Sound Financial Bancorp, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Special Note Regarding Forward-Looking Statements Certain matters discussed in this Form 10-Q constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our financial condition, results of operations, plans, objectives, future performance or business. Forward-looking statements are not statements of historical fact, are based on certain assumptions and are generally identified by use of the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, assumptions and statements about, among other things, expectations of the business environment in which we operate, projections of future performance or financial items, perceived opportunities in the market, potential future credit experience, and statements regarding our mission and vision. These forward-looking statements are based upon current management expectations and may, therefore, involve risks and uncertainties. Our actual results, performance, or achievements may differ materially from those suggested, expressed, or implied by forward-looking statements as a result of a wide variety or range of factors including, but not limited to: • the effect of the novel coronavirus disease 2019 (“COVID-19”) pandemic, including on our credit quality and business operations, as well as its impact on general economic and financial market conditions and other uncertainties resulting from the COVID-19 pandemic, such as the extent and duration of the impact on public health, the U.S. and global economies, and consumer and corporate clients, including economic activity, employment levels and market liquidity; • changes in consumer spending, borrowing and savings habits; • changes in economic conditions, either nationally or in our market area; • the risks of lending and investing activities, including changes in the level and direction of loan delinquencies and write-offs and changes in estimates of the adequacy of our allowance for loan losses; • monetary and fiscal policies of the Board of Governors of the Federal Reserve System ("Federal Reserve") and the U.S. Government and other governmental initiatives affecting the financial services industry; • fluctuations in the demand for loans, the number of unsold homes, land and other properties; • fluctuations in real estate values and both residential and commercial and multifamily real estate market conditions in our market area; • our ability to access cost-effective funding; • uncertainty regarding the future of the London Interbank Offered Rate ("LIBOR"), and the potential transition away from LIBOR toward new interest rate benchmarks; • our ability to control operating costs and expenses; • secondary market conditions for loans and our ability to sell loans in the secondary market; • fluctuations in interest rates; • results of examinations of Sound Financial Bancorp and Sound Community Bank by their regulators, including the possibility that the regulators may, among other things, require us to increase our allowance for loan losses or to write-down assets, change Sound Community Bank's regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings; • inability of key third-party providers to perform their obligations to us; • our ability to attract and retain deposits; • competitive pressures among financial services companies; • our ability to successfully integrate any assets, liabilities, clients, systems, and management personnel we may acquire into our operations and our ability to realize related revenue synergies and expected cost savings and other benefits within the anticipated time frames or at all; • the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; • our ability to keep pace with technological changes, including our ability to identify and address cyber-security risks such as data security breaches, "denial of service" attacks, "hacking" and identity theft, and other attacks on our information technology systems or on the third-party vendors who perform several of our critical processing functions; • changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods, including as a result of the Coronavirus Aid, Relief, and Economic Securities Act of 2020 ("CARES Act") and the Consolidated Appropriations Act, 2021 ("CAA 2021"); • legislative or regulatory changes such as the Dodd-Frank Wall Street Reform and Consumer Protection Act and its implementing regulations that adversely affect our business, and the availability of resources to address such changes; 30 • our ability to retain or attract key employees or members of our senior management team; • costs and effects of litigation, including settlements and judgments; • our ability to implement our business strategies; • staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; • our ability to pay dividends on our common stock; • the possibility of other-than-temporary impairments of securities held in our securities portfolio; • other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services, including the CARES Act, CAA 2021 and recent COVID 19 vaccination and stimulus efforts, and • the other risks described from time to time in our filings with the U.S. Securities and Exchange Commission (the "SEC"), including this Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2020 (“2020 Form 10-K”). We wish to advise readers not to place undue reliance on any forward-looking statements and that the factors listed above could materially affect our financial performance and could cause our actual results for future periods to differ materially from any such forward-looking statements expressed with respect to future periods and could negatively affect our stock price performance. We do not undertake and specifically decline any obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. General Sound Financial Bancorp, a Maryland corporation, is a bank holding company for its wholly owned subsidiary, Sound Community Bank. Substantially all of Sound Financial Bancorp’s business is conducted through Sound Community Bank, a Washington state-chartered commercial bank. As a Washington commercial bank, the Bank’s regulators are the Washington Department of Financial Institutions and the Federal Deposit Insurance Corporation (the “FDIC”). The Federal Reserve is the primary federal regulator for Sound Financial Bancorp. We also sell insurance products and services for clients through Sound Community Insurance Agency, Inc., a wholly owned subsidiary of the Bank. Sound Community Bank’s deposits are insured up to applicable limits by the FDIC. At March 31, 2021, Sound Financial Bancorp, on a consolidated basis, had assets of $936.7 million, net loans held-for-portfolio of $608.4 million, deposits of $816.7 million and stockholders’ equity of $87.6 million. The shares of Sound Financial Bancorp are traded on NASDAQ Capital Market under the symbol “SFBC.” Our executive offices are located at 2400 3rd Avenue, Suite 150, Seattle, Washington, 98121. Our principal business consists of attracting retail and commercial deposits from the general public and investing those 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 commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable. We also offer a variety of secured and unsecured consumer loan products, including manufactured home loans, floating home loans, automobile loans, boat loans and recreational vehicle loans. As part of our business, we focus on residential mortgage loan originations, a significant portion of which we sell to Fannie Mae and other correspondents and the remainder of which we retain for our loan portfolio consistent with our asset/liability objectives. 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 held in our loan portfolio. 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. Critical Accounting Policies Certain of our accounting policies require management to make difficult, complex or subjective judgments, which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. 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. Our methodologies for analyzing the allowance for loan losses, 31 other-than-temporary impairment, mortgage servicing rights, other real estate owned and deferred tax asset accounts are described in our 2020 Form 10-K. COVID-19 Response The Company continues to offer a variety of relief options designed to support our clients and communities we serve during the ongoing COVID-19 pandemic. Paycheck Protection Program ("PPP") Participation. The CARES Act was signed into law on March 27, 2020, and authorized the Small Business Administration (“SBA”) to temporarily guarantee loans under a loan program called the Paycheck Protection Program, or PPP. As a qualified SBA lender, the Company was automatically authorized to originate PPP loans upon commencement of the program in April 2020. PPP loans have: (a) an interest rate of 1.0%, (b) a two-year loan term to maturity; and (c) principal and interest payments deferred for six months from the date of disbursement. The SBA guarantees 100% of the PPP loans made to eligible borrowers. The entire principal amount of the borrower’s PPP loan, including any accrued interest, is eligible to be forgiven and repaid by the SBA. The first round of the program expired on August 8, 2020, and a second round reopened the program beginning January 1, 2021 through May 31, 2021. During the first quarter of 2021, we continued our participation in the initial SBA PPP by processing applications for PPP loan forgiveness. As of March 31, 2021, we had received SBA forgiveness for 807 PPP loans totaling $52.7 million out of the $74.8 million in PPP loans funded during the first PPP program. During the first quarter of 2021, we began accepting and processing loan applications under the second PPP program enacted in December 2020. As of March 31, 2021, we have funded 471 PPP loans totaling $39.1 million under the second PPP program. As of March 31, 2021, there was a total of 573 PPP loans outstanding totaling $61.2 million. The following table summarizes our PPP participation as of March 31, 2021 (dollars in thousands): Funded At March 31, 2021 Total Number of Loans Average Loan Amount Outstanding Number of Loans First PPP $ 74,776 909 $ 82 $ 22,093 102 Second PPP 39,108 471 83 39,108 471 Total PPP loans $ 113,884 1,380 $ 83 $ 61,201 573 The SBA processing fees for the approved loans totaled $4.6 million at March 31, 2021. Loan Modifications. 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. As of March 31, 2021, we had $3.6 million of residential loans under payment relief related to COVID-19, which consisted of six residential loans totaling $926,000 that have entered into a second payment forbearance agreement with a weighted-average loan-to-value of 74%, four residential loans totaling $586,000 that have entered into a third payment forbearance agreement with a weighted-average loan-to value of 61%, and seven residential loans totaling $1.9 million that have entered into a fourth forbearance agreement with a weighted-average loan-to-value of 64%. We had $9.1 million in commercial loans still under payment relief related to COVID-19 at March 31, 2021, which consisted of one commercial loan totaling $1.5 million that is subject to a second interest-only payment agreement with a loan-to-value of 49%, and four commercial loans totaling $4.1 million that are subject to a third interest-only payment agreement with a weighted-average loan-to-value of 52%. The foregoing weighted-average loan-to-values are based on appraisals obtained at the time of loan origination and the current loan amount. All of these loan modifications have been made in response to the COVID-19 pandemic and are not classified as troubled debt restructurings pursuant to applicable accounting and regulatory guidance until the earlier of 60 days after the national emergency termination date or January 1, 2022. 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. Support for Clients, Employees and Community during Pandemic. We remain focused on keeping our employees safe and the Bank running effectively to serve its clients. The Bank is managing branch access and occupancy levels in relation to cases and close contact scenarios, following governmental restrictions and public health authority guidelines, and encouraging remote work and supporting employees with paid time off. As of March 31, 2021, all of our branch lobbies were open. We continue to work closely with our borrowers to evaluate pandemic related challenges. We also continue to support our not-for-profit organizations albeit most activity is virtual. 32 Comparison of Financial Condition at March 31, 2021 and December 31, 2020 General. Total assets increased $75.2 million, or 8.7%, to $936.7 million at March 31, 2021 from $861.4 million at December 31, 2020. The increase was primarily a result of a higher balances in cash and cash equivalents, and the origination of PPP loans. Cash and Securities. Cash and cash equivalents increased $75.8 million, or 39.1%, to $269.6 million at March 31, 2021 from $193.8 million at December 31, 2020 primarily due to deposit growth. Available-for-sale securities, which consist of municipal bonds and agency mortgage-backed securities decreased $1.1 million, or 11.2%, to $9.1 million at March 31, 2021 from $10.2 million at December 31, 2020 as a result of normal pay downs in investment securities during the quarter. Loans. Loans held-for-portfolio, net, increased $1.1 million, or 0.2%, to $608.4 million at March 31, 2021 from $607.4 million at December 31, 2020, driven by our origination of PPP loans. The following table reflects the changes in the loan mix of our loan portfolio at March 31, 2021, as compared to December 31, 2020 (dollars in thousands): March 31, 2021 December 31, 2020 Amount Change Percent Change One-to-four family $ 129,995 $ 130,657 $ (662) (0.5) % Home equity 13,763 16,265 (2,502) (15.4) Commercial and multifamily 251,459 265,774 (14,315) (5.4) Construction and land 63,112 62,752 360 0.6 Manufactured homes 20,781 20,941 (160) (0.8) Floating homes 39,868 39,868 — — Other consumer 14,942 15,024 (82) (0.5) Commercial business 83,669 64,217 19,452 30.3 Deferred loan fees (3,212) (2,135) (1,077) 50.4 Total loans held-for-portfolio, gross 614,377 613,363 1,014 0.2 Allowance for loan losses (5,935) (6,000) 65 (1.1) Total loans held-for-portfolio, net $ 608,442 $ 607,363 $ 1,079 0.2 % The largest increase in the loan portfolio was in commercial business loans which increased $19.5 million, or 30.3%, to $83.7 million, at March 31, 2021, compared to $64.2 million at December 31, 2020, driven by our origination of 471 PPP loans totaling $39.1 million during the three months ended March 31, 2021. PPP loans are 100% guaranteed by the SBA. At March 31, 2021, our loan portfolio, net of deferred loan fees, remained well-diversified. Commercial and multifamily real estate loans accounted for 40.7% of total loans, one-to-four family loans, including home equity loans accounted for 23.3% of total loans, commercial business loans accounted for 13.6% of total loans, and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans accounted for 12.2% of total loans at March 31, 2021. Construction and land loans accounted for 10.2% of total loans at March 31, 2021. 33 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. It is our best estimate of probable credit losses inherent in our loan portfolio. The following table reflects the adjustments in our allowance during the periods indicated (dollars in thousands): Three Months Ended March 31, 2021 2020 Balance at beginning of period $ 6,000 $ 5,640 Charge-offs (71) (6) Recoveries 6 9 Net (charge-offs)/recoveries (65) 3 Provision for loan losses during the period — 250 Balance at end of period $ 5,935 $ 5,893 Ratio of net (charge-offs)/recoveries during the period to average loans outstanding during the period (0.01) % — % March 31, 2021 December 31, 2020 Allowance as a percentage of nonperforming loans (end of period) 218.92 % 208.04 % Allowance as a percentage of total loans (end of period) 0.97 % 0.98 % Our allowance for loan losses decreased $65,000, or 1.1%, to $5.9 million at March 31, 2021, from $6.0 million at December 31, 2020. Specific loan loss reserves decreased to $334,000 at March 31, 2021, compared to $378,000 at December 31, 2020, while general loan loss reserves decreased to $5.0 million at March 31, 2021, compared to $5.2 million at December 31, 2020 and the unallocated reserve increased to $570,000 at March 31, 2021, compared to $406,000 at December 31, 2020. The decrease in the general reserve was a result of declining loan balances as substantially all of the increase in loans held-for-portfolio during the quarter resulted from the origination of PPP loans. The $61.2 million balance of PPP loans was omitted from the calculation for the allowance for loan losses at March 31, 2021, as these loans are 100% guaranteed by the SBA and management expects that the great majority of PPP borrowers will seek full or partial forgiveness of their loan obligations from the SBA within a short time frame, which in turn will reduce the Bank’s loan balance for the amount forgiven. Net charge-offs for the three months ended March 31, 2021 totaled $65,000, compared to net recoveries of $3,000 for the three months ended March 31, 2020. At March 31, 2021, the allowance for loan losses as a percentage of total loans and nonperforming loans was 0.97% and 218.92%, respectively, compared to 0.98% and 208.04%, respectively, at December 31, 2020. Mortgage Servicing Rights. The fair value of mortgage servicing rights was $4.1 million at March 31, 2021, an increase of $329,000 or 8.7% from $3.8 million at December 31, 2020. We record mortgage servicing rights on loans sold with servicing retained and upon acquisition of a servicing portfolio. Mortgage servicing rights are carried at fair value. If the fair value of our mortgage servicing rights fluctuates significantly, our financial results could be materially impacted. Nonperforming Assets. At March 31, 2021, nonperforming assets totaled $3.3 million, or 0.35% of total assets, compared to $3.5 million, or 0.40% of total assets at December 31, 2020. The table below sets forth the amounts and categories of nonperforming assets at the dates indicated (dollars in thousands): Nonperforming Assets March 31, 2021 December 31, 2020 Amount Change Percent Change Nonaccrual loans $ 2,711 $ 2,884 $ (173) (6.0) % OREO and repossessed assets 575 594 (19) (3.2) Total nonperforming assets $ 3,286 $ 3,478 $ (192) (5.5) % Nonaccrual loans decreased $173,000, or 6.00%, to $2.7 million at March 31, 2021 from $2.9 million at December 31, 2020. The percentage of nonaccrual loans to total loans was 0.44% at March 31, 2021, compared to 0.47% of total loans at December 31, 2020. 34 OREO and repossessed assets were $575,000 at March 31, 2021 and $594,000 at December 31, 2020. At March 31, 2021, OREO and repossessed assets 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. It is currently leased to a not-for-profit organization headquartered in our market area at a below market rate. Deposits. Total deposits increased $68.7 million, or 9.2%, to $816.7 million at March 31, 2021 from $748.0 million at December 31, 2020. The increase was due primarily to disbursements of PPP loan proceeds into borrowers’ deposit accounts as well as stimulus funds deposited and reduced withdrawals reflecting changes in customer spending habits due to the COVID-19 pandemic. We continue our efforts to grow noninterest-bearing deposits, which increased $56.2 million, or 42.4%, to $188.7 million at March 31, 2021, compared to $132.5 million at December 31, 2020. Noninterest-bearing deposits represented 23.1% of total deposits at March 31, 2021, compared to 17.7% at December 31, 2020. A summary of deposit accounts with the corresponding weighted-average cost of funds at the dates indicated is presented below (dollars in thousands): March 31, 2021 December 31, 2020 Amount Wtd. Avg. Rate Amount Wtd. Avg. Rate Noninterest-bearing demand $ 183,291 — % $ 129,299 — % Interest-bearing demand 269,514 0.28 230,492 0.44 Savings 93,207 0.14 83,778 0.27 Money market 73,536 0.30 65,748 0.39 Time deposits 191,752 2.21 235,473 2.43 Escrow (1) 5,393 — 3,191 — Total deposits $ 816,693 0.67 % $ 747,981 1.01 % (1) Escrow balances shown in noninterest-bearing deposits on the consolidated balance sheets. Stockholders’ Equity. Total stockholders’ equity increased $2.1 million, or 2.4%, to $87.6 million at March 31, 2021 from $85.5 million at December 31, 2020. This increase primarily reflects $2.5 million in net income for the three months ended March 31, 2021, partially offset by the payment of cash dividends of $702,000 to common stockholders during the three months ended March 31, 2021. 35 Average Balances, Net Interest Income, Yields Earned and Rates Paid The following table presents, for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Income and yields on tax-exempt obligations have not been computed on a tax equivalent basis. All average balances are daily average balances. 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). March 31, 2021 2020 Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Interest-earning assets: Loan $ 628,397 $ 7,886 5.09 % $ 621,306 $ 8,408 5.43 % Investments and interest-bearing accounts 228,752 113 0.20 61,607 238 1.58 Total interest-earning assets (1) 857,149 7,999 3.77 682,913 8,646 5.09 Interest-bearing liabilities: Savings and money market accounts 155,854 64 0.17 110,594 93 0.34 Demand and NOW accounts 248,887 185 0.30 161,689 232 0.58 Certificate accounts 214,517 1,046 1.98 246,990 1,534 2.50 Subordinated notes 11,596 168 5.88 — — — Borrowings — — — 7,785 59 3.05 Total interest-bearing liabilities 630,854 1,463 0.94 % 527,058 1,918 1.46 % Net interest income $ 6,536 $ 6,728 Net interest rate spread 2.83 % 3.63 % Net earning assets $ 226,295 $ 155,855 Net interest margin 3.09 % 3.96 % Average interest-earning assets to average interest-bearing liabilities 135.87 % 129.57 % (1) Calculated net of deferred loan fees, loan discounts and loans in process. 36 Rate/Volume Analysis The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between changes related to outstanding balances and changes due to interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate (dollars in thousands). Three Months Ended March 31, 2021 vs. 2020 Increase (Decrease) due to Total Increase (Decrease) Volume Rate Interest-earning assets: Loans $ 89 $ (611) $ (522) Investments and interest-bearing accounts 83 (208) (125) Total interest-earning assets 172 (819) (647) Interest-bearing liabilities: Savings and Money Market accounts 19 (48) $ (29) Demand and NOW accounts 65 (112) (47) Certificate accounts (158) (330) (488) Subordinated debt 168 — 168 Borrowings — (59) (59) Total interest-bearing liabilities $ 94 $ (549) $ (455) Change in net interest income $ (192) Comparison of Results of Operation for the Three Months Ended March 31, 2021 and 2020 General. Net income increased $1.5 million, or 149.8%, to $2.5 million, or $0.93 per diluted common share, for the three months ended March 31, 2021, compared to $981,000, or $0.38 per diluted common share, for the three months ended March 31, 2020. The increase was primarily a result of an increase in noninterest income of $2.0 million for the three months ended March 31, 2021, driven by an increase of $1.7 million in gains on sale of loans. Interest Income. Interest income decreased $647,000, or 7.5%, to $8.0 million for the three months ended March 31, 2021, from $8.6 million for the three months ended March 31, 2020, primarily due to a 34 basis point decline in average loan yields. Interest income on loans decreased $522,000, or 6.2%, to $7.9 million for the three months ended March 31, 2020, despite higher average total loan balances resulting primarily from PPP loans made by the Bank. The average balance of total loans was $628.4 million for the three months ended March 31, 2021, compared to $621.3 million for the three months ended March 31, 2020. The average yield on total loans was 5.09% for three months ended March 31, 2021, compared to 5.43% for the three months ended March 31, 2020. The average yield on loans decreased primarily due to decreases in interest rates on resetting 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, the effects of which were partially offset by the impact of PPP loans. For the three months ended March 31, 2021, the average balance of PPP loans was $53.9 million and the average yield on PPP loans was 5.68%, including the recognition of the net deferred fees. Interest income included $755,000 in fees earned related to PPP loans in the three months ended March 31, 2021 compared to none in same period a year ago. At March 31, 2021, PPP deferred loan origination fees of $1.9 million remain to be accreted into interest income during the remaining life of the loans. 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. Interest income on the investment portfolio and cash and cash equivalents decreased $125,000, or 52.5%, to $113,000 for the three months ended March 31, 2021, compared to $238,000 for the three months ended March 31, 2020. The decrease in the interest income on investment securities and cash and cash equivalents was due to lower average yields primarily due to downward adjustments for adjustable rate investment securities reflecting the decrease in market interest rates and secondarily 37 due to lower yields on purchases of new investment securities compared to the existing portfolio. The average yield on investments and cash and cash equivalents was 0.20% for the three months ended March 31, 2021, compared to 1.58% for the three months ended March 31, 2020. Interest Expense. Interest expense decreased $455,000, or 23.7%, to $1.5 million for the three months ended March 31, 2021, from $1.9 million for the three months ended March 31, 2020, primarily as a result of declining deposit costs and a higher percentage of noninterest bearing deposits to total deposits. Interest expense on deposits decreased $564,000, or 30.3%, to $1.3 million for the three months ended March 31, 2021, compared to $1.9 million for the same period a year ago. The decrease was primarily the result of a decline in the weighted-average cost of deposits reflecting reduce rates paid on deposits. In addition, deposit costs were favorably impacted by a $59.4 million increase in average noninterest bearing deposits to $161.1 million for the three months ended March 31, 2021, compared to $101.7 million for the same period last year. The weighted-average cost of total deposits decreased 53 basis points to 0.67% for the quarter ended March 31, 2021, from 1.20% for the quarter ended March 31, 2020. In September 2020, we completed a private placement of $12.0 million in aggregate principal amount of 5.25% Fixed-to-Floating Rate Subordinated Notes due 2030, resulting in net proceeds after placement fees and offering expenses, of approximately $11.6 million. Interest expense on borrowings, comprised solely of interest expense on our subordinated notes, increased $109,000, or 184.7%, to $168,000 for the three months ended March 31, 2021, compared to $59,000 for the three months ended March 31, 2020, which was related solely to FHLB advances. Average borrowings increased $3.8 million, to $11.6 million at March 31, 2021, consisting solely of subordinated notes, from $7.8 million at March 31, 2020, which consisted of solely FHLB advances. The weighted-average cost of the subordinated notes was 5.88% at March 31, 2021, while the weighted-average cost of the FHLB advances was 3.05% at March 31, 2020. Net Interest Income. Net interest income decreased $192,000, or 2.9%, to $6.5 million for the three months ended March 31, 2021, from $6.7 million for the three months ended March 31, 2020. Our net interest margin was 3.09% and 3.96% for the three months ended March 31, 2021 and 2020, respectively. The decreases in both net interest income and net interest margin were primarily 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. During the quarter ended March 31, 2021, the average yield earned on PPP loans, including the recognition of the net deferred fees for PPP loans repaid and forgiven by the SBA, resulted in a positive impact in the net interest margin of six basis points, compared to no impact for the quarter ended March 31, 2020 as PPP loans were not being originated during that time. Provision/(Recapture) for Loan Losse s. We establish provisions for loan losses, which are charged to earnings, based on our review of the level of the allowance for loan losses required to reflect management’s best estimate of the probable incurred credit losses in the loan portfolio. In evaluating the level of the allowance for loan losses, management considers historical loss experience, the types of loans and the amount of loans in the loan portfolio, adverse situations that may affect borrowers’ ability to repay, estimated value of any underlying collateral, peer group data, prevailing economic conditions, and current factors. Large groups of smaller balance homogeneous loans, such as one- to four- family, small commercial and multifamily, home equity and consumer loans, are evaluated in the aggregate using historical loss factors adjusted for current economic conditions and other relevant data. 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. No provision for loan losses was recorded for the three months ended March 31, 2021, compared to a provision for loan losses of $250,000 for the three months ended March 31, 2020. The decrease in the provision for loan losses was primarily due to decreases in the balance of loans held-for-portfolio and to a lesser extent a $961,000 decrease in non-performing loans. Our allowance for loan losses as of March 31, 2021, not only reflects probable and inherent credit losses based upon the economic conditions that existed as of March 31, 2021, but also gives consideration to the potential losses from impacts of the COVID-19 pandemic which have declined as the economy in our markets improve as initial COVID-19 restrictions have been lifted. Net charge-offs for the three months ended March 31, 2021 totaled $65,000, compared to net recoveries of $3,000 for the three months ended March 31, 2020. 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. A further decline in national and local economic conditions, as a result of the COVID-19 pandemic or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company’s financial condition and results of operations. 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, 38 which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination. Noninterest Income. Noninterest income increased $2.0 million, or 281.4%, to $2.7 million for the three months ended March 31, 2021, as compared to $709,000 for the three months ended March 31, 2020, as reflected below (dollars in thousands): Three Months Ended March 31, Amount Change Percent Change 2021 2020 Service charges and fee income $ 532 $ 494 $ 38 7.7 % Earnings on cash surrender value of BOLI 82 15 67 446.7 Mortgage servicing income 312 244 68 27.9 Fair value adjustment on mortgage servicing rights (275) (362) 87 (24.0) Net gain on sale of loans 2,053 318 1,735 nm Total noninterest income $ 2,704 $ 709 $ 1,995 281.4 % The increase in noninterest income during the three months ended March 31, 2021 compared to the same period in 2020 was primarily due to increases in gain on sale of loans. As a result of reductions in market interest rates, refinance and home purchases have increased significantly over the last year, increasing our residential loans originated for sale. Loans sold during the three months ended March 31, 2021, totaled $68.1 million, compared to $14.1 million during the three months ended March 31, 2020. Noninterest Expense. Noninterest expense increased $216,000, or 3.6%, to $6.2 million during the three months ended March 31, 2021, compared to $5.9 million during the three months ended March 31, 2020, as reflected below (dollars in thousands): Three Months Ended March 31, Amount Change Percent Change 2021 2020 Salaries and benefits $ 3,644 $ 3,235 $ 409 12.6 % Operations 1,206 1,394 (188) (13.5) Regulatory assessments 101 250 (149) (59.6) Occupancy 448 497 (49) (9.9) Data processing 779 570 209 36.7 Net gain on OREO and repossessed assets (16) — (16) nm Total noninterest expense $ 6,162 $ 5,946 $ 216 3.6 % The increase in noninterest expense during the three months ended March 31, 2021 compared to the same period in 2020 was primarily due to increases of $409,000 in salaries and benefits and $209,000 in data processing expense, partially offset by a $188,000 decrease in operation expense and a $149,000 decrease in regulatory assessments. Salaries and benefits increased primarily due to discretionary bonuses paid for added efforts associated with the Company's COVID-19 response and implementation and execution of the SBA's PPP, higher stock compensation expense related to the vesting of stock awards during the quarter ended March 31, 2021, and higher nonqualified deferred compensation. Data processing expense increased due to technology investments and variable costs associated with loan origination system activity. Operations expense decreased primarily due to lower loan expenses and office operations, and regulatory assessments decreased as the three months ended March 31, 2020 included regulatory examination costs. The efficiency ratio for the quarter ended March 31, 2021 was 66.69%, compared to 79.95% for the quarter ended March 31, 2020. The improvement in the efficiency ratio was primarily due to higher noninterest income for the three months ended March 31, 2021. Income Tax Expense . We incurred income tax expense of $627,000 for the three months March 31, 2021, as compared $260,000 for the same period in 2020. The effective tax rates for the three months ended March 31, 2021 and March 31, 2020 were 20.37% and 20.95%, respectively. 39 Liquidity and Capital Resources The Management Discussion and Analysis in Item 7 of the Company’s 2020 Form 10-K contains an overview of Sound Financial Bancorp’s and the Bank’s liquidity management, sources of liquidity and cash flows. This discussion updates that disclosure for the three months ended March 31, 2021. The Bank’s primary sources of funds are deposits, principal and interest payments on loans and borrowings. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. The Bank’s primary investing activity is loan originations. The Bank maintains liquidity levels it believes to be adequate to fund loan commitments, investment opportunities, deposit withdrawals and other financial commitments. At March 31, 2021, the Bank had $278.7 million in cash and investment securities available-for-sale and $10.7 million in loans held-for-sale generally available for its cash needs. Also, at March 31, 2021, the Bank had the ability to borrow an additional $204.8 million in FHLB advances based on existing collateral pledged, and could access $23.7 million through the Federal Reserve’s Discount Window. Additionally, as of March 31, 2021, the Bank was approved to utilize the PPPLF. The Bank may utilize the PPPLF pursuant to which the Bank will pledge PPP loans at face value as collateral to obtain FRB non-recourse loans. During the quarter ended and as of March 31, 2021, the Bank did not utilize the PPPLF as it held a substantial cash and cash equivalent position as a result of PPP disbursed funds remaining unused in borrower deposit accounts and due to deposit customers increasing their balances due to COVID-19. At March 31, 2021, we also had available a total of $20.0 million in credit facilities with other financial institutions, with no balance outstanding. The Bank uses these sources of funds primarily to meet ongoing commitments, pay maturing deposits and fund withdrawals and loan commitments. At March 31, 2021, outstanding loan commitments, including unused lines and letters of credit totaled $83.0 million, including $27.8 million of undisbursed construction and land loans. Certificates of deposit scheduled to mature in one year or less at March 31, 2021, totaled $133.9 million. Cash and cash equivalents increased $75.8 million to $269.6 million as of March 31, 2021, from $193.8 million as of December 31, 2020. Net cash provided by operating activities was $7.8 million for the three months ended March 31, 2021. Net cash used in investing activities totaled $54,000 during the three months ended March 31, 2021 and consisted primarily of increases in proceeds from principal payments. The $68.0 million of net cash provided by financing activities during the three months ended March 31, 2021 primarily was the result of a $68.7 million net increase in deposits. At March 31, 2021, the Company, on an unconsolidated basis, had $5.8 million in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs. The Company’s principal source of liquidity is dividends and ESOP loan repayments from the Bank. The long-term ability of the Company to pay dividends to its stockholders is based primarily upon the ability of the Bank to make capital distributions to the Company. So long as the Bank remains well capitalized after each capital distribution (as evidenced by maintaining a Community Bank Leverage Ratio ("CBLR") greater than the required percentage), as discussed below, and operates in a safe and sound manner, it is management's belief that its banking regulators will continue to allow the Bank to distribute its earnings to the Company, although no assurance can be given in this regard. Except as set forth above, management is not aware of any trends, events, or uncertainties that will have, or that are reasonably likely to have a material impact on liquidity, capital resources or operations. In the normal course of operations, we engage in a variety of financial transactions that are not recorded in our financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit. A summary of our off-balance sheet loan commitments at March 31, 2021, is as follows (in thousands): March 31, 2021 Commitments to make loans $ 30,312 Unfunded construction commitments 27,844 Unused lines of credit 24,733 Irrevocable letters of credit 80 Total loan commitments $ 82,969 Regulatory Capital Consistent with our goal to operate a sound and profitable financial organization, we actively seek to maintain a well-capitalized status for the Bank per the regulatory framework for prompt corrective action ("PCA"). Qualifying institutions that elect to use the CBLR framework, such as the Bank and the Company, that maintain the required minimum leverage ratio will 40 be considered to have satisfied the generally applicable risk-based and leverage capital requirements in the regulatory agencies' capital rules, and to have met the capital requirements for the well capitalized category under the agencies’ PCA framework. As of March 31, 2021, both the Bank’s and Company’s CBLR was 10.32%, which exceeded the minimum requirements. See "Part I, Item 1. Business – Regulation of Sound Community Bank – Capital Rules " in the Company's 2020 Form 10-K for additional information related to regulatory capital. Item 3. Quantitative and Qualitative Disclosures About Market Risk The Company provided information about market risk in Item 7A of its 2020 Form 10-K. There have been no material changes in our market risk since our 2020 Form 10-K.