ALERUS FINANCIAL CORPORATION The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the "Selected Financial Data" and our audited consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, this discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under "Cautionary Note Regarding ForwardLooking Statements," "Risk Factors" and elsewhere in this report, may cause actual results to differ materially from those projected in the forwardlooking statements. We assume no obligation to update any of these forwardlooking statements.
Overview
We are a diversified financial services company headquartered inGrand Forks, North Dakota . Through our subsidiary,Alerus Financial , National Association, we provide innovative and comprehensive financial solutions to businesses and consumers through four distinct business lines-banking, retirement and benefit services, wealth management and mortgage. These solutions are delivered through a relationshiporiented primary point of contact along with responsive and clientfriendly technology. Our primary banking market areas are the states ofNorth Dakota ,Minnesota , specifically, the Twin Cities MSA, andArizona , specifically, the Phoenix MSA. In addition to our offices located in our banking markets, our retirement and benefit services business administers plans in all 50 states through offices located inMichigan ,Minnesota andNew Hampshire . Our business model produces strong financial performance and a diversified revenue stream, which has helped us establish a brand and culture yielding both a loyal client base and passionate and dedicated employees. We believe our clientfirst and advicebased philosophy, diversified business model and history of high performance and growth distinguishes us from other financial service providers. We generate a majority of our overall revenue from noninterest income, which is driven primarily by our retirement and benefit services, wealth management and mortgage business lines. The remainder of our revenue consists of net interest income, which we derive from offering our traditional banking products and services. As ofDecember 31, 2019 , we had$2.4 billion of total assets,$1.7 billion of total loans,$2.0 billion of total deposits,$285.7 million of stockholders' equity,$28.9 billion of AUA and$6.1 billion of AUM. For the year endedDecember 31, 2019 we had$946.4 million of mortgage originations.
Net Interest Income
Net interest income represents interest income less interest expense. We
generate interest income on interestearning assets, primarily loans and
availableforsale securities. We incur interest expense on interestbearing
liabilities, primarily interestbearing deposits and borrowings. To evaluate net
interest income, we measure and monitor: (i) yields on loans, availableforsale
securities and other interestearning assets; (ii) the costs of deposits and
other funding sources; (iii) the rates incurred on borrowings and other
interestbearing liabilities; and (iv) the regulatory risk weighting associated
with the assets. Interest income is primarily impacted by loan growth and loan
repayments, along with changes in interest rates on the loans. Interest expense
is primarily impacted by changes in deposit balances along with the volume and
type of interestbearing liabilities. Net interest income is primarily impacted
by changes in market interest rates, the slope of the yield curve, and interest
we earn on interestearning assets or pay on interestbearing liabilities.
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Noninterest Income
Noninterest income primarily consists of the following:
· Our retirement and benefit services business, which includes retirement plan
administration, retirement plan investment advisory, HSA, ESOP, payroll and
other benefit services, is our Company's largest source of noninterest income.
Over half of our retirement and benefit services fees are transaction or
participant based fees and are impacted by the number of plans and
participants. The remainder of noninterest income is based on the market value
of the related AUA and AUM and impacted by the level of contributions,
withdrawals, new business, lost business and fluctuation in market values.
· Wealth management includes personal trust, investment and brokerage services.
Our Company earns trust, investment, and IRA fees from managing assets,
including corporate trusts, personal trusts, and separately managed accounts.
Trust and investment management fees are primarily based on a tiered scale
relative to the market value of the AUM. Trust and investment management fees
are primarily impacted by rates charged and increases and decreases in AUM. AUM
is primarily impacted by opening and closing of client advisory and trust
accounts, contributions and withdrawals, and the fluctuation in market values.
· Mortgage noninterest income consists of gains on originating and selling
mortgages and origination fees. Mortgage gains are primarily impacted by the
level of originations, amount of loans sold, the type of loans sold and market
conditions.
· Service charges on deposit accounts are comprised of income generated through
deposit account related service charges such as: electronic transfer fees,
treasury management fees, bill pay fees, and other banking fees. Banking fees
are primarily impacted by the level of business activities and cash movement
activities of our clients.
· Other noninterest income consists of debit card interchange income, income
earned on the growth of the cash surrender value of life insurance policies we
hold on certain key employees, loan servicing income net of the related
amortization, and any other income which does not fit within one of the
specific noninterest income lines described above. Other noninterest income is
generally impacted by business activities and level of transactions.
Noninterest Expense
Noninterest expense is comprised primarily of the following:
· Compensation and employee taxes and benefits-include all forms of personnel
related expenses including salary, commissions, incentive compensation, payroll
related taxes, stockbased compensation, benefit plans, health insurance,
401(k) plan match costs, ESOP and other benefit related expenses. Compensation
and employee benefit costs are primarily impacted by changes in headcount and
fluctuations in benefits costs.
· Occupancy and equipment-costs related to owning and leasing our office space,
depreciation charges for the furniture, fixtures and equipment, amortization of
leasehold improvements, utilities and other occupancyrelated expenses.
Occupancy and equipment costs are primarily impacted by the number and size of
the locations we occupy.
· Business services, software and technology-costs related to contracts with core
system and thirdparty data processing providers, software and information
technology services to support office activities and internal networks. We
believe our technology spending enhances the efficiency of our employees and
enables us to provide outstanding service to our clients. Technology and
information system costs are
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primarily impacted by the number of locations we occupy, the number of employees, clients and volume of transactions we have and the level of service we require from our thirdparty technology vendors.
· Intangible amortization expense is the result of acquisitions of fee income and
banking companies. Identified intangible assets with definite lives consist of
client relationship intangibles and are amortized on a straightline basis over
the period representing the estimated remaining lives of the assets. The amount
of expense is impacted by the timing of acquisitions and the estimated
remaining lives of the assets.
· Professional fees and assessments-costs related to legal, accounting, tax,
consulting, personnel recruiting, directors fees, insurance and other
outsourcing arrangements. Professional services costs are primarily impacted by
corporate activities requiring specialized services.
also included in this line and represents the assessments that we pay to the
· Other operational expenses-includes costs related to marketing, donations,
promotions, and expenses associated with office supplies, postage, travel
expenses, meals and entertainment, dues and memberships, costs to maintain or
prepare other real estate owned, or OREO, for sale, and other general corporate
expenses that do not fit within one of the specific noninterest expense lines
described above. Other operational expenses are generally impacted by our
business activities and needs.
Operating Segments
We measure the overall profitability of business operations based on income
before income tax. We allocate costs to our segments, which consist primarily of
compensation and overhead expense directly attributable to the products and
services within banking, retirement and benefit services, wealth management, and
mortgage. We measure the profitability of each segment based on the direct
allocations of expense as we believe it better approximates the contribution
generated by our reportable operating segments. All indirect overhead
allocations and income tax expense is allocated to corporate administration. A
description of each segment is provided in Note 21 (Segment Reporting) of the
Company's audited consolidated financial statements included elsewhere in this
report.
Critical Accounting Policies
As a result of the complex and dynamic nature of our business, management must
exercise judgment in selecting and applying the most appropriate accounting
policies for its various areas of operations. The policy decision process not
only ensures compliance with current GAAP, but also reflects management's
discretion with regard to choosing the most suitable methodology for reporting
our financial performance. It is management's opinion that the accounting
estimates covering certain aspects of the business have more significance than
others due to the relative importance of those areas to overall performance, or
the level of subjectivity in the selection process. These estimates affect the
reported amounts of assets and liabilities as well as disclosures of revenues
and expenses during the reporting period. Actual results could differ from these
estimates. The most critical of the accounting policies are discussed below.
Investment securities-Investment securities can be classified as trading,
availableforsale, and equity. The appropriate classification is based
partially on our ability to hold the securities to maturity and largely on
management's intentions with respect to either holding or selling the
securities. The classification of investment securities is significant since it
directly impacts the accounting for unrealized gains and losses on securities.
Unrealized gains and losses on availableforsale securities are recorded in
accumulated other comprehensive income or loss, as a separate component of
stockholders' equity, and do not affect earnings until realized. The fair values
of investment securities are generally determined by reference to quoted market
prices, where available. If quoted market prices are not available, fair values
are based on quoted market prices of comparable instruments, or a discounted
cash flow model using market estimates of interest rates and volatility.
Investment securities with significant declines in fair value are evaluated to
determine whether they should be considered otherthantemporarily impaired. An
unrealized loss is generally deemed to be otherthantemporary and a credit loss
is deemed to exist if the present value of the expected future cash flows is
less than the amortized cost basis of the debt security. The credit loss
component of an otherthantemporary impairment writedown is recorded in
current earnings, while the remaining portion of the impairment loss is
recognized in other
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comprehensive income (loss), provided we do not intend to sell the underlying
debt security, and it is not likely that we will be required to sell the debt
security prior to recovery of the full value of its amortized cost basis.
Allowance for loan losses-The allowance for loan losses reflects management's
best estimate of probable loan losses in our loan portfolio. Determination of
the allowance for loan losses is inherently subjective. It requires significant
estimates, including the amounts and timing of expected future cash flows on
impaired loans, appraisal values of underlying collateral for collateralized
loans, and the amount of estimated losses on pools of homogeneous loans which is
based on historical loss experience, expected duration and consideration of
current economic trends, all of which may be susceptible to significant change.
Intangible assets-As a result of acquisitions, we carry goodwill and
identifiable intangible assets. Goodwill represents the cost of acquired
companies in excess of the fair value of net assets at the acquisition date.
Goodwill is evaluated at least annually or when business conditions suggest
impairment may have occurred. Should impairment occur, goodwill will be reduced
to its revised carrying value through a charge to earnings. Core deposits and
other identifiable intangible assets are amortized to expense over their
estimated useful lives. The determination of whether or not impairment exists is
based upon discounted cash flow modeling techniques that require management to
make estimates regarding the amount and timing of expected future cash flows. It
also requires them to select a discount rate that reflects the current return
requirements of the market in relation to present riskfree interest rates,
required equity market premiums, and companyspecific performance and risk
metrics, all of which are susceptible to change based on changes in economic and
market conditions and other factors. Future events or changes in the estimates
used to determine the carrying value of goodwill and identifiable intangible
assets could have a material impact on our results of operations.
Income taxes-Income tax expense or benefit is the total of the current year
income tax due or refundable and the change in deferred tax assets and
liabilities. Deferred tax assets and liabilities are the expected future tax
amounts for the temporary differences between carrying amounts and tax bases of
assets and liabilities, computed using enacted tax rates. A valuation allowance,
if needed, reduces deferred tax assets to the amount expected to be realized. A
tax position is recognized as a benefit only if it is "more likely than not"
that the tax position would be sustained in a tax examination, with a tax
examination being presumed to occur. The amount recognized is the largest amount
of tax benefit that is greater than 50% likely of being realized on examination.
For tax positions not meeting the "more likely than not" test, no tax benefit is
recorded. Interest and penalties related to income tax matters are recognized in
income tax expense.
On December 22, 2017 , the U.S government enacted Public Law 115-97, commonly
known as, the Tax Cuts and Jobs Act, a comprehensive tax legislation, which
reduced the federal income tax rate for C corporations from 35% to 21%,
effective January 1, 2018 . As a result of the reduction in the U.S corporate
income tax rate from 35% to 21%, we remeasured our deferred tax assets and
recognized $4.8 million of tax expense in the Consolidated Statement of Income
for the year ended December 31, 2017 . See Note 20 (Income Taxes) of the
Company's audited consolidated financial statements included elsewhere in this
report.
Fair value measurements-Fair value is the price that would be received to sell
an asset, or paid to transfer a liability, in the principal or most advantageous
market for an asset or liability in an orderly transaction between market
participants at the measurement date. The degree of management judgment involved
in determining the fair value of a financial instrument is dependent upon the
availability of quoted market prices, or observable market inputs. For financial
instruments that are traded actively and have quoted market prices or observable
market inputs, there is minimal subjectivity involved in measuring fair value.
However, when quoted market prices or observable market inputs are not fully
available, significant management judgement may be necessary to estimate fair
value. In developing our fair value measurements, we maximize the use of
observable inputs and minimize the use of unobservable inputs.
Financial assets that are recorded at fair value on a recurring basis include
investment securities and derivative financial instruments. As of December 31,
2019 and 2018, $314.8 million or 13.4% and $253.4 million or 11.6%,
respectively, of our total assets consisted of financial assets recorded at fair
value on a recurring basis and most of these financial assets consisted of
available-for-sale investment securities. The fair value of financial assets on
a recurring basis are classified in either Levels 1 or 2 of the fair value
hierarchy. Financial liabilities that are recorded at fair value
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on a recurring basis are comprised of derivative financial instruments. As ofDecember 31, 2019 and 2018,$109 thousand and$7 thousand , respectively represented less than 1% of our total liabilities in those years and were classified as Level 2 of the fair value hierarchy. We have no fair value assets or liabilities classified in Level 3 of the fair value hierarchy. A further discussion regarding the fair value of assets and liabilities, and the classification of Level 1, 2, and 3 hierarchies, is disclosed in Note 26 (Fair Value of Assets and Liabilities) of the Company's audited consolidated financial statements included elsewhere in this report.
A summary of the accounting policies used by management is disclosed in Note 1 (Significant Accounting Policies) of the Company's audited consolidated financial statements included elsewhere in this report.
Results of Operations
Summary
Net income for the year endedDecember 31, 2019 was$29.5 million , an increase of$3.7 million , or 14.2%, compared to$25.9 million for the year endedDecember 31, 2018 . Diluted earnings per common share was$1.91 in 2019, compared to$1.84 for 2018. Return on average total assets was 1.34% in 2019, compared to 1.21% for 2018. The increase in net income was primarily due to an increase of$11.4 million in noninterest income primarily due to an increase in mortgage banking revenue. We also had a$1.3 million decrease in provision for loan losses due to the improved credit quality of our loan portfolio. These improvements were partially offset by a$6.2 million , or 4.6%, increase in noninterest expense driven by a$4.6 million increase in compensation,$1.9 million in business services, software and technology expense, and$1.6 million in employee taxes and benefits. Net income for the year endedDecember 31, 2018 was$25.9 million , an increase of$10.9 million , or 72.4%, compared to$15.0 million for the year endedDecember 31, 2017 . Diluted earnings per common share was$1.84 in 2018, compared to$1.07 for 2017. Return on average total assets was 1.21% in 2018, compared to 0.75% for 2017. The increase in net income was primarily driven by a$10.3 million decrease in income taxes, as a result of the impact from the Tax Cuts and Jobs Act. Other contributing factors included a$7.6 million increase in net interest income offset by increases of$5.3 million in provision for loan losses and$1.4 million in noninterest expense.
Net Interest Income-With Nontaxable Income Converted to Fully Taxable Equivalent, or FTE
Net interest income totaled$74.9 million in 2019, a decrease of$788 thousand , or 1.04%, from 2018. Net interest margin decreased 19 basis points to 3.65%, in 2019, from the 3.84% reported in 2018. The decreases were primarily a result of a$42.7 million , or 3.1%, increase in average interestbearing liabilities and a 41 basis point increase in the average rate paid on interestbearing liabilities, partially offset by a$29.1 million , or 1.7%, increase in average total loans and an 8 basis point increase in the average yield on interest earning assets. Net interest income totaled$75.7 million in 2018, an increase of$7.2 million , or 10.4%, from 2017. Net interest margin increased 10 basis points to 3.84% from the 3.74% reported in 2017. The increases were attributable to a$137.0 million , or 7.5% increase in average earning assets and a 31 basis point increase in the earningasset yield, partially offset by a$77.1 million increase in average interest-bearing liabilities and a 29 basis point increase in the cost of interestbearing liabilities. The following table sets forth information related to our average balance sheet, average yields on assets, and average rates of liabilities for the periods indicated. We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. Average loan balances include loans that have been placed on nonaccrual, while 63
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interest previously accrued on these loans is reversed against interest income.
In these tables, adjustments are made to the yields on taxexempt assets in
order to present taxexempt income and fully taxable income on a comparable
basis.
Year ended December 31,
2019 2018 2017
Interest Average Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
(dollars in thousands) Balance Expense Rate Balance Expense Rate Balance Expense Rate
Interest Earning Assets
Interest-bearing deposits with
banks $ 34,876 $ 656 1.88 % $ 8,336 $ 166 1.99 % 39,045 $ 379 0.97 %
Investment securities (3) 266,204 6,586 2.47 % 255,247 6,232 2.44 % 286,313 6,858 2.40 %
Loans held for sale 36,035 1,138 3.16 % 19,255 607 3.15 % 23,887 609 2.55 %
Loans
Commercial:
Commercial and industrial 500,652 27,288 5.45 % 483,182 25,019 5.18 % 449,901 21,449 4.77 %
Real estate construction 23,625 1,287 5.45 % 39,024 2,161 5.54 % 44,492 2,243 5.04 %
Commercial real estate 448,869 22,237 4.95 % 475,778 22,853 4.80 % 464,688 21,667 4.66 %
Total commercial 973,146 50,812 5.22 % 997,984 50,033 5.01 % 959,081 45,359 4.73 %
Consumer
Residential real estate first
mortgage 455,635 19,257 4.23 % 400,458 16,420 4.10 % 243,655 10,464 4.29 % Residential real estate junior lien
184,972 10,422 5.63 % 190,838 10,305 5.40 % 188,420 9,026 4.79 % Other revolving and installment 93,226 4,336 4.65 %
88,605 3,929 4.43 % 83,886 3,476 4.14 % Total consumer 733,833 34,015 4.64 % 679,901 30,654 4.51 % 515,961 22,966 4.45 % Total loans (1) (3) 1,706,979 84,827 4.97 %
1,677,885 80,687 4.81 % 1,475,042 68,325 4.63 %
8,664 440 5.08 % 9,281 473 5.10 % 8,715 331 3.80 %
Total interest earning assets 2,052,758 93,647 4.56 % 1,970,004 88,165 4.48 % 1,833,002 76,502 4.17 %
Noninterest earning assets 159,235 159,402 168,501
Total assets $ 2,211,993 $ 2,129,406 $ 2,001,503
Interest-Bearing Liabilities
Interest-bearing demand
deposits (2) $ 428,162 $ 1,995 0.47 % $ 405,512 $ 1,034 0.25 % $ 336,876 $ 408 0.12 %
Money market and savings
deposits (2) 681,621 8,320 1.22 % 626,041 3,950 0.63 % 619,687 1,627 0.26 %
Time deposits (2) 186,781 3,019 1.62 % 206,846 2,008 0.97 % 219,164 1,485 0.68 %
Short-term borrowings 71,421 1,805 2.53 % 86,851 1,896 2.18 % 72,445 943 1.30 %
Long-term debt 58,789 3,610 6.14 % 58,813 3,591 6.11 % 58,803 3,504 5.96 %
Total interest-bearing
liabilities 1,426,774 18,749 1.31 % 1,384,063 12,479 0.90 % 1,306,975 7,967 0.61 %
Noninterest-Bearing Liabilities
and Stockholders' Equity
Noninterest-bearing deposits
(2) 512,586 528,552 488,295
Other noninterest-bearing
liabilities 41,549 29,450 29,454
Stockholders' equity 231,084 187,341 176,779
Total liabilities and
stockholders' equity $ 2,211,993 $ 2,129,406 $ 2,001,503
Net interest income $ 74,898 $ 75,686 $ 68,535
Net interest rate spread 3.25 % 3.58 % 3.56 %
Net interest rate margin (3) 3.65 % 3.84 % 3.74 %
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(1) Includes loans held for sale. (2) Includes deposits held for sale.
(3) Fully taxequivalent adjustment was calculated utilizing a marginal income
tax rate of 21.0 percent and 35.0 percent for years prior to 2018.
(4) Average balances have been reclassed from noninterest earning assets.
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Rate/Volume Analysis
The table below presents the effect of volume and rate changes on interest
income and expense for the periods indicated. Changes in volume are changes in
the average balance multiplied by the previous year's average rate. Changes in
rate are changes in the average rate multiplied by the average balance from the
previous year. The net changes attributable to the combined impact of both rate
and volume have been allocated proportionately to the changes due to volume and
the changes due to rate.
Year ended December 31, 2019 Year ended December 31, 2018
Compared with Compared with
Year ended December 31, 2018 Year ended December 31, 2017
Change due to: Interest Change due to: Interest
(tax-equivalent basis,
dollars in thousands) Volume Rate Variance Volume Rate Variance
Interest earning assets
Interest-bearing deposits
with banks $ 528 $ (38) $ 490 $ (298) $ 85 $ (213)
Investment securities 267 87 354 (746) 120 (626)
Loans held for sale 529 2 531 (118) 116 (2)
Loans
Commercial:
Commercial and industrial 905 1,364 2,269 1,587 1,983 3,570
Real estate construction (853) (21) (874) (276) 194 (82)
Commercial real estate (1,292) 676 (616) 517 669 1,186
Total commercial (1,240) 2,019 779 1,828 2,846 4,674
Consumer
Residential real estate first
mortgage 2,262 575 2,837 6,734 (778) 5,956
Residential real estate
junior lien (317) 434 117 116 1,163 1,279
Other revolving and
installment 205 202 407 196 257 453
Total consumer 2,150 1,211 3,361 7,046 642 7,688
Total loans (1) 910 3,230 4,140 8,874 3,488 12,362
Federal Reserve/FHLB Stock (31) (2) (33) 22 120 142
Total interest income 2,203 3,279 5,482 7,734 3,929 11,663
Interest-bearing liabilities
Interest-bearing demand
deposits (2) 57 904 961 83 543 626
Money market and savings
deposits (2) 350 4,020 4,370 17 2,306 2,323
Time deposits (2) (195) 1,206 1,011 (83) 606 523
Short-term borrowings (336) 245 (91) 188 765 953
Long-term debt (1) 20 19 1 86 87
Total interest expense (125) 6,395 6,270 206 4,306 4,512
Change in net interest income $ 2,328 $ (3,116) $ (788) 7,528
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(1) Includes loans held for sale. (2) Includes deposits held for sale.
Provision for Loan Losses
The provision for loan losses was$7.3 million for the year endedDecember 31, 2019 , compared to$8.6 million for the year endedDecember 31, 2018 . The provision in 2019 was primarily due to$5.6 million of net charge-offs,$1.8 million more provision for pass rated credits, due to loan growth,$1.4 million more provision for specific reserves on impaired loans, and$1.7 million less provision related to the decrease in criticized loan balances. The provision for loan losses was$8.6 million for the year endedDecember 31, 2018 , compared to$3.3 million for the year endedDecember 31, 2017 . The increase of$5.3 million in provision for loan losses in 2018 was primarily due to$3.3 million more provision related to the increase in criticized loan balances,$0.9 million more provision for specific reserves on impaired loans,$0.7 million more provision for net chargeoffs, and$0.4 million for pass rated credits due to loan growth. The provision for loan losses on offbalance sheet items, a component of "other expense" in our Consolidated Statements of Income, reflects management's assessment of the adequacy of the allowance for loan losses on lendingrelated commitments. See "Financial Condition-Allowance for Loan Losses." 65 Table of Contents Noninterest Income The following table presents noninterest income for the years endedDecember 31, 2019 , 2018, and 2017. Year ended December 31, (dollars in thousands) 2019 2018 $ Change
% Change 2018 2017 $ Change % Change
Retirement and benefit services
0.8 % $ 63,316 $ 62,390 $ 926 1.5 %
Wealth management 15,502 14,900 602 4.0 % 14,900 13,953 947 6.8 %
Mortgage banking 25,805 17,630 8,17546.4 % 17,630 19,748 (2,118) (10.7) % Service charges on deposit accounts 1,772 1,808 (36)
(2.0) % 1,808 1,854 (46) (2.5) %
Net gains (losses) on investment
securities 357 85 272 320.0 % 85 (13) 98 (753.8) %
Other 6,947 5,010 1,937 38.7 % 5,010 5,113 (103) (2.0) %
Total noninterest income $ 114,194 $ 102,749 $ 11,445
11.1 %
57.7 % 60.4 %
Total noninterest income increased by $11.4 million , or 11.1%, to $114.2 million
in 2019 as compared to 2018. The increase in noninterest income was primarily
due to an $8.2 million increase in mortgage banking as a result of higher
mortgage originations and a transition from best efforts to mandatory delivery.
Mortgage originations for 2019 were $946.4 million , a $166.7 million , or 21.4%
increase from 2018. In addition, other noninterest income increased $1.9 million
compared to 2018, due to a $1.5 million gain on the sale of our Duluth, MN
branch and a $542 thousand gain on the sale of a parcel of land in Grand Forks,
ND .
Total noninterest income decreased by $296 thousand , or 0.3%, to $102.7 million
in 2018 as compared to 2017. Retirement and benefit services for 2018 was
$63.3 million , an increase of $926 thousand , or 1.5%, from the prior year, due
to the combination of expanded business activities from an acquisition of
Alliance Benefit Group North Central States, Inc. , or ABGNCS, in 2016 and new
client generation. Wealth management for 2018 was $14.9 million , an increase of
$947 thousand from the prior year. The increase was due to organic growth and
through leveraging synergies by retaining terminated retirement and benefit
services participants. Mortgage banking for 2018 was $17.6 million , a decrease
of $2.1 million or 10.7% from the prior year level. The decrease was primarily
driven by a corresponding decrease in origination volume. Mortgage originations
for 2018 of $779.7 million decreased $87.3 million or 10.1% as a result of
higher home mortgage rates throughout the year.
Noninterest income as a percent of total operating revenue, which consists of
net interest income plus noninterest income, was 60.5% in 2019, up from 57.7%
the prior year. The increase in 2019 was due to an 11.1% increase in noninterest
income, while net interest income decreased 0.9%. This ratio decreased from
60.4% in 2017 to 57.7% in 2018, due to net interest income increasing by 11.2%,
while noninterest income decreased by 0.3%.
Noninterest Expense
The following table presents noninterest expense for the years ended
Year ended December 31,
(dollars in thousands) 2019 2018 $ Change % Change 2018 2017 $ Change % Change
Compensation $ 74,018 $ 69,403 $
4,615 6.6 %
19,456 17,866 1,590 8.9 % 17,866 16,490 1,376 8.3 % Occupancy and equipment expense
10,751 11,086 (335) (3.0) % 11,086 10,892 194 1.8 % Business services, software and technology expense
16,381 14,525 1,856 12.8 % 14,525 12,976 1,549 11.9 % Intangible amortization expense
4,081 4,638 (557) (12.0) % 4,638 5,623 (985) (17.5) % Professional fees and assessments
4,011 5,098 (1,087) (21.3) % 5,098 6,158 (1,060) (17.2) % Marketing and business development
3,162 3,459 (297) (8.6) % 3,459 3,271 188 5.7 %
Supplies and postage 2,722 2,737 (15) (0.5) % 2,737 2,609 128 4.9 %
Travel 1,787 1,738 49 2.8 % 1,738 1,530 208 13.6 % Mortgage and lending expenses
2,853 2,153 700 32.5 % 2,153 2,235 (82) (3.7) % Other
3,315 3,622 (307) (8.5) % 3,622 5,560 (1,938) (34.9) % Total noninterest expense
$ 142,537 $ 136,325 $ 6,212 4.6 %$ 136,325 $ 134,920 $ 1,405 1.0 % 66 Table of Contents Total noninterest expense increased$6.2 million , or 4.6%, to$142.5 million for the year endedDecember 31, 2019 , from$136.3 million for 2018. The increase in noninterest expense was primarily due to increases of$4.6 million in compensation,$1.6 million in employee taxes and benefits,$1.9 million in business services, software and technology expense, and$700 thousand in mortgage and lending expenses. These increases were partially offset by decreases of$1.1 million in professional fees and assessments, and$557 in intangible amortization expense. The increase in compensation expense was primarily driven by increased incentives related to mortgage banking due to higher mortgage originations, in addition to usual cost of living adjustments. The increase in employee taxes and benefits was primarily due to the corresponding increase in compensation along with a$448 thousand increase in cost of group insurance. The increase in business services, software and technology expense was due to continued investments in digital delivery solutions for our clients along with the full implementation of our new client relationship management software. The increase in mortgage and lending expenses was directly related to the increase mortgage originations. The decrease in professional fees and assessments was due to a$671 thousand decrease in consulting related expenses and a$490 thousand decrease in regulatory assessments primarily due to small bank assessments credits applied against our quarterlyFDIC assessments. The decrease in intangible amortization expense is normal runoff of intangible assets and core deposit premiums from past acquisitions. Total noninterest expense increased$1.4 million , or 1.0%, to$136.3 million for the year endedDecember 31, 2018 , from$134.9 million for 2017. The increase in noninterest expense was primarily due to an increase in compensation of$1.8 million resulting from the addition of 38 fulltime equivalent employees in 2018. Employee taxes benefits and taxes increased$1.4 million due in part to the increased number of employees and an increase in group insurance of$690 thousand . Business services, software, and technology expense increased$1.5 million as our Company invested in a new client relationship manager software and digital delivery of solutions to clients. Amortization expense decreased$1.0 million to$4.6 million as a result of past acquisitions being fully amortized during the year. Professional fees and assessments decreased$1.1 million due to legal expenses in 2017 related to litigation and a settlement of the related litigation of$330 thousand received in 2018. Other noninterest expense decreased$1.9 million during 2018 due to expense accruals of$450.0 thousand in 2017 for litigation, which were reversed in 2018. In addition, the trueup liability for the loans covered under the loss share agreement with theFDIC was$3.2 million in 2017 and in 2018 the loss share agreement was terminated for$220 thousand less than the amount recorded as payable to theFDIC . Finally, there was$520 thousand of branch closure expenses recognized in 2017 and no expenses related to branch closures in 2018.
Income Taxes
For the year endedDecember 31, 2019 , we recognized income tax expense of$9.4 million on$38.9 million of pretax income resulting in an effective tax rate of 24.1%, compared to the same period in 2018, in which we recognized an income tax expense of$7.2 million on$33.0 million of pretax income, resulting in an effective tax rate of 21.7%. The increase in the effective tax rate was primarily due to a reduction in excess tax benefits from stockbased compensation and a reduction in tax exempt interest income from investment securities. For the year endedDecember 31, 2018 , we recognized income tax expense of$7.2 million on$33.0 million of pretax income resulting in an effective tax rate of 21.7%, compared to the same period in 2017, in which we recognized an income tax expense of$17.5 million on$32.5 million of pretax income, resulting in an effective tax rate of 53.9%. The increase in the effective rate for 2017 was primarily attributable to onetime expenses from the revaluation of net deferred tax assets related to the enactment of the Tax Cuts and Jobs Act in addition to a$1.4 million impairment of deferred tax assets related to loans acquired in 2014 that we were unable to recognize certain tax benefits. OnDecember 22, 2017 , the Tax Cuts and Jobs Act was signed into law. Among other things, the Tax Cuts and Jobs Act lowered the corporate tax rate to 21% from the existing maximum rate of 35.0%, effective for tax years including or commencingJanuary 1, 2018 . ASC 740, Income Taxes, requires existing deferred tax assets and liabilities to be measured at the enacted tax rate expected to be applied when the temporary differences are to be realized or settled. Thus, as of the date of enactment, deferred taxes were remeasured based upon the new 21% tax rate. The change in tax rate resulted in a deferred tax expense of$4.8 million from the writedown of the net deferred tax assets. The effect of this change in tax law was recorded as a component of the income tax provision including those deferred assets and liabilities that were established through a financial statement component other than continuing operations. 67 Table of Contents Segment Reporting We determine reportable segments based on the significance of the services offered, the significance of those services to our financial condition and operating results, and our regular review of the operating results of those services. We have four operating segments-banking, retirement and benefit services, wealth management, and mortgage. These segments are components for which financial information is prepared and evaluated regularly by management in deciding how to allocate resources and assess performance. The selected financial information presented for each segment sets forth net interest income, provision for loan losses, noninterest income, and direct noninterest expense before indirect overhead allocations. Corporate administration includes the indirect overhead and is set forth in the table below along with income tax expense and the consolidated net income. The segment net income before taxes represents direct revenue and expense before indirect allocations and income taxes. Certain reclassification adjustments have been made between corporate administration and the various lines of business for consistency in presentation.
For additional financial information on our segments see Note 21 (Segment Reporting) of the Company's audited consolidated financial statements included elsewhere in this report.
Banking
The banking segment offers a complete line of loan, deposit, cash management,
and treasury services through 15 offices in
The banking segment reported net income before taxes and indirect allocations of$33.4 million for the year endedDecember 31, 2019 , a decrease of$233 thousand compared to 2018. The decrease was driven primarily by a decrease of$1.0 million in net interest income partially offset by a decrease in provision for loan losses of$1.3 million . Net interest income decreased$1.0 million as average deposits increased$42.2 million while average loans only increased$29.1 million . Noninterest expense increased 1.3%, or$566 thousand in 2019 compared to 2018, primarily due to the$479 thousand increase in intercompany expense which was allocated to the mortgage segment for the residential real estate loans delivered to the Bank's balance sheet. The banking segment reported net income before taxes and indirect allocations of$33.6 million for 2018, a decrease of$4.6 million compared to the prior period due to a$5.3 million increase in provision expense. Net interest income increased$7.5 million as average loans grew$202.8 million from$1.5 billion to$1.7 billion and average deposits increased$102.9 million from$1.7 billion to$1.8 billion during the period. Noninterest expense rose 18.4% or$6.6 million in 2018 compared to 2017, primarily due to the intercompany expense of$6.3 million which was allocated to the mortgage and retirement and benefit services segments for the residential real estate loans and deposit balances delivered to the Bank's balance sheet.
Retirement and Benefit Services
Retirement and benefit services provides the following services nationally: recordkeeping and administration services to qualified retirement plans; ESOP trustee, recordkeeping and administration; investment fiduciary services to retirement plans; HSA, flex spending account, and government health insurance program recordkeeping and administration services to employers; payroll and human resource information system services for employers. The division services approximately 6,700 retirement plans and more than 355,000 plan participants. In addition, the division employs nearly 300 professionals, and operates within our banking markets as well asAlbert Lea, Minnesota ,Lansing, Michigan ,Manchester, New Hampshire and 13 satellite offices. The retirement and benefit services segment reported net income before taxes and indirect allocations of$28.4 million for the year endedDecember 31, 2019 , an increase of$1.5 million from the$26.9 million for 2018. Revenue of$63.8 million , comprised of$28.9 million in asset based revenue and$34.9 million in participant and transaction revenues, increased$495 thousand or 0.8% primarily due to an increase in participant and transaction based revenue of 68
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$2.0 million or 6.0%, partially offset by a decrease in asset based revenue of$1.5 million or 4.9%. The decline in the asset based revenue was the result of fee compression and an ongoing shift from asset based fees to participant and transaction based fees. Noninterest expense declined$1.0 million or 2.8% due to the reduction in allocation expense of$1.8 million , as the division was credited for sourcing deposits which are being held on the banking division's balance sheet, partially offset by an$886 thousand increase in compensation and$375 thousand in employee benefit expenses. The retirement and benefit services segment reported net income before taxes and indirect allocations of$26.9 million for 2018, an increase of$6.5 million from the$20.4 million of net income before taxes and indirect allocations earned in 2017. Revenue of$63.3 million included$30.4 million of asset based revenue and$32.9 million of participant and transaction revenues, and increased$926 thousand or 1.5% due to a$1.2 million decline in asset based revenues and$2.1 million increase in participant and transaction revenues. The shifts in revenue are the result of fee compression and an ongoing shift from asset based fees to participant and transaction based fees. Noninterest expense declined$5.6 million or 13.3%. The reduction in expense was due to a$3.2 million decline in allocation expense as the division is credited for sourcing deposits which are being held on the banking division's balance sheet. Personnel related expenses also decreased by$1.4 million and intangible amortization expense decreased by$1.0 million . The following table presents changes in the combined assets under administration and asset under management for our retirement and benefit services segment for the periods presented. Year ended December 31, (dollars in thousands) 2019 2018 2017 AUA & AUM balance beginning of period$ 27,812,149 $ 29,366,365 $ 26,111,299 Inflows (1) 5,009,789 4,637,646 4,816,574 Outflows (2) (5,406,667) (4,981,204) (4,822,892) Market impact (3) 4,489,377 (1,210,658) 3,261,384 AUA & AUM balance end of period$ 31,904,648 $ 27,812,149 $ 29,366,365 Yield (4) 0.21 % 0.22 % 0.22 %
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(1) Inflows include new account assets, contributions, dividends and interest.
(2) Outflows include closed account assets, withdrawals and client fees. (3) Market impact reflects gains and losses on portfolio investments.
(4) Retirement and benefit services noninterest income divided by simple average
ending balances.
AUA and AUM for the retirement and benefit services segment were
AUA and AUM were$27.8 billion atDecember 31, 2018 , a decrease of$1.6 billion compared to the total atDecember 31, 2017 . The decrease was the result of a$1.2 billion decline related to the market impact and a$343.6 million decrease due to outflows exceeding inflows for the twelve months endedDecember 31, 2018 .
Wealth Management
The wealth management division provides advisory and planning services, investment management, and trust and fiduciary services to clients across our Company's footprint.
Wealth management reported net income before taxes and indirect allocations of$8.3 million for the year endedDecember 31, 2019 , an increase of$176 thousand from 2018. Noninterest income increased$602 thousand or 4.0% as compared to 2018, primarily due to an increase in combined assets under administration and assets under management partially offset by a 3 basis points reduction in yield. Wealth management noninterest expense of$7.2 million increased$364 thousand or 5.3% from 2018 primarily due to an increase in compensation expense. 69
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Wealth management reported net income before taxes and indirect allocations of$8.1 million for the year endedDecember 31, 2018 , an increase of$1.8 million from 2017.Wealth management noninterest income for 2018 was$14.9 million , an increase of$947 thousand from the prior year. The increase was due to the additional clients generated by both organic growth and through leveraging synergies of retirement and benefit services. Wealth management noninterest expense of$6.8 million decreased$816 thousand from 2017 primarily due to intercompany allocations. The following table presents changes in the wealth management combined assets under administration and assets under management, disaggregated by product, for the periods presented. Year ended December 31, (dollars in thousands) 2019 2018 2017 Dimension balance beginning of period$ 1,276,905 $ 1,369,580 $ 1,148,464 Inflows (1) 545,606 218,171 520,283 Outflows (2) (329,974) (199,187) (422,156) Market impact (3) 159,917 (111,659) 122,989 Dimension balance end of period$ 1,652,454 $ 1,276,905 $ 1,369,580 Yield (4)(6) 0.54 % 0.57 % 0.55 % Blue Print balance beginning of period$ 348,605 $ 334,648 $ 260,374 Inflows (1) 117,846 104,643 85,492 Outflows (2) (58,832) (55,938) (42,325) Market impact (3) 62,318 (34,748) 31,107 Blue Print balance end of period$ 469,937 $ 348,605 $ 334,648 Yield (4)(6) 0.98 % 1.04 % 1.03 % Trust balance beginning of period$ 226,305 $ 222,738 $ 215,154 Inflows (1) 200,766 251,327 216,880 Outflows (2) (187,648) (297,514) (174,838) Market impact (3) 51,254 49,754 (34,458) Trust balance end of period$ 290,677 $ 226,305 $ 222,738 Yield (4)(6) 0.60 % 0.65 % 0.73 % Total Wealth Management balance beginning of period$ 1,851,815 $ 1,926,966 $ 1,623,992 Inflows (1) 864,218 574,141 822,655 Outflows (2) (576,454) (552,639) (639,319) Market impact (3) 273,489 (96,653) 119,638 Total Wealth Management balance end of period (5)$ 2,413,068 $ 1,851,815 $ 1,926,966 Yield (4)(6) 0.63 % 0.66 % 0.66 %
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(1) Inflows include new account assets, contributions, dividends and interest.
(2) Outflows include closed account assets, withdrawals and client fees.
(3) Market impact reflects gains and losses on portfolio investments.
(4) Wealth management noninterest income divided by simple average ending
balances.
(5) Total wealth management does not include brokerage assets of
2018 and 2017, respectively.
(6) Yield does not include brokerage revenue of
respectively.
AUM for the wealth management segment was$2.4 billion , excluding$690.0 million of brokerage assets, atDecember 31, 2019 , an increase of$561.3 million compared to the total atDecember 31, 2018 . The increase was driven by an increase of$273.5 million related to the market impact, in addition to inflows exceeding outflows by$287.8 million .
AUM was
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to the market impact and partially offset by a
Mortgage
The mortgage division offers first and second mortgage loans through a
centralized mortgage unit in
Mortgage reported net income before taxes and indirect allocations of$5.2 million for the year endedDecember 31, 2019 , an increase of$3.9 million from the$1.3 million reported in 2018. Mortgage noninterest income for 2019 of$25.8 million increased$8.2 million , or 46.4%, from the same period in 2018. The increase was primarily driven by an increase in mortgage originations and the transitions to mandatory delivery of mortgages into the secondary market. Mortgage originations for the year endedDecember 31, 2019 were$946.4 million , an increase of$166.7 million or 21.4%, from 2018. The increase in noninterest income was partially offset by an increase of$4.7 million in noninterest expense, primarily due to increased incentive compensation directly related to the increase in mortgage originations. Mortgage reported net income before taxes and indirect allocation of$1.3 million for the year endedDecember 31, 2018 , a decrease of$1.8 million from the$3.0 million reported in 2017. Mortgage noninterest income for 2018 of$17.6 million decreased$2.1 million or 10.7% from the prior year level. The decrease was primarily driven by a corresponding decrease in origination volume. Mortgage originations for 2018 of$779.7 million decreased$87.3 million or 10.1% year over year. Mortgage noninterest expense for 2018 decreased$249 thousand or 1.4% from the prior year. The decrease consisted of lower incentive compensation and various lending expenses correlated to the decline in origination volume offset by additional investments in talent and technology. Financial Condition Overview Total assets were$2.4 billion atDecember 31, 2019 , an increase of$177.8 million compared to$2.2 billion atDecember 31, 2018 . The increase in total assets was primarily due to increases of$103.4 million in cash and cash equivalents,$60.2 million in available-for-sale investment securities,$32.4 million in loans held for sale, and$19.4 million in loans, offset by a reduction in loans held for branch sale of$32.0 million . In addition, we recognized an operating lease rightofuse asset which totaled$8.3 million atDecember 31, 2019 . The increase in loans held for sale was primarily due to higher loan originations. The increase in loans was primarily driven by growth in our commercial real estate and commercial and industrial portfolios. The increase in securities availableforsale was a result of management's decision to extend the duration while increasing the portfolio yield and harvesting gains on lower yielding and shorter duration securities. The increase in cash and cash equivalents was primarily due to an increase in cash balances held with theFederal Reserve Bank . We maintain a cash balance at theFederal Reserve and manage this liquidity balance on a daily basis as required, and may have significant cash balance fluctuations in the ordinary course of business based on inflows and outflows from changing loan totals, investment activity, and deposit flows. Total assets were$2.2 billion atDecember 31, 2018 , an increase of$43.0 million compared to$2.1 billion atDecember 31, 2017 . The increase was primarily due to an increase of$127.4 million in total loans, offset by an increase of$5.6 million in the allowance for loan losses, partially offset by a decrease of$81.3 million in cash and due from banks, a$16.8 million decrease in securities availableforsale, and a$4.6 million decrease in other intangible assets. The increase in loans was primarily driven by growth in the residential mortgage portfolio of$92.9 million as well as an increase of$30.1 million in the commercial and industrial portfolio. The decrease in cash and due from banks and securities availableforsale reflects management's decision to invest in higher yielding assets. 71 Table of ContentsInvestment Securities
The following table presents the fair value of our investment securities portfolio for the periods indicated:
December 31, 2019 December 31, 2018 December 31, 2017
Percent of Percent of Percent of
(dollars in thousands) Balance Portfolio Balance Portfolio Balance Portfolio
Trading $ - - % $ 1,539 0.6 % $ 1,945 0.7 %
Available-for-sale
U.S. Treasury and agencies 21,240 6.8 % 19,142 7.5 % 18,944 6.9 %
Obligations of state and
political agencies 68,648 21.9 % 66,387 26.0 % 74,475 27.1 %
Mortgage backed securities
Residential Agency 182,538 58.3 % 126,998 49.9 % 148,630 54.2 %
Commercial 30,685 9.8 % 28,767 11.3 % 14,211 5.2 %
Asset backed securities 144 - % 399 0.2 % 541 0.2 %
Corporate bonds 7,095 2.3 % 8,481 3.3 % 10,220 3.7 %
Total available-for-sale 310,350 99.1 % 250,174 98.2 % 267,021 97.3 %
Equity 2,808 0.9 % 3,165 1.2 % 5,445 2.0 %
Total investment securities $ 313,158 100.0 % $ 254,878 100.0 % $ 274,411 100.0 %
The composition of our investment securities portfolio reflects our investment
strategy of maintaining an appropriate level of liquidity for normal operations
while providing an additional source of revenue. The investment portfolio also
provides a balance to interest rate risk and credit risk in other categories of
the balance sheet, while providing a vehicle for the investment of available
funds, furnishing liquidity, and supplying securities to pledge as collateral.
At December 31, 2019 total investment securities were $313.2 million compared to
$254.9 million at December 31, 2018 . Investment securities as a percentage of
total assets were 13.3% and 11.7%, as of December 31, 2019 and December 31,
2018 , respectively. The increase in securities was primarily in residential
agency mortgage backed securities. Securities with a carrying value of
$136.2 million were pledged at December 31, 2019 , to secure public deposits and
for other purposes required or permitted by law.
At December 31, 2018 , total investment securities were $254.9 million , or 11.7%
of total assets, compared to $274.4 million , or 12.8% of total assets, at
December 31, 2017 . The $19.5 million decrease in securities from December 31,
2017 to December 31, 2018 , primarily reflected decreases in obligations of state
and political subdivisions and mortgage backed residential agency securities.
Securities with a carrying value of $149.0 million were pledged at December 31,
2018 , to secure public deposits and for other purposes required or permitted by
law.
The net pretax unrealized market value gain on the availableforsale
investment portfolio as of December 31, 2019 was $2.6 million , as compared to a
$4.8 million loss as of December 31, 2018 . This increase is indicative of the
interest rate movements during the year and the changes in the size and
composition of the portfolio.
The net pretax unrealized market value loss on the availableforsale
investment portfolio as of
The investment portfolio is principally composed ofU.S. Treasury debentures,U.S. Agency mortgagebacked passthroughs,U.S. Agency , Commercial Mortgage Obligations, or CMOs and municipal bonds. The portfolio does not include any private label mortgagebacked securities or private label collateralized mortgage obligations. As ofDecember 31, 2019 , the Bank held 114 taxexempt state and local municipal securities totaling$49.6 million . As ofDecember 31, 2018 , the Bank held 127 taxexempt state and local municipal securities totaling$58.5 million . Other than the aforementioned investments, atDecember 31, 2019 andDecember 31, 2018 , there were no 72 Table of Contents
holdings of securities of any one issuer, other than the
As ofDecember 31, 2019 andDecember 31, 2018 , all of the availableforsale debt securities in an unrealized loss position were investment grade. For the years endedDecember 31, 2019 and 2018, we evaluated all of our debt securities for credit impairment and determined there were no credit losses evident and we did not record any otherthantemporary impairment. Furthermore, we do not intend to sell and it is more likely than not that we will not be required to sell these debt securities before the anticipated recovery of the amortized cost basis. Periodic reviews are conducted to identify and evaluate each investment that has an unrealized loss for otherthantemporary impairment. An unrealized loss exists when the current estimated fair value of an individual security is less than its amortized cost basis. Unrealized losses that are determined to be temporary in nature are recorded, net of tax, in accumulated other comprehensive income for availableforsale securities. The securities availableforsale presented in the following table are reported at fair value and by contractual maturity as ofDecember 31, 2019 . Actual timing may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, the mortgage backed securities receive monthly principal payments, which are not reflected below. The yields below are calculated on a tax equivalent basis. Maturity as of December 31, 2019 One year or less One to five years Five to ten years After ten years Fair Average Fair Average Fair Average Fair Average (dollars in thousands) Value Yield Value Yield Value Yield Value Yield Available-for-sale U.S. Treasury and agencies$ 9,990 1.52 % $ - - %$ 5,731 3.21 %$ 5,519 2.44 % Obligations of state and political agencies 753 2.00 % 16,824 1.48 % 23,084 1.95 % 27,987 2.60 % Mortgage backed securities Residential Agency 30 4.12 % 3,494 2.33 % 48,415 2.56 % 130,599 2.71 % Commercial - - % 1,936 2.89 % 7,735 2.38 % 21,014 6.59 %
Asset backed securities - 5.43 % - - % - - % 144 5.44 % Corporate bonds 4,034 2.51 % 3,061 2.67 % - - % - - % Total available-for-sale$ 14,807 1.82 %$ 25,315 1.85 % $
84,965 2.42 %$ 185,263 2.66 % Loans The loan portfolio represents a broad range of borrowers comprised of commercial and industrial, commercial real estate, residential real estate, and consumer financing loans.
Commercial and industrial loans include financing for commercial purposes in various lines of businesses, including manufacturing, service industry and professional service areas. Commercial and industrial loans are generally secured with the assets of the company and/or the personal guarantee of the business owners.
Commercial real estate loans consist of term loans secured by a mortgage lien on
the real property, such as office and industrial buildings, retail shopping
centers and apartment buildings, as well as commercial real estate construction
loans that are offered to builders and developers.
Residential real estate loans represent loans to consumers for the purchase or
refinance of a residence. These loans are generally financed over a 15 to
30year term and, in most cases, are extended to borrowers to finance their
primary residence with both fixedrate and adjustablerate terms. Real estate
construction loans are also offered to consumers who wish to build their own
homes and are often structured to be converted to permanent loans at the end of
the construction phase, which is typically twelve months. Residential real
estate loans also include home equity loans and lines of credit that are secured
by a first or secondlien on the borrower's residence. Home equity lines of
credit consist mainly of revolving lines of credit secured by residential real
estate.
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Consumer loans include loans made to individuals not secured by real estate,
including loans secured by automobiles or watercraft, and personal unsecured
loans.
Loans outstanding, by type, as of the dates presented are as follows:
December 31, 2019 December 31, 2018 December 31, 2017 December 31, 2016 December 31, 2015
Percent of Percent of Percent of Percent of Percent of
(dollars in thousands) Balance Portfolio Balance Portfolio Balance Portfolio Balance Portfolio Balance Portfolio
Commercial
Commercial and industrial $ 479,144 27.8 % $ 510,706
30.0 %
26,378 1.5 % 18,965 1.1 % 22,348 1.4 % 35,174 2.6 % 16,780 1.5 %
Commercial real estate 494,703 28.8 % 439,963 25.9 % 444,857 28.3 % 391,533 28.6 % 273,825 24.3 %
Total commercial 1,000,225 58.1 % 969,634 57.0 % 947,800 60.2 % 899,156 65.8 % 711,553 63.2 %
Consumer
Residential real estate first
mortgage 457,155 26.6 % 448,143 26.3 % 348,964 22.2 % 202,217 14.8 %
170,663 15.1 %
Residential real estate junior
lien 177,373 10.3 % 188,855 11.1 % 195,103 12.4 % 178,795 13.1 %
163,348 14.5 %
Other revolving and installment 86,526 5.0 % 95,218 5.6 % 82,607 5.2 % 86,784 6.3 % 81,357 7.2 %
Total consumer 721,054 41.9 % 732,216 43.0 % 626,674 39.8 % 467,796 34.2 % 415,368 36.8 %
Total loans $ 1,721,279 100.0 % $ 1,701,850 100.0 % $ 1,574,474 100.0 % $ 1,366,952 100.0 % $ 1,126,921 100.0 %
Total loans outstanding of $1.7 billion as of December 31, 2019 , increased
$19.4 million , or 1.1%, from December 31, 2018 . The increase in total loans was
represented by increases in our commercial real estate loans of $54.7 million ,
real estate construction of $7.4 million and residential real estate first
mortgage loans of $9.0 million . These increases were offset by decreases of
$31.6 million in commercial and industrial, $11.5 million in residential real
estate junior liens and $8.7 million in other revolving and installment loans.
On January 15, 2019 , we announced an agreement to sell our branch offices
located in Duluth, Minnesota , including loans attributable to those offices, to
another financial institution. These loans were classified as held for branch
sale in our consolidated financial statements and totaled $32.0 million as of
December 31, 2018 . The transaction closed on April 26, 2019 .
Total loans outstanding of
Our loan portfolio is highly diversified. The long-term goal of the overall portfolio mix is to retain balance with approximately one third of the portfolio in each of the commercial and industrial, commercial real estate, and residential real estate categories. As ofDecember 31, 2019 , approximately 27.8% of loans outstanding were commercial and industrial, while 28.8% of loans outstanding were commercial real estate, and 36.9% of loans outstanding were residential real estate. The commercial lending portfolio is also broadly diversified by industry type as demonstrated by the following distributions atDecember 31, 2019 : real estate (33%), retail trade (12%), finance & insurance (10%),wholesale trade (9%), construction (8%), healthcare (6%), manufacturing (5%), professional services (4%), agricultural (4%), transportation (3%), restaurant & lodging (2%), management of companies (2%), and administrative and support (1%). A variety of other industries with less than a 1% share of the total portfolio comprise the remaining 1%. The loan portfolio is also diversified by market distribution with 51.8% of the portfolio in the Twin Cities MSA, 39.4% in the easternNorth Dakota cities ofGrand Forks andFargo and 8.8% in the Phoenix MSA, as ofDecember 31, 2019 .
We originate both fixed and adjustable rate residential real estate loans conforming to the underwriting guidelines of the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation, as well as home equity loans and lines of credit that are secured by first or junior liens. Most of our fixed rate residential loans, along with some of our adjustable rate mortgages are sold to other financial institutions with which we have established a correspondent lending relationship.
Our consumer mortgage loans have minimal direct exposure to subprime mortgages
as the loans are underwritten to conform to secondary market standards. Volume
in this portion of the loan portfolio has been strong over the last few years
due to low longterm interest rates and comparatively stable real estate
valuations in our primary
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markets. As of December 31, 2019 , our consumer mortgage portfolio was $634.5
million which was a slight decline from $637.0 million as of December 31, 2018 .
Consumer mortgages had increased $92.9 million , or 17.1%, in 2018. Market
interest rates, expected duration, and our overall interest rate sensitivity
profile continue to be the most significant factors in determining whether we
choose to retain versus sell portions of new consumer mortgage originations.
The combined total of generalpurpose business lending to commercial,
industrial, nonprofit and municipal customers, mortgages on commercial property
and dealer floor plan financing is characterized as commercial lending activity.
As of December 31, 2019 , the commercial loan portfolio was $1.0 billion , an
increase of $30.6 million , or 3.2%, from $969.6 million as of December 31, 2018 .
Highly competitive conditions continue to prevail in the small and middle market
commercial segments in which we primarily operate. We maintain a commitment to
generating growth in our business portfolio in a manner that adheres to our twin
goals of maintaining strong asset quality and producing profitable margins. We
continue to invest in additional personnel, technology, and business development
resources to further strengthen our capabilities in this important product
category.
The following table shows the maturities and type of interest rates for the loan
portfolio as of
December 31, 2019
After one
One year but within After
(dollars in thousands) or less five years five years Total
Commercial
Commercial and industrial $ 175,919 $ 236,914 $ 66,311 $ 479,144
Real estate construction 6,644 12,880 6,854 26,378
Commercial real estate 50,761 225,606 218,336 494,703
Total commercial 233,324 475,400 291,501 1,000,225
Consumer
Residential real estate first mortgage 19,973 18,059 419,123 457,155
Residential real estate junior lien 21,896 78,909 76,568 177,373
Other revolving and installment 14,046 60,704 11,776 86,526
Total consumer 55,915 157,672 507,467 721,054
Total loans $ 289,239 $ 633,072 $ 798,968 $ 1,721,279
Sensitivity of loans to changes in interest rates
Fixed interest rates $ 489,400 $ 375,939
Floating interest rates 143,672 423,029
Total $ 633,072 $ 798,968
As of December 31, 2019 , 57.2% of the loan portfolio bears interest at fixed
rates and 42.8% at floating rates. The expected life of our loan portfolio will
differ from contractual maturities because borrowers may have the right to
curtail or prepay their loans with or without penalties. Consequently, the table
above includes information limited to contractual maturities of the underlying
loans.
Asset Quality
Our strategy for credit risk management includes welldefined, centralized
credit policies; uniform underwriting criteria; and ongoing risk monitoring and
review processes for all commercial and consumer credit exposures. The strategy
also emphasizes diversification on a geographic, industry, and client level;
regular credit examinations; and management reviews of loans experiencing
deterioration of credit quality. We strive to identify potential problem loans
early, take necessary chargeoffs promptly, and maintain adequate reserve levels
for probable loan losses inherent in the portfolio. Management performs ongoing,
internal reviews of any problem credits and continually assesses the adequacy of
the allowance. We utilize an internal lending division, Special Credit Services,
to develop and implement strategies for the management of individual
nonperforming loans.
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Nonperforming assets consist of loans 90 days or more past due, nonaccrual
loans, foreclosed assets and other real estate owned. We do not consider
performing troubled debt restructurings, or TDRs, to be nonperforming assets,
but they are included as part of impaired assets. The level of nonaccrual loans
is an important element in assessing asset quality. Loans are classified as
nonaccrual when principal or interest is in default for 90 days or more, unless
in the opinion of management, the loan is well secured and in the process of
collection. Exclusive of any delinquency, a loan will be placed in nonaccrual
when there is deterioration in the financial condition of the borrower and full
payment of principal and interest is not expected.
A loan is categorized as a TDR if a concession is granted, such as to provide
for the reduction of either interest or principal due to deterioration in the
financial condition of the borrower. Typical concessions include reduction of
the interest rate on the loan to a rate considered lower than market and other
modification of terms including forgiveness of a portion of the loan balance,
extension of the maturity date, and/or modifications from principal and interest
payments to interestonly payments for a certain period. Loans are not
classified as TDRs when the modification is shortterm or results in only an
insignificant delay or shortfall in the payments to be received.
Credit Quality Indicators
Loans are categorized into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. A risk rating is assigned to all commercial loans, except pools of homogeneous loans. We periodically perform detailed internal and external reviews of risk rated loans over a certain threshold to identify credit risks and to assess the overall collectability of the portfolio. During the internal reviews, management monitors and analyzes the financial condition of borrowers and guarantors, trends in the industries in which the borrowers operate, and the estimated fair values of collateral securing the loans. These credit quality indicators are used to assign a risk rating to each individual loan. The following definitions are used for risk ratings:
Pass. Higher quality loans that do not fit any of the other categories described below. This category includes loans risk rated with the following ratings: minimal credit risk, modest credit risk, average credit risk, acceptable credit risk, acceptable with risk and management attention.
Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution's credit position. Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a welldefined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
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Criticized loans represent loans that are categorized as special mention,
substandard, and doubtful. The following table presents criticized loans by type
as of
December 31, December 31, December 31,
(dollars in thousands) 2019 2018 2017
Commercial
Commercial and industrial $ 30,838 $ 51,141 $ 24,654
Real estate construction 1,259 1,055 3,468
Commercial real estate 32,409 32,785 30,235
Total commercial 64,506 84,981 58,357
Consumer
Residential real estate first mortgage 797 19 246
Residential real estate junior lien 1,251 2,485 2,644
Other revolving and installment 6 - 23
Total consumer 2,054 2,504 2,913
Total loans $ 66,560 $ 87,485 $ 61,270
Criticized loans as a percent of total loans 3.87 % 5.14 % 3.89 %
The following table presents information regarding nonperforming assets as of
the dates presented:
December 31, December 31, December 31, December 31, December 31,
(dollars in thousands) 2019 2018 2017 2016 2015
Nonaccrual loans (1) $ 7,379 $ 6,963 $ 5,873 $ 7,616 $ 9,546 Accruing loans 90+ days past due
448 - - 48 1,605
Total nonperforming loans 7,827 6,963 5,873 7,664 11,151
OREO and repossessed assets 8 204 483 1,917 877
Total nonperforming assets 7,835 7,167 6,356 9,581 12,028
Total restructured accruing loans 957 823 240 576 345
Total nonperforming assets and
restructured accruing loans $ 8,792 $
7,990 $ 6,596
0.45 % 0.41 % 0.37 % 0.56 % 0.85 %
Nonperforming assets to total assets 0.33 % 0.33 % 0.30 % 0.47 % 0.60 %
Allowance for loan losses to
nonperforming loans 306 % 318 % 282 % 205 % 154 %
--------------------------------------------------------------------------------
(1) Nonaccrual loans included nonperforming TDRs of
indicated above.
Interest income lost on nonaccrual loans approximated$0.4 million ,$0.3 million , and$0.2 million for the years endedDecember 31, 2019 , 2018, and 2017, respectively. There was no interest income included in net income related to nonaccrual loans for the years endedDecember 31, 2019 , 2018, and 2017.
Allowance for Loan Losses
The allowance for loan losses is maintained at a level management believes is
sufficient to absorb incurred losses in the loan portfolio given the conditions
at the time. Management determines the adequacy of the allowance based on
periodic evaluations of the loan portfolio and other factors. These evaluations
are inherently subjective as they require management to make material estimates,
all of which may be susceptible to significant change. The allowance is
increased by provisions charged to expense and decreased by actual chargeoffs,
net of recoveries.
The allowance for loan losses represents management's assessment of probable
credit losses inherent in the loan portfolio. The allowance for loan losses
consists of specific components, based on individual evaluation of certain
loans, and general components for homogeneous pools of loans with similar risk
characteristics.
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Impaired loans include loans placed on nonaccrual status and TDRs. Loans are
considered impaired when, based on current information and events, it is
probable that all amounts due, in accordance with the original contractual terms
of the loan agreement, will not be collected. When determining if all amounts
due in accordance with the original contractual terms of the loan agreement will
be collected, the borrower's overall financial condition, resources and payment
record, support from guarantors, and the realizable value of any collateral, are
taken into consideration. Loans that experience insignificant payment delays and
payment shortfalls generally are not classified as impaired. Management
determines the significance of payment delays and payment shortfalls on a
casebycase basis, taking into consideration all of the circumstances
surrounding the loan and the borrower, including the length of the delay, the
reasons for the delay, the borrower's prior payment record, and the amount of
the shortfall in relation to the principal and interest owed.
All impaired loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the discounted expected future cash flows or at the fair value of collateral if repayment is collateral dependent.
The allowance for nonimpaired loans is based on historical losses adjusted for current qualitative factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history over the most recent five years. This actual loss experience is adjusted for economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in chargeoffs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. These factors are inherently subjective and are driven by the repayment risk associated with each portfolio segment. These portfolio segments include commercial and industrial, real estate construction, commercial real estate, residential real estate first mortgage, residential real estate junior liens, and other revolving and installment. In the ordinary course of business, we enter into commitments to extend credit, including commitments under credit arrangements, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded when they are funded. A reserve for unfunded commitments is established using historical loss data and utilization assumptions. This reserve is located under accrued expenses and other liabilities on the Consolidated Balance Sheets. The provision for unfunded commitments was a reversal of$308 thousand for the year endedDecember 31, 2019 compared to an expense of$540 thousand for the year endedDecember 31, 2018 . 78 Table of Contents
The following table presents, by loan type, the changes in the allowance for loan losses for the periods presented.
Year ended
December 31,
(dollars in thousands) 2019 2018 2017 2016 2015
Balance-beginning of period $ 22,174 $ 16,564 $ 15,615 $ 14,688 $ 17,063
Commercial loan charge-offs
Commercial and Industrial (6,540) (3,123) (3,287) (1,629) (6,906)
Real estate construction (1) (60) - (1,655) -
Commercial real estate - (600) - (43) (400)
Total commercial loan
charge-offs (6,541) (3,783) (3,287) (3,327) (7,306)
Consumer loan charge-offs
Residential real estate first
mortgage - (29) - - (5)
Residential real estate junior
lien (465) (133) (1,124) (829) (596)
Other revolving and installment (572) (308) (429) (280) (270)
Total consumer loan charge-offs (1,037) (470) (1,553) (1,109) (871)
Total loan charge-offs (7,578) (4,253) (4,840) (4,436) (8,177)
Commercial loan recoveries
Commercial and Industrial 1,470 750 930 1,084 233
Real estate construction 3 2 279 587 697
Commercial real estate 150 81 73 188 166
Total commercial recoveries 1,623 833 1,282 1,859 1,096
Consumer loan recoveries
Residential real estate first
mortgage - - 103 211 10
Residential real estate junior
lien 232 207 872 94 287
Other revolving and installment 161 213 252 139 209
Total consumer loan recoveries 393 420 1,227 444 506
Total loan recoveries 2,016 1,253 2,509 2,303 1,602
Net loan charge-offs
(recoveries) 5,562 3,000 2,331 2,133 6,575
Commercial loan provision
Commercial and Industrial 5,213 6,911 3,244 507 6,574
Real estate construction 51 (35) (416) 1,304 (1,656)
Commercial real estate (1,467) 1,889 352 269 (1,223)
Total commercial loan provision 3,797 8,765 3,180 2,080 3,695
Consumer loan provision
Residential real estate first
mortgage 292 (226) 182 (328) 60
Residential real estate junior
lien 1,825 (171) 247 453 505
Other revolving and installment 383 (24) 276 16 11
Total consumer loan provision 2,500 (421) 705 141 576
Unallocated provision expense 1,015 266 (605) 839 (71)
Total loan loss provision 7,312 8,610 3,280 3,060 4,200
Balance-end of period $ 23,924 $ 22,174 $ 16,564 $ 15,615 $ 14,688
Total loans $ 1,721,279 $ 1,701,850 $ 1,574,474 $ 1,366,952 $ 1,126,921
Average total loans 1,706,979 1,677,885 1,475,042 1,345,208 1,124,601
Allowance for loan losses as
a percentage of total loans 1.39 % 1.30 % 1.05 % 1.14 % 1.30 %
Net charge-offs/(recoveries) to
average total loans 0.33 % 0.18 % 0.16 % 0.16 % 0.58 %
The allowance for loan losses was $23.9 million at December 31, 2019 , compared
to $22.2 million at December 31, 2018 . The $1.8 million increase in the
allowance for loan losses was due to additional provision for loan losses of
$7.3 million offset by net loan chargeoffs of $5.6 million . The level of
nonperforming loans to total loans at
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The allowance for loan losses was$22.2 million atDecember 31, 2018 , compared to$16.6 million atDecember 31, 2017 . The$5.6 million increase in the allowance for loan losses year over year was due to additional provision for loan losses of$5.3 million . Net loan chargeoffs as a percentage of average loans remained consistent with prior periods at 0.18% in 2018 compared to 0.16% in 2017. The level of nonperforming assets to total loans was also stable at 0.42% as ofDecember 31, 2018 , compared to 0.40% atDecember 31, 2017 . The additional provision for loan losses increased the allowance to loan losses to total loans to 1.30% atDecember 31, 2018 , compared to 1.05% atDecember 31, 2017 . The following table presents the allocation of the allowance for loan losses as of the dates presented.December 31, 2019 December 31, 2018
December 31, 2017 December 31, 2016 December 31, 2015
Percentage Percentage Percentage Percentage Percentage
Allocated of loans to Allocated of loans to Allocated of loans to Allocated of loans to Allocated of loans to
(dollars in
thousands) Allowance total loans Allowance total loans Allowance total loans Allowance total loans Allowance total loans
Commercial and
industrial $ 12,270 27.8 % $ 12,127 30.0 % $ 7,589 30.5 % $ 6,509 34.6 % $ 6,740 37.4 %
Real estate
construction 303 1.5 % 250 1.1 % 343 1.4 % 674 2.6 % 245 1.5 %
Commercial real
estate 4,962 28.8 % 6,279 25.9 % 4,909 28.3 % 4,484 28.6 % 4,070 24.3 %
Residential real
estate first
mortgage 1,448 26.6 % 1,156 26.3 % 1,411 22.2 % 1,037 14.8 % 1,242 15.1 %
Residential real
estate junior lien 2,397 10.3 % 805 11.1 % 902 12.4 % 907 13.1 % 1,189 14.5 %
Other revolving
and installment 352 5.0 % 380 5.6 % 499 5.2 % 488 6.3 % 525 7.2 %
Unallocated 2,192 - % 1,177 - % 911 - % 1,516 - % 677 - %
Total loans $ 23,924 100.0 % $ 22,174 100.0 % $ 16,564 100.0 % $ 15,615 100.0 % $ 14,688 100.0 %
Deposits
Total deposits were $1.97 billion as of December 31, 2019 , an increase of $196.2
million , or 11.1%, from December 31, 2018 . The increase was due to an increase
of $169.2 million in interest-bearing deposits and an increase of $27.1 million
in noninterest-bearing deposits. The increase in interest-bearing deposits was
primarily due to a $108.0 million increase in synergistic deposits from our
retirement and benefit services and wealth management segments and a $13.6
million increase in HSA deposits. Noninterest-bearing deposits represented 29.3%
of total deposits as of December 31, 2019 .
Deposits decreased $59.9 million between 2018 and 2017. The decrease was due to
temporary deposits on the balance sheet held for terminated plans from the
retirement division. Time deposits decreased $33.7 million during 2018, as we
allowed higher rate single service accounts to roll off the balance sheet.
Nonpublic, core deposits are frequently considered to be a bank's most
attractive source of funding because they are generally stable, do not need to
be collateralized, carry a relatively low rate, generate solid fee income and
provide a strong client base for which a variety of loan, deposit, and other
financial servicerelated solutions can be provided. Our Company's funding
composition continues to benefit from a high level of nonpublic, core deposits,
which increased $35.0 million or 2.7% in 2018. This increase included
$11.1 million or 11.9% of growth in the HSA portfolio which carries an average
cost of 0.16%.
Interestbearing deposit costs were 1.03% and 0.56% for the year ended
We compete for local deposits by offering products with competitive rates and
rely on the deposit portfolio to fund loans and other asset growth. Management
understands the importance of core deposits as a stable source of funding and
may periodically implement various deposit promotion strategies to encourage
core deposit growth. For periods of rising interest rates, management has
modeled the aggregate yields for nonmaturity deposits and time deposits to
increase at a slower pace than the increase in underlying market rates, which
results in net interest margin expansion and projections of an increase in net
interest income. The mix of average deposits has been changing throughout the
last several years. The weighting of core funds (noninterest checking, interest
checking, savings, and
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money market accounts) has increased, while time deposits' weighting has decreased. This change in deposit mix reflects our focus on expanding core account relationships and customers' preference for unrestricted accounts in the low interest rate environment.
The following table details composition and percentage composition of our deposit portfolio by category for the periods indicated.
Year ended Year ended Year ended
December 31, 2019 December 31, 2018 December 31, 2017
Average Average Average Average Average Average
(dollars in thousands) Balance Rate Balance Rate Balance Rate
Noninterest-bearing demand $ 512,586 - % $ 528,552 - % $ 488,295 - %
Interest-bearing demand 428,162 0.47 % 405,512 0.25 % 336,876 0.12 %
Money market and savings 681,621 1.22 % 626,041 0.63 % 619,687 0.26 %
Time deposits 186,781 1.62 % 206,846 0.97 % 219,164 0.68 %
Total deposits (1) $ 1,809,150 0.74 % $ 1,766,951 0.56 % $ 1,664,022 0.30 %
--------------------------------------------------------------------------------
(1) Includes deposits held for sale
The following table shows the contractual maturity of time deposits, including certificate of deposit account registry services, or CDARS, and IRA deposits of$100 thousand and over, that were outstanding as of the date presented. December 31, (dollars in thousands) 2019 Maturing in: 3 months or less$ 34,217 3 months to 6 months 55,262 6 months to 1 year 4,510 1 year or greater 15,757 Total$ 109,746
Borrowings and Subordinated Debt
We utilize both shortterm and longterm borrowings as part of our
asset/liability management and funding strategies. Shortterm borrowings
consists of FHLB advances and federal funds purchased. We had no shortterm
borrowings outstanding at
Shortterm borrowings were$93.5 million atDecember 31, 2018 , an increase of$63.5 million from$30.0 million atDecember 31, 2017 . FHLB advances were secured by specific investment securities and real estate loans with a carrying amount of approximately$881.2 million and$834.6 million atDecember 31, 2019 and 2018, respectively. Longterm debt is utilized to fund longer term assets and as a source of regulatory capital. AtDecember 31, 2019 , we had$50.0 million of outstanding subordinated notes. The notes currently bear interest at a fixed rate of 5.75% per year, payable semiannually throughDecember 30, 2020 , and then convert automatically to floating rate notes that reset quarterly to an interest rate equal to the threemonth LIBOR plus 412 basis points. The notes mature onDecember 30, 2025 , and we have the option to redeem or prepay any or all of the subordinated notes without premium or penalty any time afterDecember 30, 2020 or at any time in the event of certain changes that affect the deductibility of interest for tax purposes or the treatment of the notes as Tier 2 Capital.
Junior subordinated debentures issued to capital trusts that issued trust
preferred securities were
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amortization on the junior subordinated notes assumed in the
Selected financial information pertaining to the components of our borrowings and subordinated debt as of the dates indicated is as follows:
December 31, 2019 December 31 ,
2018
Percent of Percent of Percent of
(dollars in thousands) Balance Portfolio Balance Portfolio Balance Portfolio
Fed funds purchased $ - - % $ 93,460 61.4 % $ - - %
FHLB short-term advances - - % - - % 30,000 33.8 %
Subordinated notes 49,625 84.4 % 49,562 32.5 % 49,500 55.7 %
Junior subordinated debentures 8,504 14.5 % 8,392 5.5 % 8,278 9.3 %
Finance lease liability 640 1.1 % 870 0.6 % 1,041 1.2 %
Total borrowed funds $ 58,769 100.0 % $ 152,284 100.0 % $ 88,819 100.0 %
Capital Resources
The following table summarizes the changes in our stockholders' equity for the
periods indicated.
For the years ended December 31,
(dollars in thousands) 2019 2018 2017
Beginning balance $ 196,954 $ 179,594 $ 168,251
Net income 29,540 25,866 15,001
Other comprehensive income (loss) 5,537 (2,541) 979
Common stock repurchased (1,948) (356) (294)
Common stock issued - - 1,448
Common stock dividends (8,909) (7,456) (6,729)
Stockbased compensation expense 1,750 1,847 938
Initial public offering of 3,289,000 shares of common
stock net of issuance costs 62,804 - -
Ending balance $ 285,728 $ 196,954 $ 179,594
Total stockholders' equity was $285.7 million at December 31, 2019 , compared to
$197.0 million at December 31, 2018 . The increase was primarily due $62.8
million of net proceeds received from our initial public offering, $29.5 million
of net income, $5.5 million increase in accumulated other comprehensive income
and partially offset by $8.9 million in common stock dividends.
We strive to maintain an adequate capital base to support our activities in a
safe and sound manner while at the same time attempting to maximize stockholder
value. Capital adequacy is assessed against the risk inherent in our balance
sheet, recognizing that unexpected loss is the common denominator of risk and
that common equity has the greatest capacity to absorb unexpected loss.
We are subject to various regulatory capital requirements both at the Company
and at the Bank level. Failure to meet minimum capital requirements could result
in certain mandatory and possible additional discretionary actions by regulators
that, if undertaken, could have an adverse material effect on our financial
statements. Under capital adequacy guidelines and the regulatory framework for
prompt corrective action, specific capital guidelines must be met that involve
quantitative measures of assets, liabilities, and certain offbalance sheet
items as calculated under regulatory accounting policies. We have consistently
maintained regulatory capital ratios at or above the wellcapitalized standards.
During the first quarter of 2015, regulations implementing the Basel III
regulatory capital framework and the DoddFrank Act became effective, which
include requirements that were subject to a multiyear phasein period. These
rules modified the calculation of the various capital ratios, added a new ratio,
the Common Equity Tier 1 Capital ratio, and revised the adequately and well
capitalized thresholds. As of January 1, 2019 , the rules require us to maintain
a
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capital conservation buffer of common equity capital that exceeds by more than
2.50% the minimum risk weighted asset ratios. The capital conservation buffer
requirement was 2.50%, 1.875%, and 1.25% as of December 31, 2019 , 2018, and
2017, respectively, which is not reflected in the tables below.
At
The table below sets forth the actual capital amounts and ratios for the Company
and the Bank as of the dates indicated, as well as the regulatory capital ratios
for the Company and the Bank to meet the minimum capital adequacy standards and
for the Bank to be considered well-capitalized under the prompt corrective
action framework. See Note 25 (Regulatory Matters) for additional disclosures.
December 31, December 31, December 31,
Capital Ratios 2019 2018 2017
Alerus Financial Corporation
Common equity tier 1 capital to risk weighted assets 12.48 % 8.43 % 7.83 %
Tier 1 capital to risk weighted assets 12.90 % 8.87 % 8.29 %
Total capital to risk weighted assets 16.73 % 12.86 % 12.17 %
Tier 1 capital to average assets 11.05 % 7.51 % 7.07 %
Tangible common equity to tangible assets (1) 10.38 % 6.91 % 6.01 %
Alerus Financial , National Association Common equity tier 1 capital to risk weighted assets 11.91 % 11.39 % 11.01 % Tier 1 capital to risk weighted assets 11.91 % 11.39 % 11.01 % Total capital to risk weighted assets 13.15 % 12.62 % 11.99 % Tier 1 capital to average assets 10.20 %
9.63 % 9.40 %
--------------------------------------------------------------------------------
(1) Represents a non-GAAP financial measure. See "Non-GAAP to GAAP
Reconciliations and Calculation of Non-GAAP Financial Measures."
Contractual Obligations and OffBalance Sheet Arrangements
Off-Balance Sheet Arrangements
In the normal course of business, we enter into various transactions to meet the financing needs of clients, which, in accordance with GAAP, are not included in the consolidated balance sheets. These transactions include commitments to extend credit, standby letters of credit, and commercial letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. Most of these commitments are expected to expire without being drawn upon. All off-balance sheet commitments are included in the determination of the amount of risk-based capital that the Company and the Bank are required to hold. Our exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, standby letters of credit, and commercial letters of credit is represented by the contractual or notional amount of those instruments. We decrease our exposure to losses under these commitments by subjecting them to credit approval and monitoring procedures. We assess the credit risk associated with certain commitments to extend credit and establishes a liability for probable credit losses.
Further information related to financial instruments can be found in Note 15 (Financial Instruments with Off-Balance Sheet Risk) in the notes to the consolidated financial statements found elsewhere in this report.
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Contractual Obligations
In the ordinary course of our operations, we enter into certain contractual
obligations. The following table presents our contractual obligations as of
December 31, 2019 .
December 31, 2019
Less than One to Three to Over
(dollars in thousands) one year three years five years five years Total
Operating lease obligations $ 2,197 $ 3,123 $ 2,386 $ 2,272 $ 9,978
Time deposits 158,834 23,274 7,220 6,754 196,082
Subordinated notes payable - - - 49,625 49,625
Junior subordinated debenture
(Trust I) - - - 3,402 3,402
Junior subordinated debenture
(Trust II) - - - 5,102 5,102
Finance lease liability 251 460 - - 711
Total contractual obligations
Liquidity Liquidity management is the process by which we manage the flow of funds necessary to meet our financial commitments on a timely basis and at a reasonable cost and to take advantage of earnings enhancement opportunities. These financial commitments include withdrawals by depositors, credit commitments to borrowers, expenses of our operations, and capital expenditures. Liquidity is monitored and closely managed by our asset and liability committee, or ALCO, a group of senior officers from the finance, enterprise risk management, deposit, investment, treasury, and lending areas. It is ALCO's responsibility to ensure we have the necessary level of funds available for normal operations as well as maintain a contingency funding policy to ensure that potential liquidity stress events are planned for, quickly identified, and management has plans in place to respond. ALCO has created policies which establish limits and require measurements to monitor liquidity trends, including modeling and management reporting that identifies the amounts and costs of all available funding sources.
At
The Bank is a member of the FHLB, which provides short and longterm funding to its members through advances collateralized by real estaterelated assets and other select collateral, most typically in the form of debt securities. The actual borrowing capacity is contingent on the amount of collateral available to be pledged to the FHLB. As ofDecember 31, 2019 we had$881.2 million of collateral pledged to the FHLB. Based on this collateral we are eligible to borrow up to$552.4 million and had$552.2 million available capacity as ofDecember 31, 2019 . In addition, we can borrow up to$102.0 million through unsecured lines of credit we have established with four other banks. In addition, because the Bank is "well capitalized," we can accept wholesale deposits up to 20.0% of total assets based on current policy limits. Management believed that we had adequate resources to fund all of our commitments as ofDecember 31, 2019 andDecember 31, 2018 . Our primary sources of liquidity include liquid assets, as well as unencumbered securities that can be used to collateralize additional funding. AtDecember 31, 2019 , we had$144.0 million of cash and cash equivalents of which$107.6 million are interestearning deposits held at theFederal Reserve , FHLB and other correspondent banks. Though remote, the possibility of a funding crisis exists at all financial institutions. Accordingly, management has addressed this issue by formulating a liquidity contingency plan, which has been reviewed and approved by both the Bank's board of directors and the ALCO. The plan addresses the actions that we would take in response to both a shortterm and longterm funding crisis. 84
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A shortterm funding crisis would most likely result from a shock to the financial system, either internal or external, which disrupts orderly shortterm funding operations. Such a crisis would likely be temporary in nature and would not involve a change in credit ratings. A longterm funding crisis would most likely be the result of both external and internal factors and would most likely result in drastic credit deterioration. Management believes that both potential circumstances have been fully addressed through detailed action plans and the establishment of trigger points for monitoring such events.
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