged investments and reductions in taxes on income related to excess tax benefits resulting from the exercise and vesting of stock awards during the periods. Net Interest Income: The following tables set forth, for the periods indicated, information regarding (i) the total dollar amount of interest income from interest-earning assets and the resultant average yields on those assets; (ii) the total dollar amount of interest expense and the average rate of interest on our interest-bearing liabilities; (iii) net interest income; (iv) net interest rate spread; and (v) net interest margin: 48 Six Months Ended June 30, 2022 2021 (in thousands) Average Balance Interest Average Yield/Cost Average Balance Interest Average Yield/Cost Assets: Interest-earning assets: Loans (1) $ 5,962,689 $ 113,143 3.79 % $ 5,635,181 $ 111,020 3.93 % Investment securities (1) 1,082,243 15,302 2.83 % 1,049,091 12,268 2.34 % FHLB Stock, Fed Funds and other 73,499 595 1.61 % 77,315 331 0.85 % Total interest-earning assets 7,118,431 129,040 3.62 % 6,761,587 123,619 3.65 % Noninterest-earning assets 537,619 564,602 Total assets $ 7,656,050 $ 7,326,189 Interest-bearing liabilities: Interest-bearing deposits: (2) Demand deposits $ 539,253 $ 320 0.12 % $ 517,456 $ 355 0.14 % Money market and savings 3,075,616 2,736 0.18 % 2,936,982 2,285 0.16 % Certificates of deposit 924,062 2,121 0.46 % 1,128,904 3,783 0.68 % Total 4,538,931 5,177 0.23 % 4,583,342 6,423 0.28 % Borrowings: Borrowings 415,007 2,429 1.16 % 191,422 303 0.32 % Long-term debt 214,414 4,511 4.20 % 125,878 2,723 4.32 % Total interest-bearing liabilities 5,168,352 12,117 0.47 % 4,900,642 9,449 0.39 % Noninterest-bearing liabilities: Demand deposits (2) 1,706,217 1,487,708 Other liabilities 130,612 212,664 Total liabilities 7,005,181 6,601,014 Shareholders' equity 650,869 725,175 Total liabilities and shareholders' equity $ 7,656,050 $ 7,326,189 Net interest income $ 116,923 $ 114,170 Net interest spread 3.15 % 3.26 % Net interest margin 3.28 % 3.37 % (1) Includes taxable-equivalent adjustments primarily related to tax-exempt income on certain loans and securities of $2.3 million and $1.7 million for the six months ended June 30, 2022 and 2021, respectively. The estimated federal statutory tax rate was 21% for the periods presented. (2) Cost of deposits including noninterest-bearing deposits, was 0.17% and 0.21% for the six months ended June 30, 2022 and 2021, respectively. Net interest income for the six months ended June 30, 2022 increased $2.1 million as compared to the six months ended June 30, 2021 due to increases in the average balance of interest earning assets, partially offset by a decrease in our net interest margin. Our net interest margin decreased from 3.37% in the six months ended June 30, 2021 compared to 3.28% in the six months ended June 30, 2022 due to an eight basis point increase in the rate paid on interest-bearing liabilities, primarily due to increases in our cost of borrowings. Our cost of borrowings increased from 32 basis points during the first six months of 2021 to 116 basis points during the first six months of 2022 due to the significant increase in market interest rates during the first half of 2022 and the impact of the $100 million subordinated notes offering completed in January 2022. The increase in interest-earning assets was due to the high level of loan originations and purchases of investment securities during the second quarter of 2022. Provision for Credit Losses: As a result of the favorable performance of our loan portfolio, a stable low level of nonperforming assets and an improved outlook of the estimated impact of COVID-19 on our loan portfolio, we recorded a $9 million recovery of our allowance for credit losses in the six months ended June 30, 2022 compared to a $4 million recovery of our allowance for credit losses in the six months ended June 30, 2021. 49 Noninterest Income consisted of the following: Six Months Ended June 30, (in thousands) 2022 2021 Noninterest income Gain on loan origination and sale activities (1) Single family $ 10,118 $ 42,023 Commercial 3,448 12,707 Loan servicing income 6,965 2,679 Deposit fees 4,293 3,821 Other 3,747 5,827 Total noninterest income $ 28,571 $ 67,057 (1) May include loans originated as held for investment. Loan servicing income, a component of noninterest income, consisted of the following: Six Months Ended June 30, (in thousands) 2022 2021 Single family servicing income, net Servicing fees and other $ 7,823 $ 7,910 Changes - amortization (1) (5,940) (10,874) Net 1,883 (2,964) Risk management, single family MSRs: Changes in fair value due to assumptions (2) 14,626 6,439 Net gain (loss) from economic hedging (15,500) (7,567) Subtotal (874) (1,128) Single Family servicing income (loss) 1,009 (4,092) Commercial loan servicing income: Servicing fees and other 10,005 10,248 Amortization of capitalized MSRs (4,049) (3,477) Total 5,956 6,771 Total loan servicing income $ 6,965 $ 2,679 (1) Represents changes due to collection/realization of expected cash flows and curtailments. (2) Principally reflects changes in model assumptions, including prepayment speed assumptions, which are primarily affected by changes in mortgage interest rates. 50 The decrease in noninterest income for the six months ended June 30, 2022 as compared to the six months ended June 30, 2021 was due to a decrease in gain on loan origination and sale activities, which was partially offset by higher loan servicing income. The $41.2 million decrease in gain on loan origination and sale activities was due to a $31.9 million decrease in single family gain on loan origination and sale activities and a $9.3 million decrease in CRE and commercial gain on loan origination and sale activities. The decrease in single family gain on loan origination and sale activities was due to a decrease in rate lock volume and margins as a result of the effects of increasing interest rates. The decrease in CRE and commercial gain on loan origination and sale activities was primarily due to an 75% decrease in the volume of loans sold. The $4.3 million increase in loan servicing income was primarily due to lower levels of prepayments. Noninterest Expense consisted of the following: Six Months Ended June 30, (in thousands) 2022 2021 Noninterest expense Compensation and benefits $ 62,222 $ 70,213 Information services 14,842 13,733 Occupancy 12,263 12,465 General, administrative and other 15,783 13,012 Total noninterest expense $ 105,110 $ 109,423 The $4.3 million decrease in noninterest expense in the six months ended June 30, 2022 as compared to the six months ended June 30, 2021 was due to lower compensation and benefit costs, partially offset by increases in information services and general, administrative and other expenses. The $8.0 million decrease in compensation and benefits expense is primarily due to reduced commission expense on lower loan origination volumes in our single family mortgage operations. The increase in information services costs was due to the implementation of new systems in the second quarter of 2022 and higher activity levels. The increase in general, administrative and other costs was primarily due to a $1.9 million reimbursement of legal costs received from our insurance carrier in the first six months of June 30, 2021and nonrecurring costs expended on litigation activities and legal matters in 2022. 51 Financial Condition During the six months ended June 30, 2022, our total assets increased $1.4 billion due primarily to a $1.2 billion increase in loans held for investment and a $231 million increase in investment securities which were partially offset by a decrease of $129 million in loans held for sale. Loans held for investment increased due to $2.1 billion of originations, which were partially offset by prepayments and scheduled payments of $831 million. Total liabilities increased $1.5 billion due to increases in borrowings and long-term debt. The $1.4 billion increase in borrowings was used to fund the growth in our loans and investment securities. Long-term debt increased due to our $100 million subordinated notes offering completed in January 2022. 52 Credit Risk Management As of June 30, 2022, our ratio of nonperforming assets to total assets remained low at 0.13% while our ratio of total loans delinquent over 30 days to total loans was 0.31%. The Company recorded a $9 million recovery of our allowance for credit losses for the six months ended June 30, 2022 as a result of the favorable performance of our loan portfolio, a stable low level of nonperforming assets and an improved outlook of the estimated impact of COVID-19 on our loan portfolio. As a result of the recovery of COVID-19 reserves, and the change in the composition of our portfolio to lower credit risk loans, specifically a higher proportion of multifamily permanent loans, our overall ratio of ACL to LHFI decreased from 0.88% at December 31, 2021 to 0.56% at June 30, 2022. Management considers the current level of the ACL to be appropriate to cover estimated lifetime losses within our LHFI portfolio. The following table presents the ACL by product type: At June 30, 2022 At December 31, 2021 (in thousands) Amount Rate (1) Amount Rate (1) CRE Non-owner occupied CRE $ 2,180 0.31 % $ 7,509 1.06 % Multifamily 10,074 0.29 % 5,854 0.24 % Construction/land development Multifamily construction 566 1.30 % 507 1.34 % CRE construction 185 0.90 % 150 1.06 % Single family construction 10,687 3.08 % 6,411 2.16 % Single family construction to permanent 1,159 0.73 % 1,055 0.71 % Total 24,851 0.52 % 21,486 0.59 % Commercial and industrial loans Owner occupied CRE 1,092 0.23 % 5,006 1.10 % Commercial business 3,578 0.91 % 12,273 3.39 % Total 4,670 0.54 % 17,279 2.11 % Consumer loans Single family 4,027 0.56 % 4,394 0.68 % Home equity and other 3,807 1.20 % 3,964 1.31 % Total 7,834 0.76 % 8,358 0.88 % Total ACL $ 37,355 0.56 % $ 47,123 0.88 % (1) The ACL rate is calculated excluding balances related to loans that are insured by the FHA or guaranteed by the VA or SBA. Liquidity and Sources of Funds Liquidity risk management is primarily intended to ensure we are able to maintain sources of cash to adequately fund operations and meet our obligations, including demands from depositors, draws on lines of credit and paying any creditors, on a timely and cost-effective basis, in various market conditions. Our liquidity profile is influenced by changes in market conditions, the composition of the balance sheet and risk tolerance levels. The Company has established liquidity guidelines and operating plans that detail the sources and uses of cash and liquidity. The Company's primary sources of liquidity include deposits, loan payments and investment securities payments, both principal and interest, borrowings, and proceeds from the sale of loans and investment securities. Borrowings include advances from the FHLB, federal funds purchased and borrowing from other financial institutions. Additionally, the Company may sell stock or issue long-term debt to raise funds. While scheduled principal repayments on loans and investment securities are a relatively predictable source of funds, deposit inflows and outflows and prepayments of loans and investment securities are greatly influenced by interest rates, economic conditions and competition. The Company’s contractual cash flow obligations include the maturity of certificates of deposit, short-term and long-term borrowings, interest on certificates of deposit and borrowings, operating leases and fees for information technology related 53 services and professional services. Obligations for certificates of deposit and short-term borrowings are typically satisfied through the renewal of these instruments or the generation of new deposits or use of available short-term borrowings. Interest payments and obligations related to leases and services are typically met by cash generated from our operations. The Company has $64 million of Senior Notes which mature in 2026 which it expects to pay off from available cash or from the issuance of new debt. At June 30, 2022 and December 31, 2021, the Bank had available borrowing capacity of $809 million and $1.8 billion, respectively, from the FHLB, and $323 million and $274 million, respectively, from the FRBSF and $1.0 billion and $1.0 billion under borrowing lines established with other financial institutions. Cash Flows For the six months ended June 30, 2022, cash and cash equivalents increased by $10 million compared to an increase of $30 million during the six months ended June 30, 2021. As excess liquidity can reduce the Company’s earnings and returns, the Company manages its cash positions to minimize the level of excess liquidity and does not attempt to maximize the level of cash and cash equivalents. The following discussion highlights the major activities and transactions that affected our cash flows during these periods. Cash flows from operating activities The Company's operating assets and liabilities are used to support our lending activities, including the origination and sale of mortgage loans. For the six months ended June 30, 2022, net cash of $145 million was provided by operating activities, primarily from cash proceeds from the sale of loans exceeding cash used to fund LHFS. For the six months ended June 30, 2021, net cash of $55 million was provided by operating activities, primarily from cash proceeds from the sale of loans exceeding cash used to fund LHFS. We believe that cash flows from operations, available cash balances and our ability to generate cash through short-term debt borrowings are sufficient to fund our operating liquidity needs. We are currently not aware of any trends or demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in our liquidity increasing or decreasing in any material way that will impact our capital needs during or beyond the next 12 months. Cash flows from investing activities The Company's investing activities primarily include AFS investment securities and loans originated as held for investment. For the six months ended June 30, 2022, net cash of $1.6 billion was used in investing activities primarily from the origination of LHFI net of principal repayments and the purchase of AFS investment securities. For the six months ended June 30, 2021, net cash of $44 million was provided by investing activities primarily from principal payments and the proceeds from the sale of LHFI and AFS securities, which were partially offset by the origination of LHFI and the purchase of AFS securities. Cash flows from financing activities The Company's financing activities are primarily related to deposits and net proceeds from borrowings. For the six months ended June 30, 2022, net cash of $1.4 billion was provided by financing activities, primarily due to an increase in short-term borrowings and proceeds from the issuance of the subordinated notes, partially offset by repurchases of and dividends paid on our common stock. For the six months ended June 30, 2021, net cash of $69 million was used in financing activities, primarily due to net repayment of short-term borrowings, repurchases of and dividends paid on our common stock, which was partially offset by growth in deposits. 54 Off-Balance Sheet Arrangements In the normal course of business, we are a party to financial instruments that carry off-balance sheet risk. These financial instruments (which include commitments to originate loans and commitments to purchase loans) include potential credit risk in excess of the amount recognized in the accompanying consolidated financial statements. These transactions are designed to (1) meet the financial needs of our customers, (2) manage our credit, market or liquidity risks, (3) diversify our funding sources and/or (4) optimize capital. These commitments include the following: (in thousands) At June 30, 2022 At December 31, 2021 Unused consumer portfolio lines $ 474,796 $ 405,992 Commercial portfolio lines (1) 836,296 820,131 Commitments to fund loans 59,450 90,852 Total $ 1,370,542 $ 1,316,975 (1) Within the commercial portfolio, undistributed construction loan proceeds, where the Company has an obligation to advance funds for construction progress payments, were $576 million and $584 million at June 30, 2022 and December 31, 2021, respectively. Capital Resources and Dividend Policy The capital rules applicable to United States based bank holding companies and federally insured depository institutions (“Capital Rules”) require the Company (on a consolidated basis) and the Bank (on a stand-alone basis) to meet specific capital adequacy requirements that, for the most part, involve quantitative measures, primarily in terms of the ratios of their capital to their assets, liabilities, and certain off-balance sheet items, calculated under regulatory accounting practices. In addition, prompt corrective action regulations place a federally insured depository institution, such as the Bank, into one of five capital categories on the basis of its capital ratios: (i) well capitalized; (ii) adequately capitalized; (iii) undercapitalized; (iv) significantly undercapitalized; or (v) critically undercapitalized. A depository institution’s primary federal regulatory agency may determine that, based on certain qualitative assessments, the depository institution should be assigned to a lower capital category than the one indicated by its capital ratios. At each successive lower capital category, a depository institution is subject to greater operating restrictions and increased regulatory supervision by its federal bank regulatory agency. The following table sets forth the capital and capital ratios of HomeStreet Inc. (on a consolidated basis) and HomeStreet Bank as compared to the respective regulatory requirements applicable to them: At June 30, 2022 Actual For Minimum Capital Adequacy Purposes To Be Categorized As "Well Capitalized" (dollars in thousands) Amount Ratio Amount Ratio Amount Ratio HomeStreet, Inc. Tier 1 leverage capital (to average assets) $ 673,552 8.38 % $ 321,579 4.0 % NA NA Common equity Tier 1 capital (to risk-weighted assets) 613,552 8.66 % 318,688 4.5 % NA NA Tier 1 risk-based capital (to risk-weighted assets) 673,552 9.51 % 424,917 6.0 % NA NA Total risk-based capital (to risk-weighted assets) 814,000 11.49 % 566,557 8.0 % NA NA HomeStreet Bank Tier 1 leverage capital (to average assets) $ 781,155 9.78 % $ 319,539 4.0 % $ 399,424 5.0 % Common equity Tier 1 capital (to risk-weighted assets) 781,155 11.66 % 301,423 4.5 % 435,388 6.5 % Tier 1 risk-based capital (to risk-weighted assets) 781,155 11.66 % 401,897 6.0 % 535,863 8.0 % Total risk-based capital (to risk-weighted assets) 823,005 12.29 % 535,863 8.0 % 669,828 10.0 % 55 At December 31, 2021 Actual For Minimum Capital Adequacy Purposes To Be Categorized As "Well Capitalized" (dollars in thousands) Amount Ratio Amount Ratio Amount Ratio HomeStreet, Inc. Tier 1 leverage capital (to average assets) $ 723,232 9.94 % $ 291,098 4.0 % NA NA Common equity Tier 1 capital (to risk-weighted assets) 663,232 10.84 % 275,281 4.5 % NA NA Tier 1 risk-based capital (to risk-weighted assets) 723,232 11.82 % 367,041 6.0 % NA NA Total risk-based capital (to risk-weighted assets) 774,695 12.66 % 489,388 8.0 % NA NA HomeStreet Bank Tier 1 leverage capital (to average assets) $ 727,753 10.11 % $ 287,990 4.0 % $ 359,988 5.0 % Common equity Tier 1 capital (to risk-weighted assets) 727,753 12.87 % 254,442 4.5 % 367,527 6.5 % Tier 1 risk-based capital (to risk-weighted assets) 727,753 12.87 % 339,256 6.0 % 452,341 8.0 % Total risk-based capital (to risk-weighted assets) 778,723 13.77 % 452,341 8.0 % 565,426 10.0 % As of each of the dates set forth in the above table, the Company exceeded the minimum required capital ratios applicable to it and the Bank’s capital ratios exceeded the minimums necessary to qualify as a well-capitalized depository institution under the prompt corrective action regulations. In addition to the minimum capital ratios, both HomeStreet Inc. and HomeStreet Bank are required to maintain a capital conservation buffer consisting of additional Common Equity Tier 1 Capital of more than 2.5% above the required minimum levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses. The required ratios for capital adequacy set forth in the above table do not include the Capital Rules’ additional capital conservation buffer, though each of the Company and Bank maintained capital ratios necessary to satisfy the capital conservation buffer requirements as of the dates indicated. At June 30, 2022, capital conservation buffers for the Company and the Bank were 3.49% and 4.29%, respectively. The Company paid a quarterly cash dividend of $0.35 per common share in the second quarter of 2022. It is our current intention to continue to pay quarterly dividends, and on July 28, 2022 we declared another cash dividend of $0.35 per common share payable on August 23, 2022 to shareholders of record as of the close of business on August 9, 2022. The amount and declaration of future cash dividends are subject to approval by our Board of Directors and certain regulatory restrictions. We had no material commitments for capital expenditures as of June 30, 2022. However, we intend to take advantage of opportunities that may arise in the future to grow our businesses, which may include opening additional offices or acquiring complementary businesses that we believe will provide us with attractive risk-adjusted returns. As a result, we may seek to obtain additional borrowings and to sell additional shares of our common stock to raise funds which we might need for these purposes. There is no assurance, however, that, if required, we will succeed in obtaining additional borrowings or selling additional shares of our common stock on terms that are acceptable to us, if at all, as this will depend on market conditions and other factors outside of our control, as well as our future results of operations. 56 Non-GAAP Financial Measures To supplement our unaudited condensed consolidated financial statements presented in accordance with GAAP, we use certain non-GAAP measures of financial performance. In this Quarterly Report on Form 10-Q, we use the following non-GAAP measures: (i) tangible common equity and tangible assets as we believe this information is consistent with the treatment by bank regulatory agencies, which excluded intangible assets from the calculation of capital ratios; and (ii) an efficiency ratio which is the ratio of noninterest expenses to the sum of net interest income and noninterest income, excluding certain items of income or expense and excluding taxes incurred and payable to the state of Washington as such taxes are not classified as income tax expenses and we believe including them in noninterest expenses impacts the comparability of our results to those companies whose operations are in states where assessed taxes on business are classified as income tax expense. These supplemental performance measures may vary from, and may not be comparable to, similarly titled measures provided by other companies in our industry. Non-GAAP financial measures are not in accordance with, or an alternative for, GAAP. Generally, a non-GAAP financial measure is a numerical measure of a company’s performance that either excludes or includes amounts that are not normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP. A non-GAAP financial measure may also be a financial metric that is not required by GAAP or other applicable requirements. We believe that these non-GAAP financial measures, when taken together with the corresponding GAAP financial measures, provide meaningful supplemental information regarding our performance by providing additional information used by management that is not otherwise required by GAAP or other applicable requirements. Our management uses, and believes that investors benefit from referring to, these non-GAAP financial measures in assessing our operating results and when planning, forecasting and analyzing future periods. These non-GAAP financial measures also facilitate a comparison of our performance to prior periods. We believe these measures are frequently used by securities analysts, investors and other parties in the evaluation of companies in our industry. Rather, these non-GAAP financial measures should be considered in addition to, not as a substitute for or superior to, financial measures prepared in accordance with GAAP. In the information below, we have provided reconciliations of, where applicable, the most comparable GAAP financial measures to the non-GAAP measures used in this Quarterly Report on Form 10-Q, or a reconciliation of the non-GAAP calculation of the financial measure. 57 Reconciliations of non-GAAP results of operations to the nearest comparable GAAP measures: As of or for the quarter ended As of or for the six months ended June 30, (in thousands) June 30, 2022 March 31, 2022 2022 2021 Return on average tangible equity (annualized) Average shareholders' equity $ 603,664 $ 698,598 $ 650,869 $ 725,175 Less: Average goodwill and other intangibles (31,380) (31,624) (31,501) (32,631) Average tangible equity $ 572,284 $ 666,974 $ 619,368 $ 692,544 Net income $ 17,721 $ 19,951 $ 37,672 $ 58,820 Adjustments (tax effected) Amortization on core deposit intangibles 191 191 382 465 Tangible income applicable to shareholders $ 17,912 $ 20,142 $ 38,054 $ 59,285 Ratio 12.6 % 12.2 % 12.4 % 17.3 % Efficiency ratio Noninterest expense Total $ 50,637 $ 54,473 $ 105,110 $ 109,423 Adjustments: Legal fees recovery — — — 1,900 State of Washington taxes (579) (506) (1,085) (1,181) Adjusted total $ 50,058 $ 53,967 $ 104,025 $ 110,142 Total revenues Net interest income $ 60,056 $ 54,546 $ 114,602 $ 112,489 Noninterest income 13,013 15,558 28,571 67,057 Total $ 73,069 $ 70,104 $ 143,173 $ 179,546 Ratio 68.5 % 77.0 % 72.7 % 61.3 % Effective tax rate used in computations above 22.0 % 22.0 % 22.0 % 21.0 % As of (in thousands, except share data) June 30, 2022 December 31, 2021 Tangible book value per share Shareholders' equity $ 580,767 $ 715,339 Less: goodwill and other intangibles (31,219) (31,709) Tangible shareholder's equity $ 549,548 $ 683,630 Common shares outstanding 18,712,789 20,085,336 Computed amount $ 29.37 $ 34.04 Tangible common equity to tangible assets Tangible shareholder's equity (per above) $ 549,548 $ 683,630 Tangible assets Total assets 8,582,886 7,204,091 Less: Goodwill and other intangibles (31,219) (31,709) Net $ 8,551,667 $ 7,172,382 Ratio 6.4 % 9.5 % 58