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 2020 Form 10-K 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 2020 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 Worcester 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 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. The first round of PPP lending resulted in 1,495 loans for $129.0 million, of which 1,037 loans have been forgiven or paid down in the amount of $102.3 million as of June 30, 2021. The second round of PPP lending which began in 2021, resulted in 959 loans for $67.3 million, of which 223 loans have been forgiven or paid down in the amount of $7.2 million. As of June 30, 2021, the Company had 1,195 PPP loans totaling $86.8 million that were outstanding, inclusive of loans issued during both the first and second rounds of the PPP. This 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.
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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”) and the Consolidated Appropriations Act of 2021 (“CAA”), the Company is providing modifications where appropriate, including interest only payments or payment deferrals for clients that could be adversely affected by the COVID-19 pandemic. Section 4013 of the CARES Act and CAA 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 and December 2020, short-term modifications made to borrowers 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. Since the beginning of the pandemic and through June 30, 2021, the Company had executed principal and/or interest deferrals on outstanding loan balances of $221.1 million, of which only $9.5 million, or 0.65% of the total portfolio, remained on deferral as of June 30, 2021.
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)
June 30, 2021
June 30, 2021
(6 months or less)
(3 months)
Modified
Hospitality Industry
$
108,823
$
9,526
$
9,526
$
-
8.75
%
Non-owner occupied Retail Stores
139,580
-
-
-
—
Non-owner occupied Restaurants
6,255
-
-
-
—
Owner-occupied Retail Stores
13,741
-
-
-
—
Owner-occupied Restaurants
16,276
-
-
-
—
Oil & Gas Industry
-
-
-
-
—
Other Commercial Loans
754,139
-
-
-
—
Total Commercial Loans
1,038,814
9,526
9,526
-
0.92
Residential 1-4 family Personal
222,713
-
-
-
—
Residential 1-4 family Rentals
107,939
-
-
-
—
Home Equity Loans
43,809
-
-
-
—
Total Residential Real Estate Loans
374,461
-
-
-
—
Consumer Loans
62,823
-
-
-
—
Mortgage Warehouse Loans
-
-
-
-
—
Credit Card, Overdrafts and Other
(3,669)
-
-
-
—
TOTAL LOANS
$
1,472,429
$
9,526
$
9,526
$
-
0.65
%
Liquidity
We are vigilantly monitoring our liquidity position on an ongoing basis. 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. 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
At the present time all share repurchases have been suspended due to the current status of our merger with Severn. Once the merger is consummated, the Company intends to resume its current share buyback program in which $546 thousand remains available. The Board of directors and management will re-evaluate the need for an additional stock repurchase program once the current plan is exhausted or expires.
Dividends and Capital
We currently expect to maintain our quarterly cash dividend based on our strong capital position. At June 30, 2021, 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
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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.
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 2020 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 and other factors, 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 2020 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. 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. 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 June 30, 2021, the Company had only one banking reporting unit.
OVERVIEW
The Company reported net income of $4.0 million for the second quarter of 2021, or diluted income per common share of $0.34, compared to net income of $5.3 million, or diluted income per common share of $0.43, for the second quarter of 2020. For the first quarter of 2021, the Company reported net income of $4.0 million, or diluted income per common share of $0.34. When comparing net income for the second quarter of 2021 to the second quarter of 2020, the decrease was due to salary and wages being deferred in the second quarter of 2020 due to the originations of the first round of PPP loans. Despite these salary and wage deferrals, net interest income increased when compared to the second quarter of 2020 by $1.1 million, while a reduced provision for credit losses of $350 thousand and higher noninterest income of $134 thousand had a positive impact on net income. When comparing the second quarter of 2021 to the first quarter of 2021, the net income was essentially unchanged, from period to period with offsetting variances related to higher net interest income of $303 thousand and noninterest income of $346 thousand, partially offset by an increase in the provision for credit losses of $225 thousand and noninterest expense of $377 thousand. Merger-related expenses of $377 thousand were recorded in
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the second quarter of 2021, which had an impact on the profitability of the quarter when compared to the linked and previous quarters.
For the first six months of 2021, the Company reported net income of $8.0 million, or diluted income per common share of $0.68, compared to net income of $8.5 million, or diluted income per common share of $0.68, for the first six months of 2020. When comparing net income for the first six months of 2021 to the first six months of 2020, the decrease in net income was primarily due to the deferral of salaries and wages as previously mentioned above, as well as an increase in almost all noninterest expense line items for a total of $3.4 million, partially offset by improvements in net interest income of $2.4 million, noninterest income of $339 thousand and a reduced provision for credit losses of $275 thousand. The reason for the similar diluted income per share for both periods despite the lower net income in 2021, was due to buybacks of the Company’s common stock, resulting in fewer outstanding shares period over period.
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 $14.1 million for the second quarter of 2021 and $13.1 million for the second quarter of 2020. Tax-equivalent net interest income was $13.8 million for the first quarter of 2021. The increase in net interest income when comparing the second quarter of 2021 to the second quarter of 2020, was the result of higher interest and fees on loans and income from taxable investment securities, coupled with a decrease in interest expense. Net interest income increased for the second quarter of 2021 when compared to the first quarter of 2021 due to an increase in income from taxable investment securities and a decrease in interest expense. Net interest margin is tax-equivalent net interest income (annualized) divided by average earning assets. The net interest margin for the second quarter of 2021 was 2.91%, which was a decrease of 50bps when compared to 3.41% for the second quarter of 2020 and a decrease of 9bps when compared to 3.00% for the first quarter of 2021. The decline in net interest margin in the second quarter of 2021 when compared to the first quarter of 2021 and the second quarter of 2020, was significantly impacted by excess liquidity and the decrease in yields of taxable investment securities. Without excess liquidity of $100 million, the margin for the second quarter of 2021 would have been 3.07%.
Interest Income
On a tax-equivalent basis, interest income increased $938 thousand, or 6.4%, for the second quarter of 2021 when compared to the second quarter of 2020. The increase was the result of higher interest and fees on loans and income from investment securities. The primary driver for the increase in interest income on loans was the higher average volume of loans of $70.4 million, which included PPP lending. The average balance of investment securities increased $178.2 million, providing $457 thousand of additional income, despite a decrease in the average yield of 84bps.
On a tax-equivalent basis, interest income increased $189 thousand, or 1.2%, for the second quarter of 2021 when compared to the first quarter of 2021. The increase was primarily a result of taxable investment securities which were purchased during the second quarter of 2021, resulting in a higher average balance in these securities of $58.3 million.
Interest Expense
Interest expense decreased $135 thousand, or 8.6%, when comparing the second quarter of 2021 to the second quarter of 2020. The decrease in interest expense from the second quarter of 2020 was a result of the decrease in the average rate paid on interest-bearing deposits of 29bps. This decrease in interest expense was partially offset by the issuance of subordinated debt in the third quarter of 2020 which added $370 thousand of additional expense for the second quarter of 2021.
Interest expense decreased $116 thousand, or 7.5%, when comparing the second quarter of 2021 to the first quarter of 2021. The decrease in interest expense on deposits was due to a 6bps decline in the average rate paid on interest-bearing deposits, specifically time deposits that matured and renewed during the second quarter of 2021.
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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 June 30, 2021 and 2020.
For Three Months Ended
For Three Months Ended
June 30, 2021
June 30, 2020
Average
Income(1)/
Yield/
Average
Income(1)/
Yield/
(Dollars in thousands)
Balance
Expense
Rate
Balance
Expense
Rate
Earning assets
Loans (2), (3)
$
1,444,684
$
14,419
4.00
%
$
1,374,324
$
13,982
4.09
%
Investment securities:
Taxable
286,121
1,095
1.53
107,908
638
2.37
Interest-bearing deposits
218,704
55
0.10
57,713
11
0.07
Total earning assets
1,949,509
15,569
3.20
%
1,539,945
14,631
3.82
%
Cash and due from banks
16,908
18,167
Other assets
109,457
90,981
Allowance for credit losses
(14,660)
(10,706)
Total assets
$
2,061,214
$
1,638,387
Interest-bearing liabilities
Demand deposits
$
405,473
132
0.13
%
$
298,568
145
0.20
%
Money market and savings deposits
605,202
251
0.17
426,963
246
0.23
Certificates of deposit $100,000 or more
135,376
350
1.04
130,582
586
1.81
Other time deposits
143,821
323
0.90
150,675
579
1.54
Interest-bearing deposits
1,289,872
1,056
0.33
1,006,788
1,556
0.62
Securities sold under retail repurchase agreements and short-term FHLB advances
3,123
2
0.26
2,030
1
0.20
Advances from FHLB - long-term
—
—
—
824
6
2.93
Subordinated debt
24,474
370
6.06
—
—
—
Total interest-bearing liabilities
1,317,469
1,428
0.43
%
1,009,642
1,563
0.62
%
Noninterest-bearing deposits
532,276
420,275
Other liabilities
13,937
9,628
Stockholders’ equity
197,532
198,842
Total liabilities and stockholders’ equity
$
2,061,214
$
1,638,387
Net interest spread
$
14,141
2.77
%
$
13,068
3.20
%
Net interest margin
2.91
%
3.41
%
Tax-equivalent adjustment
Loans
$
38
$
37
Total
$
38
$
37
(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 accreted 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 $2.4 million, or 9.2%, during the six months ended June 30, 2021 compared to the six months ended June 30, 2020. The higher net interest income was due to an increase in interest income of $1.6 million, or 5.4% and a decrease in interest expenses on interest-bearing deposits of $1.4 million, or 38.0%. Despite the improved results, compression in the margin was due to lower yields on earning assets, specifically taxable investment securities of 71bps and interest-bearing deposits with the Fed of 54bps. This resulted in a net interest margin of 2.96% for the six months ended June 30, 2021 compared to 3.45% for the six months ended June 30, 2020.
Interest Income
On a tax-equivalent basis, interest income increased $1.6 million, or 5.4%, for the six months ended June 30, 2021 when compared to the six months ended June 30, 2020. The increase was primarily due to higher interest and fees on loans of $1.0 million, or 3.6% and taxable investment securities of $668 thousand, or 49.2%. The increase in interest and fees on
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loans was due to a higher average balance of loans of $128.9 million, or 9.8%, which included PPP loans which have a lower yield than more traditional loans, resulting in a lower overall yield of 23bps. The increase in interest on taxable investment securities was due to a higher average balance in these securities of $138.5 million, or 116.7%, despite the decline in the average yield of such securities of 71bps.
Interest Expense
Interest expense decreased $760 thousand, or 20.4%, when comparing the six months ended June 30, 2021 to the six months ended June 30, 2020. The decrease in interest expense was due to a decline in the rates paid on interest-bearing deposits of 37bps and the elimination of long-term advances from FHLB. These improvements were partially offset by the addition of subordinated debt, issued in the third quarter of 2020, which added $729 thousand in interest expense for the first six months of 2021.
The following tables present the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the six months ended June 30, 2021 and 2020.
For Six Months Ended
For Six Months Ended
June 30, 2021
June 30, 2020
Average
Income(1)/
Yield/
Average
Income(1)/
Yield/
(Dollars in thousands)
Balance
Expense
Rate
Balance
Expense
Rate
Earning assets
Loans (2), (3)
$
1,447,767
$
28,821
4.01
%
$
1,318,883
$
27,813
4.24
%
Investment securities:
Taxable
257,130
2,025
1.59
118,659
1,357
2.30
Interest-bearing deposits
204,048
102
0.10
57,685
183
0.64
Total earning assets
1,908,945
30,948
3.27
%
1,495,227
29,353
3.95
%
Cash and due from banks
18,070
18,020
Other assets
106,251
90,068
Allowance for credit losses
(14,448)
(10,626)
Total assets
$
2,018,818
$
1,592,689
Interest-bearing liabilities
Demand deposits
$
421,816
288
0.14
%
$
291,372
540
0.37
%
Money market and savings deposits
565,341
481
0.17
418,608
712
0.34
Brokered Deposits
—
—
—
—
—
—
Certificates of deposit $100,000 or more
133,073
756
1.14
129,995
1,183
1.83
Other time deposits
144,367
715
1.00
150,659
1,180
1.58
Interest-bearing deposits
1,264,597
2,240
0.36
990,634
3,615
0.73
Securities sold under retail repurchase agreements and federal funds purchased
2,683
3
0.23
1,632
3
0.37
Advances from FHLB - short-term
—
—
—
—
—
—
Advances from FHLB - long-term
—
—
—
7,912
113
2.87
Subordinated debt
24,459
729
6.01
—
—
—
Total interest-bearing liabilities
1,291,739
2,972
0.46
%
1,000,178
3,731
0.75
%
Noninterest-bearing deposits
518,030
386,478
Other liabilities
12,383
9,446
Stockholders’ equity
196,666
196,587
Total liabilities and stockholders’ equity
$
2,018,818
$
1,592,689
Net interest spread
$
27,976
2.81
%
$
25,622
3.20
%
Net interest margin
2.96
%
3.45
%
Tax-equivalent adjustment
Loans
$
74
$
73
Total
$
74
$
73
(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 accreted loan fees, net of costs and accretion of discounts on acquired loans, which are included in the yield calculations.
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Noninterest Income
Total noninterest income for the second quarter of 2021 increased $134 thousand, or 4.8%, when compared to the second quarter of 2020. The increase from the second quarter of 2020 was due to higher deposit related fees, other bank service charges and trust and investment fee income, partially offset by the absence of gains on sale of investment securities. Noninterest income increased $346 thousand, or 13.5%, when compared to the first quarter of 2021 primarily due to higher deposit related fees and service charges.
Total noninterest income for the six months ended June 30, 2021 increased $339 thousand, or 6.6%, when compared to the same period in 2020. The increase in noninterest income primarily consisted of increases in deposit related fees, other bank service charges and trust and investment fee income, partially offset by the absence of gains on sale of investment securities. The increases in deposit related fees and other bank service charges were mostly due to the local government-imposed shutdowns in 2020 and a return to a more normalized local economy and consumer demand for products and services in 2021.
Noninterest Expense
Total noninterest expense for the second quarter of 2021 increased $3.2 million, or 41.9%, when compared to the second quarter of 2020 and increased $377 thousand, or 3.6%, when compared to the first quarter of 2021. The increase in noninterest expenses when compared to the second quarter of 2020 was primarily driven by salary and wages being deferred in the second quarter of 2020, the result of originating first round PPP loans. Absent the increased deferrals of salaries and wages related to the first round of PPP, increases in furniture and fixtures, data processing, FDIC insurance and merger-related expenses resulted in the overall increase in noninterest expenses. The significant growth in new and existing customer accounts accounted for the increase in data processing costs and FDIC insurance premiums. The increase in noninterest expense when compared to the first quarter of 2021 was primarily due to merger-related expenses, salaries and wages, furniture and fixtures and legal and professional fees, partially offset by lower employee benefit costs due to lower payroll taxes and medical claims. The increase in salaries and wages was mainly attributed to the deferral of costs associated with originating the second round of PPP loans in the first quarter of 2021. The increase in furniture and fixtures when compared to both the second quarter of 2020 and the first quarter of 2021 was due to an on-going branch renovation.
Total noninterest expense for the six months ended June 30, 2021 increased $3.4 million, or 18.7%, when compared to the same period in 2020. The increase was mainly the result of the absence of the deferral in salaries and wages due to PPP loan originations in 2020, higher data processing costs, FDIC insurance premiums and occupancy costs. The higher occupancy costs are associated with a new branch lease in Ocean City, Maryland which will open in 2022. In addition, the Company recorded merger-related expenses of $377 thousand for the first six months of 2021 due to the pending acquisition of Severn.
Provision for Credit Losses
The provision for credit losses was $650 thousand for the second quarter of 2021, $1.0 million for the second quarter of 2020 and $425 thousand for the first quarter of 2021. The ratio of the allowance for credit losses to period-end loans was 1.02% at June 30, 2021, 0.95% at December 31, 2020 and 0.98% at March 31, 2021. Excluding PPP loans, the ratio of the allowance for credit losses to period-end loans was 1.09% at June 30, 2021, higher than both the 1.04% at December 31, 2020 and the 1.07% at March 31, 2021. The primary drivers of the increased percentage of the allowance to total loans, excluding PPP loans, as compared to December 31, 2020 and March 31, 2021, were significant loan originations in the second quarter of 2021, specifically within the construction and consumer loan portfolios, which require a higher level of allowance than the PPP loans which were forgiven during the second quarter of 2021, coupled with pandemic related qualitative factors which have remained elevated due to uncertainty and associated risks with the COVID-19 virus/variants and lagging vaccination rates. The Company reported net recoveries in the second quarter of 2021 of $125 thousand, compared to net recoveries of $61 thousand for the fourth quarter of 2020 and no net charge offs or recoveries for the first quarter of 2021.
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The provision for credit losses for the six months ended June 30, 2021 and 2020 was $1.1 million and $1.4 million, respectively, while net recoveries were $125 thousand and net charge-offs were $767 thousand, respectively. The decrease in provision for credit losses was the result of lower charge-offs in 2021 and overall improved credit quality. The ratio of allowance to total loans increased from 0.95% at December 31, 2020, to 1.02% at June 30, 2021. Excluding PPP loans, the ratio of the allowance for credit losses to period-end loans was 1.09% at June 30, 2021, higher than the 1.04% at December 31, 2020. The primary drivers for the increase in the percentage of allowance for credit losses to total loans were significant originations within the construction and consumer loan portfolios, which require a higher level of allowance than the PPP loans that were forgiven during the second quarter of 2021, as well as continued elevated pandemic related qualitative factors. The ratio of annualized net recoveries to average loans was 0.03% for the first half of 2021, compared to annualized net charge-offs of 0.12% for the first half of 2020. Management will continue to evaluate the adequacy of the allowance for credit losses as more economic data becomes available and as changes within the Company’s portfolio are known.
Income Taxes
The Company reported income tax expense of $1.4 million for the second quarter of 2021, $1.8 million for the second quarter of 2020 and $1.4 million for the first quarter of 2021. Income tax expense decreased when compared to the second quarter of 2020 due to lower pre-tax earnings and stayed flat when compared to the first quarter of 2021. The effective tax rate for the first and second quarter of 2021 was 26.4% and was 25.2% for the second quarter of 2020. Income tax expense for the six months ended June 30, 2021 and the six months ended June 30, 2020 remained flat at $2.9 million.
ANALYSIS OF FINANCIAL CONDITION
Loans
Loans totaled $1.472 billion at June 30, 2021 and $1.454 billion at December 31, 2020, an increase of $18.2 million, or 1.2%. Excluding PPP loans, the increase in total loans was $68.6 million, or 4.7%, due to significant loan growth late in the second quarter of 2021. The increase in loans, excluding PPP loans, was comprised of increases in consumer loans of $32.9 million, or 104.6%, commercial loans of $10.9 million, or 5.2%, construction loans of $10.0 million, or 9.4%, and residential real estate loans of $6.3 million, or 1.4%. These increases were partially offset by a decrease in commercial real estate loans of $6.0 million, or less than 1%. Construction loans included deferred fees, net of deferred costs, of $549 thousand and discounts on acquired loans of $625 thousand at June 30, 2021, compared to deferred costs, net of deferred fees, of $622 thousand and discounts on acquired loans of $754 thousand at December 31, 2020. Outstanding PPP loans totaled $86.8 million at June 30, 2021 and $122.8 million at December 31, 2020, a decrease of $36.0 million or 29.3%. The decrease was primarily due to forgiveness on first round PPP loans originated in 2020, partially offset by the origination of second round PPP loans in 2021. We do not engage in foreign or subprime lending activities. See Note 4, “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 $116.8 million, or 7.9% of total loans, at June 30, 2021 and $106.8 million, or 7.3% of total loans, at December 31, 2020. Commercial real estate loans were $655.3 million, or 44.5% of total loans, at June 30, 2021, compared to $661.2 million, or 45.5% of total loans, at December 31, 2020.
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,
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and the Company has experienced significant growth in its commercial real estate portfolio in recent years. At June 30, 2021, non-owner-occupied commercial real estate loans (including construction, land and land development loans) represented 302.3% of total risk-based capital. At such time, construction, land and land development loans represented 56.8% of total risk-based capital.
The commercial real estate portfolio (including construction) has increased 41.7% 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 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 $15.1 million at June 30, 2021, $13.9 million at December 31, 2020 and $14.3 million at March 31, 2021. There were net recoveries of $125 thousand for the second quarter of 2021, compared to net recoveries of $61 thousand for the fourth quarter of 2020 and no net charge offs or recoveries for the first quarter of 2021. The ratio of annualized net recoveries to average loans was 0.03% for the second quarter of 2021, compared to annualized net recoveries of 0.02% for the fourth quarter of 2020 and 0% for the first quarter of 2021.
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 1.02% at June 30, 2021 and 0.95% at December 31, 2020. Excluding PPP loans, the ratio of the allowance for credit losses to period-end loans as 1.09% at June 30, 2021, higher than the 1.04% at December 31, 2020. The increase in the percentage of the allowance to total loans at June 30, 2021, compared to December 31, 2020, was primarily due to significant loan growth in the second quarter of 2021 as previously discussed. 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 June 30, 2021.
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The following tables present a summary of the activity in the allowance for credit losses at or for the three and six months ended June 30, 2021 and 2020.
For the Three Months Ended June 30,
2021
2020
Percentage of net
Percentage of net
charge-offs (recoveries)
charge-offs (recoveries)
(annualized) to
(annualized) to
average loans
average loans
Net (charge-offs)
outstanding
Net (charge-offs)
outstanding
(Dollars in thousands)
recoveries
during the year
recoveries
during the year
Construction
$
5
(0.02)
%
$
5
(0.02)
%
Residential real estate
57
(0.05)
4
-
Commercial real estate
64
(0.04)
(331)
0.21
Commercial
(2)
-
24
(0.04)
Consumer
1
(0.01)
10
(0.16)
Total
$
125
(0.03)
%
$
(288)
0.08
%
Average loans outstanding during the period
$
1,444,684
$
1,374,324
Allowance for credit losses at period end as a percentage of total period end loans (1)
1.02
%
0.79
%
Allowance for credit losses at period end as a percentage of average loans (2)
1.04
%
0.81
%
Allowance for credit losses at period end as a percentage of period end nonaccrual loans
382.27
%
95.20
%
(1) At June 30, 2021, the loan balances used to calculate the ratio include PPP loans of $86.8 million. Excluding PPP loans, the ratio is 1.09%. At June 30, 2020, the loan balances used to calculate the ratio included PPP loans of $122.9 million. Excluding PPP loans, the ratio is 0.86%.
(2) At June 30, 2021, the quarter-to-date average loan balances used to calculate the ratio include PPP loans of $116.9 million. Excluding PPP loans, the ratio is 1.14%. At June 30, 2020, the quarter-to-date average loan balances used to calculate the ratio included PPP loans of $90.2 million. Excluding PPP loans, the ratio is 0.86%.
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For the Six Months Ended June 30,
2021
2020
Percentage of net
Percentage of net
charge-offs (recoveries)
charge-offs (recoveries)
(annualized) to
(annualized) to
average loans
average loans
Net (charge-offs)
outstanding
Net (charge-offs)
outstanding
(Dollars in thousands)
recoveries
during the year
recoveries
during the year
Construction
$
10
(0.02)
%
$
8
(0.01)
%
Residential real estate
63
(0.03)
(184)
0.09
Commercial real estate
64
(0.02)
(601)
0.20
Commercial
(11)
0.01
5
(0.01)
Consumer
(1)
-
5
(0.04)
Total
$
125
(0.03)
%
$
(767)
0.12
%
Average loans outstanding during the period
$
1,447,767
$
1,318,883
Allowance for credit losses at period end as a percentage of total period end loans (1)
1.02
%
0.79
%
Allowance for credit losses at period end as a percentage of average loans (2)
1.04
%
0.84
%
Allowance for credit losses at period end as a percentage of period end nonaccrual loans
382.27
%
95.20
%
(1) At June 30, 2021, the loan balances used to calculate the ratio include PPP loans of $86.8 million. Excluding PPP loans, the ratio is 1.09%. At June 30, 2020, the loan balances used to calculate the ratio included PPP loans of $122.9 million. Excluding PPP loans, the ratio is 0.86%.
(2) At June 30, 2021, the year-to-date average loan balances used to calculate the ratio include PPP loans of $124.3 million. Excluding PPP loans, the ratio is 1.14%. At June 30, 2020, the year-to-date average loan balances used to calculate the ratio included PPP loans of $45.1 million. Excluding PPP loans, the ratio is 0.87%.
Nonperforming Assets and Accruing TDRs
As shown in the following table, nonperforming assets were $4.9 million and $6.3 million at June 30, 2021 and December 31, 2020, respectively. The balance of nonperforming assets decreased primarily due to a decline in nonaccrual loans of $1.5 million, or 27.6%. Accruing troubled debt restructurings (“TDRs”) decreased $659 thousand, or 9.4%, over the same time period. Other real estate owned properties increased to $203 thousand from $0 at December 31, 2020. The ratio of nonaccrual loans and accruing TDRs to total loans decreased to 0.70% at June 30, 2021 from 0.86% at December 31, 2020.
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 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.
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The following table summarizes our nonperforming assets and accruing TDRs at June 30, 2021 and December 31, 2020.
(Dollars in thousands)
June 30, 2021
December 31, 2020
Nonperforming assets
Nonaccrual loans
$
3,947
$
5,455
Total loans 90 days or more past due and still accruing
752
804
Other real estate owned
203
—
Total nonperforming assets
$
4,902
$
6,259
Total accruing TDRs
$
6,338
$
6,997
As a percent of total loans:
Nonaccrual loans
0.27
%
0.38
%
Accruing TDRs
0.43
%
0.48
%
Nonaccrual loans and accruing TDRs
0.70
%
0.86
%
As a percent of total loans and other real estate owned:
Nonperforming assets
0.33
%
0.43
%
Nonperforming assets and accruing TDRs
0.76
%
0.91
%
As a percent of total assets:
Nonaccrual loans
0.19
%
0.28
%
Nonperforming assets
0.23
%
0.32
%
Accruing TDRs
0.30
%
0.36
%
Nonperforming assets and accruing TDRs
0.53
%
0.69
%
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 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 June 30, 2021, 36.5% of the portfolio of debt securities was classified as available for sale and 63.5% was classified as held to maturity, compared to 68.0% and 32.0% respectively, at December 31, 2020. See Note 3 – “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 $317.4 million at June 30, 2021, a $107.1 million, or 50.9%, increase since December 31, 2020. The increase was primarily due to the purchases of held to maturity securities of $136.4 million, partially offset by proceeds from maturities and sales of available for sale securities of $23.9 million, during 2021. Due to the excess liquidity experienced in 2020 and 2021, the Company strategically purchased short duration held to maturity 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 from maturities and paydowns, as well as excess liquidity to fund loan growth. At June 30, 2021, 84.2% of the securities available for sale were mortgage-backed and 15.8% were U.S. Government agencies, compared to 83.1% and 16.9%, respectively, at year-end 2020. At June 30, 2021, 58.4% of the securities held to maturity were mortgage-backed, 31.7% were U.S. Government agencies and 9.9% were other debt securities, compared to 41.5%, 28.7% and 29.2%, respectively, at year-end 2020. Our investments in mortgage-backed securities are issued or guaranteed by U.S. Government agencies or government-sponsored agencies.
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Deposits
Total deposits at June 30, 2021 amounted to $1.88 billion, an increase of $179.9 million, or 10.6%, when compared to the level at December 31, 2020. The increase in total deposits consisted of increases in the following categories: Savings and money market accounts of $150.6 million, noninterest-bearing deposits of $28.9 million and other time deposits of $2.7 million, partially offset by a decrease in checking accounts of $2.3 million. The significant movement within deposit accounts continues to be impacted by direct government stimulus payments to our customers and new account openings.
Short-Term Borrowings
Short-term borrowings consisted of securities sold under agreements to repurchase, which increased by $1.9 million, or 176.9%, to $2.9 million at June 30, 2021 when compared to December 31, 2020. 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 June 30, 2021 and December 31, 2020, the Company had no outstanding short-term or long-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. On August 25, 2020, the Company entered into Subordinated Note Purchase Agreements with certain Purchasers pursuant to which the Company issued and sold $25.0 million in aggregate principal amount with an initial interest rate of 5.375% Fixed-to-Floating Rate Subordinated Notes due September 1, 2030.
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 $50.3 million for the first six months of 2021 compared to an increase of $31.3 million for the first six months of 2020. The increase in cash and cash equivalents in 2021 was mainly due to the significant increase in deposits, the direct result of new account openings, government stimulus and significant increases in municipal accounts. The Company expects these funds to be utilized over the coming months, which may result in deposit balance fluctuations.
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 correspondent 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 $298.9 million and $316.7 million at June 30, 2021 and December 31, 2020, 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 $3.7 million to $198.7 million at June 30, 2021 when compared to December 31, 2020 primarily due to the current year’s retained earnings, partially offset by dividends paid during the first six months of 2021 and the change in fair value of available-for-sale securities recorded in accumulated other comprehensive income.
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.
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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 was 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 Company has not opted-in to the CBLR framework.
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 June 30, 2021, the Bank’s capital levels remained characterized as “well-capitalized” under the rules.
The following tables present the applicable capital ratios as of June 30, 2021 and December 31, 2020.
Tier 1
Common Equity
Tier 1
Total
leverage
Tier 1
risk-based
risk-based
June 30, 2021
ratio
ratio
capital ratio
capital ratio
Shore United Bank
9.32
%
13.15
%
13.15
%
14.21
%
Tier 1
Common Equity
Tier 1
Total
leverage
Tier 1
risk-based
risk-based
December 31, 2020
ratio
ratio
capital ratio
capital ratio
Shore United Bank
9.73
%
13.21
%
13.21
%
14.25
%
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.