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 subsidiaries.
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.
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 2021 Form 10-K and other reports filed by us 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.
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 2021 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, N.A. The Bank operates 30 full-service branches in Baltimore City, Baltimore County, Howard County, Kent County, Queen Anne’s County, Caroline County, Talbot County, Dorchester County, Anne Arundel County and Worcester County in Maryland, Kent County, Delaware and in Accomack County, Virginia. The Company engages in trust and wealth management services through Wye Financial Partners, a division of Shore United Bank, N.A. The Company also engages in title work for real estate transactions through Mid-MD Title.
The shares of common stock of Shore Bancshares, Inc. are listed on the NASDAQ Global Select Market under the symbol “SHBI”.
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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.
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 2021 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 loans acquired in a business combination, the allowance for credit losses and goodwill 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.
Loans Acquired in a Business Combination
Acquired loans are classified as either (i) purchase credit-impaired (“PCI”) loans or (ii) purchased performing loans and are recorded at fair value on the date of acquisition.
PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. When determining fair value, PCI loans are aggregated into pools of loans based on common risk characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the “nonaccretable difference.” Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the “accretable yield” and is recognized as interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows.
On a quarterly basis, we evaluate our estimate of cash flows expected to be collected on PCI loans. Estimates of cash flows for PCI loans require significant judgment. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses resulting in an increase to the allowance for loan losses. Subsequent significant increases in cash flows may result in a reversal of post-acquisition provision for loan losses or a transfer from nonaccretable difference to accretable yield that increases interest income over the remaining life of the loan, or pool(s) of loans. Disposals of loans, which may include sale of loans to third parties, receipt of payments in full or in part from the borrower or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount.
PCI loans are not classified as nonperforming by the Company at the time they are acquired, regardless of whether they had been classified as nonperforming by the previous holder of such loans, and they will not be classified as nonperforming so long as, at quarterly re-estimation periods, we believe we will fully collect the new carrying value of the pools of loans.
The Company accounts for purchased performing loans using the contractual cash flows method of recognizing discount accretion based on the acquired loans’ contractual cash flows. Purchased performing loans are recorded at fair value, including a credit discount. The fair value discount is accreted as an adjustment to yield over the estimated lives of the
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loans. There is no allowance for loan losses established at the acquisition date for purchased performing loans. A provision for loan losses may be required for any deterioration in these loans in future periods.
Allowance for Credit Losses
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 2021 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
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 September 30, 2022, the Company had a banking and mortgage reporting unit.
OVERVIEW
The Company reported net income of $9.7 million for the third quarter of 2022, or diluted income per common share of $0.49, compared to net income of $4.6 million, or diluted income per common share of $0.39, for the third quarter of 2021. For the second quarter of 2022, the Company reported net income of $7.5 million, or diluted income per common share of $0.38. Net income, excluding merger related expenses, for the third quarter of 2022 was $9.8 million or $0.49 per diluted common share, compared to net income, excluding merger related expenses, of $7.7 million or $0.39 per diluted common share for the second quarter of 2022. When comparing net income, excluding merger related expenses, for the third quarter of 2022 to the third quarter of 2021, net income increased $4.7 million, primarily due to increases in net interest income of $11.7 million and noninterest income of $2.4 million, partially offset by an increase in noninterest expenses of $7.3 million primarily resulting from the acquisition of Severn Bank (“Severn”) in November 2021. When comparing the third quarter of 2022 to the second quarter of 2022, net income, excluding merger related expenses, increased $2.1 million, due to increases in net interest income of $2.7 million and a decrease in noninterest expense of $1.1 million partially offset by a decrease in in noninterest income of $489 thousand. Merger-related expenses recorded for the third quarter of 2022 and the second quarter of 2022 were $159 thousand and $241 thousand, respectively.
For the first nine months of 2022, the Company reported net income of $22.8 million, or diluted income per common share of $1.15, compared to net income of $12.6 million, or diluted income per common share of $1.08, for the first nine months of 2021. When comparing net income for the first nine months of 2022 to the first nine months of 2021, the increase in net income was primarily due to an increase in net interest income of $30.9 million and noninterest income of $8.9 million. These improvements to income were partially offset by an increase in noninterest expense of $26.0 million resulting primarily from the Severn merger.
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 $27.4 million for the third quarter
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of 2022 and $15.6 million for the third quarter of 2021. Tax-equivalent net interest income was $24.7 million for the second quarter of 2022. The increase in net interest income when comparing the third quarter of 2022 to the third quarter of 2021 and the second quarter of 2022, was due to increases in interest and fees on loans and income from taxable investment securities, partially offset by increases in interest expense on interest-bearing deposits and subordinated debt primarily due to the acquisition of Severn. Net interest margin is tax-equivalent net interest income (annualized) divided by average earning assets. The net interest margin for the third quarter of 2022 was 3.38% which was an increase of 39bps when compared to 2.99% for the third quarter of 2021 and an increase of 28bps when compared to 3.10% for the second quarter of 2022. The improvement in net interest margin in the third quarter of 2022 when compared to the third quarter of 2021 and the second quarter of 2022 was due to higher average loan balances, accretion income from purchased loans and higher rates paid on lower yielding assets.
Interest Income
On a tax-equivalent basis, interest income increased $13.7 million, or 80.8%, for the third quarter of 2022 when compared to the third quarter of 2021. The improvement to interest income was the result of increases in interest and fees on loans, income from investment securities and higher yields on interest-bearing deposits with other banks. The primary driver for the increase in interest income on loans was the higher average volume of loans of $840.0 million, significantly impacted by the acquisition of Severn in the fourth quarter of 2021 coupled with a higher average yield of 29bps. The average balance of taxable investment securities increased $284.2 million, providing $1.9 million of additional income.
On a tax-equivalent basis, interest income increased $3.9 million, or 14.6%, for the third quarter of 2022 when compared to the second quarter of 2022. The increase was primarily a result of growth in the average balance in loans of $110.1 million, or 5.0%. In addition, the average balance of taxable investment securities increased $72.1 million, or 13.2%, and the average yield increased 31bps, which provided $793 thousand of additional income.
Interest Expense
Interest expense increased $2.0 million, or 148.9%, when comparing the third quarter of 2022 to the third quarter of 2021. The increase in interest expense from the third quarter of 2021 was the result of increases in expenses on interest-bearing deposits of $1.6 million and both long-term advances from FHLB and subordinated debt for a combined $341 thousand, all of which were significantly impacted by the acquisition of Severn in the 4 th quarter of 2021.
Interest expense increased $1.2 million, or 58.8%, when comparing the third quarter of 2022 to the second quarter of 2022 primarily due to an increase in interest expense on deposits. The increase in the interest expense comparing the third quarter of 2022 to the second quarter of 2022 was primarily due to increases in average balances of money market and savings accounts and interest-bearing checking accounts. The rates paid on interest-bearing deposits increased to 48bps in the third quarter of 2022 from 29 bps in the second quarter of 2022.
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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, 2022 and 2021.
For Three Months Ended
For Three Months Ended
September 30, 2022
September 30, 2021
Average
Income(1)/
Yield/
Average
Income(1)/
Yield/
(Dollars in thousands)
Balance
Expense
Rate
Balance
Expense
Rate
Earning assets
Loans (2), (3)
$
2,327,279
$
25,960
4.43
%
$
1,487,281
$
15,518
4.14
%
Investment securities:
Taxable
618,378
3,186
2.06
334,205
1,318
1.58
Interest-bearing deposits
264,576
1,466
2.20
250,019
97
0.15
Total earning assets
3,210,233
30,612
3.78
%
2,071,505
16,933
3.24
%
Cash and due from banks
31,724
19,453
Other assets
218,163
108,989
Allowance for credit losses
(15,755)
(15,499)
Total assets
$
3,444,365
$
2,184,448
Interest-bearing liabilities
Demand deposits
$
646,399
1,071
0.66
%
$
462,950
165
0.14
%
Money market and savings deposits
1,034,580
907
0.35
644,330
295
0.18
Certificates of deposit $100,000 or more
222,697
308
0.55
136,059
243
0.71
Other time deposits
215,014
275
0.51
142,777
246
0.68
Interest-bearing deposits
2,118,690
2,561
0.48
1,386,116
949
0.27
Securities sold under retail repurchase agreements and short-term FHLB advances
—
—
—
2,718
2
0.29
Advances from FHLB - long-term
10,035
16
0.63
—
—
—
Subordinated debt
42,953
684
6.33
24,504
359
5.81
Total interest-bearing liabilities
2,171,678
3,261
0.60
%
1,413,338
1,310
0.37
%
Noninterest-bearing deposits
893,968
557,109
Other liabilities
21,336
13,120
Stockholders’ equity
357,383
200,881
Total liabilities and stockholders’ equity
$
3,444,365
$
2,184,448
Net interest spread
$
27,351
3.18
%
$
15,623
2.87
%
Net interest margin
3.38
%
2.99
%
Tax-equivalent adjustment
Loans
$
36
$
34
Total
$
36
$
34
(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 $30.9 million, or 70.8%, during the nine months ended September 30, 2022 compared to the nine months ended September 30, 2021. The higher net interest income was due to an increase in interest income of $33.8 million, or 70.6%, specifically increased interest and fees on loans of $27.2 million, or 61.4%, primarily due to an increase in the average loan balance of $774.0 million, or 53.0%, coupled with accretion income from acquired loans of $2.1 million for the nine months of 2022. Taxable investment securities and interest on deposits with other banks increased $4.2 million and $2.3 million, respectively. The increase in interest expense was the result of an increase in the average balance on interest bearing deposits of $819.8 million, or 62.8%. Interest on long term borrowings increased by $688 thousand due to the acquisition of long-term advances from the FHLB and junior subordinated debt acquired as part of the Severn acquisition. This resulted in a net interest margin of 3.09% for the nine months ended September 30, 2022 compared to 2.97% for the nine months ended September 30, 2021.
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Interest Income
On a tax-equivalent basis, interest income increased $33.8 million, or 70.6%, for the nine months ended September 30, 2022 when compared to the nine months ended September 30, 2021. The increase was primarily due to higher interest and fees on loans of $27.2 million, or 61.4%, and taxable investment securities of $4.2 million, or 126.2%. The increase in interest and fees on loans was due to a higher average balance of loans of $774.0 million, or 53.0%, primarily due to the acquisition of Severn in the 4 th quarter of 2021 as well as organic growth during the year. The increase in interest on taxable investment securities was due to a higher average balance in these securities of $282.4 million, or 99.8%.
Interest Expense
Interest expense increased $2.9 million, or 68.3%, when comparing the nine months ended September 30, 2022 to the nine months ended September 30, 2021. The increase in interest expense was the result of an increase in average interest-bearing deposits of $819.8 million, or 62.8%. Interest on long-term borrowings increased by $688 thousand due to the acquisition of long-term advances with the FHLB and junior subordinated debt acquired as part of the Severn acquisition.
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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, 2022 and 2021.
For Nine Months Ended
For Nine Months Ended
September 30, 2022
September 30, 2021
Average
Income(1)/
Yield/
Average
Income(1)/
Yield/
(Dollars in thousands)
Balance
Expense
Rate
Balance
Expense
Rate
Earning assets
Loans (2), (3)
$
2,235,092
$
71,575
4.28
%
$
1,461,083
$
44,339
4.06
%
Investment securities:
Taxable
565,535
7,562
1.79
283,104
3,343
1.58
Interest-bearing deposits
424,790
2,546
0.80
219,540
199
0.12
Total earning assets
3,225,417
81,683
3.39
%
1,963,727
47,881
3.26
%
Cash and due from banks
14,383
18,536
Other assets
222,236
107,174
Allowance for credit losses
(15,095)
(14,802)
Total assets
$
3,446,941
$
2,074,635
Interest-bearing liabilities
Demand deposits
$
627,213
1,652
0.35
%
$
435,678
453
0.14
%
Money market and savings deposits
1,046,230
2,027
0.26
591,959
777
0.18
Certificates of deposit $100,000 or more
247,635
931
0.50
134,080
998
1.00
Other time deposits
204,283
819
0.54
143,832
961
0.89
Interest-bearing deposits
2,125,361
5,429
0.34
1,305,549
3,189
0.33
Securities sold under retail repurchase agreements and federal funds purchased
913
2
0.29
2,695
5
0.25
Advances from FHLB - long-term
10,075
45
0.60
—
—
—
Subordinated debt
42,878
1,731
5.40
24,474
1,088
5.94
Total interest-bearing liabilities
2,179,227
7,207
0.44
%
1,332,718
4,282
0.43
%
Noninterest-bearing deposits
891,233
531,199
Other liabilities
21,932
12,631
Stockholders’ equity
354,549
198,087
Total liabilities and stockholders’ equity
$
3,446,941
$
2,074,635
Net interest spread
$
74,476
2.95
%
$
43,599
2.83
%
Net interest margin
3.09
%
2.97
%
Tax-equivalent adjustment
Loans
$
117
$
108
Total
$
117
$
108
(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.
Noninterest Income
Total noninterest income for the third quarter of 2022 increased $2.4 million, or 83.7%, when compared to the third quarter of 2021. The increase from the third quarter of 2021 was largely the result of the addition of Severn in the fourth quarter of 2021 which contributed in part to increases in service charges on deposit accounts of $704 thousand and added mortgage-banking revenue of $680 thousand and title revenue from Mid-Maryland Title Company of $397 in the third quarter of 2022. Noninterest income decreased $489 thousand, or 8.4%, when compared to the second quarter of 2022 primarily due to a decrease in revenue associated with the mortgage division of $416 thousand and other bank fee income of $132 thousand, partially offset by increases in service charges on deposit accounts $71 thousand.
Total noninterest income for the nine months ended September 30, 2022, increased $8.9 million, or 105.8%, when compared to the same period in 2021. The increase in noninterest income primarily consisted of revenue associated with the mortgage division, service charges on deposit related fees, title company revenue and other noninterest income. The
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increases in other noninterest income were primarily due to increases in rental income and other loan fee income as a result of the Severn acquisition.
Noninterest Expense
Total noninterest expense for the third quarter of 2022, excluding merger-related expenses, increased $7.3 million, or 64.4%, when compared to the third quarter of 2021 and decreased $1.1 million, or 5.5%, when compared to the second quarter of 2022. The increase in noninterest expense when compared to the third quarter of 2021 was primarily due to increases in salaries and wages, employee related benefits, occupancy expense, data processing, amortization of intangible assets and legal and professional fees, which were all significantly impacted by adding Severn branches and its operations. The decrease in noninterest expense when compared to the second quarter of 2022 was primarily due to increased deferrals of direct loan origination costs for salaries and employee benefits associated with the elevated level of loan originations during the quarter, as well as various cost savings related to the merger with Severn.
Total noninterest expense for the nine months ended September 30, 2022, excluding merger-related expenses, increased $25.8 million, or 79.6%, when compared to the same period in 2021. The increase was primarily a result of higher salaries, employee benefits, occupancy expense, other intangibles, data processing costs, other noninterest expenses, and FDIC insurance premiums due to significant increases in new and existing customers and the acquisition of Severn.
Provision for Credit Losses
The provision for credit losses was $675 thousand for the third quarter of 2022, $290 thousand for the third quarter of 2021 and $200 thousand for the second quarter of 2022. The increase in the provision for credit losses during the third quarter of 2022 as compared to the prior quarters was primarily attributable to significant loan growth. The ratio of the allowance for credit losses to period-end loans was 0.68% at September 30, 2022, 0.68% at June 30, 2022 and 1.04% at September 30, 2021. Excluding PPP loans and acquired loans, the ratio of the allowance for credit losses to period-end loans was 0.84% at September 30, 2022, slightly lower than the 0.89% at June 30, 2022 and lower than the 1.07% at September 30, 2021. The decline in the percentage of the allowance from the third quarter of 2021 was primarily the result of lower historical loss experience as well as lower pandemic related qualitative reserves. The Company reported net recoveries in the third quarter of 2022 of $119 thousand, compared to net recoveries of $147 thousand for the third quarter of 2021 and net recoveries of $573 thousand for the second quarter of 2022. Management continually evaluates the adequacy of the allowance for credit losses as changes in the environment and within the portfolio become known.
The provision for credit losses for the nine months ended September 30, 2022 and 2021 was $1.5 million and $1.4 million, respectively, while net recoveries were $858 thousand and $272 thousand, respectively. The increase in provision for credit losses was the result of an increase in loans held for investment in the first nine months of 2022 of $283 million compared to $41 million for the first nine months of 2021. The ratio of allowance to total loans increased from 0.66% at December 31, 2021, to 0.68% at September 30, 2022. Excluding PPP and acquired loans, the ratio of the allowance for credit losses to period-end loans was 0.84% at September 30, 2022, lower than the 0.93% at December 31, 2021. The primary drivers for the decrease in the percentage of allowance for credit losses to total loans were due to lower historical loss experience and reduced pandemic relative qualitative factors. The ratio of annualized net recoveries to average loans was (0.05%) for the first nine months of 2022, compared to annualized net recoveries to average loans of (0.02%) for the first nine months of 2021. 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 $3.4 million for the third quarter of 2022, $1.7 million for the third quarter of 2021 and $2.7 million for the second quarter of 2022. Income tax expense increased when compared to both the third quarter of 2021 and second quarter of 2022 due to higher pre-tax earnings. The effective tax rate for the third quarter of 2022 was 26.2%, 26.2% for the second quarter of 2022, and 26.4% for the third quarter of 2021. Income tax expense was $8.0 million for the nine months ended September 30, 2022, and $4.5 million for the nine months ended September 30,
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2021. The effective tax rate was 26.0% for the nine months ended September 30, 2022, and 26.4% for the nine months ended September 30, 2021.
ANALYSIS OF FINANCIAL CONDITION
Loans Held for Sale
We originate residential mortgage loans for sale on the secondary market, which we have elected to carry at fair value. At September 30, 2022 and December 31, 2021, the fair value of loans held for sale amounted to $8.3 million and $37.7 million, respectively.
When we sell mortgage loans we make certain representations to the purchaser related to loan ownership, loan compliance and legality, and accurate documentation, among other things. If a loan is found to be out of compliance with any of the representations subsequent to the date of purchase, we may be required to repurchase the loan or indemnify the purchaser.
Loans Held for Investment
The following tables represent the composition of the Company’s loan portfolio at September 30, 2022 and December 31, 2021.
September 30, 2022
Loans acquired from
(Dollars in thousands)
Legacy Loans
Severn acquisition
Total Loans
Construction
$
201,571
$
28,548
$
230,119
Residential real estate
610,691
147,372
758,063
Commercial real estate
830,421
192,832
1,023,253
Commercial
121,843
38,296
160,139
Consumer
229,266
752
230,018
Total loans excluding PPP loans
1,993,792
407,800
2,401,592
PPP loans
250
41
291
Total loans
$
1,994,042
$
407,841
$
2,401,883
Allowance for credit losses
(16,277)
Total loans, net
$
2,385,606
December 31, 2021
Loans acquired from
(Dollars in thousands)
Legacy Loans
Severn acquisition
Total Loans
Construction
$
145,151
$
94,202
$
239,353
Residential real estate
469,863
184,906
654,769
Commercial real estate
679,816
216,413
896,229
Commercial
128,485
47,332
175,817
Consumer
124,496
951
125,447
Total loans excluding PPP loans
1,547,811
543,804
2,091,615
PPP loans
18,371
9,189
27,560
Total loans
$
1,566,182
$
552,993
$
2,119,175
Allowance for credit losses
(13,944)
Total loans, net
$
2,105,231
The acquisition of Severn added $584.6 million in total loans as of October 31, 2021, of which $407.8 million in total loans remained outstanding as of September 30, 2022. Excluding these loans and legacy PPP loans, total legacy loans increased $445.9 million, or 28.8%, when compared to December 31, 2021. At September 30, 2022 and December 31, 2021, PPP loans accounted for $250 thousand and $18.4 million of total legacy loans, respectively. Most of our loans, excluding PPP loans, are secured by real estate and are classified as construction, residential or commercial real estate loans. The increase in legacy loans, excluding PPP loans, was comprised of increases in consumer loans of $104.8
million, or 84.2%, construction loans of $56.4 million, or 38.9%, residential real estate loans of $140.8 million, or 30.0%, and commercial real estate loans of $150.6 million, or 22.2%, partially offset by a decrease in commercial loans of $6.7
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million, or 5.2%, at September 30, 2022 compared to December 31, 2021. At September 30, 2022, the legacy loan portfolio, excluding PPP loans, was comprised of 41.7% commercial real estate, 30.6% residential real estate, 11.5% consumer, 10.1% construction and 6.1% commercial. That compares to 43.9%, 30.4%, 8.0%, 9.4% and 8.3, respectively, at December 31, 2021. Outstanding PPP loans totaled $291 thousand at September 30, 2022 and $27.6 million at December 31, 2021, a decrease of $27.3 million or 98.9%. The decrease was primarily due to forgiveness on first and second round PPP loans originated in 2020 and 2021. 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 $230.1 million, or 9.6% of total loans, at September 30, 2022 and $239.4 million, or 11.3% of total loans, at December 31, 2021. Commercial real estate loans were $1.02 billion, or 42.6% of total loans, at September 30, 2022, compared to $896.2 million, or 42.3% of total loans, at December 31, 2021.
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, 2022, non-owner-occupied commercial real estate loans (including construction, land and land development loans) represented 288.8% of total risk-based capital. At such time, construction, land and land development loans represented 67.3% of total risk-based capital.
The commercial real estate portfolio (including construction) has increased 110.8% 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 $16.3 million at September 30, 2022, $13.9 million at December 31, 2021 and $15.5 million at September 30, 2021. There were net recoveries of $119 thousand for the third quarter of 2022, compared to net recoveries of $573 thousand for the second quarter of 2022 and net recoveries of $147 thousand for the third quarter of 2021. The ratio of annualized net recoveries to average loans was 0.02% for the third quarter of 2022, compared to
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annualized net recoveries of 0.10% for the second quarter of 2022 and annualized net recoveries of 0.04% for the third 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 0.68% at September 30, 2022 and 0.66% at December 31, 2021. Excluding PPP loans and acquired loans from Severn and Northwest, the ratio of the allowance for credit losses to period-end loans was 0.84% at September 30, 2022, lower than the 0.93% at December 31, 2021. The decrease in the percentage of the allowance to total loans, excluding PPP loans and acquired loans, at September 30, 2022 compared to December 31, 2021, was primarily the result of improved credit quality, including lower historical loss experience as well as lower pandemic related qualitative factors. 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, 2022.
The following tables present a summary of the activity in the allowance for credit losses at or for the three and nine months ended September 30, 2022 and 2021.
For the Three Months Ended
September 30, 2022
September 30, 2021
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)
Average balances
recoveries
during the year
Average balances
recoveries
during the year
Construction
$
239,120
$
2
-
%
$
130,590
$
161
(0.49)
%
Residential real estate
730,738
12
(0.01)
460,890
9
(0.01)
Commercial real estate
980,174
243
(0.10)
656,278
—
-
Commercial
150,143
(142)
0.38
145,217
(29)
0.08
Consumer
213,984
4
(0.01)
94,306
6
(0.03)
Total
$
2,314,159
$
119
(0.02)
%
$
1,487,281
$
147
(0.04)
%
Allowance for credit losses at period end as a percentage of total period end loans (1)
0.68
%
1.04
%
Allowance for credit losses at period end as a percentage of total period end loans (2)
0.84
%
1.10
%
Allowance for credit losses at period end as a percentage of average loans (3)
0.70
%
1.04
%
Allowance for credit losses at period end as a percentage of period end nonaccrual loans
833.86
%
449.09
%
(1) At September 30, 2022 and September 30, 2021, these ratios included all loans held for investment, including PPP loans of $291 thousand and $41.5 million, respectively.
(2) At September 30, 2022 and September 30, 2021, these ratios exclude PPP loans, acquired loans and the associated purchase discount mark on the acquired loans from both Severn and Northwest.
(3) At September 30, 2022 and September 30, 2021, these ratios included all loans held for investment, including average PPP loans of $749 thousand and $63.9 million, respectively.
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For the Nine Months Ended
September 30, 2022
September 30, 2021
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)
Average balances
recoveries
during the year
Average balances
recoveries
during the year
Construction
$
251,150
$
9
-
%
$
121,107
$
171
(0.19)
%
Residential real estate
680,107
127
(0.02)
453,469
72
(0.02)
Commercial real estate
938,892
942
(0.13)
638,234
64
(0.01)
Commercial
165,692
(216)
0.17
183,434
(40)
0.03
Consumer
181,443
(4)
-
64,839
5
(0.01)
Total
$
2,217,284
$
858
(0.05)
%
$
1,461,083
$
272
(0.02)
%
Allowance for credit losses at period end as a percentage of total period end loans (1)
0.68
%
1.04
%
Allowance for credit losses at period end as a percentage of total period end loans (2)
0.84
%
1.10
%
Allowance for credit losses at period end as a percentage of average loans (3)
0.73
%
1.06
%
Allowance for credit losses at period end as a percentage of period end nonaccrual loans
833.86
%
449.09
%
(1) At September 30, 2022 and September 30, 2021, these ratios included all loans held for investment, including PPP loans of $291 thousand and $41.5 million, respectively.
(2) At September 30, 2022 and September 30, 2021, these ratios exclude PPP loans, acquired loans and the associated purchase discount mark on the acquired loans from both Severn and Northwest.
(3) At September 30, 2022 and September 30, 2021, these ratios included all loans held for investment, including average PPP loans of $8.9 million and $103.9 million, respectively.
Nonperforming Assets and Accruing TDRs
As shown in the following table, nonperforming assets were $3.0 million at both September 30, 2022 and December 31, 2021. The balance of nonperforming asset changes from September 30, 2022 to December 31, 2021 were an increase in total loans 90 days or more past due and still accruing of $323 thousand offset by a decrease in other real estate owned of $335 thousand and nonaccrual assets of $52 thousand. Accruing troubled debt restructurings (“TDRs”) decreased $1.2 million, or 21.3%, over the same time period. Other real estate owned properties decreased to $197 thousand at September 30, 2022 from $532 thousand at December 31, 2021. The ratio of nonaccrual loans and accruing TDRs to total loans ratio at September 30, 2022 was 0.27% compared to 0.36% at December 31, 2021.
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 September 30, 2022 and December 31, 2021.
(Dollars in thousands)
September 30, 2022
December 31, 2021
Nonperforming assets
Nonaccrual loans
$
1,949
$
2,004
Total loans 90 days or more past due and still accruing
644
508
Other real estate owned
197
532
Total nonperforming assets
$
2,790
$
3,044
Total accruing TDRs
$
4,458
$
5,667
As a percent of total loans:
Nonaccrual loans
0.08
%
0.09
%
Accruing TDRs
0.19
%
0.27
%
Nonaccrual loans and accruing TDRs
0.27
%
0.36
%
As a percent of total loans and other real estate owned:
Nonperforming assets
0.12
%
0.14
%
Nonperforming assets and accruing TDRs
0.30
%
0.41
%
As a percent of total assets:
Nonaccrual loans
0.06
%
0.06
%
Nonperforming assets
0.08
%
0.09
%
Accruing TDRs
0.13
%
0.16
%
Nonperforming assets and accruing TDRs
0.21
%
0.25
%
Investment Securities
The investment portfolio is comprised of debt and equity securities. 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 ability to hold such securities until maturity. At September 30, 2022, 14.7% of the portfolio of debt securities was classified as available for sale and 85.3% was classified as held to maturity, compared to 22.6% and 77.4% respectively, at December 31, 2021. 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 $668.2 million at September 30, 2022, a $141.1 million, or 26.8%, increase since December 31, 2021. The increase was primarily due to purchases of held to maturity securities of $207.5 million, purchases of restricted securities of $5.7 million and purchases of equity securities of $12 thousand partially offset by proceeds from maturities and principal repayments of available for sale securities of $16.7 million and held to maturity securities of $40.6 million. At September 30, 2022, 76.6% of the securities available for sale were mortgage-backed, 21.2% were U.S. Government agencies and 2.2% were corporate bonds, compared to 79.2%, 19.1% and 1.7%, respectively, at year-end 2021. At September 30, 2022, 71.0% of the securities held to maturity were mortgage-backed, 26.8% were U.S. Government agencies, 2.1% were subordinated debt instruments and less than 1% were community reinvestment bonds, compared to 74.8%, 21.4%, 3.6% and less than 1%, respectively, at year-end 2021. Our investments in mortgage-backed securities are issued or guaranteed by U.S. Government agencies or government-sponsored agencies. The decline in fair values on available for sale securities in the third quarter of 2022 was the result of the recent increases in interest rates and are not indicative of any credit concerns due to the Company holding high quality securities.
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Deposits
Total deposits at September 30, 2022 amounted to $3.02 billion, a decrease of $10.9 million, or less than 1%, when compared to the level at December 31, 2021. The decrease in total deposits consisted of a decrease in money market and savings accounts of $72.5 million, $33.7 million in noninterest bearing deposits and $30.6 million in time deposits partially offset by an increase in interest bearing checking accounts of $125.8 million.
Short-Term Borrowings
The Company had no short-term borrowings as of September 30, 2022, compared to short-term borrowings consisting of securities sold under agreements to repurchase of $4.1 million at December 31, 2021. 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, 2022 and December 31, 2021, the Company had no outstanding short-term advances with the FHLB.
Long-Term Debt
The Company occasionally borrows from the FHLB to meet longer term liquidity needs, specifically to fund loan growth when liquidity from deposit growth is not sufficient. The acquisition of Severn added $10.1 million in long-term FHLB borrowings, which carried an interest rate of 2.19%. The balance of this debt was $10.0 million and $10.1 million at September 30, 2022 and December 31, 2021 respectively. The long-term FHLB borrowings were paid off in October of 2022.
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% of Fixed-to-Floating Rate Subordinated Notes due September 1, 2030.
As a result of the Severn merger, the Company acquired Junior Subordinated Debt Securities due in 2035 (“2035 Debentures”) which had an outstanding principal balance of $20.6 million. The debt balance of $18.4 million at September 30, 2022 and $18.2 million at December 31, 2021 wasthe presented net of a fair value adjustment of $2.2 million and $2.4 million, respectively.
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 decrease in cash and cash equivalents was $420.3 million for the first nine months of 2022 compared to an increase of $123.9 million for the first nine months of 2021. The decrease in cash and cash equivalents in 2022 was mainly due to funding net loan growth of $280.9 million and purchases of securities held to maturity of $207.5 million.
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 $298.7 million and $363.7 million at September 30, 2022 and December 31, 2021, 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 $6.5 million, or 1.9%, to $357.2 million at September 30, 2022 when compared to December 31, 2021 primarily due to the current year’s retained earnings, partially offset by an increase in unrealized losses
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of $9.8 million (net of tax) on available for sale securities and dividends paid which are recorded in accumulated other comprehensive income (loss).
The Bank and the Company are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
In July 2013, federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule currently applies to all depository institutions and bank holding companies and savings and loan holding companies with total consolidated assets of more than $3 billion. The Company had total consolidated assets of more than $3 billion as of December 31, 2021, due to the acquisition of Severn in the fourth quarter of 2021. As such, the Company was required to comply with the consolidated capital requirements for the first quarterly report date following the effective date of the business combination as its total assets exceeded $3 billion.
Quantitative measures established by regulation to ensure capital adequacy require the Bank and the Company to maintain minimum ratios of common equity Tier 1, Tier 1, and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1,250%. The Bank and Company are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. The Bank and the Company were well capitalized at September 30, 222.
The following tables present the applicable capital ratios for the Company and the Bank as of September 30, 2022 and December 31, 2021.
Tier 1
Common Equity
Tier 1
Total
leverage
Tier 1
risk-based
risk-based
September 30, 2022
ratio
ratio
capital ratio
capital ratio
Shore Bancshares, Inc.
9.36
%
11.95
%
12.69
%
14.34
%
Shore United Bank
9.59
%
13.05
%
13.05
%
13.71
%
Tier 1
Common Equity
Tier 1
Total
leverage
Tier 1
risk-based
risk-based
December 31, 2021
ratio
ratio
capital ratio
capital ratio
Shore Bancshares, Inc.
9.43
%
12.76
%
12.76
%
15.36
%
Shore United Bank
9.48
%
13.90
%
13.90
%
14.55
%
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.