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Item 7. Management’s Discussion and Analysis

2021-03-30 compared with 2020-03-12 · 266 added, 145 removed, 257 unchanged (62% of the section changed)

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This discussion and analysis reviews our consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations.

The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in Item 8 of this Form 10-K.

The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in "Part II.

Financial Statements and Supplementary Data" of this Form 10-K.

The information contained in this section should be read in conjunction with these Consolidated Financial Statements and footnotes and the business and financial information provided in this Form 10-K.

Our principal business consists of attracting retail and commercial deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one- to four- family residences (including home equity loans and lines of credit), commercial and multifamily real estate, construction and land, consumer and commercial business loans.

Our principal business consists of attracting retail and commercial deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one-to-four family residences (including home equity loans and lines of credit), commercial and multifamily real estate, construction and land, and consumer and commercial business loans.

Our commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable.

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We sell loans which conform to the underwriting standards of Fannie Mae (“conforming”) in which we retain the servicing of the loan in order to maintain the direct customer relationship and to generate noninterest income.

Residential loans

which do not conform to the underwriting standards of Fannie Mae (“non-conforming”), are either held in our loan portfolio or sold with servicing released.

Residential loans which do not conform to the underwriting standards of Fannie Mae (“non-conforming”), are either held in our loan portfolio or sold with servicing released.

We originate and retain a significant amount of commercial real estate loans, including those secured by owner-occupied and nonowner-occupied commercial real estate, multifamily property, mobile home parks and construction and land development loans.

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Our operating revenues are derived principally from earnings on interest-earning assets, service charges and fees, and gains on the sale of loans.

Our primary sources of funds are deposits (both retail and brokered), FHLB advances, and payments received on loans and securities.

Our primary sources of funds are deposits (both retail and brokered), FHLB advances, borrowings through the Federal Reserve, and payments received on loans and securities.

We offer a variety of deposit accounts that provide a wide range of interest rates and terms, including savings, money market, NOW, interest-bearing and noninterest-bearing demand accounts, and certificates of deposit.

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Our commercial loan portfolio (commercial and multifamily real estate and commercial business loans) increased to $330.0 million or 53.6% of our loan portfolio at December 31, 2020, from $300.2 million or 48.3% of our loan portfolio at December 31, 2019, and $291.4 million or 46.9% of our loan portfolio at December 31, 2018.

In addition to higher balances in commercial lending, we also benefit from additional lending opportunities in our consumer loan portfolio.

Our consumer loan portfolio, which includes manufactured and floating homes and other consumer loans, increased to $72.7 million or 11.7% of our loan portfolio at December 31, 2019 , from $67.6 million or 10.9% of our loan portfolio at December 31, 2018 , and $51.1 million or 9.3% of our loan portfolio as of December 31, 2017 .

In addition to higher balances in commercial lending, we also benefit from lending opportunities in our consumer loan portfolio.

Our consumer loan portfolio, which includes manufactured and floating homes and other consumer loans, increased to $75.8 million or 12.4% of our loan portfolio at December 31, 2020, from $72.7 million or 11.7% of our loan portfolio at December 31, 2019, and $67.6 million or 10.9% of our loan portfolio at December 31, 2018.

Additional commercial and multifamily real estate and consumer loans have improved our net interest income and helped diversify our loan portfolio mix.

Our recapture from the allowance for loan losses was $125,000 for the year ended December 31, 2019 , compared to a provision for loan losses expense of $525,000 and $500,000 for the years ended December 31, 2018 and 2017, respectively.

The recapture in the current year was due to changes in the composition and size of our loan portfolio during the year.

Our provision for loan losses was $925,000 for the year ended December 31, 2020, compared to a recapture of loan loss expense of $125,000 for the year ended December 31, 2019 and a provision for loan losses of $525,000 for the year ended December 31, 2018.

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Recent Accounting Standards

For a discussion of recent accounting standards, please see Note 2 - Accounting Pronouncements Recently Issued or Adopted in the Notes to Consolidated Financial Statements contained in Item 8 of this report on Form 10-K.

For a discussion of recent accounting standards, see "Note 2—Accounting Pronouncements Recently Issued or Adopted" in the Notes to Consolidated Financial Statements contained in "Part II.

Financial Statements and Supplementary Data" of this report on Form 10-K.

Critical Accounting Policies

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Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers.

Management believes that its critical accounting policies include determining the allowance for loan losses, accounting for other-than-temporary impairment of securities, accounting for mortgage servicing rights, accounting for other real estate owned, and accounting for deferred income taxes.

For additional information on our accounting policies see "Note 1 - Organization and Significant Accounting Policies" in the Notes to Consolidated Financial Statements contained in Item 8 of this report on Form 10-K.

Management believes that its critical accounting policies include determining the allowance for loan losses, accounting for other-than-temporary impairment of securities, accounting for MSRs, accounting for other real estate owned, and accounting for deferred income taxes.

For additional information on our accounting policies see "Note 1—Organization and Significant Accounting Policies" in the Notes to Consolidated Financial Statements contained in "Part II.

Financial Statements and Supplementary Data" of this report on Form 10-K.

Allowance for Loan Loss.

The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio as of the balance sheet date.

The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio at the balance sheet date.

The allowance is established through the provision for loan losses, which is charged to income.

the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans.

Among the material estimates required to establish the allowance are:

loss exposure at default;

the amount and timing of future cash flows on impaired loans;

value of collateral;

and determination of historical and current loss factors to be applied to the various elements of the portfolio.

All of these estimates are susceptible to significant change.

Management reviews the level of the allowance at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions and other factors related to the collectability of the loan portfolio.

Determining the amount of the allowance for loan losses necessarily involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans.

The allowance consists of specific, general and unallocated components.

The general component of the allowance for loan losses covers non-impaired loans and is determined using a formula-based approach.

The formula first incorporates either the historical loss rates of the Company or the historical loss rates of their peer group if minimal loss history exists.

This historical loss rate factor is then adjusted for qualitative factors.

Qualitative factors are used to estimate losses related to factors that are not captured in the historical loss rates and are based on management’s evaluation of available internal and external data and involve significant management judgement.

Qualitative factors include changes in lending standards, changes in economic conditions, changes in the nature and volume of loans, changes in lending management, changes in delinquencies, changes in the loan review system, changes in the value of collateral, the existence of concentrations, and the impact of other external factors.

Finally, the general component of the allowance for loan losses is adjusted for changes in the assigned grades of loans, which include the following:

pass, watch, special mention, substandard, doubtful, and loss.

As loans are downgraded from watch to the lower categories, they are assigned an additional factor to account for the increased credit risk.

Loan grades involve significant management judgment.

For such loans that are also classified as impaired, a specific component within the allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan are lower than the carrying value of that loan.

An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses.

The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Management reviews the level of the allowance at least quarterly.

To strengthen our loan review and classification process, we engage an independent consultant to review our classified loans and a significant sample of recently originated non-classified loans annually.

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In addition, the determination of the amount of our allowance for loan losses is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination.

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Other-Than-Temporary Impairment of Securities .

Management reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment ("OTTI"), taking into consideration current market conditions;

Management reviews investment securities on an ongoing basis for the presence of OTTI, taking into consideration current market conditions;

fair value in relationship to cost;

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and other factors.

For debt securities, if management intends to sell the security or it is likely that we will be required to sell the security before recovering our cost basis, the entire impairment loss would be recognized in earnings as an OTTI.

If management does not intend to sell the security and it is not more likely than not that we will be required to sell the security, but management does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings.

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Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI.

The remaining impairment related to all other factors, i.e.

, the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive income (loss).

The remaining impairment related to all other factors, i.e., the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive income (loss).

Impairment losses related to all other factors are presented as separate components within accumulated other comprehensive income (loss).

Mortgage Servicing Rights .

We record mortgage servicing rights on loans sold to Fannie Mae with servicing retained as well as for acquired servicing rights.

We stratify our capitalized mortgage servicing rights based on the type, term and interest rates of the underlying loans.

Mortgage servicing rights are carried at fair value.

We record MSRs on loans sold to Fannie Mae with servicing retained as well as for acquired servicing rights.

We stratify our capitalized MSRs based on the type, term and interest rates of the underlying loans.

MSRs are carried at fair value.

The value is determined through a discounted cash flow analysis, which uses interest rates, prepayment speeds and delinquency rate assumptions as inputs.

All of these assumptions require a significant degree of management judgment.

If our assumptions prove to be incorrect, the value of our mortgage servicing rights could be negatively impacted.

If our assumptions prove to be incorrect, the value of our MSRs could be negatively impacted.

We use a third party to assist us in the preparation of the analysis of the market value each quarter.

Other Real Estate Owned .

Other real estate owned ("OREO") represents real estate that we have taken control of in partial or full satisfaction of significantly delinquent loans.

OREO represents real estate that we have taken control of in partial or full satisfaction of significantly delinquent loans.

At the time of foreclosure, OREO is recorded at the fair value less costs to sell, which becomes the property's new basis.

Any write-downs based on the asset's fair value at the date of acquisition are charged to the allowance for loan and lease losses.

Any write-downs based on the asset's fair value at the date of acquisition are charged to the allowance for loan losses.

After foreclosure, management periodically performs valuations such that the real estate is carried at the lower of its new cost basis or fair value, net of estimated costs to sell.

Subsequent valuation adjustments are recognized within net (loss) gain on OREO.

Revenue and expenses from operations and subsequent adjustments to the carrying amount of the property are included in other non-interest expense in the consolidated statements of income.

Revenue and expenses from operations and subsequent adjustments to the carrying amount of the property are included in other noninterest expense in the consolidated statements of income.

In some instances, we may make loans to facilitate the sales of OREO.

Management reviews all sales for which it is the lending institution for compliance with sales treatment under provisions established by ASC Topic 360, "Accounting for Sales of Real Estate".

Management reviews all sales for which it is the lending institution for compliance with sales treatment under provisions established by Accounting Standards Codification ("ASC") Topic 360, "Accounting for Sales of Real Estate" .

Any gains related to sales of OREO are deferred until the buyer has a sufficient initial and continuing investment in the property.

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The deferred income provision represents the difference between net deferred tax asset/liability at the beginning and end of the reported period.

In formulating our deferred tax asset, we are required to estimate our income and taxes in the jurisdiction in

which we operate.

In formulating our deferred tax asset, we are required to estimate our income and taxes in the jurisdiction in which we operate.

This process involves estimating our actual current tax exposure for the reported period together with assessing temporary differences resulting from differing treatment of items, such as depreciation and the provision for loan losses, for tax and financial reporting purposes.

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Business and Operating Strategies and Goals

Our goal is to deliver returns to stockholders by increasing higher-yielding assets (including consumer, commercial and multifamily real estate and commercial business loans), increasing lower costing core deposit balances, managing expenses, managing problem assets and exploring expansion opportunities.

Our goal is to deliver returns to stockholders by increasing higher-yielding assets (including consumer, commercial and multifamily real estate and commercial business loans), increasing lower-cost core deposit balances, managing expenses, managing problem assets and exploring expansion opportunities.

We seek to achieve these results by focusing on the following objectives:

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Nonperforming assets were $3.5 million, or 0.40% of total assets, at December 31, 2020 compared to $5.2 million or 0.73% of total assets, at December 31, 2019.

We continue to seek to reduce the level of non-performing assets through collections, modifications and sales of OREO.

We continue to seek to reduce the level of nonperforming assets through collections, modifications and sales of OREO.

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We also take proactive steps to resolve our non-performing loans, including negotiating payment plans, forbearances, loan modifications and loan extensions on delinquent loans when such actions have been deemed appropriate.

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We intend to prudently maintain the percentage of our assets consisting of higher-yielding commercial and multifamily real estate and commercial business loans, which offer higher risk-adjusted returns, shorter maturities and more sensitivity to interest-rate fluctuations than one-to-four family mortgage loans, while maintaining our focus on residential lending.

In addition, we continue to focus on consumer products, such as floating and manufactured homes loans.

In addition, we continue to focus on consumer products, such as floating and manufactured home loans.

With our long experience and expertise in residential lending we believe we can be effective in capturing mortgage banking opportunities and grow consumer deposits.

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In addition to our retail branches, we maintain state of the art technology-based products, such as business cash management, business remote deposit products, business and consumer mobile banking applications and consumer remote deposit products.

Total deposits increased to $616.7 million , which includes $8.0 million of brokered deposits at December 31, 2019 , from $553.6 million at December 31, 2018 , and $514.4 million at December 31, 2017.

At December 31, 2019 , core deposits, which we define as our non-time deposit accounts and time deposit accounts of less than $250,000, increased $22.1 million to $491.3 million, while FHLB advances decreased $76.5 million to $7.5 million from December 31, 2018 .

Total deposits increased to $748.0 million at December 31, 2020, from $616.7 million at December 31, 2019, and $553.6 million at December 31, 2018.

At December 31, 2020, core deposits, which we define as our non-time deposit accounts and time deposit accounts of less than $250,000, increased $129.7 million to $668.1 million, while FHLB advances decreased $7.5 million to zero from the balance at December 31, 2019.

Maintaining Our Client Service Focus.

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We compete with other financial service providers by relying on the strength of our customer service and relationship banking approach.

We believe that one of our strengths is that our employees are also significant stockholders through our employee stock ownership ("ESOP") and 401(k) plans.

We believe that one of our strengths is that our employees are also significant stockholders through our ESOP and 401(k) plans.

We also offer incentives that are designed to reward employees for achieving high-quality client relationship growth.

Expanding our presence, including through digital channels and streamlining operations, within our existing and contiguous market areas and by capturing business opportunities resulting from changes in the competitive

Expanding Our Presence, Including Through Digital Channels and Streamlining Operations, Within Our Existing and Contiguous Market Areas and by Capturing Business Opportunities Resulting from Changes in the Competitive Environment.

We believe that opportunities currently exist within our market area to grow our franchise.

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We continue to be disciplined as it pertains to future expansion, acquisitions and de novo branching focusing on the markets in Western Washington, which we know and understand.

COVID 19 Response

In response to the COVID-19 pandemic, the Company is offering a variety of relief options designed to support our clients and communities we serve.

Paycheck Protection Program Participation.

The CARES Act was signed into law on March 27, 2020, and authorized the SBA to temporarily guarantee loans under a loan program called the PPP.

As a qualified SBA lender, the Company was automatically authorized to originate PPP loans upon commencement of the program in April 2020.

The SBA guarantees 100% of the PPP loans made to eligible borrowers.

PPP loans have:

(a) an interest rate of 1.0%, (b) a two-year loan term to maturity;

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and (c) principal and interest payments deferred for six months from the date of disbursement.

The entire principal amount of the borrower’s PPP loan, including any accrued interest, is eligible to be forgiven and repaid by the SBA.

Through the conclusion of the PPP on August 8, 2020, we funded $74.8 million in PPP loans, with an average loan amount of $82,000.

Many of the PPP applications have been from our existing clients but we are also serving those in our communities who have not had a banking relationship with us in the past.

In addition to the 1% interest earned on these loans, the SBA pays us fees for processing PPP loans in the following amounts:

(i) 5% for loans of not more than $350,000;

(ii) 3% for loans of more than $350,000 and less than $2,000,000;

and (iii) 1% for loans of at least $2,000,000.

We may not collect any fees from the loan applicants.

The following table summarizes our PPP participation at December 31, 2020 (dollars in thousands):

Funded At December 31, 2020

Total Outstanding Number of Loans Average Loan Amount Outstanding Number of Loans

Existing clients $ 31,555 363 $ 87 $ 11,322 $ 170

New clients 43,221 546 79 31,947 412

Total PPP loans $ 74,776 909 $ 82 $ 43,269 582

The SBA processing fees for the approved PPP loans totaled $2.9 million for the year ended December 31, 2020.

These fees are deferred and recognized in interest income over the life of the PPP loans.

For the year ended December 31, 2020, interest income included $467,000 in fees earned related to PPP loans.

Recent legislation reopened the PPP through March 31, 2021, by authorizing $284.5 billion in funding for eligible small businesses and non-profits.

In January 2021, the Bank began accepting and processing loan applications under this second PPP program and will continue working with clients to assist them with accessing other borrowing options, including SBA and other government-sponsored lending programs, as appropriate.

Loan Modifications.

We are providing payment relief for both consumer and business clients due to the COVID-19 pandemic.

At December 31, 2020, we are continuing to provide payment relief for both consumer and business clients, most of which relief involves interest only or payment deferrals that range from 90 to 180 days.

Deferred loans are re-evaluated at the end of the deferral period and will either return to the original loan terms or be reassessed at that time to determine if a further modification should be granted and if a downgrade in risk rating is appropriate.

At December 31, 2020, we have provided payment relief related to COVID-19 on 49 commercial loans totaling $37.2 million and 84 residential loans totaling $19.0 million, of which 40 commercial loans totaling $29.1 million and 55 residential loans totaling $14.6 have resumed their normal loan payments, matured, or have paid-off.

The $4.4 million of residential loans that are still under payment relief at December 31, 2020, include eight residential loans totaling $907,000 that have entered into a second payment forbearance agreement with a weighted average loan-to-value of 66%, 10 residential loans totaling $2.0 million that have entered into a third payment forbearance agreement with a weighted average loan-to value of 57%, and three residential loans totaling $525,000 that have entered into a fourth forbearance agreement with a weighted average loan-to-value of 65%.

The $8.1 million in commercial loans that are still under payment relief at December 31, 2020, include three commercial loans totaling $1.7 million that have entered into a second interest-only payment agreement with a weighted average loan-to-value of 65%, and one commercial loan totaling $2.4 million that has entered into a third interest-only payment agreement with a loan-to-value of 47%.

The COVID-19 loan modifications discussed above were not classified as TDRs in accordance with the guidance of the CARES Act and related regulatory banking guidance.

The CARES Act provides that the short-term modification of loans as a result of the COVID-19 pandemic, made on a good faith basis to borrowers who were current as defined under the CARES Act prior to any relief, are not TDRs.

This includes short-term (up to twelve months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant.

Borrowers are considered current under the CARES Act (as extended by the CAA, 2021) and related regulatory banking guidance if they are less than 30 days past due on their contractual payments at the time a modification program is implemented and the relief is executed prior to December 31, 2020 or the earlier of 60 days after the national emergency termination date or January 1 2022, whichever is earlier.

As of December 31, 2020, we had no new pending requests for payment relief.

We believe the steps we are taking are necessary to effectively manage our portfolio and assist our clients through the ongoing uncertainty surrounding the duration, impact and government response to the COVID-19 pandemic.

S upport for Clients, Employees and Community during Pandemic.

Our retail locations continue to operate with full service, in compliance with various mandates and recommendations including masks, distancing and capacity management.

The majority of back office and administrative employees have worked remotely throughout the pandemic.

We monitor and

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conform our practices based on updates from the Center for Disease Control, World Health Organization, Financial Regulatory Agencies, and local and state health departments.

We continue to work closely with our borrowers to evaluate pandemic related challenges.

We also continue to support our not-for-profit organizations, although most activity is virtual.

Comparison of Financial Condition at December 31, 2020 and December 31, 2019

Total assets increased by $141.5 million, or 19.7%, to $861.4 million at December 31, 2020, from $719.9 million at December 31, 2019.

The increase was primarily a result of the capitalization of right of use assets of $7.6 million, combined with a higher balance in available for sale securities, which increased $4.3 million, partially offset by decreases in cash and cash equivalents of $6.0 million and in FHLB stock.

FHLB stock decreased $2.9 million to $1.2 million at December 31, 2019, from $4.1 million at December 31, 2018, as a result of reduced borrowing needs due to deposit growth.

The adoption of accounting guidance for leases (“ASU 2016-02”) in 2019 required the Company to recognize right of use lease assets and corresponding lease liabilities on the balance sheet.

The increase was primarily a result of a higher balances in cash and cash equivalents and loans held-for-sale.

Cash and Securities.

Cash, cash equivalents and our available-for-sale securities decreased $1.7 million , or 2.5% , to $65.1 million at December 31, 2019 .

Cash and cash equivalents decreased $6.0 million , or 9.8% , to $55.8 million at December 31, 2019 .

The decrease in total cash and cash equivalents, combined with our deposit growth was primarily utilized to fund loan originations, purchases of investment securities and reduce FHLB borrowings during the year.

Available-for-sale securities, which consist primarily of agency mortgage-backed securities, increased $4.3 million , or 86.0%, to $9.3 million at December 31, 2019 from $5.0 million at December 31, 2018 , primarily as a result of investment securities purchased during the year.

At December 31, 2019 , our securities portfolio consisted of 13 agency mortgage-backed securities and eight municipal securities with a fair value of $9.3 million .

At December 31, 2018 , our securities portfolio consisted of six agency mortgage-backed securities and eight municipal bonds with a fair value of $5.0 million .

During the year ended December 31, 2019 we did not recognize any non-cash OTTI charges on our investment securities.

At December 31, 2019 , five agency mortgage-backed securities had unrealized losses but management determined the decline in value was not related to specific credit deterioration.

Cash, cash equivalents and our available-for-sale securities increased by $139.0 million, or 213.6%, to $204.0 million at December 31, 2020.

Cash and cash equivalents increased $138.1 million, or 247.6%, to $193.8 million at December 31, 2020.

The increase in total cash and cash equivalents was due to deposit growth and the proceeds from the issuance of $12 million in subordinated notes during the third quarter of 2020.

Available-for-sale securities, which consist of agency mortgage-backed securities and municipal bonds, increased $912,000, or 9.8%, to $10.2 million at December 31, 2020, from $9.3 million at December 31, 2019, primarily due to the purchase of investment securities during the year.

At December 31, 2020, our securities portfolio consisted of 16 agency mortgage-backed securities and 10 municipal bonds with a fair value of $10.2 million.

At December 31, 2019, our securities portfolio consisted of 13 agency mortgage-backed securities and eight municipal bonds with a fair value of $9.3 million.

During the year ended December 31, 2020 we did not recognize any non-cash OTTI losses on our investment securities.

At December 31, 2020, six agency mortgage-backed securities had unrealized losses of $6,000, but management determined the decline in value was not related to specific credit deterioration.

The unrealized losses were caused by changes in interest rates and the widening of market spreads subsequent to purchase of these securities.

We do not intend to sell these securities and it is more likely than not that we will not be required to sell these securities before anticipated recovery of the remaining amortized cost basis.

Loans held for portfolio, net, excluding loans held-for-sale, increased $478,000 , or 0.1% , to $614.2 million at December 31, 2019 from $613.8 million at December 31, 2018 .

Loans held-for-sale decreased to $1.1 million at December 31, 2019 from $1.2 million at December 31, 2018 .

Loans held-for-portfolio, net, decreased $6.9 million, or 1.1%, to $607.4 million at December 31, 2020 from $614.2 million at December 31, 2019.

Loans held-for-sale increased to $11.6 million at December 31, 2020 from $1.1 million at December 31, 2019.

The following table reflects the changes in the loan mix, excluding deferred fees, of our portfolio at December 31, 2020, as compared to December 31, 2019 (dollars in thousands):

December 31, Amount Percent

2020 2019 Change Change

One-to-four family $ 130,657 $ 149,393 $ (18,736) (12.5) %

Home equity 16,265 23,845 (7,580) (31.8)

Commercial and multifamily 265,774 261,268 4,506 1.7

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Commercial business 64,217 38,931 25,286 65.0

All categories of our loan portfolio increased at December 31, 2019 , compared to December 31, 2018 , except for one-to-four family and home equity loan portfolios.

The largest dollar increases in the loan portfolio were in construction and land loans which increased $10.5 million , or 16.1% , to $75.8 million , commercial and multifamily loans which increased $8.6 million , or 3.4% , to $261.3 million , floating homes loans which increased $3.0 million , or 7.3% , to $43.8 million , and other consumer loans which increased $1.7 million , or 25.3% , to $8.3 million .

These increases were offset by decreases in the one-to-four family loans portfolio, which decreased $20.4 million , or 12.0% , to $149.4 million primarily as a result of the sale of $16.2 million of residential loans during the first quarter of 2019, and the home equity loan portfolio, which decreased $3.8 million , or 13.8% , to $23.8 million .

The increase in our commercial and multifamily real estate loan portfolio was primarily a result of opportunities in the markets where we do business and an emphasis by our commercial lenders to originate these types of loans.

Commercial and multifamily real estate loans are generally higher yielding loans and have contributed to diversifying our loan portfolio.

We have also experienced appreciation in residential market prices and have low inventory of homes for sale due to continued strong demand.

Floating and manufactured home loans increased as a result of increased demand for these types of loans by well-qualified borrowers coupled with less competition for these types of loans.

The loan portfolio remains well-diversified with commercial and multifamily real estate loans accounting for 42.0% of the portfolio, one-to-four family real estate loans, including home equity loans accounting for approximately 27.9% of the portfolio and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans accounting for 11.7% of the total loans portfolio at December 31, 2019 .

Total loans $ 615,498 $ 621,907 $ (6,409) (1.0) %

The largest dollar increases in the loan portfolio were in commercial business loans, which increased $25.3 million or 65.0% to $64.2 million, driven by the origination of PPP loans, other consumer loans, which increased $6.7 million or 81.0%, to $15.0 million, and commercial and multifamily real estate loans, which increased $4.5 million or 1.7%, to $265.8 million.

These increases were offset by decreases in the one-to-four family loans portfolio, which decreased $18.7 million, or 12.5%, to $130.7 million, primarily as a result of increased sales of conforming one-to-four family loans to Fannie Mae rather than retaining the loans for portfolio, construction and land loans, which decreased $13.0 million or 17.2%, to $62.8 million, home equity loans, which decreased $7.6 million, or 31.8%, to $16.3 million, and floating home loans which decreased $3.9 million, or 9.0%, to $39.9 million.

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The loan portfolio remains well-diversified with commercial and multifamily real estate loans accounting for 43.2% of the portfolio, one-to-four family real estate loans, including home equity loans, accounting for approximately 23.8% of the portfolio and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans accounting for 12.4% of the total loan portfolio at December 31, 2020.

Construction and land loans accounted for 10.2% of the portfolio and commercial business loans accounted for the remaining 10.4% of the portfolio at December 31, 2020.

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The table below sets forth the amounts and categories of nonperforming assets in our loan portfolio at the dates indicated (dollars in thousands):

December 31, Amount Percent

2020 2019 Change Change

Nonaccrual loans $ 2,884 $ 4,657 $ (1,773) (38.1) %

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Total nonperforming assets $ 3,478 $ 5,232 $ (1,754) (33.5) %

Nonaccrual loans increased $2.0 million or 74.6%, to $4.7 million at December 31, 2019 , compared to the prior year.

Nonaccrual loans decreased $1.8 million or 38.1%, to $2.9 million at December 31, 2020, compared to the prior year.

Nonaccrual loans were 0.47% of total loans at December 31, 2020, compared to 0.75% of total loans at December 31, 2019.

We had no loans greater than 90 days delinquent and still accruing at December 31, 2020 and 2019.

OREO and repossessed assets were $575,000 at both December 31, 2019 and 2018.

OREO and repossessed assets at December 31, 2019 consisted solely of a former bank branch property located in Port Angeles, Washington which was acquired in 2015 as a part of three branches purchased from another financial institution.

OREO and repossessed assets were $594,000 and $575,000 at December 31, 2020 and 2019, respectively.

OREO and repossessed assets at December 31, 2020 and 2019 primarily consisted of a former bank branch property located in Port Angeles, Washington which was acquired in 2015 as a part of three branches purchased from another financial institution.

It is currently leased to a not-for-profit organization headquartered in our market area at a below market rate.

We sold one residential OREO property during 2019 resulting in a net loss of $21,000 and one residential OREO property in 2018 resulting in a net loss of $74,000.

The addition to OREO and repossessed assets in 2020 is a manufactured home located in Everett, Washington.

Allowance for Loan Losses.

The allowance for loan losses is maintained to cover losses that are probable and can be estimated on the date of evaluation in accordance with generally accepted accounting principles in the United States.

The allowance for loan losses is maintained to cover losses that are probable and can be estimated on the date of evaluation in accordance with generally accepted accounting principles in the U.S.

It is our best estimate of probable incurred credit losses in our loan portfolio.

2 unchanged sentences

Balance at beginning of period $ 5,640 $ 5,774

Charge-offs (690) (52)

Recoveries 125 43

Net (charge-offs) recoveries (565) (9)

(Recapture) provision charged to operations

Provision (recapture) charged to operations 925 (125)

Balance at end of period $ 6,000 $ 5,640

2 unchanged sentences

Allowance as a percentage of total loans (end of period) 0.98 % 0.91 %

Our allowance for loan losses decreased $134,000 , or 2.32%, to $5.6 million at December 31, 2019 , from $5.8 million at December 31, 2018 .

We recorded a recapture from the allowance for loan losses of $125,000 for the year ended December 31, 2019 , compared to a provision for loan losses of $525,000 for the year ended December 31, 2018 .

The recapture in the current year was due to changes in the composition and size of our loan portfolio during the year.

Specific loan loss reserves decreased to $724,000 at December 31, 2019 compared to $736,000 at December 31, 2018 , while general loan loss reserves stayed consistent at $4.0 million at December 31, 2019 and 2018, respectively, and the unallocated reserve decreased to $948,000 at December 31, 2019 , compared to $1.0 million at December 31, 2018 .

The overall decrease in the allowance for loan losses was primarily due to changes in the composition of our loan portfolio during the year, largely as a result of the sale of $16.2 million of residential loans during the first quarter of 2019.

Loans individually evaluated for impairment increased to $12.4 million at December 31, 2019 , compared to $5.9 million at December 31, 2018 .

Net charge-offs were $9,000 for the year ended December 31, 2019 , compared to net recoveries of $8,000 for the year ended December 31, 2018 .

Our allowance for loan losses increased $360,000, or 6.4%, to $6.0 million at December 31, 2020, from $5.6 million at December 31, 2019.

We recorded a provision for loan losses of $925,000 for the year ended December 31, 2020, compared to a

Table of Conten t s

recapture from the allowance for loan losses of $125,000 for the year ended December 31, 2019.

Our allowance for loan losses at December 31, 2020 not only reflects probable credit losses based upon the conditions that existed at December 31, 2020, but also gives consideration to potential losses from impacts of the COVID-19 pandemic.

Specific loan loss reserves decreased to $378,000 at December 31, 2020 compared to $724,000 at December 31, 2019, while general loan loss reserves increased to $5.2 million at December 31, 2020 from $4.0 million at December 31, 2019, and the unallocated reserve decreased to $406,000 at December 31, 2020, compared to $948,000 at December 31, 2019.

Loans individually evaluated for impairment decreased by $6.5 million to $5.9 million at December 31, 2020, compared to $12.4 million at December 31, 2019.

Net charge-offs were $565,000 for the year ended December 31, 2020, compared to net charge-offs of $9,000 for the year ended December 31, 2019.

The increase in 2020 charge-offs is primarily related to one commercial borrower who was forced into bankruptcy after a tragic vehicle accident.

Our line of credit to this borrower was approved in July, 2019 for $975,000, secured by business assets including 19 vehicles, and fully advanced at the time of bankruptcy.

Because the vehicles were specialized for offering land and sea tours, their value was depressed due to the pandemic.

As a result, our liquidation of the collateral resulted in a loss of $514,000.

At December 31, 2020, the allowance for loan losses as a percentage of total loans and nonperforming loans was 0.98% and 208.04%, respectively, compared to 0.91% and 121.11%, respectively, at December 31, 2019.

Total deposits increased $131.3 million, or 21.3%, to $748.0 million at December 31, 2020 from $616.7 million at December 31, 2019.

The increase was primarily due to increases in certificates of deposit, savings and money market deposits, partially offset by a $5.1 million , or 3.1% decrease in interest bearing demand deposits.

The certificates of deposits increased $59.6 million, or 31.1%, to $251.4 million at December 31, 2019 from $164.9 million at December 31, 2018 , savings increased $3.8 million, or 7.1%, to $57.9 million at December 31, 2019 from $54.1 million at December 31, 2018 , and money market deposits increased $3.6 million, or 7.8%, to $50.3 million at December 31, 2019 from $46.7 million at December 31, 2018 .

The increase at December 31, 2019 compared to December 31, 2018 was a result of our effort to grow deposits, which allowed us to reduce our reliance on higher cost FHLB borrowings and stabilize our cost of funds during the year.

The year over year increase in deposits included $8.0 million of brokered deposits at December 31, 2019 .

There were no brokered deposits outstanding at December 31, 2018.

The increase was due to growth in all deposit categories, except for certificates of deposit.

Interest-bearing demand deposits increased $70.7 million, or 44.3%, to $230.5 million at December 31, 2020 from $159.8 million at December 31, 2019.

Noninterest-bearing demand deposits increased $34.3 million, or 36.1%, to $129.3 million at December 31, 2020 from $95.0 million at December 31, 2019.

Savings deposits increased $25.8 million or 44.6%, to $83.8 million at December 31, 2020 from $57.9 million at December 31, 2019, and money market deposits increased $15.4 million, or 30.6%, to $65.7 million at December 31, 2020, from $50.3 million at December 31, 2019.

These increases were partially offset by a decrease of $15.9 million, or 6.3%, in certificates of deposit to $235.5 million at December 31, 2020 from $251.4 million at December 31, 2019.

The increase in total deposits at December 31, 2020 compared to December 31, 2019 was the result of developing relationships with PPP borrowers who were not previously clients, adding new consumer clients, and expanding relationships with existing clients, as well as reduced withdrawals, reflecting changes in customer spending habits due to the COVID-19 pandemic.

A summary of deposit accounts with the corresponding weighted-average cost at December 31, 2020 and 2019 is presented below (dollars in thousands):

December 31, 2019

December 31, 2018

December 31, 2020 December 31, 2019

Rate Amount Wtd.

Noninterest-bearing demand $ 129,299 — % $ 94,973 — %

Interest-bearing demand 230,492 0.44 159,774 0.54

FHLB advances decreased $76.5 million , or 91.1% , to $7.5 million at December 31, 2019 , with a weighted-average cost of 3.05% , from $84.0 million at December 31, 2018 , with a weighted-average cost of 2.72% , as we utilized our increase in deposits for funding needs.

Savings 83,778 0.27 57,936 0.33

Money market 65,748 0.39 50,337 0.49

Certificates of deposit 235,473 2.43 251,387 2.23

Escrow 3,191 — 2,311 —

Total $ 747,981 1.01 % $ 616,718 1.16 %

(1) Escrow balances shown in noninterest-bearing deposits on the Consolidated Balance Sheets.

FHLB advances decreased $7.5 million to zero at December 31, 2020, as we utilized our increase in deposits for funding needs.

We rely on FHLB advances to fund interest-earning assets when deposits alone cannot fully fund interest-earning asset growth.

In September 2020, we completed a private placement of $12.0 million in aggregate principal of subordinated notes, resulting in net proceeds, after placement fees and offering expenses, of approximately $11.6 million.

Stockholders' Equity.

Total stockholders' equity increased $7.8 million, or 10.0%, to $85.5 million at December 31, 2020, from $77.7 million December 31, 2019.

This increase primarily reflects net income of $6.7 million , stock-based compensation of $267,000, and ESOP share allocations of $395,000, partially offset by cash dividends of $1.4 million.

This increase primarily reflects net income of $8.9 million, stock-based compensation of $338,000, ESOP share allocations of $324,000 and proceeds of $239,000 received in connection with stock option exercises, partially offset by cash dividends paid to stockholders of $2.1 million and repurchases of the Company's stock of $73,000.

Table of Conten t s

Average Balances, Net Interest Income, Yields Earned and Rates Paid

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Nonaccrual loans have been included in the table as loans carrying a zero yield for the period they have been on nonaccrual (dollars in thousands).

2020 2019 2018

Balance Interest

Interest-earning assets:

$ 665,389 $ 34,439 5.18 % $ 599,944 $ 33,090 5.52 % $ 589,205 $ 31,881 5.41 %

Investments and interest-bearing accounts 104,328 497 0.48 64,386 1,491 2.32 60,628 1,286 2.12

Total interest-earning assets (1)

769,717 34,936 4.54 664,330 34,581 5.21 649,833 33,167 5.10

Interest-bearing liabilities:

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Certificate accounts 242,963 5,749 2.37 235,363 5,555 2.36 174,922 2,765 1.58

Subordinated notes 3,365 191 5.67 — — — — — —

Borrowings 16,610 255 1.54 24,406 752 3.08 69,900 1,521 2.18

Total interest-bearing liabilities 580,619 7,450 1.28 % 517,989 7,617 1.47 % 515,979 5,360 1.04 %

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(1) Calculated net of deferred loan fees, loan discounts and loans in process.

Table of Conten t s

Rate/Volume Analysis

5 unchanged sentences

2019 Year Ended December 31,

Increase (Decrease) due to

Increase (Decrease)

Increase (Decrease) due to

Increase (Decrease) due to Total

Increase (Decrease) Increase (Decrease) due to Total

Increase (Decrease)

Volume Rate Volume Rate

Interest-earning assets:

Loans $ 3,387 $ (2,038) $ 1,349 $ 592 $ 617 $ 1,209

Investments and interest-bearing accounts 190 (1,184) (994) 87 118 205

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Certificate accounts 180 14 194 1,426 1,363 2,789

Subordinated debt 191 — 191

Borrowings (120) (377) (497) (1,401) 632 (769)

Total interest-bearing liabilities $ 484 $ (651) $ (167) $ (58) $ 2,315 $ 2,257

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Comparison of Results of Operation for the Years Ended December 31, 2020 and 2019

Net income decreased $360,000 to $6.7 million , or $2.57 per diluted common share for the year ended December 31, 2019 , from $7.0 million , or $2.74 per diluted common share for the year ended December 31, 2018 .

The primary reasons for the decrease in net income in 2019 compared to 2018 was due to a lower net interest income and noninterest income, partially offset by a recapture from the allowance for loan losses of $125,000.

Net income increased $2.3 million to $8.9 million, or $3.42 per diluted common share, for the year ended December 31, 2020, from $6.7 million, or $2.57 per diluted common share, for the year ended December 31, 2019.

The increase in net income in 2020 compared to 2019 was primarily due to higher noninterest income, particularly gain on sale of loans, and increased net interest income, partially offset by an increase in the provision for loan losses and an increase in income tax expense.

Interest Income.

Total interest income increased by $1.4 million , or 4.3% , to $34.6 million for the year ended December 31, 2019 , from $33.2 million for the year ended December 31, 2018 .

Interest income on loans increased $1.2 million , or 3.8% , to $33.1 million for the year ended December 31, 2019, compared to $31.9 million for the year ended December 31, 2018, due to higher average loan balances and yields.

Total interest income increased by $355,000, or 1.0%, to $34.9 million for the year ended December 31, 2020, from $34.6 million for the year ended December 31, 2019.

Interest income on loans increased $1.3 million, or 4.1%, to $34.4 million for the year ended December 31, 2020, compared to $33.1 million for the year ended December 31, 2019, due to higher average loan balances, partially offset by a decrease in average yield.

The average loans held-for-portfolio balance was $665.4 million for the year ended December 31, 2020, compared to $599.9 million for the year ended December 31, 2019.

The average yield on loans held-for-portfolio was 5.18% for the year ended December 31, 2020, compared to 5.52% for the year ended December 31, 2020.

The increase in the average loan yield during 2019 was due to the change in the composition of the loan portfolio, with an increase in higher yielding commercial and multifamily real estate and construction and land loans.

Interest income on the investment portfolio increased $205,000, or 15.9%, to $1.5 million during the year ended December 31, 2019, compared to $1.3 million during the year ended December 31, 2018, due to higher average investment balance and yields in 2019.

The average yield on loans decreased compared to the same period in the prior year due primarily to decreases in interest rates on adjustable-rate instruments, following decreases to short-term rates over the last year, including the emergency 150-basis point reduction in the targeted federal funds rate in March 2020 due to the COVID-19 pandemic, and secondarily, due to the impact of PPP loans.

For the year ended December 31, 2020, the average balance of PPP loans was $46.7 million and the average yield on PPP loans was 4.32%, including the recognition of the net deferred fees.

Interest income included $467,000 in fees earned related to PPP loans during 2020 compared to none in the prior year.

The impact of PPP loans on loan yields will change during any period based on the volume of prepayments or amounts forgiven by the SBA as certain criteria are met but is expected to cease completely after the two- or five-year maturity of the loans.

The change in interest income on investments and interest-bearing accounts was primarily due to the decline in short-term interest rates in 2020 discussed above.

Interest Expense.

Interest expense increased $2.3 million , or 42.1% , to $7.6 million during the year ended December 31, 2019 , compared to $5.4 million during the year ended December 31, 2018 as a result of both a higher weighted average cost and balance of deposits, partially offset by a decrease in the average balance of Federal Home Loan Bank ("FHLB") borrowings.

Interest expense on deposits increased $3.0 million , or 78.8% , to $6.9 million for the year ended December 31, 2019 , compared to the prior year, driven by an increase of $47.5 million, or 10.6%, in the average balance of interest-bearing deposits to $493.6 million, and a 45 basis point increase in the weighted average rate paid on interest-bearing deposits to 1.16% for the year ended

December 31, 2019 , from 0.71% for the year ended December 31, 2018.

The average balance of total deposits increased $52.8 million, to $590.0 million for the year ended December 31, 2019 as compared to $537.2 million for the same period in 2018.

Interest expense on FHLB borrowings decreased $769,000 , or 50.6% , to $752,000 for the year ended December 31, 2019 from $1.5 million for the year ended December 31, 2018 , due to a $45.5 million, or 65.1% decrease in the average balance of FHLB borrowings to $24.4 million from $69.9 million for the year ended December 31, 2018 .

Interest expense decreased $167,000, or 2.2%, to $7.5 million during the year ended December 31, 2020, compared to $7.6 million during the year ended December 31, 2019, primarily due to lower average balances and rates paid on

Table of Conten t s

borrowings and lower rates paid on interest-bearing deposits, partially offset by higher average interest-bearing deposit balances and the issuance of subordinated notes, with its commensurate interest expense.

Interest expense on deposits increased $139,000, or 2.0%, to $7.0 million for the year ended December 31, 2020, compared to the prior year, primarily driven by an increase of $67.1 million, or 13.6%, in the average balance of interest-bearing deposit accounts to $560.6 million.

Average balances in all types of interest-bearing deposits increased in 2020.

The resulting negative impact to interest expense was partially offset by 15-basis point decrease in the weighted-average rate paid on interest-bearing deposits, which decreased to 1.01% for the year ended December 31, 2020, from 1.16% for the year ended December 31, 2019.

Although the average balance of certificate accounts accounted for 11.3% of the increase in the average balance in interest-bearing deposits year over year, due to the average rate paid on this type of account relative to other deposits, it contributed $194,000 to the increase in interest expense year over year.

In September 2020, we completed a private placement of $12.0 million in aggregate principal of subordinated notes, resulting in net proceeds after placement fees and offering expenses, of approximately $11.6 million.

Interest expense on our subordinated notes totaled $191,000 for the year ended December 31, 2020.

Interest expense on borrowings, which include FHLB advances and Federal Reserve discount window and the PPPLF program, decreased $497,000, or 66.1%, to $255,000 for the year ended December 31, 2020 from $752,000 for the year ended December 31, 2019, due to a $7.8 million, or 31.9% decrease in the average balance of borrowings to $16.6 million for the year ended December 31, 2020, from $24.4 million for the year ended December 31, 2019.

The weighted-average interest rate on borrowings was 1.54% in 2020 and 3.08% in 2019.

The need for borrowings declined significantly in 2020 due to increased liquidity resulting from growth in customer deposits.

Our overall weighted-average cost of interest-bearing liabilities was 1.28% for the year ended December 31, 2020, compared to 1.47% for the year ended December 31, 2019.

Net Interest Income.

Net interest income decreased $843,000 , or 3.0% , to $27.0 million for the year ended December 31, 2019 , from $27.8 million for the year ended December 31, 2018 .

The decrease primarily resulted from an increase in net interest expense due to rates paid on deposits and higher average deposit balances, partially offset by increased interest income on loans and investments and decreased interest expense paid on FHLB borrowings.

Net interest income increased $522,000, or 1.9%, to $27.5 million for the year ended December 31, 2020, from $27.0 million for the year ended December 31, 2019, primarily as a result of higher interest income on loans and lower overall interest expense.

Our net interest margin was 3.57% for the year ended December 31, 2020, compared to 4.06% for the year ended December 31, 2019.

The decrease was primarily due to yields earned on interest-earning assets declining at a faster rate than interest rates paid on interest-bearing liabilities.

Provision for Loan Losses .

The low interest-rate environment putting downward pressure on income from adjustable-rate loans and investments and an increase in costs related to interest-bearing deposits adversely impacted net interest margin for the current year.

The decreases were also due to yields earned on interest-earning assets declining at a faster rate than interest rates paid on interest-bearing liabilities as changes in the average rate paid on interest-bearing deposits tend to lag changes in market interest rate.

The lower average yield on PPP loans, including recognition of deferred loan fees, also contributed to the decline in the net interest margin.

Provision (Recapture) for Loan Losses.

We establish our allowance for loan losses through provisions for loan losses, which are charged to earnings, at a level required to reflect management's best estimate of the probable incurred credit losses in the loan portfolio.

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Loans, for which management has concerns about the borrowers' ability to repay, are evaluated individually, and specific loss allocations are provided for these loans when necessary.

We recorded a recapture from the allowance for loan losses of $125,000 for the year ended December 31, 2019 , compared to a

provision for loan losses of $525,000 for the year ended December 31, 2018 .

The recapture in the current year was due to changes in the composition of our loan portfolio during the year.

Net loan charge-offs were $9,000 for the year ended December 31, 2019 , compared to net recoveries of $8,000 for the year ended December 31, 2018 .

Nonperforming loans increased $2.0 million during the year to $4.7 million at December 31, 2019 , compared to $2.7 million a year ago.

Nonperforming loans to total loans increased to 0.75% at December 31, 2019 from 0.43% at December 31, 2018 .

The allowance for loan losses decreased to $5.6 million at December 31, 2019 compared to $5.8 million at December 31, 2018 .

See "- Comparison of Financial Condition at December 31, 2019 and December 31, 2018 – Delinquencies and Nonperforming Assets" for more information on nonperforming loans in 2019.

While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations.

We recorded a provision for loan losses of $925,000 for the year ended December 31, 2020, compared to a recapture from the allowance for loan losses of $125,000 for the year ended December 31, 2019.

The increase in the provision primarily reflects current economic conditions and gives consideration of probable loan losses due to the potential effects from higher forecasted unemployment rates and lower gross domestic product, as well as the impact on other economic conditions from COVID-19.

The recapture in the prior year was due to changes in the composition of our loan portfolio during the year.

Net loan charge-offs were $565,000 and $9,000 for the years ended December 31, 2020 and 2019.

Nonperforming loans decreased $1.8 million during the year to $2.9 million at December 31, 2020, compared to $4.7 million a year ago.

Nonperforming loans to total loans decreased to 0.47% at December 31, 2020 from 0.75% at December 31, 2019.

The allowance for loan losses increased to $6.0 million at December 31, 2020 compared to $5.6 million at December 31, 2019.

See "—Comparison of Financial Condition at December 31, 2020 and December 31, 2019— Delinquencies and Nonperforming Assets" for more information on nonperforming loans.

Table of Conten t s

amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations.

Noninterest Income.

Noninterest income decreased $260,000 , or 6.1% , to $4.0 million for the year ended December 31, 2019 , as compared to $4.3 million for the year ended December 31, 2018 as reflected below (dollars in thousands):

Year Ended December 31,

Noninterest income increased $3.4 million, or 84.9%, to $7.4 million for the year ended December 31, 2020, as compared to $4.0 million for the year ended December 31, 2019 as reflected below (dollars in thousands):

Year Ended December 31, Amount Percent

2020 2019 Change Change

Service charges and fee income $ 1,905 $ 1,954 $ (49) (2.5) %

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Mortgage servicing income 1,027 1,002 25 2.5

Fair value adjustment on mortgage servicing rights

Fair value adjustment on MSRs (1,857) (760) (1,097) 144.3

Net gain on sale of loans 6,022 1,449 4,573 315.6

Total noninterest income $ 7,445 $ 4,026 $ 3,419 84.9 %

NM = not meaningful

The decrease in noninterest income from one year ago was primarily due to a $247,000 decrease in the mark-to-market

adjustment on fair value of mortgage servicing rights during the year ended December 31, 2019 , combined with one-time proceeds of $490,000 recognized in other noninterest income from the sale of Visa B Shares during year ended December 31, 2018 .

The decrease was partially offset by a $411,000 increase in the net gain on sale of loans.

The increase in noninterest income from one year ago was primarily due to a $4.6 million increase in gain on sale of loans, partially offset by a $1.1 million decrease in the mark-to-market adjustment on fair value of MSRs during the year ended December 31, 2020.

Demand for one-to-four family loans grew significantly in 2020 as homeowners, taking advantage of historically low interest rates, refinanced their homes.

In addition, the pandemic increased demand for single-family homes outside downtown metropolitan areas.

Noninterest Expense .

Noninterest expense remained relatively flat, decreasing $38,000 , or 0.2%, to $22.8 million for the year ended December 31, 2019 , from the year ended December 31, 2018 , as reflected below (dollars in thousands):

Year Ended December 31,

Noninterest expense decreased $107,000, or 0.5%, to $22.7 million for the year ended December 31, 2020, from the year ended December 31, 2019, as reflected below (dollars in thousands):

Year Ended December 31, Amount Percent

2020 2019 Change Change

Salaries and benefits $ 12,083 $ 12,402 $ (319) (2.6) %

Operations 5,461 5,905 (444) (7.5)

Regulatory assessments 590 279 311 111.5

Occupancy 1,881 2,060 (179) (8.7)

Data processing 2,658 2,104 554 26.3

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Total noninterest expense $ 22,678 $ 22,785 $ (107) (0.5) %

Salaries and benefits decreased $373,000 as a result of lower commissions on loan originations paid during the year and regulatory assessments decreased $153,000 as a result of a small bank credit awarded by the Federal Deposit Insurance Corporation ("FDIC").

These decreases were partially offset by a $433,000 increase in operations expense and $185,000 increase in data processing expense.

Operations expense increased due to increases in marketing and adverting expense of $133,000, wire fraud expenses of $114,000, travel and conference expense of $88,000, charitable contributions of $81,000 and consulting expenses of $37,000.

Salaries and benefits decreased $319,000 due to an increase in deferred loan origination costs which had the effect of lowering up-front commission expense.

Operations expense decreased due to decreases in professional and consulting fees, travel and conference and marketing and advertising expense.

Data processing expense increased due to technology investments and variable costs associated with loan origination activity.

Regulatory assessments increased $311,000 to its pre-2019 level, as the Bank utilized all of its remaining regulatory assessment credits in 2019.

The efficiency ratio, which is noninterest expense as a percentage of net interest income and noninterest income, for the year ended December 31, 2020 was 64.90%, compared to 73.52% for the year ended December 31, 2019.

The increase in the efficiency ratio compared to the prior year was primarily due to higher interest expense on deposits.

The improvement in the efficiency ratio compared to the prior year was primarily due to the increase in noninterest income earned during the current year.

Income Tax Expense .

The provision for income taxes decreased $55,000 , or 3.2% to $1.7 million for the year ended December 31, 2019 , compared to the year ended December 31, 2018 due to a decrease in taxable net income.

The provision for income taxes increased $740,000, or 44.8% to $2.4 million for the year ended December 31, 2020, compared to $1.7 million for the year ended December 31, 2019, due to an increase in taxable net income and higher effective tax rate.

The effective tax rates for the years ended December 31, 2020 and 2019 were 21.1% and 19.8%, respectively.

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Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds.

On a longer term basis, we maintain a strategy of investing in various loan products and investment securities, including mortgage-backed securities.

On a longer-term basis, we maintain a strategy of investing in

Table of Conten t s

various loan products and investment securities, including mortgage-backed securities.

We use our sources of funds primarily to meet ongoing commitments, pay maturing deposits, fund deposit withdrawals and fund loan commitments.

We maintain cash and investments that qualify as liquid assets to maintain adequate liquidity to ensure safe and sound operations and meet demands for client funds (particularly withdrawals of deposits).

At December 31, 2019 , we had $65.1 million in cash and investment securities available for sale and $1.1 million in loans held-for-sale.

At December 31, 2020, we had $204.0 million in cash and available-for-sale investment securities and $11.6 million in loans held-for-sale.

We can also obtain funds from borrowings, primarily FHLB advances.

At December 31, 2019 , we had the ability to borrow an additional $217.8 million in FHLB advances, subject to certain collateral requirements and we had access to additional borrowings of $41.7 million through the Federal Reserve's Discount Window, subject to certain collateral requirements.

At December 31, 2020, we had the ability to borrow an additional $213.7 million in FHLB advances, subject to certain collateral requirements and we had access to additional borrowings of $23.6 million through the Federal Reserve's discount window and PPPLF program, subject to certain collateral requirements.

We had no outstanding advances or borrowings with the Federal Reserve at December 31, 2020.

In addition, we also had available $20.0 million of credit facilities with other financial institutions, with no balance outstanding at December 31, 2020 or 2019.

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Our liquidity, represented by cash and cash-equivalents, is a product of our operating, investing and financing activities.

As disclosed in our Consolidated Statements of Cash Flows in Item 8 of this Annual Report on Form 10-K, cash and cash equivalents decreased $6.0 million to $55.8 million as of December 31, 2019 , from $61.8 million at December 31, 2018 .

Net cash provided by operating activities was $11.1 million for the year ended December 31, 2019 .

Net cash of $5.8 million was used in investing activities for the year ended December 31, 2019 and consisted principally of purchase of investment securities.

There was $11.3 million of cash used in financing activities for the year ended December 31, 2019 which primarily consisted of a $76.5 million net decrease in FHLB advances, partially offset by a $63.1 million increase in deposits.

As disclosed in our "Consolidated Statements of Cash Flows" in Item 8.

Financial Statements and Supplementary Data of this Annual Report on Form 10-K, cash and cash equivalents increased $138.1 million to $193.8 million at December 31, 2020, from $55.8 million at December 31, 2019.

Net cash used in operating activities was $484,000 for the year ended December 31, 2020.

Net cash of $4.5 million was provided by investing activities for the year ended December 31, 2020, primarily provided by loan maturities.

Net cash provided by financing activities of $134.0 million for the year ended December 31, 2020, primarily consisted of a $131.3 million increase in deposits and $11.6 million in net proceeds from the issuance of subordinated notes, partially offset by $7.5 million decrease in FHLB advances.

Sound Financial Bancorp is a separate legal entity from Sound Community Bank and must provide for its own liquidity.

1 unchanged sentence

Sound Financial Bancorp's primary source of funds is dividends from Sound Community Bank, which are subject to regulatory limits.

During the third quarter of 2020, the Company completed a private placement of $12.0 million in aggregate principal of subordinated notes resulting in net proceeds, after placement fees and offering expenses, of approximately $11.6 million.

The Company contributed $5.5 million of the net proceeds from the sale of the subordinated notes to the Bank and retained the remaining net proceeds to be used for general corporate purposes.

At December 31, 2020 Sound Financial Bancorp, on an unconsolidated basis, had $6.8 million in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs.

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Based on this management strategy, we believe that a majority of maturing deposits will remain with us.

See also the Consolidated Statements of Cash Flows, included in Item 8, "Financial Statements and Supplementary Data," of this Form 10-K, for further information.

See also the "Consolidated Statements of Cash Flows" included in Item 8.

Financial Statements and Supplementary Data of this Form 10-K, for further information.

Table of Conten t s

Off-Balance Sheet Activities

11 unchanged sentences

Sound Community Bank is subject to minimum capital requirements imposed by regulations of the FDIC.

Based on its capital levels at December 31, 2019 , Sound Community Bank exceeded these requirements as of that date.

Capital adequacy requirements are quantitative measures established by regulation that require Sound Community Bank to maintain minimum amounts and ratios of capital.

Based on its capital levels at December 31, 2020, Sound Community Bank exceeded these requirements at that date.

Consistent with our goals to operate a sound and profitable organization, our policy is for Sound Community Bank to maintain a "well-capitalized" status under the regulatory capital categories of the FDIC.

Based on capital levels at December 31, 2019 , Sound Community Bank was considered to be well-capitalized.

Management monitors the capital levels to provide for current and future business opportunities and to maintain Sound Community Bank's "well-capitalized" status.

For additional details see Note 15 in the Notes to Consolidated Financial Statements contained in "Item 8.

Beginning January 2020, the Bank elected to use the CBLR framework.

A bank that elects to use the CBLR framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act will generally be considered "well-capitalized" and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%.

As required by the CARES Act, the FDIC has temporarily lowered the CBLR to 8.0% beginning in the second quarter of 2020 through the end of the year.

Beginning in 2021, the CBLR will increase to 8.5% for that calendar year.

The CBLR will return to 9.0% on January 1, 2022.

To be eligible to utilize the CBLR, the Bank also must have total consolidated assets of less than $10 billion, off-balance sheet exposures of 25.0% or less of its total consolidated assets, and trading assets and trading liabilities of 5.0% or less of its total consolidated assets, all as of the end of the most recent quarter.At December 31, 2020, the Bank’s CBLR was 10.40%.

For additional details, see “Note 16—Capital” in the Notes to Consolidated Financial Statements contained in "Item 8.

Financial Statements and Supplementary Data" and "Item 1.

Business—How We Are Regulated—Regulation of Sound Community Bank—Capital Rules" of this Form 10-K.

Prior to January 1, 2020, Sound Community Bank followed the FDIC’s prompt corrective actions standards.

In order to be considered well-capitalized under the prompt corrective action standards, a bank must have a ratio of CET1 capital to risk-weighted assets of at least 6.5%, a ratio of Tier 1 capital to risk-weighted assets of at least 8.0%, a ratio of total capital to risk-weighted assets of at least 10.0%, and a leverage ratio of at least 5.0%, and the bank must not be subject to a regulatory capital requirement imposed on it as an individual bank.

Table of Conten t s

The following table shows the capital ratios of Sound Community Bank at December 31, 2019 (dollars in thousands):

Minimum Capital

Minimum Required to be

Actual Minimum Capital

Requirements Minimum Required to be

Well-Capitalized Under Prompt

Corrective Action Provisions

Amount Ratio Amount Ratio Amount Ratio

Tier 1 Capital to average total adjusted assets (1)

$ 74,031 10.22 % $ 28,981 4.0 % $ 36,226 5.0 %

Common Equity Tier 1 to risk-weighted assets (2)

74,031 12.07 27,601 4.5 39,868 6.5

Tier 1 Capital to risk-weighted assets (2)

74,031 12.07 36,801 6.0 49,068 8.0

Total Capital to risk-weighted assets (2)

$ 79,974 13.04 % $ 49,068 8.0 % $ 61,335 10.0 %

(1) Based on total adjusted assets of $724,527 at December 31, 2019.

(2) Based on risk-weighted assets of $613,354 at December 31, 2019.

In addition to the minimum CET1, Tier 1 and total capital ratios, Sound Financial Bancorp and Sound Community Bank must maintain a capital conservation buffer consisting of additional CET1 capital greater than 2.5% of risk-weighted assets above the required minimum risk-based capital levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses.

At December 31, 2019, the conservation buffer requirement was 2.50% and the Bank's actual conservation buffer was 5.04%.

For a bank holding company with less than $3.0 billion in assets, the capital guidelines apply on a bank-only basis and the Federal Reserve expects the holding company's subsidiary banks to be "well-capitalized" under the prompt corrective action regulations.

If Sound Financial Bancorp was subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets, at December 31, 2020, Sound Financial Bancorp would have exceeded all regulatory capital requirements.

The estimated regulatory capital ratios calculated for Sound Financial Bancorp as of December 31, 2019 were 9.55% for Tier 1

Capital to total adjusted assets (leverage ratio), 11.08% for both Common Equity Tier 1 risk-based capital, and Tier 1 Capital to risk-based assets, and 11.94% for Total Capital to risk weighted assets.

The estimated CBLR calculated for Sound Financial Bancorp for Sound Financial Bancorp at December 31, 2020 was 10.40%.

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7. Management’s Discussion and Analysis