1ST CONSTITUTION BANCORP When used in this Quarterly Report on Form 10-Q for the three-month period endedMarch 31, 2020 (this "Form 10-Q"), the words "the Company," "we," "our," and "us" refer to1ST Constitution Bancorp and, as the context requires, its wholly-owned subsidiary,1ST Constitution Bank (the "Bank"), and the Bank's wholly-owned subsidiaries, 1STConstitution Investment Company of New Jersey, Inc. ,FCB Assets Holdings, Inc. , 204South Newman Street Corp. and249 New York Avenue , LLC. 1ST Constitution Capital Trust II ("Trust II"), a subsidiary of the Company, is not included in the Company's consolidated financial statements as it is a variable interest entity and the Company is not the primary beneficiary. Trust II, a subsidiary of the Company, was created inMay 2006 to issue trust preferred securities to assist the Company in raising additional capital. This discussion and analysis of the operating results for the three months endedMarch 31, 2020 and financial condition atMarch 31, 2020 is intended to help readers analyze the accompanying financial statements, notes and other supplemental information contained in this Form 10-Q. Results of operations for the three-month period endedMarch 31, 2020 are not necessarily indicative of results to be attained for any other periods. This discussion and analysis should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this Form 10-Q and Part II, Item 7 of the Company's Form 10-K (Management's Discussion and Analysis of Financial Condition and Results of Operation) for the year endedDecember 31, 2019 , as filed with theSecurities and Exchange Commission (the "SEC") onMarch 16, 2020 . Forward-Looking Statements This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act").The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. When used in this and in future filings by the Company with theSEC , and in the Company's written and oral statements made with the approval of an authorized executive officer of the Company, the words or phrases "will," "will likely result," "could," "anticipates," "believes," "continues," "expects," "plans," "will continue," "is anticipated," "estimated," "project" or "outlook" or similar expressions (including confirmations by an authorized executive officer of the Company of any such expressions made by a third party with respect to the Company) are intended to identify forward-looking statements. The Company cautions readers not to place undue reliance on any such forward-looking statements, each of which speaks only as of the date made. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. These forward-looking statements are based upon our opinions and estimates as of the date they are made and are not guarantees of future performance. Although we believe that the expectations reflected in these forward-looking statements are reasonable, such forward-looking statements are subject to known and unknown risks and uncertainties that may be beyond our control, which could cause actual results, performance and achievements to differ materially from results, performance and achievements projected, expected, expressed or implied by the forward-looking statements. Examples of factors or events that could cause actual results to differ materially from historical results or those anticipated, expressed or implied include, without limitation, changes in the overall economy and interest rate changes; inflation, market and monetary fluctuations; the ability of our customers to repay their obligations; the accuracy of our financial statement estimates and assumptions, including the adequacy of the estimate made in connection with determining the adequacy of the allowance for loan losses; increased competition and its effect on the availability and pricing of deposits and loans; significant changes in accounting, tax or regulatory practices and requirements; changes in deposit flows, loan demand or real estate values; the enactment of legislation or regulatory changes; changes in monetary and fiscal policies of theU.S. government; changes to the method that LIBOR rates are determined and to the potential phasing out of LIBOR after 2021; changes in loan delinquency rates or in our levels of non-performing assets; our ability to declare and pay dividends; changes in the economic climate in the market areas in which we operate; the frequency and magnitude of foreclosure of our loans; changes in consumer spending and saving habits; the effects of the health and soundness of other financial institutions, including the need of theFDIC to increase theDeposit Insurance Fund assessments; technological changes; the effects of climate change and harsh weather conditions, including hurricanes and man-made disasters; the economic impact of any future terrorist threats and attacks, acts of war or threats thereof and the response ofthe United States to any such threats and attacks; our ability to integrate acquisitions and achieve cost savings; other risks described from time to time in our filings with theSEC ; and our ability to manage the risks involved in the foregoing. 35 -------------------------------------------------------------------------------- In addition, statements about the potential effects and impacts of the COVID-19 pandemic on the Company's business, financial condition, liquidity and results of operations may constitute forward-looking statements and are subject to the risk that actual results may differ, possibly materially, from what is reflected in such forward-looking statements due to factors and future developments that are uncertain, unpredictable and, in many cases, beyond our control, including the scope, duration and extent of the pandemic, actions taken by governmental authorities in response to the pandemic and the direct and indirect impact of the pandemic on our employees, customers, business and third-parties with which we conduct business. Further, the foregoing factors may be exacerbated by the ultimate impact of the COVID-19 pandemic, which is unknown at this time. For a discussion of certain COVID-19-related risks, see Part II, Item 1A - Risk Factors of this Form 10-Q. Although management has taken certain steps to mitigate any negative effect of the aforementioned factors, significant unfavorable changes could severely impact the assumptions used and have an adverse effect on profitability. Any forward-looking statements made by us or on our behalf speak only as of the date they are made, and we do not undertake any obligation to update any forward-looking statement to reflect the impact of subsequent events or circumstances, except as required by law.
General
The Company is a bank holding company registered under theBank Holding Company Act of 1956, as amended. The Company was organized under the laws of theState of New Jersey inFebruary 1999 for the purpose of acquiring all of the issued and outstanding stock of the Bank, a full-service commercial bank that began operations inAugust 1989 , thereby enabling the Bank to operate within a bank holding company structure. The Company became an active bank holding company onJuly 1, 1999 . Other than its ownership interest in the Bank, the Company currently conducts no other significant business activities. The Bank operates 26 branches and manages its investment portfolio through its subsidiary, 1STConstitution Investment Company of New Jersey, Inc. FCB Assets Holdings, Inc. , a subsidiary of the Bank, is used by the Bank to manage and dispose of repossessed real estate.
On
COVID-19 Impact and Response
The sudden emergence of the COVID-19 global pandemic has created widespread
uncertainty, social and economic disruption and highly volatile financial
markets. Mandated business and school closures, restrictions on travel and
social distancing have resulted in almost all businesses and employees being
adversely impacted and a dramatic increase in unemployment levels in a short
period of time.
In the first quarter of 2020, the Company did not experience a significant
increase in loan delinquencies or down- grades in credit ratings of loans
directly related to the pandemic. However, the economic disruption will more
severely impact businesses, borrowers and consumers in the second quarter of
2020, which may continue with increasing severity in future periods. Management
increased the provision for loan losses in response to the deterioration in the
economic operating conditions and higher incurred losses in the loan portfolio.
Management may further increase the provision and allowance for loan losses in
response to changes in economic conditions and the performance of the loan
portfolio in future periods.
The future effect of the COVID-19 pandemic on the Company's operations and
financial performance will depend on future developments related to the
duration, extent and severity of the pandemic and the length of time that
mandated business and school closures, restrictions on travel and social
distancing remain in place. The Company's operations rely on third-party vendors
to process, record and monitor transactions. If any of these vendors are unable
to provide these services, our ability to serve customers could be disrupted.
The pandemic could negatively impact customers' ability to conduct banking and
other financial transactions. The Company's operations could be adversely
impacted if key personnel or a significant number of employees were unable to
work due to illness or restrictions.
In the event that the COVID-19 pandemic continues to disrupt business for a
prolonged period of time, the fair value of assets could be negatively impacted,
which could result in a combination of valuation impairments on our intangible
assets, investments, loans, deferred tax assets and OREO. As a result of the
recent emergence of the pandemic and the uncertainty, it is not possible to
determine the overall future impact of the pandemic on the Company's business
and the results of operations. However, if the pandemic continues for an
extended period of time, there could be a material adverse effect on the
Company's business, results of operations, financial condition and cash flows.
36
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On March 27, 2020 , the Coronavirus Aid, Relief and Economic Security Act ("CARES
Act") was signed into law. Among other things, the CARES ACT provides relief to
borrowers, including the option to defer loan payments while not affecting their
credit and access to additional credit through the Small Business Administration
("SBA") Pay Check Protection Program ("PPP").
In response to the COVID-19 pandemic, the Company has taken the following
actions:
To protect our employees and customers we have:
• Adjusted branch hours and temporarily closed our branch lobbies, except on
an appointment only basis.
• Continued to service our customers through drive-up facilities, ATMs and
our robust technology capabilities that allow customers to execute
transactions and apply for residential mortgage loans through our website
www.momentummortgage.com through their mobile devices and computers.
• Assigned employees to work remotely where practical.
To support our loan and deposit customers and the communities we serve:
• We are working tirelessly to provide access to additional credit and
provided forbearance on loan interest and or principal of up to 90 days
where management has determined that it is warranted. As of March 31 ,
2020,
and or principal by borrowers up to 90 days. As of
million of commercial loans and
home equity loans had been modified and the Bank had committed to modify
home equity loans to provide deferral of interest and or principal by
borrowers up to 90 days.
• As a long-standing
we are actively participating in the SBA's PPP program. As of
2020, we have accepted and funded 162 applications for PPP loans totaling
PPP loans in process.
• As more information becomes available, we intend to evaluate the benefits
of utilizing the Main Street New Loan Facility ("Facility") established by
the
Reserve") under the CARES Act to provide financing to our customers and
communities. This Facility is intended to facilitate lending by banks to
small and medium-sized businesses that were not eligible to participate in
the PPP.
• We are participating in the
are pledging the PPP loans to collateralize a like amount of borrowings
from the Federal Reserve at a favorable interest rate of 0.35% up to a 2
year term.
The spread of COVID-19 and the restrictions implemented to contain its spread
did not significantly impact the Company's financial condition as of March 31,
2020 . However, the future impact of the pandemic is highly uncertain and cannot
be predicted and there is no assurance that it will not have a material adverse
impact on our future results. The extent of the impact will depend on future
developments, including further actions taken to mitigate the spread of
COVID-19, the extent and severity of the outbreak and the duration of the
government mandates and business closures. During the quarter ended March 31,
2020 , we did not experience a significant increase in loan delinquencies or
downgrades in credit ratings of loans directed related to the pandemic, but we
expect the economic disruption will more severely impact the businesses, clients
and communities we serve, and therefore our business, in the second quarter of
2020. For a discussion of certain COVID-19-related risks, see Part II, Item 1A -
Risk Factors of this Form 10-Q.
37
--------------------------------------------------------------------------------RESULTS OF OPERATIONS
Three Months Ended
Summary
The Company reported net income of$3.4 million and diluted earnings per share of$0.33 for the three months endedMarch 31, 2020 compared to net income of$3.4 million and diluted earnings per share of$0.39 for the three months endedMarch 31, 2019 . Return on average total assets and return on average shareholders' equity were 0.89% and 8.01%, respectively, for the three months endedMarch 31, 2020 compared to return on average total assets and return on average shareholders' equity of 1.18% and 10.75%, respectively, for the three months endedMarch 31, 2019 . Book value per share was$16.97 atMarch 31, 2020 compared to$16.74 atDecember 31, 2019 . Management anticipates that the Company's results of operations and net income will be impacted in the foreseeable future due to the economic disruption related to the COVID-19 pandemic. • The provision for loan losses and allowance for loan losses may increase as borrowers continue to be negatively affected by the contraction of economic activity and the dramatic increase in unemployment. • Due to the asset sensitive nature of the Company's balance sheet, theFederal Reserve's reduction in the targeted fed funds rate to zero to
0.25% and the concomitant decline in the prime rate to 3.25% in
will cause a reduction in the average yield of loans tied to the prime
rate and the net interest margin and may cause a reduction in net interest
income in the second quarter of 2020. The net interest margin will also be
impacted by the funding of the PPP loans with a 1.0% interest rate, which
will be partially offset by the recognition of the loan fees earned on
these loans. The timing and impact to the net interest margin will becontingent on how quickly and the extent to which the PPP loans become
grants that are repaid by the SBA over the next two years.
• It is expected that residential real estate sales, and therefore theorigination and sale of residential mortgages will decline as a result of
the restrictions implemented to contain the spread of COVID-19, such as
mandated business closures and social distancing measures. This in turn,
would result in a decrease in non-interest income and lower gains on sales
of loans.
• A significant increase in non-performing loans could result in increased
non-interest expense due to higher expenses for loan collection and
recovery costs.
During the first quarter of 2020, management determined that a triggering event
had occurred with respect to goodwill, which required a review of goodwill for
impairment. Management completed its review of goodwill and concluded that it
was more likely than not that the fair value of goodwill exceeded the carrying
amount of goodwill at March 31, 2020 . Accordingly, goodwill was not impaired at
March 31, 2020 .
COVID-19 could cause a further and sustained decline in the Company's stock
price or the occurrence of what management would deem to be a triggering event
that could, under certain circumstances, cause us to perform a new goodwill
impairment test and could result in an impairment charge being necessary in the
future. In the event that the Company concludes that all or a portion of its
goodwill is impaired, a non-cash charge for the amount of such impairment would
be recorded to earnings. Such a charge would have no impact on tangible capital
or regulatory capital.
FIRST QUARTER 2020 HIGHLIGHTS• Return on average total assets and return on average shareholders' equity
were 0.89% and 8.01%, respectively.
• Book value per share was
• Net interest income was
a tax equivalent basis.
• A provision for loan losses of
were recorded.
• Total loans were
commercial real estate and construction loans totaled
increased
of 2020, mortgage warehouse loans declined $11.9 million to $224.8
million , reflecting the seasonal nature of residential lending in the
Bank's markets.
• Total deposits were
million from
• Non-performing assets increased
total assets, and included $470,000 of OREO at March 31, 2020 .
Earnings Analysis
38
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The Company's results of operations depend primarily on net interest income,
which is primarily affected by the market interest rate environment, the shape
of the U.S. Treasury yield curve and the difference between the yield on
interest-earning assets and the rate paid on interest-bearing liabilities. Other
factors that may affect the Company's operating results are general and local
economic and competitive conditions, government policies and actions of
regulatory authorities.
Net Interest Income
Net interest income, the Company's largest and most significant component of
operating income, is the difference between interest and fees earned on loans
and other earning assets and interest paid on deposits and borrowed funds. This
component represented 84.0% of the Company's net revenues (defined as net
interest income plus non-interest income) for the three months ended March 31,
2020 compared to 85.7% of net revenues for the three months ended March 31,
2019 . Net interest income also depends upon the relative amount of average
interest-earning assets, average interest-bearing liabilities and the interest
rate earned or paid on them, respectively.
39
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The following table sets forth the Company's consolidated average balances of
assets and liabilities and shareholders' equity, as well as interest income and
interest expense on related items, and the Company's average yield or rate for
the three months ended March 31, 2020 and 2019. The average rates are derived by
dividing interest income and interest expense by the average balance of assets
and liabilities, respectively.
Three months ended March 31, 2020 Three months ended March 31, 2019
(Dollars in thousands
except yield/cost Average Average Average Average
information) Balance Interest Yield Balance Interest Yield
Assets
Interest-earning assets:
Federal funds
sold/short-term
investments $ 24,557 $ 89 1.46 % $ 8,004 $ 47 2.38 %
Investment securities:
Taxable 168,376 1,056 2.51 % 160,825 1,270 3.16 %
Tax-exempt (1) 65,194 555 3.40 % 59,837 558 3.73 %
Total investment
securities 233,570 1,611 2.76 % 220,662 1,828 3.31 %
Loans: (2)Commercial real estate 574,640 7,355 5.06 % 390,251 5,011 5.14 % Mortgage warehouse lines 175,275 2,035 4.64 % 123,394 1,824 5.91 % Construction 147,496 2,179 5.94 % 155,864 2,662 6.93 % Commercial business 142,793 1,803 5.08 % 122,878 1,823 6.02 % Residential real estate 90,360 996 4.36 % 47,274 535 4.53 % Loans to individuals 30,497 392 5.08 % 22,748 275 4.84 % Loans held for sale 3,986 35 3.51 % 1,363 17 4.99 % All other loans 1,803 10 2.19 % 1,013 10 3.95 % Total loans 1,166,850 14,805 5.10 % 864,785 12,157 5.70 % Total interest-earning assets 1,424,977$ 16,505 4.66 % 1,093,451$ 14,032 5.20 % Non-interest-earning assets: Allowance for loan losses (9,454 ) (8,535 ) Cash and due from banks 13,383 10,479 Other assets 122,482 74,307 Total non-interest-earning assets 126,411 76,251 Total assets$ 1,551,388 $ 1,169,702 Liabilities and shareholders' equity Interest-bearing liabilities: Money market and NOW accounts$ 401,837 $ 760 0.76 %
265,053 604 0.92 % 189,175 426 0.91 %
Certificates of deposit 359,881 1,874 2.09 % 247,735 1,317 2.16 %
Short-term borrowings 18,915 62 1.32 % 26,199 173 2.68 %
Redeemable subordinated
debentures 18,557 152 3.24 % 18,557 198 4.27 %
Total interest-bearing
liabilities 1,064,243 $ 3,452 1.30 % 816,621 $ 2,688 1.33 %
Non-interest-bearing
liabilities:
Demand deposits 283,520 208,079
Other liabilities 31,793 16,798
Total non-interest-bearing
liabilities 315,313 224,877
Shareholders' equity 171,832 128,204
Total liabilities and
shareholders' equity $ 1,551,388 $ 1,169,702
Net interest spread (3) 3.36 % 3.87 %
Net interest income and
margin (4) $ 13,053 3.68 % $ 11,344 4.21 %
(1) Tax equivalent basis, using federal tax rate of 21% in 2020 and 2019.
(2) Loan origination fees are considered an adjustment to interest income. For
the purpose of calculating loan yields, average loan balances include
non-accrual
loans with no related interest income and the average balance of loans held for
sale.
(3) The net interest spread is the difference between the average yield on
interest-earning assets and the average rate paid on interest-bearing
liabilities.
(4) The net interest margin is equal to net interest income divided by average
interest-earning assets.
40-------------------------------------------------------------------------------- Net interest income was$12.9 million for the quarter endedMarch 31, 2020 and increased$1.7 million compared to net interest income of$11.2 million for the first quarter of 2019. Total interest income was$16.4 million for the three months endedMarch 31, 2020 compared to$13.9 million for the three months endedMarch 31, 2019 . The increase in total interest income was primarily due to a net increase of$302.1 million in average loans, reflecting growth in all segments of the loan portfolio except construction loans. The growth in average loans included approximately$207.2 million of loans from the Shore Merger. Average interest-earning assets were$1.4 billion with a tax-equivalent yield of 4.66%, for the first quarter of 2020, compared to average interest-earning assets of$1.1 billion , with a tax-equivalent yield of 5.20%, for the first quarter of 2019. The yield on average interest-earning assets for the first quarter of 2020 declined 54 basis points to 4.66%, primarily due to the sharp decline in market interest rates beginning in the third quarter of 2019 and continuing through the first quarter of 2020. TheFederal Reserve reduced the targeted federal funds rate 50 basis points in the third quarter and 25 basis points in the fourth quarter of 2019 and, in response to the COVID-19 pandemic, further reduced the targeted federal funds rate by 150 basis points inMarch 2020 . The prime rate was 5.50% in the first quarter of 2019. As a result of the reductions in the targeted federal funds rate in 2019, the prime rate declined to 4.75% inOctober 2019 and declined further to 3.25% inMarch 2020 . AtMarch 31, 2020 , the Bank had approximately$434 million of loans with an interest rate tied to the prime rate and approximately$51 million of loans with an interest rate tied to either 1- or 3-month LIBOR. The decline in market interest rates and the prime rate had a negative effect on the yield of the loan portfolio and investment securities in the first quarter of 2020. Interest expense on average interest-bearing liabilities was$3.5 million , with an interest cost of 1.30%, for the first quarter of 2020, compared to$2.7 million , with an interest cost of 1.33%, for the first quarter of 2019. The$764,000 increase in interest expense on interest-bearing liabilities for the first quarter of 2020 reflected primarily an increase of$247.6 million in average interest bearing liabilities. The average cost of interest-bearing deposits was 1.27% for the first quarter of 2020 compared to 1.22% for the first quarter of 2019 and declined from the peak interest cost for the third quarter of 2019 of 1.41%. The higher interest cost of interest-bearing deposits for the first quarter of 2020 compared to the first quarter of 2019 primarily reflects (i) the rising and higher interest rate environment in 2018, which carried into the first two quarters of 2019, (ii) the lag effect on the interest cost of deposits as market interest rates declined sharply in the first quarter of 2020, (iii) competitive factors for deposits and (iv) the term structure of certificates of deposit ("CDs"). The interest rates paid on deposits generally do not adjust quickly to sharp changes in market interest rates and decline over time in a falling interest rate environment. The lower level of short-term interest rates in the first quarter of 2020 compared to the first quarter of 2019 resulted in a decline in the interest cost of short-term borrowings and the redeemable subordinated debentures. The growth in average interest-bearing liabilities included average interest-bearing deposits of$176.5 million acquired in the Shore Merger. Of the total increase in average interest-bearing liabilities, CDs increased$112.1 million , which generally have a higher interest cost than other types of interest-bearing deposits. AtMarch 31, 2020 , there were$259 million of CDs with an average interest cost of 2.10% that mature within the next 12 months. Management will continue to adjust the interest rates paid on deposits to reflect the then current interest rate environment and competitive factors. The net interest margin on a tax-equivalent basis decreased 53 basis points to 3.68% for the first quarter of 2020 compared to 4.21% for the first quarter of 2019 due primarily to the 54 basis point decline in the yield of average interest-earning assets. Due to the sharp decline in the prime rate in the third and fourth quarters of 2019 followed by the further decline in the prime rate in March of 2020, the yield of loans declined 60 basis points to 5.10% and the interest cost of deposits was not reduced as quickly and to the same extent as the decline in the yield of loans. The 150 basis point decline in the prime rate inMarch 2020 and the significantly lower interest rate environment had only a partial effect on the yield of loans tied to the prime rate, net interest income and the net interest margin in the first quarter of 2020. Management anticipates that the net interest margin will decline in the second quarter of 2020 due to the full quarter's effect of the lower prime rate. The net interest margin will also be impacted by the funding of the PPP loans with a 1.0% interest rate, which will be partially offset by the recognition of the loan fees earned on these loans. The timing and impact to the net interest margin will be contingent on how quickly and to the extent that the PPP loans become grants that are repaid by the SBA over the next two years. The interest cost of interest bearing deposits is not expected to decline as quickly and to the same extent as the decline in the yield of interest earning assets.
Provision for Loan Losses
Management considers a complete review of the following specific factors in determining the provisions for loan losses: historical losses by loan category, the level of non-accrual loans and problem loans as identified through internal review and classification, collateral values and the growth, size and risk elements of the loan portfolio. In addition to these factors, management takes into consideration current economic conditions and local real estate market conditions. Prior toMarch 2020 , when the impacts of the COVID-19 pandemic began to be realized, the general economic environment inNew Jersey and theNew York City metropolitan area had been positive with stable and expanding economic activity, and the Company had generally experienced stable loan credit quality over the past five years. 41
-------------------------------------------------------------------------------- The Company recorded a provision for loan losses of$895,000 for the first quarter of 2020 compared to a provision for loan losses of$300,000 for the first quarter of 2019. The significant increase in the provision for loan losses in the first quarter of 2020 includes an additional provision of approximately$388,000 , which reflected an increase in the qualitative factors for national and local economic conditions due to a weakening economic operating environment primarily resulting from the existing and anticipated impacts of the COVID-19 pandemic. The higher provision also reflects, to a lesser extent, the growth and change in mix of the loan portfolio. AtMarch 31, 2020 total loans were$1.2 billion and the allowance for loan losses was$10.0 million , or 0.82% of total loans, compared to total loans of$874.3 million and an allowance for loan losses of$8.7 million , or 1.00% of total loans, atMarch 31, 2019 . Included in loans atMarch 31, 2020 were$208.4 million of loans that were acquired in the Shore Merger. The decrease in the allowance as a percentage of loans was due primarily to acquisition accounting for the Shore Merger, which resulted in the Shore loans being recorded at their fair value as of the effective time of the merger. The unaccreted general credit fair value discount related to the former Shore loans was$2.2 million atMarch 31, 2020 . Due to the economic disruption and uncertainty caused by the COVID-19 pandemic, the provision for loan losses may increase in future periods as borrowers are affected by the expected severe contraction of economic activity and the dramatic increase in unemployment. This may result in increases in loan delinquencies, down-grades of loan credit ratings and charge-offs in future periods. The provision for loan losses may increase significantly to reflect the decline in the performance of the loan portfolio and the higher level of incurred losses.
Non-Interest Income
Non-interest income was$2.5 million for the first quarter of 2020, an increase of$590,000 compared to$1.9 million for the first quarter of 2019. Gains on the sale of loans increased$425,000 , service charges on deposit accounts increased$47,000 , income on Bank-owned life insurance increased$41,000 and other income increased$69,000 as compared to the prior year period. In the first quarter of 2020,$34.0 million of residential mortgages were sold and$1.2 million of gains were recorded compared to$19.6 million of residential mortgage loans sold and$715,000 of gains recorded in the first quarter of 2019. Management believes that the increase in residential mortgage loans sold was due primarily to increased residential mortgage lending activity as a result of lower mortgage interest rates in the 2020 period compared to the 2019 period. In the first quarter of 2020,$2.7 million of SBA loans were sold and gains of$226,000 were recorded compared to$4.7 million of SBA loans sold and gains of$330,000 recorded in the first quarter of 2019. SBA guaranteed commercial lending activity and loan sales vary from period to period, and the level of activity is due primarily to the timing of loan originations. Non-interest income may decline as the origination and sale of residential mortgages may decrease due to the negative effect that mandated business closures and social distancing may have on the purchase of homes, which would result in lower gains on sales of loans. The origination and sale of SBA loans may also decrease due to lower demand for financing by customers. Non-Interest Expenses For the three months endedMarch 31, 2020 , non-interest expenses were$9.8 million compared to$8.1 million for the three months endedMarch 31, 2019 , representing an increase of$1.7 million , or 21.0%. The primary reason for the increase was$979,000 of expenses included with respect to the former Shore operations in the first quarter of 2020. 42 --------------------------------------------------------------------------------
The following table presents the major components of non-interest expenses for
the three months ended
Three months ended March 31 ,
(Dollars in thousands) 2020 2019
Salaries and employee benefits $ 6,169$ 4,963 Occupancy expense 1,170 1,021 Data processing expenses 446 348 Equipment expense 411 324 Marketing 44 80 Telephone 125 96 Regulatory, professional and consulting fees 464 457 Insurance 119 90 Supplies 97 66 FDIC insurance expense 34 100 Other real estate owned expenses 17
48
Amortization of intangible assets 122 32 Other expenses 575 469 Total $ 9,793$ 8,094 Salaries and employee benefits, which represent the largest portion of non-interest expenses, increased by$1.2 million , or 24.3%, to$6.2 million for the three months endedMarch 31, 2020 compared to$5.0 million for the three months endedMarch 31, 2019 , due primarily to salaries and benefits for former Shore employees ($486,000 ) who joined the Company, higher commissions expense of$328,000 related to the origination of residential mortgage loans primarily for sale, merit increases and increases in employee benefit expenses. Occupancy expense increased$149,000 to$1.2 million , or 14.6%, due primarily to the addition of the five former Shore branch offices, compared to$1.0 million in 2019. Data processing expenses increased to$446,000 in the first quarter of 2020 compared to$348,000 for the first quarter of 2019 due primarily to the addition of the Shore operations ($85,000 ) and increases in loans, deposits and other customer services.FDIC insurance expense declined to$34,000 from the$100,000 in the first quarter of 2019, due to the small bank assessment credit received of$123,000 for the fourth quarter of 2019. The full credit has been applied and no further credits will be received. Amortization of intangible assets increased$90,000 to$122,000 for the three months endedMarch 31, 2020 compared to$32,000 for the three months endedMarch 31, 2019 due primarily to the$94,000 amortization of a core deposit intangible related to the Shore Merger.
Other expenses increased
Non-interest expenses may increase, if there is a significant increase in non-performing loans, due to higher expenses for loan collection and recovery costs. In addition,FDIC insurance expense may increase if the Bank's financial condition is adversely impacted by a higher level of non-performing loans and assets. Income Taxes Income tax expense was$1.3 million for the first quarter of 2020 resulting in an effective tax rate of 27.3%, compared to income tax expense of$1.3 million , which resulted in an effective tax rate of 27.7% for the first quarter of 2019. 43
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FINANCIAL CONDITION
Total consolidated assets were$1.61 billion atMarch 31, 2020 , an increase of$24.6 million from total consolidated assets of$1.59 billion atDecember 31, 2019 . This increase was due primarily to a$19.7 million increase in total investment securities and a$5.8 million increase in loans held for sale. The increase in assets was funded primarily by a$20.7 million increase in deposits and a$2.1 million increase in short-term borrowings.
Cash and Cash Equivalents
Cash and cash equivalents totaled$12.0 million atMarch 31, 2020 compared to$14.8 million atDecember 31, 2019 , representing a decrease of$2.8 million . The decrease in cash and cash equivalents reflects a short-term decrease in interest-earning deposits, partially offset by an increase in cash and due from banks, as a result of current market conditions.
Loans Held for Sale
Loans held for sale were
Investment securities represented approximately 15.7% of total assets atMarch 31, 2020 and approximately 14.7% of total assets atDecember 31, 2019 . Total investment securities increased$19.7 million to$252.1 million atMarch 31, 2020 from$232.4 million atDecember 31, 2019 . Purchases of investment securities totaled$35.1 million during the three months endedMarch 31, 2020 , and proceeds from calls, maturities and payments totaled$14.9 million during this same period. Securities available for sale are investments that may be sold in response to changing market and interest rate conditions or for other business purposes. Activity in this portfolio is undertaken primarily to manage liquidity and interest rate risk and to take advantage of market conditions that create economically attractive returns. AtMarch 31, 2020 , securities available for sale were$163.7 million , an increase of$7.9 million , or 5.1%, compared to securities available for sale of$155.8 million atDecember 31, 2019 . AtMarch 31, 2020 , the securities available for sale portfolio had net unrealized gains of$226,000 compared to net unrealized gains of$414,000 atDecember 31, 2019 . These net unrealized gains were reflected, net of tax, in shareholders' equity as a component of accumulated other comprehensive income (loss). Securities held to maturity, which are carried at amortized historical cost, are investments for which there is the positive intent and ability to hold to maturity. AtMarch 31, 2020 , securities held to maturity were$88.4 million , an increase of$11.8 million from$76.6 million atDecember 31, 2019 . The fair value of the held to maturity portfolio was$91.1 million atMarch 31, 2020 .
Loans
The loan portfolio, which represents the Company's largest asset, is a significant source of both interest and fee income. Elements of the loan portfolio are subject to differing levels of credit and interest rate risk. The Company's primary lending focus continues to be the financing of mortgage warehouse lines, construction loans, commercial business loans, owner-occupied commercial mortgage loans and commercial real estate loans on income-producing assets.
The following table represents the components of the loan portfolio at
44
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March 31, 2020 December 31, 2019
(Dollars in thousands) Amount % Amount %
Commercial real estate $ 576,886 47 % $ 567,655 47 %
Mortgage warehouse lines 224,793 19 236,672 20
Construction loans 145,599 12 148,939 12
Commercial business 150,068 12 139,271 11
Residential real estate 89,347 7 90,259 7
Loans to individuals 30,556 3 32,604 3
Other loans 141 - 137 -
Total loans 1,217,390 100 % 1,215,537 100 %
Deferred loan costs, net 417 491
Total loans, including deferred
loans costs, net $ 1,217,807 $ 1,216,028
Total loans remained relatively steady, increasing only $1.8 million , or 0.1%,
to $1.2 billion at March 31, 2020 compared to $1.2 billion at December 31, 2019 .
Commercial business loans and commercial real estate loans increased by $10.8
million and $9.2 million , respectively. Partially offsetting these increases,
mortgage warehouse lines and construction loans decreased $11.9 million and $3.3
million , respectively.
Commercial real estate loans totaled $576.9 million at March 31, 2020 ,
representing an increase of $9.2 million compared to $567.7 million at December
31, 2019 . Commercial real estate loans consist primarily of loans to businesses
that are collateralized by real estate assets employed in the operation of the
business and loans to real estate investors to finance the acquisition and/or
improvement of owned income-producing commercial properties.
The Bank's mortgage warehouse funding group provides revolving lines of credit
that are available to licensed mortgage banking companies. The warehouse line of
credit is used by the mortgage banker to finance the origination of one-to-four
family residential mortgage loans that are pre-sold to the secondary mortgage
market, which includes state and national banks, national mortgage banking
firms, insurance companies and government-sponsored enterprises, including the
Federal National Mortgage Association, the Federal Home Loan Mortgage
Corporation and the Government National Mortgage Association . On average, an
advance under the warehouse line of credit remains outstanding for a period of
less than 30 days, with repayment coming directly from the sale of the loan into
the secondary mortgage market. The Bank collects interest and a transaction fee
at the time of repayment. Mortgage warehouse totaled $224.8 million at March 31,
2020 compared to $236.7 million at December 31, 2019 . In the first quarter of
2020, $855.6 million of residential mortgage loans were financed through the
mortgage warehouse funding group compared to $644.0 million during the first
quarter 2019.
Construction loans totaled $145.6 million at March 31, 2020 compared to $148.9
million at December 31, 2019 . Construction financing is provided to businesses
to expand their facilities and operations and to real estate developers for the
acquisition, development and construction of residential properties and
income-producing properties. First mortgage construction loans are made to
developers and builders for single family homes or multi-family buildings that
are pre-sold or are to be sold or leased on a speculative basis. The Bank lends
to developers and builders with established relationships, successful operating
histories and sound financial resources.
Commercial business loans totaled $150.1 million at March 31, 2020 compared to
$139.3 million at December 31, 2019 . Commercial business loans consist primarily
of loans to small and middle market businesses and are typically working capital
loans used to finance inventory, receivables or equipment needs. These loans are
generally secured by business assets of the commercial borrower.
Residential real estate loans totaled $89.3 million at March 31, 2020 compared
to $90.3 million at December 31, 2019 . Loans to individuals, which are comprised
primarily of home equity loans, totaled $30.6 million at March 31, 2020 compared
to $32.6 million at December 31, 2019 .
The ability of the Company to enter into larger loan relationships and
management's philosophy of relationship banking are key factors in the Company's
strategy for loan growth. The ultimate collectability of the loan portfolio and
recovery of the carrying amount of real estate are subject to changes in the
economic environment and real estate market in the Company's market region,
which is primarily New Jersey and the New York City metropolitan area.
If the economic disruption caused by the COVID-19 pandemic continues for an extended period of time, the Company may experience a decline in the origination of new loans and total loans could decline.
45
--------------------------------------------------------------------------------Non-Performing Assets
Non-performing assets consist of non-performing loans and other real estate owned. Non-performing loans are composed of (1) loans on non-accrual basis and (2) loans which are contractually past due 90 days or more as to interest and principal payments but which have not been classified as non-accrual. Included in non-accrual loans are loans, the terms of which have been restructured to provide a reduction or deferral of interest and/or principal because of deterioration in the financial position of the borrower and have not performed in accordance with the restructured terms. Loan payments that are deferred due to COVID-19 continue to accrue interest and are not presented as past due in the table below. The Bank's policy with regard to non-accrual loans is that, generally, loans are placed on non-accrual status when they are 90 days past due, unless these loans are well secured and in process of collection or, regardless of the past due status of the loan, when management determines that the complete recovery of principal or interest is in doubt. Consumer loans are generally charged off after they become 120 days past due. Subsequent payments on loans in non-accrual status are credited to income only if collection of principal is not in doubt. AtMarch 31, 2020 , non-performing loans increased by$8.7 million to$13.2 million from$4.5 million atDecember 31, 2019 , and the ratio of non-performing loans to total loans increased to 1.08% atMarch 31, 2020 compared to 0.37% atDecember 31, 2019 . During the three months endedMarch 31, 2020 ,$513,000 of non-performing loans were resolved,$165,000 of loans were charged-off and$9.2 million of loans were placed on non-accrual. During the first quarter of 2020, a$7.5 million participation in a construction loan,$1.5 million in commercial real estate loans,$84,000 in commercial business loans and$108,000 of loans to individuals were placed on non-accrual.
The major segments of non-accrual loans consist of commercial business, commercial real estate and residential real estate loans, which are in the process of collection. The table below sets forth non-performing assets and risk elements in the Bank's portfolio for the periods indicated. (Dollars in thousands)
March 31, 2020 December 31, 2019
Non-performing loans:
Loans 90 days or more past due and still accruing $ - $ -
Non-accrual loans 13,198 4,497
Total non-performing loans 13,198 4,497
Other real estate owned 470 571
Total non-performing assets 13,668 5,068
Performing troubled debt restructurings 6,112 6,132
Performing troubled debt restructurings and total non-performing assets$ 19,780 $
11,200
Non-performing loans to total loans 1.08 % 0.37 % Non-performing loans to total loans excluding mortgage warehouse lines 1.33 % 0.46 % Non-performing assets to total assets 0.85 % 0.32 % Non-performing assets to total assets excluding mortgage warehouse lines 0.99 % 0.38 % Total non-performing assets and performing troubled 1.23 % 0.71 % debt restructurings to total assets Non-performing assets increased by$8.6 million to$13.7 million atMarch 31, 2020 from$5.1 million atDecember 31, 2019 . OREO totaled$470,000 atMarch 31, 2020 compared to$571,000 atDecember 31, 2019 . One residential lot acquired in the Shore Merger with a carrying value of$101,000 was sold in the first quarter of 2020. OREO atMarch 31, 2020 was comprised of 5 residential lots acquired in the Shore Merger with a carrying value of$377,000 and land with a carrying value of$93,000 that was foreclosed in the second quarter of 2018. AtMarch 31, 2020 , the Bank had 13 loans totaling$6.4 million that were troubled debt restructurings. Three of these loans totaling$335,000 are included in the above table as non-accrual loans and the remaining ten loans totaling$6.1 million were performing. AtDecember 31, 2019 , the Bank had 13 loans totaling$6.4 million that were troubled debt restructurings. Three of these loans totaling$345,000 are included in the above table as non-accrual loans and the remaining nine loans totaling$6.1 million were performing.
In accordance with
46
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of deteriorated credit quality totaling $5.2 million that were not classified as
non-performing loans. At December 31, 2019 , there were 11 loans acquired with
evidence of deteriorated credit quality totaling $4.6 million that were not
classified as non-performing loans.
Management takes a proactive approach in addressing delinquent loans. The
Company's President and Chief Executive Officer meets weekly with all loan
officers to review the status of credits past due 10 days or more. An action
plan is discussed for delinquent loans to determine the steps necessary to
induce the borrower to cure the delinquency and restore the loan to a current
status. In addition, delinquency notices are system-generated when loans are
five days past due and again at 15 days past due.
In most cases, the Company's collateral is real estate. If the collateral is
foreclosed upon, the real estate is carried at fair market value less the
estimated selling costs. The amount, if any, by which the recorded amount of the
loan exceeds the fair market value of the collateral, less estimated selling
costs, is a loss that is charged to the allowance for loan losses at the time of
foreclosure or repossession. Resolution of a past-due loan through foreclosure
can be delayed if the borrower files a bankruptcy petition because a collection
action cannot be continued unless the Company first obtains relief from the
automatic stay provided by the United States Bankruptcy Reform Act of 1978, as
amended.
Management periodically reviews the level of loan concentrations by industry,
borrower and geography. In response to the COVID-19 pandemic, management
identified certain industries that were most likely to be adversely impacted in
the near-term by the economic disruption caused by the pandemic. The following
table summarizes those industry concentrations, as well as the amount of loan
modification and forbearance granted, the amount of PPP loans funded and the
amount of loans that are guaranteed by the SBA for which the SBA will be paying
the interest and principal for the next six months within each such industry.
% of
Total COVID-19 SBA Paying
(Dollars in thousands) Balance Loans Deferrals P&I PPP Loans
Hotels $ 67,849 5.6% $ 41,367 $ 1,667 $ 462
Restaurant-food service 50,523 4.1% 15,140 4,408 4,220
Allowance for Loan Losses and Related Provision
The allowance for loan losses is maintained at a level sufficient to absorb estimated credit losses in the loan portfolio as of the date of the financial statements. The allowance for loan losses is a valuation reserve available for losses incurred or inherent in the loan portfolio and other extensions of credit. The determination of the adequacy of the allowance for loan losses is a critical accounting policy of the Company. The Company's primary lending emphasis is the origination of commercial business, construction and commercial real estate loans and mortgage warehouse lines of credit. Based on the composition of the loan portfolio, the inherent primary risks are deteriorating credit quality, a decline in the economy and a decline inNew Jersey andNew York City metropolitan area real estate market values. Any one, or a combination, of these events may adversely affect the loan portfolio and may result in increased delinquencies, loan losses and increased future provision levels.
Due to the economic disruption and uncertainty caused by the pandemic, the allowance for loan losses may increase in future periods as borrowers are affected by the expected severe contraction of economic activity and the dramatic increase in unemployment. This may result in increases in loan delinquencies, down-grades of loan credit ratings and charge-offs in future periods. The allowance for loan losses may increase significantly to reflect the decline in the performance of the loan portfolio and the higher level of incurred losses.
All, or part, of the principal balance of commercial business and commercial real estate loans and construction loans are charged off against the allowance as soon as it is determined that the repayment of all, or part, of the principal balance is highly unlikely. Consumer loans are generally charged off no later than 120 days past due on a contractual basis, earlier in the event of bankruptcy, or if there is an amount deemed uncollectible. Because all identified losses are charged off, no portion of the allowance for loan losses is restricted to any individual loan or groups of loans and the entire allowance is available to absorb any and all loan losses. Management reviews the adequacy of the allowance on at least a quarterly basis to ensure that the provision for loan losses has been charged against earnings in an amount necessary to maintain the allowance at a level that is adequate based on management's assessment of probable estimated losses. The Company's methodology for assessing the adequacy of the allowance for loan losses consists of several key elements and is consistent withU.S. GAAP and interagency supervisory guidance. The allowance for loan losses 47 -------------------------------------------------------------------------------- methodology consists of two major components. The first component is an estimation of losses associated with individually identified impaired loans, which follows ASC Topic 310. The second major component is an estimation of losses under ASC Topic 450, which provides guidance for estimating losses on groups of loans with similar risk characteristics. The Company's methodology results in an allowance for loan losses that includes a specific reserve for impaired loans, an allocated reserve and an unallocated portion. When analyzing groups of loans, the Company follows the Interagency Policy Statement on the Allowance for Loan and Lease Losses. The methodology considers the Company's historical loss experience adjusted for changes in trends, conditions and other relevant factors that affect repayment of the loans as of the evaluation date. These adjustment factors, known as qualitative factors, include:
• Delinquencies and non-accruals;
• Portfolio quality; • Concentration of credit;
• Trends in volume of loans;
• Quality of collateral; • Policy and procedures;
• Experience, ability and depth of management;
• Economic trends - national and local; and
• External factors - competition, legal and regulatory.
The methodology includes the segregation of the loan portfolio into loan types
with a further segregation into risk rating categories, such as special mention,
substandard, doubtful and loss. This allows for an allocation of the allowance
for loan losses by loan type; however, the allowance is available to absorb any
loan loss without restriction. Larger-balance, non-homogeneous loans
representing significant individual credit exposures are evaluated individually
through the internal loan review process. This process produces the watch
list. The borrower's overall financial condition, repayment sources, guarantors
and value of collateral, if appropriate, are evaluated. Based on this
evaluation, an estimate of probable losses for the individual larger-balance
loans is determined, whenever possible, and used to establish specific loan loss
reserves. In general, for non-homogeneous loans not individually assessed and
for homogeneous groups of loans, such as residential mortgages and consumer
credits, the loans are collectively evaluated based on delinquency status, loan
type and historical losses. These loan groups are then internally risk rated.
The watch list includes loans that are assigned a rating of special mention,
substandard, doubtful and loss. Loans classified as special mention have
potential weaknesses that deserve management's close attention. If uncorrected,
the potential weaknesses may result in deterioration of the repayment
prospects. Loans classified as substandard have a well-defined weakness or
weaknesses that jeopardize the liquidation of the debt. They include loans that
are inadequately protected by the current net worth and paying capacity of the
obligor or of the collateral pledged, if any. Loans classified as doubtful have
all the weaknesses inherent in loans classified as substandard with the added
characteristic that collection or liquidation in full, on the basis of current
conditions and facts, is highly improbable. Loans rated as doubtful are placed
in non-accrual status. Loans classified as a loss are considered uncollectible
and are charged-off against the allowance for loan losses.
The specific allowance for impaired loans is established for specific loans that
have been identified by management as being impaired. These loans are considered
to be impaired primarily because the loans have not performed according to
payment terms and there is reason to believe that repayment of the loan
principal in whole, or in part, is unlikely. The specific portion of the
allowance is the total amount of potential unconfirmed losses for these
individual impaired loans. To assist in determining the fair value of loan
collateral, the Company often utilizes independent third-party qualified
appraisal firms, which employ their own criteria and assumptions that may
include occupancy rates, rental rates and property expenses, among others.
The second category of reserves consists of the allocated portion of the
allowance. The allocated portion of the allowance is determined by taking pools
of outstanding loans that have similar characteristics and applying historical
loss experience for each pool. This estimate represents the potential
unconfirmed losses within the portfolio. Individual loan pools are created for
commercial business loans, commercial real estate loans, construction loans,
warehouse lines of credit and various types of loans to individuals. The
historical estimation for each loan pool is then adjusted to account for current
conditions, current loan portfolio performance, loan policy or management
changes or any other qualitative factor that management believes may cause
future losses to deviate from historical levels.
The Company also maintains an unallocated allowance. The unallocated allowance
is used to cover any factors or conditions that may cause a potential loan loss
but are not specifically identifiable. It is prudent to maintain an unallocated
portion of the allowance because no matter how detailed an analysis of potential
loan losses is performed, these estimates, by definition, lack
precision. Management must make estimates using assumptions and information that
is often subjective and changing rapidly.
48
--------------------------------------------------------------------------------The following discusses the risk characteristics of each of our loan portfolios.
Commercial Business
The Company offers a variety of commercial loan services, including term loans, lines of credit and loans secured by equipment and receivables. A broad range of short-to-medium term commercial loans, both secured and unsecured, are made available to businesses for working capital (including inventory and receivables), business expansion (including acquisition and development of real estate and improvements) and the purchase of equipment and machinery. Commercial business loans are granted based on the borrower's ability to generate cash flow to support its debt obligations and other cash related expenses. A borrower's ability to repay commercial business loans is substantially dependent on the success of the business itself and on the quality of its management. As a general practice, the Company takes, as collateral, a security interest in any available real estate, equipment, inventory, receivables or other personal property of its borrowers, although the Company occasionally makes commercial business loans on an unsecured basis. Generally, the Company requires personal guarantees of its commercial business loans to offset the risks associated with such loans. Much of the Company's lending is in northern and centralNew Jersey and theNew York City metropolitan area. As a result of this geographic concentration, a significant broad-based deterioration in economic conditions inNew Jersey and theNew York City metropolitan area could have a material adverse impact on the Company's loan portfolio. A prolonged decline in economic conditions in our market area could restrict borrowers' ability to pay outstanding principal and interest on loans when due. The value of assets pledged as collateral may decline and the proceeds from the sale or liquidation of these assets may not be sufficient to repay the loan.
Commercial real estate loans are made to businesses to expand their facilities and operations and to real estate operators to finance the acquisition of income producing properties. The Company's loan policy requires that borrowers have sufficient cash flow to meet the debt service requirements and the value of the property meets the loan-to-value criteria set in the loan policy. The Company monitors loan concentrations by borrower, by type of property and by location and other criteria. The Company's commercial real estate portfolio is largely secured by real estate collateral located inNew Jersey and theNew York City metropolitan area. Conditions in the real estate markets in which the collateral for the Company's loans are located strongly influence the level of the Company's non-performing loans. A decline in theNew Jersey andNew York City metropolitan area real estate markets could adversely affect the Company's loan portfolio. Decreases in local real estate values would adversely affect the value of property used as collateral for the Company's loans. Adverse changes in the economy also may have a negative effect on the ability of our borrowers to make timely repayments of their loans. Construction Financing Construction financing is provided to businesses to expand their facilities and operations and to real estate developers for the acquisition, development and construction of residential and commercial properties. First mortgage construction loans are made to developers and builders primarily for single family homes and multi-family buildings that are presold or are to be sold or leased on a speculative basis. The Company lends to builders and developers with established relationships, successful operating histories and sound financial resources. Management has established underwriting and monitoring criteria to minimize the inherent risks of real estate construction lending. The risks associated with speculative construction lending include the borrower's inability to complete the construction process on time and within budget, the sale or rental of the project within projected absorption periods and the economic risks associated with real estate collateral. Such loans may include financing the development and/or construction of residential subdivisions. This activity may involve financing land purchases and infrastructure development (such as roads, utilities, etc.), as well as construction of residences or multi-family dwellings for subsequent sale by the developer/builder. Because the sale or rental of developed properties is integral to the success of developer business, loan repayment may be especially subject to the volatility of real estate market values.
Mortgage Warehouse Lines of Credit
The Company'sMortgage Warehouse Funding Group provides revolving lines of credit that are available to licensed mortgage banking companies. The warehouse line of credit is used by the mortgage banker to originate one-to-four family residential mortgage loans that are pre-sold to the secondary mortgage market, which includes state and national banks, national mortgage banking firms, insurance companies and government-sponsored enterprises, including the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, theGovernment National Mortgage Association and others. On average, an advance under the warehouse line of credit remains outstanding for a period of less than 30 days, with repayment coming directly from the sale of the loan into the secondary mortgage market. Interest and a transaction fee are collected by the Bank at the time of repayment. 49 -------------------------------------------------------------------------------- As a separate class of the total loan portfolio, the warehouse loan portfolio is individually analyzed as a whole for allowance for loan losses purposes. Warehouse lines of credit are subject to the same inherent risks as other commercial lending, but the overall degree of risk differs. While the Company's loss experience with this type of lending has been non-existent since the product was introduced in 2008, there are other risks unique to this lending that still must be considered in assessing the adequacy of the allowance for loan losses. These unique risks may include, but are not limited to, (i) credit risks relating to the mortgage bankers that borrow from us, (ii) the risk of intentional misrepresentation or fraud by any of such mortgage bankers, (iii) changes in the market value of mortgage loans originated by the mortgage banker, the sale of which is the expected source of repayment of the borrowings under a warehouse line of credit, due to changes in interest rates during the time in warehouse or (iv) unsalable or impaired mortgage loans so originated, which could lead to decreased collateral value and the failure of a purchaser of the mortgage loan to purchase the loan from the mortgage banker.
Consumer
The Company's consumer loan portfolio is comprised of residential real estate loans, home equity loans and other loans to individuals. Individual loan pools are created for the various types of loans to individuals. The principal risk is the borrower becomes unemployed or has a significant reduction in income. In general, for homogeneous groups such as residential mortgages and consumer credits, the loans are collectively evaluated based on delinquency status, loan type and historical losses. These loan groups are then internally risk rated.
The Company considers the following credit quality indicators in assessing the risk in the loan portfolio:
•Consumer credit scores; •Internal credit risk grades; •Loan-to-value ratios; •Collateral; and •Collection experience. Management also evaluated the potential that incurred losses had increased with respect to the concentrations in hotels and restaurant-food service loans. In reviewing the loans in the hotels concentration, management noted that all loans were current, except for one loan with a balance of$1.3 million that was on non-accrual, and the weighted average loan to value of the hotel loans was 55%.
With the respect to the restaurant-food service concentration, management
observed that all loans with balances greater than
On the basis of this review and the evaluation of the loans in the hotels and restaurant-food service concentrations, management concluded that if loan defaults increase it would require a substantial decrease in the value of the collateral supporting these loans for there to be a significant increase in incurred losses in the hotels and restaurant-food service concentrations atMarch 31, 2020 . 50 --------------------------------------------------------------------------------
The following table presents, for the periods indicated, an analysis of the allowance for loan losses and other related data:
Three Months Ended Year Ended December Three Months Ended
(Dollars in thousands) March 31, 2020 31, 2019 March 31, 2019
Balance, beginning of period $ 9,271 $ 8,402 $ 8,402
Provision charged to operating
expenses 895 1,350 300
Loans charged off:
Residential real estate loans - - -
Commercial business and commercial
real estate (165 ) (463 ) -
Loans to individuals - (7 ) -
All other loans - (43 ) -
Total loans charged off (165 ) (513 ) -
Recoveries:
Commercial business and commercial
real estate - 26 -
Loans to individuals - 6 2
All other loans - - -
Total recoveries - 32 2
Net (charge offs) recoveries (165 ) (481 ) 2
Balance, end of period $ 10,001 $ 9,271 $ 8,704
Loans:
At period end $ 1,217,807 $ 1,216,028 $ 874,333
Average during the period 1,166,850 964,920 864,785
Net (charge offs) recoveries to
average loans outstanding (0.01 )% (0.05 )% - %
Net (charge offs) recoveries to
average loans outstanding, excluding
mortgage warehouse loans (0.02 )% (0.06 )% 0.01 %
Allowance for loan losses to:
Total loans at period end 0.82 % 0.76 % 1.00 % Total loans at period end excluding mortgage warehouse loans 0.90 % 0.84 % 1.09 % Non-performing loans 75.78 % 206.16 % 248.76 %
The following table represents the allocation of the allowance for loan losses
among the various categories of loans and certain other information as of
March 31, 2020 December 31, 2019
As a % Loans as a % of As a % Loans as a % of
(Dollars in thousands) Amount of Loan Class Total Loans
Amount of Loan Class Total Loans
Commercial real estate loans $ 4,800 0.83 % 48 % $ 4,524 0.80 % 47 %
Commercial Business 1,771 1.18 % 12 % 1,409 1.01 % 11 %
Construction loans 1,706 1.17 % 12 % 1,389 0.93 % 12 %
Residential real estate loans 430 0.48 % 7 % 412 0.46 % 7 %
Loans to individuals 188 0.61 % 3 % 185 0.57 % 3 %
Subtotal 8,895 0.90 % 82 % 7,919 0.81 % 80 %
Mortgage warehouse lines 1,027 0.18 % 18 % 1,083 0.46 % 20 %
Unallocated reserves 79 - - 269 - -
Total $ 10,001 0.82 % 100 % $ 9,271 0.76 % 100 %
For the first three months of 2020, the Company recorded a provision for loan
losses of $895,000 , charge-offs of $165,000 compared to a provision for loan
losses of $300,000 , no charge-offs and recoveries of loans previously
charged-off of $2,000 recorded for the
51
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first three months of 2019. The higher provision for loan losses recorded for
the first three months of 2020 was due primarily to an additional provision of
approximately $388,000 related to an increase in the qualitative factors as a
result of a weakening national and local economic environment resulting from the
existing and anticipated impacts of the COVID-19 pandemic and, to a lesser
extent, the growth and change in the mix of the loan portfolio.
At March 31, 2020 , the allowance for loan losses was $10.0 million , or 0.82% of
loans, compared to $9.3 million , or 0.76% of loans, at December 31, 2019 and
$8.7 million , or 1.00% of loans, at March 31, 2019 . The allowance for loan
losses was 75.8% of non-performing loans at March 31, 2020 compared to 206.2% of
non-performing loans at December 31, 2018 and 248.8% of non-performing loans at
March 31, 2019 .
Management believes that the allowance for loan losses is adequate in relation
to credit risk exposure levels and the estimated incurred and inherent losses in
the loan portfolio at March 31, 2020 . However, it is expected that the economic
disruption resulting from the COVID-19 pandemic will more significantly impact
businesses, borrowers, employees and consumers in the second quarter of 2020,
which may continue with increasing severity in future periods. Management may
further increase the provision for loan losses and the allowance for loan losses
in response to changes in economic conditions and the performance of the loan
portfolio in future periods.
Deposits
Deposits, which include demand deposits (interest bearing and non-interest
bearing), savings deposits and time deposits, are a fundamental and
cost-effective source of funding. The flow of deposits is influenced
significantly by general economic conditions, changes in market interest rates
and competition. The Company offers a variety of products designed to attract
and retain customers, with the Company's primary focus on the building and
expanding of long-term relationships.
The following table summarizes deposits at March 31, 2020 and December 31, 2019 :
(Dollars in thousands) March 31, 2020 December 31, 2019
Demand
Non-interest bearing $ 299,147 $ 287,555
Interest bearing 397,236 393,392
Savings 266,295 259,033
Certificates of deposit 335,354 337,382
Total $ 1,298,032 $ 1,277,362
At March 31, 2020 , total deposits were $1.30 billion , an increase of $20.7
million , or 1.6%, from $1.28 billion at December 31, 2019 . Non-interest bearing
demand deposits increased $11.6 million , interest-bearing demand deposits
increased $3.8 million and savings deposits increased $7.3 while certificates of
deposit decreased $2.0 million when compared to the levels at December 31, 2019 .
The COVID-19 pandemic may impact the Bank's ability to increase and or retain
customers' deposits. If the pandemic continues for an extended period of time,
businesses may experience a loss of revenue and consumers may experience a
reduction of income, which may cause them to withdraw their funds to pay
expenses or reduce their ability to increase their deposits.
Borrowings
Borrowings are mainly comprised ofFederal Home Loan Bank of New York ("FHLB") borrowings and overnight funds purchased. These borrowings are primarily used to fund asset growth not supported by deposit generation. AtMarch 31, 2020 , the Company had$94.1 million of short-term borrowings from the FHLB compared to$92.1 million of short-term borrowings from the FHLB atDecember 31, 2019 . InApril 2020 the Bank began participating in theFederal Reserve's Paycheck Protection Program Liquidity Facility ("PPPLF"), which is a liquidity and borrowing program to allow participating banks to borrow 100% of the PPP loans funded at an interest rate of 0.35% for up to two years.
Liquidity
AtMarch 31, 2020 , the amount of liquid assets and the Bank's access to off-balance sheet liquidity remained at a level management deemed adequate to ensure that contractual liabilities, depositors' withdrawal requirements and other operational and customer credit needs could be satisfied. Liquidity management refers to the Company's ability to support asset growth while satisfying the borrowing needs and deposit withdrawal requirements of customers. In addition to maintaining liquid assets, factors such as capital position, profitability, asset 52 -------------------------------------------------------------------------------- quality and availability of funding affect a bank's ability to meet its liquidity needs. On the asset side, liquid funds are maintained in the form of cash and cash equivalents, federal funds sold, investment securities held to maturity maturing within one year, securities available for sale and loans held for sale. Additional asset-based liquidity is derived from scheduled loan repayments as well as investment repayments of principal and interest. Investment securities and loans may also be pledged to the FHLB to collateralize additional borrowings. On the liability side, the primary source of liquidity is the ability to generate core deposits. Long-term and short-term borrowings are used as supplemental funding sources when growth in the core deposit base does not keep pace with that of interest-earning assets. The Bank has established a borrowing relationship with the FHLB that further supports and enhances liquidity. The FHLB provides member banks with a fully secured line of credit of up to 50% of a bank's quarter-end total assets. Under the terms of this facility, the Bank's total credit exposure to the FHLB cannot exceed 50% of its total assets, or$805.4 million , atMarch 31, 2020 . In addition, the aggregate outstanding principal amount of the Bank's advances, letters of credit, the dollar amount of the FHLB's minimum collateral requirement for off-balance sheet financial contracts and advance commitments cannot exceed 30% of the Bank's total assets, unless the Bank obtains approval from the FHLB's Board of Directors or its Executive Committee. These limits are further restricted by a member's ability to provide eligible collateral to support its obligations to the FHLB as well as the ability to meet the FHLB's stock requirement. AtMarch 31, 2020 andDecember 31, 2019 , the Bank pledged approximately$385.5 million and$308.5 million of loans, respectively, to support the FHLB borrowing capacity. AtMarch 31, 2020 andDecember 31, 2019 , the Bank had available borrowing capacity of$168.2 million and$131.2 million , respectively, at the FHLB. The Bank also maintains unsecured federal funds lines of$46.0 million with two correspondent banks, all of which were unused and available atMarch 31, 2020 . AtApril 30, 2020 the Bank had an outstanding balance of$40.1 million with theFederal Reserve Bank under the PPPLF program. The Bank may borrow additional funds under this facility up to 100% of the PPP loans. In addition, the Bank has access to theFederal Reserve Bank of New York Discount Window facility. At this time the Bank has not pledged investment securities or loans, which would be required, to support borrowings through the Discount Window facility. The Consolidated Statements of Cash Flows present the changes in cash from operating, investing and financing activities. AtMarch 31, 2020 , the balance of cash and cash equivalents was$12.0 million . Net cash used in operating activities totaled$1.5 million for the three months endedMarch 31, 2020 compared to net cash provided by operating activities of$5.1 million for the three months endedMarch 31, 2019 . A source of funds is net income from operations adjusted for activity related to loans originated for sale and sold, the provision for loan losses, depreciation and amortization expenses and net amortization of premiums and discounts on securities. Net cash used in operating activities for the three months endedMarch 31, 2020 compared to net cash provided by operating activities for the three months endedMarch 31, 2019 was due primarily to the net funding of loans held for sale of approximately$4.4 million in the first three months of 2020 compared to net sales of loans held for sale of approximately$2.9 million in the first three months of 2019. Net cash used in investing activities totaled$23.0 million for the three months endedMarch 31, 2020 compared to$1.0 million for the three months endedMarch 31, 2019 . The loans and securities portfolios are a source of liquidity, providing cash flows from maturities and periodic payments of principal. The primary use of cash by investing activities for the three months endedMarch 31, 2020 was the purchase of$35.1 million of investment securities compared to$23.7 million in the first three months of 2019. Partially offsetting these purchases was$14.9 million of payments, calls and maturities of investment securities in the first quarter of 2020 compared to$11.7 million of payments, calls and maturities in the first quarter of 2019. During the three months endedMarch 31, 2020 , net loans increased$1.8 million compared to a decrease in net loans of$8.9 million during the three months endedMarch 31, 2019 . There were no sales of investment securities in the three months endedMarch 31, 2020 and 2019. Net cash provided by financing activities was$21.7 million for the three months endedMarch 31, 2020 compared to$5.8 million used in financing activities for the three months endedMarch 31, 2019 . The primary source of funds for the 2020 period was the increase in both the deposits and short-term borrowings of$20.7 million and$2.1 million , respectively. The primary use of funds for the three months endedMarch 31, 2019 was the$49.7 million reduction in short-term borrowings, which was partially offset by an increase in deposits of$44.5 million . Management believes that the Company's and the Bank's liquidity resources are adequate to provide for the Company's and the Bank's planned operations.
Shareholders' Equity and Dividends
Shareholders' equity increased by
The Company began declaring and paying cash dividends on its common stock inSeptember 2016 and has declared and paid a cash dividend for each quarter since then. The timing and the amount of the payment of future cash dividends, if any, on the Company's 53 -------------------------------------------------------------------------------- common stock will be at the discretion of the Company's Board of Directors and will be determined after consideration of various factors, including the level of earnings, cash requirements, regulatory capital and financial condition.
The Company's common stock is quoted on the Nasdaq Global Market under the symbol, "FCCY."
OnJanuary 21, 2016 , the Board of Directors of the Company authorized a common stock repurchase program. Under the common stock repurchase program, the Company may repurchase in the open market or privately negotiated transactions up to 5% of its common stock outstanding on the date of approval of the stock repurchase program, which limitation is adjusted for any subsequent stock dividends. In the first quarter of 2020, 6,028 shares of common stock were repurchased to satisfy income tax withholding requirements on taxable income from the vesting of restricted share grants. Disclosure of repurchases of shares of common stock of the Company that were made during the quarter endedMarch 31, 2020 is set forth under Part II, Item 2 of this Form 10-Q, "Unregistered Sales ofEquity Securities and Use of Proceeds." Capital Resources The Company and the Bank are subject to various regulatory capital requirements administered by federal and state 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 direct material effect on the Company's and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of Common Equity Tier 1, Total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and Tier I capital to average assets (Leverage ratio, as defined). As ofMarch 31, 2020 andDecember 31, 2019 , the Company and the Bank met all capital adequacy requirements to which they were subject. To be categorized as adequately capitalized, the Company and the Bank must maintain minimum Common Equity Tier 1, Total capital to risk-weighted assets, Tier 1 capital to risk-weighted assets and Tier I leverage capital ratios as set forth in the below table. As ofMarch 31, 2020 andDecember 31, 2019 , the Bank's capital ratios exceeded the regulatory standards for well-capitalized institutions. Certain bank regulatory limitations exist on the availability of the Bank's assets for the payment of dividends by the Bank without prior approval of bank regulatory authorities. InJuly 2013 , theFederal Reserve Board and theFDIC approved revisions to their capital adequacy guidelines and prompt corrective action rules that implemented and addressed the revised standards of Basel III and addressed relevant provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. TheFederal Reserve Board's final rules and theFDIC's interim final rules (which became final inApril 2014 with no substantive changes) apply to all depository institutions, top-tier bank holding companies with total consolidated assets of$500 million or more (which was subsequently increased to$1 billion or more inMay 2015 ) and top-tier savings and loan holding companies ("banking organizations"). Among other things, the rules established a Common Equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets) and increased the minimum Tier 1 capital to risk-based assets requirement (from 4% to 6% of risk-weighted assets). Banking organizations are also required to have a total capital ratio of at least 8% and a Tier 1 leverage ratio of at least 4%. The rules also limited a banking organization's ability to pay dividends, engage in share repurchases or pay discretionary bonuses if the banking organization does not hold a "capital conservation buffer" consisting of 2.5% of Common Equity Tier 1 capital to risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements. The rules became effective for the Company and the Bank onJanuary 1, 2015 . The capital conservation buffer requirement began phasing in onJanuary 1, 2016 at 0.625% of Common Equity Tier 1 capital to risk-weighted assets and increased by that amount each year until fully implemented inJanuary 2019 at 2.5% of Common Equity Tier 1 capital to risk-weighted assets. AtMarch 31, 2020 , the Company and the Bank maintained a capital conservation buffer in excess of 2.5%. Management believes that the Company's and the Bank's capital resources are adequate to support the Company's and the Bank's current strategic and operating plans. However, if the financial position of the Company and the Bank are materially adversely impacted by the economic disruption caused by the COVID-19 pandemic, the Company and or the Bank may be required to increase its regulatory capital position. 54
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The Company's actual capital amounts and ratios are presented in the following
table:
To Be Well Capitalized
Under Prompt
For Capital Corrective Action
Actual Adequacy Purposes Provision
(Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio
As of March 31, 2020
Common equity Tier 1 (CET1) $ 135,817 9.84 % $ 62,122 4.50 % N/A N/A
Total capital to risk-weighted assets 163,818 11.87 % 110,439
8.00 % N/A N/A
Tier 1 capital to risk-weighted assets 153,817 11.14 % 82,829
6.00 % N/A N/A
Tier 1 leverage capital 153,817 10.17 % 60,521 4.00 % N/A N/A
As of December 31, 2019 :
Common equity Tier 1 (CET1) $ 133,046 9.70 % $ 61,604 4.50 % N/A N/ATotal capital to risk-weighted assets 160,317 11.69 % 109,519
8.00 % N/A N/A
Tier 1 capital to risk-weighted assets 151,046 11.01 % 82,139
6.00 % N/A N/A
Tier 1 leverage capital 151,046 10.56 % 57,245 4.00 % N/A N/A
The Bank's actual capital amounts and ratios are presented in the following
table:
To Be Well Capitalized
Under Prompt
For Capital Corrective Action
Actual Adequacy Purposes Provision
(Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio
As of March 31, 2020
Common equity Tier 1 (CET1) $ 153,586 11.13 % $ 62,097 4.50% $ 89,696 6.50%
Total capital to risk-weighted assets 163,587 11.85 % 110,395 8.00% 137,993 10.00%
Tier 1 capital to risk-weighted assets 153,586 11.13 % 82,796 6.00% 110,395 8.00%
Tier 1 leverage capital 153,586 10.15 % 60,498 4.00% 75,623 5.00%
As ofDecember 31, 2019 : Common equity Tier 1 (CET1)$ 150,725 10.99 %$ 61,579 4.50%$ 88,948 6.50% Total capital to risk-weighted assets 159,996 11.67 % 109,474 8.00% 136,843 10.00% Tier 1 capital to risk-weighted assets 150,725 10.99 % 82,106 6.00% 109,474 8.00% Tier 1 leverage capital 150,725 10.54 % 57,222 4.00% 71,528 5.00% Interest Rate Sensitivity Analysis The largest component of the Company's total income is net interest income, and the majority of the Company's financial instruments are composed of interest rate-sensitive assets and liabilities with various terms and maturities. The primary objective of management is to maximize net interest income while minimizing interest rate risk. Interest rate risk is derived from timing differences and the magnitude of relative changes in the repricing of assets and liabilities, loan prepayments, deposit withdrawals and differences in lending and funding rates. Management actively seeks to monitor and control the mix of interest rate-sensitive assets and interest rate-sensitive liabilities. Under the interest rate risk policy established by the Company's Board of Directors, the Company established quantitative guidelines with respect to interest rate risk and how interest rate shocks are projected to affect net interest income and the economic value of equity. Summarized below is the projected effect of a parallel shift of an increase of 200 and 300 basis points, respectively, in market interest rates on net interest income and the economic value of equity. Due to the historically low interest rate environment atMarch 31, 2020 a parallel shift down was not presented. 55 --------------------------------------------------------------------------------
Based upon the current interest rate environment, as of
Next 12 Months
(Dollars in thousands) Net Interest Income Economic Value of Equity (2)
Interest Rate Change in Dollar
Basis Points (1) Amount $ Change % Change Dollar Amount $ Change % Change
+300 $ 55,541 $ 1,627 3.02 % $ 198,001 $ (6,086 ) (2.98 )%
+200 54,721 807 1.50 % 200,604 (3,483 ) (1.71 )%
- 53,914 - - % 204,087 - - %
(1) Assumes an instantaneous and parallel shift in interest rates at all
maturities.
(2) Economic value of equity is the discounted present value of expected cash
flows from assets, liabilities and off-balance sheet contracts.
The Company employs many assumptions to calculate the impact of changes in interest rates on assets and liabilities, and actual results may not be similar to projections due to several factors, including the timing and frequency of rate changes, market conditions and the shape of the yield curve. Actual results may also differ due to management's actions, if any, in response to changing rates. In calculating these exposures, the Company utilized an interest rate simulation model that is validated by third-party reviewers periodically. Off-Balance Sheet Arrangements and Contractual Obligations As ofMarch 31, 2020 , there were no material changes to the Company's off-balance sheet arrangements and contractual obligations disclosed under Part II, Item 7 of the Company's Annual Report Form 10-K (Management's Discussion and Analysis of Financial Condition and Results of Operation) for the year endedDecember 31, 2019 . Management continues to believe that the Company has adequate capital and liquidity available from various sources to fund projected contractual obligations and commitments. 56
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