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, including, without limitation, as a result of employment levels, labor shortages and the effects of inflation, a potential recession, the failure of the U.S. Congress to increase the debt ceiling, or slowed economic growth caused by increasing political instability from acts of war including Russia’s invasion of Ukraine, as well as increasing oil prices and supply chain disruptions, and any governmental or societal responses to recent bank failures or new COVID-19 variants; • changes in consumer spending, borrowing and savings habits; • 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 credit 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, including maintaining the confidence of depositors; • the possibility that unexpected outflows of uninsured deposits may require us to sell investment securities at a loss; • the transition away from the London Interbank Offered Rate (“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 credit 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 changes in banking, securities and tax law, in regulatory policies and principles, or the interpretation of regulatory capital or other rules, and other 32 governmental initiatives affecting the financial services industry 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; • 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 quality and composition of our securities portfolio and the impact of any adverse changes in the securities markets; • the effects of climate change, severe weather events, natural disasters, pandemics, epidemics and other public health crises, acts of war or terrorism, and other external events on our business; • 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 reports filed with or furnished to 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, 2022 (“2022 Form 10-K”). We caution 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, that is not a member of the Federal Reserve System, the Bank’s regulators are the Washington Department of Financial Institutions and the Federal Deposit Insurance Corporation (the “FDIC”). As a bank holding company, Sound Financial Bancorp is regulated by the Federal Reserve. 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, 2023, Sound Financial Bancorp, on a consolidated basis, had assets of $1.00 billion, net loans held-for-portfolio of $862.0 million, deposits of $841.6 million and stockholders’ equity of $98.6 million. The common stock of Sound Financial Bancorp is listed on the 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), loans secured by commercial and multifamily real estate, construction and land loans, consumer loans 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 the origination of residential mortgage loans, 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 that 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 that 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 properties and mobile home parks, as well as construction and land development loans. Critical Accounting Estimates 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 33 borrowers. Management believes that its critical accounting estimates include determining the allowance for credit 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. There have been no material changes in the Company’s critical accounting policies and estimates as previously disclosed in the Company’s 2022 Form 10-K, except as disclosed in “Note 1 —Basis of Presentation” in the Notes to Condensed Consolidated Financial Statements in this report. Comparison of Financial Condition at March 31, 2023 and December 31, 2022 General. Total assets increased $28.0 million, or 2.9%, to $1.00 billion at March 31, 2023 from $976.4 million at December 31, 2022. The increase primarily was a result of loan growth and an increase in cash and cash equivalents. Cash and Securities. Cash and cash equivalents increased $23.7 million, or 41.1%, to $81.6 million at March 31, 2023 from $57.8 million at December 31, 2022, primarily due to due to an increase in deposits, primarily certificate and money market accounts, partially offset by the repayment of FHLB overnight advances. Investment securities decreased $1.6 million, or 13.0%, to $10.8 million at March 31, 2023, compared to $12.4 million at December 31, 2022. Held-to-maturity securities totaled $2.2 million at March 31, 2023 and December 31, 2022. Available-for-sale securities totaled $8.6 million at March 31, 2023, compared to $10.2 million at December 31, 2022. The decrease in available-for-sale securities was primarily due the maturity of $1.6 million in treasury bills and regularly scheduled payments and maturities. Loans. Loans held-for-portfolio, net, increased $3.6 million, or 0.4%, to $862.0 million at March 31, 2023 from $858.4 million at December 31, 2022, driven by increases in construction and land, commercial business and manufactured home loans, partially offset by declines in commercial real estate, multifamily, floating homes and other consumer loans. The increase from December 31, 2022 in total loans held-for-portfolio primarily resulted from the funding of commercial construction projects and a new commercial and industrial relationship. The following table reflects the changes in the loan mix of our loan portfolio at March 31, 2023, as compared to December 31, 2022 (dollars in thousands): March 31, 2023 December 31, 2022 Amount Change Percent Change One-to-four family $ 274,687 $ 274,638 $ 49 — % Home equity 19,631 19,548 83 0.4 Commercial and multifamily 307,558 313,358 (5,800) (1.9) Construction and land 125,983 116,878 9,105 7.8 Manufactured homes 27,904 26,953 951 3.5 Floating homes 73,579 74,443 (864) (1.2) Other consumer 17,378 17,923 (545) (3.0) Commercial business 25,192 23,815 1,377 5.8 Premiums for purchased loans 946 973 (26) (2.7) Deferred loan fees (2,313) (2,548) 234 (9.2) Total loans held-for-portfolio, gross 870,545 865,981 4,564 0.5 Allowance for credit losses — loans (8,532) (7,599) (933) 12.3 Total loans held-for-portfolio, net $ 862,013 $ 858,382 $ 3,631 0.4 % The increase in construction and land loans during the period was primarily due to advances of commercial construction loans. The increase in commercial business loans was primarily the result of a new commercial business relationship. These increases were partially offset by payoffs and paydowns during the period, including the payoff of $2.7 million related to two multifamily loans. At March 31, 2023, our loan portfolio, net of deferred loan fees, remained well-diversified. Commercial and multifamily real estate loans accounted for 35.3% of total loans, one-to-four family loans, including home equity loans, accounted for 33.7% of total loans, commercial business loans accounted for 2.9% of total loans, and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans, accounted for 13.6% of total loans at March 31, 2023. Construction and land loans accounted for 14.4% of total loans at March 31, 2023. Loans held-for-sale totaled $1.4 million at March 31, 2023, compared to none at December 31, 2022. The increase was primarily due to timing of mortgage originations and sales. 34 Allowance for Credit Losses. The following table reflects the adjustments in our allowance for credit losses (“ACL”) during the periods indicated (dollars in thousands): Three Months Ended March 31, 2023 2022 Allowance for Credit Losses — Loans: Balance at beginning of period $ 7,599 $ 6,306 Impact of Adoption of ASU 2016-16 760 — Charge-offs (79) (32) Recoveries 7 8 Net charge-offs (72) (24) Provision for credit losses during the period 245 125 Balance at end of period 8,532 $ 6,407 Reserve for Unfunded Commitments: Balance at beginning of period 335 404 Adoption of ASU 2016-13 695 — (Reversal of) provision for credit losses (235) 15 Balance at end of period 795 419 Allowance for credit losses $ 9,327 $ 6,826 Ratio of net charge-offs during the period to average loans outstanding during the period (0.03) % (0.01) % Our ACL — loans increased $933 thousand, or 12.3%, to $8.5 million at March 31, 2023, from $7.6 million at December 31, 2022. The change in the ACL - loans from December 31, 2022 to March 31, 2023 was primarily a result of the adjustment for the adoption of ASU 2016-16. The provision for credit losses had a minimal impact on the change in the ACL as a result of the growth in the loan portfolio primarily related to construction advances that were outstanding at December 31, 2022 funding during the three months ended March 31, 2023, thus reducing the reserve for unfunded commitments and increasing the ACL - loans. Net charge-offs for the three months ended March 31, 2023 totaled $72 thousand, compared to net charge-offs of $24 thousand for the three months ended March 31, 2022. At March 31, 2023, the ACL - loans as a percentage of total loans and nonperforming loans was 0.98% and 659.97%, compared to 0.88% and 256.81%, at December 31, 2022, respectively. See “Comparison of Results of Operations for the Three Months Ended March 31, 2023 and 2022 — Provision for Credit Losses.” 35 The following tables show certain credit ratios at and for the periods indicated and each component of the ratio's calculations (dollars in thousands). March 31, 2023 December 31, 2022 Allowance for credit losses - loans as a percentage of total loans outstanding at period end 0.98 % 0.88 % Allowance for credit losses — loans $ 8,532 $ 7,599 Total loans outstanding $ 871,912 $ 867,556 Nonaccrual loans as a percentage of total loans outstanding at period end 0.15 % 0.34 % Total nonaccrual loans $ 1,293 $ 2,959 Total loans outstanding $ 871,912 $ 867,556 Allowance for credit losses - loans as a percentage of nonaccrual loans at period end 659.94 % 256.81 % Allowance for credit losses — loans $ 8,532 $ 7,599 Total nonaccrual loans $ 1,293 $ 2,959 Allowance for credit losses as a percentage of total loans outstanding at period end 1.07 % 0.91 % Allowance for credit losses $ 9,327 $ 7,934 Total loans outstanding $ 871,912 $ 867,556 Allowance for credit losses as a percentage of nonaccrual loans at period end 721.46 % 268.13 % Allowance for credit losses $ 9,327 $ 7,934 Total nonaccrual loans $ 1,293 $ 2,959 36 Three Months Ended March 31, 2023 2022 ($ in thousands) Net recoveries (charge-offs) during period to average loans outstanding: One-to-four family: — % — % Net recoveries (charge-offs) $ — $ — Average loans outstanding $ 274,261 $ 211,315 Home equity: — % 0.06 % Net recoveries (charge-offs) $ — $ 2 Average loans outstanding $ 19,580 $ 13,449 Commercial and multifamily real estate: — % — % Net (charge-offs) recoveries $ — $ — Average loans outstanding $ 310,960 $ 279,237 Construction and land: — % — % Net (charge-offs) recoveries $ — $ — Average loans outstanding $ 120,704 $ 65,314 Manufactured homes: — % — % Net recoveries $ — $ — Average loans outstanding $ 27,279 $ 21,896 Floating homes: — % — % Net (charge-offs) recoveries $ — $ — Average loans outstanding $ 74,043 $ 59,797 Other consumer: (1.68) % (0.50) % Net (charge-offs) $ (72) $ (21) Average loans outstanding $ 17,333 $ 16,892 Commercial business: — % (0.08) % Net (charge-offs) $ — $ (5) Average loans outstanding $ 24,107 $ 25,657 Total loans: (0.03) % (0.01) % Net recoveries (charge-offs) $ (72) $ (24) Average loans outstanding $ 868,266 $ 693,556 Nonperforming Assets. At March 31, 2023, nonperforming assets, which are comprised of nonaccrual loans and other real estate owned (“OREO”), totaled $1.9 million, or 0.19% of total assets, compared to $3.6 million, or 0.37% of total assets at December 31, 2022. The table below sets forth the amounts and categories of nonperforming assets at the dates indicated (dollars in thousands): Nonperforming Assets March 31, 2023 December 31, 2022 Amount Change Percent Change Total nonperforming loans $ 1,293 $ 2,958 $ (1,665) (56.3) OREO and repossessed assets 575 659 (84) (12.7) Total nonperforming assets $ 1,868 $ 3,617 $ (1,749) (48.4) % Nonperforming assets, which are comprised of nonaccrual loans, nonperforming modified loans and OREO, decreased $1.7 million, or 48.4%, to $1.9 million at March 31, 2023 from $3.6 million at December 31, 2022. The decrease in nonperforming 37 assets primarily was due to the payoff of $1.5 million in nonperforming one-to-four family loans related to a single borrower and the write-off of one residential property for $84 thousand during the three months ended March 31, 2023. The percentage of nonperforming loans to total loans was 0.15% at March 31, 2023, compared to 0.34% of total loans at December 31, 2022. Mortgage Servicing Rights. The fair value of mortgage servicing rights was $4.6 million at March 31, 2023, a decrease of $100 thousand, or 2.1%, from $4.7 million at December 31, 2022. 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. Deposits and Borrowings. Total deposits increased $32.9 million, or 4.1%, to $841.6 million at March 31, 2023 from $808.8 million at December 31, 2022. The increase was primarily a result of higher balances in certificate and money market accounts, partially offset by lower balances in all other deposit products, largely driven by consumer behavior to move funds from lower rate deposit products into higher rate deposit products. Noninterest-bearing deposits decreased $117 thousand, or 0.1%, to $173.1 million at March 31, 2023, compared to $173.2 million at December 31, 2022. Noninterest-bearing deposits represented 20.6% of total deposits at March 31, 2023, compared to 21.4% at December 31, 2022. 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, 2023 December 31, 2022 Amount Wtd. Avg. Rate Amount Wtd. Avg. Rate Noninterest-bearing demand $ 168,522 — % $ 170,549 — % Interest-bearing demand 235,836 0.43 254,982 0.21 Savings 83,991 0.05 95,641 0.05 Money market 77,624 0.55 74,639 0.28 Time deposits 271,117 2.66 210,305 0.97 Escrow (1) 4,557 — 2,647 — Total deposits $ 841,647 1.05 % $ 808,763 0.37 % (1) Escrow balances shown in noninterest-bearing deposits on the Condensed Consolidated Balance Sheets. Scheduled maturities of time deposits at March 31, 2023, are as follows (in thousands): Year Ending December 31, Amount 2023 $ 180,202 2024 52,826 2025 31,541 2026 1,734 2027 4,686 Thereafter 128 $ 271,117 Savings, demand, and money market accounts have no contractual maturity. Certificates of deposit have maturities of six years or less. The aggregate amount of time deposits in denominations of more than $250,000 at March 31, 2023 and December 31, 2022, totaled $82.1 million and $56.1 million, respectively. Deposit amounts in excess of $250,000 are not federally insured. As of March 31, 2023, uninsured deposits totaled $174.1 million, which represented 20.7% of total deposits, as compared to uninsured deposits of $161.9 million, or 20.0% of total deposits as of December 31, 2022. The uninsured amounts are estimates based on the methodologies and assumptions used for the Bank’s regulatory reporting requirements. The increase in uninsured deposits primarily related to the increase in certificates of deposit. Borrowings, comprised of FHLB advances, decreased $8.0 million to $35.0 million at March 31, 2023 from $43.0 million at December 31, 2022, primarily as a result of paydowns of our FHLB advances due to the increase in deposits. Subordinated notes, net totaled $11.7 million at both March 31, 2023 and December 31, 2022. 38 Stockholders’ Equity. Total stockholders’ equity increased $900 thousand, or 0.9%, to $98.6 million at March 31, 2023, from $97.7 million at December 31, 2022. This increase primarily reflects $2.2 million of net income earned during the current quarter, a $83 thousand decrease in accumulated other comprehensive loss, net of tax, and $247 thousand in proceeds from exercises of stock options, partially offset by the payment of $442 thousand in dividends to the Company’s stockholders. In addition, stockholders' equity was impacted by the adoption of CECL in the first quarter of 2023, which as of January 1, 2023, resulted in an after-tax decrease to opening retained earnings of $1.1 million. 39 Average Balances, Net Interest Income, Yields Earned and Rates Paid The following tables present, 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, 2023 2022 Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Interest-earning assets: Loans receivable $ 867,724 $ 11,381 5.32 % $ 694,920 $ 8,075 4.71 % Investments, cash and cash equivalents 80,244 793 4.01 190,385 138 0.29 Total interest-earning assets (1) 947,968 12,174 5.21 885,305 8,213 3.76 Interest-bearing liabilities: Savings and money market accounts 164,270 93 0.23 196,128 30 0.06 Demand and NOW accounts 241,088 267 0.45 315,181 122 0.16 Certificate accounts 246,578 1,776 2.92 102,315 275 1.09 Subordinated notes 11,683 168 5.83 11,637 168 5.85 Borrowings 44,911 499 4.51 — — — Total interest-bearing liabilities 708,530 2,803 1.60 % 625,261 595 0.39 % Net interest income $ 9,371 $ 7,618 Net interest rate spread 3.60 % 3.38 % Net earning assets $ 239,438 $ 260,044 Net interest margin 4.01 % 3.49 % Average interest-earning assets to average interest-bearing liabilities 133.79 % 141.59 % Noninterest-bearing deposits $ 172,805 $ 194,556 Total deposits 824,741 2,136 1.05 % 808,180 427 0.21 % Total funding (2) 881,335 2,803 1.29 % 819,817 595 0.29 % (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 table presents, for the periods indicated, 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). 40 Three Months Ended March 31, 2023 vs. 2022 Increase (Decrease) due to Total Increase (Decrease) Volume Rate Interest-earning assets: Loans receivable $ 2,266 $ 1,040 $ 3,306 Investments, cash and cash equivalents (1,088) 1,743 655 Total interest-earning assets 1,178 2,783 3,961 Interest-bearing liabilities: Savings and Money Market accounts (18) 81 63 Demand and NOW accounts (82) 227 145 Certificate accounts 1,039 462 1,501 Subordinated notes 1 (1) — Borrowings 499 — 499 Total interest-bearing liabilities $ 1,439 $ 769 $ 2,208 Change in net interest income $ 1,753 Comparison of Results of Operation for the Three Months Ended March 31, 2023 and 2022 General. Q1 2023 vs Q1 2022 . Net income increased $445 thousand, or 25.8%, to $2.2 million, or $0.83 per diluted common share, for the three months ended March 31, 2023, compared to $1.7 million, or $0.65 per diluted common share, for the three months ended March 31, 2022. The increase was primarily the result of a $1.8 million increase in net interest income and a $130 thousand decrease in the provision for credit losses, partially offset by a $554 thousand decrease in noninterest income and a $795 thousand increase in noninterest expense. Interest Income Q1 2023 vs Q1 2022 . Interest income increased $4.0 million, or 48.2%, to $12.2 million for the three months ended March 31, 2023, from $8.2 million for the three months ended March 31, 2022, primarily due to higher average loan balances, a 61 basis point increase in the average loan yield and a 371 basis point increase in the average yield on investments and interest-bearing cash, partially offset by a lower average balance of investments and interest-bearing cash. Interest income on loans increased $3.3 million, or 40.9%, to $11.4 million for the three months ended March 31, 2023, compared to $8.1 million for the three months ended March 31, 2022. The average balance of total loans was $867.7 million for the three months ended March 31, 2023, compared to $694.9 million for the three months ended March 31, 2022 primarily resulting from increased balances related to construction advances, partially offset by a decrease in commercial and multifamily loans resulting from the payoff of a few large multifamily loans during the past year. The average yield on total loans was 5.32% for three months ended March 31, 2023, compared to 4.71% for the three months ended March 31, 2022. The average yield on total loans increased primarily due to variable rate loans adjusting to higher market interest rates and new loan originations at higher interest rates. Interest income on the investment portfolio and cash and cash equivalents increased $655 thousand, or 474.6%, to $793 thousand for the three months ended March 31, 2023, compared to $138 thousand for the three months ended March 31, 2022. 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 $80.2 million for the three months ended March 31, 2023, compared to $190.4 million for the three months ended March 31, 2022. The decrease in average balances was due to lower average cash balances as we redeployed funds into higher interest-earning assets, specifically loans and, to a lesser extent, investment securities. The average yield on investments and cash and cash equivalents increased to 4.01% for the three months ended March 31, 2023, compared to 0.29% for the three months ended March 31, 2022, as a result of the rising interest rate environment. Interest Expense Q1 2023 vs Q1 2022 . Interest expense increased $2.2 million, or 371.1%, to $2.8 million for the three months ended March 31, 2023, from $595 thousand for the three months ended March 31, 2022. Interest expense on deposits increased $1.7 million, or 41 400.2%, to $2.1 million for the three months ended March 31, 2023, compared to $427 thousand for the same period a year ago. The increase was primarily the result of a $44.9 million increase in the average balance of borrowings and a $144.3 million increase in the average balance of certificate accounts, as well as higher average rates paid on all interest-bearing deposits, partially offset by a $106.0 million decrease in the average balance of interest-bearing deposits other than certificate accounts. The increase in the rate paid on certificate accounts contributed to a 84 basis point increase in the average cost of total deposits to 1.05% for the quarter ended March 31, 2023, from 0.21% for the quarter ended March 31, 2022. Interest expense on borrowings, comprised solely of FHLB advances, was $499 thousand for the three months ended March 31, 2023, compared to none for the three months ended March 31, 2022, reflecting the increased use of FHLB advances to supplement our liquidity needs. Interest expense on subordinated notes was $168 thousand for both three month periods ended March 31, 2023 and 2022. Net Interest Income. Q1 2023 vs Q1 2022 . Net interest income increased $1.8 million, or 23.0%, to $9.4 million for the three months ended March 31, 2023, from $7.6 million for the three months ended March 31, 2022. Our net interest margin was 4.01% and 3.49% for the three months ended March 31, 2023 and 2022, respectively. The increase in net interest income primarily was the result of higher interest income earned on loans, investments and interest-bearing cash, partially offset by higher interest expense paid on deposits and borrowings. The increase in net interest margin primarily was due to the higher interest income earned on interest-earning assets, driven by the higher average balance of and yield earned on loans, the increase in rates paid on interest-bearing liabilities and the higher average balance of borrowings. Since March 2022, in response to inflation, the Federal Open Market Committee of the Federal Reserve has increased the target range for the federal funds rate by 475 basis points, including 50 basis points during the first quarter of 2023, to a range of 4.75% to 5.00% as of March 31, 2023. In May 2023, the FOMC increased the target range for the federal funds rate another 25 basis points to a range of 5.00% to 5.25%. Provision for Credit Losse s. A provision for credit losses of $10 thousand was recorded for the three months ended March 31, 2023, consisting of a provision for credit losses on loans of $245 thousand and a release of reserve for unfunded loan commitments of $235 thousand. This compared to a provision for credit losses of $140 thousand for the three months ended March 31, 2022, consisting of a provision for loan losses and unfunded loan commitments of $125 thousand and $15 thousand respectively. The decrease in the provision for credit losses resulted primarily from changes in methodology used to reserve for credit losses. The Company adopted the CECL standard as of January 1, 2023, which resulted in a one-time upward adjustment to the ACL - loans of $760 thousand and an ACL - unfunded loan commitments of $695 thousand, and an after-tax decrease to opening retained earnings of $1.1 million. All amounts prior to January 1, 2023 were calculated using the previous incurred loss methodology to compute our allowance for loan losses, which is not directly comparable to the new current expected credit losses methodology. The provision for credit losses for the three months ended March 31, 2023 also reflects assumptions related to our forecast concerning the economic environment as a result of local, national and global events, including recent bank failures. In addition, expected loss estimates consider various factors, including customer-specific information, changes in risk ratings, projected delinquencies, and the impact of economic conditions on borrowers' ability to repay. Net charge-offs for the three months ended March 31, 2023 totaled $72 thousand, compared to net charge-offs of $24 thousand for the three months ended March 31, 2022. While we believe the estimates and assumptions used in our determination of the adequacy of the ACL 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 have a material adverse impact on our financial condition and results of operations. A further decline in national and local economic conditions, as a result of the effects of inflation, and a potential recession or slowed economic growth, among other factors, could result in a material increase in the ACL and have a material adverse impact on our financial condition and results of operations. In addition, the determination of the amount of our ACL 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. 42 Noninterest Income. Noninterest income decreased $554 thousand, or 36.4%, to $1.0 million for the three months ended March 31, 2023, as compared to $1.5 million for the three months ended March 31, 2022, as reflected below (dollars in thousands): Three Months Ended March 31, Amount Change Percent Change 2023 2022 Service charges and fee income $ 581 $ 549 $ 32 5.8 % Earnings on cash surrender value of BOLI 151 21 130 619.0 Mortgage servicing income 299 320 (21) (6.6) Fair value adjustment on mortgage servicing rights (140) 268 (408) (152.2) Net gain on sale of loans 78 365 (287) (78.6) Total noninterest income $ 969 $ 1,523 $ (554) (36.4) % The decrease in noninterest income during the three months ended March 31, 2023 compared to the same quarter in 2022 primarily was due to a $287 thousand decrease in net gain on sale of loans as a result of a decline in both the amount of loans originated for sale and gross margins earned on loans sold and a $408 thousand decrease in the fair value adjustment on mortgage servicing rights due primarily to a decrease in the servicing portfolio, partially offset by a $130 thousand increase in earnings on cash surrender value of BOLI, reflecting recent price increases in the securities markets. Loans sold during the quarter ended March 31, 2023, totaled $3.9 million, compared to $12.2 million during the quarter ended March 31, 2022. Noninterest Expense. Noninterest expense increased $795 thousand, or 11.7%, to $7.6 million during the three months ended March 31, 2023, compared to $6.8 million during the three months ended March 31, 2022, as reflected below (dollars in thousands): Three Months Ended March 31, Amount Change Percent Change 2023 2022 Salaries and benefits $ 4,485 $ 4,167 $ 318 7.6 % Operations 1,441 1,299 142 10.9 Regulatory assessments 153 101 52 51.5 Occupancy 459 432 27 6.3 Data processing 993 821 172 21.0 Total noninterest expense $ 7,615 $ 6,820 $ 795 11.7 % The increase in noninterest expense during the three months ended March 31, 2023 compared to the same quarter in 2022 was mainly attributable to an increase in salaries and benefits of $318 thousand, primarily due to higher wages and lower deferred compensation, 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. Operations expense increased $142 thousand compared to the quarter ended March 31, 2022 due to increases in various accounts including travel expenses, debit card processing, audit fees, fixed assets, state and local taxes, charitable contributions and office expenses. These increases were partially offset by lower loan origination costs due to lower mortgage origination volume and decreases in various accounts, including marketing, legal and professional fees. The efficiency ratio for the quarter ended March 31, 2023 was 73.65%, compared to 74.61% for the quarter ended March 31, 2022. The improvement in the efficiency ratio for the current quarter compared to the same period in the prior year is primarily due to net interest income rising at a faster rate than the increase in noninterest expense and the decline in noninterest income. Income Tax Expense . We incurred income tax expense of $547 thousand for the three months ended March 31, 2023, compared to $458 thousand for the same period in 2022. The effective tax rates for the three months ended March 31, 2023 and March 31, 2022 were 20.15% and 21.00%, respectively. Capital and Liquidity The Management Discussion and Analysis in Item 7 of the Company’s 2022 Form 10-K contains an overview of Sound Financial Bancorp’s and the Bank’s liquidity management, sources of liquidity and cash flows. Although, there have been no 43 material changes in our liquidity management, sources of liquidity and cash flows since our 2022 Form 10-K, this discussion updates that disclosure for the three months ended March 31, 2023. Capital. Stockholders’ equity totaled $98.6 million at March 31, 2023 and $97.7 million at December 31, 2022. In addition to net income of $2.2 million, other sources of capital during the three months ended March 31, 2023 included $247 thousand in proceeds from stock option exercises and other comprehensive income, net of tax, of $83 thousand. Uses of capital during the three months ended March 31, 2023 primarily included $442 thousand of dividends paid on common stock and $9 thousand of stock repurchases. In addition, stockholders' equity was impacted by the adoption of CECL in the first quarter of 2023, which as of January 1, 2023, resulted in an after-tax decrease to opening retained earnings of $1.1 million. We paid regular quarterly dividends of $0.17 per common share during the three months ended March 31, 2023 and 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, which equates to a dividend payout ratio of 20.39% in the first quarter of 2023 and 41.15% in the first quarter of 2022. The Company expects to continue paying quarterly cash dividends on its common stock, subject to the Board of Directors' discretion to change 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 2023 at the new rate of $0.19 per share, which the Company announced in April 2023, our average total dividend paid each quarter would be approximately $494 thousand based on the number of our current outstanding shares as of March 31, 2023. 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 2022 Form 10-K. Stock Repurchase Programs. From time to time, our board of directors has authorized stock repurchase programs. In general, stock repurchases allow us to proactively manage our capital position and return excess capital to stockholders. Stock repurchases may also provide us with shares of common stock necessary to satisfy obligations related to stock compensation awards. As of March 31, 2023, approximately $2.1 million of our common stock remained available for repurchase under our existing stock repurchase program. Purchases under the Company’s existing stock repurchase program may be made through open market purchases, privately-negotiated transactions, or otherwise in compliance with Rule 10b-18 under the Securities Exchange Act of 1934, as well as any constraints specified in any trading plan that may be adopted in accordance with SEC Rule 10b5-1. The repurchase program may be suspended, terminated or modified at any time for any reason, including market conditions, the cost of repurchasing shares, the availability of alternative investment opportunities, liquidity, and other factors deemed appropriate. The Company’s stock repurchase program does not obligate the Company to purchase any particular number of shares. 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 challenges 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. 44 As of March 31, 2023, we had $92.4 million in cash and available-for-sale investment securities and $1.4 million in loans held-for-sale. At March 31, 2023, we had the ability to borrow $197.0 million in FHLB advances and access to additional borrowings of $22.0 million through the Federal Reserve's discount window, in each case subject to certain collateral requirements. We had $35.0 million in outstanding advances with the FHL B and none with the Federal Reserve at March 31, 2023. We also had a $20.0 million credit facility with PCBB available, with no balance outstanding at March 31, 2023. 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, 2023, 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 Condensed Consolidated Financial Statements contained in "Item 1. Financial Statements" 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 Condensed Consolidated Financial Statements elsewhere in this report for the expected timing of such payments as of March 31, 2023. These include payments related to (i) long-term borrowings (Note 8—Borrowings, FHLB Stock and Subordinated Notes) and (ii) operating leases (Note 11—Leases). See 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 Condensed 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 agreement. 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 condensed 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, 2023 December 31, 2022 Residential mortgage commitments $ 8,693 $ 3,184 Unfunded construction commitments 50,089 65,072 Unused lines of credit 28,828 32,793 Irrevocable letters of credit 255 275 Total loan commitments $ 87,864 $ 101,324 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 its 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 Sound Financial Bancorp 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 2022 Form 10-K. At March 31, 2023 Sound Financial Bancorp, on an unconsolidated basis, had $2.2 million in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs. See also the “Condensed Consolidated Statements of Cash Flows” included in “Item 1. Financial Statements and Supplementary Data” of this Form 10-Q, for further information. 45 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, 2023, the Bank and Company’s CBLR was 10.94% and 9.93%, respectively, which exceeded the minimum requirement of 9%. In February 2019, the U.S. federal bank regulatory agencies approved a final rule modifying their regulatory capital rules and providing an option to phase-in over a three-year period the Day 1 adverse regulatory capital effects of the CECL accounting standard. The capital relief is phased into regulatory capital at 25% per year over a three-year transition period. The final rule was adopted and became effective in September 2020. The Company implemented the CECL model commencing January 1, 2023 and elected to phase in the full effect of CECL on regulatory capital over the three-year transition period. See "Part I, Item 1. Business – Regulation of Sound Community Bank – Capital Rules " in the Company's 2022 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 2022 Form 10-K. There have been no material changes in our market risk since our 2022 Form 10-K.