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 differences between the actual outcome of credit-related events and our estimates could require an additional provision for 40 credit losses. For example, if the projected unemployment rate was downgraded one grade for all periods, the amount of the ACL at September 30, 2022 would increase by approximately $14 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. 41 Summary Financial Data Quarter Ended Nine Months Ended September 30, (in thousands, except per share data and FTE data) September 30, 2022 June 30, 2022 2022 2021 Select Income Statement data: Net interest income $ 63,018 $ 60,056 $ 177,620 $ 169,973 Provision for credit losses — — (9,000) (9,000) Noninterest income 13,322 13,013 41,893 91,355 Noninterest expense 49,889 50,637 154,999 161,372 Net income: Before income taxes 26,451 22,432 73,514 108,956 Total 20,367 17,721 58,039 85,990 Net income per share - diluted 1.08 0.94 3.03 4.03 Select Performance Ratios: Return on average equity - annualized 13.4 % 11.8 % 12.2 % 15.8 % Return on average tangible equity - annualized (1) 14.2 % 12.6 % 13.0 % 16.7 % Return on average assets - annualized 0.91 % 0.89 % 0.96 % 1.57 % Efficiency ratio (1) 68.4 % 68.5 % 71.2 % 61.8 % Net interest margin 3.00 % 3.27 % 3.17 % 3.39 % Other data Full time equivalent employees 935 956 935 983 (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. 42 As of (in thousands, except share and per share data) September 30, 2022 December 31, 2021 Selected Balance Sheet Data Loans held for sale $ 13,787 $ 176,131 Loans held for investment, net 7,175,881 5,495,726 ACL 37,606 47,123 Investment securities 1,311,941 1,006,691 Total assets 9,072,887 7,204,091 Deposits 6,610,231 6,146,509 Borrowings 1,569,000 41,000 Long-term debt 224,314 126,026 Total shareholders' equity 552,789 715,339 Other data: Book value per share $ 29.53 $ 35.61 Tangible book value per share (1) $ 27.92 $ 34.04 Total equity to total assets 6.1 % 9.9 % Tangible common equity to tangible assets (1) 5.8 % 9.5 % Shares outstanding at period end 18,717,557 20,085,336 Loans to deposit ratio 109.3 % 93.0 % Credit Quality: ACL to total loans (2) 0.53 % 0.88 % ACL to nonaccrual loans 306.6 % 386.2 % Nonaccrual loans to total loans 0.17 % 0.22 % Nonperforming assets to total assets 0.15 % 0.18 % Nonperforming assets $ 13,991 $ 12,936 Regulatory Capital Ratios: Bank Tier 1 leverage ratio 9.15 % 10.11 % Total risk-based capital 12.57 % 13.77 % Company Tier 1 leverage ratio 7.61 % 9.94 % Total risk-based capital 11.43 % 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. 43 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 only sold $5 million of multifamily portfolio loans in the first nine 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. As part of this transaction, we transferred $191 million of deposits and sold $43 million of loans. In October 2022, we announced an agreement to purchase three branches in southern California, which is expected to close in the first quarter of 2023, whereby we will assume approximately $490 million in deposits and purchase approximately $22 million in loans. These transactions allow us to focus our retail banking branch strategy on the larger metropolitan markets in the western United States. Management's Overview of the Third Quarter 2022 Financial Performance Third Quarter of 2022 Compared to the Second Quarter of 2022 General: Our net income and income before taxes were $20.4 million and $26.5 million, respectively, in the third quarter of 2022, as compared to $17.7 million and $22.4 million, respectively, in the second quarter of 2022. The $4.0 million increase in income before taxes was due to higher net interest income, higher noninterest income and lower noninterest expense. Income Taxes: Our effective tax rate was 23.0% in the third quarter of 2022 as compared to 21.0% in second quarter of 2022 and a statutory rate of 25.3%. While our effective tax rate was lower than our statutory rate due to the benefits of tax advantaged investments, our effective tax rate in the third quarter of 2022 was higher than the second quarter of 2022 due to the diminishing impact of tax-exempt interest. 44 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 September 30, 2022 June 30, 2022 (in thousands) Average Balance Interest Average Yield/Cost Average Balance Interest Average Yield/Cost Assets: Interest-earning assets: Loans (1) $ 7,070,998 $ 73,522 4.09 % $ 6,231,081 $ 60,008 3.82 % Investment securities (1) 1,252,923 10,087 3.22 % 1,134,929 8,415 2.97 % FHLB Stock, Fed Funds and other 112,824 1,060 3.68 % 80,998 487 2.38 % Total interest-earning assets 8,436,745 84,669 3.95 % 7,447,008 68,910 3.68 % Noninterest-earning assets 462,939 498,290 Total assets $ 8,899,684 $ 7,945,298 Liabilities and shareholders' equity: Interest-bearing deposits: (2) Demand deposits $ 532,434 $ 197 0.15 % $ 552,749 $ 177 0.13 % Money market and savings 2,879,121 3,345 0.46 % 3,050,173 1,615 0.21 % Certificates of deposit 1,440,960 4,779 1.32 % 961,052 1,101 0.46 % Total 4,852,515 8,321 0.68 % 4,563,974 2,893 0.25 % Borrowings: Borrowings 1,530,449 9,493 2.43 % 761,606 2,338 1.21 % Long-term debt 224,259 2,571 4.56 % 224,167 2,404 4.28 % Total interest-bearing liabilities 6,607,223 20,385 1.22 % 5,549,747 7,635 0.55 % Noninterest-bearing liabilities: Demand deposits (2) 1,576,387 1,668,631 Other liabilities 112,796 123,256 Total liabilities 8,296,406 7,341,634 Shareholders' equity 603,278 603,664 Total liabilities and shareholders' equity $ 8,899,684 $ 7,945,298 Net interest income $ 64,284 $ 61,275 Net interest rate spread 2.74 % 3.13 % Net interest margin 3.00 % 3.27 % (1) Includes taxable-equivalent adjustments primarily related to tax-exempt income on certain loans and securities of $1.3 million and $1.2 million for the quarters ended September 30, 2022 and June 30, 2022. The estimated federal statutory tax rate was 21% for the periods presented. (2) Cost of all deposits, including noninterest-bearing demand deposits was 0.51% and 0.19% for the quarters ended September 30, 2022 and June 30, 2022, respectively. Net interest income was $3.0 million higher in the third quarter of 2022 as compared to the second quarter of 2022 due primarily to a 13% increase in average interest earning assets, which was partially offset by a decrease in our net interest margin from 3.27% to 3.00%. The increase in the average balance of interest-earning assets was due to the high level of loan originations during the third quarter. Our net interest margin decreased to 3.00% as a 67 basis point increase in the cost of interest-bearing liabilities was partially offset by a 27 basis point increase in the yield on interest-earning assets. Yields on interest-earning assets increased as the yields on loan originations during the third quarter were higher than the rates of our existing portfolio of loans and yields on adjustable rate loans increased due to increases in the indexes on which their pricing is based. The increase in the rates paid on our interest-bearing liabilities was due to higher deposit costs, higher borrowing costs and an increase in the proportion of higher cost borrowings used as our sources of funding. Our cost of borrowings increased 122 basis points during the third quarter while the cost of deposits increased 32 basis points. Additionally, our average borrowings increased by $769 million to fund the growth of our loan portfolio. The increases in yields on interest-earning assets and the rates paid on interest-bearing liabilities were due to the significant increases in market interest rates during the first nine months of 2022. 45 Provision for Credit Losses: No provision for credit losses was recorded during the second or third 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 growth in our loan portfolio. Noninterest Income consisted of the following: Quarter Ended (in thousands) September 30, 2022 June 30, 2022 Noninterest income Gain on loan origination and sale activities (1) Single family $ 1,778 $ 3,949 CRE, multifamily and SBA 869 1,343 Loan servicing income 2,741 3,661 Deposit fees 2,223 2,218 Other 5,711 1,842 Total noninterest income $ 13,322 $ 13,013 (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) September 30, 2022 June 30, 2022 Single family servicing income, net Servicing fees and other $ 3,986 $ 3,952 Changes - amortization (1) (2,112) (2,515) Net 1,874 1,437 Risk management, single family MSRs: Changes in fair value due to assumptions (2) 1,989 4,323 Net gain (loss) from economic hedging (2,981) (5,317) Subtotal (992) (994) Single Family servicing income (loss) 882 443 Commercial loan servicing income: Servicing fees and other 3,687 5,555 Amortization of capitalized MSRs (1,828) (2,337) Total 1,859 3,218 Total loan servicing income $ 2,741 $ 3,661 (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 increase in noninterest income in the third quarter of 2022 as compared to the second quarter of 2022 was primarily due to an increase in other income due to a $4.3 million gain on sale of five eastern Washington branches. This increase was partially offset by a decrease in net 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 primarily due to a decrease in rate lock volume as a result of the effects of increasing interest rates. 46 Noninterest Expense consisted of the following: Quarter Ended (in thousands) September 30, 2022 June 30, 2022 Noninterest expense Compensation and benefits $ 27,341 $ 30,191 Information services 7,038 7,780 Occupancy 6,052 5,898 General, administrative and other 9,458 6,768 Total noninterest expense $ 49,889 $ 50,637 The $0.7 million decrease in noninterest expense in the third quarter of 2022 as compared to the second quarter of 2022 was primarily due to lower compensation and benefit costs, which was partially offset by higher general, administrative and other costs. The decrease in compensation and benefit costs was due to reduced headcount due to the sale of the five eastern Washington branches and lower commission and bonus expenses. General, administrative and other costs increased in the third quarter of 2022 as compared to second quarter of 2022 due to an increase in marketing costs related to our promotional deposit products and higher FDIC fees due to our larger asset base. Nine Months Ended September 30, 2022 Compared to Nine Months Ended September 30, 2021 General: Our net income and income before taxes were $58.0 million and $73.5 million, respectively, in the nine months ended September 30, 2022, as compared to $86.0 million and $109.0 million, respectively, in the nine months ended September 30, 2021. The $35.4 million decrease in income before taxes was due to lower noninterest income, partially offset by higher net interest income and lower noninterest expense. Income Taxes: Our effective tax rate during nine months ended September 30, 2022 and 2021 was 21.1% and our statutory rate was 25.3% in 2022 and 24.2% in 2021. 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. 47 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: Nine Months Ended September 30, 2022 2021 (in thousands) Average Balance Interest Average Yield/Cost Average Balance Interest Average Yield/Cost Assets: Interest-earning assets: Loans (1) $ 6,336,185 $ 186,665 3.90 % $ 5,615,624 $ 167,322 3.95 % Investment securities (1) 1,139,761 25,389 2.97 % 1,030,726 18,084 2.34 % FHLB Stock, Fed Funds and other 86,752 1,655 2.50 % 100,972 472 0.62 % Total interest-earning assets 7,562,698 213,709 3.74 % 6,747,322 185,878 3.65 % Noninterest-earning assets 512,452 558,224 Total assets $ 8,075,150 $ 7,305,546 Interest-bearing liabilities: Interest-bearing deposits: (2) Demand deposits $ 536,956 $ 517 0.13 % $ 521,579 $ 543 0.14 % Money market and savings 3,009,398 6,081 0.27 % 2,955,153 3,338 0.15 % Certificates of deposit 1,098,255 6,900 0.84 % 1,087,195 5,049 0.62 % Total 4,644,609 13,498 0.39 % 4,563,927 8,930 0.26 % Borrowings: Borrowings 790,907 11,922 1.99 % 137,754 347 0.33 % Long-term debt 217,732 7,082 4.33 % 125,902 4,076 4.31 % Total interest-bearing liabilities 5,653,248 32,502 0.76 % 4,827,583 13,353 0.37 % Noninterest-bearing liabilities: Demand deposits (2) 1,662,465 1,552,201 Other liabilities 124,606 200,032 Total liabilities 7,440,319 6,579,816 Shareholders' equity 634,831 725,730 Total liabilities and shareholders' equity $ 8,075,150 $ 7,305,546 Net interest income $ 181,207 $ 172,525 Net interest spread 2.98 % 3.28 % Net interest margin 3.17 % 3.39 % (1) Includes taxable-equivalent adjustments primarily related to tax-exempt income on certain loans and securities of $3.6 million and $2.6 million for the nine months ended September 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 0.29% and 0.20% for the nine months ended September 30, 2022 and 2021, respectively. Net interest income for the nine months ended September 30, 2022 increased $7.6 million as compared to the nine months ended September 30, 2021 due primarily to increases in the average balance of interest earning assets, partially offset by a decrease in our net interest margin. The increase in interest-earning assets was due to the high level of loan originations and purchases of investment securities during the first nine months of 2022. Our net interest margin decreased from 3.39% in the nine months ended September 30, 2021 to 3.17% in the nine months ended September 30, 2022 due to a 39 basis point increase in the rates paid on interest-bearing liabilities which was partially offset by a nine basis point increase in the yield on interest earning assets. The increase in yield on interest-earning assets was primarily due to higher yields on investment securities due to adjustments to yields realized from longer estimated lives of certain securities and the yields of securities purchased during the first nine months of 2022 being higher than the yields on our existing portfolio. The increase in the rates paid on our interest-bearing liabilities was due to higher deposit costs, higher borrowing costs and an increase in the proportion of higher cost borrowings used as our sources of funding. The increases in the rates paid on deposits was due to the significant increase in market interest rates during the first nine months of 2022. Our average borrowings increased by $653 million to fund the growth of our loan portfolio and investment securities. Our cost of borrowings increased from 33 basis points during the first nine months of 2021 to 199 basis points during the first nine months of 2022 due to the significant increase in market interest rates during the first nine months of 2022 and the impact of the $100 million subordinated notes offering completed in January 2022. 48 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 both the nine months ended September 30, 2022 and 2021. Noninterest Income consisted of the following: Nine Months Ended September 30, (in thousands) 2022 2021 Noninterest income Gain on loan origination and sale activities (1) Single family $ 11,896 $ 56,272 Commercial 4,317 15,967 Loan servicing income 9,706 4,693 Deposit fees 6,516 5,912 Other 9,458 8,511 Total noninterest income $ 41,893 $ 91,355 (1) May include loans originated as held for investment. Loan servicing income, a component of noninterest income, consisted of the following: Nine Months Ended September 30, (in thousands) 2022 2021 Single family servicing income, net Servicing fees and other $ 11,809 $ 11,788 Changes - amortization (1) (8,052) (15,453) Net 3,757 (3,665) Risk management, single family MSRs: Changes in fair value due to assumptions (2) 16,615 7,186 Net gain (loss) from economic hedging (18,481) (7,860) Subtotal (1,866) (674) Single Family servicing income (loss) 1,891 (4,339) Commercial loan servicing income: Servicing fees and other 13,692 14,267 Amortization of capitalized MSRs (5,877) (5,235) Total 7,815 9,032 Total loan servicing income $ 9,706 $ 4,693 (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 for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 was due to a decrease in gain on loan origination and sale activities, which was partially offset by higher loan servicing income and the $4.3 million gain on sale of five eastern Washington branches. The $56.0 million decrease in gain on loan origination and sale activities was due to a $44.4 million decrease in single family gain on loan origination and sale activities and a $11.7 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 72% decrease in the volume of loans sold. The $5.0 million increase in loan servicing income was primarily due to lower levels of prepayments. 49 Noninterest Expense consisted of the following: Nine Months Ended September 30, (in thousands) 2022 2021 Noninterest expense Compensation and benefits $ 89,563 $ 101,388 Information services 21,880 20,635 Occupancy 18,315 18,170 General, administrative and other 25,241 21,179 Total noninterest expense $ 154,999 $ 161,372 The $6.4 million decrease in noninterest expense in the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 was due to lower compensation and benefit costs, partially offset by increases in information services and general, administrative and other expenses. The $11.8 million decrease in compensation and benefit costs was primarily due to reduced commission expense on lower loan origination volumes in our single family mortgage operations, lower bonus expense and lower headcount, which were partially offset by wage increases given in 2022. 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 nine months of 2021, nonrecurring costs expended on litigation activities and legal matters in 2022 and an increase in marketing costs related to our promotional deposit products. 50 Financial Condition During the nine months ended September 30, 2022, our total assets increased $1.9 billion due primarily to a $1.7 billion increase in loans held for investment and a $305 million increase in investment securities which were partially offset by a decrease of $162 million in loans held for sale. Loans held for investment increased due to $3.0 billion of originations, which were partially offset by prepayments and scheduled payments of $1.3 billion. Total liabilities increased $2.0 billion due to increases in deposits, borrowings and long-term debt. Deposits increased $464 million primarily due to increased balances of brokered deposits and certificates of deposit related to our promotional products. The $1.5 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. Credit Risk Management As of September 30, 2022, our ratio of nonperforming assets to total assets remained low at 0.15% while our ratio of total loans delinquent over 30 days to total loans was 0.30%. The Company recorded a $9 million recovery of our allowance for credit losses for the nine months ended September 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 0.53% at September 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 September 30, 2022 At December 31, 2021 (in thousands) Amount Rate (1) Amount Rate (1) CRE Non-owner occupied CRE $ 2,106 0.32 % $ 7,509 1.06 % Multifamily 11,183 0.29 % 5,854 0.24 % Construction/land development Multifamily construction 665 1.06 % 507 1.34 % CRE construction 160 0.86 % 150 1.06 % Single family construction 9,564 2.77 % 6,411 2.16 % Single family construction to permanent 1,140 0.70 % 1,055 0.71 % Total 24,818 0.48 % 21,486 0.59 % Commercial and industrial loans Owner occupied CRE 969 0.23 % 5,006 1.10 % Commercial business 3,719 1.04 % 12,273 3.39 % Total 4,688 0.59 % 17,279 2.11 % Consumer loans Single family 4,464 0.56 % 4,394 0.68 % Home equity and other 3,636 1.09 % 3,964 1.31 % Total 8,100 0.71 % 8,358 0.88 % Total ACL $ 37,606 0.53 % $ 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. 51 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 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 September 30, 2022 and December 31, 2021, the Bank had available borrowing capacity of $1.0 billion and $1.8 billion, respectively, from the FHLB, and $337 million and $274 million, respectively, from the FRBSF and $1.2 billion and $1.0 billion under borrowing lines established with other financial institutions. Cash Flows For the nine months ended September 30, 2022, cash and cash equivalents decreased by $8 million compared to an increase of $161 million during the nine months ended September 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 nine months ended September 30, 2022, net cash of $209 million was provided by operating activities, primarily from cash proceeds from the sale of LHFS exceeding cash used to fund LHFS. For the nine months ended September 30, 2021, net cash of $182 million was provided by operating activities, primarily from cash proceeds from the sale of LHFS 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 nine months ended September 30, 2022, net cash of $2.4 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 nine months ended September 30, 2021, net cash of $155 million was used in investing activities primarily from the origination of LHFI net of principal repayments and the purchase of AFS securities, partially offset by the proceeds from the sale of loans originated as LHFI and AFS securities. Cash flows from financing activities 52 The Company's financing activities are primarily related to deposits and net proceeds from borrowings. For the nine months ended September 30, 2022, net cash of $2.2 billion was provided by financing activities, primarily due to an increase in short-term borrowings, growth in deposits and proceeds from the issuance of the subordinated notes, partially offset by repurchases of and dividends paid on our common stock. For the nine months ended September 30, 2021, net cash of $134 million was provided by financing activities, primarily due to growth in deposits, partially offset by net repayment of short-term borrowings and repurchases of and dividends paid on our common stock. 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 September 30, 2022 At December 31, 2021 Unused consumer portfolio lines $ 507,962 $ 405,992 Commercial portfolio lines (1) 821,837 820,131 Commitments to fund loans 39,469 90,852 Total $ 1,369,268 $ 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 $562 million and $584 million at September 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: 53 At September 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) $ 689,911 7.61 % $ 362,628 4.0 % NA NA Common equity Tier 1 capital (to risk-weighted assets) 629,911 8.66 % 327,160 4.5 % NA NA Tier 1 risk-based capital (to risk-weighted assets) 689,911 9.49 % 436,214 6.0 % NA NA Total risk-based capital (to risk-weighted assets) 830,827 11.43 % 581,618 8.0 % NA NA HomeStreet Bank Tier 1 leverage capital (to average assets) $ 824,718 9.15 % $ 360,653 4.0 % $ 450,817 5.0 % Common equity Tier 1 capital (to risk-weighted assets) 824,718 11.96 % 310,292 4.5 % 448,199 6.5 % Tier 1 risk-based capital (to risk-weighted assets) 824,718 11.96 % 413,722 6.0 % 551,630 8.0 % Total risk-based capital (to risk-weighted assets) 867,047 12.57 % 551,630 8.0 % 689,537 10.0 % 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 September 30, 2022, capital conservation buffers for the Company and the Bank were 3.43% and 4.57%, respectively. The Company paid a quarterly cash dividend of $0.35 per common share in the third quarter of 2022. It is our current intention to continue to pay quarterly dividends, and on October 27, 2022, we declared another cash dividend of $0.35 per common share payable on November 22, 2022 to shareholders of record as of the close of business on November 8, 2022. The amount and declaration of future cash dividends are subject to approval by our Board of Directors and certain regulatory restrictions. 54 Other than the acquisition of three branches in southern California, which is expected to close in the first quarter of 2023, whereby we will be purchasing $5.2 million of land and buildings, we had no material commitments for capital expenditures as of September 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. 55 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 excludes 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 expense 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. 56 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 nine months ended September 30, (in thousands, except ratio and rate) September 30, 2022 June 30, 2022 2022 2021 Return on average tangible equity (annualized) Average shareholders' equity $ 603,278 $ 603,664 $ 634,831 $ 725,730 Less: Average goodwill and other intangibles (30,602) (31,380) (31,198) (32,484) Average tangible equity $ 572,676 $ 572,284 $ 603,633 $ 693,246 Net income $ 20,367 $ 17,721 $ 58,039 $ 85,990 Adjustments (tax effected) Amortization on core deposit intangibles 186 191 568 694 Tangible income applicable to shareholders $ 20,553 $ 17,912 $ 58,607 $ 86,684 Ratio 14.2 % 12.6 % 13.0 % 16.7 % Efficiency ratio Noninterest expense Total $ 49,889 $ 50,637 $ 154,999 $ 161,372 Adjustments: Legal fees recovery — — — 1,900 State of Washington taxes (629) (579) (1,714) (1,759) Adjusted total $ 49,260 $ 50,058 $ 153,285 $ 161,513 Total revenues Net interest income $ 63,018 $ 60,056 $ 177,620 $ 169,973 Noninterest income 13,322 13,013 41,893 91,355 Gain on sale of branches (4,270) — (4,270) — Total $ 72,070 $ 73,069 $ 215,243 $ 261,328 Ratio 68.4 % 68.5 % 71.2 % 61.8 % Effective tax rate used in computations above 22.0 % 22.0 % 22.0 % 21.0 % As of (in thousands, except share data) September 30, 2022 December 31, 2021 Tangible book value per share Shareholders' equity $ 552,789 $ 715,339 Less: goodwill and other intangibles (30,215) (31,709) Tangible shareholder's equity $ 522,574 $ 683,630 Common shares outstanding 18,717,557 20,085,336 Computed amount $ 27.92 $ 34.04 Tangible common equity to tangible assets Tangible shareholder's equity (per above) $ 522,574 $ 683,630 Tangible assets Total assets 9,072,887 7,204,091 Less: Goodwill and other intangibles (30,215) (31,709) Net $ 9,042,672 $ 7,172,382 Ratio 5.8 % 9.5 % 57