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 2022 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, long-term value creation, capital management, reduction in volatility, reliability of earnings, net interest margins, provisions and allowances for credit losses, cost reduction initiatives, and restructuring activities 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 fiscal year ended December 31, 2022 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. 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 SEC'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 SEC. Copies of our Securities Exchange Act reports are also 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 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 credit losses. For example, if the projected unemployment rate was downgraded one grade for all periods, the amount of the ACL at September 30, 2023 would increase by approximately $8 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. 43 The valuation of MSRs is based on various assumptions which are set forth in Note 6– Mortgage Banking Operations of the financial statements. Note 6 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. 44 Summary Financial Data Quarter Ended Nine Months Ended September 30, (in thousands, except per share data and FTE data) September 30, 2023 June 30, 2023 2023 2022 Select Income Statement data: Net interest income $ 38,912 $ 43,476 $ 131,764 $ 177,620 Provision for credit losses (1,110) (369) (886) (9,000) Noninterest income 10,464 10,311 30,965 41,893 Noninterest expense 49,089 90,781 192,361 154,999 Net income (loss): Before income tax (benefit) expense 1,397 (36,625) (28,746) 73,514 Total 2,295 (31,442) (24,089) 58,039 Net income (loss) per share - diluted 0.12 (1.67) (1.28) 3.03 Core net income: (1) Total 2,295 3,180 10,533 58,039 Core net income per share - diluted 0.12 0.17 0.56 3.03 Select Performance Ratios: Return on average equity - annualized 1.7 % (21.7) % (5.7) % 12.2 % Return on average tangible equity - annualized (1) 2.2 % 2.9 % 3.1 % 13.0 % Return on average assets - annualized Net income (loss) 0.10 % (1.32) % (0.34) % 0.96 % Core (1) 0.10 % 0.13 % 0.15 % 0.96 % Efficiency ratio (1) 98.3 % 93.7 % 92.7 % 71.2 % Net interest margin 1.74 % 1.93 % 1.96 % 3.17 % Other data Full time equivalent employees 901 910 910 935 (1) Core net income, return on average tangible equity, core return on average assets and the efficiency ratio are non-GAAP financial measures. For a reconciliation of core net income, core return on average assets and return on average tangible equity to the nearest comparable GAAP financial measure and the computation of the efficiency ratio, see “Non-GAAP Financial Measures” elsewhere in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. 45 As of (in thousands, except share and per share data) September 30, 2023 December 31, 2022 Selected Balance Sheet Data Loans held for sale $ 33,879 $ 17,327 Loans held for investment, net 7,400,501 7,384,820 ACL 40,000 41,500 Investment securities 1,294,634 1,400,212 Total assets 9,458,751 9,364,760 Deposits 6,745,551 7,451,919 Borrowings 1,873,000 1,016,000 Long-term debt 224,671 224,404 Total shareholders' equity 502,487 562,147 Other data: Book value per share $ 26.74 $ 30.01 Tangible book value per share (1) $ 26.18 $ 28.41 Total equity to total assets 5.3 % 6.0 % Tangible common equity to tangible assets (1) 5.2 % 5.7 % Shares outstanding at period end 18,794,030 18,730,380 Loans to deposit ratio 110.8 % 99.9 % Credit Quality: ACL to total loans (2) 0.55 % 0.57 % ACL to nonaccrual loans 103.2 % 412.7 % Nonaccrual loans to total loans 0.52 % 0.14 % Nonperforming assets to total assets 0.42 % 0.13 % Nonperforming assets $ 39,749 $ 11,893 Regulatory Capital Ratios: Bank Tier 1 leverage 8.49 % 8.63 % Total risk-based capital 13.32 % 12.59 % Common equity Tier 1 capital 12.64 % 11.92 % Company Tier 1 leverage 7.01 % 7.25 % Total risk-based capital 12.62 % 11.53 % Common equity Tier 1 capital 9.52 % 8.72 % (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. 46 Current Developments Our core financial results continue to be adversely impacted by increases in interest rates. We have continued to raise new deposits through promotional certificates of deposit and have reduced new loan originations. Additionally, we have reduced controllable expenses where possible, reduced staff to the minimum levels to transact current business volume in a safe and sound manner and we have focused our new loan origination activity primarily on floating rate products such as commercial and industrial loans, residential construction loans and home equity loans. Our net interest margin decreased in the first nine months of 2023 due to decreases in lower cost transaction and savings deposits and overall higher funding costs. We expect that any future migration of lower cost deposit accounts to higher yielding alternatives to be replaced with higher cost promotional deposit accounts or wholesale funding alternatives. Management's Overview of the Third Quarter 2023 Financial Performance Third Quarter of 2023 Compared to the Second Quarter of 2023 Non-core amounts: During the second quarter of 2023 , the non-core item is a $39.9 million goodwill impairment charge. General: Our net income (loss) and income (loss) before taxes were $2.3 million and $1.4 million, respectively, in the third quarter of 2023, as compared to $(31.4) million and $(36.6) million, respectively, in the second quarter of 2023. Our core net income and core income before taxes in the third quarter of 2023 were $2.3 million and $1.4 million, respectively, as compared to $3.2 million and $3.2 million, respectively, in the second quarter of 2023, which excludes the impact of the goodwill impairment charge. The $1.8 million decrease in core income before taxes was due to lower net interest income which was partially offset by a larger recovery of allowance for credit losses and lower noninterest expense. Income Taxes: The income tax benefit realized in the third quarter of 2023 was due to the recognition of return to accrual differences related to tax exempt income. Our effective tax rate for the second quarter of 2023 of 14.2% was significantly impacted by the goodwill impairment charge, a portion of which was not deductible for tax purposes. Our core income effective tax rate for the second quarter of 2023 was 1.6%, which is lower than our statutory tax rate of 24.7% primarily due to the significantly higher proportion of tax exempt revenues in comparison to our overall core income before tax. 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: Quarter Ended September 30, 2023 June 30, 2023 (in thousands) Average Balance Interest Average Yield/Cost Average Balance Interest Average Yield/Cost Assets: Interest-earning assets: Loans (1) $ 7,461,220 $ 86,118 4.54 % $ 7,499,800 $ 86,051 4.56 % Investment securities (1) 1,356,410 13,232 3.90 % 1,444,819 13,790 3.82 % FHLB Stock, Fed Funds and other 189,730 2,498 5.18 % 165,188 2,022 4.87 % Total interest-earning assets 9,007,360 101,848 4.46 % 9,109,807 101,863 4.45 % Noninterest-earning assets 426,288 453,010 Total assets $ 9,433,648 $ 9,562,817 Liabilities and shareholders' equity: Interest-bearing deposits: (2) Demand deposits $ 356,986 $ 162 0.18 % $ 413,438 $ 271 0.26 % Money market and savings 2,120,304 7,773 1.45 % 2,291,841 7,951 1.38 % Certificates of deposit 2,614,735 25,905 3.93 % 2,879,546 27,171 3.78 % Total 5,092,025 33,840 2.63 % 5,584,825 35,393 2.54 % Borrowings: Borrowings 2,051,584 24,847 4.81 % 1,630,102 18,829 4.62 % Long-term debt 224,614 3,107 5.49 % 224,523 3,009 5.34 % Total interest-bearing liabilities 7,368,223 61,794 3.33 % 7,439,450 57,231 3.08 % Noninterest-bearing liabilities: Demand deposits (2) 1,430,834 1,437,133 Other liabilities 99,222 104,062 Total liabilities 8,898,279 8,980,645 Shareholders' equity 535,369 582,172 Total liabilities and shareholders' equity $ 9,433,648 $ 9,562,817 Net interest income $ 40,054 $ 44,632 Net interest rate spread 1.13 % 1.37 % Net interest margin 1.74 % 1.93 % (1) Includes taxable-equivalent adjustments primarily related to tax-exempt income on certain loans and securities of $1.1 million and $1.2 million for the quarters ended September 30, 2023 and June 30, 2023, respectively. The estimated federal statutory tax rate was 21% for the periods presented. (2) Cost of all deposits, including noninterest-bearing demand deposits was 2.06% and 2.02% for the quarters ended September 30, 2023 and June 30, 2023, respectively. Our net interest income in the third quarter of 2023 was $4.6 million lower than the second quarter of 2023 due to a decrease in our net interest margin from 1.93% to 1.74%. The decrease in our net interest margin was due to a 25 basis point increase in the cost of interest-bearing liabilities caused in part by an increase in the proportion of higher cost borrowings to the total balance of interest-bearing liabilities. The increase in the cost of interest-bearing liabilities was due to overall higher deposit, long term debt and borrowing costs. During the third quarter, the cost of deposits increased 4 basis points during the third quarter, the cost of long term debt increased 15 basis points and the cost of borrowings increased 19 basis points. The increases in the rates paid on interest-bearing liabilities were due to the significant increases in market interest rates during 2023. 48 Provision for Credit Losses: A $1.1 million recovery of our allowance for credit losses was recognized during the third quarter of 2023 compared to a $0.4 million recovery of our allowance for credit losses in the second quarter of 2023. The recovery for the third quarter of 2023 was primarily due to reduced levels of higher risk land and development loans which resulted in lower expected losses. The recovery in the second quarter of 2023 reflects a decrease in our unfunded commitment reserve as our allowance for credit losses remained unchanged at $41.5 million and our net charge-offs realized in the quarter were nominal. Noninterest Income consisted of the following: Quarter Ended (in thousands) September 30, 2023 June 30, 2023 Noninterest income Gain on loan origination and sale activities (1) Single family $ 2,267 $ 2,171 CRE, multifamily and SBA 105 285 Loan servicing income 3,092 3,259 Deposit fees 2,455 2,704 Other 2,545 1,892 Total noninterest income $ 10,464 $ 10,311 (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, 2023 June 30, 2023 Single family servicing income, net Servicing fees and other $ 3,852 $ 3,868 Changes - amortization (1) (1,564) (1,626) Net 2,288 2,242 Risk management, single family MSRs: Changes in fair value due to assumptions (2) 785 1,320 Net gain (loss) from economic hedging (1,160) (1,592) Subtotal (375) (272) Single Family servicing income 1,913 1,970 Commercial loan servicing income: Servicing fees and other 2,553 2,724 Amortization of capitalized MSRs (1,374) (1,435) Total 1,179 1,289 Total loan servicing income $ 3,092 $ 3,259 (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. Noninterest income in the third quarter of 2023 was consistent with the second quarter of 2023. 49 Noninterest Expense consisted of the following: Quarter Ended (in thousands) September 30, 2023 June 30, 2023 Noninterest expense Compensation and benefits $ 27,002 $ 27,776 Information services 7,579 7,483 Occupancy 5,306 5,790 General, administrative and other 9,202 9,875 Goodwill impairment charge — 39,857 Total noninterest expense $ 49,089 $ 90,781 The $41.7 million decrease in noninterest expenses in the third quarter of 2023, as compared to the second quarter of 2023 was primarily due to a $39.9 million goodwill impairment charge in the second quarter of 2023. Nine Months Ended September 30, 2023 Compared to Nine Months Ended September 30, 2022 Non-core amounts: During the nine months ended September 30, 2023 , the non-core item is a $39.9 million goodwill impairment charge. General: Our net income (loss) and income (loss) before taxes were $(24.1) million and $(28.7) million, respectively, in the nine months ended September 30, 2023, as compared to $58.0 million and $73.5 million, respectively, in the nine months ended September 30, 2022. Our core net income and core income before taxes in the nine months ended September 30, 2023, which excludes the impact of the goodwill impairment charge, was $10.5 million and $11.1 million, as compared to $58.0 million and $73.5 million, respectively, in the nine months ended September 30, 2022. The $62.4 million decrease in core income before taxes was due to a lower net interest income, a lower recovery of provision for credit losses and lower noninterest income, partially offset by lower noninterest expense. Income Taxes: Our effective tax rate of 16.2% during the nine months ended September 30, 2023 was significantly impacted by the goodwill impairment charge, a portion of which was not deductible for tax purposes. Our core income effective tax rate for the first nine months of 2023 and 2022 was 5.2% and 21.1% respectively, which is lower than our statutory tax rate of 24.7% and 25.3%, respectively, primarily due to the significantly higher proportion of tax exempt revenues in comparison to our overall core income before tax. Our effective tax rate in the nine months ended September 30, 2022 was also lower than the statutory rate due to the benefits of tax advantaged loans and investments and reductions in taxes on income related to excess tax benefits resulting from the vesting of stock awards during the period. 50 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, 2023 2022 (in thousands) Average Balance Interest Average Yield/Cost Average Balance Interest Average Yield/Cost Assets: Interest-earning assets: Loans (1) $ 7,477,454 $ 254,959 4.51 % $ 6,336,185 $ 186,665 3.90 % Investment securities (1) 1,417,438 40,755 3.83 % 1,139,761 25,389 2.97 % FHLB Stock, Fed Funds and other 160,833 6,270 5.19 % 86,752 1,655 2.50 % Total interest-earning assets 9,055,725 301,984 4.42 % 7,562,698 213,709 3.74 % Noninterest-earning assets 452,976 512,452 Total assets $ 9,508,701 $ 8,075,150 Interest-bearing liabilities: Interest-bearing deposits: (2) Demand deposits $ 399,962 $ 732 0.24 % $ 536,956 $ 517 0.13 % Money market and savings 2,320,958 23,077 1.32 % 3,009,398 6,081 0.27 % Certificates of deposit 2,736,363 74,794 3.65 % 1,098,255 6,900 0.84 % Total 5,457,283 98,603 2.41 % 4,644,609 13,498 0.39 % Borrowings: Borrowings 1,677,276 59,016 4.69 % 790,907 11,922 1.99 % Long-term debt 224,525 9,081 5.37 % 217,732 7,082 4.33 % Total interest-bearing liabilities 7,359,084 166,700 3.02 % 5,653,248 32,502 0.76 % Noninterest-bearing liabilities: Demand deposits (2) 1,459,506 1,662,465 Other liabilities 124,911 124,606 Total liabilities 8,943,501 7,440,319 Shareholders' equity 565,200 634,831 Total liabilities and shareholders' equity $ 9,508,701 $ 8,075,150 Net interest income $ 135,284 $ 181,207 Net interest spread 1.40 % 2.98 % Net interest margin 1.96 % 3.17 % (1) Includes taxable-equivalent adjustments primarily related to tax-exempt income on certain loans and securities of $3.5 million and $3.6 million for the nine months ended September 30, 2023 and 2022, respectively. The estimated federal statutory tax rate was 21% for the periods presented. (2) Cost of deposits including noninterest-bearing deposits, was 1.90% and 0.29% for the nine months ended September 30, 2023 and 2022, respectively. Net interest income for the nine months ended September 30, 2023 decreased $45.9 million as compared to the nine months ended September 30, 2022 due primarily to a decrease in our net interest margin partially offset by increases in the average balance of interest earning assets. The increase in interest-earning assets was due to loan originations and purchases of investment securities during 2022. Our net interest margin decreased from 3.17% in the nine months ended September 30, 2022 to 1.96% in the nine months ended September 30, 2023 due to a 226 basis point increase in the rates paid on interest-bearing liabilities which was partially offset by a 68 basis point increase in the yield on interest earning assets. Yields on interest-earning assets increased as the yields on loan originations during the last two years 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 higher yields on our investment securities were primarily due to adjustments to yields realized from longer estimated lives of certain securities and the yields of securities purchased during the past year 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 were due to the significant increase in market interest rates over the prior year and the decrease in the proportion of noninterest-bearing deposits to total deposits. Our average borrowings increased by $886 million to fund the growth of our loan portfolio and investment securities. Our cost of borrowings increased from 199 basis points during the nine months ended September 30, 2022 to 469 basis points during the nine months ended September 30, 2023 due to the significant increase in market interest rates during the last two years. 51 Provision for Credit Losses: A $0.9 million recovery of our allowance for credit losses was recognized during the nine months ended September 30, 2023 compared to a $9.0 million recovery of our allowance for credit losses in the nine months ended September 30, 2022. The recovery of our allowance for credit losses in 2023 was the result of economic conditions performing better than expected, improved single-family collateral forecasts, changes in portfolio composition and a decrease in our unfunded commitment reserve offset slightly by deteriorated commercial collateral conditions. The recovery of our allowance for credit losses in 2022 was the 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. Noninterest Income consisted of the following: Nine Months Ended September 30, (in thousands) 2023 2022 Noninterest income Gain on loan origination and sale activities (1) Single family $ 6,656 $ 11,896 Commercial 582 4,317 Loan servicing income 9,390 9,706 Deposit fees 7,817 6,516 Other 6,520 9,458 Total noninterest income $ 30,965 $ 41,893 (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) 2023 2022 Single family servicing income, net Servicing fees and other $ 11,643 $ 11,809 Changes - amortization (1) (4,874) (8,052) Net 6,769 3,757 Risk management, single family MSRs: Changes in fair value due to assumptions (2) 1,794 16,615 Net gain (loss) from economic hedging (2,833) (18,481) Subtotal (1,039) (1,866) Single Family servicing income 5,730 1,891 Commercial loan servicing income: Servicing fees and other 8,023 13,692 Amortization of capitalized MSRs (4,363) (5,877) Total 3,660 7,815 Total loan servicing income $ 9,390 $ 9,706 (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. 52 The decrease in noninterest income for the nine months ended September 30, 2023 as compared to the nine months ended September 30, 2022 was due to a decrease in gain on loan origination and sale activities and other income, which was partially offset by higher deposit fees. The $9.0 million decrease in gain on loan origination and sale activities was due to a $5.2 million decrease in single family gain on loan origination and sale activities and a $3.7 million decrease in commercial real estate and commercial and industrial 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 mortgage interest rates. The decrease in commercial real estate and commercial and industrial gain on loan origination and sale activities was primarily due to an 87% decrease in loans sold volume as a result of increasing interest rates. The $2.9 million decrease in other income was primarily due to a $4.3 million gain on sale of branches realized in the nine months ended September 30, 2022. The $1.3 million increase in deposit fee income was primarily due to higher early withdrawals fees. Noninterest Expense consisted of the following: Nine Months Ended September 30, (in thousands) 2023 2022 Noninterest expense Compensation and benefits $ 84,031 $ 89,563 Information services 22,207 21,880 Occupancy 16,834 18,315 General, administrative and other 29,432 25,241 Goodwill impairment charge 39,857 — Total noninterest expense $ 192,361 $ 154,999 The $37.4 million increase in noninterest expenses in the nine months ended September 30, 2023 as compared to nine months ended September 30, 2022 was due to a $39.9 million goodwill impairment charge and higher general, administrative and other costs which were partially offset by lower compensation and benefit costs and occupancy costs. The $5.5 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 staffing levels and lower bonus expense, which were partially offset by wage increases given in the first nine months of 2023 and a reduction in deferred costs due to lower levels of loan production. The increase in general, administrative and other costs was primarily due to higher FDIC fees due to our larger asset base, which were partially offset by a reduction in legal fees due to charges related to nonrecurring costs expended on litigation activities and legal matters in the nine months ended September 30, 2022. 53 Financial Condition During the nine months ended September 30, 2023, our total assets increased $94 million due primarily to a $154 million increase in cash. Loans held for investment were relatively unchanged as $1.0 billion of originations was offset by prepayments and scheduled payments of $1.0 billion. During the first nine months of 2023 total liabilities increased $154 million due to an increase in borrowings, partially offset by a decrease in deposits. The $706 million decrease in deposits was due to a $473 million decrease in brokered certificates of deposit and a $1.1 billion decrease in non-certificates of deposit balances which were partially offset by a $455 million increase in certificates of deposit balances related to our promotional products. The decrease in deposits was offset by $373 million in deposits that we acquired as part of the branch acquisition in the first quarter of 2023. The $857 million of additional borrowings were used to replace maturing brokered deposits and increase our on-balance sheet cash balances. Credit Risk Management As of September 30, 2023, our ratio of nonperforming assets to total assets remained low at 0.42% while our ratio of total loans delinquent over 30 days to total loans was 0.64%. The increase in nonaccrual assets during the first nine months of 2023 was due to one customer relationship which consists of $27 million of loans that were classified as collateral dependent and nonaccrual in the second quarter of 2023. These loans are current in their payments and are overcollateralized. Our overall ratio of ACL to LHFI was 0.55% at September 30, 2023 as compared to 0.57% at December 31, 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, 2023 At December 31, 2022 (in thousands) Amount Rate (1) Amount Rate (1) CRE Non-owner occupied CRE $ 2,365 0.37 % $ 2,102 0.32 % Multifamily 10,706 0.27 % 10,974 0.28 % Construction/land development Multifamily construction 1,592 1.12 % 998 1.05 % CRE construction 153 0.83 % 196 1.03 % Single family construction 9,745 3.63 % 12,418 3.51 % Single family construction to permanent 991 0.72 % 1,171 0.74 % Total 25,552 0.50 % 27,859 0.53 % Commercial and industrial loans Owner occupied CRE 1,102 0.26 % 1,030 0.23 % Commercial business 3,601 0.94 % 3,247 0.91 % Total 4,703 0.58 % 4,277 0.54 % Consumer loans Single family 5,783 0.58 % 5,610 0.62 % Home equity and other 3,962 1.07 % 3,754 1.06 % Total 9,745 0.71 % 9,364 0.74 % Total ACL $ 40,000 0.55 % $ 41,500 0.57 % (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. 54 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, borrowings from the Bank Term Funding Program 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, 2023 and December 31, 2022, the Bank had available borrowing capacity of $2.2 billion and $2.6 billion, respectively, from the FHLB, and $331 million and $340 million, respectively, from the FRBSF and $1.2 billion, in both periods, under borrowing lines established with other financial institutions. Cash Flows For the nine months ended September 30, 2023, cash and cash equivalents increased by $154 million compared to a decrease of $8 million during the nine months ended September 30, 2022. 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, 2023, net cash of $1.5 million was used in operating activities, as cash generated from earnings was offset by cash used to fund LHFS in excess of proceeds from the sale of loans and increases in other assets. 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 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 nine months ended September 30, 2023, net cash of $392 million was provided by investing activities primarily from net cash acquired from an acquisition, principal repayments on AFS securities and LHFI principal repayments in excess of originations, partially offset by the purchase of AFS investment securities and net FHLB stock purchases. 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. Cash flows from financing activities The Company's financing activities are primarily related to deposits and net proceeds from borrowings. For the nine months ended September 30, 2023, net cash of $237 million was used in financing activities, primarily due to decreases in deposits and dividends paid on our common stock, partially offset by an increase in short-term and long-term 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. 55 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, 2023 At December 31, 2022 Unused consumer portfolio lines $ 572,245 $ 531,784 Commercial portfolio lines (1) 718,051 788,108 Commitments to fund loans 22,183 46,067 Total $ 1,312,479 $ 1,365,959 (1) Within the commercial portfolio, undistributed construction loan proceeds, where the Company has an obligation to advance funds for construction progress payments were $439 million and $525 million at September 30, 2023 and December 31, 2022, 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 September 30, 2023 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) $ 678,863 7.01 % $ 387,527 4.0 % NA NA Common equity Tier 1 capital (to risk-weighted assets) 618,863 9.52 % 292,624 4.5 % NA NA Tier 1 risk-based capital (to risk-weighted assets) 678,863 10.44 % 390,165 6.0 % NA NA Total risk-based capital (to risk-weighted assets) 820,875 12.62 % 520,220 8.0 % NA NA HomeStreet Bank Tier 1 leverage capital (to average assets) $ 821,627 8.49 % $ 387,312 4.0 % $ 484,139 5.0 % Common equity Tier 1 capital (to risk-weighted assets) 821,627 12.64 % 292,409 4.5 % 422,369 6.5 % Tier 1 risk-based capital (to risk-weighted assets) 821,627 12.64 % 389,879 6.0 % 519,839 8.0 % Total risk-based capital (to risk-weighted assets) 865,323 13.32 % 519,839 8.0 % 649,799 10.0 % 56 At December 31, 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) $ 693,112 7.25 % $ 382,467 4.0 % NA NA Common equity Tier 1 capital (to risk-weighted assets) 633,112 8.72 % 326,876 4.5 % NA NA Tier 1 risk-based capital (to risk-weighted assets) 693,112 9.54 % 435,834 6.0 % NA NA Total risk-based capital (to risk-weighted assets) 837,828 11.53 % 581,112 8.0 % NA NA HomeStreet Bank Tier 1 leverage capital (to average assets) $ 822,891 8.63 % $ 381,506 4.0 % $ 476,883 5.0 % Common equity Tier 1 capital (to risk-weighted assets) 822,891 11.92 % 310,582 4.5 % 448,618 6.5 % Tier 1 risk-based capital (to risk-weighted assets) 822,891 11.92 % 414,109 6.0 % 552,146 8.0 % Total risk-based capital (to risk-weighted assets) 868,993 12.59 % 552,146 8.0 % 690,182 10.0 % As 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 both the Company and Bank maintained capital ratios necessary to satisfy the capital conservation buffer requirements as of the dates indicated. At September 30, 2023, capital conservation buffers for the Company and the Bank were 4.44% and 5.32%, respectively. The Company paid a quarterly cash dividend of $0.10 per common share in the third quarter of 2023 and on October 26, 2023, we declared a cash dividend of $0.10 per common share payable on November 22, 2023 to shareholders of record as of the close of business on November 8, 2023. It is our current intention to continue to pay quarterly dividends, however, the amount and declaration of future cash dividends are subject to our level of profitability, approval by our Board of Directors and certain legal and regulatory restrictions. We had no material commitments for capital expenditures as of September 30, 2023. 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/or 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. 57 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 exclude intangible assets from the calculation of capital ratios; (ii) core income and effective tax rate on core income before taxes, which excludes goodwill impairment charges and the related tax impact as we believe this measure is a better comparison to be used for projecting future results and (iii) an efficiency ratio which is the ratio of noninterest expense 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 taxes and we believe including them in noninterest expense impacts the comparability of our results to those companies whose operations are in states where assessed taxes on business are classified as income taxes. 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. 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, or the calculation of the non-GAAP financial measures. 58 Reconciliations of non-GAAP results of operations to the nearest comparable GAAP measures: For the Quarter Ended Nine Months Ended September 30, (in thousands, except ratio, rate and share data) September 30, 2023 June 30, 2023 2023 2022 Core net income Net income (loss) $ 2,295 $ (31,442) $ (24,089) $ 58,039 Adjustments (tax effected) Goodwill impairment charge — 34,622 34,622 — Total $ 2,295 $ 3,180 $ 10,533 $ 58,039 Core diluted earnings per share Fully diluted shares 18,792,893 18,775,022 18,774,593 19,137,848 Ratio $ 0.12 $ 0.17 $ 0.56 $ 3.03 Return on average tangible equity (annualized) Average shareholders' equity $ 535,369 $ 582,172 $ 565,200 $ 634,831 Less: Average goodwill and other intangibles (10,917) (51,138) (30,934) (31,198) Average tangible equity $ 524,452 $ 531,034 $ 534,266 $ 603,633 Core net income (per above) $ 2,295 $ 3,180 $ 10,533 $ 58,039 Adjustments (tax effected) Amortization on core deposit intangibles 614 614 1,687 568 Tangible income applicable to shareholders $ 2,909 $ 3,794 $ 12,220 $ 58,607 Ratio 2.2 % 2.9 % 3.1 % 13.0 % Efficiency ratio Noninterest expense Total $ 49,089 $ 90,781 $ 192,361 $ 154,999 Adjustments: Goodwill impairment charge — (39,857) (39,857) — State of Washington taxes (572) (526) (1,653) (1,714) Adjusted total $ 48,517 $ 50,398 $ 150,851 $ 153,285 Total revenues Net interest income $ 38,912 $ 43,476 $ 131,764 $ 177,620 Noninterest income 10,464 10,311 30,965 41,893 Gain on sale of branches — — — (4,270) Total $ 49,376 $ 53,787 $ 162,729 $ 215,243 Ratio 98.3 % 93.7 % 92.7 % 71.2 % Return on Average assets (annualized) - Core Average Assets $ 9,433,648 $ 9,562,817 $ 9,508,701 $ 8,075,150 Core net income - per above 2,295 3,180 10,533 58,039 Ratio 0.10 % 0.13 % 0.15 % 0.96 % Effective tax rate used in computations above (1) 22.0 % 22.0 % 22.0 % 22.0 % (1) ) Effective tax rate indicated is used for all adjustment except the goodwill impairment charge as a portion of this charge was not deductible for tax purposes. Instead, a computed effective rate of 13.1% was used for the goodwill impairment charge. 59 As of (in thousands, except ratio, rate and share data) September 30, 2023 December 31, 2022 Tangible book value per share Shareholders' equity $ 502,487 $ 562,147 Less: goodwill and other intangibles (10,429) (29,980) Tangible shareholder's equity $ 492,058 $ 532,167 Common shares outstanding 18,794,030 18,730,380 Computed amount $ 26.18 $ 28.41 Tangible common equity to tangible assets Tangible shareholder's equity (per above) $ 492,058 $ 532,167 Tangible assets Total assets $ 9,458,751 $ 9,364,760 Less: Goodwill and other intangibles (per above) (10,429) (29,980) Net $ 9,448,322 $ 9,334,780 Ratio 5.2 % 5.7 % 60