What changed in this filing

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Item 7. Management’s Discussion and Analysis

2023-03-14 compared with 2022-03-15 · 129 added, 110 removed, 355 unchanged (40% of the section changed)

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

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

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 properties and mobile home parks, and construction and land development loans.

We originated $125.6 million and $243.9 million of one-to-four family residential mortgage loans during the years ended December 31, 2022 and 2021, respectively.

We also purchased $24.1 million of one-to-four family residential mortgage loans during the year ended December 31, 2021.

During these same periods, we sold $147.4 million and $258.2 million, respectively, of one-to-four family residential mortgage loans.

We had no purchases of one-to-four family residential mortgage loans during the year ended December 31, 2022 and $24.1 million of purchases during the year ended December 31, 2021.

During those two years, we sold $20.3 million and $147.4 million, respectively, of one-to-four family residential mortgage loans.

Our strategic plan targets consumers, small- and medium-size businesses, and professionals in our market area for loans and deposits.

In pursuit of these goals and by managing the size of our loan portfolio, we focus on including a significant amount of commercial business and commercial and multifamily real estate loans in our portfolio.

A significant portion of these loans have adjustable rates, higher yields or shorter terms and higher credit risk than traditional fixed-rate mortgages.

Our commercial loan portfolio (commercial and multifamily real estate and commercial business loans) decreased to $306.2 million or 44.5% of our loan portfolio at December 31, 2021, from $330.0 million or 53.6% of our loan portfolio at December 31, 2020, as most of the PPP loans held in our commercial business loan portfolio have been repaid to us by the SBA.

In managing the size of, and concentrations within, our loan portfolio we typically focus on including a significant amount of commercial business and commercial and multifamily real estate loans.

A significant portion of our commercial business and commercial and multifamily real estate loans have adjustable rates, higher yields and shorter terms, and higher credit risk than traditional residential fixed-rate mortgage loans.

During 2022, however, due to a generally illiquid jumbo loan market, we retained a higher proportion of jumbo loans than we have historically, resulting in commercial business and commercial and multifamily real estate loans making up a lower percentage of our overall portfolio.

Our commercial loan portfolio (commercial and multifamily real estate and commercial business loans) increased to $337.2 million at December 31, 2022 from $306.2 million at December 31, 2021, but decreased as a percentage of our total loan portfolio to 38.9% from 44.5% at December 31, 2022 and 2021, respectively.

Our consumer loan portfolio, which includes manufactured and floating homes and other consumer loans, increased to $119.3 million or 13.8% of our loan portfolio at December 31, 2022, from $97.7 million or 14.2% of our loan portfolio at December 31, 2021.

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

The continuing low interest rate environment is expected to continue to put downward pressure on loan yields and the yields on other floating rate interest earning assets as well, which may adversely affect our net interest income and net interest margin in 2021.

The increasing interest rate environment is expected to continue to put downward pressure on our net gain on sale of loans, as well as increase borrowing costs which may adversely affect our net interest income and net interest margin in 2023.

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

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

An offset to net interest income is the provision for loan losses, or the recapture of the provision for loan losses, that is required to establish the allowance for loan losses at a level that adequately provides for probable losses inherent in our loan portfolio.

As our loan portfolio increases, or due to an increase for probable losses inherent in our loan portfolio, our allowance for loan losses may increase, resulting in a decrease to net interest income after the provision.

Improvements in loan risk ratings, increases in property values, or receipt of recoveries of amounts previously charged off may partially or fully offset any required increase to allowance for loan losses due to loan growth or an increase in probable loan losses.

Our provision for loan losses was $425 thousand for the year ended December 31, 2021, compared to $925 thousand for the year ended December 31, 2020, primarily due to economic improvements in our markets as initial COVID-19 restrictions implemented in the second quarter of last year have been lifted.

As our loan portfolio increases, or due to an increase for probable incurred losses in our loan portfolio, our provision for loan losses may increase, resulting in a decrease to net income.

Our provision for loan losses was $1.2 million for the year ended December 31, 2022, compared to $425 thousand for the year ended December 31, 2021, primarily due to loan growth.

Effective January 1, 2023, the Company adopted Accounting Standards Update (“ASU”) No.

2016-13, Financial Instruments - Credit Losses (Topic 326):

Measurement of Credit Losses on Financial Instruments, also known as CECL.

CECL replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses.

Adoption of this guidance is expected to result in an increase to our allowance for credit losses and reserve for unfunded commitments totaling between $1.0 million to $2.0 million in the aggregate.

This estimate may change as the Company continues to improve and refine its processes and methodology.

See “Note 2—Accounting Pronouncements Recently Issued or Adopted” in the Notes to Consolidated Financial Statements contained in “Part II.

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

Our noninterest expenses consist primarily of salaries, employee benefits, incentive pay, expenses for occupancy, online and mobile services, marketing, professional fees, data processing, charitable contributions, FDIC deposit insurance premiums and regulatory expenses.

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

Summary of Critical Accounting Policies and Estimates

Certain of our accounting policies are important to an understanding of our financial condition, since they 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.

Critical Accounting Estimates

We prepare our consolidated financial statements in accordance with GAAP.

In doing so, we have to make estimates and assumptions.

Our critical accounting estimates are those estimates that involve a significant level of uncertainty at the time the estimate was made, and changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations.

Accordingly, actual results could differ materially from our estimates.

We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis.

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 MSRs, accounting for other real estate owned, and accounting for deferred income taxes.

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

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

We have reviewed our critical accounting estimates with the audit committee of our Board of Directors.

See "Note 1—Organization and Significant Accounting Policies" in the Notes to Consolidated Financial Statements contained in "Part II.

Financial Statements and Supplementary Data" of this report on Form 10-K for a summary of significant accounting policies.

Allowance for Loan Loss.

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

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

An unallocated component is maintained to cover uncertainties that could affect

management's estimate of probable losses.

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

Management reviews the level of the allowance at least quarterly and performs a sensitivity analysis on the assumptions utilized in the estimate.

Management reviews the level of the allowance at least quarterly and performs a sensitivity analysis on the significant assumptions utilized in estimating the allowance for loan losses for collectively evaluated loans.

Utilizing a range of potential positive and negative changes to qualitative loss factors ranging from 5 to 20 basis points, the Bank's allowance for loan losses would change by a range of approximately $433 thousand to $1.7 million, respectively.

This sensitivity analysis and related range of impact on the Bank's allowance for loan losses is a hypothetical analysis and is not intended to represent management’s judgments or assumptions of qualitative loss factors that were utilized at December 31, 2022.

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

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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 future provisions will not exceed 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.

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.

Other-Than-Temporary Impairment of Securities .

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

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

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

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

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They are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled and are determined using the assets and liability method of accounting.

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

The deferred income provision represents the difference between net deferred tax asset/liability at the beginning

and end of the reported period.

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

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We are focused on monitoring existing performing loans, resolving nonperforming assets and selling foreclosed assets.

Nonperforming assets were

$6.2 million, or 0.68% of total assets, at December 31, 2021 compared to $3.5 million or 0.40% of total assets, at December 31, 2020.

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

Nonperforming assets were $3.6 million, or 0.37% of total assets, at December 31, 2022 compared to $6.2 million or 0.68% of total assets, at December 31, 2021.

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

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

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We continue to develop correspondent relationships to sell nonconforming mortgage loans servicing released.

We also intend to selectively add additional products to further diversify revenue sources and to capture more of each client's banking relationship by offering additional services to our clients.

We continue to refine our products and services for additional business and automate services, such as automating consumer loans originations this past year, in an effort to improve customer service.

We also intend to selectively add products to further diversify revenue sources and to capture more of each client's banking relationship by offering additional services.

We continue to refine our products and services for additional business and automate services, such as automating consumer loan originations this past year, in an effort to improve customer service.

We intend to further build relationships with medium and small businesses through new and improving existing service offerings, including remote deposit.

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Total deposits increased to $808.8 million at December 31, 2022, from $798.3 million at December 31, 2021.

At December 31, 2021, core deposits, which we define as our non-time deposit accounts and time deposit accounts of less than $250 thousand, increased $131.3 million to $755.2 million from $623.9 million at December 31, 2020.

As a result of the increased liquidity from core deposits, we did not borrow against our lines of credit.

At December 31, 2022, core deposits, which we define as our non-time deposit accounts and time deposit accounts of less than $250 thousand, decreased $9.5 million to $745.7 million from $755.2 million at December 31, 2021.

As a result of the decreased liquidity from core deposits, we increased our rates paid on certificates of deposit and borrowed against our FHLB lines of credit.

Maintaining Our Client Service Focus.

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

We anticipate continued organic growth as the local economy and loan demand remains strong, through our marketing efforts and as a result of the opportunities created as a result of the consolidation of financial institutions that is occurring in our market area.

We anticipate continued organic growth as the local economy and loan demand remains strong, through our marketing efforts and as a result of the opportunities created from the consolidation of financial institutions occurring in our market area.

In addition, by delivering high-quality, client-focused products and services, we expect to attract additional borrowers and depositors and thus increase our market share and revenue generation.

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Total assets $ 976,351 $ 919,691

Cash and cash equivalents 57,836 183,590

Total loans held for portfolio, net 858,382 680,092

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Available-for-sale securities, at fair value 10,207 8,419

Held-to-maturity securities, at amortized cost 2,199 —

Bank-owned life insurance ("BOLI"), net 21,314 21,095

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Total deposits 808,763 798,320

Borrowings 43,000 —

Subordinated notes, net 11,676 11,634

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Total assets increased by $56.7 million, or 6.2%, to $976.4 million at December 31, 2022, from $919.7 million at December 31, 2021.

The increase was primarily a result of an increase in loans held-for-portfolio and BOLI, partially offset by lower balances in cash and cash equivalents and decreases in loans held-for-sale.

The increase was primarily a result of an increase in loans held-for-portfolio and investment securities, partially offset by lower balances in cash and cash equivalents and decreases in loans held-for-sale.

Cash and Securities.

Cash, cash equivalents and our available-for-sale securities decreased by $12.0 million, or 5.9%, to $192.0 million at December 31, 2021 compared to the prior year.

Cash, cash equivalents, available-for-sale securities and held-to-maturity securities decreased by $121.8 million, or 63.4%, to $70.2 million at December 31, 2022 compared to the prior year.

Cash and cash equivalents decreased $125.8 million, or 68.5%, to $57.8 million due to deploying cash earning a nominal yield into higher earning loans and investments.

Available-for-sale securities, which consist of agency mortgage-backed securities and municipal bonds, decreased $1.8 million, or 17.6%, to $8.4 million at December 31, 2021, primarily due to calls of securities, regularly scheduled payments and maturities outpacing purchases of securities during the year.

Available-for-sale securities, which consist of agency mortgage-backed securities and municipal bonds, increased $1.8 million, or 21.2%, to $10.2 million at December 31, 2022, primarily due to purchases of securities during the year outpacing calls of securities and regularly scheduled payments and maturities.

Held-to-maturity securities totaled $2.2 million at December 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.

Loans held-for-portfolio, net, increased $178.3 million, or 26.2%, to $858.4 million at December 31, 2022 from $680.1 million at December 31, 2021.

Loans held-for-sale decreased to $3.1 million at December 31, 2021 from $11.6 million at December 31, 2020 primarily due to a decline in mortgage originations reflecting reduced refinance activity.

Loans held-for-sale decreased to $0 at December 31, 2022 from $3.1 million at December 31, 2021 primarily due to a decline in mortgage originations, reflecting reduced refinance activity and the timing of originations.

The following table reflects the changes in the loan mix, excluding premiums and deferred fees, of our portfolio at December 31, 2022, as compared to December 31, 2021 (dollars in thousands):

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Total loans $ 867,556 $ 687,868 $ 179,688 26.1

The largest dollar increases in the loan portfolio were in one-to-four family loans portfolio, which increased $77.0 million, or 58.9%, to $207.7 million driven largely by jumbo residential mortgages, floating home loans which increased $19.4 million, or 48.7%, to $59.3 million, and commercial and multifamily real estate loans, which increased $12.4 million or 4.7%, to $278.2 million.

These increases were partially offset by decreases in commercial business loans, which decreased $36.2 million or 56.4% to $28.0 million, resulting from the forgiveness by the SBA of $82.8 million of PPP loans, and a decrease in home

equity loans of $3.0 million, or 18.5%, to $13.3 million.

We had 32 PPP loans outstanding totaling $4.2 million as of December 31, 2021.

The largest dollar increases in the loan portfolio were in one-to-four family loans, which increased $67.0 million, or 32.3%, to $274.6 million, driven equally by jumbo and conforming residential mortgages, construction and land loans, which increased $53.8 million, or 85.2%, to $116.9 million, and commercial and multifamily real estate loans, which increased $35.2 million or 12.6%, to $313.4 million.

We also saw increases in our floating homes and manufactured housing loan portfolios.

The increase in loans held-for-portfolio primarily resulted from focused marketing campaigns, increased utilization of digital marketing tools and the addition of experienced lending staff.

These increases were partially offset by a decrease in commercial business loans, which decreased $4.2 million or 15.0% to $23.8 million, primarily from the SBA loan forgiveness on PPP loans of $5.2 million.

We had 2 PPP loans outstanding totaling $17 thousand as of December 31, 2022.

The loan portfolio remains well-diversified with commercial and multifamily real estate loans accounting for 36.1% of the portfolio, one-to-four family real estate loans, including home equity loans, accounting for approximately 33.9% of the portfolio and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans, accounting for 13.8% of the total loan portfolio at December 31, 2022.

Construction and land loans accounted for 13.5% of the portfolio and commercial business loans accounted for the remaining 2.7% of the portfolio at December 31, 2022.

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.

All of these loan modifications have been made in response to the COVID-19 pandemic.

At December 31, 2021, there were two one-to-four family residential loans totaling $64 thousand operating under forbearance agreements due to COVID-19.

Since these loans were performing loans that were current on their payments prior to the COVID-19 pandemic, these modifications are not considered TDRs pursuant to applicable accounting and regulatory guidance until 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.

Nonperforming Assets.

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Total nonperforming assets $ 3,618 $ 6,211 $ (2,593) (41.8) %

Nonperforming loans increased $2.7 million or 92.5%, to $5.6 million at December 31, 2021, compared to the prior year primarily due to a $2.4 million commercial and multifamily loan.

Nonperforming loans decreased $2.6 million or 46.7%, to $3.0 million at December 31, 2022, compared to the prior year-end primarily due to the payoff of a $2.3 million commercial and multifamily loan.

One-to-four family loans (consisting of nine loans) made up the largest portion of our nonperforming loan portfolio at December 31, 2022, accounting for $2.1 million or 72.2% of total nonperforming loans.

Subsequent to December 31, 2022, $1.5 million of the $2.1 million one-to-four family nonperforming loans were paid off in full.

Nonperforming loans were 0.34% of total loans at December 31, 2022, compared to 0.81% of total loans at December 31, 2021.

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Balance at end of period $ 7,599 $ 6,306

Ratio of net (charge-offs) recoveries during the period to average loans outstanding during the period (0.02) % (0.08) %

Ratio of net recoveries (charge-offs) during the period to average loans outstanding during the period 0.01 % (0.02) %

Allowance as a percentage of nonperforming loans 256.81 % 113.58 %

Allowance as a percentage of total loans (end of period) 0.88 % 0.92 %

Our allowance for loan losses increased $306 thousand, or 5.1%, to $6.3 million at December 31, 2021, from $6.0 million at December 31, 2020.

Specific loan loss reserves decreased to $293 thousand at December 31, 2021, compared to $378 thousand at December 31, 2020, while general loan loss reserves increased to $5.6 million at December 31, 2021, compared to $5.2 million at December 31, 2020 and the unallocated reserve decreased to $395 thousand at December 31, 2021, compared to $406 thousand at December 31, 2020.

The decrease in the unallocated reserve was primarily a result of the increase in the loan portfolio at December 31, 2021, partially offset by a positive adjustment in the qualitative factors applied to real estate related loans as a result of the improvement in economic conditions related to the strong housing market.

The $4.2 million balance of PPP loans was omitted from the calculation for the allowance for loan losses at December 31, 2021, 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 year ended December 31, 2021 totaled $119 thousand, compared to $565 thousand for the year ended December 31, 2020.

At December 31, 2021, the allowance for loan losses as a percentage of total loans and nonperforming loans was 0.92% and 113.59%, respectively, compared to 0.98% and 208.04%, respectively, at December 31, 2020.

Our allowance for loan losses increased $1.3 million, or 20.5%, to $7.6 million at December 31, 2022, from $6.3 million at December 31, 2021.

Specific loan loss reserves decreased to $184 thousand at December 31, 2022, compared to $293 thousand at December 31, 2021, while general loan loss reserves increased to $6.9 million at December 31, 2022, compared to $5.6 million at December 31, 2021 and the unallocated reserve increased to $488 thousand at December 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 December 31, 2022, partially offset by a negative adjustment in the qualitative factors applied to construction loans and manufactured homes loans as a result of the rising interest rate environment.

Total deposits increased $10.4 million, or 1.3%, to $808.8 million at December 31, 2022 from $798.3 million at December 31, 2021.

The increase was due primarily due to higher balances in existing client accounts, developing further relationships with PPP borrowers who were not previously clients, as well as 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 $58.0 million, or 43.8%, to $190.5 million at December 31, 2021, compared to $132.5 million at December 31, 2020.

Noninterest-bearing deposits represented 23.9% of total deposits at December 31, 2021, compared to 17.7% at December 31, 2020.

The increase was primarily due to an increase in certificate accounts, which was primarily used to fund organic loan growth in 2022.

While we continue our efforts to grow noninterest-bearing deposits, the increasing interest rate environment has increased competition for lower interest-bearing deposits and clients have transitioned funds back into higher yielding accounts.

As a result, our noninterest-bearing demand balances (including escrow accounts) decreased $17.3 million, or 9.1%, to $173.2 million at December 31, 2022, compared to $190.5 million at December 31, 2021.

Noninterest-bearing (including escrow accounts) deposits represented 21.4% of total deposits at December 31, 2022, compared to 23.9% at December 31, 2021.

A summary of deposit accounts with the corresponding weighted-average cost at December 31, 2022 and 2021 is presented below (dollars in thousands):

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Certificates of deposit 210,305 0.97 105,722 1.57

Escrow 2,782 — 3,191 —

2,647 — 2,782 —

Total $ 808,763 0.37 % $ 798,320 0.41 %

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

FHLB advances remained at zero throughout 2021, as we utilized our increase in deposits for funding needs.

FHLB advances increased to $43.0 million at December 31, 2022, reaching as high as $114 million during 2022, as we utilized our FHLB line of credit to offset the decrease in deposits for funding needs.

There were no FHLB advances at December 31, 2021.

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

Subordinated notes, net totaled $11.6 million at each of December 31, 2021 and 2020.

Subordinated notes, net totaled $11.7 million and $11.6 million at December 31, 2022 and 2021, respectively.

For additional information regarding our borrowings, see "Note 10—Borrowings, FHLB Stock and Subordinated Notes" in the Notes to Consolidated Financial Statements contained in "Part II.

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Total stockholders’ equity increased $4.3 million, or 4.7%, to $97.7 million at December 31, 2022, from $93.4 million at December 31, 2021.

This increase primarily reflects $9.2 million in net income for the year ended December 31, 2021, partially offset by the payment of cash dividends of $2.0 million to common stockholders during the year ended December 31, 2021.

This increase primarily reflects $8.8 million in net income for the year ended December 31, 2022, partially offset by the payment of cash dividends of $2.0 million to common stockholders, the repurchase of $1.7 million of common stock and unrealized losses on our securities portfolio resulting in an other comprehensive loss, net of tax benefit, of $1.3 million during the year ended December 31, 2022.

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

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Net gain on sale of loans 546 4,190

Other income — —

Total noninterest income 4,582 7,329

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Net income $ 8,804 $ 9,156

Net income increased $219 thousand, or 2.5%, to $9.2 million, or $3.46 per diluted common share, for the year ended December 31, 2021, compared to $8.9 million, or $3.42 per diluted common share, for the year ended December 31, 2020.

The increase was primarily a result of a $3.5 million decrease in interest expense and a $500 thousand decrease in the provision for loan losses for the year ended December 31, 2021, partially offset by a $1.1 million decrease in interest income and a $2.7 million increase in noninterest expense.

Net income decreased $352 thousand, or 3.8%, to $8.8 million, or $3.35 per diluted common share, for the year ended December 31, 2022, compared to $9.2 million, or $3.46 per diluted common share, for the year ended December 31, 2021.

The decrease was primarily a result of $2.7 million decrease in noninterest income, a $2.4 million increase in noninterest expense, a $546 thousand increase in interest expense and a $800 thousand increase in the provision for loan losses for the year ended December 31, 2022, partially offset by a $5.9 million increase in interest income.

Interest Income.

Interest income decreased $1.1 million, or 3.0%, to $33.9 million for the year ended December 31, 2021, from $34.9 million for the year ended December 31, 2020.

The decrease was primarily due to a 65 basis point decline in average yield on interest-earning assets and a $15.3 million decline in the average balance of outstanding loans.

Interest income on loans decreased $1.1 million, or 3.0%, to $33.4 million for the year ended December 31, 2021, compared to $34.4 million for the year ended December 31, 2020, driven by lower average total loans resulting primarily from the decline in commercial and multifamily loans and commercial business loans, partially offset a two basis points decline in the average yield on loans.

Interest income increased $5.9 million, or 17.5%, to $39.8 million for the year ended December 31, 2022, from $33.9 million for the year ended December 31, 2021.

The increase was primarily due to a $133.3 million increase in the average balance of outstanding loans, and, to a lesser extent, a 108 basis point increase in the average yield on investments and interest-bearing cash and cash equivalents.

Interest income on loans increased $4.8 million, or 14.3%, to $38.2 million for the year ended December 31, 2022, compared to $33.4 million for the year ended December 31, 2021, driven by the increase in the average balance of total loans outstanding.

This increase was partially offset a 27 basis points decline in the average yield on loans due to the decline in the percentage of higher yielding commercial and multifamily real estate and commercial business loans as a percentage of the total loan portfolio, as previously discussed, and the effects of the SBA's loan forgiveness on PPP loans.

The average balance of total loans was $783.4 million for the year ended December 31, 2022, compared to $650.0 million for the year ended December 31, 2021.

The average yield on total loans was 4.87% for the year ended December 31, 2022, compared to 5.14% for the year ended December 31, 2021.

For the year ended December 31, 2021, the average balance of PPP loans was $35.3 million and the average yield on PPP loans was 8.55%, including the recognition of the net deferred fees, with a positive impact on average loan yield of 20 basis points.

For the year ended December 31, 2020, the average balance of PPP loans was $46.7 million and the average yield on PPP loans was 4.30%, including the recognition of deferred fees, with a negative impact on average loan yield of six basis points.

Interest income included $3.0 million in fees earned related to PPP loans in the year ended December 31, 2021, compared to $2.0 million in the same period a year ago.

Interest income on the investment portfolio and cash and cash equivalents decreased $12 thousand, or 2.4%, to $485 thousand for the year ended December 31, 2021, compared to $497 thousand for the year ended December 31, 2020.

The decrease in the interest income on investment securities and cash and cash equivalents was due to lower average yields, partially offset by higher average balances.

The average yield on investments and cash and cash equivalents was 0.22% for the year ended December 31, 2021, compared to 0.48% for the year ended December 31, 2020, primarily due to the substantial increase in cash and cash equivalents earning a nominal yield.

For the year ended December 31, 2022, the average balance of PPP loans was $1.1 million and the average yield on PPP loans was 13.41%, including the recognition of the net deferred fees, with a positive impact on average loan yield of one basis point.

For the year ended December 31, 2021, the average balance of PPP loans was $35.3 million and the average yield on PPP loans was 8.55%, including the recognition of deferred fees, with a positive impact on average loan yield of 20 basis points.

Interest income included $148 thousand in fees earned related to PPP loans in the year ended December 31, 2022, compared to $3.0 million in the prior year.

Interest income on the investment portfolio and cash and cash equivalents increased $1.1 million, or 233.6%, to $1.6 million for the year ended December 31, 2022, compared to $485 thousand for the year ended December 31, 2021.

The increase was due to higher average yields, partially offset by lower average balances.

The average yield on investments and cash and cash equivalents was 1.30% for the year ended December 31, 2022, compared to 0.22% for the year ended December 31, 2021,

primarily due to the deployment of a portion of cash and cash equivalents earning a nominal yield into higher yielding investment securities and the impact of rising rates.

Interest Expense.

Interest expense decreased $3.5 million, or 46.9%, to $4.0 million for the year ended December 31, 2021, from $7.5 million for the year ended December 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 $3.7 million, or 53.1%, to $3.3 million for the year ended December 31, 2021, compared to $7.0 million for the same period a year ago.

The decrease was primarily the result of a decline in the average cost of deposits reflecting reduced market rates paid on deposits and the change in the mix of deposits reflecting the managed runoff of higher cost certificates of deposit.

The average cost of total deposits decreased 60 basis points to 0.41% for the year ended December 31, 2021, from 1.01% for the year ended December 31, 2020.

Interest expense on borrowings and subordinated notes increased $226 thousand, or 50.7%, to $672 thousand for the year ended December 31, 2021, which was comprised solely of interest expense on our subordinated notes, compared to $446 thousand for the year ended December 31, 2020, which was comprised of interest expense on subordinated notes for one quarter in 2020 and FHLB advances.

Average borrowings and subordinated notes decreased $8.3 million, to $11.6 million for the year ended December 31, 2021, which consisted solely of subordinated notes, from $20.0 million for the year ended December 31, 2020, which consisted of both FHLB advances and subordinated notes.

Interest expense increased $546 thousand, or 13.8%, to $4.5 million for the year ended December 31, 2022, from $4.0 million for the year ended December 31, 2021, primarily as a result of an increase in the average balance of borrowings, partially offset by a decrease in the average balance of certificate accounts and, to a lesser extent, lower total deposit costs.

Interest expense on deposits decreased $332 thousand, or 10.1%, to $3.0 million for the year ended December 31, 2022, compared to $3.3 million for the same period a year ago.

The decrease was primarily the result of a decline in the average cost of deposits reflecting reduced market rates paid on deposits through the middle of 2022, partially offset by the change in the mix of deposits in the latter half of 2022 reflecting the impact of the rising interest rate environment.

The average cost of total deposits decreased four basis points to 0.37% for the year ended December 31, 2022, from 0.41% for the year ended December 31, 2021.

Interest expense on borrowings and subordinated notes increased $878 thousand, or 130.7%, to $1.6 million for the year ended December 31, 2022, which was comprised of interest expense on subordinated notes and FHLB advances, compared to $672 thousand for the year ended December 31, 2021, which was comprised solely of interest expense on our subordinated notes.

Average borrowings and subordinated notes increased $27.3 million, to $38.9 million for the year ended December 31, 2022, which consisted of both FHLB advances and subordinated notes, from $11.6 million for the year ended December 31, 2021, which consisted solely of subordinated notes.

The average cost of the subordinated notes and FHLB advances was 3.98% for the year ended December 31, 2022, compared to 5.79% for the year ended December 31, 2021.

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Our net interest margin was 3.89% and 3.43% for the years ended December 31, 2022 and 2021, respectively.

The increase in net interest income primarily resulted from the decline in the average rate paid on deposits and a decline in the average balance of certificates of deposit accounts, partially offset by a decline in the average loan balance.

The decrease in net interest margin was primarily due to a decline in rates paid on interest-bearing liabilities exceeding the decline in yields earned on interest-earning assets.

During the year ended December 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 to the net interest margin of 22 basis points, compared to a positive impact of five basis points from our origination of low yielding PPP loans during the same period in 2020.

The increase in net interest income primarily resulted from the increase in the average loan balance and an increase in the average rate paid on investments and interest-bearing cash, partially offset by an increase in the average balance of and rate paid on interest-bearing liabilities and declines in the average rate paid on loans and the average balance of investments and interest-bearing cash.

The increase in net interest margin was primarily due to an increase in yields earned on interest-earning assets exceeding the increase in rates paid on interest-bearing liabilities.

During the year ended December 31, 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 one basis point, compared to a positive impact of 22 basis points from our origination of PPP loans in 2021.

Provision for Loan Losses.

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

A provision for loan losses of $425 thousand was recorded for the year ended December 31, 2021, compared to $925 thousand provision for loan losses for the year ended December 31, 2020.

The $500 thousand decrease in the provision for loan losses during the year was primarily due to a decrease in the average balance of loans held-for-portfolio between the periods, a positive adjustment to the qualitative factors applied to real estate related loans as a result of improvement in economic conditions related to the strong housing market, partially offset by a $2.7 million increase in non-performing loans from December 31, 2020.

Our allowance for loan losses as of December 31, 2021, not only reflects probable and inherent credit losses based upon the economic conditions that existed as of December 31, 2021, but also reflects the inherent economic improvements in our markets as initial COVID-19 restrictions implemented in the second quarter of last year have been lifted.

Net charge-offs for the year ended December 31, 2021 totaled $119 thousand, compared to $565 thousand for the year ended December 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, that future provisions will not exceed past provisions, or that any increased provisions which may be required in the future will not adversely impact our financial condition and results of operations.

A provision for loan losses of $1.2 million was recorded for the year ended December 31, 2022, compared to $425 thousand provision for loan losses for the year ended December 31, 2021.

The $800 thousand increase in the provision for loan losses during the year was primarily due to an increase in the average balance of loans held-for-portfolio between the periods, a negative adjustment to the qualitative factors applied to construction and manufactured homes loans as a result of inflation and the impact of the rising interest rate environment, partially offset by a $2.6 million decrease in non-performing loans from December 31, 2021.

Our allowance for loan losses as of December 31, 2022, reflects probable and inherent credit losses based upon the economic conditions that existed as of December 31, 2022.

Net recoveries for the year ended December 31, 2022 totaled $68 thousand, compared to net charge-offs of $119 thousand for the year ended December 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, that future provisions will not exceed past provisions, or that any increased provisions which may be required in the future will not materially impact our financial condition and results of operations.

Noninterest Income.

Noninterest income decreased $116 thousand, or 1.6%, to $7.3 million for the year ended December 31, 2021, as compared to $7.4 million for the year ended December 31, 2020, as reflected below (dollars in thousands):

Noninterest income decreased $2.7 million, or 37.5%, to $4.6 million for the year ended December 31, 2022, as compared to $7.3 million for the year ended December 31, 2021, as reflected below (dollars in thousands):

Year Ended December 31, Amount

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Total noninterest income $ 4,582 $ 7,329 $ (2,747) (37.5) %

The decrease in noninterest income during the year ended December 31, 2021, compared to the same period in 2020 primarily was due to the decrease in net gain on sale of loans, partially offset by improvement in the fair value adjustment on mortgage servicing rights, and increases in service charges and fees, and mortgage servicing income.

Net gain on sale of loans decreased due to the decrease in sales volume, primarily due to lower originations due to reduced refinance activity, partially offset by higher margins on sale.

The decrease in noninterest income during the year ended December 31, 2022, compared to the same period in 2021 primarily was due to the decrease in net gain on sale of loans, and decreases in mortgage servicing income and earnings on cash surrender value of BOLI, partially offset by improvement in the fair value adjustment on mortgage servicing rights, and increases in service charges and fees.

Net gain on sale of loans decreased due to the decrease in sales volume, primarily due to lower originations due to reduced refinance activity and the rising interest rate environment, in addition to lower gross margins on sale.

Loans sold during the year ended December 31, 2022, totaled $20.9 million, compared to $149.4 million during the year ended December 31, 2021.

Service charges and fee income increased primarily due to higher debit/ATM interchange fees.

Mortgage servicing income was higher as a result of our mortgage servicing portfolio increasing to $508.1 million at December 31, 2021 compared to $488.7 million at December 31, 2020.

Earnings on cash surrender value of BOLI decreased as a result of declining market values.

Mortgage servicing income was lower as a result of our mortgage servicing portfolio decreasing to $472.5 million at December 31, 2022 compared to $508.1 million at December 31, 2021.

The increase in the fair value adjustment on mortgage servicing rights was primarily due to the decreased prepayment speeds as a result of the rising interest rate environment.

Service charges and fee income increased primarily from higher ATM and consumer deposit activity fees.

Noninterest Expense .

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Total noninterest expense $ 27,776 $ 25,396 $ 2,380 9.4 %

Salaries and benefits, the largest driver of noninterest expense, increased primarily due to discretionary bonuses paid for added efforts associated with the Company's COVID-19 response, higher wages, lower deferred compensation and higher medical expenses, partially offset by a decrease in commission expense related to a decline in mortgage originations during 2021 as compared to 2020.

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

Operations expense increased primarily due to increases in marketing expenses, reserve for unfunded commitments, and professional fees.

The increase in the reserve for unfunded commitments primarily resulted from an increase in construction loan commitments.

Regulatory assessments decreased due to lower FDIC assessments in 2021 and regulatory exam costs included in the 2020 balance.

Occupancy expense decreased due to the closure of one branch location in June 2020.

Salaries and benefits, the largest driver of noninterest expense, increased primarily due to higher wages, lower deferred compensation and higher medical expenses, partially offset by a decrease in incentive compensation as a result of a lower percentage earned on loans originated, changes to incentive compensation programs, such as the addition of non-production performance requirements, and lower commission expense related to a decline in mortgage originations.

Data processing expense increased due to technology investments and contract rate increases.

Regulatory assessments increased due to higher FDIC assessments in 2022 as a result of the increase in our asset size.

The efficiency ratio for the year ended December 31, 2022 was 69.65%, compared to 68.18% for the year ended December 31, 2021.

The weakening in the efficiency ratio for the year ended December 31, 2021 was primarily due to higher noninterest expense and lower revenues.

The weakening in the efficiency ratio for the year ended December 31, 2022 was primarily due to higher noninterest expense.

Income Tax Expense .

The provision for income taxes decreased $119 thousand, or 5.0% to $2.3 million for the year ended December 31, 2021, compared to $2.4 million for the year ended December 31, 2020, due to a lower effective tax rate, partially offset by an increase in taxable net income.

The provision for income taxes decreased $200 thousand, or 8.8% to $2.1 million for the year ended December 31, 2022, compared to $2.3 million for the year ended December 31, 2021, due to a lower effective tax rate and a decrease in taxable net income.

The effective tax rates for the years ended December 31, 2022 and 2021 were 19.1% and 19.9%, respectively.

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Shareholders’ equity totaled $97.7 million at December 31, 2022 and $93.4 million at December 31, 2021.

In addition to net income of $9.2 million, other sources of capital during 2021 included $182 thousand in proceeds from stock option exercises, $468 thousand related to the allocation of ESOP shares during the year and $360 thousand related to stock-based compensation.

Uses of capital during 2021 included $2.0 million of dividends paid on common stock, other comprehensive loss, net of tax, of $101 thousand and $152 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 2021, and regularly quarterly dividends per share of $0.15 per share during 2020 and a special dividend of $0.20 per common share during 2020.

In addition to net income of $8.8 million, other sources of capital during 2022 included $223 thousand in proceeds from stock option exercises and $475 thousand related to stock-based compensation.

Uses of capital during 2022 included $2.0 million of dividends paid on common stock, other comprehensive loss, net of tax, of $1.3 million and $1.7 million 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 both 2022 and 2021.

This equates to a dividend payout ratio of 23.1% in 2022 and 22.3% 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 during 2022 at this rate of $0.17 per share, our average total dividend paid each quarter would be approximately $446 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).

Assuming continued payment during 2023 at this rate of $0.17 per share, our average total dividend paid each quarter would be approximately $442 thousand based on the number of our outstanding shares at December 31, 2022.

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 this Form 10-K.

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Shares purchased under such plans may also provide us with shares of common stock necessary to satisfy obligations related to stock compensation awards.

On April 28, 2021, the Company’s board of directors authorized a stock repurchase program to allow the Company to repurchase, over a six-month period, up to $2.0 million of the Company’s outstanding shares in the open market or in privately negotiated transactions.

On October 27, 2021, the Company’s board of directors authorized a new stock repurchase, effective upon the expiration of the prior stock repurchase program on October 28, 2021, with the same parameters as the prior stock repurchase program.

The Company's current stock repurchase program authorizes us to repurchase up to $4.0 million of Company common stock, of which approximately $2.1 million remained available for future repurchases as of December 31, 2022.

The current stock repurchase program is set to expire on July 31, 2023.

The actual timing, number and value of shares repurchased under the stock repurchase program will depend on a number of factors, including constraints specified pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 of the SEC, price, general business and market conditions, and alternative investment opportunities.

See “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” contained in Item 5, Part II of this Form 10-K for additional information relating to stock repurchases.

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These scenarios are incorporated into our contingency funding plan, which provides the basis for the identification of our liquidity needs.

As of December 31, 2021, we had $192.0 million in cash and available-for-sale investment securities and $3.1 million in loans held-for-sale.

As of December 31, 2022, we had $68.0 million in cash and available-for-sale investment securities and no loans held-for-sale.

At December 31, 2022, we had the ability to borrow an additional $199.0 million in FHLB advances and access to additional borrowings of $20.8 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 December 31, 2021.

We had $43.0 million in outstanding advances with the FHLB at December 31, 2022 and no outstanding borrowings with the Federal Reserve at December 31, 2022.

In addition, we also had available $20.0 million of credit facilities with other financial institutions, with no balance outstanding at December 31, 2022.

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Refer to the accompanying notes to consolidated financial statements elsewhere in this report for the expected timing of such payments as of December 31, 2022.

These include payments related to (i) long-term borrowings (Note 10—Borrowings, FHLB Stock and Subordinated Notes), (ii) time deposits with stated maturity dates (Note 9—Deposits) (iii) operating leases (Note 12—Leases) and (iv) commitments to extend credit and standby letters of credit (Note 18—Commitments and Contingencies).

These include payments related to (i) short and long-term borrowings (Note 10—Borrowings, FHLB Stock and Subordinated Notes), (ii) time deposits with stated maturity dates (Note 9—Deposits) (iii) operating leases (Note 12—Leases) and (iv) commitments to extend credit and standby letters of credit (Note 18—Commitments and Contingencies).

In addition, we incur capital expenditures on an ongoing basis to expand and improve our product offerings, enhance and modernize our technology infrastructure, and to introduce new technology-based products to compete effectively in our markets.

We evaluate capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and our expected return on investment.

The amount of capital investment is influenced by, among other things, current and projected demand for our services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations.

Based on current capital allocation objectives, there are no projects scheduled for capital investments in premises and equipment during the year ending December 31, 2023 that would materially impact liquidity.

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

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See, “Business — How We Are Regulated — Limitations on Dividends and Stock Repurchases” contained in Item 1, Part I of this Form 10-K.

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

During the year ended December 31, 2020, the Company completed a private placement of $12.0 million in aggregate principal of subordinated notes resulting in net proceeds, after placement fees and offering expenses, of approximately $11.6 million.

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

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

Financial Statements and Supplementary Data" and "Item 1.

Statements and Supplementary Data" and "Item 1.

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

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

What changed 10-K

Item 7. Management’s Discussion and Analysis