HAWTHORN BANCSHARES, INC. Forward-Looking Statements
This report contains certain forward-looking statements with respect to the
financial condition, results of operations, plans, objectives, future
performance and business of the Company,
· statements that are not historical in nature, and
· statements preceded by, followed by or that include the words believes,
expects, may, will, should, could, anticipates, estimates, intends or similar
expressions.
Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:
· competitive pressures among financial services companies may increase
significantly,
· changes in the interest rate environment may reduce interest margins,
· general economic conditions, either nationally or in
favorable than expected and may adversely affect the quality of our loans and
other assets,
· increases in non-performing assets in the Company's loan portfolios and adverse
economic conditions may necessitate increases to our provisions for loan
losses,
· costs or difficulties related to any integration of any business of the Company
and its acquisition targets may be greater than expected,
· legislative, regulatory or tax law changes may adversely affect the business in
which the Company and its subsidiaries are engaged,
· changes may occur in the securities markets and,
· effects of the COVID-19 pandemic, or other adverse external events.
We have described under the caption Risk Factors in the Company's Annual Report on Form 10K for the year endedDecember 31, 2019 , and in other reports filed with theSEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that have not been identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.
Overview
Crucial to the Company's community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, the Company, with$1.5 billion in assets atMarch 31, 2020 , provides a broad range of commercial and personal banking services. The Bank's specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate,Small Business Administration (SBA) loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include theMissouri communities in and surroundingJefferson City ,Columbia ,Clinton ,Warsaw ,Springfield ,St. Louis , and the greaterKansas City metropolitan area. The Company's primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company's business is commercial, commercial real estate development, and residential mortgage 37
lending. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancing activity.
The success of the Company's growth strategy depends primarily on the ability of its banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company's financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company's growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control. The Company's subsidiary bank is a full-service bank conducting a general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, the Bank provides trust services. The deposit accounts of the Bank are insured by theFederal Deposit Insurance Corporation (FDIC) to the extent provided by law. The operations of the Bank are supervised and regulated by theFDIC and theMissouri Division of Finance . Periodic examinations of the Bank are conducted by representatives of theFDIC and theMissouri Division of Finance . Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. The Company is subject to supervision and examination by theBoard of Governors of theFederal Reserve System .
Significant Developments and Transactions
Each item listed below materially affects the comparability of our results of operations for the three months endedMarch 31, 2020 and 2019, and our financial condition as ofMarch 31, 2020 andDecember 31, 2019 , and may affect the comparability of financial information we report in future fiscal periods. Impact of COVID-19. The progression of the COVID-19 pandemic inthe United States has had an adverse impact on our financial condition and results of operations as of and for the three months endedMarch 31, 2020 , and is expected to have a complex and significant adverse impact on the economy, the banking industry and our Company in future fiscal periods, all subject to a high degree of uncertainty. Effects on Our Market Areas. Our commercial and consumer banking products and services are delivered primarily inMissouri , where individual and governmental responses to the COVID-19 pandemic have led to a broad curtailment of economic activity beginningMarch 2020 . InMissouri , the Director of theMissouri Department of Health and Senior Services issued an order that individuals stay at home and that businesses abide by certain limitations on gathering sizes. This order was effective fromApril 6, 2020 and currently extends throughMay 3, 2020 . EffectiveMay 4, 2020 , the governor ofMissouri announced a partial relaxation of these limitations by lifting the stay at home order for individuals and allowing businesses to reopen subject to social distancing guidelines. The Bank and its branches have remained open during these orders because banking is deemed an essential business, although it has suspended lobby access at its branches fromMarch 18, 2020 untilMay 4, 2020 .Missouri has experienced a dramatic increase in unemployment levels as a result of the curtailment of business activities, with over 400,000 new claims filed fromMarch 14 through April 18, 2020 , representing approximately 13% ofMissouri's labor force, according to theMissouri Department of Labor and Industrial Relations , and these levels are expected to rise further. To date, the public health and economic effects of COVID-19 have been significant in larger metropolitan areas, while management has observed that these effects have been much less significant in smaller cities and communities, where our banking operations are primarily focused. 38 Policy and Regulatory Developments. Federal, state and local governments and regulatory authorities have enacted and issued a range of policy responses to the COVID-19 pandemic, including the following:
· The
0.50% on
of 0.0% - 0.25%.
· On
supporting small and midsized business, as well as state and local governments
impacted by COVID-19. The
Lending Program, which establishes two new loan facilities intended to
facilitate lending to small and midsized businesses: (1) the Main Street New
Loan Facility (MSNLF), and (2) the Main Street Expanded Loan Facility (MSELF).
MSNLF loans are unsecured term loans originated on or after
while MSELF loans are provided as upsized tranches of existing loans originated
before
billion. The program is designed for businesses with up to 10,000 employees or
they are seeking financial support because of COVID-19 and that they will not
use proceeds from the loan to pay off debt. The
that it would provide additional funding to banks offering PPP loans to
struggling small businesses. Lenders participating in the PPP will be able to
exclude loans financed by the facility from their leverage ratio. In addition,
the
local governments with up to
Department backing
CARES Act. The facility will make short-term financing available to cities with
a population of more than one million or counties with a population of greater
than two million. The
Primary and Secondary Market Corporate Credit Facilities to support up to
billion in credit to corporate debt issuers. This will allow companies that
were investment grade before the onset of COVID-19 but then subsequently
downgraded after
will be scaled up in scope to include the triple A-rated tranche of commercial
mortgage-backed securities and newly issued collateralized loan obligations.
The size of the facility is
Effects on Our Business. The COVID-19 pandemic and the specific developments referred to above will continue to have a significant impact on our business. In particular, we anticipate that a significant portion of the Bank's borrowers in the hotel, restaurant, gaming, long-term healthcare and retail industries will continue to endure significant economic distress, which has caused, and will continue to cause, them to draw on their existing lines of credit and adversely affect their ability to repay existing indebtedness, and is expected to adversely impact the value of collateral. These developments, together with economic conditions generally, are also expected to impact our commercial real estate portfolio, particularly with respect to real estate with exposure to these industries, our consumer loan business and loan portfolio, and the value of certain collateral securing our loans. As a result, we anticipate that our financial condition, capital levels and results of operations will be adversely affected, as described in further detail below.
Our Response. We have taken numerous steps in response to the COVID-19 pandemic, including the following:
· To protect the health and safety of our employees and customers, on
2020, we closed our banking center lobbies but continued to serve clients by
appointment or through our drive-up lanes.
· To meet the financial needs of our customers, we have instituted the following
measures:
o The Company has received requests for payment modifications totaling
million through
their specific needs.
o The Bank participated, as a lender, in the
("SBA") Payroll Protection Program ("PPP") and began taking applications on the
first day of the program. Through
in PPP loans that had been approved by the SBA.
39
o To account for the probable increased losses inherent in the loan portfolio,
Management recorded an additional
the three months ended
CRITICAL ACCOUNTING POLICIES
The following accounting policies are considered most critical to the understanding of the Company's financial condition and results of operations. These critical accounting policies require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to the critical accounting policies on the business operations are discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations, where such policies affect the reported and expected financial results.
Allowance for Loan Losses
Management has identified the accounting policy related to the allowance for
loan losses as critical to the understanding of the Company's results of
operations, since the application of this policy requires significant management
assumptions and estimates that could result in materially different amounts to
be reported if conditions or underlying circumstances were to change. Further
discussion of the methodology used in establishing the allowance and the impact
of any associated risks related to these policies on the Company's business
operations is provided in note 1 to the Company's unaudited consolidated
financial statements and is also discussed in the Lending and Credit Management
section below. Many of the loans are deemed collateral dependent for purposes of
the measurement of the impairment loss, thus the fair value of the underlying
collateral and sensitivity of such fair values due to changing market
conditions, supply and demand, condition of the collateral and other factors can
be volatile over periods of time. Such volatility can have an impact on the
financial performance of the Company.
40SELECTED CONSOLIDATED FINANCIAL DATA
The following table presents selected consolidated financial information for the Company as of and for each of the three months endedMarch 31, 2020 and 2019, respectively. The selected consolidated financial data should be read in conjunction with the unaudited consolidated financial statements of the Company, including the related notes, presented elsewhere herein.
Selected Financial Data
Three Months Ended
March 31 ,
(In thousands, except per share data) 2020 2019 Per Share Data Basic earnings per share
$ 0.14 $ 0.74 Diluted earnings per share 0.14 0.74 Cash dividends paid on common stock 753 603 Book value per share 18.64 16.75 Market price per share 18.35 22.35 Selected Ratios (Based on average balance sheets) Return on total assets 0.23 % 1.23 % Return on stockholders' equity 2.96 % 18.41 %
Stockholders' equity to total assets 7.80 % 6.68 % Efficiency ratio (1)
70.72 % 72.07 %
Net interest spread 3.28 % 2.96 %
Net interest margin 3.55 % 3.27 %
(Based on end-of-period data)
Stockholders' equity to assets 7.64 % 6.82 %
Total risk-based capital ratio 14.80 % 13.39 %
Tier 1 risk-based capital ratio 12.81 % 11.41 %
Common equity Tier 1 capital 9.64 % 8.65 %
Tier 1 leverage ratio (2) 10.43 % 9.38 %
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(1)Efficiency ratio is calculated as non-interest expense as a percentage of revenue. Total revenue includes net interest income and non-interest income.
(2)Tier 1 leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets.
Use of Non-GAAP Measures
Several financial measures in this report are non-GAAP, meaning they are not presented in accordance with generally accepted accounting principles (GAAP) in theU.S. The non-GAAP items presented in this report are non-GAAP net income, non-GAAP basic earnings per share, non-GAAP diluted earnings per share, non-GAAP return on average assets and non-GAAP return on average common equity. These measures include the adjustments to exclude the additional loan loss provision recorded in the quarter endedMarch 31, 2020 caused by the impact on current economic conditions due to the COVID-19 pandemic and the impact of the gain on the sale of ourBranson branch that closed during the quarter endedMarch 31, 2019 . The Company believes that the exclusion of these items provides a useful basis for evaluating the Company's underlying performance, but should not be considered in isolation and is not in accordance with, or a substitute for, evaluating performance utilizing GAAP financial information. The Company uses non-GAAP measures to analyze its financial performance and to make financial comparisons to prior periods presented on a similar basis. The Company believes that providing such adjusted results allows investors to better understand the Company's comparative operating performance for the periods presented. Non-GAAP measures are not formally defined by GAAP or codified in the federal banking regulations, and other entities may use calculation methods that differ from those used by the Company. The Company has reconciled each of these measures to a comparable GAAP measure below: 41 Income Statement Data Three Months Ended (In thousands, except per share data) March 31, Net income - GAAP$ 868 $ 4,666 Effect of ALL provision COVID-19 (a) 2,370 - Effect of net gain on branch sale (b) - (1,638) Net income - non-GAAP$ 3,238 $ 3,028 Per Share Data Basic earnings per share - GAAP$ 0.14 $ 0.74 Effect of ALL provision COVID-19 (a) 0.38 - Effect of net gain on branch sale (b) - (0.26) Basic earnings per share - non-GAAP$ 0.52 $ 0.48 Diluted earnings per share - GAAP$ 0.14 $ 0.74 Effect of ALL provision COVID-19 (a) 0.38 - Effect of net gain on branch sale (b) - (0.26) Diluted earnings per share - non-GAAP$ 0.52 $ 0.48 Key Ratios Return on average total assets - GAAP 0.23 % 1.23 % Effect of ALL provision COVID-19 (a) 0.63 - Effect of net gain on branch sale (b) - (0.43) Return on average total assets - non-GAAP 0.86 % 0.80 % Return on average stockholders' equity - GAAP 2.96 % 18.41 % Effect of ALL provision COVID-19 (a) 8.08 - Effect of net gain on branch sale (b) - (6.46)
Return on average stockholders' equity - non-GAAP 11.04 % 11.95 %
(a) An additional
was recorded during the quarter due to current economic conditions resulting
from the COVID-19 pandemic.
(b) The gain on the sale of the
million after tax for the three months ended
RESULTS OF OPERATIONS ANALYSIS
The Company has prepared all of the consolidated financial information in this report in accordance with accounting principles generally accepted inthe United States of America (U.S. GAAP). In preparing the consolidated financial statements in accordance withU.S. GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates. Three Months Ended March 31, (In thousands) 2020 2019 $ Change % Change Net interest income$ 12,526 $ 11,629 $ 897 7.7 % Provision for loan losses 3,300 150 3,150 NM Non-interest income 2,248 2,091 157 7.5 Investment securities (losses) gains, net (1) 1 (2) (200.0) Gain on branch sale, net - 2,074 (2,074) (100.0) Non-interest expense 10,448 9,888 560 5.7 Income before income taxes 1,025 5,757 (4,732) (82.2) Income tax expense 157 1,091 (934) (85.6) Net income$ 868 $ 4,666 $ (3,798) (81.4) % NM = not meaningful 42 Consolidated net income of$868,000 , or$0.14 per diluted share, for the three months endedMarch 31, 2020 decreased$3.8 million compared to$4.7 million , or$0.74 per diluted share, for the three months endedMarch 31, 2019 . For the three months endedMarch 31, 2020 , the return on average assets was 0.23%, the return on average stockholders' equity was 2.96%, and the efficiency ratio was 70.7%. Net interest income was$12.5 million for the three months endedMarch 31, 2020 compared to$11.6 million for the three months endedMarch 31, 2019 . The net interest margin (expressed on a fully taxable equivalent basis) increased to 3.55% for the three months endedMarch 31, 2020 , compared to 3.27% for the three months endedMarch 31, 2019 . These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below. A$3.3 million provision for loan losses was required for the three months endedMarch 31, 2020 compared to a$150,000 provision for the three months endedMarch 31, 2019 . In March of 2020, an additional$3.0 million was recorded during the quarter due to current economic conditions resulting from the COVID-19 pandemic. The Company's net loan charge-offs were$84,000 for the three months endedMarch 31, 2020 , compared to net recoveries of$43,000 for the three months endedMarch 31, 2019 . Non-performing loans totaled$8.1 million , or 0.68% of total loans, atMarch 31, 2020 compared to$5.1 million , or 0.43% of total loans, atDecember 31, 2019 , and$5.6 million , or 0.48% of total loans, atMarch 31, 2019 . These changes are discussed in greater detail under the Lending and Credit Management section below.
Non-interest income increased
Investment securities (losses) gains, net The Company recognized an unrealized loss of$1,000 for the three months endedMarch 31, 2020 , compared to an unrealized gain of$1,000 for the three months endedMarch 31, 2019 related to equity securities. These changes are discussed in greater detail under Investment securities (losses) gains, net section below. Gain on branch sale, net OnFebruary 8, 2019 ,Hawthorn Bank , a wholly-owned subsidiary ofHawthorn Bancshares, Inc. , completed the sale of its branch located inBranson, Missouri toBranson Bank ,Branson, Missouri . The Company sold the land and building for$3.5 million with a net book value of$1.7 million and transferred approximately$10.6 million in deposits, subject to future adjustments required in the definitive agreement for a deposit premium of 4.1%, or$0.3 million , excluding future contingent adjustments. The sale resulted in a pre-tax gain of approximately$2.1 million , or$1.6 million after tax for the three months endedMarch 31, 2019 . Non-interest expense increased$560,000 , or 5.7%, for the three months endedMarch 31, 2020 compared to the three months endedMarch 31, 2019 . These changes are discussed in greater detail under the Non-interest Income and Expense section below.
Average Balance Sheets
Net interest income is the largest source of revenue resulting from the
Company's lending, investing, borrowing, and deposit gathering activities. It is
affected by both changes in the level of interest rates and changes in the
amounts and mix of interest earning assets and interest bearing liabilities. The
following table presents average balance sheets, net interest
43
income, average yields of earning assets, average costs of interest bearing
liabilities, net interest spread and net interest margin on a fully taxable
equivalent basis for each of the periods ended March 31, 2020 and 2019,
respectively.
Three Months Ended March 31,
2020 2019
Interest Rate Interest Rate
Average Income/ Earned/ Average Income/ Earned/
(In thousands) Balance Expense(1) Paid(1) Balance Expense(1) Paid(1)
ASSETS
Loans: (2) (3)
Commercial $ 199,082 $ 2,570 5.19 % $ 205,728 $ 2,742 5.41 %
Real estate construction -
residential 23,467 323 5.54 28,454 420 5.99
Real estate construction -
commercial 85,573 1,108 5.21 109,769 1,403 5.18
Real estate mortgage - residential 250,757 3,132 5.02 243,853 3,047 5.07
Real estate mortgage - commercial 573,133 7,005 4.92 526,069 6,240 4.81
Installment and other consumer 31,441 357 4.57 32,238 336 4.23
Total loans $ 1,163,453 $ 14,495 5.01 % $ 1,146,111 $ 14,188 5.02 %
Loans held for sale $ 1,892 $ 5 1.06 % $ 490 $ - - %
Investment securities:
U.S. Treasury $ 758 $ 4 2.12 % $ 2,491 $ 13 2.12 %
U.S. government and federal agency
obligations 37,167 195 2.11 51,963 239 1.87
Obligations of states and political
subdivisions 36,785 270 2.95 38,937 255 2.66
Mortgage-backed securities 104,029 525 2.03 116,330 667 2.33
Other debt securities 4,402 60 5.48 4,409 64 5.89
Total investment securities $ 183,141 $ 1,054 2.31 % $ 214,130 $ 1,238 2.34 %
Other investment securities 6,253 100 6.43 5,677 66 4.71
Federal funds sold and interest
bearing deposits in other financial
institutions 82,215 325 1.59 99,013 602 2.47
Total interest earning assets $ 1,436,954 $ 15,979 4.47 % $ 1,465,421 $ 16,094 4.45 %
All other assets 83,136 84,740
Allowance for loan losses (12,584) (11,786)
Total assets $ 1,507,506 $ 1,538,375
LIABILITIES AND STOCKHOLDERS' EQUITY
NOW accounts $ 185,642 $ 290 0.63 % $ 238,076 $ 781 1.33 %
Savings 100,862 22 0.09 92,426 17 0.07
Interest checking 47,295 173 1.47 10,556 49 1.88
Money market 270,520 462 0.69 295,335 869 1.19
Time deposits 323,103 1,165 1.45 362,660 1,371 1.53
Total interest bearing deposits $ 927,422 $ 2,112 0.92 % $ 999,053 $ 3,087 1.25 %
Federal funds purchased and
securities sold under agreements to
repurchase 26,290 37 0.57 20,836 33 0.64
Federal Home Loan Bank advances and
other borrowings 108,031 632 2.35 95,133 542 2.31
Subordinated notes 49,486 501 4.07 49,486 624 5.11
Total borrowings $ 183,807 $ 1,170 2.56 % $ 165,455 $ 1,199 2.94 %
Total interest bearing liabilities $ 1,111,229 $ 3,282 1.19 % $ 1,164,508 $ 4,286 1.49 %
Demand deposits 261,244 256,014
Other liabilities 17,433 15,049
Total liabilities 1,389,906 1,435,571
Stockholders' equity 117,600 102,804
Total liabilities and stockholders'
equity $ 1,507,506 $ 1,538,375
Net interest income (FTE) $ 12,697 $ 11,808
Net interest spread 3.28 % 2.96 %
Net interest margin 3.55 % 3.27 %
-------------------------------------------------------------------------------- (1)Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the three months endedMarch 31, 2020 and 2019. Such adjustments totaled$171,000 and$179,000 for the three months endedMarch 31, 2020 and 2019, respectively.
(2)Non-accruing loans are included in the average amounts outstanding.
(3)Fees and costs on loans are included in interest income.
44
Rate and Volume Analysis
The following table summarizes the changes in net interest income on a fully
taxable equivalent basis, by major category of interest earning assets and
interest bearing liabilities, identifying changes related to volumes and rates
for the three months ended March 31, 2020 compared to the three months ended
March 31, 2019 . The change in interest due to the combined rate/volume variance
has been allocated to rate and volume changes in proportion to the absolute
dollar amounts of change in each.
Three Months Ended March 31,
2020 vs. 2019
Change due to
Total Average Average
(In thousands) Change Volume Rate
Interest income on a fully taxable equivalent basis:
(1)
Loans: (2) (3)
Commercial $ (172) $ (88) $ (84)
Real estate construction - residential (97) (71) (26)
Real estate construction - commercial (295) (314) 19
Real estate mortgage - residential 85 86 (1)
Real estate mortgage - commercial 765 572 193
Installment and other consumer 21 (8) 29
Loans held for sale 5 - 5
Investment securities:
U.S. Treasury (9) (9) -
U.S. government and federal agency obligations (44) (75) 31
Obligations of states and political subdivisions 15 (15) 30
Mortgage-backed securities (142) (67) (75)
Other debt securities (4) - (4)
Other investment securities 34 8 26
Federal funds sold and interest bearing deposits in
other financial institutions (277) (90) (187)
Total interest income (115) (71) (44)
Interest expense:
NOW accounts (491) (145) (346)
Savings 5 2 3
Interest checking 124 137 (13)
Money market (407) (68) (339)
Time deposits (206) (145) (61)
Federal funds purchased and securities sold under
agreements to repurchase 4 8 (4)
Federal Home Loan Bank advances and other borrowings 90 75 15
Subordinated notes (123) - (123)
Total interest expense (1,004) (136) (868)
Net interest income on a fully taxable equivalent
basis $ 889 $
65
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(1)Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 21%, net of nondeductible interest expense, for the three months endedMarch 31, 2020 and 2019. Such adjustments totaled$171,000 for the three months endedMarch 31, 2020 compared to$179,000 for the three months endedMarch 31, 2019 .
(2)Non-accruing loans are included in the average amounts outstanding.
(3)Fees and costs on loans are included in interest income.
Financial results for the quarter endedMarch 31, 2020 compared to the quarter endedMarch 31, 2019 , reflected an increase in net interest income, on a tax equivalent basis, of$889,000 , or 7.53%. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) increased to 3.55% for the quarter endedMarch 31, 2020 , compared to 3.27% for the quarter endedMarch 31, 2019 . Net interest income and net interest margin increased primarily due to an increase in average loan balances along with a decrease in average interest bearing liabilities and rates paid in the three month comparative periods. 45 Average interest-earning assets decreased$28.5 million , or 1.94%, to$1.44 billion for the three months endedMarch 31, 2020 compared to$1.47 billion for the three months endedMarch 31, 2019 , and average interest bearing liabilities decreased$53.3 million , or 4.58%, to$1.11 billion for the three months endedMarch 31, 2020 compared to$1.16 billion for the three months endedMarch 31, 2019 . Total interest income (expressed on a fully taxable equivalent basis) was$16.0 million for the three endedMarch 31, 2020 compared to$16.1 million for the three months endedMarch 31, 2019 . The Company's rates earned on interest earning assets were 4.47% for the three months endedMarch 31, 2020 compared to 4.45% for the three months endedMarch 31, 2019 .
Interest income on loans increased to
Average loans outstanding increased$17.3 million , or 1.51%, to$1.16 billion for the three months endedMarch 31, 2020 compared to$1.15 billion for the three months endedMarch 31, 2019 . The average yield on loans decreased to 5.01% for the three months endedMarch 31, 2020 compared to 5.02% for the three months endedMarch 31, 2019 . See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio. Total interest expense decreased to$3.3 million for the three months endedMarch 31, 2020 compared to$4.3 million for the three months endedMarch 31, 2019 . The Company's rates paid on interest bearing liabilities were 1.19% for the three months endedMarch 31, 2020 compared to 1.49% for the three months endedMarch 31, 2019 . See the Liquidity Management section for further discussion.
Interest expense on deposits decreased to
Average interest bearing deposits decreased$71.6 million , or 7.17%, to$927.4 million for the three months endedMarch 31, 2020 compared to$999.1 million for the three months endedMarch 31, 2019 . These decreases were primarily due to a decrease in public funds resulting from the loss of a public fund account at renewal, decreases in NOW accounts, brokered and CDAR certificates of deposits due to lower market rates paid during the current quarter. The average cost of deposits decreased to 0.92% for the three months endedMarch 31, 2020 compared to 1.25% for the three months endedMarch 31, 2019 . The decrease was primarily due to generally lower market interest rates quarter over quarter.
Interest expense on borrowings was approximately
Average borrowings increased to$183.8 million for the three months endedMarch 31, 2020 compared to$165.5 million for the three months endedMarch 31, 2019 . The increase in average borrowings was primarily due to an increase in FHLB advances to fund liquidity needs. The average cost of borrowings decreased to 2.56% for the three months endedMarch 31, 2020 compared to 2.94% for the three months endedMarch 13, 2019 . The decrease in cost of funds primarily resulted from lower market interest rates. See the Liquidity Management section for further discussion. 46
Non-interest income and expense
Non-interest income for the periods indicated was as follows:
Three Months Ended March 31,
(In thousands) 2020 2019 $ Change % Change
Non-interest income
Service charges and other fees $ 799 $ 862 $ (63) (7.3) %
Bank card income and fees 693 695 (2) (0.3)
Trust department income 379 293 86 29.4
Real estate servicing fees, net (87) 84 (171) (203.6)
Gain on sales of mortgage loans, net 419 105 314 299.0 Other 45 52 (7) (13.5) Total non-interest income$ 2,248 $ 2,091 $ 157 7.5 %
Non-interest income as a % of total
revenue * 15.2 % 15.2 %
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*Total revenue is calculated as net interest income plus non-interest income.
Total non-interest income increased
Service charges and fees decreased$63,000 , or 7.3%, to$799,000 for the quarter endedMarch 31, 2020 compared to$862,000 for the quarter endedMarch 31, 2019 . The decrease in fees was a result in a change to the nonsufficient funds service charges (NSF) in 2019. Trust department income increased$86,000 , or 29.4%, to$379,000 for the quarter endedMarch 31, 2020 compared to$293,000 for the quarter endedMarch 31, 2019 . The increase was primarily due to one-time fees received during the first quarter endedMarch 31, 2020 . The Company also added new Trust department personnel during the fourth quarter of 2019. Real estate servicing fees, net of the change in valuation of mortgage servicing rights (MSRs) decreased$171,000 , or 203.6%, to$(87,000) for the quarter endedMarch 31, 2020 compared to$84,000 for the quarter endedMarch 31, 2019 . Mortgage loan servicing fees earned on loans sold were$188,000 for the three months endedMarch 31, 2020 compared to$178,000 for the three months endedMarch 31, 2019 . The current quarter's MSR valuation decreased$275,000 fromDecember 31, 2019 primarily due to increased prepayment assumptions. There was a dramatic drop in rates fromDecember 31, 2019 toMarch 31, 2020 , especially in the ten yearTreasury rate resulting in an incentive for borrowers to refinance their existing loans. The Company was servicing$270.6 million of mortgage loans atMarch 31, 2020 compared to$271.4 million and$275.7 million atDecember 31, 2019 andMarch 31, 2019 , respectively. Gain on sales of mortgage loans increased$314,000 , or 299.0%, to$419,000 for the quarter endedMarch 31, 2020 compared to$105,000 for the quarter endedMarch 31, 2019 . During the fourth quarter of 2019, the Company focused on the growth of a new mortgage loan department and began offering new mortgage loan products in addition to Freddie and Fannie loans. The Company sold$13.2 million of loans for the three months endedMarch 31, 2020 compared to$5.1 million for the three months endedMarch 31, 2019 . Other Income decreased$7,000 , or 13.5%, to$45,000 for the quarter endedMarch 31, 2020 compared to$52,000 for the quarter endedMarch 31, 2019 . The decrease in the current quarter was primarily due to decreased brokerage income, and insurance commissions and a decrease in income earned on bank owned life insurance policies due to one of the Company's polices being redeemed in the third quarter of 2019. 47 Investment securities (losses) gains, net for the periods indicated were as follows: Three Months Ended March 31, (in thousands) 2020 2019 Investment securities (losses) gains, net Available for sale securities: Gains realized on sales $ - $
-
Losses realized on sales -
-
Other-than-temporary impairment recognized -
-
Other investment securities: Fair value adjustments, net (1)
1
Investment securities (losses) gains, net $ (1) $
1
During the three months endedMarch 31, 2020 , the Company received$681,000 from the proceeds from the sale of available for sale debt securities and recognized an immaterial gain. There were no securities sales during the three months endedMarch 31, 2019 . The Company recognized an unrealized loss of$1,000 for the three months endedMarch 31, 2020 , compared to an unrealized gain of$1,000 for the three months endedMarch 31, 2019 related to equity securities.
Non-interest expense for the periods indicated was as follows:
Three Months Ended March 31,
(In thousands) 2020 2019 $ Change % Change
Non-interest expense
Salaries $ 4,512 $ 3,972 $ 540 13.6 %
Employee benefits 1,609 1,466 143 9.8
Occupancy expense, net 766 698 68 9.7
Furniture and equipment expense 695 809 (114) (14.1)
Processing, network and bank card expense 976 1,001 (25) (2.5)
Legal, examination, and professional fees 367 329 38 11.6
Advertising and promotion 249 258 (9) (3.5)
Postage, printing, and supplies 241 210 31 14.8
Other 1,033 1,145 (112) (9.8)
Total non-interest expense $ 10,448 $ 9,888 $ 560 5.7 %
Efficiency ratio* 70.7 % 72.1 %
Number of full-time equivalent employees 303 286
--------------------------------------------------------------------------------
*Efficiency ratio is calculated as non-interest expense as a percent of revenue. Total revenue includes net interest income and non-interest income.
Total non-interest expense increased
Salaries increased
The increase was primarily due to adding 17 full-time equivalent (FTE) employees to expand the Company's new mortgage loan department. In addition, annual merit increases average approximately 4.0% each year and are granted in the first quarter of each year. Employee benefits increased$143,000 , or 9.8%, to$1.6 million for the quarter endedMarch 31, 2020 compared to$1.5 million for the quarter endedMarch 31, 2019 . The increase for the quarter endedMarch 31, 2020 over the quarter endedMarch 31, 2019 was primarily due to higher pension cost due to lower annual discount rate assumptions compared to the prior year's annual assumptions, an increase in payroll taxes due to increase in FTE mentioned above, partially offset by a decrease in medical plan premiums due to savings realized from fewer benefit claims. 48 Furniture and equipment expense decreased$114,000 , or 14.1%, to$695,000 for the quarter endedMarch 31, 2020 compared to$809,000 for the quarter endedMarch 31, 2019 . The decrease for the quarter endedMarch 31, 2020 over the quarter endedMarch 31, 2019 was primarily due to a decrease in reoccurring core maintenance agreement expenses. In addition, the Company recognized a$55,000 gain on sale of land adjacent to one of its branches. Other non-interest expense decreased$112,000 , or 9.8%, to$1.0 million for the quarter endedMarch 31, 2020 compared to$1.1 million for the quarter endedMarch 31, 2019 . The decrease was primarily related to aFDIC assessment credit received in the third quarter of 2019 through the first quarter of 2020, a decrease in real estate foreclosure expenses, and a decrease in insurance expense.
Income taxes
Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 15.3% for the three months endedMarch 31, 2020 compared to 18.9% for the three months endedMarch 31, 2019 . The decrease in the effective tax rate was primarily attributable to the impact of tax-free revenues having a greater impact to pre-tax income due to the reduced level of earnings this quarter.
Lending and Credit Management
Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 76.3% of total assets as ofMarch 31, 2020 compared to 77.5% as ofDecember 31, 2019 . Lending activities are conducted pursuant to an established loan policy approved by the Bank's Board of Directors. The Bank's credit review process is overseen by regional loan committees with established loan approval limits. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.
A summary of loans, by major class within the Company's loan portfolio as of the dates indicated is as follows:
March 31, December 31,
(In thousands) 2020 2019
Commercial, financial, and agricultural
Real estate construction - residential 23,913 23,035
Real estate construction - commercial 87,497 84,998
Real estate mortgage - residential 246,859 252,643
Real estate mortgage - commercial 585,900 576,635
Installment and other consumer 30,696 32,464
Total loans $ 1,180,522 $ 1,168,797
Percent of categories to total loans:
Commercial, financial, and agricultural 17.4 % 17.0 %
Real estate construction - residential 2.0 2.0
Real estate construction - commercial 7.4 7.3
Real estate mortgage - residential 20.9 21.6
Real estate mortgage - commercial 49.6 49.3
Installment and other consumer 2.6
2.8
Total 100.0 % 100.0 %
The Company extends credit to its local community market through traditional
real estate mortgage products. The Company does not participate in extending
credit to sub-prime residential real estate markets. The Company does not lend
funds for transactions defined as "highly leveraged" by bank regulatory
authorities or for foreign loans. Additionally, the Company does not have any
concentrations of loans exceeding 10% of total loans that are not otherwise
disclosed in the loan portfolio composition table. The Company does not have any
interest-earning assets that would have been included in nonaccrual, past due,
or restructured loans if such assets were loans.
49
The Company generally does not retain long-term fixed rate residential mortgage
loans in its portfolio. Fixed rate loans conforming to standards required by the
secondary market are offered to qualified borrowers, but are not funded until
the Company has a non-recourse purchase commitment from the secondary market at
a predetermined price. During the three months ended March 31, 2020 , the Company
sold approximately $13.2 million of loans to investors, compared to $5.1 million
for the three months ended March 31, 2019 . At March 31, 2020 , the Company was
servicing approximately $270.6 million of loans sold to the secondary market
compared to $271.4 million at December 31, 2019 , and $275.7 million at March 31,
2019 .
Risk Elements of the Loan Portfolio
Management, the senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Loans in excess of$2.0 million in aggregate and all adversely classified credits identified by management are reviewed by the senior loan committee. In addition, all other loans are reviewed on a risk weighted selection process. The senior loan committee reviews and reports to the board of directors, on a monthly basis, past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided in the FASB's ASC Topic 310-10-35 in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered necessary by management to provide for probable losses inherent in the loan portfolio.
Non-performing Assets
The following table summarizes non-performing assets at the dates indicated:
March 31, December 31, March 31,
(In thousands) 2020 2019 2019
Nonaccrual loans:
Commercial, financial, and agricultural $ 3,111 $ 982 $ 1,747
Real estate construction - residential - - -
Real estate construction - commercial 408 137 151
Real estate mortgage - residential 3,211 2,135 2,803
Real estate mortgage - commercial 1,068 1,359 508
Installment and other consumer 46 141 222
Total $ 7,844 $ 4,754 $ 5,431
Loans contractually past - due 90 days or
more and still accruing:
Commercial, financial, and agricultural $ - $ - $ -
Real estate construction - residential - - -
Real estate construction - commercial - - -
Real estate mortgage - residential 190 304 140
Real estate mortgage - commercial - - -
Installment and other consumer 27 12 5
Total $ 217 $ 316 $ 145
Total non-performing loans (a) 8,061 5,070 5,576
Other real estate owned and repossessed
assets 12,769 12,781 13,537
Total non-performing assets $ 20,830 $ 17,851 $ 19,113
50
Loans held for investment $ 1,180,522 $ 1,168,797 $ 1,153,640
Allowance for loan losses to loans 1.33 % 1.07 % 1.03 %
Non-performing loans to loans (a) 0.68 % 0.43 % 0.48 %
Non-performing assets to loans (b) 1.76 % 1.53 % 1.66 %
Non-performing assets to assets (b) 1.36 % 1.20 % 1.24 % Allowance for loan losses to non-performing loans 194.68 % 246.09 % 212.43 %
(a) Non-performing loans include loans 90 days past due and accruing, nonaccrual
loans, and non-performing TDRs included in nonaccrual loans.
(b) Non-performing assets include non-performing loans and other real estate
owned and repossessed assets.
(c) Loan totals do not include loans held for sale.
Total non-performing assets were$20.8 million , or 1.76% of total loans, atMarch 31, 2020 compared to$17.9 million , or 1.53% of total loans, atDecember 31, 2019 , and$19.1 million , or 1.66% of total loans, atMarch 31, 2019 , respectively. Non-performing loans included$1.2 million of loans classified as TDRs atMarch 31, 2020 compared to$1.6 million and$1.9 million atDecember 31, 2019 andMarch 31, 2019 , respectively. As ofMarch 31, 2020 , approximately$5.8 million compared to$9.0 million and$5.4 million atDecember 31, 2019 andMarch 31, 2019 , respectively, of loans classified as substandard, which include performing TDRs, and are not included in the non-performing asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. Management believes the general allowance was sufficient to cover the risks and probable losses related to such loans atMarch 31, 2020 andDecember 31, 2019 , respectively. Total non-accrual loans atMarch 31, 2020 increased$3.1 million , 65.0%, to$7.8 million compared to$4.8 million atDecember 31, 2019 . The increase in non-accrual loans primarily consisted of increases in commercial, financial, and agricultural loans, and real estate mortgage residential loans related to one loan relationship. Loans past due 90 days and still accruing interest atMarch 31, 2020 , were$217,000 compared to$316,000 atDecember 31, 2019 . Other real estate and repossessed assets were$12.8 million atMarch 31, 2020 andDecember 31, 2019 , respectively. During the three months endedMarch 31, 2020 , there were no non-accrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to$116,000 during the three months endedMarch 31, 2019 .
The following table summarizes the Company's TDRs at the dates indicated:
March 31, 2020 December 31, 2019
Number of Recorded Specific Number of Recorded Specific
(In thousands) contracts Investment Reserves contracts Investment Reserves
Performing TDRs
Commercial, financial and agricultural 5 $ 521 $ 175 5 $ 532 $ 177
Real estate mortgage - residential 6 1,554 32 6 1,615 33
Real estate mortgage - commercial 2 350 7 2 352 7
Installment and other consumer 5 88 7 2 36 2
Total performing TDRs 18 $ 2,513 $ 221 15 $ 2,535 $ 219
Non-performing TDRs
Commercial, financial and agricultural 6 $ 480 $ 77 6 $ 496 $ 99
Real estate mortgage - residential 6 757 76 6 782 117
Real estate mortgage - commercial 1 6 1 2 266 -
Installment and other consumer - - - 2 72 7
Total non-performing TDRs 13 $ 1,243 $ 154 16 $ 1,616 $ 223
Total TDRs 31 $ 3,756 $ 375 31 $ 4,151 $ 442
51
At March 31, 2020 , loans classified as TDRs totaled $3.8 million , with $375,000
of specific reserves compared to $4.2 million of loans classified as TDRs, with
$442,000 of specific reserves at December 31, 2019 . Both performing and
nonperforming TDRs are considered impaired loans. When an individual loan is
determined to be a TDR, the amount of impairment is based upon the present value
of expected future cash flows discounted at the loan's effective interest rate
or the fair value of the underlying collateral less applicable selling costs if
the loan is collateral dependent. The net decrease in total TDRs from December
31, 2019 to March 31, 2020 was primarily due to $383,000 of payments received on
TDRs, partially offset by one new TDR totaling $6,000 .
Allowance for Loan Losses and Provision
Allowance for Loan Losses
The following table is a summary of the allocation of the allowance for loan
losses:
March 31, December 31,
(In thousands) 2020 2019Allocation of allowance for loan losses at end of period: Commercial, financial, and agricultural
$ 3,623 $ 2,918 Real estate construction - residential 117 64 Real estate construction - commercial 622 369 Real estate mortgage - residential 2,363 2,118 Real estate mortgage - commercial 8,614 6,547 Installment and other consumer 351 381 Unallocated 3 80 Total$ 15,693 $ 12,477 The allowance for loan losses (ALL) was$15.7 million , or 1.33% of loans outstanding, atMarch 31, 2020 compared to$12.5 million , or 1.07%, atDecember 31, 2019 , and$11.8 million , or 1.03% atMarch 31, 2019 . The ratio of the allowance for loan losses to nonperforming loans was 194.68% atMarch 31, 2020 , compared to 246.09% atDecember 31, 2019 , and 212.43% atMarch 31, 2019 . The following table is a summary of the general and specific allocations of the allowance for loan losses: March 31, December 31, (In thousands) 2020 2019 Allocation of allowance for loan losses: Individually evaluated for impairment - specific reserves$ 570 $ 615 Collectively evaluated for impairment - general reserves 15,123 11,862 Total$ 15,693 $ 12,477 The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. AtMarch 31, 2020 ,$570,000 of the Company's ALL was allocated to impaired loans totaling approximately$10.4 million compared to$615,000 of the Company's ALL allocated to impaired loans totaling approximately$7.4 million atDecember 31, 2019 . Management determined that$5.4 million , or 53%, of total impaired loans required no reserve allocation atMarch 31, 2020 compared to$2.6 million , or 35%, atDecember 31, 2019 , primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability. The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying loss rates to pools of loans by asset type. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type. In the first quarter of 2019, management adjusted the look-back period to begin with loss history in the first quarter 2012 as 52 the starting point through the current quarter and it will continue to include this starting point going forward. At that time, Management determined that with the extended economic recovery then existing, the look-back period should be expanded to include the current economic cycle. The look-back period will then be adjusted once a sustained loss producing downturn is recognized by allowing the look-back period to shift forward by eliminating the earliest loss period and replenishing it with losses from the most recent period. The look-back period is consistently evaluated for relevance given the current facts and circumstances. These historical loss rates for each risk group are used as the starting point to determine loss rates for measurement purposes. The historical loan loss rates are multiplied by loss emergence periods (LEP) which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss. The Company's methodology includes qualitative risk factors that allow management to adjust its estimates of losses based on the most recent information available and to address other limitations in the quantitative component that is based on historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions and developments, the nature, volume and terms of loans in the portfolio, including changes in volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans, loan concentrations, assessment of trends in collateral values, assessment of changes in the quality of the Company's internal loan review department, and changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices.
The specific and general reserve allocations represent management's best estimate of probable losses inherent in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.
As a result of rapidly increasing unemployment rates resulting from the COVID-19 virus, management determined that the first quarter 2020 allowance for loan loss economic qualitative adjustment should be temporarily adapted to utilize current published statistics rather than the lagging statistics that had been utilized historically. While these lagging indicators have been very reliable for some time, they do not accurately capture the risk that has been brought about by rapid changes in the economy. Based upon the change in the national unemployment rate available as ofMarch 31, 2020 , the economic qualitative adjustment was increased according to the Company's methodology to account for the uncertainty in economic conditions compared to the lookback period. Management believes this temporary alteration will be a better indicator until the economy stabilizes and the true impact can be measured. The more significant changes fromDecember 31, 2019 toMarch 31, 2020 in the allocations of the allowance for loan losses to the loan portfolios listed above was primarily attributed to the additional economic qualitative factor adjustment resulting from the COVID-19 pandemic.
Provision
A$3.3 million provision for loan losses was required for the three months endedMarch 31, 2020 compared to a$150,000 provision for the three months endedMarch 31, 2019 . In March of 2020, an additional$3.0 million was recorded during the quarter due to current economic conditions resulting from the COVID-19 pandemic. 53 The following table summarizes loan loss experience for the periods indicated: Three Months Ended March 31, (In thousands) 2020 2019 Analysis of allowance for loan losses: Balance beginning of period$ 12,477 $ 11,652 Charge-offs: Commercial, financial, and agricultural 41 53 Real estate construction - residential - - Real estate construction - commercial - - Real estate mortgage - residential 19 84 Real estate mortgage - commercial 22 8 Installment and other consumer 52 52 Total charge-offs 134 197 Recoveries: Commercial, financial, and agricultural$ 25 $ 108 Real estate construction - residential - - Real estate construction - commercial - - Real estate mortgage - residential 9 99 Real estate mortgage - commercial 2 - Installment and other consumer 14 33 Total recoveries 50 240 Net charge-offs 84 (43) Provision for loan losses 3,300 150 Balance end of period$ 15,693 $ 11,845 Net Loan Charge-offs The Company's net charge-offs were$84,000 , or 0.01% of average loans, for the three months endedMarch 31, 2020 compared to net recoveries of$43,000 , or 0.00% of average loans, for the three months endedMarch 31, 2019 . The increase in net charge-offs for the three months endedMarch 31, 2020 compared to the three months endedMarch 31, 2019 was primarily related to one commercial loan relationship recovery and one real estate mortgage - residential recovery received during the first quarter of 2019.
Loans Held For Sale
The Company designates certain long-term fixed rate personal real estate loans as held for sale, and the Company carries them at the lower of cost or fair value. The loans are primarily sold to Freddie Mac, Fannie Mae, andPennyMac . AtMarch 31, 2020 , the carrying amount of these loans was$4.3 million . In the fourth quarter of 2019 the Company expanded its current home loan program to better serve our customers. This expansion began with hiring new mortgage lending personnel and expanding the bank's available loan products and upgrading the Company's operating systems. New home loan programs for its customers includeVA loans, designed for military families and veterans;USDA loans for those buying homes in rural communities; and FHA loans, which offer low down payments and flexible underwriting guidelines. In addition, we have added several secondary market investors, allowing us to sell loans on the secondary market versus servicing them at the Company. This provides us with the ability to offer clients more aggressive pricing and improve our bottom line. 54
Liquidity and Capital Resources
Liquidity Management
The role of liquidity management is to ensure funds are available to meet depositors' withdrawal and borrowers' credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by the Company, management prefers to focus on transaction accounts and full service relationships with customers. The Company's Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for the Company's liquidity position and profile. A combination of daily, weekly, and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital, and exposure to contingent draws on the Company's liquidity. The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company's most liquid assets are comprised of available-for-sale investment securities, not including other debt securities, federal funds sold, and excess reserves held at theFederal Reserve . March 31, December 31, (In thousands) 2020 2019
Federal funds sold and other overnight interest-bearing deposits
$ 58,619 $ 55,545 Certificates of deposit in other banks 11,106
10,862
Available-for-sale investment securities 198,049 175,093 Total$ 267,774 $ 241,500 Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was$198.0 million atMarch 31, 2020 and included an unrealized net gain of$2.7 million . The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately$13.4 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company's deposit base. The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at theFederal Reserve Bank , and for other purposes required by law. AtMarch 31, 2020 andDecember 31, 2019 , the Company's unpledged securities in the available for sale portfolio totaled approximately$48.3 million and$35.3 million , respectively.
Total investment securities pledged for these purposes were as follows:
March 31, December 31,
(In thousands) 2020 2019
Investment securities pledged for the purpose of securing:
$ 9,521 $ 9,385 Federal funds purchased and securities sold under agreements to repurchase 41,047 38,238 Other deposits 99,193 92,189 Total pledged, at fair value$ 149,761 $ 139,812 Liquidity is available from the Company's base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than$250,000 , less all brokered deposits under$250,000 . AtMarch 31, 2020 , such deposits totaled$1.0 billion and represented 86.3% of the Company's total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships. 55
Core deposits at
March 31, December 31,
(In thousands) 2020 2019
Core deposit base:
Non-interest bearing demand $ 272,578 $ 261,166
Interest checking 202,213 227,662
Savings and money market 353,936 346,593
Other time deposits 189,497 197,089
Total $ 1,018,224 $ 1,032,510
Time deposits and certificates of deposit of $250,000 and greater at March 31,
2020 and December 31, 2019 were $111.8 million and $104.3 million , respectively.
The Company had brokered deposits totaling $42.6 million and $45.2 million at
March 31, 2020 and December 31, 2019 , respectively.
Other components of liquidity are the level of borrowings from third party
sources and the availability of future credit. The Company's outside borrowings
are comprised of securities sold under agreements to repurchase, Federal Home
Loan Bank advances, and subordinated notes. Federal funds purchased are
overnight borrowings obtained mainly from upstream correspondent banks with
which the Company maintains approved credit lines. As of March 31, 2020 ,
under agreements with these unaffiliated banks, the Bank may borrow up to $50.0
million in federal funds on an unsecured basis and $15.9 million on a secured
basis. There were no federal funds purchased outstanding at March 31, 2020 .
Securities sold under agreements to repurchase are generally borrowed overnight
and are secured by a portion of the Company's investment portfolio. At March 31,
2020 , there were $30.8 million in repurchase agreements. The Company may
periodically borrow additional short-term funds from the Federal Reserve Bank
through the discount window, although no such borrowings were outstanding at
March 31, 2020 .
The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB) and has
access to credit products of the FHLB. As of March 31, 2020 , the Bank had $133.8
million in outstanding borrowings with the FHLB. In addition, the Company has
$49.5 million in outstanding subordinated notes issued to wholly-owned grantor
trusts, funded by preferred securities issued by the trusts.
Borrowings outstanding at March 31, 2020 and December 31, 2019 were as follows:
March 31, December 31,
(In thousands) 2020 2019
Borrowings:
Federal funds purchased and securities sold under
agreements to repurchase $ 30,764 $ 27,272
Federal Home Loan Bank advances 133,837 96,895
Subordinated notes 49,486 49,486
Other borrowings 24 24
Total $ 214,111 $ 173,677
The Company pledges certain assets, including loans and investment securities to
the Federal Reserve Bank , FHLB, and other correspondent banks as security to
establish lines of credit and borrow from these entities. Based on the type and
value of collateral pledged, the FHLB establishes a collateral value from which
the Company may draw advances against this collateral. This collateral is also
used to enable the FHLB to issue letters of credit in favor of public fund
depositors of the Company. The Federal Reserve Bank also establishes a
collateral value of assets pledged to support borrowings from the discount
window. The following table reflects collateral value of assets pledged,
borrowings, and letters of credit outstanding, in addition to the estimated
future funding capacity available to the Company as follows:
56
March 31, December 31,
2020 2019
Federal Federal
Funds Funds
Federal Purchased Federal Purchased
(In thousands) FHLB Reserve Bank Lines
Total FHLB
- - (81,000) (115,000) - - (115,000)
Advances outstanding (133,837) - - (133,837) (96,895) - - (96,895)
Total available
AtMarch 31, 2020 , loans of$510.3 million were pledged at theFederal Home Loan Bank as collateral for borrowings and letters of credit. AtMarch 31, 2020 , investments totaling$18.1 million were pledged to secure federal funds purchase lines and borrowing capacity at theFederal Reserve Bank . Based upon the above, management believes the Company has more than adequate liquidity, both on balance sheet and through the additional funding capacity with the FHLB, theFederal Reserve Bank and Federal funds purchased lines to meet future anticipated needs. This includes the impact of the COVID-19 pandemic that is difficult to currently measure. Management believes the most significant impact to the Company's liquidity position will be short-term as the SBA PPP loans are expected to be forgiven by the SBA and mostly paid off within the next two to three months. In addition, loan modifications are generally for two to three months at which time resumption of regular payments is generally expected. The longer-term impact on the Company's liquidity from the pandemic will be closely monitored and addressed as the need arises.
The Company also has available additional liquidity by pledging the PPP loans to
either the FHLB or the
Sources and Uses of Funds
Cash and cash equivalents were$75.3 million atMarch 31, 2020 compared to$78.1 million atDecember 31, 2019 . The$2.8 million decrease resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the three months endedMarch 31, 2020 . Cash outflow used in operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities used total cash of$542,000 for the three months endedMarch 31, 2020 . Investing activities consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio used total cash of$34.3 million . The cash outflow primarily consisted of$44.0 million purchase of investment securities and$11.8 million increase in loans, partially offset by$23.5 million from maturities, calls, and sales of investment securities. Financing activities provided cash of$32.0 million , resulting primarily from a$37.0 million increase in net FHLB advances, and an$11.4 million increase in demand deposits, partially offset by an$18.0 million decrease in interest bearing transaction accounts. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2020. In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company's various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company's liquidity. The Company had$362.7 million in unused loan commitments and standby letters of credit as ofMarch 31, 2020 . Although the Company's current liquidity resources are adequate to fund this commitment level the nature of these commitments is such that the likelihood of such a funding demand is very low. The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company's ongoing liquidity needs primarily include funding its operating expenses and paying cash 57 dividends to its shareholders. The Company paid cash dividends to its shareholders totaling approximately$753,000 and$603,000 for the three months endedMarch 31, 2020 and 2019, respectively. A large portion of the Company's liquidity is obtained from the Bank in the form of dividends. The Bank did not declare or pay dividends during the three months endedMarch 31, 2020 , and declared and paid$1.5 million in dividends to the Company during the three months endedMarch 31, 2019 . AtMarch 31, 2020 andDecember 31, 2019 , the Company had cash and cash equivalents totaling$781,000 and$2.6 million , respectively.
Capital Management
The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of the Company and the Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. InJuly 2013 , the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for the Company began onJanuary 1, 2015 .The Federal Reserve System's (FRB) capital adequacy guidelines require that bank holding companies maintain a Common Equity Tier 1 risk-based capital ratio equal to at least 4.5% of its risk-weighted assets, a Tier 1 risk-based capital ratio equal to at least 6% of its risk-weighted assets and a total risk-based capital ratio equal to at least 8% of its risk-weighted assets. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 4%. In addition, the final rules establish a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer requirement began being phased in over four years beginning in 2016. OnJanuary 1, 2016 , the first phase of the requirement went into effect at 0.625% of risk-weighted assets, and increased each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of risk weighted assets onJanuary 1, 2019 . AtDecember 31, 2019 , the capital conservation buffer of 2.5%, effectively raised the minimum required risk-based capital ratios to 7% Common Equity Tier 1 Capital, 8.5% Tier 1 Capital and 10.5% Total Capital on a fully phased-in basis. 58 Under the Basel III requirements, atMarch 31, 2020 andDecember 31, 2019 , the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of periods indicated:
Required - Basel III Considered Well-
Actual Fully Phased-In * Capitalized
(in thousands) Amount Ratio Amount Ratio Amount Ratio
March 31, 2020
Total Capital (to risk-weighted
assets):
Company $ 181,453 14.80 % $ 128,756 10.50 % $ - N.A %
Bank 179,656 14.73 128,076 10.50 121,977 10.00
Tier 1 Capital (to risk-weighted
assets):
Company $ 157,082 12.81 % $ 104,231 8.50 % $ - N.A %
Bank 164,395 13.48 103,680 8.50 97,582 8.00
Common Equity Tier 1 Capital (to
risk-weighted assets):
Company $ 118,192 9.64 % $ 85,837 7.00 % $ - N.A %
Bank 164,395 13.48 85,384 7.00 79,285 6.50
Tier 1 leverage ratio (to adjusted
average assets):
Company $ 157,082 10.43 % $ 60,250 4.00 % $ - N.A %
Bank 164,395 10.98 59,886 4.00 74,857 5.00
December 31, 2019
Total Capital (to risk-weighted
assets):
Company $ 179,430 14.89 % $ 126,511 10.50 % $ - N.A %
Bank 175,459 14.60 126,165 10.50 120,158 10.00
Tier 1 Capital (to risk-weighted
assets):
Company $ 157,139 13.04 % $ 102,414 8.50 % $ - N.A %
Bank 162,822 13.55 102,134 8.50 96,126 8.00
Common Equity Tier 1 Capital (to
risk-weighted assets)
Company $ 118,793 9.86 % $ 84,341 7.00 % $ - N.A %
Bank 162,822 13.55 84,110 7.00 78,102 6.50
Tier 1 leverage ratio:
Company $ 157,139 10.73 % $ 58,562 4.00 % $ - N.A %
Bank 162,822 11.18 58,280 4.00 72,850 5.00© Edgar Online, source
