SOUTHERN FIRST BANCSHARES INC 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with the financial statements and the related notes and the other statistical information also included in this Annual Report on Form 10-K. OVERVIEW Our business model continues to be client-focused, utilizing relationship teams to provide our clients with a specific banker contact and support team responsible for all of their banking needs. The purpose of this structure is to provide a consistent and superior level of professional service, and we believe it provides us with a distinct competitive advantage. We consider exceptional client service to be a critical part of our culture, which we refer to as “ClientFIRST.” At December 31, 2021, we had total assets of $2.93 billion, a 17.8% increase from total assets of $2.48 billion at December 31, 2020. The largest components of our total assets are loans which were $2.49 billion and $2.14 billion at December 31, 2021 and 2020, respectively. Our liabilities and shareholders’ equity at December 31, 2021 totaled $2.65 billion and $277.9 million, respectively, compared to liabilities of $2.25 billion and shareholders’ equity of $228.3 million at December 31, 2020. The principal component of our liabilities is deposits which were $2.56 billion and $2.14 billion at December 31, 2021 and 2020, respectively. Like most community banks, we derive the majority of our income from interest received on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings. Another key measure is the difference between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread. In addition to earning interest on our loans and investments, we earn income through fees and other charges to our clients. Our net income available to common shareholders for the years ended December 31, 2021 and 2020 was $46.7 million and $18.3 million, or diluted earnings per share (“EPS”) of $5.85 and $2.34 for the years ended December 31, 2021 and 2020, respectively. The increase in net income resulted primarily from a decrease in our provision for loan losses and an increase in net interest income, partially offset by a decrease in noninterest income and an increase in income tax expense. In addition, our net income available to shareholders was $27.9 million, or EPS of $3.58 for the year ended December 31, 2019. Our mortgage banking segment reported pre-tax income of $3.8 million and $11.1 million for the years ended December 31, 2021 and 2020, respectively. Noninterest income, which consists mainly of realized and unrealized gains associated with the fair value of commitments and loans held for sale, was $11.4 million as compared to $19.8 million for the years ended December 31, 2021 and 2020, respectively. The $8.4 million decrease during the 2021 period was driven by a decline in sales activity combined with a decrease in the fair value of derivatives associated with mortgage loan commitments. Noninterest expense consists mainly of salaries, commissions and benefits for mortgage employees, professional fees and outside services and data processing costs. Noninterest expense was $8.8 million and $9.9 million for the years ended December 31, 2021 and 2020, respectively. The $1.1 million decrease during 2021 was driven by a decrease in salaries and benefits expense primarily related to commissions paid on sales activity. COVID-19 UPDATE Our historically careful underwriting practices and diverse loan portfolio has helped minimize the adverse impact of the pandemic on the Company. In addition, the combination of the vaccine rollout, government stimulus payments, and reduced spending during the pandemic are likely contributing factors mitigating the impact of the pandemic on our business, financial condition, results of operations, and our clients as of December 31, 2021. In addition, as economic forecasts improved in 2021, we recaptured a portion of our provision for loan losses, compared with higher provision expense in 2020. However, there are continuing concerns that indicate a slower return to pre-pandemic routines, such as concerns relate to increases in new COVID-19 cases, hospitalizations and deaths leading to additional government imposed restrictions; refusals to receive the vaccine along with concerns related to new strains of the virus; supply chain issues remaining unresolved longer than anticipated; labor shortages and wage increases continuing to impact many industries; consumer confidence and spending falls; and rising geopolitical tensions. Given the ongoing and dynamic nature of the circumstances surrounding the pandemic, it is difficult to predict its future adverse financial impact to the 46 Table of Contents Company, although we expect to continue to be impacted by the pandemic in 2022. Specifically, we expect the following balance sheet and income statement categories could be affected: ● our net interest income and net interest margin may continue to be negatively affected by the low interest rate environment until the level of general interest rates rise; ● although the economy has experienced a certain level of recovery in 2021, economic assumptions used to calculate our allowance for loan losses may deteriorate causing us to increase our allowance, which may be exacerbated by our adoption of CECL, expected on January 1, 2022, which is anticipated to create more volatility in the level of our allowance, as compared to the “incurred loss” standard that we currently use. Today, the majority of our team has returned to working in the office at this time; however, we maintain the ability to shift to working remotely as needed. Our offices operate as they did prior to the COVID-19 pandemic with in-person meetings with clients. We believe this strategy, combined with our digital technology, has been extremely effective in serving our clients, and allowed us to consolidate our three Columbia, South Carolina offices into one location. The sale of our two Columbia office buildings was completed on October 9, 2020. We are focused on servicing the financial needs of our commercial and consumer clients and have offered flexible loan payment arrangements, including short-term loan modifications or forbearance payments, and reduced or waived certain fees on deposit accounts. We continue to assist clients with these accommodations on a case by case basis. Future governmental actions may require these and other types of client-related responses. Through December 31, 2020, we had granted deferrals on loan payments for 864 loans, with aggregate outstanding principal balances of approximately $599.6 million as of December 31, 2020, of which 91% were commercial loans. As of December 31, 2020, 98% of these loans had reached the end of their deferral period and had begun to resume normal payments. During 2021, we granted short-term deferrals or modifications on five loans, all within our hotel portfolio, with aggregate outstanding principal balances of $20.0 million, of which all have returned to normal payment status at December 31, 2021. At the onset of the pandemic, we began to monitor our commercial clients in the tourism and hospitality industries closely as we considered these industries to be at higher risk for credit loss due to business shut-downs and travel restrictions. As of December 31, 2020, loans related to hotels and restaurants totaled $123.5 million, of which approximately $61.5 million had received deferral arrangements and 78% had returned to normal payments. In addition, none of these loans were past due 30 days or more or on nonaccrual status as of December 31, 2020. During the first quarter of 2021, we downgraded ten loans in our hotel portfolio to special mention and substandard, so that we could continue to monitor these loans for risk of credit loss due to the pandemic. As of December 31, 2021, loans related to hotels and restaurants totaled $124.5 million. We will continue to review and evaluate the current financial performance and other relevant factors in order to determine the appropriate risk ratings for these loans. We continue to monitor unfunded commitments through the pandemic, including home equity lines of credit, for evidence of increased credit exposure as borrowers utilize these lines for liquidity purposes. We are also monitoring the impact of the COVID-19 pandemic on the operations and value of our investments. We mark to market our publicly traded investments and review our investment portfolio for impairment at each period end. Because of changing economic and market conditions affecting issuers, we may be required to recognize further impairments on the securities we hold as well as reductions in other comprehensive income. We cannot currently determine the ultimate impact of the pandemic on the long-term value of our investment portfolio. We believe there could be potential stresses on liquidity management as a result of the COVID-19 pandemic. For instance, as clients manage their own liquidity stress, we could experience an increase in the utilization of existing lines of credit. As of December 31, 2021, all of our capital ratios, and the Bank’s capital ratios, were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession brought about by the COVID-19 pandemic, our reported and regulatory capital ratios could be adversely impacted by further credit losses. We maintain access to multiple sources of liquidity, including a $15.0 million holding company line of credit with another bank which could be used to support capital ratios at the Bank. 47 Table of Contents SELECTED FINANCIAL DATA The following table sets forth our selected historical consolidated financial information for the periods and as of the dates indicated. We derived our balance sheet and income statement data for the years ended December 31, 2021, 2020, and 2019 from our audited consolidated financial statements. You should read this information together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and the related notes thereto, which are included elsewhere in this Annual Report on Form 10-K. Years Ended December 31, (dollars in thousands, except per share data) 2021 2020 2019 BALANCE SHEET DATA Total assets $ 2,925,548 $ 2,482,587 2,267,195 Investment securities 124,302 98,364 74,642 Loans (1) 2,489,877 2,142,867 1,943,525 Allowance for loan losses 30,408 44,149 16,642 Deposits 2,563,826 2,142,758 1,876,124 FHLB advances and other borrowings - 25,000 110,000 Subordinated debentures 36,106 35,998 35,890 Common equity 277,901 228,294 205,860 Preferred stock - - - Shareholders’ equity 277,901 228,294 205,860 SELECTED RESULTS OF OPERATIONS DATA Interest income $ 93,167 $ 94,818 92,652 Interest expense 5,435 15,008 25,383 Net interest income 87,732 79,810 67,269 Provision for loan losses (12,400 ) 29,600 2,300 Net interest income after provision for loan losses 100,132 50,210 64,969 Noninterest income 17,101 27,353 14,983 Noninterest expenses 56,430 53,744 44,473 Income before income tax expense 60,803 23,819 35,479 Income tax expense 14,092 5,491 7,621 Net income 46,711 18,328 27,858 Preferred stock dividends - - - Net income available to common shareholders $ 46,711 $ 18,328 27,858 PER COMMON SHARE DATA Basic $ 5.96 $ 2.37 3.70 Diluted 5.85 2.34 3.58 Book value 35.07 29.37 26.83 Weighted average number of common shares outstanding: Basic, in thousands 7,844 7,719 7,528 Diluted, in thousands 7,989 7,824 7,773 SELECTED FINANCIAL RATIOS Performance Ratios: Return on average assets 1.75 % 0.76 % 1.35 % Return on average equity 18.64 % 8.49 % 14.72 % Return on average common equity 18.64 % 8.49 % 14.72 % Net interest margin, tax equivalent (2) 3.45 % 3.55 % 3.43 % Efficiency ratio (3) 53.83 % 50.15 % 54.07 % Asset Quality Ratios: Nonperforming assets to total loans (1) 0.20 % 0.43 % 0.35 % Nonperforming assets to total assets 0.17 % 0.37 % 0.30 % Net charge-offs to average total loans 0.06 % 0.10 % 0.08 % Allowance for loan losses to nonperforming loans 625.16 % 547.14 % 244.95 % Allowance for loan losses to total loans 1.22 % 2.06 % 0.86 % Holding Company Capital Ratios: Total risk-based capital ratio 14.90 % 14.38 % 13.73 % Tier 1 risk-based capital ratio 12.65 % 11.97 % 11.63 % Leverage ratio 10.19 % 9.70 % 10.10 % Common equity tier 1 ratio (4) 12.09 % 11.32 % 10.94 % Tangible common equity (5) 9.50 % 9.20 % 9.08 % Growth Ratios: Change in assets 17.84 % 9.50 % 19.29 % Change in loans 16.19 % 10.26 % 15.87 % Change in deposits 19.65 % 14.21 % 13.83 % Change in net income to common shareholders 154.86 % -34.21 % 24.99 % Change in earnings per common share - diluted 150.00 % -34.64 % 24.31 % Footnotes to table: (1) Excludes loans held for sale. (2) The tax-equivalent adjustment to net interest income adjusts the yield for assets earning tax-exempt income to a comparable yield on a taxable basis. (3) Noninterest expense divided by the sum of net interest income and noninterest income. (4) The common equity tier 1 ratio is calculated as the sum of common equity divided by risk-weighted assets. (5) The common equity ratio is calculated as total equity less preferred stock divided by total assets. 48 Table of Contents CRITICAL ACCOUNTING ESTIMATES We have adopted various accounting policies that govern the application of accounting principles generally accepted in the U.S. and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in Note 1 to our Consolidated Financial Statements as of December 31, 2021. Certain accounting policies inherently involve a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported, which could have a material impact on the carrying values of our assets and liabilities and our results of operations. We consider these accounting policies and estimates to be critical accounting policies. We have identified the determination of the allowance for loan losses, the fair valuation of financial instruments and income taxes to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates. Therefore, management has reviewed and approved these critical accounting policies and estimates and has discussed these policies with the Company’s Audit Committee. Allowance for Loan Losses The allowance for loan loss is management’s estimate of credit losses that will result from the inability of our borrowers to make required loan payments. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. The allowance consists of general and specific components. For purposes of establishing the general reserve, we segment the loan portfolio into homogeneous groups of loans that possess similar risk characteristics and calculate the estimated loss based on historical loss percentages. In contrast, loans that do not share risk characteristics with other loans, such as impaired loans, are evaluated on an individual, or loan-by-loan, basis to determine whether a reserve is required based on the estimated cash flows or fair value of a collateral dependent loan. Our allowance levels are influenced by loan volume, loan grade or delinquency status, historic loss experience and other economic conditions. Fair Valuation of Financial Instruments Certain assets and liabilities are measured at fair value on a recurring basis, including securities and derivative instruments. Assets and liabilities carried at fair value inherently include subjectivity and may require the use of significant assumptions, adjustments and judgment including, among others, discount rates, rates of return on assets, cash flows, default rates, loss rates, terminal values and liquidation values. A significant change in assumptions may result in a significant change in fair value, which in turn, may result in a higher degree of financial statement volatility and could result in significant impact on our results of operations, financial condition or disclosures of fair value information. The fair value hierarchy requires use of observable inputs first and subsequently unobservable inputs when observable inputs are not available. Our fair value measurements involve various valuation techniques and models, which involve inputs that are observable (Level 1 or Level 2 in fair value hierarchy), when available. The level of judgment required to determine fair value is dependent on the methods or techniques used in the process. Assets and liabilities that are measured at fair value using quoted prices in active markets (Level 1) do not require significant judgment while the valuation of assets and liabilities when quoted market prices are not available (Levels 2 and 3) may require significant judgment to assess whether observable or unobservable inputs for those assets and liabilities provide reasonable determination of fair value. See Note 14 to the Consolidated Financial Statements for additional information regarding the fair values measured at each level of the fair value hierarchy, additional discussion regarding fair value measurements, and a brief description of how fair value is determined for categories that have unobservable inputs. 49 Table of Contents Income Taxes The financial statements have been prepared on the accrual basis. When income and expenses are recognized in different periods for financial reporting purposes versus for the purposes of computing income taxes currently payable, deferred taxes are provided on such temporary differences. Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. RESULTS OF OPERATIONS Net Interest Income and Margin Our level of net interest income is determined by the level of earning assets and the management of our net interest margin. For the years ended December 31, 2021, 2020, and 2019, our net interest income was $87.7 million, $79.8 million, and $67.3 million, respectively. The $7.9 million, or 9.9%, increase in net interest income during 2021, compared to 2020, was driven by a $249.1 million increase in average earning assets, partially offset by a $69.7 million increase in our average interest-bearing liabilities. The increase in average earning assets was primarily related to an increase in average loans, while the increase in average interest-bearing liabilities was primarily driven by an increase in interest-bearing deposits. During 2020, our net interest income increased $12.5 million, or 18.6%, compared to 2019, while average interest-earning assets increased $328.1 million and average interest-bearing liabilities increased $152.2 million. Interest income for the years ended December 31, 2021, 2020, and 2019 was $93.2 million, $94.8 million, and $92.7 million, respectively. A significant portion of our interest income relates to our strategy to maintain a large portion of our assets in higher earning loans compared to lower yielding investments and federal funds sold. As such, 98.3% of our interest income related to interest on loans during 2021, compared to 98.2% during 2020 and 96.0% during 2019. Also, included in interest income on loans was $1.4 million related to the net amortization of loan fees and capitalized loan origination costs for the years ended December 31, 2021 and 2020 and $1.2 million for the year ended December 31, 2019. Interest expense was $5.4 million, $15.0 million, and $25.4 million for the years ended December 31, 2021, 2020, and 2019, respectively. Interest expense on deposits for 2021 represented 71.9% of total interest expense, compared to 87.0% for 2020, and 93.5% for 2019, while interest expense on borrowings represented 28.1% of total interest expense for 2021, compared to 13.0% for 2020, and 6.5% for 2019. The decrease in interest expense on deposits during 2021 resulted from a decrease in deposit rates. We have included a number of tables to assist in our description of various measures of our financial performance. For example, the “Average Balances, Income and Expenses, Yields and Rates” table shows the average balance of each category of our assets and liabilities as well as the yield we earned or the rate we paid with respect to each category during 2021, 2020, and 2019. Similarly, the “Rate/Volume Analysis” table demonstrates the effect of changing interest rates and changing volume of assets and liabilities on our financial condition during the periods shown. We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included tables to illustrate our interest rate sensitivity with respect to interest-earning and interest-bearing accounts. The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities at December 31, 2021, 2020 and 2019. We derived these yields or costs by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. During the same periods, we had no securities purchased with agreements to resell. All investments were owned at an original maturity of over one year. Nonaccrual loans are included in earning assets in the following tables. Loan yields have been reduced to reflect the negative impact on our earnings of loans on nonaccrual status. The net of capitalized loan costs and fees are amortized into interest income on loans. 50 Table of Contents Average Balances, Income and Expenses, Yields and Rates For the Year Ended December 31, 2021 2020 2019 (dollars in thousands) Average Balance Income/ Expense Yield/ Rate Average Balance Income/ Expense Yield/ Rate Average Balance Income/ Expense Yield/ Rate Interest-earning assets Federal funds sold and interest-bearing deposits with banks $ 123,379 $ 233 0.19 % $ 105,344 $ 270 0.26 % $ 71,797 $ 1,622 2.26 % Investment securities, taxable 92,812 1,110 1.20 % 74,517 1,253 1.68 % 72,137 1,961 2.72 % Investment securities, nontaxable (1) 11,331 292 2.58 % 6,262 210 3.36 % 7,376 182 2.46 % Loans (2) 2,314,257 91,599 3.96 % 2,106,569 93,133 4.42 % 1,813,259 88,929 4.90 % Total earning assets 2,541,779 93,234 3.67 % 2,292,692 94,866 4.14 % 1,964,569 92,694 4.72 % Nonearning assets 126,654 103,212 101,647 Total assets $ 2,668,433 $ 2,395,904 $ 2,066,216 Interest-bearing liabilities NOW accounts $ 306,669 204 0.07 % $ 255,514 352 0.14 % $ 205,513 555 0.27 % Savings & money market 1,176,820 2,454 0.21 % 1,003,339 7,513 0.75 % 864,708 15,086 1.74 % Time deposits 176,301 1,251 0.71 % 301,078 5,190 1.72 % 363,431 8,089 2.23 % Total interest-bearing deposits 1,659,790 3,909 0.24 % 1,559,931 13,055 0.84 % 1,433,652 23,730 1.66 % FHLB advances and other borrowings 704 11 1.56 % 30,990 338 1.09 % 21,914 736 3.36 % Subordinated debt 36,049 1,515 4.20 % 35,940 1,615 4.49 % 19,133 917 4.79 % Total interest-bearing liabilities 1,696,543 5,435 0.32 % 1,626,861 15,008 0.92 % 1,474,699 25,383 1.72 % Noninterest-bearing liabilities 721,267 553,098 402,216 Shareholders’ equity 250,623 215,945 189,301 Total liabilities and shareholders’ equity $ 2,668,433 $ 2,395,904 $ 2,066,216 Net interest spread 3.35 % 3.22 % 3.00 % Net interest income(tax equivalent)/margin $ 87,799 3.45 % $ 79,858 3.48 % $ 67,311 3.43 % Less: tax-equivalent adjustment (1) (67 ) (48 ) (42 ) Net interest income $ 87,732 $ 79,810 $ 67,269 (1) The tax-equivalent adjustment to net interest income adjusts the yield for assets earning tax-exempt income to a comparable yield on a taxable basis. (2) Includes loans held for sale and nonaccrual loans. Our net interest margin, on a tax-equivalent basis (TE), was 3.45%, 3.48% and 3.43% for the years ended December 31, 2021, 2020 and 2019, respectively. Our net interest margin (TE) decreased three basis points in 2021, compared to 2020, due to the growth in average interest-earning assets at reduced yields being greater than the growth in interest-bearing liabilities which were also at reduced rates. During 2020, our net interest margin increased five basis points, compared to 2019, as the cost of our interest-bearing liabilities decreased quicker than the yield on our interest-earning assets due to our deposits repricing more frequently to market prices than our loan yields. Our average interest-earning assets increased by $249.1 million during the year ended December 31, 2021, compared to 2020, while the related yield on our interest-earning assets decreased by 47 basis points. The increase in average interest-earning assets was driven primarily by a $207.7 million increase in average loan balances combined with a $18.0 million increase in federal funds sold and interest-bearing deposits with banks. In addition, the reduction in yield on our interest earning assets was driven by a 46 basis point decrease in loan yield as our loan portfolio continues to show the impact of the Federal Reserve’s aggregate 225 basis point interest rate reduction since August 2019. During the year ended December 31, 2020, our average interest-earning assets increased by $328.1 million, compared to 2019, while the yield on our interest-earning assets decreased by 58 basis points. The increase in average interest-earning assets was driven primarily by a $293.3 million increase in average loan balances combined with a $33.5 million increase in federal funds sold and interest-bearing deposits with banks. In addition, our loan yield decreased 48 basis points during 2020. Our average interest-bearing liabilities increased by $69.7 million during 2021 while the cost of our interest-bearing liabilities decreased by 60 basis points. The increase in average interest-bearing liabilities was driven primarily by a $99.9 million increase in average interest-bearing deposits at an average rate of 0.24%. During 2020, our average interest-bearing liabilities increased by $152.2 million, compared to 2019, while the cost of our interest-bearing liabilities decreased by 80 basis points. 51 Table of Contents Our net interest spread was 3.35% for the year ended December 31, 2021, compared to 3.22% for the same period in 2020 and 3.00% for 2019. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The 60 basis point decrease in the cost of our interest-bearing liabilities partially offset by a 47 basis point decrease in yield on our interest-earning assets resulted in a 13 basis point increase in our net interest spread for the 2021 period. We anticipate continued pressure on our net interest spread and net interest margin in future periods as our loan yield continues to decline due to new and renewed loans pricing at rates lower than our current portfolio rate. Rate/Volume Analysis Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume. The following tables set forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented. Years Ended December 31, 2021 vs. 2020 December 31, 2020 vs. 2019 Increase (Decrease) Due to Change in Increase (Decrease) Due to Change in (dollars in thousands) Volume Rate Rate/ Volume Total Volume Rate Rate/ Volume Total Interest income Loans $ 9,182 (9,754 ) (962 ) (1,534 ) 14,385 (8,763 ) (1,418 ) 4,204 Investment securities 409 (380 ) (109 ) (80 ) 33 (708 ) (11 ) (686 ) Federal funds sold 46 (71 ) (12 ) (37 ) 758 (1,438 ) (672 ) (1,352 ) Total interest income 9,637 (10,205 ) (1,083 ) (1,651 ) 15,176 (10,909 ) (2,101 ) 2,166 Interest expense Deposits 6,455 (10,439 ) (5,162 ) (9,146 ) 2,088 (11,731 ) (1,032 ) (10,675 ) FHLB advances and other borrowings (330 ) 146 (143 ) (327 ) 305 (497 ) (206 ) (398 ) Subordinated debt 5 (105 ) - (100 ) 805 (57 ) (50 ) 698 Total interest expense 6,130 (10,398 ) (5,305 ) (9,573 ) 3,198 (12,285 ) (1,288 ) (10,375 ) Net interest income $ 3,507 193 4,222 7,922 11,978 1,376 (813 ) 12,541 Net interest income, the largest component of our income, was $87.7 million for the year ended December 31, 2021, a $7.9 million increase from net interest income of $79.8 million for the year ended December 31, 2020. The increase in net interest income was driven by a $9.6 million decrease in interest expense, partially offset by a $1.7 million decrease in interest income. Reduced rates on our interest-bearing liabilities was the primary driver of the decrease in interest expense which was partially offset by a $69.7 million increase in the average balance of those liabilities. Interest income decreased $1.7 million driven by a decrease in rates on interest earning assets. Net interest income, the largest component of our income, was $79.8 million for the year ended December 31, 2020, a $12.5 million increase from net interest income of $67.3 million for the year ended December 31, 2019. The increase in net interest income was driven by a $10.4 million decrease in interest expense and a $2.2 million increase in interest income. Reduced rates on our interest-bearing liabilities was the primary driver of the decrease in interest expense which was partially offset by a $152.2 million increase in the average balance of those liabilities. Interest income increased $2.2 million driven by an increase in average loan balances that was partially offset by a decrease in yield across all interest earning assets. Provision for Loan Losses We have established an allowance for loan losses through a provision for loan losses charged as an expense on our statements of income. We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Please see the discussion below under “Results of Operations – Allowance for Loan Losses” for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance. Following is a summary of the activity in the allowance for loan losses. December 31, (dollars in thousands) 2021 2020 2019 Balance, beginning of period $ 44,149 16,642 15,762 Provision for (reversal of) loan losses (12,400 ) 29,600 2,300 Loan charge-offs (2,166 ) (3,414 ) (1,515 ) Loan recoveries 825 1,321 95 Net loan charge-offs (1,341 ) (2,093 ) (1,420 ) Balance, end of period $ 30,408 44,149 16,642 52 Table of Contents For the year ended December 31, 2021, there was a reversal of the provision for loan losses of $12.4 million, bringing the allowance for loan losses to $30.4 million, or 1.22% of gross loans. In comparison, we added $29.6 million and $2.3 million to the provision for loan losses during the years ended December 31, 2020 and 2019, respectively, resulting in an allowance for loan losses of $44.1 million, or 2.06% of gross loans, as of December 31, 2020, and an allowance for loan losses of $16.6 million, or 0.86% of gross loans, as of December 31, 2019. The negative provision during 2021 was driven by a reduction in qualitative adjustment factors related to the overall improvement in economic conditions at both the national and regional levels as well as improvement in the credit quality of our loan portfolio, and a reduction in the historical loss percentages of our various loan categories due to the low charge-off percentage during the historical loss period. The increased provision during 2020 was driven by an increase to our qualitative environmental factors related to the uncertain economic and business conditions arising from the pandemic at both the national and regional levels. Factors such as the continued impact on the tourism and hospitality industries due to the pandemic, an increase in permanent job losses and unemployment rates as well as uncertainty in the political realm drove this increase. During the year ended December 31, 2021, our net charge-offs were $1.3 million, representing 0.06% of average loans, and consisted of $2.2 million in loans charged-off, partially offset by $825 thousand of recoveries on loans previously charged-off. In addition, nonperforming assets decreased to 0.17% of total assets while our level of classified assets increased to 12.61% at December 31, 2021. We reported net charge-offs of $2.1 million and $1.4 million for the years ended December 31, 2020 and 2019, respectively, including recoveries of $1.3 million and $95,000 in 2020 and 2019, respectively. The net charge-offs of $2.1 million and $1.4 million during 2020 and 2019, respectively, represented 0.10% and 0.08% of the average outstanding loan portfolios for 2020 and 2019, respectively. Noninterest Income The following table sets forth information related to our noninterest income. Year ended December 31, (dollars in thousands) 2021 2020 2019 Mortgage banking income $ 11,376 19,785 9,923 Service fees on deposit accounts 757 860 1,061 ATM and debit card income 2,092 1,741 1,728 Income from bank owned life insurance 1,231 1,091 1,001 Gain on sale of investment securities - 3 727 Loss on extinguishment of debt - (37 ) (1,496 ) Net lender fees on PPP loan sale - 2,247 - Other income 1,645 1,663 2,039 Total noninterest income $ 17,101 27,353 14,983 Noninterest income was $17.1 million for the year ended December 31, 2021, a $10.3 million, or 37.5%, decrease compared to noninterest income of $27.4 million for the year ended December 31, 2020. The decrease in noninterest income during 2021, compared to 2020, resulted primarily from the following: · Mortgage banking income decreased $8.4 million, or 42.5%, driven by low inventory in the housing market, lower refinance volumes, and a decrease in margin on loan sales. We do not expect mortgage origination volume to continue at levels seen in 2020 which will reduce the amount of mortgage banking income recorded in future periods in comparison to prior periods. · Service fees on deposit accounts declined $103,000, or 12.0%, related primarily to a reduction in Non-sufficient Funds (“NSF”) income and lockbox services income. · Net lender fees on PPP loan sale totaled $2.2 million during the 2020 period due to net fee income on the PPP loans we originated and then sold to a third party during the second quarter of 2020. Offsetting these decreases in noninterest income was an increase in ATM and debit card income which was driven by additional transaction volume and an increase in bank owned life insurance as we purchased $7.5 million in additional life insurance. 53 Table of Contents Noninterest income was $27.4 million for the year ended December 31, 2020, a $12.4 million, or 82.6%, increase compared to noninterest income of $15.0 million for the year ended December 31, 2019. The increase in noninterest income during 2020, compared to 2019 resulted primarily from the following: · Mortgage banking income increased $9.9 million, or 99.4%, driven by higher mortgage origination volume during 2020 due to the favorable interest rate environment for mortgage loans. · Loss on extinguishment of debt decreased as a result of fewer prepayment penalties related to the paydown of FHLB Advances. More detail on these transactions is included in the 2019 discussion below. · Net lender fees on PPP loan sale totaled $2.2 million and related to the net fee income on the PPP loans we originated and then sold to a third party during the second quarter of 2020. Offsetting these increases during 2020 were decreases in service fees on deposit accounts and other income. The decrease in service fees on deposit accounts is directly related to the impact of COVID-19 as we have waived certain fees in an effort to assist our clients during this time. During the fourth quarter of 2019, the Company sold its Health Savings Account (“HSA”) deposit accounts, which totaled $6.2 million, to a nationwide HSA servicer and recognized a gain of approximately $745,000 from the sale. Also during the fourth quarter of 2019, the Company sold $29.5 million of investment securities from its existing investment portfolio, recognizing a gain of approximately $720,000 and paid off $25.0 million of FHLB advances that resulted in a prepayment penalty of $1.5 million. Noninterest Expenses The following table sets forth information related to our noninterest expenses. Years ended December 31, (dollars in thousands) 2021 2020 2019 Compensation and benefits $ 28,854 26,287 23,826 Mortgage production costs 8,753 9,898 6,436 Occupancy 6,950 6,226 5,513 Other real estate owned (income) expenses, net 385 1,223 (26 ) Outside service and data processing costs 4,865 4,223 3,782 Insurance 1,149 1,380 813 Professional fees 2,057 1,771 1,327 Marketing 873 628 791 Other 2,544 2,108 2,011 Total noninterest expenses $ 56,430 53,744 44,473 Noninterest expenses were $56.4 million for the year ended December 31, 2021, a $2.7 million, or 5.0%, increase from noninterest expense of $53.7 million for 2020. The increase in total noninterest expenses during 2021, compared to 2020, resulted primarily from the following: · Compensation and benefits expense increased $2.6 million, or 9.8%, during 2021 relating primarily to a $2.5 million increase in salaries and incentive compensation. During 2021, we grew by 24 employees. 13 of which were hired to support growth in our North Carolina offices. · Occupancy expenses increased $724,000, or 11.6%, driven by increased rent expense and depreciation on our new office in Charlotte, North Carolina as well as additional depreciation, insurance, property taxes and maintenance expenses related to all of our properties. · Outside service and data processing costs increased $642,000, or 15.2%, primarily due to increased electronic banking, software licensing costs and ATM card related expenses. · Professional fees increased $286,000, or 16.1%, driven by increased audit, legal and various consulting fees. Partially offsetting the above increases were the following decreases in noninterest expense: · Mortgage production costs decreased $1.1 million, or 11.6%, driven by a decrease in salaries and benefits expense, primarily related to commissions paid on sales activity. · Other real estate owned expenses decreased $838,000 due to one large valuation adjustment on a commercial property in 2020. · Insurance expenses decreased $231,000, or 16.7%, resulting primarily from reduced FDIC assessments during 2021. Noninterest expenses were $53.7 million for the year ended December 31, 2020, a $9.3 million, or 20.8%, increase from noninterest expense of $44.5 million for 2019. 54 Table of Contents The increase in total noninterest expenses during 2020, compared to 2019, resulted primarily from the following: · Compensation and benefits expense increased $2.5 million, or 10.3%, during 2020 relating primarily to a $1.3 million increase in benefits expense, which includes insurance, 401k expenses and executive retirement plans. Base and incentive compensation also increased by $1.1 million as we continue to grow our existing markets. · Mortgage production costs, which primarily includes compensation and benefits, professional fees, software licensing costs and credit bureau fees, increased $3.5 million, or 53.8%, driven by higher mortgage commissions as a result of the increased origination volume during 2020. · Occupancy expenses increased $713,000, or 12.9%, driven by increased rent expense primarily due to office expansion in Atlanta, Georgia as well as additional depreciation, insurance, property taxes and maintenance expenses related to all of our owned properties. · Other real estate owned expenses increased $1.2 million due to a valuation adjustment on one commercial property. · Outside service and data processing costs increased $441,000, or 11.7%, primarily due to increased electronic banking, software licensing costs and ATM card related expenses. · Insurance expenses increased $567,000, or 69.7%, resulting primarily from higher FDIC assessments during the year. · Professional fees increased $444,000, or 33.5%, driven by increased audit, legal and various consulting fees. Our efficiency ratio was 53.8% for 2021 compared to 50.2% for 2020. The efficiency ratio represents the percentage of one dollar of expense required to be incurred to earn a full dollar of revenue and is computed by dividing noninterest expense by the sum of net interest income and noninterest income. The increase during the 2021 period relates primarily to the decrease in noninterest income, combined with the increase in noninterest expense compared to 2020. Income Taxes Income tax expense was $14.1 million, $5.5 million and $7.6 million for the years ended December 31, 2021, 2020 and 2019, respectively. Our effective tax rate was 23.2% for the year ended December 31, 2021, compared to 23.1% for 2020, and 21.5% for 2019. The increase in the effective rate for the 2021 and 2020 periods is related to the greater impact of various employee stock option transactions that occurred during the 2019 period. Investment Securities At December 31, 2021 and 2020, our investment securities portfolio was $124.3 million and $98.4 million, respectively, and represented approximately 4.2% and 4.0% of our total assets, respectively. Our available for sale investment portfolio included Corporate bonds, US treasuries, U.S. agency securities, SBA securities, state and political subdivisions, mortgage-backed securities, and asset-backed securities with a fair value of $120.3 million and amortized cost of $121.2 million for an unrealized loss of $937,000 at December 31, 2021 compared to a fair value of $94.7 million and amortized cost of $93.4 million for an unrealized gain of $1.3 million at December 31, 2020. The amortized costs and the fair value of our investments are as follows. December 31, 2021 2020 2019 Amortized Fair Amortized Fair Amortized Fair (dollars in thousands) Cost Value Cost Value Cost Value Available for Sale Corporate bonds $ 2,198 2,188 - - - - US treasuries 999 992 - - - - US government agencies 14,504 14,169 6,500 6,493 500 499 SBA securities 429 438 504 485 550 531 State and political subdivisions 24,887 25,176 18,614 19,388 4,205 4,184 Asset-backed securities 10,136 10,164 11,587 11,529 13,351 13,167 Mortgage-backed securities 68,065 67,154 56,229 56,834 49,465 49,313 Total $ 121,218 120,281 93,434 94,729 68,071 67,694 Contractual maturities and yields on our investments are shown in the following table. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. 55 Table of Contents December 31, 2021 Less Than One Year One to Five Years Five to Ten Years Over Ten Years Total (dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield Available for Sale Corporate bonds $ - - $ - - $ 2,188 1.98 % $ - - $ 2,188 1.98 % US treasuries - - - - 992 1.27 % - - 992 1.27 % US government agencies - - 2,482 0.36 % 8,756 1.31 % 2,932 1.79 % 14,169 1.24 % SBA securities - - - - - - 438 1.01 % 438 1.01 % State and political subdivisions - - 470 2.13 % 4,282 1.61 % 20,423 2.21 % 25,176 2.11 % Asset-backed securities - - - - 1,614 1.79 % 8,550 0.97 % 10,164 1.10 % Mortgage-backed securities 387 2.10 % 4,411 1.29 % 9,121 1.59 % 53,235 1.38 % 67,154 1.40 % Total $ 387 2.10 % $ 7,363 1.03 % $ 26,953 1.53 % $ 85,578 1.55 % $ 120,281 1.52 % Other investments are comprised of the following and are recorded at cost which approximates fair value. December 31, (dollars in thousands) 2021 2020 Federal Home Loan Bank stock $ 1,241 3,103 Other investments 2,377 129 Investment in Trust Preferred subsidiaries 403 403 Total $ 4,021 3,635 Loans Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Average loans for the years ended December 31, 2021 and 2020 were $2.31 billion and $2.11 billion, respectively. Before allowance for loan losses, total loans outstanding at December 31, 2021 and 2020 were $2.49 billion and $2.14 billion, respectively. The principal component of our loan portfolio is loans secured by real estate mortgages. As of December 31, 2021, our loan portfolio included $2.13 billion, or 85.5%, of real estate loans, compared to $1.81 billion, or 84.6%, as of December 31, 2020. Most of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral, in order to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types. In addition to traditional residential mortgage loans, we issue second mortgage residential real estate loans and home equity lines of credit. Home equity lines of credit totaled $154.8 million as of December 31, 2021, of which approximately 49% were in a first lien position, while the remaining balance was second liens, compared to $157.0 million as of December 31, 2020, of which approximately 45% were in first lien positions and the remaining balance was in second liens. The average home equity loan had a balance of approximately $81,000 and a loan to value of approximately 62% as of December 31, 2021, compared to an average loan balance of $83,000 and a loan to value of approximately 62% as of December 31, 2020. Further, 1.0% and 0.2% of our total home equity lines of credit were over 30 days past due as of December 31, 2021 and 2020, respectively. Following is a summary of our loan composition for each of the five years ended December 31, 2021. Of the $347.0 million in loan growth in 2021, $165.6 million of growth was in commercial related loans, while $181.4 million of growth was in consumer related loans, specifically consumer real estate mortgages which grew by $158.1 million during 2021. The increase in consumer real estate loans is related to our focus to continue to originate high quality 1-4 family consumer real estate loans. Our average consumer real estate loan currently has a principal balance of $454,000, a term of 21 years, and an average rate of 3.47%. 56 Table of Contents December 31, 2021 2020 2019 % of % of % of (dollars in thousands) Amount Total Amount Total Amount Total Commercial Owner occupied RE $ 488,965 19.6 % $ 433,320 20.2 % $ 407,851 21.0 % Non-owner occupied RE 666,833 26.8 % 585,269 27.3 % 501,878 25.8 % Construction 64,425 2.6 % 61,467 2.9 % 80,486 4.1 % Business 333,049 13.4 % 307,599 14.4 % 308,123 15.9 % Total commercial loans 1,553,272 62.4 % 1,387,655 64.8 % 1,298,338 66.8 % Consumer Real estate 694,401 27.9 % 536,311 25.0 % 398,245 20.5 % Home equity 154,839 6.2 % 156,957 7.3 % 179,738 9.3 % Construction 59,846 2.4 % 40,525 1.9 % 41,471 2.1 % Other 27,519 1.1 % 21,419 1.0 % 25,733 1.3 % Total consumer loans 936,605 37.6 % 755,212 35.2 % 645,187 33.2 % Total gross loans, net of deferred fees 2,489,877 100.0 % 2,142,867 100.0 % 1,943,525 100.0 % Less – allowance for loan losses (30,408 ) (44,149 ) (16,642 ) Total loans, net $ 2,459,469 $ 2,098,718 $ 1,926,883 Maturities and Sensitivity of Loans to Changes in Interest Rates The information in the following table is based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties. The following table summarizes the composition and maturities of the loan portfolio. December 31, 2021 (dollars in thousands) One year or less After one but within five years After five but within fifteen years After fifteen years Total Commercial Owner occupied RE $ 16,858 120,480 316,261 35,366 488,965 Non-owner occupied RE 47,453 329,085 263,317 26,978 666,833 Construction 4,882 16,393 29,310 13,840 64,425 Business 66,833 152,732 109,008 4,476 333,049 Total commercial loans 136,026 618,690 717,896 80,660 1,553,272 Consumer Real estate 14,632 45,219 162,655 471,895 694,401 Home equity 2,178 21,280 125,427 5,954 154,839 Construction 962 594 8,956 49,334 59,846 Other 8,071 15,711 3,341 396 27,519 Total consumer loans 25,843 82,804 300,379 527,579 936,605 Total gross loan, net of deferred fees $ 161,869 701,494 1,018,275 608,239 2,489,877 57 Table of Contents The following table summarizes the loans due after one year by category. Interest Rate (dollars in thousands) Fixed Floating or Adjustable Commercial Owner occupied RE 463,589 8,518 Non-owner occupied RE 533,565 85,815 Construction 57,139 2,404 Business 191,522 74,694 Total commercial loans 1,245,815 171,431 Consumer Real estate 679,756 13 Home equity 12,850 139,811 Construction 58,884 - Other 13,220 6,228 Total consumer loans 764,710 146,052 Total gross loan, net of deferred fees 2,010,525 317,483 Nonperforming Assets Nonperforming assets include real estate acquired through foreclosure or deed taken in lieu of foreclosure and loans on nonaccrual status. The following table shows the nonperforming assets and the related percentage of nonperforming assets to total assets and gross loans for the five years ended December 31, 2021. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction in principal when received. Our policy with respect to nonperforming loans requires the borrower to make a minimum of six consecutive payments in accordance with the loan terms before that loan can be placed back on accrual status. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. December 31, (dollars in thousands) 2021 2020 2019 Commercial Owner occupied RE $ - - - Non-owner occupied RE 270 1,143 188 Construction - 139 - Business - 195 235 Consumer Real estate 989 2,536 1,829 Home equity 653 547 431 Construction - - - Other - - - Nonaccruing troubled debt restructurings (TDRs) 2,952 3,509 4,111 Total nonaccrual loans, including nonaccruing TDRs 4,864 8,069 6,794 Other real estate owned - 1,169 - Total nonperforming assets $ 4,864 9,238 6,794 Asset Quality Ratios: Nonperforming assets/total assets 0.17 % 0.37 % 0.30 % Nonaccrual loans/gross loans 0.20 % 0.38 % 0.35 % Total loans over 90 days past due (1) $ 554 2,296 2,038 Loans over 90 days past due and still accruing - - - Accruing troubled debt restructurings 3,299 4,893 5,219 (1) Loans over 90 days are included in nonaccrual loans At December 31, 2021, nonperforming assets were $4.9 million, or 0.17% of total assets and 0.20% of gross loans, compared to $9.2 million, or 0.37% of total assets and 0.43% of gross loans at December 31, 2020. Nonaccrual loans decreased $3.2 million to $4.9 million at December 31, 2021 from $8.1 million at December 31, 2020. During 2021, we added three new loans totaling $1.1 million to nonaccrual, while nine loans totaling $1.4 million paid off, three loans totaling $1.5 million were returned to accruing status and one loan totaling $367,000 was transferred to other real estate owned. The amount of foregone interest income on the nonaccrual loans for the years ended December 31, 2021 and 2020 was approximately $55,000 and $61,000, respectively. 58 Table of Contents At December 31, 2021, our allowance for loan losses represented 625.16% of nonaccrual loans, compared to 547.14% at year-end 2020 and 244.95% at year-end 2019. A significant portion, or 95.1%, of nonaccrual loans at December 31, 2021 were secured by real estate. We have evaluated the underlying collateral on these loans and believe that the collateral on these loans is sufficient to minimize future losses. As a result of this level of coverage on nonaccrual loans, we believe the allowance for loan losses of $30.4 million for the year ended December 31, 2021 is adequate. As a general practice, most of our commercial loans and a portion of our consumer loans are originated with relatively short maturities of less than ten years. As a result, when a loan reaches its maturity we frequently renew the loan and thus extend its maturity using similar credit standards as those used when the loan was first originated. Due to these loan practices, we may, at times, renew loans which are classified as nonaccrual after evaluating the loan’s collateral value and financial strength of its guarantors. Nonaccrual loans are renewed at terms generally consistent with the ultimate source of repayment and rarely at reduced rates. In these cases, we will generally seek additional credit enhancements, such as additional collateral or additional guarantees to further protect the loan. When a loan is no longer performing in accordance with its stated terms, we will typically seek performance under the guarantee. In addition, approximately 86% of our loans are collateralized by real estate and approximately 97% of our impaired loans are secured by real estate. We use third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require us to review impaired loans at least annually and determine whether it is necessary to obtain an updated appraisal, either through a new external appraisal or an internal appraisal evaluation. We individually review our impaired loans on a quarterly basis to determine the level of impairment. As of December 31, 2021, we do not have any impaired loans carried at a value in excess of the appraised value. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement. At December 31, 2021, impaired loans totaled approximately $8.2 million for which $2.9 million of these loans have a reserve of approximately $836,000 allocated in the allowance. During 2021, the average recorded investment in impaired loans was approximately $12.5 million. At December 31, 2020, impaired loans totaled approximately $13.0 million for which $5.1 million of these loans had a reserve of approximately $1.7 million allocated in the allowance. During 2020, the average recorded investment in impaired loans was approximately $14.6 million. We consider a loan to be a TDR when the debtor experiences financial difficulties and we provide concessions such that we will not collect all principal and interest in accordance with the original terms of the loan agreement. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. As of December 31, 2021 and 2020, we had $6.3 million and $8.4 million, respectively, in loans that we considered TDRs. As permitted by the CARES Act, we do not consider loan modifications to borrowers affected by COVID-19 to be TDRs unless the borrower was 30 days or more past due before December 31, 2019. See Notes 1 and 5 to the Consolidated Financial Statements for additional information on TDRs. In addition, potential problem loans, which are loans rated substandard and not included in nonperforming loans or TDRs, amounted to approximately $35.9 million, or 1.44% of gross loans at December 31, 2021, compared to $19.6 million, or 0.92% of gross loans at December 31, 2020. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms. The increase in potential problem loans since December 31, 2020 is primarily the result of five hotel loans that were downgraded during the first quarter of 2021, increasing total potential problem loans by approximately $13.7 million. As of December 31, 2021 these five loans were each accruing and performing as agreed. Allowance for Loan Losses At December 31, 2021 and December 31, 2020, the allowance for loan losses was $30.4 million and $44.1 million, respectively, or 1.22% and 2.06% of outstanding loans, respectively. The allowance for loan losses as a percentage of our outstanding loan portfolio decreased from the prior year primarily due a reduction in qualitative adjustment factors related to the overall improvement in economic conditions at both the national and regional levels as well as a reduction in the historical loss percentages of our various loan categories. In addition, despite the increase in potential problem loans, the credit quality of our loan portfolio improved with our nonperforming assets decreasing to 0.17% compared to 0.37%, as a percentage of total assets, at December 31, 2021 and 2020, respectively. However, our classified assets increased to 12.6% of capital as of December 31, 2021, compared to 8.2% of capital as of December 31, 2020 due to the five hotel loans that were downgraded during the first quarter of 2021. See Note 4 to the Consolidated Financial Statements for more information on our allowance for loan losses. 59 Table of Contents The negative provision during 2021 was driven by a reduction in qualitative adjustment factors related to the overall improvement in economic conditions at both the national and regional levels as well as improvement in the credit quality of our loan portfolio, and a reduction in the historical loss percentages of our various loan categories due to the low charge-off percentage during the historical loss period. The following table summarizes the net charge-off detail as a percentage of average loans by loan composition for the three years ended December 31, 2021. Year ended December 31, (dollars in thousands) 2021 2020 2019 Amount % Amount % Amount % Net charge-offs: Commercial Owner occupied RE $ 94 0.00 % $ (29 ) 0.00 % $ (110 ) 0.01 % Non-owner occupied RE (573 ) 0.03 % (838 ) 0.04 % (237 ) 0.01 % Construction - - - - - - Business (943 ) 0.04 % (839 ) 0.04 % (867 ) 0.05 % Total commercial (1,422 ) 0.06 % (1,706 ) 0.08 % (1,214 ) 0.07 % Consumer Real estate 18 0.00 % (116 ) 0.01 % 37 0.00 % Home equity 62 0.00 % (230 ) 0.01 % (172 ) 0.01 % Construction - - - - - - Other 1 0.00 % (41 ) 0.00 % (71 ) 0.00 % Total consumer 81 0.00 % (387 ) 0.02 % (206 ) 0.01 % Net loan charge-offs $ (1,341 ) $ (2,093 ) $ (1,420 ) Net loan charge-offs as a % of average loans 0.06 % 0.10 % 0.08 % The following table summarizes the allocation of the allowance for loan losses among the various loan categories. Year ended December 31, (dollars in thousands) 2021 2020 Amount % (1) Amount % (1) Commercial Owner occupied RE $ 4,754 19.6 % $ 8,145 20.2 % Non-owner occupied RE 10,518 26.8 % 12,049 27.3 % Construction 625 2.6 % 1,154 2.9 % Business 4,861 13.4 % 7,845 14.4 % Total commercial 20,758 62.4 % 29,193 64.8 % Consumer Real estate 7,054 27.9 % 10,453 25.0 % Home equity 1,698 6.2 % 3,249 7.3 % Construction 578 2.4 % 747 1.9 % Other 320 1.1 % 507 1.0 % Total consumer 9,650 37.6 % 14,956 35.2 % Total allowance for loan losses $ 30,408 100.0 % $ 44,149 100.0 % (1) Percentage of loans in each category to total loans Deposits and Other Interest-Bearing Liabilities Our primary source of funds for loans and investments is our deposits and advances from the FHLB. In the past, we have chosen to obtain a portion of our certificates of deposits from areas outside of our market in order to obtain longer term deposits than are readily available in our local market. Our internal guidelines regarding the use of brokered CDs limit our brokered CDs to 20% of total deposits. In addition, we do not obtain time deposits of $100,000 or more through the Internet. These guidelines allow us to take advantage of the attractive terms that wholesale funding can offer while mitigating the related inherent risk. 60 Table of Contents Our retail deposits represented $2.56 billion, or 100.0% of total deposits at December 31, 2021. At December 31, 2020, retail deposits represented $2.12 billion, or 99.0% of our total deposits, and brokered deposits were $22.0 million, representing 1.0% of our total deposits, at December 31, 2020. Our loan-to-deposit ratio was 97%, 100%, and 104% at December 31, 2021, 2020, and 2019, respectively. The following table shows the average balance amounts and the average rates paid on deposits held by us. December 31, 2021 2020 2019 (dollars in thousands) Amount Rate Amount Rate Amount Rate Noninterest bearing demand deposits $ 671,223 - % $ 513,576 - % $ 367,674 - % Interest bearing demand deposits 306,669 0.07 % 255,514 0.14 % 205,513 0.27 % Money market accounts 1,143,904 0.21 % 981,226 0.76 % 849,225 1.78 % Savings accounts 32,916 0.05 % 22,113 0.05 % 15,483 0.06 % Time deposits less than $100,000 30,217 0.54 % 41,406 1.40 % 58,043 1.88 % Time deposits greater than $100,000 146,084 0.75 % 259,672 1.27 % 305,388 1.72 % Total deposits $ 2,331,013 0.17 % $ 2,073,507 0.57 % $ 1,801,326 1.22 % During the 12 months ended December 31, 2021, our average transaction account balances increased by $382.3 million, or 21.6%, while our average time deposit balances decreased by $124.8 million, or 41.4%. Core deposits exclude out-of-market deposits and time deposits of $250,000 or more and provide a relatively stable funding source for our loan portfolio and other earning assets. Our core deposits were $2.48 billion, $2.01 billion, and $1.66 billion at December 31, 2021, 2020 and 2019, respectively. All of our time deposits are certificates of deposits. The maturity distribution of our time deposits of $250,000 or more is as follows: December 31, (dollars in thousands) 2021 2020 Three months or less $ 35,151 118,714 Over three through six months 13,746 608 Over six through twelve months 20,521 1,416 Over twelve months 14,995 10,117 Total $ 84,413 130,855 Time deposits that meet or exceed the FDIC insurance limit of $250,000 at December 31, 2021 and December 31, 2020 were $84.4 million and $130.9 million, respectively. At December 31, 2021 and 2020, the Company estimates that it has approximately $1.2 billion and $879.1 million, respectively, in uninsured deposits including related interest accrued and unpaid. Since it is not reasonably practicable to provide a precise measure of uninsured deposits, the amounts above are estimates and are based on the same methodologies and assumptions used for the bank’s regulatory reporting requirements by the FDIC for the Call Report. Liquidity and Capital Resources Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities. Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control. 61 Table of Contents At December 31, 2021 and 2020, our cash and cash equivalents amounted to $167.2 million and $100.7 million, or 5.7% and 4.1% of total assets, respectively. Our investment securities at December 31, 2021 and 2020 amounted to $124.3 million and $98.4 million, or 4.2% and 4.0% of total assets, respectively. Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner. Our ability to maintain and expand our deposit base and borrowing capabilities serves as our primary source of liquidity. We plan to meet our future cash needs through the liquidation of temporary investments, the generation of deposits, and from additional borrowings. In addition, we will receive cash upon the maturity and sale of loans and the maturity of investment securities. We maintain five federal funds purchased lines of credit with correspondent banks totaling $118.5 million to meet short-term liquidity needs. There were no borrowings against the lines at December 31, 2021. We are also a member of the FHLB of Atlanta, from which applications for borrowings can be made. The FHLB requires that securities, qualifying mortgage loans, and stock of the FHLB owned by the Bank be pledged to secure any advances from the FHLB. The unused borrowing capacity currently available from the FHLB at December 31, 2021 was $580.7 million, based on the Bank’s $1.2 million investment in FHLB stock, as well as qualifying mortgages available to secure any future borrowings. However, we are able to pledge additional securities to the FHLB in order to increase our available borrowing capacity. In addition, at December 31, 2021 we had $254.5 million of letters of credit outstanding with the FHLB to secure client deposits. We also have a line of credit with another financial institution for $15.0 million, which was unused at December 31, 2021. The line of credit was renewed on December 21, 2021 at an interest rate of One Month CME Term SOFR plus 3.5% and a maturity date of December 20, 2023. We believe that our existing stable base of core deposits, federal funds purchased lines of credit with correspondent banks, and borrowings from the FHLB will enable us to successfully meet our long-term liquidity needs. However, as short-term liquidity needs arise, we have the ability to sell a portion of our investment securities portfolio to meet those needs. Total shareholders’ equity was $277.9 million at December 31, 2021 and $228.3 million at December 31, 2020. The $49.6 million increase during 2021 is due primarily to net income to common shareholders of $46.7 million, stock option exercises and expenses of $4.7 million and $1.8 million loss in other comprehensive income. The following table shows the return on average assets (net income divided by average total assets), return on average equity (net income divided by average equity), equity to assets ratio (average equity divided by average assets), and tangible common equity ratio (total equity less preferred stock divided by total assets) for the three years ended December 31, 2021. Since our inception, we have not paid cash dividends. December 31, (dollars in thousands) 2021 2020 2019 Return on average assets 1.75 % 0.76 % 1.35 % Return on average equity 18.64 % 8.49 % 14.72 % Return on average common equity 18.64 % 8.49 % 14.72 % Average equity to average assets ratio 9.39 % 9.01 % 9.16 % Tangible common equity to assets ratio 9.50 % 9.20 % 9.08 % Under the capital adequacy guidelines, regulatory capital is classified into two tiers. These guidelines require an institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, minus certain intangible assets. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed to be inherent in the type of asset. Tier 2 capital consists of Tier 1 capital plus the general reserve for loan losses, subject to certain limitations. We are also required to maintain capital at a minimum level based on total average assets, which is known as the Tier 1 leverage ratio. Regulatory capital rules, which we refer to Basel III, impose minimum capital requirements for bank holding companies and banks. The Basel III rules apply to all national and state banks and savings associations regardless of size and bank holding companies and savings and loan holding companies other than “small bank holding companies,” generally holding companies with consolidated assets of less than $3 billion (such as the Company). In order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a “capital conservation buffer” on top of our minimum risk-based capital requirements. This buffer must consist solely of common equity Tier 1, but the buffer applies to all three measurements (common equity Tier 1, Tier 1 capital and total capital). The capital conservation buffer consists of an additional amount of CET1 equal to 2.5% of risk-weighted assets. 62 Table of Contents To be considered “well-capitalized” for purposes of certain rules and prompt corrective action requirements, the Bank must maintain a minimum total risked-based capital ratio of at least 10%, a total Tier 1 capital ratio of at least 8%, a common equity Tier 1 capital ratio of at least 6.5%, and a leverage ratio of at least 5%. As of December 31, 2021, our capital ratios exceed these ratios and we remain “well capitalized.” The following table summarizes the capital amounts and ratios of the Bank and the regulatory minimum requirements. See Note 23 to the Consolidated Financial Statements for ratios of the Company. Actual For capital adequacy purposes minimum (1) To be well capitalized under prompt corrective action provisions minimum (dollars in thousands) Amount Ratio Amount Ratio Amount Ratio As of December 31, 2021 Total Capital (to risk weighted assets) $ 331,052 14.36 % $ 184,418 8.00 % $ 230,522 10.00 % Tier 1 Capital (to risk weighted assets) 302,217 13.11 % 138,313 6.00 % 184,418 8.00 % Common Equity Tier 1 (to risk weighted assets) 302,217 13.11 % 103,735 4.50 % 149,839 6.50 % Tier 1 Capital (to average assets) 302,217 10.55 % 114,537 4.00 % 143,172 5.00 % As of December 31, 2020 Total Capital (to risk weighted assets) $ 279,414 13.92 % $ 160,554 8.00 % $ 200,693 10.00 % Tier 1 Capital (to risk weighted assets) 254,092 12.66 % 120,416 6.00 % 160,554 8.00 % Common Equity Tier 1 (to risk weighted assets) 254,092 12.66 % 90,312 4.50 % 130,451 6.50 % Tier 1 Capital (to average assets) 254,092 10.26 % 99,094 4.00 % 123,867 5.00 % As of December 31, 2019 Total Capital (to risk weighted assets) $ 250,847 13.31 % $ 150,807 8.00 % $ 188,510 10.00 % Tier 1 Capital (to risk weighted assets) 234,205 12.42 % 113,106 6.00 % 150,807 8.00 % Common Equity Tier 1 (to risk weighted assets) 234,205 12.42 % 84,829 4.50 % 122,531 6.50 % Tier 1 Capital (to average assets) 234,205 10.80 % 86,772 4.00 % 108,465 5.00 % (1) Ratios do not include the capital conservation buffer of 2.5%. On September 30, 2019, the Company sold and issued $23.0 million in aggregate principal amount of its 4.75% Fixed-to-Floating Rate Subordinated Notes due 2029 to eligible purchasers in a private offering. The Company intends to use the proceeds from the offering, which were approximately $22.5 million, for general corporate purposes, including providing capital to the Bank and supporting organic growth. The Notes rank junior in right to payment to the Company’s current and future senior indebtedness. The Notes are intended to qualify as Tier 2 capital for regulatory capital purposes for the Company. The ability of the Company to pay cash dividends is dependent upon receiving cash in the form of dividends from the Bank. The dividends that may be paid by the Bank to the Company are subject to legal limitations and regulatory capital requirements. Effect of Inflation and Changing Prices The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on an historical cost basis in accordance with generally accepted accounting principles. Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude. As discussed previously, we seek to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation. 63 Table of Contents Off-Balance Sheet Risk Commitments to extend credit are agreements to lend to a client as long as the client has not violated any material condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. At December 31, 2021, unfunded commitments to extend credit were approximately $618.7 million, of which $205.4 million were at fixed rates and $413.3 million were at variable rates. At December 31, 2020, unfunded commitments to extend credit were $480.1 million, of which approximately $114.6 million were at fixed rates and $365.5 million were at variable rates. A majority of the unfunded commitments related to commercial business lines of credit and home equity lines of credit. Based on historical experience, we anticipate that a significant portion of these lines of credit will not be funded. We evaluate each client’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. The type of collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate. At December 31, 2021 and 2020, there were $10.2 million and $8.7 million of commitments under letters of credit, respectively. The credit risk and collateral involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients. Since most of the letters of credit are expected to expire without being drawn upon, they do not necessarily represent future cash requirements. Except as disclosed in this Annual Report, we are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements or transactions that could result in liquidity needs or other commitments that significantly impact earnings. Market Risk and Interest Rate Sensitivity Market risk is the risk of loss from adverse changes in market prices and rates, which principally arises from interest rate risk inherent in our lending, investing, deposit gathering, and borrowing activities. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not generally arise in the normal course of our business. We actively monitor and manage our interest rate risk exposure to seek to control the mix and maturities of our assets and liabilities utilizing a process we call asset/liability management. The essential purposes of asset/liability management are to seek to ensure adequate liquidity and to maintain an appropriate balance between interest sensitive assets and liabilities in order to minimize potentially adverse impacts on earnings from changes in market interest rates. Our asset/liability management committee (“ALCO”) monitors and considers methods of managing exposure to interest rate risk. We have both an internal ALCO consisting of senior management that meets at various times during each month and a board ALCO that meets monthly. The ALCOs are responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities within board-approved limits. As of December 31, 2021, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward and downward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the Consolidated Financial Statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market conditions. Interest rate scenario Change in net interest income from base Up 300 basis points (13.99 )% Up 200 basis points (9.01 )% Up 100 basis points (4.30 )% Base - Down 100 basis points (1.87 )% Down 200 basis points (2.91 )% Down 300 basis points (3.45 )% 64 Table of Contents Contractual Obligations We have commitments with various investment partners under the Small Business Investment Company (“SBIC”) and the Rural Business Investment Company (“RBIC”) Programs for which we have committed to make capital contributions from time to time. We utilize a variety of short-term and long-term borrowings to supplement our supply of lendable funds, to assist in meeting deposit withdrawal requirements, and to fund growth of interest-earning assets in excess of traditional deposit growth. Certificates of deposit, structured repurchase agreements, FHLB advances, and subordinated debentures serve as our primary sources of such funds. Obligations under noncancelable operating lease agreements are payable over several years with the longest obligation expiring in 2032. We do not feel that any existing noncancelable operating lease agreements are likely to materially impact our financial condition or results of operations in an adverse way. Contractual obligations relative to these agreements are noted in the table below. Option periods that we have not yet exercised are not included in this analysis as they do not represent contractual obligations until exercised. The following table provides payments due by period for obligations under long-term borrowings and operating lease obligations as of December 31, 2021. December 31, 2021 Payments Due by Period (dollars in thousands) Within One Year Over One to Two Years Over Two to Three Years Over Three to Four Years After Five Years Total Certificates of deposit $ 119,674 20,195 6,810 5,803 110 152,592 Subordinated debentures - - - - 36,106 36,106 Operating lease obligations 1,974 1,939 1,990 2,046 26,188 34,137 Total $ 121,648 22,134 8,800 7,849 62,404 222,835 Accounting, Reporting, and Regulatory Matters See Note 1 – Summary of Significant Accounting Policies and Activities in our “Notes to Consolidated Financial Statements” for a discussion on the effects of recently issued accounting pronouncements. Item 7A. Quantitative and Qualitative Disclosures about Market Risk See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Market Risk and Interest Rate Sensitivity and – Liquidity and Capital Resources. 65 Table of Contents PART II