Item 2. Management’s Discussion and Analysis
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Unless the context clearly suggests otherwise, references to “the Company”, “we”, “our”, and “us” in the remainder of this report are to Shore Bancshares, Inc. and its consolidated subsidiary.
Forward-Looking Information
This Quarterly Report on Form 10-Q contains forward-looking statements. These forward-looking statements reflect our current views with respect to, among other things, future events and our financial performance. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “continue,” “will,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “project,” “projection,” “forecast,” “goal,” “target,” “would,” “aim” and “outlook,” or the negative version of those words or other comparable words or phrases of a future or forward-looking nature. These forward-looking statements are not historical facts, and are based on current expectations, estimates and projections about our industry and management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. The inclusion of these forward-looking statements should not be regarded as a representation by us or any other person that such expectations, estimates and projections will be achieved. Accordingly, we caution you that any such forward-looking statements are not guarantees of future performance and are subject to risks, assumptions and uncertainties that are difficult to predict. New risks and uncertainties may emerge from time to time, and it is not possible for us to predict their occurrence. In addition, we cannot assess the impact of each risk and uncertainty on our business or the extent to which any risk or uncertainty, or combination of risks and uncertainties, may cause actual results to differ materially from those contained in any forward-looking statements.
Further, given its ongoing and dynamic nature, it is difficult to predict the full impact of the novel coronavirus (“COVID-19”) outbreak on our business. The extent of such impact will depend on future developments, which are highly uncertain, including when the coronavirus can be controlled and abated and when and how the economy may be fully reopened. As the result of the COVID-19 pandemic and the related adverse local and national economic consequences, we could be subject to any of the following risks, any of which could have a material, adverse effect on our business, financial condition, liquidity, and results of operations: the demand for our products and services may decline, making it difficult to grow assets and income; if the economy is unable to substantially reopen, and high levels of unemployment continue for an extended period of time, loan delinquencies, problem assets, and foreclosures may increase, resulting in increased charges and reduced income; collateral for loans, especially real estate, may decline in value, which could cause loan losses to increase; our allowance for loan losses may increase if borrowers experience financial difficulties, which will adversely affect our net income; the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us; as the result of the decline in the Federal Reserve’s target federal funds rate to near 0%, the yield on our assets may decline to a greater extent than the decline in our cost of interest-bearing liabilities, reducing our net interest margin and spread and reducing net income; our cybersecurity risks are increased as the result of an increase in the number of employees working remotely; and FDIC premiums may increase if the agency experiences additional resolution costs.
If one or more of the factors affecting our forward-looking information and statements proves incorrect, then our actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements contained in this Quarterly Report on Form 10-Q and other reports and registration statements filed by us with the Securities and Exchange Commission (“SEC”). For information on the factors that could cause actual results to differ from the expectations stated in the forward- looking statements, see “Risk Factors” under Part I, Item 1A of our 2019 Form 10-K in addition to Part II, Item 1A - Risk Factors of this Quarterly Report on Form 10-Q and other reports as filed with the SEC.
Any forward-looking statement speaks only as of the date of this report, and we do not undertake any obligation to publicly update or review any forward-looking statement, whether because of new information, future developments or otherwise, except as required by law.
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Introduction
The following discussion and analysis is intended as a review of significant factors affecting the Company’s financial condition and results of operations for the periods indicated. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and related notes presented elsewhere in this report, as well as the audited consolidated financial statements and related notes included in the 2019 Annual Report.
Shore Bancshares, Inc. is the largest independent financial holding company headquartered on the Eastern Shore of Maryland. It is the parent company of Shore United Bank. The Bank operates 22 full-service branches in Baltimore County, Howard County, Kent County, Queen Anne’s County, Talbot County, Caroline County, Dorchester County and Wicomico County in Maryland, Kent County, Delaware and Accomack County, Virginia. The Company engages in trust and wealth management services through Wye Financial Partners, a division of Shore United Bank.
The shares of common stock of Shore Bancshares, Inc. are listed on the NASDAQ Global Select Market under the symbol “SHBI”.
Shore Bancshares, Inc. maintains an Internet site at www.shorebancshares.com on which it makes available free of charge its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.
COVID-19 Pandemic
The outbreak of COVID-19, which was declared a pandemic by the World Health Organization on March 11, 2020, has led to adverse impacts on economic conditions and created uncertainty in financial markets. Correspondingly, in early March 2020, the Company began preparing for potential disruptions and government limitations of activity in the markets in which we serve. Our team activated our Business Continuity Program and was able to quickly execute on multiple initiatives to adjust our operations to protect the health and safety of our employees and clients. Since the beginning of the crisis, we have been in close contact with our clients, assessing the level of impact on their businesses, and providing relief programs according to each client’s specific situation and qualifications. We have also enhanced awareness of digital banking offerings, expanded services at our drive through locations, and allowed customers to make appointments in the branch for critical services. The Company’s branches remain open and have taken steps to comply with various government directives regarding “social distancing,” as well as, enhanced cleaning and disinfecting of all surface areas to protect its clients and employees.
Small Business Administration’s Paycheck Protection Program
We established our process for participating in the Small Business Administration’s Paycheck Protection Program (“PPP”) that enabled our clients to utilize this valuable resource beginning in April 2020. Loans under the PPP are designed to provide assistance for small businesses during the COVID-19 pandemic to help meet the costs associated with payroll, mortgage interest, rent and utilities. These loans are guaranteed by the SBA and forgiveness of the loans, by the SBA, is granted to the borrower if the borrower uses at least 60% of the funds to cover payroll costs and benefits. Forgiveness is also based on the small business maintaining or quickly rehiring their employees and maintaining salary levels for their employees. Loans under the PPP do not require any collateral or personal guarantees, as such, these loans are included in the Company’s commercial loans segment. Through August 8, 2020, our team was able to process 1,488 PPP loans for approximately $126.7 million in the first and second rounds of the program, which has allowed us to further strengthen and deepen our client relationships, while positively impacting thousands of individuals. We are also closely monitoring the credit quality of the loan portfolio and monitor lines of credit draws for deviation from normal activity to improve loan performance and reduce credit risk.
Short-term Modifications for Borrowers
In keeping with regulatory guidance to work with borrowers during this unprecedented situation and as outlined in Section 4013 of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), the Company is providing modifications where appropriate, including interest only payments or payment deferrals for clients that could be adversely affected by
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the COVID-19 pandemic. Section 4013 of the CARES Act also addressed COVID-19 related modifications and specified that such modifications made on loans that were current as of December 31, 2019 are not TDRs. In accordance with interagency guidance issued in April 2020, these short-term modifications made to a borrower affected by the COVID-19 pandemic and governmental shutdown orders, such as payment deferrals, fee waivers and extensions of repayment terms, do not need to be identified as TDRs if the loans were current at the time a modification plan was implemented. For the nine months ended September 30, 2020, the Company had executed principal and/or interest deferrals on outstanding loan balances of $221.1 million, of which only $12.9 million, or 0.91% of the total portfolio remained on deferral as of September 30, 2020.
Loans
Loans Modified
Modified to
Total Loan
Total Loans
to Interest
Payment
Percentage
Balance as of
Modified as of
Only Payments
Deferral
of Loans
(Dollars in thousands)
September 30, 2020
September 30, 2020
(6 months or less)
(3 months)
Modified
Hospitality Industry
$
113,833
$
4,659
$
-
$
4,659
4.09
%
Non-owner occupied Retail Stores
101,304
-
-
-
—
Non-owner occupied Restaurants
11,173
-
-
-
—
Owner-occupied Retail Stores
14,471
160
160
-
1.11
Owner-occupied Restaurants
9,215
220
220
-
2.39
Oil & Gas Industry
-
-
-
-
—
Other Commercial Loans
765,998
6,374
2,089
4,285
0.83
Total Commercial Loans
1,015,994
11,413
2,469
8,944
1.12
Residential 1-4 family Personal
231,547
-
-
-
—
Residential 1-4 family Rentals
100,852
1,073
300
773
1.06
Home Equity Loans
46,609
-
-
-
—
Total Residential Real Estate Loans
379,008
1,073
300
773
0.28
Consumer Loans
29,774
435
-
435
1.46
Mortgage Warehouse Loans
-
-
-
-
—
Credit Card, Overdrafts and Other
(811)
-
-
-
—
TOTAL LOANS
$
1,423,965
$
12,921
$
2,769
$
10,152
0.91
%
Liquidity
We are vigilantly monitoring our liquidity position on an ongoing basis as the circumstances surrounding the pandemic continue to evolve. The Company has several available sources of on and off-balance sheet liquidity. Currently, the Company has not needed to tap into these available liquidity sources due to payment deferrals by customers, funding of PPP loans, or organic loan growth. The potential for increased reliance on available liquidity sources may be required based on the effects of the pandemic and their impact on the level of deposits and other factors. Additional discussion on our liquidity as of the report date is reflected in the “Liquidity and Capital Resources” section of management’s discussion and analysis.
Share Repurchases
We reinstated our common stock repurchase program on September 1, 2020. During the third quarter of 2020, we repurchased 288,400 shares of the Company’s common stock at an average cost of $10.56 per share or $3.1 million in the aggregate.
Dividends and Capital
We currently expect to maintain our quarterly cash dividend based on our strong capital position. At September 30, 2020, the Bank exceeded all the capital requirements to which it was subject, and based on the most recent notification from its primary federal regulator is considered to be well-capitalized. There are no conditions or events since that notification that management believes would change the Bank’s classification. We are closely monitoring our capital position and are taking appropriate steps to ensure our level of capital remains strong. Our capital, while significant, may deteriorate in future periods due to the impact of the pandemic and limit our ability to pay dividends.
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Critical Accounting Policies
The Company’s consolidated financial statements are prepared in accordance with GAAP and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have 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.
The most significant accounting policies that the Company follows are presented in Note 1 of the 2019 Annual Report. These policies, along with the disclosures presented in the notes to the financial statements and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for credit losses and goodwill and other intangible assets are critical accounting policies. These policies are considered critical because they relate to accounting areas that require the most subjective or complex judgments, and, as such, could be most subject to revision as new information becomes available.
The allowance for credit losses represents management’s estimate of credit losses inherent in the loan portfolio as of the balance sheet date. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of similar loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheets. Note 1 to the 2019 Annual Report describes the methodology used to determine the allowance for credit losses. A discussion of the allowance determination and factors driving changes in the amount of the allowance for credit losses is included in the Provision for Credit Losses and Allowance for Credit Losses sections below.
Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability. Goodwill and other intangible assets are required to be recorded at fair value at inception. Determining fair value is subjective, requiring the use of estimates, assumptions and management judgment. Goodwill is tested at least annually for impairment, usually during the fourth quarter, or on an interim basis if circumstances dictate. Intangible assets that have finite lives are amortized over their estimated useful lives and also are subject to impairment testing. Impairment testing requires a qualitative assessment or that the fair value of each of the Company’s reporting units be compared to the carrying amount of its net assets, including goodwill. If the fair value of a reporting unit is less than book value, an expense may be required to write down the related goodwill to record an impairment loss. As of September 30, 2020, the Company had only one banking reporting unit.
OVERVIEW
The Company reported net income of $3.4 million for the third quarter of 2020, or diluted income per common share of $0.27, compared to net income of $4.2 million, or diluted income per common share of $0.33, for the third quarter of 2019. For the second quarter of 2020, the Company reported net income of $5.3 million, or diluted income per common share of $0.43. When comparing net income for the third quarter of 2020 to the third quarter of 2019, the decrease was due to an increase in noninterest expense of $447 thousand, coupled with an increase in provision for credit losses of $1.3 million, partially offset by an increase in net interest income of $603 thousand. When comparing net income from continuing operations for the third quarter of 2020 to the second quarter of 2020, the decrease was primarily due to an increase in noninterest expenses of $2.2 million. Net interest income increased $252 thousand in the third quarter when compared to the second quarter, which was more than offset by an increase in provision for credit losses of $500 thousand and a decrease in noninterest income of $188 thousand.
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For the first nine months of 2020, the Company reported net income of $11.8 million, or diluted income per common share of $0.95, compared to net income of $12.3 million, or diluted income per common share of $0.95, for the first nine months of 2019. When comparing net income from continuing operations for the first nine months of 2020 to the first nine months of 2019, the decrease was primarily due to increases in the provision for credit losses of $2.4 million and noninterest expenses of $131 thousand, partially offset by higher net interest income of $1.5 million and noninterest income of $376 thousand.
RESULTS OF OPERATIONS
Net Interest Income
Tax-equivalent net interest income is net interest income adjusted for the tax-favored status of income from certain loans and investments. As shown in the table below, tax-equivalent net interest income was $13.3 million for the third quarter of 2020 and $12.7 million for the third quarter of 2019. Tax-equivalent net interest income was $13.1 million for the second quarter of 2020. The increase in net interest income for the third quarter of 2020 when compared to the third quarter of 2019 was due to lower interest expenses on interest bearing deposits of $819 thousand, or 35.8% and the elimination of short and long-term advances from the Federal Home Loan Bank (“FHLB“) which reduced interest expense by a combined $220 thousand. These improvements to net interest income were partially offset by decreases in interest income on taxable investment securities of $140 thousand, or 16.1%, and interest-bearing deposits with other banks of $190 thousand, or 85.2%. Net interest income increased for the third quarter of 2020 when compared to the second quarter of 2020 due to increases in the average balances in loans of $32.4 million, taxable investment securities of $28.1 million and interest-bearing deposits with other banks of $69.8 million. These increases in the average balances on earning assets contributed $304 thousand to interest income over the second quarter, despite a decline in the weighted average yield on these assets of 26 basis points (bps). In addition, the weighted average rate paid on interest-bearing deposits declined by 8bps in the third quarter when compared to the second quarter, reducing interest expense by $87 thousand. However, this decline was more than offset by the $148 thousand of additional interest expense related to subordinated debt issued during the third quarter. Net interest margin is tax-equivalent net interest income (annualized) divided by average earning assets. The net interest margin for the third quarter of 2020 was 3.17%, which was a decrease of 35bps when compared to 3.52% for the third quarter of 2019 and a decrease of 24bps when compared to 3.41% for the second quarter of 2020. The decline in net interest margin in the third quarter of 2020 when compared to the second quarter of 2020 and the third quarter of 2019, was significantly impacted by excess liquidity of approximately $100 million, which has yet to be fully invested. This excess liquidity was due to deposit inflows related to customers retaining PPP loan proceeds, customers improving their liquidity position by participating in our deferred loan program and the result of new business and municipal relationships acquired during 2020. Without this excess liquidity, the margin for the third quarter would have been 3.37%.
Interest Income
On a tax-equivalent basis, interest income decreased $302 thousand, or 2.0%, for the third quarter of 2020 when compared to the third quarter of 2019. The decrease was due to a decrease in the average yield on interest-bearing deposits with other banks of 203bps resulting from Federal Reserve interest rate cuts during 2020 and decreases in both the average balance and average yield of taxable investment securities of $19.3 million, or 12.4%, and 10bps, respectively. The average balance of loans increased $171.3 million, or 13.9%, between the comparable periods and the average yield on loans decreased 53bps, which was the direct result of adding 1,488 PPP loans with an average yield of 2.00%.
On a tax-equivalent basis, interest income increased $305 thousand, or 2.1%, for the third quarter of 2020 when compared to the second quarter of 2020. The increase was primarily due to increases in the average balance of loans of $32.4 million, or 2.4%, and the average balance of investment securities of $28.1 million, or 14.4%, despite the decrease in the average yield on these earning assets of a combined 31bps. The average balance on interest-bearing deposits increased $69.8 million, or 200.0%, while the average yield also increased 3bps, resulting in an additional $22 thousand in interest income. The significant volume increases in total deposits was the result of deposit inflows previously stated above.
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Interest Expense
Interest expense decreased $895 thousand, or 35.6%, when comparing the third quarter of 2020 to the third quarter of 2019. The decrease was a direct result of lower interest expenses paid on interest-bearing deposits of $819 thousand and the elimination of short and long-term advances from FHLB borrowings of $220 thousand. The average rate paid on interest-bearing deposits decreased 44bps, partially offset by the addition of subordinated debt issued during the third quarter of 2020, which added $148 thousand of interest expense. The average balance of noninterest-bearing deposits increased $103.7 million, or 29.2% between the comparable quarters.
Interest expense increased $55 thousand, or 3.5%, when comparing the third quarter of 2020 to the second quarter of 2020. The increase in interest expense was mainly due to the addition of subordinated debt issued in the third quarter, which added $148 thousand of interest expense, partially offset by the decrease of $87 thousand in interest expense on interest-bearing deposits and the payoff of long-term advances from FHLB borrowings. The average balance of noninterest-bearing deposits increased $38.3 million, or 9.1%, when compared to the second quarter of 2020. The payoff of long-term advances from FHLB borrowings matured in April of 2020 which carried a rate of 2.82%. Due to the excess liquidity position of the Bank there was no need to renew these borrowings.
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The following tables present the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the three months ended September 30, 2020 and 2019.
For Three Months Ended
For Three Months Ended
September 30, 2020
September 30, 2019
Average
Income(1)/
Yield/
Average
Income(1)/
Yield/
(Dollars in thousands)
Balance
Expense
Rate
Balance
Expense
Rate
Earning assets
Loans (2), (3)
$
1,406,683
$
14,173
4.01
%
$
1,235,374
$
14,145
4.54
%
Investment securities:
Taxable
136,017
730
2.14
155,324
870
2.24
Interest-bearing deposits
127,494
33
0.10
41,554
223
2.13
Total earning assets
1,670,194
14,936
3.56
%
1,432,252
15,238
4.22
%
Cash and due from banks
18,860
18,127
Other assets
94,755
73,823
Allowance for credit losses
(11,865)
(10,412)
Total assets
$
1,771,944
$
1,513,790
Interest-bearing liabilities
Demand deposits
$
370,922
174
0.19
%
$
252,386
447
0.70
%
Money market and savings deposits
442,322
229
0.21
389,268
658
0.67
Brokered Deposits
—
—
—
14,568
84
2.29
Certificates of deposit $100,000 or more
127,983
539
1.68
119,200
537
1.78
Other time deposits
148,223
528
1.42
149,708
563
1.49
Interest-bearing deposits
1,089,450
1,470
0.54
925,130
2,289
0.98
Securities sold under retail repurchase agreements and federal funds purchased
1,575
1
0.25
1,434
5
1.38
Advances from FHLB - short-term
—
—
—
16,295
112
2.73
Advances from FHLB - long-term
—
—
—
15,000
108
2.86
Subordinated debt
9,859
148
5.97
—
—
—
Total interest-bearing liabilities
1,100,884
1,619
0.59
%
957,859
2,514
1.04
%
Noninterest-bearing deposits
458,622
354,927
Other liabilities
11,359
7,884
Stockholders’ equity
201,079
193,120
Total liabilities and stockholders’ equity
$
1,771,944
$
1,513,790
Net interest spread
$
13,317
2.97
%
$
12,724
3.18
%
Net interest margin
3.17
%
3.52
%
Tax-equivalent adjustment
Loans
$
34
$
44
Total
$
34
$
44
(1) All amounts are reported on a tax-equivalent basis computed using the statutory federal income tax rate of 21.0%, exclusive of nondeductible interest expense.
(2) Average loan balances include nonaccrual loans.
(3) Interest income on loans includes amortized loan fees, net of costs, and accretion of discounts on acquired loans, which are included in the yield calculations.
Net Interest Income
Tax-equivalent net interest income increased $1.5 million, or 3.9%, during the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019. The increase in net interest income was due to decreases in interest expenses on interest-bearing deposits of $1.4 million, or 21.0% and short and long-term advances from FHLB borrowings of $679 thousand, or 85.3%, partially offset by the addition of subordinated debt issued in the third quarter of 2020, which added $148 thousand of interest expense. Also offsetting the cost savings in interest expenses was a decrease in the average yield on earning assets of 43bps. This resulted in a net interest margin of 3.35% for the nine months ended September 30, 2020 compared to 3.56% for the nine months ended September 30, 2019.
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Interest Income
On a tax-equivalent basis, interest income decreased $433 thousand, or 1.0%, for the nine months ended September 30, 2020 when compared to the nine months ended September 30, 2019. The decrease was primarily due to a decline in the average balance of taxable investment securities of $35.5 million, or 22.2%, and the lower average yield on interest-bearing deposits with other banks of 192bps. The average balance of loans increased $128.7 million, or 10.6%, while the average yield declined 39bps, in part due to the funding of 1,488 PPP loans during the second and third quarters of 2020 which had an average yield of 2.00%.
Interest Expense
Interest expense decreased $1.9 million, or 26.1%, when comparing the nine months ended September 30, 2020 to the nine months ended September 30, 2019. The decrease in interest expense was due to a decline in the rates paid on interest-bearing deposits of 30bps and the payoff of short and long-term advances from FHLB borrowings of $32.8 million, or 86.2%. The payoff of long-term advances from FHLB borrowings matured in April of 2020 which carried a rate of 2.82%. Due to the excess liquidity position of the Bank there was no need to renew these borrowings. The decreases in both short and long-term advances from FHLB borrowings, were partially offset by the addition of subordinated debt issued in the third quarter of 2020 of $25 million and an increase in the average balance of noninterest-bearing deposits of $68.7 million, or 20.1%.
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The following tables present the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the nine months ended September 30, 2020 and 2019.
For Nine Months Ended
For Nine Months Ended
September 30, 2020
September 30, 2019
Average
Income(1)/
Yield/
Average
Income(1)/
Yield/
(Dollars in thousands)
Balance
Expense
Rate
Balance
Expense
Rate
Earning assets
Loans (2), (3)
$
1,348,362
$
41,986
4.16
%
$
1,219,623
$
41,468
4.55
%
Investment securities:
Taxable
124,487
2,087
2.24
160,035
2,755
2.30
Interest-bearing deposits
81,125
216
0.36
29,279
499
2.28
Total earning assets
1,553,974
44,289
3.81
%
1,408,937
44,722
4.24
%
Cash and due from banks
18,302
17,520
Other assets
91,642
64,775
Allowance for credit losses
(11,042)
(10,419)
Total assets
$
1,652,876
$
1,480,813
Interest-bearing liabilities
Demand deposits
$
318,083
714
0.30
%
$
242,364
1,188
0.66
%
Money market and savings deposits
426,570
941
0.29
386,113
2,268
0.79
Brokered Deposits
—
—
—
19,144
344
2.40
Certificates of deposit $100,000 or more
129,319
1,722
1.78
108,504
1,251
1.54
Other time deposits
149,841
1,708
1.52
145,381
1,389
1.28
Interest-bearing deposits
1,023,813
5,085
0.66
901,506
6,440
0.96
Securities sold under retail repurchase agreements and federal funds purchased
1,613
4
0.33
964
12
1.66
Advances from FHLB - short-term
—
—
—
23,070
463
2.68
Advances from FHLB - long-term
5,255
113
2.87
15,000
321
2.86
Subordinated debt
3,310
148
5.97
—
—
—
Total interest-bearing liabilities
1,033,991
5,350
0.69
%
940,540
7,236
1.03
%
Noninterest-bearing deposits
410,702
341,966
Other liabilities
10,088
9,213
Stockholders’ equity
198,095
189,094
Total liabilities and stockholders’ equity
$
1,652,876
$
1,480,813
Net interest spread
$
38,939
3.12
%
$
37,486
3.21
%
Net interest margin
3.35
%
3.56
%
Tax-equivalent adjustment
Loans
$
107
$
119
Total
$
107
$
119
________________________________________
(1)
All amounts are reported on a tax-equivalent basis computed using the statutory federal income tax rate of 21.0%, exclusive of nondeductible interest expense.
(2) Average loan balances include nonaccrual loans.
(3)
Interest income on loans includes amortized loan fees, net of costs, and accretion of discounts on acquired loans, which are included in the yield calculations.
Noninterest Income
Total noninterest income for the third quarter of 2020 increased $52 thousand, or 2.1%, when compared to the third quarter of 2019. The increase from the third quarter of 2019 was mainly due to additional income from BOLI purchased late in 2019 and other bank and loan fees, partially offset by lower service charges on deposit accounts. Noninterest income decreased $188 thousand, or 6.8%, when compared to the second quarter of 2020 primarily due to the sale of available for sale investment securities at a gain of $347 thousand in the second quarter. Absent the sale of these securities, noninterest income would have increased $159 thousand, or 6.6%, for the third quarter of 2020, which was primarily the result of increases in loan fee income and service charges on deposit accounts.
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Total noninterest income from continuing operations for the nine months ended September 30, 2020 increased $376 thousand, or 5.1%, when compared to the same period in 2019. The increase in noninterest income primarily consisted of increases in BOLI income, gains on sales of available for sale securities and other bank services, partially offset by a decrease in service charges on deposit accounts which was primarily due to the effect of COVID-19 on activity.
Noninterest Expense
Total noninterest expense from continuing operations for the third quarter of 2020 increased $447 thousand, or 4.8%, when compared to the third quarter of 2019 and increased $2.2 million, or 28.3%, when compared to the second quarter of 2020. The increase in noninterest expenses when compared to the third quarter of 2019 was primarily due to higher salaries and wages, employee benefits and data processing fees, partially offset by decreases in other real estate owned expenses and other loan expenses. The increases in employee benefit expense and data processing fees when compared to 2019, are the result of higher health insurance claims and the increase level of new deposit and loan relationships in 2020. The increase in noninterest expense when compared to the second quarter of 2020 was primarily related to higher salaries and wages, due to the significant volume of PPP loans originated in the second quarter which resulted in heightened deferrals of direct origination costs during the second quarter of 2020. The deferred origination costs are being amortized over the lives of the related PPP loans and will be accelerated upon forgiveness or repayment.
Total noninterest expense from continuing operations for the nine months ended September 30, 2020 increased $131 thousand, or less than 1%, when compared to the same period in 2019. The increase was a result of higher costs related to employee benefits and higher data processing fees, which were almost entirely offset by decreases in salaries and wages due to the deferral of direct origination costs related to the origination of PPP loans, FDIC insurance premiums, other real estate owned expenses, and other loan related expenses. The deferred costs for salaries and wages are being recognized over the lives of the related loans as previously mentioned.
Provision for Credit Losses
The provision for credit losses was $1.5 million for the third quarter of 2020, $200 thousand for the third quarter of 2019 and $1.0 million for the second quarter of 2020. The ratio of the allowance for credit losses to period-end loans was 0.90% at September 30, 2020. Excluding PPP loans, the ratio of the allowance for credit losses to period-end loans was 0.98% at September 30, 2020, higher than both the 0.85% at September 30, 2019 and the 0.86% at June 30, 2020. The primary drivers of the increased percentage of the allowance to total loans, excluding PPP loans, and the increase in provision for loan losses as compared to both the prior periods were the new and elevated qualitative factors within the allowance model related to economic conditions and the COVID-19 pandemic. The Company reported net recoveries in the third quarter of 2020 of $187 thousand, compared to net charge-offs of $67 thousand for the third quarter of 2019 and $288 thousand for the second quarter of 2020.
The provision for credit losses for the nine months ended September 30, 2020 and 2019 was $2.9 million and $500 thousand, respectively, while net charge-offs were $580 thousand and $405 thousand, respectively. The increase in provision for credit losses was the result of new and elevated qualitative factors within the allowance model related to economic conditions and the COVID-19 pandemic. Excluding PPP loans, the ratio of the allowance for credit losses to period-end loans increased to 0.98% at September 30, 2020 from 0.84% at December 31, 2019. As previously discussed, this ratio increased primarily due to the addition of qualitative factors in the analysis of the allowance for loan losses. The ratio of annualized net charge-offs to average loans was 0.06% for the first nine months of 2020 and 0.04% for the first nine months of 2019. Management will continue to evaluate the adequacy of the allowance for credit losses as more economic data becomes available and the risk profile of the portfolio is more clearly defined.
Income Taxes
The Company reported income tax expense from continuing operations of $1.1 million for the third quarter of 2020, $1.4 million for the third quarter of 2019 and $1.8 million for the second quarter of 2020. Income tax expense decreased when compared to the third quarter of 2019 and the second quarter of 2020 due to lower pre-tax earnings. The effective tax rate on continuing operations for the third and second quarter of 2020 was 25.2%. The effective tax rate for the third quarter
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of 2019 was 25.1%. Income taxes from continuing operations for the nine months ended September 30, 2020 as compared to the nine months ended September 30, 2019 decreased $214 thousand or 5.1%, due to a decrease in pre-tax income.
ANALYSIS OF FINANCIAL CONDITION
Loans
Loans totaled $1.424 billion at September 30, 2020 and $1.249 billion at December 31, 2019, an increase of $175.3 million, or 14.0%. The increase was primarily due to the origination of 1,488 PPP loans totaling $126.7 million. Excluding PPP loans, organic growth for the first nine months of 2020 was $48.6 million, which consisted of increases in commercial real estate loans of $43.1 million, consumer loans of $9.8 million and construction loans of $6.2 million, partially offset by decreases in residential real estate loans of $366 thousand and commercial loans, excluding PPP loans, of $10.1 million. Loans included deferred fees, net of deferred costs, of $12 thousand and discounts on acquired loans of $825 thousand at September 30, 2020, compared to deferred costs, net of deferred fees, of $1.8 million and discounts on acquired loans of $1.1 million at December 31, 2019. We do not engage in foreign or subprime lending activities. See Note 5, “Loans and Allowance for Credit Losses”, in the Notes to Consolidated Financial Statements and below under the caption “Allowance for Credit Losses” for additional information.
Our loan portfolio has a commercial real estate loan concentration, which is generally defined as a combination of certain construction and commercial real estate loans. Construction loans were $106.0 million, or 7.4% of total loans, at September 30, 2020 and $99.8 million, or 8.0% of total loans, at December 31, 2019. Commercial real estate loans were $629.6 million, or 44.2% of total loans, at September 30, 2020, compared to $586.6 million, or 47.0% of total loans, at December 31, 2019.
The federal banking regulators have issued guidance for those institutions which are deemed to have concentrations in commercial real estate lending. Pursuant to the supervisory criteria contained in the guidance for identifying institutions with a potential commercial real estate concentration risk, institutions which have (1) total reported loans for construction, land development, and other land acquisitions which represent 100% or more of an institution’s total risk-based capital; or (2) total non-owner occupied commercial real estate loans representing 300% or more of the institution’s total risk-based capital and the institution’s non-owner occupied commercial real estate loan portfolio (including construction) has increased 50% or more during the prior 36 months are identified as having potential commercial real estate concentration risk. Institutions which are deemed to have concentrations in commercial real estate lending are expected to employ heightened levels of risk management with respect to their commercial real estate portfolios, and may be required to hold higher levels of capital. The Company, like many community banks, has a concentration in commercial real estate loans, and the Company has experienced significant growth in its commercial real estate portfolio in recent years. At September 30, 2020, non-owner-occupied commercial real estate loans (including construction, land and land development loans) represented 291.2% of total risk-based capital. At such time, construction, land and land development loans represented 56.0% of total risk-based capital.
The commercial real estate portfolio (including construction) has increased 52.1% during the prior 36 months. Management has extensive experience in commercial real estate lending, and has implemented and continues to maintain heightened risk management procedures, as well as strong underwriting criteria with respect to its commercial real estate portfolio. Monitoring practices include periodic stress testing analysis to evaluate changes to cash flows, owing to interest rate increases and declines in net operating income. We may be required to maintain higher levels of capital as a result of our commercial real estate concentrations, which could require us to obtain additional capital or be required to sell/participate portions of loans, which may adversely affect shareholder returns.
Allowance for Credit Losses
We have established an allowance for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off loans and is decreased by current period charge-offs of uncollectible loans. Management evaluates the adequacy of the allowance for credit losses at least quarterly and adjusts the provision for credit losses based on this analysis. The evaluation of the adequacy of the allowance for credit losses is based primarily on a risk rating system of individual loans, as well as on a collective evaluation of smaller balance homogenous loans, each grouped
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by loan type. Each loan type is assigned allowance factors based on criteria such as past credit loss experience, local economic and industry trends, and other measures which may impact collectability. Please refer to the discussion above under the caption “Critical Accounting Policies” for an overview of the underlying methodology management employs to maintain the allowance.
The allowance for credit losses was $12.8 million at September 30, 2020, $10.4 million at September 30, 2019 and $11.1 million at June 30, 2020. Net recoveries for the third quarter of 2020 were $187 thousand, compared to net charge-offs of $67 thousand for the third quarter of 2019 and $288 thousand for the second quarter of 2020. The ratio of annualized net recoveries to average loans was 0.05% for the third quarter of 2020, compared to annualized net charge-offs of 0.02% for the third quarter of 2019 and 0.08% for the second quarter of 2020. Net charge-offs were $580 thousand for the nine months ended September 30, 2020, compared to $405 thousand for the nine months ended September 30, 2019. The ratio of net charge-offs to average loans was 0.06% and 0.04% for the nine months ended September 30, 2020 and September 30, 2019, respectively.
Management remains focused on its efforts to dispose of problem loans and to prudently charge-off nonperforming loans to enable the Company to continue to improve its overall credit quality. The allowance for credit losses as a percentage of period-end loans was 0.90% at September 30, 2020, 0.85% at September 30, 2019 and 0.84% at December 31, 2019. Excluding PPP loans, the ratio of the allowance for credit losses to period-end loans was 0.98% at September 30, 2020, higher than both the 0.85% and 0.84% at September 30, 2019 and December 31, 2019. The increase in the percentage of the allowance to total loans at September 30, 2020, compared to September 30, 2019 and December 31, 2019, was primarily due to new and elevated qualitative factors within the allowance model related to economic conditions and the COVID-19 pandemic. Management currently believes that the provision for credit losses and the resulting allowance were adequate to provide for probable losses inherent in our loan portfolio at September 30, 2020. However, management will continue to evaluate the adequacy of the allowance for credit losses as more economic data becomes available and as the impact of the COVID 19 pandemic on the Company’s portfolio becomes known. Increases in unemployment, declines in consumer confidence, and a reluctance on the part of businesses to invest in and expand their operations, among other things, may result in additional weakness in economic conditions, place financial strain on our borrowers and ultimately impact the credit quality of our loan portfolio. As a result, we may experience increases in the level of past due, nonaccrual and classified loans, as well as higher net charge-offs. Deterioration in credit quality in conjunction with weakness in current and expected economic conditions, may require us to record additional provisions for credit losses in excess of historical levels.
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The following table presents a summary of the activity in the allowance for credit losses at or for the three and nine months ended September 30, 2020 and 2019.
At or for Three Months Ended
At or for Nine Months Ended
September 30,
September 30,
(Dollars in thousands)
2020
2019
2020
2019
Allowance balance - beginning of period
$
11,090
$
10,305
$
10,507
$
10,343
Charge-offs:
Construction
—
—
—
(3)
Residential real estate
(10)
(86)
(201)
(509)
Commercial real estate
(1)
—
(601)
—
Commercial
(89)
(98)
(208)
(260)
Consumer
(1)
—
(8)
(29)
Total
(101)
(184)
(1,018)
(801)
Recoveries:
Construction
5
1
13
8
Residential real estate
199
12
206
23
Commercial real estate
1
7
—
114
Commercial
81
96
205
248
Consumer
2
1
14
3
Totals
288
117
438
396
Net recoveries (charge-offs)
187
(67)
(580)
(405)
Provision for credit losses
1,500
200
2,850
500
Allowance balance - end of period
$
12,777
$
10,438
$
12,777
$
10,438
Average loans outstanding during the period
$
1,406,683
$
1,235,374
$
1,348,363
$
1,219,623
Net (recoveries) charge-offs (annualized) as a percentage of average loans outstanding during the period
(0.05)
%
0.02
%
0.06
%
0.04
%
Allowance for credit losses at period end as a percentage of total period end loans (1)
0.90
%
0.85
%
0.90
%
0.85
%
Allowance for credit losses at period end as a percentage of average loans
0.91
%
0.84
%
0.95
%
0.86
%
(1) At September 30, 2020, the loan balances used to calculate the ratio include PPP loans of $126.7 million. Excluding PPP loans, the ratio is 0.98%.
Nonperforming Assets and Accruing TDRs
As shown in the following table, nonperforming assets decreased $3.6 million to $8.4 million at September 30, 2020 from $12.0 million at December 31, 2019, primarily due to a decrease in nonaccrual loans of $3.6 million, or 34.2%. Accruing TDRs decreased $234 thousand to $7.3 million at September 30, 2020 from $7.5 million at December 31, 2019. Additionally, other real estate owned decreased $36 thousand, or 48.6%, when compared to December 31, 2019. The decrease in nonaccrual loans was due to three loan relationships with commercial real estate customers with nonaccrual loans of approximately $3.5 million, for which the Bank received payoffs during the third quarter of 2020, resulting in net recoveries for the period. The decrease in accruing TDRs was due to normal payments. The ratio of nonaccrual loans and accruing TDRs to total loans decreased to 1.00% at September 30, 2020 from 1.45% at December 31, 2019.
The Company continues to focus on the resolution of its nonperforming and problem assets. The efforts to accomplish this goal include frequently contacting borrowers until the delinquency is cured or until an acceptable payment plan has been agreed upon; obtaining updated appraisals; provisioning for credit losses; charging-off loans; transferring loans to other
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real estate owned; aggressively marketing other real estate owned. The reduction of nonperforming and problem assets is and will continue to be a high priority for the Company.
The following table summarizes our nonperforming assets and accruing TDRs at September 30, 2020 and December 31, 2019.
(Dollars in thousands)
September 30, 2020
December 31, 2019
Nonperforming assets
Nonaccrual loans
Construction
$
297
$
—
Residential real estate
2,031
2,475
Commercial real estate
4,327
7,817
Commercial
283
298
Consumer
28
—
Total nonaccrual loans
6,966
10,590
Loans 90 days or more past due and still accruing
Construction
—
—
Residential real estate
307
556
Commercial real estate
1,066
770
Commercial
—
—
Consumer
—
—
Total loans 90 days or more past due and still accruing
1,373
1,326
Other real estate owned
38
74
Total nonperforming assets
$
8,377
$
11,990
Accruing TDRs
Construction
$
36
$
41
Residential real estate
3,878
4,041
Commercial real estate
3,353
3,419
Commercial
—
—
Consumer
—
—
Total accruing TDRs
$
7,267
$
7,501
As a percent of total loans:
Nonaccrual loans
0.49
%
0.85
%
Accruing TDRs
0.51
%
0.60
%
Nonaccrual loans and accruing TDRs
1.00
%
1.45
%
As a percent of total loans and other real estate owned:
Nonperforming assets
0.59
%
0.96
%
Nonperforming assets and accruing TDRs
1.10
%
1.56
%
As a percent of total assets:
Nonaccrual loans
0.38
%
0.68
%
Nonperforming assets
0.46
%
0.77
%
Accruing TDRs
0.40
%
0.48
%
Nonperforming assets and accruing TDRs
0.85
%
1.25
%
Investment Securities
The investment portfolio is comprised of debt and equity securities. Debt securities are classified as either available for sale or held to maturity. Investment securities available for sale are stated at estimated fair value based on quoted prices. They represent securities which may be sold as part of the asset/liability management strategy or in response to changing
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interest rates. Net unrealized holding gains and losses on these securities are reported net of related income taxes as accumulated other comprehensive income (loss), a separate component of stockholders’ equity.
Investment securities in the held to maturity category are stated at cost adjusted for amortization of premiums and accretion of discounts. We have the intent and current ability to hold such securities until maturity. At September 30, 2020, 87.3% of the portfolio of debt securities was classified as available for sale and 12.7% was classified as held to maturity, compared to 93.5% and 6.5% respectively, at December 31, 2019. See Note 4 – “Investment Securities”, in the Notes to Consolidated Financial Statements for additional details on the composition of our investment portfolio.
Investment securities including restricted stock totaled $164.5 million at September 30, 2020, a $27.4 million, or 20.0%, increase since December 31, 2019. The increase was primarily due to the purchases of available for sale securities of $60.5 million and held to maturity securities of $11.6 million, partially offset by proceeds from maturities and sales of these securities of $46.5 million, during 2020. Due to the excess liquidity experienced in 2020, the Company strategically purchased short duration available for sale securities and subordinated debt of other banks which earn significantly higher average yields than interest-bearing deposits with other banks. As loan demand begins to strengthen, the Company will redeploy proceeds and excess liquidity to fund loan growth. At September 30, 2020, 82.3% of the securities available for sale were mortgage-backed and 17.7% were U.S. Government agencies, compared to 80.6% and 19.4%, respectively, at year-end 2019. Our investments in mortgage-backed securities are issued or guaranteed by U.S. Government agencies or government-sponsored agencies.
Deposits
Total deposits at September 30, 2020 amounted to $1.59 billion, an increase of $252.8 million, or 18.8%, when compared to the level at December 31, 2019. The increase in total deposits consisted of increases in interest-bearing deposits of $144.1 million and noninterest-bearing deposits of $108.7 million. The growth in interest-bearing deposits was represented by increases in interest-bearing checking accounts of $109.5 million and savings and money market accounts of $37.3 million, partially offset by a decrease in other time deposits of $2.7 million. The overall increase in deposits can be attributed to a combination of factors which include, customers retaining PPP loan proceeds, customers improving their liquidity position by participating in our deferred loan program and the result of new business and municipal relationships acquired during 2020.
Short-Term Borrowings
Short-term borrowings consisted of securities sold under agreements to repurchase, which decreased by $207 thousand, or 16.9%, to $1.0 million at September 30, 2020 when compared to December 31, 2019. Securities sold under agreements to repurchase are issued in conjunction with cash management services for commercial depositors. Other short-term borrowings may consist of overnight borrowing from correspondent banks or advances from the FHLB. Short-term advances are defined as those with original maturities of one year or less. At September 30, 2020 and December 31, 2019, the Company had no outstanding short-term advances with FHLB.
Long-Term Debt
The Company uses long-term borrowings to meet longer term liquidity needs, specifically to fund loan growth when liquidity from deposit growth is not sufficient. During the third quarter of 2020, the Company sold and issued $25.0 million in aggregate principal amount of 5.375% Fixed-to-Floating Rate Subordinated Notes due September 1, 2030. The amount of outstanding long-term borrowings at December 31, 2019 consisted of long-term advances from FHLB borrowings of $15.0 million, which carried an interest rate of 2.82%. These advances were paid off in April of 2020.
Liquidity and Capital Resources
We derive liquidity through increased customer deposits, non-reinvestment of the cash flow from the investment portfolio, loan repayments, borrowings and income from earning assets. As seen in the Consolidated Statements of Cash Flows in the Financial Statements, the net increase in cash and cash equivalents was $61.5 million for the first nine months of 2020 compared to an increase of $36.1 million for the first nine months of 2019. The increase in cash and cash equivalents in
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2020 was mainly due to the significant increase in deposits, the direct result of PPP loan proceeds deposited to and remaining in these accounts as of September 30, 2020. The Company expects these funds to be utilized over the coming months, which may or may not result in a decline in deposit balances. Furthermore, the increase in cash and cash equivalents was the result of the issuance of subordinated notes in the third quarter of 2020, which net of issuance costs resulted in $24.4 million in additional liquidity.
To the extent that deposits are not adequate to fund customer loan demand, liquidity needs can be met in the short-term fund markets. The Bank has arrangements with other corresponding banks whereby it has $15 million available in federal funds lines of credit and a reverse repurchase agreement available to meet any short-term needs which may not otherwise be funded by the Bank’s portfolio of readily marketable investments that can be converted to cash. The Bank is also a member of the FHLB, which provides another source of liquidity. Through the FHLB, the Bank had collateral pledged of approximately $313.8 million and $270.1 million at September 30, 2020 and December 31, 2019, respectively. The Bank has pledged, under a blanket lien, all qualifying residential and commercial real estate loans under borrowing agreements with the FHLB.
Total stockholders’ equity increased $6.1 million to $198.9 million at September 30, 2020 when compared to December 31, 2019 primarily due to the current year’s retained earnings and a positive change in accumulated other comprehensive income of $1.7 million, or 819.8%, partially offset by dividends paid during the first nine months of 2020 and the repurchase of common stock in the third quarter of 2020.
CBLR
On September 17, 2019, the FDIC finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio (“CBLR”) framework), as required by the Economic Growth, Regulatory Relief and Consumer Protection Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework.
On April 6, 2020, in a joint statement, the FDIC, Federal Reserve and the Office of Comptroller of the Currency (“OCC”), issued two interim final rules regarding temporary changes to the CBLR framework to implement provisions of the CARES Act. Under the interim final rules, the community bank leverage ratio will be reduced to 8% beginning in the second quarter and for the remainder of calendar year 2020, 8.5% for calendar year 2021, and 9% thereafter. In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio of greater than 8%, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well-capitalized ratio requirements under the Prompt Corrective Action regulations and will not be required to report or calculate risk-based capital.
The CBLR framework was available for banks to use in their March 31, 2020 Call Report. The Bank did not opt into the CBLR framework in the first, second or third quarter of 2020.
Basel III
Under final Federal Reserve and FDIC approved rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks minimum requirements increased for both the quantity and quality of capital held by the Bank. The Basel III capital standards substantially revised the risk based capital requirements applicable to bank holding companies and their depository institution subsidiaries, including the definitions and the components of Tier 1 capital and Total Capital, the method of evaluating risk-weighted assets, institutions of a capital conservation buffer, and other matters affecting regulatory capital ratios. Strict eligibility criteria for regulatory capital instruments were also implemented under the rules.
The phase-in period for the final rules became effective for the Bank on January 1, 2015, with full compliance with all of the final rules’ requirements phased in over a multi-year schedule, which was fully phased in on January 1, 2019. As of September 30, 2020, the Bank’s capital levels remained characterized as “well-capitalized” under the rules.
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The following tables present the applicable capital ratios as of September 30, 2020 and December 31, 2019.
Tier 1
Common Equity
Tier 1
Total
leverage
Tier 1
risk-based
risk-based
September 30, 2020
ratio
ratio
capital ratio
capital ratio
Shore United Bank
10.07
%
13.31
%
13.31
%
14.30
%
Tier 1
Common Equity
Tier 1
Total
leverage
Tier 1
risk-based
risk-based
December 31, 2019
ratio
ratio
capital ratio
capital ratio
Shore United Bank
10.64
%
13.00
%
13.00
%
13.87
%
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.