TIMBERLAND BANCORP INC 10-K

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding the consolidated financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying notes thereto included in Item 8 of this Annual Report on Form 10-K. Overview Timberland Bancorp, Inc., a Washington corporation, is the holding company for Timberland Bank. The Bank opened for business in 1915 and serves consumers and businesses across Grays Harbor, Thurston, Pierce, King, Kitsap and Lewis counties, Washington with a full range of lending and deposit services through its 24 branches (including its main office in Hoquiam). At September 30, 2021, the Company had total assets of $1.79 billion, net loans receivable of $968.45 million, total deposits of $1.57 billion and total shareholders’ equity of $206.90 million. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank’s operations. On October 1, 2018, the Company completed the South Sound Acquisition. The operating results for the years ended September 30, 2019, 2020 and 2021 include the operating results produced by the net assets acquired in the South Sound Acquisition. For additional information on the South Sound Acquisition, see Note 2 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." The Bank is a community-oriented bank which has traditionally offered a variety of savings products to its retail and business customers while concentrating its lending activities on real estate secured loans. Lending activities have been focused primarily on the origination of loans secured by real estate, including residential construction loans, one- to four-family residential loans, multi-family loans and commercial real estate loans. The Bank originates adjustable-rate residential mortgage loans, some of which do not qualify for sale in the secondary market. The Bank also originates commercial business loans and other consumer loans. The profitability of the Company’s operations depends primarily on its net interest income after provision for (recapture of) loan losses. Net interest income is the difference between interest income, which is the income that the Company earns on interest-earning assets, which are primarily loans and investments, and interest expense, the amount the Company pays on its interest-bearing liabilities, which are primarily deposits and borrowings (as needed). Net interest income is affected by changes in the volume and mix of interest-earning assets, the interest earned on those assets, the volume and mix of interest-bearing liabilities and the interest paid on those interest-bearing liabilities. Management attempts to maintain a net interest margin placing it within the top quartile of its Washington State peers. Because of the length of the COVID-19 pandemic and the efficacy of the extraordinary measures being put in place to address its economic consequences are unknown until the pandemic subsides, the Company expects its net interest income and net interest margin will be adversely affected. 55 The provision for (recapture of) loan losses is dependent on changes in the loan portfolio and management’s assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions. The allowance for loan losses reflects the amount that the Company believes is adequate to cover probable credit losses inherent in its loan portfolio. The Company did not record a provision for loan losses for the year ended September 30, 2021, primarily reflecting the improving economy and the resulting decline in forecasted probable loan losses from COVID-19 during this fiscal year. The Company recorded a provision for loan losses of $3.70 million for the year ended September 30, 2020, which was due primarily to forecasted probable loan losses reflecting the potential future impact of the COVID-19 pandemic on the economy based on the economic outlook at that time.. The Company maintains its commitment to supporting its community and customers during these unprecedented times as a result of the COVID-19 pandemic. The Company remains focused on keeping its employees safe and the Bank running effectively to serve its customers. The Bank is managing branch access and occupancy levels in relation to cases and close contact scenarios, following governmental restrictions and public health authority guidelines. Some of the Company's employees are working remotely or have flexible work schedules, and protective measures within the Company's offices have been established to help ensure the safety of those employees who must work on-site. The Company has worked with loan customers on loan deferral and forbearance plans. In response to requests from borrowers, the Company made payment deferral modifications (typically 90-day payment deferrals with interest continuing to accrue or scheduled to be paid monthly) on a number of loans. The majority of these borrowers had resumed making payments as of September 30, 2021 with one loan totaling $233,000 on deferral status compared to five loans totaling $5.87 million on deferral status as of September 30, 2020. These modifications were not classified as TDRs at September 30, 2021 and 2020 in accordance with guidance of the CARES Act and related regulatory guidance. The CARES Act also authorized the SBA to temporarily guarantee loans under a new loan program called the Paycheck Protection Program. As a qualified SBA lender, the Company was automatically authorized to originate PPP loans upon commencement of the program in April 2020 through the program's initial conclusion in August 2020. The CAA 2021, which was signed into law on December 27, 2020, renewed and extended the PPP until May 31, 2021. As a result, the Company began originating PPP loans again in January 2021. As of September 30, 2021, the Company had $40.92 million in PPP loans to new and existing customers who are small to midsize businesses as well as non-profit organizations, independent contractors, and partnerships as allowed under PPP guidance. Net income is also affected by non-interest income and non-interest expense. For the year ended September 30, 2021, non-interest income consisted primarily of service charges on deposit accounts, gain on sales of loans, ATM and debit card interchange transaction fees, an increase in the cash surrender value of BOLI, servicing income on loans sold, escrow fee and other operating income. Non-interest income is also increased by net recoveries on investment securities and reduced by net OTTI losses on investment securities, if any. Non-interest income is also decreased by valuation allowances on loan servicing rights and increased by recoveries of valuation allowances on loan servicing rights, if any. Non-interest expense consisted primarily of salaries and employee benefits, premises and equipment, advertising, ATM and debit card interchange transaction fees, postage and courier expenses, amortization of CDI, state and local taxes, professional fees, FDIC insurance premiums, loan administration and foreclosure expenses, data processing and telecommunication expenses, deposit operation expenses and other non-interest expenses. Non-interest expense in certain periods are reduced by gains on the sale of premises and equipment and by gains on the sale of OREO. Non-interest income and non-interest expense are affected by the growth of the Company's operations and growth in the number and balances of loan and deposit accounts. Results of operations may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities. Operating Strategy The Company is a bank holding company which operates primarily through its subsidiary, the Bank. The Company's primary objective is to operate the Bank as a well capitalized, profitable, independent, community-oriented financial institution, serving customers in its primary market area of Grays Harbor, Pierce, Thurston, Kitsap, King and Lewis counties. The Company's strategy is to provide products and superior service to small businesses and individuals located in its primary market area. The Company's goal is to deliver returns to shareholders by focusing on the origination of higher-yielding assets (in particular, commercial real estate, construction, and commercial business loans), increasing core deposit balances, managing problem assets, efficiently managing expenses, and seeking expansion opportunities. The Company seeks to achieve these results by focusing on the following objectives: 56 Expand our presence within our existing market areas by capturing opportunities resulting from changes in the competitive environment. We currently conduct our business primarily in western Washington. We have a community bank strategy that emphasizes responsive and personalized service to our customers. As a result of the consolidation of banks in our market areas, we believe that there is an opportunity for a community and customer focused bank to expand its customer base. By offering timely decision making, delivering appropriate banking products and services, and providing customer access to our senior managers, that we believe that community banks, such as Timberland Bank, can distinguish themselves from larger banks operating in our market areas. We believe that we have a significant opportunity to attract additional borrowers and depositors and expand our market presence and market share within our extensive branch footprint. Portfolio diversification. In recent years, we have limited the origination of speculative construction loans and land development loans in favor of loans that possess credit profiles representing less risk to the Bank. We continue originating owner/builder and custom construction loans, multi-family loans, commercial business loans and commercial real estate loans which offer higher risk adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations than fixed-rate one-to four-family loans. We anticipate capturing more of each customer's banking relationship by cross selling our loan and deposit products and offering additional services to our customers. Increase core deposits and other retail deposit products. We focus on establishing a total banking relationship with our customers with the intent of internally funding our loan portfolio. We anticipate that the continued focus on customer relationships will increase our level of core deposits. In addition to our retail branches, we maintain technology based products such as business cash management and a business remote deposit product that enable us to compete effectively with banks of all sizes. Managing exposure to fluctuating interest rates. For many years, the majority of the loans the Bank has retained in its portfolio have generally possessed periodic interest rate adjustment features or have been relatively short-term in nature. Loans originated for portfolio retention have generally included ARM loans, short-term construction loans, and, to a lesser extent, commercial business loans with interest rates tied to a market index such as the Prime Rate. Longer term fixed-rate mortgage loans have generally been originated for sale into the secondary market, although from time to time, the Bank may retain a portion of its fixed-rate mortgage loan originations and extend the initial fixed-rate period of its hybrid ARM commercial real estate loans for asset/liability purposes. Continue generating revenues through mortgage banking operations. The substantial majority of the fixed-rate residential mortgage loans we originate are sold into the secondary market with servicing retained. This strategy produces gains on the sale of such loans and reduces the interest rate and credit risk associated with fixed-rate residential lending. We continue to originate custom construction and owner/builder construction loans for sale into the secondary market upon the completion of construction. Maintaining strong asset quality. We believe that strong asset quality is a key to our long-term financial success. The percentage of non-performing loans to loans receivable, net was 0.29% and 0.28% at September 30, 2021 and 2020, respectively. The Company's percentage of non-performing assets to total assets at September 30, 2021 was 0.18% compared to 0.27% at September 30, 2020. Non-performing assets have decreased to $3.17 million at September 30, 2021 from $14.98 million at September 30, 2015. We continue to seek to reduce the level of non-performing assets through collections, write-downs, modifications and sales of OREO. We also take proactive steps to resolve our non-performing loans, including negotiating payment plans, forbearances, loan modifications and loan extensions and accepting short payoffs on delinquent loans when such actions have been deemed appropriate. Although the Company plans to continue to place emphasis on certain lending products, such as commercial real estate loans, construction loans, and commercial business loans, the Company expects to continue to manage its credit exposures through the use of experienced bankers and an overall conservative approach to lending. Selected Financial Data The following table sets forth certain information concerning the consolidated financial position and results of operations of the Company and its subsidiary at and for the dates indicated. The consolidated data is derived in part from, and should be read in conjunction with, the Consolidated Financial Statements of the Company and its subsidiary presented herein. 57 At September 30, 2021 2020 2019 2018 2 2017 (In thousands) SELECTED FINANCIAL CONDITION DATA: Total assets $ 1,792,180 $ 1,565,978 $ 1,247,132 $ 1,018,290 $ 952,024 Loans receivable, net 968,454 1,013,875 886,662 725,391 690,364 MBS and other investments held-to-maturity 69,102 27,890 31,102 12,810 7,139 MBS and other investments available-for-sale 63,176 57,907 22,532 1,154 1,241 FHLB Stock 2,103 1,922 1,437 1,190 1,107 Other investments 3,000 3,000 3,000 3,000 3,000 Cash and due from financial institutions, interest-bearing deposits in banks and fed funds sold 580,196 314,452 143,015 148,864 148,188 Certificates of deposit held for investment 28,482 65,545 78,346 63,290 43,034 OREO and other repossessed assets 157 1,050 1,683 1,913 3,301 Deposits 1,570,555 1,358,406 1,068,227 889,506 837,898 FHLB advances 5,000 10,000 — — — Shareholders' equity 206,899 187,630 171,067 124,657 111,000 Year Ended September 30, 2021 2020 2019 2018 2017 (In thousands, except per share data) SELECTED OPERATING DATA: Interest and dividend income $ 54,962 $ 55,583 $ 55,725 $ 41,833 $ 38,338 Interest expense 3,104 4,701 4,565 2,778 3,197 Net interest income 51,858 50,882 51,160 39,055 35,141 Provision for loan losses — 3,700 — — (1,250) Net interest income after provision for loan losses 51,858 47,182 51,160 39,055 36,391 Non-interest income 17,161 17,188 14,341 12,544 12,368 Non-interest expense 34,591 34,063 35,580 29,177 27,516 Income (loss) before income taxes 34,428 30,307 29,921 22,422 21,243 Provision for state income taxes — — — — — Provision (benefit) for federal income taxes 6,845 6,038 5,901 5,701 7,076 Net income (loss) $ 27,583 $ 24,269 $ 24,020 $ 16,721 $ 14,167 Net income (loss) per common share: Basic $ 3.31 $ 2.91 $ 2.89 $ 2.28 $ 1.99 Diluted $ 3.27 $ 2.88 $ 2.84 $ 2.22 $ 1.92 Dividends per common share $ 1.03 $ 0.85 $ 0.78 $ 0.60 $ 0.50 Dividend payout ratio (1) 31.14 % 29.19 % 27.04 % 26.5 % 25.7 % ______________ (1) Cash dividends to common shareholders divided by net income to common shareholders. 58 At September 30, 2021 2020 2019 2018 2017 OTHER DATA: Number of real estate loans outstanding 2,290 2,508 2,766 2,550 2,593 Deposit accounts 58,454 58,566 59,547 55,441 54,707 Full-service offices 24 24 24 22 22 At or For the Year Ended September 30, 2021 2020 2019 2018 2017 KEY FINANCIAL RATIOS: Performance Ratios: Return (loss) on average assets (1) 1.64 % 1.75 % 1.96 % 1.70 % 1.53 % Return (loss) on average equity (2) 13.98 13.59 14.91 14.27 13.65 Interest rate spread (3) 3.13 3.70 4.31 4.10 3.93 Net interest margin (4) 3.25 3.90 4.50 4.23 4.07 Average interest-earning assets to average interest-bearing liabilities 162.08 155.98 148.15 144.17 137.75 Non-interest expense as a percent of average total assets 2.06 2.45 2.91 2.96 2.98 Efficiency ratio (5) 50.12 50.04 54.32 56.55 57.92 Asset Quality Ratios: Non-accrual and 90 days or more past due loans as a percent of total loans receivable, net 0.29 % 0.28 % 0.34 % 0.18 % 0.28 % Non-performing assets as a percent of total assets (6) 0.18 0.27 0.40 0.36 0.60 Allowance for loan losses as a percent of total loans receivable, net (7) 1.37 1.31 1.08 1.30 1.36 Allowance for loan losses as a percent of non-performing loans (8) 471.93 461.76 319.49 723.61 499.90 Net charge-offs (recoveries) to average outstanding loans — — (0.02) — (0.14) Capital Ratios: Total equity-to-assets ratio 11.54 % 11.98 % 13.71 % 12.24 % 11.66 % Average equity to average assets 11.74 12.85 13.17 11.90 11.25 __________________ (1) Net income divided by average total assets. (2) Net income divided by average total equity. (3) Difference between weighted average yield on interest-earning assets and weighted average cost of interest-bearing liabilities. (4) Net interest income before provision for (recapture of) loan losses as a percentage of average interest-earning assets. (5) Non-interest expenses divided by the sum of net interest income and non-interest income. (6) Non-performing assets include non-accrual loans, loans past due 90 days or more and still accruing, non-accrual investment securities, OREO and other repossessed assets. (7) Loans receivable is before the allowance for loan losses. (8) Non-performing loans include non-accrual loans and loans past due 90 days or more and still accruing. TDRs that are on accrual status are not included. Critical Accounting Policies and Estimates The Company has established various accounting policies that govern the application of GAAP in the preparation of the Company's Consolidated Financial Statements. The Company has identified six policies that, as a result of judgments, 59 estimates and assumptions inherent in those policies, are critical to an understanding of the Company's Consolidated Financial Statements. These policies relate to the methodology for the determination of the allowance for loan losses, the determination of any OTTI in the fair value of investment securities, the valuation of loan servicing rights, the valuation of OREO, the valuation of assets acquired and liabilities assumed in acquisitions and the valuation of goodwill for potential impairment. Management believes that the judgments, estimates and assumptions used in the preparation of the Company's Consolidated Financial Statements are appropriate given the factual circumstances at the time. However, given the sensitivity of the Company's Consolidated Financial Statements to these critical policies, the use of other judgments, estimates and assumptions could result in material differences in the Company's results of operations or financial condition. Further, subsequent changes in economic or market conditions could have a material impact on these estimates and our financial condition and operating results in future periods. There have been no significant changes in our application of accounting policies since September 30, 2021. For additional information concerning critical accounting policies, see Note 1 of the Notes to Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." and the following: Provision and Allowance for Loan Losses The methodology for determining the allowance for loan losses is considered a critical accounting policy by management because of the high degree of judgment involved, the subjectivity of the assumptions used, and the potential for changes in the economic environment that could result in changes to the amount of the recorded allowance for loan losses. The provision for loan losses reflects the amount required to maintain the allowance for loan losses at an appropriate level based upon management’s evaluation of the adequacy of general and specific loss reserves. Determining the amount of the allowance for loan losses involves a high degree of judgment. Among the material estimates required to establish the allowance for loan losses are: overall economic conditions; value of collateral; strength of guarantors; loss exposure at default; the amount and timing of future cash flows on impaired loans; and determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. We have established systematic methodologies for the determination of the adequacy of our allowance for loan losses. The methodologies are set forth in a formal policy and take into consideration the need for an overall general valuation allowance as well as specific allowances that are tied to individual problem loans. We increase our allowance for loan losses by charging provisions for probable loan losses against our income. The allowance for loan losses is maintained at a level sufficient to provide for probable losses based on evaluating known and inherent risks in the loan portfolio and upon our continuing analysis of the factors underlying the quality of the loan portfolio. These factors include, among others, changes in the size and composition of the loan portfolio, delinquency rates, actual loan loss experience, current and economic conditions, detailed analysis of individual loans for which full collectability may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. Realized losses related to specific assets are applied as a reduction of the carrying value of the assets and charged immediately against the allowance for loan loss reserve. Recoveries on previously charged off loans are credited to the allowance for loan losses. The reserve is based upon factors and trends identified by us at the time financial statements are prepared. Although we use the best information available, future adjustments to the allowance for loan losses may be necessary due to economic, operating, regulatory and other conditions beyond our control. The adequacy of general and specific reserves is based on our continuing evaluation of the pertinent factors underlying the quality of the loan portfolio as well as individual review of certain large balance loans. Loans are considered impaired when, based on current information and events, we determine that it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, the financial condition of the borrower, the value of the underlying collateral less selling costs and the current status of the economy. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of collateral if the loan is collateral dependent. We continue to assess the collateral of these loans and update our appraisals on large balance impaired loans on an annual basis. To the extent the property values decline, there could be additional losses on these impaired loans, which may be material. Subsequent changes in the value of impaired loans are included within the provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the provision that would otherwise be reported. Large groups of smaller-balance homogeneous loans are collectively evaluated for impairment. Loans that are collectively evaluated for impairment include residential real estate and consumer loans and, as appropriate, smaller balance non-homogeneous loans. Larger balance non-homogeneous residential construction and land, commercial real estate, commercial business loans and unsecured loans are individually evaluated for impairment. Our methodology for assessing the appropriateness of the allowance for loan losses consists of several key elements, which include specific allowances, an allocated formula allowance and an unallocated allowance. Losses on specific loans are provided for when the losses are probable and estimable. General loan loss reserves are established to provide for inherent loan portfolio risks not specifically provided for. The level of general reserves is based on analysis of potential exposures existing in 60 our loan portfolio including evaluation of historical trends, current market conditions and other relevant factors identified by us at the time the financial statements are prepared. The formula allowance is calculated by applying loss factors to outstanding loans, excluding those loans that are subject to individual analysis for specific allowances. Loss factors are based on our historical loss experience adjusted for significant environmental considerations, including the experience of other banking organizations, which in our judgment affect the collectability of the loan portfolio as of the evaluation date. The unallocated allowance is based upon our evaluation of various factors that are not directly measured in the determination of the formula and specific allowances. This methodology may result in actual losses or recoveries differing significantly from the allowance for loan losses in the Consolidated Financial Statements. While we believe the estimates and assumptions used in our determination of the adequacy of the allowance for loan losses are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. In addition, the determination of the amount of the Banks’ allowance for loan losses is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination. Fair Value Accounting and Measurement We use fair value measurements to record fair value adjustments to certain financial assets and liabilities and to determine fair value disclosures. We include in the Notes to the Consolidated Financial Statements information about the extent to which fair value is used to measure financial assets and liabilities, the valuation methodologies used and the impact on our results of operations and financial condition. Additionally, for financial instruments not recorded at fair value we disclose, where required, our estimate of their fair value. For more information regarding fair value accounting, please refer to Note 18 in the Notes to the Consolidated Financial Statements. Loan Servicing Rights Loan servicing rights are recognized as separate assets when rights are acquired through purchase or through sale of loans. Generally, purchased loan servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage loans, the value of the loan servicing right is estimated and capitalized. Fair value is based on market prices for comparable loan servicing contracts. The fair value of the loan servicing rights includes an estimate of the life of the underlying loans which is affected by estimated prepayment speeds. The estimate of prepayment speeds is based on current market conditions. Actual market conditions could vary significantly from current conditions which could result in the estimated life of the underlying loans being different which would change the fair value of the loan servicing right. Capitalized loan servicing rights are reported in other assets and are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Valuation of OREO Real estate properties acquired through foreclosure or by deed-in-lieu of foreclosure are recorded at the lower of cost or fair value less estimated costs to sell. Fair value is generally determined by management based on a number of factors, including third-party appraisals of fair value in an orderly sale. Accordingly, the valuation of OREO is subject to significant external and internal judgment. If the carrying value of the loan at the date a property is transferred into OREO exceeds the fair value less estimated costs to sell, the excess is charged to the allowance for loan losses. Management periodically reviews OREO values to determine whether the property continues to be carried at the lower of its recorded book value or fair value, net of estimated costs to sell. Any further decreases in the value of OREO are considered valuation adjustments and are charged to non-interest expense in the Consolidated Income Statements. Expenses and income from the maintenance and operations and any gains or losses from the sales of OREO are included in non-interest expense. Business Combinations The Company applies the acquisition method of accounting for business combinations. Under the acquisition method, the acquiring entity in a business combination recognizes all of the identifiable assets acquired and liabilities assumed at their acquisition date fair values. Management utilizes prevailing valuation techniques appropriate for the asset or liability being measured in determining these fair values. Any excess of the purchase price over amounts allocated to assets acquired, including identifiable intangible assets, and liabilities assumed is recorded as goodwill. Where amounts allocated to assets acquired and liabilities assumed is greater than the purchase price, a bargain purchase gain is recognized. Acquisition-related costs are expensed as incurred unless they are directly attributable to the issuance of the Company's common stock in a business combination and the Company chooses to record these acquisition-related costs through stockholders' equity. There were no 61 business combinations during the years ended September 30, 2021 and September 30, 2020. For additional information see Note (2) Business Combination of the Notes to Consolidated Financial Statements included in Item 8. Financial Statements.. Goodwill Goodwill represents the excess of the purchase consideration paid over the fair value of the assets acquired, net of the fair values of liabilities assumed in a business combination and is not amortized but is reviewed annually, or more frequently as current circumstances and conditions warrant, for impairment. An assessment of qualitative factors is completed to determine if it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The qualitative assessment involves judgment by management on determining whether there have been any triggering events that have occurred which would indicate potential impairment. If the qualitative analysis concludes that further analysis is required, then a quantitative impairment test would be completed. The quantitative goodwill impairment test is used to identify the existence of impairment and the amount of impairment loss and compares the reporting unit's estimated fair values, including goodwill, to its carrying amount. If the fair value exceeds the carry amount then goodwill is not considered impaired. If the carrying amount exceeds its fair value, an impairment loss would be recognized equal to the amount of excess, limited to the amount of total goodwill allocated to the reporting unit. The impairment loss would be recognized as a charge to earnings. Market Risk and Asset and Liability Management General. Market risk is the risk of loss from adverse changes in market prices and rates. The Bank's market risk arises primarily from interest rate risk inherent in its lending, investment, deposit and borrowing activities. The Bank, like other financial institutions, is subject to interest rate risk to the extent that its interest-earning assets reprice differently than its interest-bearing liabilities. Management actively monitors and manages its interest rate risk exposure. Although the Bank manages other risks, such as credit quality and liquidity risk, in the normal course of business, management considers interest rate risk to be its most significant market risk that could potentially have the largest material effect on the Bank's financial condition and results of operations. The Bank does not maintain a trading account for any class of financial instruments nor does it engage in hedging activities. Furthermore, the Bank is not subject to foreign currency exchange rate risk or commodity price risk. Qualitative Aspects of Market Risk. The Bank's principal financial objective is to achieve long-term profitability while reducing its exposure to fluctuating market interest rates. The Bank has sought to reduce the exposure of its earnings to changes in market interest rates by attempting to manage the difference between asset and liability maturities and interest rates. The principal element in achieving this objective is to increase the interest rate sensitivity of the Bank's interest-earning assets by retaining in its portfolio, short-term loans and loans with interest rates subject to periodic adjustments. The Bank relies on retail deposits as its primary source of funds. As part of its interest rate risk management strategy, the Bank promotes transaction accounts and certificates of deposit with terms of up to five years. The Bank has adopted a strategy that is designed to substantially match the interest rate sensitivity of assets relative to its liabilities. The primary elements of this strategy involve originating ARM loans for its portfolio, maintaining residential construction loans as a portion of total net loans receivable because of their generally shorter terms and higher yields than other one- to four-family residential mortgage loans, matching asset and liability maturities, investing in short-term securities, and originating fixed-rate loans for retention or sale in the secondary market while retaining the related loan servicing rights. Sharp increases or decreases in interest rates may adversely affect the Bank's earnings. Management of the Bank monitors the Bank's interest rate sensitivity through the use of a model provided by NXTsoft Data Analytics, LLC (“NXTsoft”), a company that specializes in providing interest rate risk and balance sheet management services to the financial services industry. Based on a rate shock analysis prepared by NXTsoft using data at September 30, 2021, an immediate increase in interest rates of 100 basis points would increase the Bank’s projected net interest income by approximately 11.6%, primarily because a larger portion of the Bank's interest rate sensitive assets than interest rate sensitive liabilities would reprice within a one-year period. Conversely, an immediate decrease in interest rates of 100 basis points would decrease the Bank's projected net interest income by approximately 4.7%. See “Quantitative Aspects of Market Risk” below for additional information. Management has sought to sustain the match between asset and liability maturities and rates, while maintaining an acceptable interest rate spread. Pursuant to this strategy, the Bank actively originates adjustable-rate loans for retention in its loan portfolio. Fixed-rate mortgage loans with maturities greater than seven years generally are originated for the immediate or future resale in the secondary mortgage market. Although the Bank has sought to originate ARM loans, the ability to originate such loans depends to a great extent on market interest rates and borrowers' preferences. In lower interest rate environments, borrowers often prefer fixed-rate loans. 62 Consumer, commercial business and construction loans typically have shorter terms and higher yields than permanent residential mortgage loans and, accordingly, reduce the Bank’s exposure to fluctuations in interest rates. At September 30, 2021, the consumer, commercial business and construction loan portfolios amounted to $35.50 million, $115.50 million and $233.21 million, respectively or 3.3%, 10.7% and 21.5%, respectively of total loans receivable. Quantitative Aspects of Market Risk. The model provided for the Bank by NXTsoft estimates the changes in net portfolio value ("NPV") and net interest income in response to a range of assumed changes in market interest rates. The model first estimates the level of the Bank's NPV (market value of assets, less market value of liabilities, plus or minus the market value of any off-balance sheet items) under the current rate environment. In general, market values are estimated by discounting the estimated cash flows of each instrument by appropriate discount rates. The model then recalculates the Bank's NPV under different interest rate scenarios. The change in NPV under the different interest rate scenarios provides a measure of the Bank's exposure to interest rate risk. The following table is provided by NXTsoft based on data at September 30, 2021: Hypothetical Net Interest Income (1)(2) Current Market Value Interest Rate Estimated $ Change % Change Estimated $ Change % Change Scenario (3) Value from Base from Base Value from Base from Base (Basis Points) (Dollars in thousands) +400 $ 64,979 $ 21,229 48.52 % $ 380,546 $ 77,037 25.38 % +300 59,502 15,752 36.00 362,045 58,536 19.29 +200 54,114 10,364 23.69 343,326 39,817 13.12 +100 48,813 5,063 11.57 323,599 20,090 6.62 BASE 43,750 — — 303,509 — — -100 41,683 (2,067) (4.73) 272,535 (30,974) (10.21) -200 41,017 (2,733) (6.25) 263,110 (40,399) (13.31) ___________ (1) Does not include loan fees. (2) Includes BOLI income, which is included in non-interest income in the Consolidated Financial Statements. (3) No rates in the model are allowed to go below zero. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan repayments and deposit decay, and should not be relied upon as indicative of actual results. Furthermore, the computations do not reflect any actions management may undertake in response to changes in interest rates. In the event of a 100 basis point decrease in interest rates, the Bank would be expected to experience a 10.6% decrease in NPV and a 4.7% decrease in net interest income. In the event of a 100 basis point increase in interest rates, a 6.9% increase in NPV and a 11.6% increase in net interest income would be expected. Based upon the modeling described above, the Bank's asset and liability structure generally results in increases in net interest income and NPV in a rising interest rate scenario and decreases in net interest income and NPV in a declining interest rate scenario. As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates of deposit could possibly deviate significantly from those assumed in calculating the table. Comparison of Financial Condition at September 30, 2021 and September 30, 2020 The Company's total assets increased by $226.20 million, or 14.4%, to $1.79 billion at September 30, 2021 from $1.57 billion at September 30, 2020. The increase in assets was primarily due to an increase in total cash and cash equivalents, and to a much lesser extent, an increase in investment securities, partially offset by decreases in CDs held for investment and loans receivable. The increase in total assets was funded primarily by an increase in total deposits. 63 Net loans receivable decreased by $45.42 million, or (4.5)%, to $968.45 million at September 30, 2021 from $1.01 billion at September 30, 2020, primarily due to decreases in SBA PPP loans, and smaller decreases in several other loan categories. These decreases to net loans receivable were partially offset by increases in commercial real estate and construction loans, and smaller increases in several other loan categories. Total deposits increased by $212.15 million, or 15.6%, to $1.57 billion at September 30, 2021 from $1.36 billion at September 30, 2020, primarily due to increases in non-interest-bearing demand account balances, NOW checking account balances, money market account balances, and savings account balances. These increases were partially offset by a decrease in certificates of deposit account balances. Shareholders' equity increased by $19.27 million, or 10.3%, to $206.90 million at September 30, 2021 from $187.63 million at September 30, 2020. The increase was primarily due to net income for the year ended September 30, 2021 of $27.58 million which was partially offset by $8.59 million in dividends paid to shareholders. A more detailed explanation of the changes in significant balance sheet categories follows: Cash and Cash Equivalents: Cash and cash equivalents increased by $265.74 million, or 84.5%, to $580.20 million at September 30, 2021 from $314.45 million at September 30, 2020. The increase was primarily a result of an increase in total deposits, which exceeded the funds required for loan originations and purchases of investment securities. CDs Held for Investment: CDs held for investment decreased by $37.06 million, or 56.5%, to $28.48 million at September 30, 2021 from $65.55 million at September 30, 2020. Funds received as CDs matured were invested into other higher yielding interest-earning assets as interest rates on CDs held for investment decreased during the year. Investment Securities and Investments in Equity Securities: Investment securities and investments in equity securities increased by $46.46 million, or 53.6%, to $133.23 million at September 30, 2021 from $86.77 million at September 30, 2020. The increase was primarily due to the purchase of U.S. Treasury and U.S. government agency securities and additional agency and private label residential mortgage-backed investment securities as the Company put a portion of its excess overnight liquidity into higher-earning investment securities during the year ended September 30, 2021. These increases were partially offset by maturities, prepayments and scheduled amortization of other investment securities. For additional details on investment securities, see "Item 1. Business - Investment Activities" and Note 4 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." FHLB Stock : FHLB stock increased by $181,000 or 9.4%, to $2.10 million at September 30, 2021 from $1.92 million at September 30, 2020, due to purchases required by the FHLB as a result of the increase in total assets. Other Investments: Other investments consist solely of the Company's investment in the Solomon Hess SBA Loan Fund LLC, which was unchanged at both September 30, 2021 and 2020. This investment is utilized to help satisfy compliance with the Company's Community Reinvestment Act ("CRA") investment test requirements. Loans Held for Sale: Loans held for sale decreased by $1.29 million, or 28.7%, to $3.22 million at September 30, 2021 from $4.51 million at September 30, 2020, primarily due to the timing and volume of mortgage banking loan sales. The Company sells longer-term fixed-rate residential loans and the guaranteed portion of SBA commercial business loans for asset-liability management purposes and to generate non-interest income. The Company sold $150.20 million in loans during the year ended September 30, 2021 compared to $167.24 million for the year ended September 30, 2020. Sales of loans over the past two years have increased, from historical levels, primarily due to increased refinance activity for one- to four-family loans due to the decrease in mortgage interest rates. Loans Receivable, Net of Allowance for Loan Losses: Net loans receivable decreased by $45.42 million, or (4.5)%, to $968.45 million at September 30, 2021 from $1.01 billion at September 30, 2020. The decrease was primarily due to an $85.90 million decrease in SBA PPP loans, a $5.64 million decrease in land loans, and smaller decreases in several other loan categories. These decreases were partially offset by a $17.08 million increase in commercial real estate loans, a $13.71 million increase in construction loans, and smaller increases in several other loan categories. The SBA PPP loan balances decreased primarily due to borrowers applying for forgiveness from the SBA and the loans being subsequently paid off by the SBA and was partially offset by new SBA PPP loans funded after the renewal of the program in December 2020. Loan originations increased by $5.16 million, or 0.9%, to $602.34 million for the year ended September 30, 2021 from $597.19 million for the year ended September 30, 2020. The increase in loan originations was primarily due to increased demand for commercial real estate and construction loans, which was partially offset by a decrease in SBA PPP loans funded. 64 For additional information on loans, see "Item 1. Business - Lending Activities" and Note 5 to the Consolidated Financial Statements contained in "Item 8, Financial Statements and Supplementary Data." Premises and Equipment, Net: Premises and equipment decreased by $668,000, or 2.9%, to $22.37 million at September 30, 2021 from $23.04 million at September 30, 2020. The decrease was primarily due to normal depreciation. For additional information on premises and equipment, see "Item 2. Properties" and Note 6 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." OREO and Other Repossessed Assets: OREO and other repossessed assets decreased by $893,000, or 85.0%, to $157,000 at September 30, 2021 from $1.05 million at September 30, 2020. The decrease was primarily due to the sales of $893,000 in OREO properties. At September 30, 2021, total OREO and other repossessed assets consisted of three land parcels totaling $157,000. For additional information on OREO and other repossessed assets, see "Item 1. Business - Lending Activities - Other Real Estate Owned and Other Repossessed Assets" and Note 7 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." Bank Owned Life Insurance ("BOLI"): BOLI increased by $597,000, or 2.8%, to $22.19 million at September 30, 2021 from $21.60 million at September 30, 2020. The increase was due to net BOLI earnings, representing the increase in cash surrender value of the BOLI policies. Goodwill: The recorded amount of goodwill remained unchanged at $15.13 million at both September 30, 2021 and September 30, 2020. The Company performed its annual review of goodwill during the quarter ended June 30, 2021 and determined that there was no impairment. As of September 30, 2021, management believes that there had been no subsequent events or changes in circumstances that would indicate a potential impairment of goodwill. For additional information on goodwill, see Note 8 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." CDI: CDI decreased by $361,000, or 22.2% to $1.26 million at September 30, 2021 from $1.63 million at September 30, 2020 due to scheduled amortization. For additional information on CDI, see Note 8 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." Loan Servicing Rights, Net: Loan servicing rights increased by $387,000, or 12.5%, to $3.48 million at September 30, 2021 from $3.10 million at September 30, 2020, primarily due to additional capitalized Freddie Mac servicing rights for loans being sold with servicing retained, and a $110,000 valuation recovery, which was partially offset by amortization. The principal amount of loans serviced for Freddie Mac and the SBA decreased by $144,000 to $426.44 million at September 30, 2021 from $426.58 million at September 30, 2020. For additional information on loan servicing rights, see Note 9 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." Operating Lease Right-of-Use Assets: Operating lease ROU assets decreased by $304,000, or 11.8%, to $2.28 million at September 30, 2021 from $2.59 million at September 30, 2020, primarily due to the amortization of the ROU assets. The operating lease ROU assets at September 30, 2021 represented the present value of three operating leases on branch facilities. For additional information on leases, see Note 10 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." Other Assets: Other assets decreased by $425,000, or 12.9%, to $2.87 million at September 30, 2021 from $3.30 million at September 30, 2020. The decrease was primarily due to decreases in miscellaneous receivables (including income tax receivables) and prepaid expenses. Deposits: Deposits increased by $212.15 million, or 15.6%, to $1.57 billion at September 30, 2021 from $1.36 billion at September 30, 2020. The increase consisted of a $93.32 million increase in non-interest bearing demand account balances, a $53.20 million increase in NOW checking account balances, a $49.20 million increase in money market account balances, and a $40.82 increase in savings account balances. These increases were partially offset by a $24.40 million decrease in certificates of deposit account balances. The increase in deposits was primarily driven by proceeds from SBA PPP loans and government stimulus checks deposited directly into customer accounts, organic growth in customer relationships and reduced withdrawals from deposit accounts due to a change in spending habits as a result of COVID-19. For additional information on deposits, see "Item 1. Business - Deposit Activities and Other Sources of Funds" and Note 11 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." FHLB Borrowings: The Company has short- and long-term borrowing lines with the FHLB with total credit available on the lines equal to 45% of the Bank's total assets, limited by available collateral. FHLB borrowings decreased to $5.00 million at September 30, 2021 from $10.00 million at September 30, 2020. At September 30, 2021, FHLB borrowings 65 consisted of a single $5.00 million borrowing, with a scheduled maturity in March 2025. For additional information on FHLB borrowings, see Note 12 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data". Operating Lease Liabilities: Operating lease liabilities decreased by $271,000, or 10.3%, to $2.36 million at September 30, 2021 from $2.63 million at September 30, 2020, primarily due to required annual lease payments. The operating lease liability at September 30, 2021 represented the present value of three operating leases on branch facilities. For additional information on leases, see Note 10 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." Other Liabilities and Accrued Expenses: Other liabilities and accrued expenses increased by $55,000, or 0.8%, to $7.37 million at September 30, 2021 from $7.31 million at September 30, 2020. The increase was primarily due to timing differences in the normal course of business. Shareholders' Equity: Total shareholders' equity increased by $19.27 million, or 10.3%, to $206.90 million at September 30, 2021 from $187.63 million at September 30, 2020. The increase was primarily due to net income of $27.58 million for the year ended September 30, 2021, which was partially offset by the payment of $8.59 million in dividends to common shareholders and the repurchase of 19,588 shares of the Company's common stock for $527,000 during the year ended September 30, 2021. For additional information on shareholders' equity, see the Consolidated Statements of Shareholders' Equity contained in "Item 8. Financial Statements and Supplementary Data." Comparison of Operating Results for the Years Ended September 30, 2021 and 2020 Net income for the year ended September 30, 2021 increased by $3.31 million, or 13.7%, to $27.58 million from $24.27 million for the year ended September 30, 2020. Net income per diluted common share increased by $0.39, or 13.5%, to $3.27 for the year ended September 30, 2021 from $2.88 for the year ended September 30, 2020. The increase in net income was primarily due to a $3.70 million decrease in the provision for loan losses and a $976,000 increase in net-interest income. These increases in net interest income were partially offset by a $528,000 increase in non-interest expense and an $807,000 increase in the provision for income taxes. A more detailed explanation of the income statement categories is presented below. Net Interest Income: Net interest income increased by $976,000, or 1.9%, to $51.86 million for the year ended September 30, 2021 from $50.88 million for the year ended September 30, 2020. The increase in net interest income was primarily due to an increase in the average balance of interest-earning assets and a decrease in the average cost of deposits, which was partially offset by a decrease in the average yield on interest-earning assets. Total interest and dividend income decreased by $621,000, or 1.1%,to$54.96 million for the year ended September 30, 2021 from $55.58 million for the year ended September 30, 2020, primarily due to a decrease in the average yield on interest-earning assets, which was partially offset by an increase in the average balance of interest-earning assets. The average yield on interest-earnings assets decreased to 3.45% for the year ended September 30, 2021 from 4.26% for the year ended September 30, 2020, as market rates decreased following the 150 basis point decrease in the targeted federal funds rate in March 2020 in response to the COVID-19 pandemic, to a range of 0.00% to 0.25% at September 30, 2021 putting downward pressure on adjustable rate instruments combined with the impact of the low loan yields on the SBA PPP loan portfolio and lower loan yields on new loan originations. The substantial increase in the average balance of interest-bearing deposits in banks and CDs balances as a result of the increase in deposit balances, is also negatively impacting the average yield on interest-earning assets.. Partially offsetting the decrease in the average yield on interest-earning assets was an increase in the average balance of interest-earning assets. Average total interest-earning assets increased by $291.83 million, or 22.4%, to $1.60 billion for the year ended September 30, 2021 from $1.30 billion for the year ended September 30, 2020. Interest income on loans receivable and loans held for sale increased by $1.19 million, or 2.3%, to $52.54 million for the year ended September 30, 2021 from $51.34 million for the year ended September 30, 2020, primarily due to a $56.34 million increase in the average balance of loans receivable during the current year. This increase was partially offset by a decrease in the average yield on loans receivable to 5.12% for the year ended September 30, 2021 from 5.29% for the year ended September 30, 2020. During the year ended September 30, 2021, the accretion of the purchase accounting fair value discount on loans acquired in the South Sound Acquisition increased interest income on loans by $340,000 compared to $597,000 for the year ended September 30, 2020. The accretion of the net fair value discount on acquired loans increased the average yield on loans by three basis points for the year ended September 30, 2021 and six basis points for the year ended September 30, 2020. The incremental accretion and the impact on loan yield will change during any period based on the volume of prepayments, but it is 66 expected to decrease over time as the balance of the net discount declines. The remaining net discount on these acquired loans was $449,000 at September 30, 2021. During the year ended September 30, 2021, a total of $942,000 in non-accrual interest, pre-payment penalties and late fees was collected compared to $911,000 for the year ended September 30, 2020. Also impacting the average yield and average interest-earning asset balances during the years ended September 30, 2021 and 2020 were SBA PPP loans originated. These PPP loans have a prescribed interest rate of 1.00% and are also subject to loan origination fees which are accreted into interest income over the life of each loan. For the year ended September 30, 2021, average PPP loans were $107.00 million and the Company recorded $1.06 million in interest income and accreted $5.07 million in PPP loan origination fees into income compared to average PPP loans of $55.40 million, $556,000 in interest income and $1.04 million in PPP loan origination fees for the year ended September 30, 2020. The Company anticipates that interest income related to PPP loans will decrease significantly during the year ending September 30, 2022 as the remaining PPP loan balances and deferred loan originations fees have been reduced. At September 30, 2021, the Company had $1.83 million in PPP deferred loan origination fees, which will be accreted into interest income over the remaining life of the PPP loans. Interest income on investment securities decreased by $384,000, or 24.3%, to $1.20 million for the year ended September 30, 2021 from $1.58 million for the year ended September 30, 2020 primarily due to a decrease in the average yield on investment securities, which was partially offset by an increase in the average balance of investment securities. Interest income on interest-bearing deposits in banks and CDs decreased by $1.42 million, or 56.0%, to $1.12 million for the year ended September 30, 2021 from $2.54 million for the year ended September 30, 2020, primarily due to an decrease in the average yield to 0.24% from 1.00% as market rates decreased. The decrease in the average yield was partially offset by an increase in the average balance of interest-bearing deposits in banks and CDs. Total interest expense decreased by $1.60 million, or 34.0%, to $3.10 million for the year ended September 30, 2021 from $4.70 million for the year ended September 30, 2020. The decrease in interest expense was primarily due to a decrease in the average cost of interest-bearing liabilities, primarily deposits, which was partially offset by an increase in the average balance of interest-bearing liabilities. The average cost of interest-bearing liabilities decreased to 0.32% for the year ended September 30, 2021 from 0.56% for the year ended September 30, 2020 as market interest rates for deposits decreased. Average interest-bearing deposits increased by $146.61 million, or 17.7%, to $976.52 million for the year ended September 30, 2021 from $829.91 million for the year ended September 30, 2020. The average balance of interest-bearing deposits increased, however, interest expense on deposits decreased by $1.62 million as a result of the decrease in the average cost of interest-bearing deposits primarily as a result of the Company decreasing the interest rates paid on deposit products because of the decreasing rate environment. The increase in the average balance of interest-bearing deposits is due primarily to proceeds from SBA PPP loans deposited directly into customer accounts, government stimulus checks and an increase in savings trends and reduced withdrawals from deposit accounts due to a change in spending habits as a result of COVID-19. The net interest margin decreased 65 basis points to 3.25% for the year ended September 30, 2021 from 3.90% for the year ended September 30, 2020. Provision for Loan Losses: There was no provision for loans losses for the year ended September 30, 2021 compared to a provision for loan losses of $3.70 million for the year ended September 30, 2020, due primarily to improvement in forecasted probable credit losses from the COVID-19 pandemic on the economy as of September 30, 2021. The provision for loan losses for the prior fiscal year was primarily due to the deteriorating economic conditions and probable loan losses driven by the impact of the COVID-19 pandemic on the U.S. and global economies. The Company had net recoveries of $55,000 for the year ended September 30, 2021 and net recoveries of $24,000 for the year ended September 30, 2020. The net charge-offs (recoveries) to average outstanding loans ratio was (0.01)% for the year ended September 30, 2021 and 0.00% for the year ended September 30, 2020. The level of delinquent loans (loans 30 or more days past due) decreased by $709,000, or 18.9%, to $3.04 million at September 30, 2021 from $3.75 million at September 30, 2020 and the level of loans graded substandard decreased by $45,000, or 1.2%, to $3.60 million at September 30, 2021 from $3.65 million at September 30, 2020. Special mention loans decreased by $852,000 or 14.5%, to $5.01 million at September 30, 2021 from $5.86 million at September 30, 2020. Non-accrual loans decreased by $51,000, or 1.8%, to $2.85 million at September 30, 2021 from $2.91 million at September 30, 2020. The Company has worked with loan customers impacted by the COVID-19 pandemic on loan deferral and forbearance plans. In response to requests from borrowers, the Company made payment deferral modifications (typically 90-day payment deferrals with interest continuing to accrue or scheduled to be paid monthly) on a number of loans since the COVID-19 pandemic began. Most of these borrowers have resumed making payments, and only one loan totaling $233,000 was on deferred status as of September 30, 2021 compared to five loans totaling $5.87 million of deferral status as of September 30, 2020. These modifications were not classified as TDRs in accordance with guidance of the CARES Act and related regulatory guidance. 67 The $40.92 million balance of SBA PPP loans was omitted from the Company's normal allowance for loan losses calculation at September 30, 2021, as these loans are fully guaranteed by the SBA and management expects that most PPP borrowers will seek full or partial forgiveness of their loan obligations from the SBA within a short time frame, which will in turn reimburse the Bank for the amount forgiven. The Company has established a comprehensive methodology for determining the allowance for loan losses. On a quarterly basis, the Company performs an analysis that considers pertinent factors underlying the quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, historic loss experience for various loan segments, changes in economic conditions, delinquency rates, a detailed analysis of impaired loans, and other factors to determine an appropriate level of allowance for loan losses. Impaired loans are subject to an impairment analysis to determine an appropriate reserve amount to be allocated to each loan. The aggregate principal impairment amount determined at September 30, 2021 was $247,000 compared to $41,000 at September 30, 2020. In accordance with GAAP, loans acquired in the South Sound Acquisition were recorded at their estimated fair value, which resulted in a net discount to the loans' contractual amounts, of which a portion reflects a discount for possible credit losses. Credit discounts are included in the determination of fair value and, as a result, no allowance for loan losses is recorded for acquired loans at the acquisition date. The discount recorded on the acquired loans is not reflected in the allowance for loan losses or related allowance coverage ratios. The remaining fair value discount on loans acquired in the South Sound Acquisition was $449,000 at September 30, 2021. The Company believes this should be considered by investors when comparing the Company's allowance for loan losses to total loans in periods prior to the South Sound Acquisition. Based on the comprehensive methodology, management believes that the allowance for loan losses of $13.47 million at September 30, 2021 (1.37% of loans receivable and 471.9% of non-performing loans) was adequate to provide for probable losses based on an evaluation of known and inherent risks in the loan portfolio at that date. While the Company believes that it has established its existing allowance for loan losses in accordance with GAAP, there can be no assurance that bank regulators, in reviewing the Company's loan portfolio, will not request the Company to increase significantly its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate. Any material increase in the allowance for loan losses would adversely affect the Company's financial condition and results of operations. For additional information, see "Item 1. Business - Lending Activities -- Allowance for Loan Losses." Non-interest Income: Total non-interest income decreased by $27,000, or 0.2%, to $17.16 million for the year ended September 30, 2021 from $17.19 million for the year ended September 30, 2020. The decrease was primarily due to a $483,000 decrease in recoveries of previously charged off receivables acquired in the South Sound Acquisition (which are recorded in the "Other, net" non- interest income category), a $236,000 decrease in service charges on deposits, a $186,000 decrease in servicing income on loans sold and smaller decreases in several other categories. These decreases were partially offset by a $706,000 increase in ATM and debit card interchange transaction fees, a $110,000 valuation recovery on loan servicing rights (compared to a $221,000 valuation allowance in the prior year), and smaller increases in several other categories. The decrease in service charges on deposits was primarily due to a decrease in overdraft fee income. The decrease in servicing income on loans sold was primarily due to increased amortization of loan servicing rights. The increase in ATM and debit card interchange transaction fees was primarily due to an increase in the dollar volume of debit card transactions. The valuation recovery on loan servicing rights was primarily due to a decrease in the projected mortgage prepayment speeds. The Company's gain on sales of loans decreased by $75,000, or 1.3%, to $5.90 million for the year ended September 30, 2021 from $5.98 million for the year ended September 30, 2020, and increased by $4.15 million, or 236.6%, from $1.75 million for the year ended September 30, 2019. The Company's gain on sales of loans over the past two fiscal years have been higher than historical averages primarily due to an increase in the dollar amount of fixed rate one- to four-family loans originated and sold and an increase in the average pricing margin. The increased mortgage banking volumes over the past two fiscal years have been largely driven by increased refinance activity for single family homes due to lower mortgage interest rates. The Company anticipates that refinance activity for single family homes will decrease and pricing spreads will compress during the year ending September 30, 2022, which will correspondingly result in a decrease in gain on sales of loans compared to the years ended September 30, 2021 and 2020. Non-interest Expense: Total non-interest expense increased by $528,000, or 1.6%, to $34.59 million for the year ended September 30, 2021 from $34.06 million for the year ended September 30, 2020. The increase was primarily due to a $399,000 increase in salaries and employee benefits expense, a $225,000 increase in data processing and telecommunications expense, a $211,000 increase in FDIC insurance expense, a $203,000 increase in ATM and debit card interchange transaction fees, and smaller increases in several other expense categories. These increases were partially offset by a $363,000 decrease in OREO and other repossessed assets expense. The increase in salaries and employee benefits expense was primarily due to 68 annual salary adjustments. The increase in data processing and telecommunications expense was primarily due to the addition of several technology products and increased processing volumes. The increases in FDIC insurance expense was primarily due to an increase in total assets and the absence of an assessment credit which reduced the expense in the year ended September 30, 2020. The increase in ATM and debit card interchange fees was primarily due to increased debit card transaction volumes. The improvement in OREO and other repossessed assets expense was primarily due to gains on the sale of OREO and a reduction in remaining OREO properties. The efficiency ratio for the year ended September 30, 2021 was 50.12% compared to 50.04% for the year ended September 30, 2020. The Company anticipates increases in non-interest expense during the year ending September 30, 2022, primarily due to inflationary pressures and the hiring of additional lending personnel. Provision for Income Taxes: The provision for income taxes increased by $807,000, or 13.4% to $6.85 million for the year ended September 30, 2021 from $6.04 million for the year ended September 30, 2020. The increase in the provision for income taxes was primarily due to higher income before income taxes. The Company's effective income tax rate was 19.9% for both the years ended September 30, 2021 and 2020. For additional information on income taxes, see Note 14 of the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." Average Balances, Interest and Average Yields/Cost The earnings of the Company depend largely on the spread between the yield on interest-earning assets and the cost of interest-bearing liabilities, as well as the relative amount of the Company's interest-earning assets and interest- bearing liability portfolios. 69 The following table sets forth, for the periods indicated, information regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities and average yields and costs. Such yields and costs for the periods indicated are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the periods presented. Year Ended September 30, 2021 2020 2019 Average Balance Interest and Dividends Yield/ Cost Average Balance Interest and Dividends Yield/ Cost Average Balance Interest and Dividends Yield/ Cost (Dollars in thousands) Interest-earning assets: Loans receivable (1)(2) $ 1,026,742 $ 52,539 5.12 % $ 970,400 $ 51,341 5.29 % $ 878,984 $ 49,127 5.59 % Investment securities (2) 103,328 1,195 1.16 72,652 1,579 2.17 38,070 1,264 3.32 Dividends from mutual funds, FHLB stock and other investments 5,989 111 1.85 5,760 128 2.22 5,324 162 3.04 Interest-bearing deposits in banks and CDs 459,145 1,117 0.24 254,558 2,535 1.00 214,481 5,172 2.41 Total interest-earning assets 1,595,204 54,962 3.45 1,303,370 55,583 4.26 1,136,859 55,725 4.90 Non-interest-earning assets 85,939 85,842 86,494 Total assets $ 1,681,143 $ 1,389,212 $ 1,223,353 Interest-bearing liabilities: Savings accounts $ 242,598 201 0.08 $ 191,618 188 0.10 $ 162,266 106 0.07 Money market accounts 186,489 560 0.30 148,506 735 0.49 154,375 1,119 0.72 NOW checking accounts 402,430 605 0.15 323,261 882 0.27 291,348 840 0.29 Certificates of deposit accounts 145,006 1,647 1.14 166,524 2,830 1.70 159,397 2,500 1.57 Long-term borrowings (3) 7,686 91 1.18 5,685 66 1.16 — — — Total interest-bearing liabilities 984,209 3,104 0.32 835,594 4,701 0.56 767,386 4,565 0.59 Non-interest-bearing deposits 488,833 364,971 290,653 Other liabilities 10,816 10,110 4,229 Total liabilities 1,483,858 1,210,675 1,062,268 Shareholders' equity 197,285 178,540 161,085 Total liabilities and shareholders' equity $ 1,681,143 $ 1,389,215 $ 1,223,353 Net interest income $ 51,858 $ 50,882 $ 51,160 Interest rate spread 3.13 % 3.70 % 4.31 % Net interest margin (4) 3.25 % 3.90 % 4.50 % Ratio of average interest-earning assets to average interest-bearing liabilities 162.08 % 155.98 % 148.15 % _______________________________________________ (1) Does not include interest on loans on non-accrual status. Includes loans held for sale and interest earned on loans held for sale. Amortized net deferred loan fees, late fees, extension fees and prepayment penalties (year ended September 30, 2021 - $6,859; year ended September 30, 2020 - $3,196 and year ended September 30, 2019 - $1,743) are included with interest and dividends. Accretion of the fair value discount on loans acquired in the South Sound Acquisition for the years ended September 30, 2021, 2020 and 2019 of $340, $597 and $645, respectively, is included with interest and dividends. (2) Average balances include loans and investment securities on non-accrual status. (3) Includes FHLB borrowings with original maturities of one year or greater. (4) Net interest income divided by total average interest-earning assets. 70 Rate/Volume Analysis The following table sets forth the effects of changing rates and volumes on net interest income on the Company. Information is provided with respect to the (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate), (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change (sum of the prior columns). Changes in both rate and volume have been allocated to rate and volume variances based on the absolute values of each. Year Ended September 30, 2021 Compared to Year Ended September 30, 2020 Increase (Decrease) Due to Year Ended September 30, 2020 Compared to Year Ended September 30, 2019 Increase (Decrease) Due to Rate Volume Net Change Rate Volume Net Change (Dollars in thousands) Interest-earning assets: Loans receivable (1) $ (1,721) $ 2,919 $ 1,198 $ (2,714) $ 4,928 $ 2,214 Investment securities (903) 519 (384) (546) 861 315 Dividends from mutual funds, FHLB stock and other investments (22) 5 (17) (46) 12 (34) Interest-bearing deposits in banks and CDs (2,661) 1,243 (1,418) (3,468) 831 (2,637) Total net change in income on interest-earning assets (5,307) 4,686 (621) (6,774) 6,632 (142) Interest-bearing liabilities: Savings accounts (32) 45 13 60 22 82 Money market accounts (333) 158 (175) (342) (42) (384) NOW checking accounts (459) 182 (277) (47) 89 42 Certificates of deposit accounts (852) (331) (1,183) 215 115 330 FHLB borrowings 1 24 25 33 33 66 Total net change in expense on interest-bearing liabilities (1,675) 78 (1,597) (81) 217 136 Net change in net interest income $ (3,632) $ 4,608 $ 976 $ (6,693) $ 6,415 $ (278) ______________ (1) Excludes interest on loans on non-accrual status. Includes loans held for sale and interest earned on loans held for sale. Liquidity and Capital Resources The Company's primary sources of funds are customer deposits, proceeds from principal and interest payments on loans, the sale of loans, maturing investment securities, maturing CDs held for investment and FHLB borrowings (if needed). While the maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The Bank must maintain an adequate level of liquidity to help ensure the availability of sufficient funds to fund its operations. The Bank generally maintains sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2021, the Bank's regulatory liquidity ratio (net cash, and short-term and marketable assets, as a percentage of net deposits and short-term liabilities) was 43.3%. At September 30, 2021, the Bank maintained an uncommitted credit facility with the FHLB that provided for immediately available borrowings up to an aggregate amount equal to 45% of total assets, limited by available collateral, under which $5.00 million was outstanding. The Bank had $391.21 million available for additional borrowings with the FHLB at September 30, 2021. The Bank maintains a short-term borrowing line with the FRB with total credit based on eligible collateral. At September 30, 2021, the Bank had no outstanding balance on this borrowing line, under which $73.81 million was available for future borrowings. The Bank also maintains a $50.00 million overnight borrowing line with PCBB. At September 30, 2021, the Bank did not have an outstanding balance on this borrowing line. Subject to market conditions, the Bank expects to utilize these borrowing facilities from time to time in the future to fund loan 71 originations and deposits withdrawals, to satisfy other financial commitments, repay maturing debt and to take advantage of investment opportunities to the extent feasible. Liquidity management is both a short and long-term responsibility of the Bank's management. The Bank adjusts its investments in liquid assets based upon management's assessment of (i) expected loan demand, (ii) projected loan sales, (iii) expected deposit flows, and (iv) yields available on interest-bearing deposits. Excess liquidity is invested generally in interest-bearing overnight deposits, CDs held for investment and short-term government and agency obligations. If the Bank requires funds beyond its ability to generate them internally, it has additional borrowing capacity with the FHLB, the FRB and PCBB. The Bank's primary investing activity is the origination of loans and, to a lesser extent, the purchase of investment securities. During the years ended September 30, 2021, 2020 and 2019, the Bank originated $602.34 million, $597.19 million and $356.04 million of loans, respectively. At September 30, 2021, the Bank had loan commitments totaling $163.29 million and undisbursed construction loans in process totaling $95.22 million. Investment securities purchased during the years ended September 30, 2021, 2020 and 2019 totaled $71.75 million, $51.47 million and $34.08 million, respectively. The Bank’s liquidity is also affected by the volume of loans sold and loan principal payments. During the years ended September 30, 2021, 2020 and 2019, the Bank sold $150.20 million, $167.24 million and $73.03 million, respectively, in loans and loan participation interests. During the years ended September 30, 2021, 2020 and 2019, the Bank received $500.03 million, $287.04 million and $241.66 million, respectively, in principal repayments. The Bank’s liquidity has been positively impacted by increases in deposit levels. During the years ended September 30, 2021, 2020 and 2019, deposits increased by $212.15 million, $290.18 million and $178.72 million, respectively. As a result, our liquid assets in the form of cash and cash equivalents, CDs held for investment and investment securities increased to $740.96 million at September 30, 2021 from $465.79 million at September 30, 2020. CDs that are scheduled to mature in less than one year from September 30, 2021 totaled $81.42 million. Historically, the Bank has been able to retain a significant amount of its deposits as they mature. Capital expenditures are incurred on an ongoing basis to expand and improve the Bank's product offerings, enhance and modernize technology infrastructure, and to introduce new technology-based products to compete effectively in the various markets. Capital expenditure projects are evaluated on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and the expected return on investment. The amount of capital investment is influenced by, among other things, current and projected demand for services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations. Based on current objectives, there are no projects scheduled for capital investments in premises and equipment during the fiscal year ending September 30, 2022 that would materially impact liquidity. The Company currently expects to continue the current practice of paying quarterly cash dividends on common stock subject to the Board of Directors' discretion to modify or terminate this practice at any time and for any reason without prior notice. The current quarterly common stock dividend rate is $0.21 per share, as approved by the Board of Directors, which is a dividend rate per share that enables the Company to balance multiple objectives of managing and investing in the Bank, and returning a substantial portion of cash to shareholders. Assuming continued payment during 2022 at this rate of $0.21 per share, the average total dividend paid each quarter would be approximately $1.76 million based on the number of current outstanding shares (which assumes no increases or decreases in the number of shares). For the fiscal year ending September 30, 2022, the Bank projects that fixed commitments will include $342,000 of operating lease payments. There are no scheduled payments and maturities of FHLB borrowings during fiscal year 2022. In addition, at September 30, 2021, there were other future obligations and accrued expenses of $7.37 million. For additional information, see Note 13 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." The Bank's management believes that the liquid assets combined with the available lines of credit provide adequate liquidity to meet current financial obligations for at least the next 12 months. Timberland Bancorp is a separate legal entity from the Bank and must provide for its own liquidity and pay its own operating expenses. Sources of capital and liquidity for Timberland Bancorp include distributions from the Bank and the issuance of debt or equity securities. At September 30, 2021, Timberland Bancorp (on an unconsolidated basis) had liquid assets of $2.93 million. Bank holding companies and federally-insured state-chartered banks are required to maintain minimum levels of regulatory capital. At September 30, 2021, Timberland Bancorp and the Bank were in compliance with all applicable capital 72 requirements. For additional details, see Note 18 to the Consolidated Financial Statements contained in “Item 8. Financial Statements and Supplementary Data” and “Item 1. Business - Regulation of the Bank - Capital Requirements.” New Accounting Pronouncements For a discussion of new accounting pronouncements and their impact on the Company, see Note 1 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data". Item 7A. Quantitative and Qualitative Disclosures About Market Risk The information contained under “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Market Risk and Asset and Liability Management” of this Form 10-K is incorporated herein by reference.