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: • potential adverse impacts to economic conditions in the Company’s local market areas, other markets where the Company has lending relationships, or other aspects of the Company’s business operations, or financial markets, generally, resulting from the COVID-19 pandemic, and any governmental or societal responses thereto; • 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; • the future of the London Interbank Offered Rate (“LIBOR”), and the 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; • legislative or regulatory changes that adversely affect our business, including as a result of COVID-19, and the availability of resources to address such changes; • 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; 31 • 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; 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, 2021 (“2021 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, 2022, Sound Financial Bancorp, on a consolidated basis, had assets of $958.9 million, net loans held-for-portfolio of $703.1 million, deposits of $836.1 million and stockholders’ equity of $93.9 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, other-than-temporary impairment, mortgage servicing rights, other real estate owned and deferred tax asset accounts are described in our 2021 Form 10-K. 32 COVID-19 Impact to the Company The Company is actively monitoring and responding to the effects of the rapidly-changing COVID 19 pandemic. The Company maintains its commitment to supporting its community and customers during the COVID-19 pandemic and remains focused on keeping its employees safe and the Bank running effectively to serve its customers. As of March 31, 2022, all banking branches are open with normal hours and substantially all employees have returned to their routine working environments. The Bank will continue to monitor branch access and occupancy levels in relation to cases and close contact scenarios and follow governmental restrictions and public health authority guideline. Comparison of Financial Condition at March 31, 2022 and December 31, 2021 General. Total assets increased $39.2 million, or 4.3%, to $958.9 million at March 31, 2022 from $919.7 million at December 31, 2021. The increase was primarily a result of increases in cash and cash equivalents, investment securities, and loans held-for-portfolio. Cash and Securities. Cash and cash equivalents increased $13.5 million, or 7.4%, to $197.1 million at March 31, 2022 from $183.6 million at December 31, 2021 primarily due to increases in noninterest-bearing and interest-bearing deposits, partially related to temporary increases in lawyer trust accounts. These increases were partially offset by the redeployment of excess liquidity into higher earning loans and investments. Investment securities increased $4.0 million, or 47.8%, to $12.4 million at March 31, 2022, compared to $8.4 million at December 31, 2021. Held-to-maturity securities totaled $2.2 million at March 31, 2022, compared to none at December 31, 2021, due to the purchase of $2.2 million in municipal bonds and agency mortgage-backed securities. Available-for-sale securities totaled $10.2 million at March 31, 2022, compared to $8.4 million at December 31, 2021, and $9.1 million at March 31, 2021. The increase in available-for-sale securities was primarily due the purchase of $2.8 million in municipal bonds and agency mortgage-backed securities, partially offset by regularly scheduled payments and maturities. Loans. Loans held-for-portfolio, net, increased $23.0 million, or 3.4%, to $703.1 million at March 31, 2022 from $680.1 million at December 31, 2021, driven by increases across all loan classes, excluding commercial business loans. The increases primarily resulted from focused marketing campaigns, increased utilization of digital marketing tools and the addition of experienced lending staff during 2021. These increases were partially offset by the decrease in commercial business loans resulting from the forgiveness by the SBA. The following table reflects the changes in the loan mix of our loan portfolio at March 31, 2022, as compared to December 31, 2021 (dollars in thousands): March 31, 2022 December 31, 2021 Amount Change Percent Change One-to-four family $ 221,832 $ 207,660 $ 14,172 6.8 % Home equity 13,798 13,250 548 4.1 Commercial and multifamily 279,892 278,175 1,717 0.6 Construction and land 70,402 63,105 7,297 11.6 Manufactured homes 22,179 21,636 543 2.5 Floating homes 59,784 59,268 516 0.9 Other consumer 18,370 16,748 1,622 9.7 Commercial business 24,452 28,026 (3,574) (12.8) Premiums for purchased loans 788 897 (109) (12.1) Deferred loan fees (2,012) (2,367) 355 (15.0) Total loans held-for-portfolio, gross 709,485 686,398 23,087 3.4 Allowance for loan losses (6,407) (6,306) (101) 1.6 Total loans held-for-portfolio, net $ 703,078 $ 680,092 $ 22,986 3.4 % The increase in one-to-four family loans was driven primarily by the origination of $13.0 million in conforming and non-conforming jumbo loans during the first quarter of 2022 and the origination of $8.5 million of conforming and non-conforming conventional loans in our portfolio. The increase in construction and land loans during the period was primarily due to disbursement of advances on previously originated loans and the increase in other consumer loans was primarily a result of larger loan sizes. The decrease in our commercial business loan portfolio was primarily due to SBA loan forgiveness. At March 31, 2022, our loan portfolio, net of deferred loan fees, remained well-diversified. Commercial and multifamily real estate loans accounted for 39.4% of total loans, one-to-four family loans, including home equity loans accounted for 33.1% of total 33 loans, commercial business loans accounted for 3.4% of total loans, and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans accounted for 14.2% of total loans at March 31, 2022. Construction and land loans accounted for 9.9% of total loans at March 31, 2022. Loans held-for-sale totaled $1.3 million at March 31, 2022, compared to $3.1 million at December 31, 2021. The decrease was primarily due to a decline in mortgage originations reflecting reduced refinance activity. 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, 2022 2021 Balance at beginning of period $ 6,306 $ 6,000 Charge-offs (32) (71) Recoveries 8 6 Net charge-offs (24) (65) Provision for loan losses during the period 125 — Balance at end of period $ 6,407 $ 5,935 Our allowance for loan losses increased $101 thousand, or 1.6%, to $6.4 million at March 31, 2022, from $6.3 million at December 31, 2021. Specific loan loss reserves decreased to $261 thousand at March 31, 2022, compared to $293 thousand at December 31, 2021, while general loan loss reserves remained mostly flat at $5.6 million at both March 31, 2022 and December 31, 2021 and the unallocated reserve increased to $517 thousand at March 31, 2022, compared to $395 thousand at December 31, 2021. The increase in the unallocated reserve was primarily a result of the increase in the loan portfolio at March 31, 2022. The $2.1 million balance of PPP loans was omitted from the calculation for the allowance for loan losses at March 31, 2022, as these loans are 100% guaranteed by the SBA and management expects that the majority of the remaining 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, 2022 totaled $24 thousand compared to net charge-offs of $65 thousand for the three months ended March 31, 2021. At March 31, 2022, the allowance for loan losses as a percentage of total loans and nonperforming loans was 0.90% and 134.97%, respectively, compared to 0.92% and 113.58%, respectively, at December 31, 2021. See “Comparison of Results of Operations for the Three Months Ended March 31, 2022 and 2021 — Provision for Loan Losses.” The following tables show certain credit ratios at and for the periods indicated and each component of the ratio's calculations. March 31, 2022 December 31, 2021 Allowance for loan losses as a percentage of total loans outstanding at period end 0.90 % 0.92 % Allowance for loan losses 6,407 6,306 Total loans outstanding 710,709 687,868 Non-accrual loans as a percentage of total loans outstanding at period end 0.67 % 0.81 % Total nonaccrual loans 4,747 5,552 Total loans outstanding 710,709 687,868 Allowance for loan losses as a percentage of non-accrual loans at period end 134.96 % 113.58 % Allowance for loan losses 6,407 6,306 Total nonaccrual loans 4,747 5,552 34 Three Months Ended March 31, 2022 2021 ($ in thousands) Net charge-offs during period to average loans outstanding: One-to-four family: — % 0.19 % Net charge-offs — 62 Average loans outstanding 211,315 130,521 Home equity: (0.05) % — % Net (recoveries) (2) — Average loans outstanding 13,449 14,532 Commercial and multifamily real estate: — % — % Net charge-offs — — Average loans outstanding 279,237 256,478 Construction and land: — % — % Net charge-offs — — Average loans outstanding 65,314 63,906 Manufactured homes: — % (0.02) % Net (recoveries) — (1) Average loans outstanding 21,896 20,692 Floating homes: — % — % Net charge-offs — — Average loans outstanding 59,797 39,692 Other consumer: 0.49 % 0.16 % Net charge-offs 21 6 Average loans outstanding 16,892 14,804 Commercial business: 0.09 % (0.01) % Net charge-offs/(recoveries) 5 (2) Average loans outstanding 25,657 75,108 Total loans: 0.01 % 0.04 % Net charge-offs 24 65 Average loans outstanding 693,556 615,735 Mortgage Servicing Rights. The fair value of mortgage servicing rights was $4.7 million at March 31, 2022, an increase of $395 thousand, or 9.2%, from $4.3 million at December 31, 2021. 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, 2022, nonperforming assets totaled $5.4 million, or 0.56% of total assets, compared to $6.2 million, or 0.68% of total assets at December 31, 2021. 35 The table below sets forth the amounts and categories of nonperforming assets at the dates indicated (dollars in thousands): Nonperforming Assets March 31, 2022 December 31, 2021 Amount Change Percent Change Nonaccrual loans $ 4,474 $ 5,130 $ (656) (12.8) % Nonperforming TDRs 273 422 (149) (35.3) Total nonperforming loans 4,747 5,552 (805) (14.5) OREO and repossessed assets 659 659 — — Total nonperforming assets $ 5,406 $ 6,211 $ (805) (13.0) % Nonperforming loans decreased $805 thousand, or 14.5%, to $4.7 million at March 31, 2022 from $5.6 million at December 31, 2021. The decrease in nonperforming assets primarily was due to decreases in one-to-four family loans and floating homes. The percentage of nonperforming loans to total loans was 0.67% at March 31, 2022, compared to 0.81% of total loans at December 31, 2021. Deposits and Borrowings. Total deposits increased $37.8 million, or 4.7%, to $836.1 million at March 31, 2022 from $798.3 million at December 31, 2021. The increase was primarily a result of deposit growth from specialty business relationships and temporary increases in lawyer trust accounts, partially offset by a managed run-off of higher costing maturing certificates of deposits. We continue our efforts to grow noninterest-bearing deposits, which increased $18.3 million, or 9.6%, to $208.8 million at March 31, 2022, compared to $190.5 million at December 31, 2021. Noninterest-bearing deposits represented 25.0% of total deposits at March 31, 2022, compared to 23.9% at December 31, 2021. 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, 2022 December 31, 2021 Amount Wtd. Avg. Rate Amount Wtd. Avg. Rate Noninterest-bearing demand $ 203,819 — % $ 187,684 — % Interest-bearing demand 333,449 0.14 307,061 0.19 Savings 106,217 0.05 103,401 0.08 Money market 89,164 0.17 91,670 0.21 Time deposits 98,493 1.13 105,722 1.57 Escrow (1) 4,949 — 2,782 — Total deposits $ 836,091 0.21 % $ 798,320 0.41 % (1) Escrow balances shown in noninterest-bearing deposits on the consolidated balance sheets. Scheduled maturities of time deposits at March 31, 2022, are as follows (in thousands): Year Ending December 31, Amount 2022 $ 43,253 2023 42,326 2024 5,685 2025 4,695 2026 2,229 Thereafter 305 $ 98,493 Savings, demand, and money market accounts have no contractual maturity. Certificates of deposit have maturities of five years or less. The aggregate amount of time deposits in denominations of more than $250,000 at March 31, 2022 and December 31, 2021, totaled $18.7 million and $19.1 million, respectively. Deposit amounts in excess of $250,000 are not federally insured. 36 There were no outstanding FHLB advances at March 31, 2022 and December 31, 2021. Subordinated notes, net totaled $11.6 million at March 31, 2022 and December 31, 2021. Stockholders’ Equity. Total stockholders’ equity increased $492 thousand, or 0.5%, to $93.9 million at March 31, 2022, from $93.4 million at December 31, 2021. This increase primarily reflects $1.7 million in net income for the three months ended March 31, 2022, partially offset by the payment of cash dividends of $709 thousand in dividends to common stockholders during the three months ended March 31, 2022 and an unrealized loss, net of tax, of $608 thousand on our available-for-sale securities as a result of declining market values. 37 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). Three Months Ended March 31, 2022 2021 Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Interest-earning assets: Loans receivable $ 694,920 $ 8,075 4.71 % $ 628,397 $ 7,886 5.09 % Investments, cash and cash equivalents 189,618 138 0.30 228,752 113 0.20 Total interest-earning assets (1) 884,538 8,213 3.77 857,149 7,999 3.78 Interest-bearing liabilities: Savings and money market accounts 196,128 30 0.06 155,854 64 0.17 Demand and NOW accounts 315,181 122 0.16 248,887 185 0.30 Certificate accounts 102,315 275 1.09 214,517 1,046 1.98 Subordinated notes 11,637 168 5.85 11,596 168 5.88 Total interest-bearing liabilities 625,261 595 0.39 % 630,854 1,463 0.94 % Net interest income $ 7,618 $ 6,536 Net interest rate spread 3.38 % 2.84 % Net earning assets $ 259,277 $ 226,295 Net interest margin 3.49 % 3.09 % Average interest-earning assets to average interest-bearing liabilities 141.47 % 135.87 % Total deposits 808,180 427 0.21 % 780,375 1,295 0.67 % Total funding (2) 819,817 595 0.29 % 791,971 1,463 0.75 % (1) Calculated net of deferred loan fees, loan discounts and loans in process. (2) Total funding is the sum of average interest-bearing liabilities and average noninterest-bearing deposits. The cost of total funding is calculated as annualized total interest expense divided by average total funding. 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). 38 Three Months Ended March 31, 2022 vs. 2021 Increase (Decrease) due to Total Increase (Decrease) Volume Rate Interest-earning assets: Loans receivable $ 773 $ (584) $ 189 Investments, cash and cash equivalents (28) 53 25 Total interest-earning assets 745 (531) 214 Interest-bearing liabilities: Savings and Money Market accounts 6 (40) (34) Demand and NOW accounts 26 (89) (63) Certificate accounts (302) (469) (771) Subordinated notes 1 (1) — Total interest-bearing liabilities $ (269) $ (599) $ (868) Change in net interest income $ 1,082 Comparison of Results of Operation for the Three Months Ended March 31, 2022 and 2021 General. Q1 2022 vs Q1 2021 . Net income decreased $728 thousand, or 29.7%, to $1.7 million, or $0.65 per diluted common share, for the three months ended March 31, 2022, compared to $2.5 million, or $0.93 per diluted common share, for the three months ended March 31, 2021. The decrease in net income was primarily the result of lower interest income earned on loans, coupled with lower noninterest income and higher noninterest expense, partially offset by lower interest expense paid on deposits. Interest Income Q1 2022 vs Q1 2021 . Interest income increased $214 thousand, or 2.7%, to $8.2 million for the three months ended March 31, 2022, from $8.0 million for the three months ended March 31, 2021, primarily due to higher average loan balances, partially offset by a 38 basis point decline in the average loan yield. Interest income on loans increased $189 thousand, or 2.4%, to $8.1 million for the three months ended March 31, 2022, compared to $7.9 million for the three months ended March 31, 2021. The average balance of total loans was $694.9 million for the three months ended March 31, 2022, compared to $628.4 million for the three months ended March 31, 2021 resulting from increased balances in all loan categories, except for commercial business loans which declined as a result of the SBA’s repayment of PPP loans. The average yield on total loans was 4.71% for three months ended March 31, 2022, compared to 5.09% for the three months ended March 31, 2021. The average yield on total loans decreased primarily due to the decrease in the recognition of net deferred fees due to loan repayments from SBA loan forgiveness of PPP loans during the period and lower rates on new originations. Interest income included $84 thousand in fees earned related to PPP loans in the three months ended March 31, 2022, compared to $768 thousand in the same period a year ago. For the three months ended March 31, 2022, the average balance of PPP loans was $3.1 million and the average yield on PPP loans was 11.05%, including the recognition of the net deferred fees, with a positive impact on loan yield of three basis points. 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 5.78%, including the recognition of deferred fees, with a positive impact on loan yield of six basis points. At March 31, 2022, PPP deferred loan origination fees of $60 thousand 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 increased $25 thousand, or 22.1%, to $138 thousand for the three months ended March 31, 2022, compared to $113 thousand for the three months ended March 31, 2021. The increase in the interest income on investment securities and cash and cash equivalents was due to higher average yields, partially offset by lower average balances. The average balance on investments and cash and cash equivalents was $189.6 million for the three months ended March 31, 2022, compared to $228.8 million for the three months ended March 31, 2021. The decrease was due to lower average cash balances as we redeployed funds into higher interest-earning assets. The average yield on investments and cash and cash equivalents increased to 0.30% for the three months ended March 31, 2022, compared 39 to 0.20% for the three months ended March 31, 2021, as a result of the rising interest rate environment and the increase in the average balance of our investment securities portfolio. Interest Expense Q1 2022 vs Q1 2021 . Interest expense decreased $868 thousand, or 59.3%, to $595 thousand for the three months ended March 31, 2022, from $1.5 million for the three months ended March 31, 2021. Interest expense on deposits decreased $868 thousand, or 67.0%, to $427 thousand for the three months ended March 31, 2022, compared to $1.3 million for the same period a year ago. The decrease was primarily the result of a 46 basis point decline in the average cost of deposits reflecting reduced rates paid on all deposits and a $112.2 million, or 52.3%, decline in the average balance of certificate accounts, partially offset by a $106.6 million, or 26.3%, increase in the average balance of interest-bearing deposits other than certificate accounts. In addition, total deposit costs were favorably impacted by a $33.4 million increase in the average balance of noninterest bearing deposits to $194.6 million for the three months ended March 31, 2022, compared to $161.1 million for the same period last year. The increase in the average balance of noninterest bearing deposits contributed to the 46 basis point decrease in the average cost of total deposits to 0.21% for the quarter ended March 31, 2022, from 0.67% for the quarter ended March 31, 2021. Net Interest Income. Q1 2022 vs Q1 2021 . Net interest income increased $1.1 million, or 16.6%, to $7.6 million for the three months ended March 31, 2022, from $6.5 million for the three months ended March 31, 2021. Our net interest margin was 3.49% and 3.09% for the three months ended March 31, 2022 and 2021, respectively. The increase in net interest income primarily resulted from the decline in the average rate paid on deposits and, to a lesser extent, higher interest income. The increase in net interest margin was primarily due to the decline in rates paid on interest-bearing liabilities as a result of the managed runoff of higher costing deposits. During the first quarter of 2022, 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 to the net interest margin of three basis points, compared to a positive impact of 18 basis points during the quarter ended March 31, 2021. Provision 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. A provision for loan losses of $125 thousand was recorded for the three months ended March 31, 2022, as compared to no provision for loan losses for the three months ended March 31, 2021. The increase in the provision for loan losses resulted primarily from the increase in our loan portfolio, partially offset by a shift in the loan portfolio composition to loan types requiring a lower general loan allowance. Our allowance for loan losses as of March 31, 2022, not only reflects probable and inherent credit losses based upon the economic conditions that existed as of March 31, 2022, but also reflects the inherent uncertainty related to the economic environment as a result of local, national and global events. Net charge-offs for the three months ended March 31, 2022 totaled $24 thousand, compared to net charge-offs of $65 thousand for the three months ended March 31, 2021. 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. 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. 40 Noninterest Income. Noninterest income decreased $1.2 million, or 43.7%, to $1.5 million for the three months ended March 31, 2022, as compared to $2.7 million for the three months ended March 31, 2021, as reflected below (dollars in thousands): Three Months Ended March 31, Amount Change Percent Change 2021 2020 Service charges and fee income $ 549 $ 532 $ 17 3.2 % Earnings on cash surrender value of BOLI 21 82 (61) (74.4) Mortgage servicing income 320 312 8 2.6 Fair value adjustment on mortgage servicing rights 268 (275) 543 (197.5) Net gain on sale of loans 365 2,053 (1,688) (82.2) Total noninterest income $ 1,523 $ 2,704 $ (1,181) (43.7) % The decrease in noninterest income during the three months ended March 31, 2022 compared to the same period in 2021 was primarily due to a $1.7 million decrease in net gain on sale of loans due to a decline in both the amount of loans originated for sale and gross margins for loans sold, partially offset by a $543 thousand improvement in the fair value adjustment on mortgage servicing rights. Loans sold during the quarter ended March 31, 2022, totaled $12.2 million, compared to $68.1 million during the quarter ended March 31, 2021. The improvement in the fair value adjustment on mortgage servicing rights resulted from loan prepayment speeds slowing during the quarter as mortgage interest rates moved slightly higher. Noninterest Expense. Noninterest expense increased $673 thousand, or 10.9%, to $6.8 million during the three months ended March 31, 2022, compared to $6.2 million during the three months ended March 31, 2021, as reflected below (dollars in thousands): Three Months Ended March 31, Amount Change Percent Change 2022 2021 Salaries and benefits $ 4,167 $ 3,644 $ 523 14.4 % Operations 1,314 1,206 108 9.0 Regulatory assessments 101 101 — — Occupancy 432 448 (16) (3.6) Data processing 821 779 42 5.4 Net gain on OREO and repossessed assets — (16) 16 (100.0) Total noninterest expense $ 6,835 $ 6,162 $ 673 10.9 % The increase in noninterest expense during the three months ended March 31, 2022 compared to the same period in 2021 was primarily due to an increase in salaries and benefits of $523 thousand as a result of higher wages and incentive compensation, higher medical expenses and lower deferred compensation, partially offset by a decrease in commission expense related to a decline in mortgage activity in first quarter of 2022 as compared to the same period in 2021. Operations expense also increased $108 thousand due to increases in various accounts including marketing expenses, office related expenses, and professional fees. The efficiency ratio for the quarter ended March 31, 2022 was 74.77%, compared to 66.69% for the quarter ended March 31, 2021. The weakening in the efficiency ratio for the current quarter compared to the same period in the prior year is primarily due to higher noninterest expense and lower revenues. Income Tax Expense . Income tax expense declined to $458 thousand from $627 thousand for the three months ended March 31, 2022 and March 31, 2021, respectively, primarily due to lower pre-tax income. The effective tax rate for both the three months ended March 31, 2022 and 2021 was 21.0% and 20.4%. 41 Capital and Liquidity The Management Discussion and Analysis in Item 7 of the Company’s 2021 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, 2022. Capital. Shareholders’ equity totaled $93.9 million at March 31, 2022 and $93.4 million at December 31, 2021. In addition to net income of $1.7 million, other sources of capital during the three months ended March 31, 2022 included $43 thousand in proceeds from stock option exercises and $203 thousand related to stock-based compensation. Uses of capital during the three months ended March 31, 2022 included $709 thousand of dividends paid on common stock, other comprehensive loss, net of tax, of $608 thousand and $160 thousand of stock repurchases. We paid regular quarterly dividends of $0.17 per common share and a special dividend of $0.10 per common share during the three months ended March 31, 2022 and 2021, which equates to a dividend payout ratio of 41.15% in 2022 and 28.64% in 2021. The Company currently expects to continue the current practice of paying quarterly cash dividends on common stock subject to the Board of Directors' discretion to modify or terminate this practice at any time and for any reason without prior notice. Assuming continued payment of the regular quarterly cash dividend during the remainder of 2022 at this rate of $0.17 per share, our average total dividend paid each quarter would be approximately $445 thousand based on the number of our current outstanding shares (which assumes no increases or decreases in the number of shares, except in connection with the anticipated vesting of currently outstanding equity awards). The dividends, if any, we may pay may be limited as more fully discussed under “Business—How We Are Regulated—Limitations on Dividends and Stock Repurchases” contained in Item 1, Part I of the Company’s 2021 Form 10-K. Stock Repurchase Plans. From time to time, our board of directors has authorized stock repurchase plans. In general, stock repurchase plans allow us to proactively manage our capital position and return excess capital to shareholders. Shares purchased under such plans may also provide us with shares of common stock necessary to satisfy obligations related to stock compensation awards. The Company’s current stock repurchase program authorizes the Company to repurchase, during the period ending October 29, 2022, up to $2.0 million of the Company’s outstanding shares in the open market, based on prevailing market prices, or in privately negotiated transactions, or pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 of the Securities and Exchange Commission. The timing, volume and price of purchases are made at our discretion, and are contingent upon our overall financial condition, as well as general market conditions. As of May 6, 2022, approximately $1.5 million of our common stock remains available for repurchase under this program. See “Unregistered Sales of Equity Securities and Use of Proceeds” contained in Item 2, Part II of this Form 10-Q for additional information relating to stock repurchases. Liquidity. Liquidity measures the ability to meet current and future cash flow needs as they become due. The liquidity of a financial institution reflects its ability to meet loan requests, to accommodate possible outflows in deposits and to take advantage of interest rate market opportunities. The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets and its access to alternative sources of funds. The objective of our liquidity management is to manage cash flow and liquidity reserves so that they are adequate to fund our operations and to meet obligations and other commitments on a timely basis and at a reasonable cost. We seek to achieve this objective and ensure that funding needs are met by maintaining an appropriate level of liquid funds through asset/liability management, which includes managing the mix and time to maturity of financial assets and financial liabilities on our balance sheet. Our liquidity position is enhanced by our ability to raise additional funds as needed in the wholesale markets. Asset liquidity is provided by liquid assets which are readily marketable or pledgeable or which will mature in the near future. Liquid assets generally include cash, interest-bearing deposits in banks, securities available for sale, maturities and cash flow from securities, sales of fixed rate residential mortgage loans in the secondary market and federal funds sold. Liability liquidity generally is provided by access to funding sources which include core deposits and advances from the FHLB and other borrowing relationships with third party financial institutions. Our liquidity position is continuously monitored and adjustments are made to the balance between sources and uses of funds as deemed appropriate. Liquidity risk management is an important element in our asset/liability management process. We regularly model liquidity stress scenarios to assess potential liquidity outflows or funding problems resulting from economic disruptions, volatility in the financial markets, unexpected credit events or other significant occurrences deemed problematic by management. These scenarios are incorporated into our contingency funding plan, which provides the basis for the identification of our liquidity needs. 42 As of March 31, 2022, we had $207.3 million in cash and available-for-sale investment securities and $1.3 million in loans held-for-sale. At March 31, 2022, we had the ability to borrow $95.8 million in FHLB advances and access to additional borrowings of $20.5 million through the Federal Reserve's discount window, in each case subject to certain collateral requirements. We had no outstanding advances or borrowings with the FHLB or Federal Reserve at March 31, 2022. In addition, we also had available $20.0 million of credit facilities with PCBB, with no balance outstanding at March 31, 2022. Subject to market conditions, we expect to utilize these borrowing facilities from time to time in the future to fund loan originations and deposit withdrawals, to satisfy other financial commitments, repay maturing debt and to take advantage of investment opportunities to the extent feasible. As of March 31, 2022, management is not aware of any events that are reasonably likely to have a material adverse effect on our liquidity, capital resources or operations. In addition, management is not aware of any regulatory recommendations regarding liquidity that would have a material adverse effect on us. For additional details, see “Note 8—Borrowings, FHLB Stock and Subordinated Notes” in the Notes to Consolidated Financial Statements contained in "Item 1. Financial Statements and Supplementary Data" of this Form 10-Q. In the ordinary course of business, we have entered into contractual obligations and have made other commitments to make future payments. Refer to the accompanying notes to consolidated financial statements elsewhere in this report for the expected timing of such payments as of March 31, 2022. These include payments related to (i) long-term borrowings (Note 8—Borrowings, FHLB Stock and Subordinated Notes) and (ii) operating leases (Note 11—Leases). Refer to the Financial Condition discussion within this Item 2 for the expected timing of such payments as of March 31, 2022 related to time deposits with stated maturity dates and the discussion below for commitments to extend credit and standby letters of credit. The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments generally represent a commitment to extend credit in the form of loans. The instruments involve, to varying degrees, elements of credit- and interest-rate risk in excess of the amount recognized in the consolidated balance sheets. The Company's exposure to credit loss, in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments as it does for on-balance-sheet instruments. Commitments to extend credit are agreements to lend to a client as long as there is no violation of any condition established by the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These commitments are not reflected in the consolidated financial statements. The Company evaluates each client's creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management's credit evaluation of the client. Financial instruments whose contract amount represents credit risk were as follow (in thousands): March 31, 2022 December 31, 2021 Residential mortgage commitments $ 10,248 $ 6,663 Unfunded construction commitments 90,619 89,797 Unused lines of credit 37,655 35,036 Irrevocable letters of credit 151 151 Total loan commitments $ 138,673 $ 131,647 Sound Financial Bancorp is a separate legal entity from Sound Community Bank and must provide for its own liquidity. In addition to its own operating expenses (many of which are paid to Sound Community Bank), Sound Financial Bancorp is responsible for paying for any stock repurchases, dividends declared to its stockholders, interest and principal on outstanding debt, and other general corporate expenses. Sound Financial Bancorp is a holding company and does not conduct operations; its sources of liquidity are generally dividends up-streamed from Sound Community Bank, interest on investment securities, if any, and borrowings from outside sources. Banking regulations may limit the dividends that may be paid to us by Sound Community Bank. See, “Business — How We Are Regulated — Limitations on Dividends and Stock Repurchases” contained in Item 1, Part I of the Company’s 2021 Form 10-K. At March 31, 2022 Sound Financial Bancorp, on an unconsolidated basis, had $3.1 million in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs. See also the "Consolidated Statements of Cash Flows" included in “Item 1. Financial Statements and Supplementary Data” of this Form 10-Q, for further information. 43 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 Community Bank Leverage Ratio, or CBLR, framework, such as the Bank and the Company, that maintain the required minimum leverage ratio will 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, 2022, the Bank and Company’s CBLR was 10.96% and 10.05%, respectively, which exceeded the minimum requirements. See "Part I, Item 1. Business – Regulation of Sound Community Bank – Capital Rules " in the Company's 2021 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 2021 Form 10-K. There have been no material changes in our market risk since our 2021 Form 10-K.