Item 2. Management’s Discussion and Analysis
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This Quarterly Report on Form 10-Q may include certain forward-looking statements based on current management expectations. Such forward-looking statements may be identified by reference to a future period or periods or by the use of forward-looking terminology, such as “may”, “will”, “believe”, “expect”, “estimate”, “anticipate”, “continue”, or similar terms or variations on those terms, or the negative of those terms. The actual results of the Company could differ materially from those management expectations. This includes statements regarding general economic conditions, public health crisis such as the governmental, social and economic effects of the COVID 19 pandemic, legislative and regulatory changes, monetary and fiscal policies of the federal government, changes in tax policies, rates and regulations of federal, state and local tax authorities and failure to integrate or profitably operate acquired businesses. Additional potential factors include changes in interest rates, the rate of inflation, deposit flows, cost of funds, demand for loan products and financial services, competition and changes in the quality or composition of loan and investment portfolios of the Company. Other factors that could cause future results to vary from current management expectations include changes in accounting principles, policies or guidelines, and other economic, competitive, governmental and technological factors affecting the Company’s operations, markets, products, services and prices, instability in the banking system, the potential for a recessionary economy and any adverse impact resulting from the COVID 19 pandemic. Further description of the risks and uncertainties to the business are included in the Company’s other filings with the Securities and Exchange Commission.
During 2022, the Federal Reserve took unprecedented action during the year to restrain inflation and improve the stability of the economy by raising the target federal funds rate several times from 25 basis points in the beginning of the year to 75 basis points toward the end of the year and brought the benchmark interest rates up by a collective 4.50 percent. During the first quarter 2023, the Federal Reserve increased the target federal funds rate another 0.25 percent and further increased the target federal funds rate another 0.25 percent in May 2023. The Federal Reserve may further increase the target federal funds rate in 2023 in an attempt to reduce inflation. Any substantial or unexpected change in market interest rates could have a material adverse effect on the Company’s financial condition and results of operations. As inflation increases and market interest rates rise, the value of our investment securities, particularly those with longer maturities, would decrease, although this effect can be less pronounced for floating rate instruments. In addition, inflation generally increases the cost of goods and services we use in our business operations, such as electricity and other utilities, which increases our non-interest expenses. Furthermore, our customers are also affected by inflation and the rising costs of goods and services used in their households and businesses, which could have a negative impact on their ability to repay their loans with us. In addition, r ecent bank failures have led to a greater focus by institutions, investors and regulators on the on-balance sheet liquidity of and funding sources for financial institutions, the composition of its deposits, including the amount of uninsured deposits, the amount of accumulated other comprehensive loss, capital levels and interest rate risk management. If we are unable to adequately manage our liquidity, deposits, capital levels and interest rate risk, it may have a material adverse effect on our financial condition and results of operations.
The majority of the assets and liabilities of a financial institution are monetary in nature, and therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an impact on the Company, particularly with respect to the growth of total assets and noninterest expenses, which tend to rise during periods of general inflation. Risks also exist due to supply and demand imbalances, employment shortages, the interest rate environment, and geopolitical tensions. It is reasonably foreseeable that estimates made in the financial statements could be materially and adversely impacted in the near term as a result of these conditions, including expected credit losses on loans and the fair value of financial instruments that are carried at fair value.
33
Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.
Critical Accounting Policies
Note 2 to the Company’s consolidated financial statements for the fiscal year ended December 31, 2022 (included in Item 8 of the Annual Report on Form 10-K for the fiscal year ended December 31, 2022) lists significant accounting policies used in the development and presentation of its financial statements. This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors that are necessary for an understanding and evaluation of the Company and its results of operations. See Note 1, "Basis of Presentation" for additional information on the adoption of ASC 326, which changes the methodology under which management calculates its reserve for loans and investment securities, now referred to as the allowance for credit losses. Management considers the measurement of the allowance for credit losses to be a critical accounting policy.
Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for credit losses, the valuation of deferred tax assets, the fair value of financial instruments, and the determination of goodwill impairment. Please refer to the discussion of the allowance for credit losses calculation under “Changes in Financial Condition - Loans” below.
Deferred income taxes reflect temporary differences in the recognition of the revenue and expenses for tax reporting and financial statement purposes, principally because certain items are recognized in different periods for financial reporting and tax return purposes. Although realization is not assured, the Company believes that it is more likely than not that all deferred tax assets will be realized.
The fair value of financial instruments is based upon quoted market prices, when available. For those instances where a quoted price is not available, fair values are based upon observable market based parameters as well as unobservable parameters. Any such valuation is applied consistently over time.
In connection with acquisitions, the Company recorded goodwill in the amount of $29.3 million, representing the excess of amounts paid over the fair value of net assets of the institutions acquired in purchase transactions, at its fair value at the date of acquisition. Goodwill is tested and deemed impaired when the carrying value of goodwill exceeds its implied fair value. The value of the goodwill can change in the future. We expect the value of the goodwill to decrease if there is a significant decrease in the franchise value of the Company or the Bank. If an impairment loss is determined in the future, we will reflect the loss as an expense for the period in which the impairment is determined, leading to a reduction of our net income for that period by the amount of the impairment loss.
Changes in Financial Condition
General
Total assets as of March 31, 2023 were $2.104 billion compared to $2.047 billion as of December 31, 2022. The increase was due primarily to a $61.7 million increase in loans receivable.
Securities
The fair value of securities available for sale as of March 31, 2023 was $418.2 million compared to $418.9 million as of December 31, 2022. In Management’s opinion the unrealized losses reflect changes in interest rates subsequent to the acquisition of specific securities. The Company concluded that the decline in the value of these securities was not indicative of a credit loss. The Company did not recognize any credit losses on these available for sale debt securities for the three months ended March 31, 2023, or other-than-temporary impairment charges for the three months ended March 31, 2022. The Company does not have the intent to sell the securities and it is more likely than not that it will not have to sell the securities before recovery of its cost basis.
34
Loans
Loans receivable totaled $1.536 billion at March 31, 2023 compared to $1.474 billion as of December 31, 2022. The $61.7 million increase in loans receivable during the three months ended March 31, 2023, was due primarily to a $16.8 million increase in commercial real estate loans, a $20.6 million increase in commercial loans and a $23.1 million increase in consumer loans.
The allowance for credit losses totaled $19,445,000 as of March 31, 2023, and represented 1.27% of total loans outstanding, compared to $16,999,000, or 1.15% of total loans outstanding, at December 31, 2022. The Company had net charge-offs for the three months ended March 31, 2023 of $320,000, compared to $82,000 in the corresponding period in 2022. The Company’s management assesses the adequacy of the allowance for credit losses on a quarterly basis. Based on management’s best judgement, the qualitative factors are applied to the final adjusted loss rate each quarter. Management considers the allowance for credit losses adequate at March 31, 2023 based on the Company’s criteria. However, there can be no assurance that the allowance for credit losses will be adequate to cover significant losses, if any, which might be incurred in the future.
As of March 31, 2023, non-performing loans totaled $2,714,000 or 0.18% of total loans compared to $1,113,000, or 0.08%, of total loans at December 31, 2022. At March 31, 2023, non-performing assets totaled $3,060,000, or 0.15%, of total assets, compared to $1,459,000, or 0.07%, of total assets at December 31, 2022.
The following table sets forth information regarding non-performing loans and foreclosed real estate at the dates indicated:
(dollars in thousands)
March 31, 2023
December 31, 2022
Loans accounted for on a non-accrual basis:
Real Estate
Residential
$
437
$
486
Commercial
1,941
402
Agricultural
—
—
Construction
—
—
Commercial and financial loans
115
61
Other agricultural loans
—
—
Consumer loans to individuals
221
164
Total non-accrual loans
2,714
1,113
Accruing loans which are contractually
past due 90 days or more
—
—
Total non-performing loans
2,714
1,113
Foreclosed real estate
346
346
Total non-performing assets
$
3,060
$
1,459
Purchased credit impaired loans (a)
$
N/A
$
6,290
Allowance for credit losses
$
19,445
$
16,999
Coverage of non-performing loans (a) (b)
716%
%
1,527%
%
Non-performing loans to total loans(a)
0.18
%
0.08
%
Non-performing loans to total assets(a)
0.11
%
0.05
%
Non-performing assets to total assets(a)
0.15
%
0.07
%
(a) Purchased impaired loans are loans obtained in acquisition transactions that as of the acquisition date were specifically identified as displaying signs of credit deterioration and for which the Company did not expect to collect all contractually required principal and interest payments. Prior to 2023, those loans were impaired at the date of acquisition, were recorded at estimated fair value and were generally delinquent in payments. The Company estimated the timing and amount of expected cash flows in excess of the estimated fair value and established an accretable discount on the acquisition date relating to these impaired loans that is recognized in interest income.
(b) Prior to 2023, loans acquired with specific evidence of deterioration in credit quality, a specific credit fair value adjustment is established at the date of acquisition and will not impact the allowance for loan losses unless actual losses exceed the established fair value adjustment.
35
Deposits
During the three-months ended March 31, 2023, total deposits increased $28.2 million due primarily to a $78.1 million increase in certificates of deposit. All other deposit categories decreased $49.9 million, net.
The following table sets forth deposit balances as of the dates indicated:
(dollars in thousands)
March 31, 2023
December 31, 2022
Non-interest bearing demand
$
419,615
$
434,529
Interest-bearing demand
220,379
237,891
Money market deposit accounts
265,933
273,165
Savings
268,116
278,372
Time deposits <$250,000
343,868
290,147
Time deposits >$250,000
238,024
213,623
Total
$
1,755,935
$
1,727,727
Borrowings
Short-term borrowings increased $15.3 million to $108.5 million at March 31, 2023, compared to $93.2 million at December 31, 2022, due primarily to an increase in overnight borrowings to fund liquidity needs.
Other borrowings as of March 31, 2023, were $40.2 compared to $40.0 million as of December 31, 2022. Federal Home Loan Bank borrowings decreased $9.8 million during the period due to scheduled principal reductions. A new $10.0 million term borrowing that was initiated under the Federal Reserve Long-Term Funding Program contributed to the variance.
Other borrowings consisted of the following:
(dollars in thousands)
March 31, 2023
December 31, 2022
Notes with the FHLB:
Amortizing fixed rate borrowing due December 2023 at 5.08%
30,189
40,000
$
30,189
$
40,000
Notes with the Federal Reserve Bank
Fixed rate borrowing due March 2024 at 4.83%
10,000
—
$
10,000
$
—
Stockholders’ Equity and Capital Ratios
As of March 31, 2023, total stockholders’ equity was $176.4 million, compared to $167.1 million as of December 31, 2022. Total stockholders’ equity increased $7.4 million due to an increase in the fair value of securities in the available-for-sale portfolio, net of tax, and $5.8 million of net income, offset partially by $2.4 million of dividends declared. The increase in fair value of securities is the result of a change in interest rates and spreads, which may impact the value of the securities. Because of interest rate volatility, the Company’s accumulated other comprehensive income could materially fluctuate for each interim and year-end period.
A comparison of the Company’s consolidated regulatory capital ratios is as follows:
March 31, 2023
December 31, 2022
Tier 1 Capital
(To average assets)
9.34%
9.36%
Tier 1 Capital
36
(To risk-weighted assets)
12.27%
12.49%
Common Equity Tier 1 Capital
(To risk-weighted assets)
12.27%
12.49%
Total Capital
(To risk-weighted assets)
13.38%
13.58%
Effective January 1, 2015, the Company and the Bank became subject to new regulatory capital rules, which, among other things, impose a new common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets), set the minimum leverage ratio for all banking organizations at a uniform 4% of total assets, increase the minimum Tier 1 capital to risk-based assets requirement (from 4% to 6% of risk-weighted assets) and assign a higher risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and to certain commercial real estate facilities that finance the acquisition, development or construction of real property. The new rules also require unrealized gains and losses on certain “available-for-sale” securities holdings to be included for purposes of calculating regulatory capital requirements unless a one-time opt out is exercised which the Company and the Bank have done. The final rule limits a banking organization’s dividends, stock repurchases and other capital distributions, and certain discretionary bonus payments to executive officers, if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets above regulatory minimum risk-based requirements. The capital conservation buffer requirement was phased in beginning January 1, 2016 and ending January 1, 2019, when the full capital conservation buffer requirement became effective. The Company and the Bank are in compliance with their respective new capital requirements, including the capital conservation buffer, as of March 31, 2022.
In December 2018, the Federal Reserve announced that a banking organization that experiences a reduction in retained earnings due to the CECL adoption as of the beginning of the fiscal year in which CECL is adopted may elect to phase in the regulatory capital impact of adopting CECL. Transitional amounts are calculated for the following items: retained earnings, temporary difference deferred tax assets and credit loss allowances eligible for inclusion in regulatory capital. When calculating regulatory capital ratios, 25% of the transitional amounts are phased in during the first year. An additional 25% of the transitional amounts are phased in over each of the next two years and at the beginning of the fourth year, the day-one effects of CECL are completely reflected in regulatory capital.
The Company adopted the transition guidance applied these effects to regulatory capital in the first quarter of 2023 upon adoption of CECL. See Note 1, "Basis of Presentation" for additional information on the adoption of CECL.
Liquidity
As of March 31, 2023, the Company had cash and cash equivalents of $29.0 million in the form of cash, due from banks and short-term deposits with other institutions. In addition, the Company had total securities available for sale of $418.2 million which could be used for liquidity needs. Total liquidity of $447.3 million as of March 31, 2023, represents 21.3% of total assets compared to $450.8 million and 22.0% of total assets as of December 31, 2022. The Company also monitors other liquidity measures, all of which were within the Company’s policy guidelines as of March 31, 2023 and December 31, 2022. Based upon these measures, the Company believes its liquidity is adequate.
Capital Resources
The Company has a line of credit commitment from Atlantic Community Bankers Bank for $7,000,000 which expires June 30, 2023. There were no borrowings under this line as of March 31, 2023 and December 31, 2022.
The Company has a line of credit commitment available which has no stated expiration date from PNC Bank for $16,000,000. There were no borrowings under this line as of March 31, 2023 and December 31, 2022.
The Company has a line of credit commitment available which has no stated expiration date from Zions Bank for $17,000,000. There were no borrowings under this line as of March 31, 2023 and December 31, 2022.
The Bank’s maximum borrowing capacity with the Federal Home Loan Bank was approximately $660,403,000 as of March 31, 2023, of which $93,366,000 was outstanding in the form of borrowings as of March 31, 2023. As of December 31, 2022, the maximum borrowing capacity was $655,344,000, of which $82,264,000 of borrowings was outstanding as of December 31, 2022. Additionally, as of March 31, 2023, the Bank had secured Letters of Credit from the Federal Home Loan Bank in the amount of $97,450,000 as collateral for specific municipal deposits. These Letters of Credit reduce the availability under the maximum borrowing capacity. As of December 31, 2022, there was $92,900,000 outstanding in the form of Letters of Credit. Advances and Letters of Credit from the Federal Home Loan Bank are secured by qualifying assets of the Bank.
37
Non-GAAP Financial Measures
This report contains or references fully taxable-equivalent (fte) interest income and net interest income, which are non-GAAP financial measures. Interest income (fte) and net interest income (fte) are derived from GAAP interest income and net interest income using an assumed tax rate of 21%. We believe the presentation of interest income (fte) and net interest income (fte) ensures comparability of interest income and net interest income arising from both taxable and tax-exempt sources and is consistent with industry practice. Interest income (fte) and Net interest income (fte) is reconciled to GAAP interest income and net interest income on page 39. Fully taxable equivalent interest income and net interest income is also reflected in the table on page 40. Although the Company believes that these non-GAAP financial measures enhance investors’ understanding of our business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP measures.
38
Results of Operations
NORWOOD FINANCIAL CORP
Consolidated Average Balance Sheets with Resultant Interest and Rates
(Tax-Equivalent Basis,
Three Months Ended March 31,
dollars in thousands)
2023
2022
Average
Average
Average
Average
Balance
Interest
Rate
Balance
Interest
Rate
(2)
(1)
(3)
(2)
(1)
(3)
Assets
Interest-earning assets:
Interest-bearing deposits with banks
$
4,213
$
48
4.56%
$
168,006
$
78
0.19%
Securities available for sale:
Taxable
421,132
2,115
2.01
363,738
1,466
1.61
Tax-exempt (1)
71,719
494
2.76
75,083
542
2.89
Total securities available for sale (1)
492,851
2,609
2.12
438,821
2,008
1.83
Loans receivable (1) (4) (5)
1,507,095
19,236
5.11
1,355,221
15,443
4.56
Total interest-earning assets
2,004,159
21,893
4.37
1,962,048
17,529
3.57
Non-interest earning assets:
Cash and due from banks
25,980
23,275
Allowance for credit losses
(19,009)
(16,573)
Other assets
64,601
103,862
Total non-interest earning assets
71,572
110,564
Total Assets
$
2,075,731
$
2,072,612
Liabilities and Stockholders' Equity
Interest-bearing liabilities:
Interest-bearing demand and money market
$
500,405
$
959
0.77
$
520,850
$
202
0.16
Savings
275,387
105
0.15
308,370
63
0.08
Time
545,804
3,298
2.42
500,375
794
0.63
Total interest-bearing deposits
1,321,596
4,362
1.32
1,329,595
1,059
0.32
Short-term borrowings
101,793
779
3.06
62,512
48
0.31
Other borrowings
37,542
477
5.08
28,407
139
1.96
Total interest-bearing liabilities
1,460,931
5,618
1.54
1,420,514
1,246
0.35
Non-interest bearing liabilities:
Demand deposits
423,221
433,823
Other liabilities
19,245
15,015
Total non-interest bearing liabilities
442,466
448,838
Stockholders' equity
172,334
203,260
Total Liabilities and Stockholders' Equity
$
2,075,731
$
2,072,612
Net interest income/spread (tax equivalent basis)
16,275
2.83%
16,283
3.22%
Tax-equivalent basis adjustment
(182)
(182)
Net interest income
$
16,093
$
16,101
Net interest margin (tax equivalent basis)
3.25%
3.32%
(1) Interest and yields are presented on a tax-equivalent basis using a marginal tax rate of 21%.
(2) Average balances have been calculated based on daily balances.
(3) Annualized
(4) Loan balances include non-accrual loans and are net of unearned income.
(5) Loan yields include the effect of amortization of deferred fees, net of costs.
39
Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense.
Increase/(Decrease)
Three months ended March 31, 2023 Compared to
Three months ended March 31, 2022
Variance due to
Volume
Rate
Net
(dollars in thousands)
Interest-earning assets:
Interest-bearing deposits with banks
$
(119)
$
89
$
(30)
Securities available for sale:
Taxable
264
385
649
Tax-exempt securities
(24)
(24)
(48)
Total securities
240
361
601
Loans receivable
1,834
1,959
3,793
Total interest-earning assets
1,955
2,409
4,364
Interest-bearing liabilities:
Interest-bearing demand and money market
(37)
794
757
Savings
(12)
54
42
Time
253
2,251
2,504
Total interest-bearing deposits
204
3,099
3,303
Short-term borrowings
222
509
731
Other borrowings
96
242
338
Total interest-bearing liabilities
522
3,850
4,372
Net interest income (tax-equivalent basis)
$
1,433
$
(1,441)
$
(8)
Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated proportionately to changes in volume and changes in rate.
40
Comparison of Operating Results for the Three Months Ended March 31, 2023 to March 31, 2022
General
For the three months ended March 31, 2023, net income totaled $5,782,000 compared to $7,128,000 earned in the three months ended March 31, 2022. The decrease in net income for the three months ended March 31, 2023 was due primarily to a $1,426,000 decrease in total other income. Earnings per share for the three-months ended March 31, 2023 were $0.71 per share for basic shares and fully diluted shares, compared to $0.87 per share for basic shares and for fully diluted shares for the three months ended March 31, 2022. The resulting annualized return on average assets and annualized return on average equity for the three months ended March 31, 2023 were 1.13% and 13.61%, respectively, compared to 1.39% and 14.22%, respectively, for the same period in 2022.
The following table sets forth changes in net income:
(dollars in thousands)
Three months ended
March 31, 2023 to March 31, 2022
Net income three months ended March 31, 2022
$
7,128
Change due to:
Net interest income
(8)
Net gains on sales of securities and loans
2
Net gains on sales of foreclosed real estate owned
(427)
Service charges and fees
(157)
Earnings and proceeds on bank-owned life insurance
37
Other income
(881)
Salaries and employee benefits
(538)
Occupancy, furniture and equipment
45
All other expenses
214
Income tax expense
367
Net income three months ended March 31, 2023
$
5,782
Net Interest Income
Net interest income on a fully taxable equivalent basis (fte) for the three months ended March 31, 2023 totaled $16,275,000 which was $8,000 lower than the comparable period in 2022. The decrease in net interest income was due primarily to a $4,372,000 increase in total interest expense, which slightly offset the $4,364,000 increase in in total interest income (fte). The fte net interest spread and net interest margin were 2.83% and 3.25%, respectively, for the three months ended March 31, 2023 compared to 3.22% and 3.32%, respectively, for the same period in 2022. See “Non-GAAP Financial Measures” described above on page 38.
For the three-months ended March 31, 2023, interest income (fte) totaled $21,893,000 with a yield on average earning assets of 4.37% compared to $17,529,000 and 3.57% for the 2022 period. Average loans increased $151.9 million during the three-months ended March 31, 2023, over the comparable period of 2022, while average securities increased $54.0 million. Average earning assets totaled $2.004 billion for the three months ended March 31, 2023, an increase of $42.1 million, over the average for the same period in 2022. See “Non-GAAP Financial Measures” described above on page 38.
Interest expense for the three months ended March 31, 2023 totaled $5,618,000 at an average cost of 1.54% compared to $1,246,000 and 0.35%, respectively, for the same period in 2022. The increase in interest expense during the three-months ended March 31, 2023 reflects the overall higher level of market interest rates. During the three months ended March 31, 2023, the average cost of time deposits, which is the most significant component of funding costs, increased 1.79% compared to the same three-month period of last year, while short-term borrowing costs increased 2.75% and other borrowing costs increased 3.12% compared to the same three-month period of last year.
Provision for Credit Losses
The Company’s provision for credit losses for the three months ended March 31, 2023 was $300,000, compared to $300,000 for the three months ended March 31, 2022. The Company makes provisions for credit losses in an amount necessary to maintain the allowance for credit losses at an acceptable level. The Company recorded a net charge-off of $320,000 for the quarter ended March 31, 2023, compared to a net charge-off of $82,000 for the similar period in 2022. At March 31, 2023, the allowance for credit
41
losses related to loans receivable represented 1.27% of loans receivable. Additionally, at March 31, 2023, the allowance for credit losses related to loans receivable represented 0.07% of non-performing loans.
Other Income
Other income totaled $1,912,000 for the three months ended March 31, 2023, compared to $3,338,000 for the same period in 2022. The decrease was due primarily to $873,000 of income recognized in 2022 on payoffs of purchased impaired loans that were carried at a discount. Gains on sales of foreclosed real estate owned decreased $427,000, while all other categories of other income decreased $126,000, net.
Other Expense
Other expense for the three months ended March 31, 2023 totaled $10,436,000 which was $279,000, or 2.7%, higher than the same period of 2022, due primarily to a $538,000 increase in salaries and employee benefits. All other categories of other expense decreased $259,000, net.
Income Tax Expense
Income tax expense totaled $1,487,000 for an effective tax rate of 20.5% for the three months ended March 31, 2023 compared to $1,854,000 for an effective tax rate of 20.7% for the three months ended March 31, 2022. The decrease in the effective tax rate in the 2023 period reflects the decreased level of taxable income.
42
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