NORTHRIM BANCORP, INC. This discussion highlights key information as determined by management but may not contain all of the information that is important to you. For a more complete understanding, the following should be read in conjunction with the Company's audited consolidated financial statements and the notes thereto as ofDecember 31, 2019 , 2018 and 2017 included in Item 8 of this report. Discussions of 2017 items and year-to-year comparisons between 2018 and 2017 that are not included in this Form 10-K can be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of our Annual Report on Form 10-K for fiscal year endedDecember 31, 2018 . This annual report contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those indicated in forward-looking statements. See "Cautionary Note Regarding Forward-Looking Statements." Executive Overview Net income attributable to the Company increased 3% to$20.7 million or$3.04 per diluted share for the year endedDecember 31, 2019 , from$20.0 million , or$2.86 per diluted share, for the year endedDecember 31, 2018 . Significant items contributing to the increase in 2019 compared to 2018 were:
• an increase in mortgage banking income due to increased mortgage production;
• an increase in net interest income resulting from higher average net
interest-earning asset balances and higher average rates;
• an increase in the gain on marketable equity securities from changes in
fair value; and
• a benefit in the provision for loan losses primarily resulting from
improvements in credit quality and recoveries.
Highlights for the year ended
income, increased 9% to
This increase mainly reflects increases in net interest income, mortgage
banking income, changes in the fair value of marketable equity securities,
and higher interest rate swap income. These increases were partially
offset by a decrease in commercial servicing revenue.
• The net interest margin increased to 4.65% in 2019 from 4.55% in 2018
mostly due to an increase in average loans to $1.01 billion in 2019
compared to $971.5 million in 2018, as well as increases in average
interest rates.
• The provision for loan losses decreased in 2019 to a benefit of $1.2
million from a benefit of $500,000 in 2018. Our nonperforming loans, net
of government guarantees, decreased to $14.0 million at the end of 2019
compared to $14.7 million at the end of 2018, while total adversely
classified loans, net of government guarantees at December 31, 2019
decreased to $22.3 million from $27.2 million at December 31, 2018 . Theallowance for loan losses ("Allowance") totaled 1.83% of total portfolio
loans at
Allowance compared to nonperforming loans, net of government guarantees,
was 137% at
• Return on average assets was 1.33% in 2019 compared to 1.34% in 2018.
• The Company continued to maintain strong capital ratios with Tier 1
Capital to Risk Adjusted Assets of 14.38% at
to 15.47% at
• The aggregate cash dividends paid by the Company in 2019 rose 21% to
million from $7.1 million paid in 2018.
• The Company repurchased 347,676 shares of its common stock in 2019 at an
average price of $36.15 per share.
31-------------------------------------------------------------------------------- Critical Accounting Policies TheSEC defines "critical accounting policies" as those that require application of management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in future periods. Our significant accounting policies are described in Note 1 in the Notes to Consolidated Financial Statements in Item 8 of this report. Not all of these significant accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies would be considered critical under theSEC's definition. Allowance for loan losses: The Company maintains an Allowance to reflect inherent losses in its loan portfolio as of the balance sheet date. The Company performs regular credit reviews of the loan portfolio to determine the credit quality and adherence to underwriting standards. When loans are originated, they are assigned a risk rating that is reassessed periodically during the term of the loan through the credit review process. The Company's risk rating methodology assigns risk ratings ranging from 1 to 10, where a higher rating represents higher risk. These risk ratings are then consolidated into five classes, which include pass, special mention, substandard, doubtful and loss. These classes are a primary factor in determining an appropriate amount for the allowance for loan losses. Each class is assessed an inherent credit loss factor that determines an amount of allowance for loan losses provided for that group of loans. This allowance is then adjusted for qualitative factors, by segment and class. Qualitative factors are based on management's assessment of current trends that may cause losses inherent in the current loan portfolio to differ significantly from historical losses. Some factors that management considers in determining the qualitative adjustment to the general reserve include loan quality trends in our own portfolio, the degree of concentrations of large borrowers in our loan portfolio, national and local economic trends, business conditions, underwriting policies and standards, trends in local real estate markets, effects of various political activities, peer group data, and internal factors such as underwriting policies and expertise of the Company's employees. Regular credit reviews of the portfolio also identify loans that are considered potentially impaired. A loan is considered impaired when based on current information and events, we determine that we will probably not be able to collect all amounts due according to the loan contract, including scheduled interest payments. When we identify a loan as impaired, we measure the impairment using discounted cash flows, except when the sole remaining source of the repayment for the loan is the liquidation of the collateral. In these cases, we use the current fair value of the collateral, less selling costs, instead of discounted cash flows. The analysis of collateral dependent loans includes appraisals on loans secured by real property, management's assessment of the current market, recent payment history and an evaluation of other sources of repayment. The Company obtains appraisals on real and personal property that secure its loans during the loan origination process in accordance with regulatory guidance and its loan policy. The Company obtains updated appraisals on loans secured by real or personal property based upon its assessment of changes in the current market or particular projects or properties, information from other current appraisals and other sources of information. The Company uses the information provided in these updated appraisals along with its evaluation of all other information available on a particular property as it assesses the collateral coverage on its performing and nonperforming loans and the impact that may have on the adequacy of its Allowance. If we determine that the value of the impaired loan is less than the recorded investment in the loan, we either recognize an impairment reserve as a specific component to be provided for in the Allowance or charge-off the impaired balance on collateral dependent loans if it is determined that such amount represents a confirmed loss. The combination of the risk rating-based allowance component and the impairment reserve allowance component lead to an allocated allowance for loan losses. Finally, the Company assesses the overall adequacy of the Allowance based on several factors including the level of the Allowance as compared to total loans and nonperforming loans in light of current economic conditions. This portion of the Allowance is deemed "unallocated" because it is not allocated to any segment or class of the loan portfolio. This portion of the Allowance provides for coverage of credit losses inherent in the loan portfolio but not captured in the credit loss factors that are utilized in the risk rating-based component or in the specific impairment component of the Allowance and acknowledges the inherent imprecision of all loss prediction models. The unallocated portion of the Allowance is based upon management's evaluation of various factors that are not directly measured in the determination of the allocated portions of the Allowance. Such factors include uncertainties in identifying triggering events that directly correlate to subsequent loss rates, uncertainties in economic conditions, risk factors that have not yet manifested themselves in loss allocation factors, and historical loss experience data that may not precisely correspond to the current portfolio. In addition, the unallocated reserve may fluctuate based upon the direction of various risk indicators. Examples of such factors include the risk as to current and prospective economic conditions, the level and trend of charge offs or recoveries, and the risk of heightened imprecision or inconsistency of appraisals used in estimating real estate values. Although this allocation process may not accurately predict credit losses by loan type or in aggregate, the total allowance for credit losses is available to absorb losses that may arise from any loan type or category. Due to the subjectivity involved in the determination of the unallocated portion of the Allowance, the relationship of the unallocated component to the total Allowance may fluctuate from period to period. 32 -------------------------------------------------------------------------------- Based on our methodology and its components, management believes the resulting Allowance is adequate and appropriate for the risk identified in the Company's loan portfolio. Given current processes employed by the Company, management believes the segments, classes, and estimated loss rates currently assigned are appropriate. It is possible that others, given the same information, may at any point in time reach different reasonable conclusions that could be material to the Company's financial statements. In addition, current loan classes and fair value estimates of collateral are subject to change as we continue to review loans within our portfolio and as our borrowers are impacted by economic trends within their market areas. Although we have established an Allowance that we consider adequate, there can be no assurance that the established Allowance will be sufficient to offset losses on loans in the future. In addition, a substantial percentage of our loan portfolio is secured by real estate; as a result, a significant decline in real estate market values may require an increase in the Allowance. Valuation of goodwill and other intangibles:Goodwill and other intangible assets with indefinite lives are not amortized but instead are periodically tested for impairment. Management performs an impairment analysis for the intangible assets with indefinite lives on an annual basis as ofDecember 31 . Additionally, goodwill and other intangible assets with indefinite lives are evaluated on an interim basis when events or circumstances indicate impairment potentially exists. The impairment analysis requires management to make subjective judgments. Events and factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors and attrition, changes in revenue growth trends, cost structures, technology, changes in discount rates and specific industry and market conditions. There can be no assurance that changes in circumstances, estimates or assumptions may result in additional impairment of all, or some portion of, goodwill or other intangible assets. The Company performed its annual goodwill impairment testing atDecember 31, 2019 and 2018 in accordance with the policy described in Note 1 to the financial statements included with this report. AtDecember 31, 2019 , the Company performed its annual impairment test by performing a qualitative assessment. Significant positive inputs to the qualitative assessment included the Company's increasing net income as compared to historical trends, the Company's stable budget-to-actual results of operations; results of regulatory examinations; peer comparisons of the Company's net interest margin; trends in the Company's cash flows; improvements in the Alaskan economy in 2019; increases in the volume of mortgage originations inAlaska ; and increases in the Company's stock price. Significant negative inputs to the qualitative assessment included the continued lower level of oil prices and the muted pace of growth in theAlaska economy. We believe that the positive inputs to the qualitative assessment noted above outweigh the negative inputs for both of the Company's operating segments, and we therefore concluded that it is more likely than not that the fair value of the Company exceeds its carrying value atDecember 31, 2019 and that no potential impairment existed at that time. Valuation of OREO: OREO represents properties acquired through foreclosure or its equivalent. Prior to foreclosure, the carrying value is adjusted to the fair value, less cost to sell, of the real estate to be acquired by an adjustment to the allowance for loan loss. The amount by which the fair value less cost to sell is greater than the carrying amount of the loan plus amounts previously charged off is recognized in earnings. Any subsequent reduction in the carrying value is charged against earnings. Management's evaluation of fair value is based on appraisals or discounted cash flows of anticipated sales. The amounts ultimately recovered from the sale of OREO may differ from the carrying value of the assets because of market factors beyond the Company's control or due to changes in the Company's strategies for recovering the investment. Servicing rights: The Company measures mortgage servicing rights ("MSRs") and commercial servicing rights ("CSRs") at fair value on a recurring basis with changes in fair value going through earnings in the period in which the change occurs. Changes in the fair value of MSRs are recorded in mortgage banking income, and changes in the fair value of CSRs are recorded in commercial servicing revenue. Fair value adjustments encompass market-driven valuation changes and the decrease in value that occurs from the passage of time, which are separately reported. Retained servicing rights are measured at fair value as of the date of sale. Initial and subsequent fair value measurements are determined using a discounted cash flow model. In order to determine the fair value of servicing rights, the present value of expected net future cash flows is estimated. Assumptions used include market discount rates, anticipated prepayment speeds, escrow calculations, delinquency rates and ancillary fee income net of servicing costs. The model assumptions for MSRs are also compared to publicly filed information from several large MSR holders, as available. Fair Value: A hierarchical disclosure framework associated with the level of pricing observability is utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. 33 -------------------------------------------------------------------------------- Impact of accounting pronouncements to be implemented in future periods InJune 2016 , the FASB issued ASU 2016-13, Financial Instruments - Credit Losses ("ASU 2016-13"). ASU 2016-13 is intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates, but will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. ASU 2016-13 is effective for the Company for fiscal years, and interim periods within those fiscal years, beginning on or afterDecember 15, 2019 , and must be applied prospectively. However, onOctober 16, 2019 the FASB voted to delay ASU 2016-13 for Smaller Reporting Companies. The Company has electedSmall Reporting Company status, which changes the effective date for ASU 2016-13 for the Company to fiscal years, and interim periods within those fiscal years, beginning on or afterDecember 15, 2022 . Our implementation process includes loss forecasting model development, evaluation of technical accounting topics, updates to our allowance documentation, reporting processes and related internal controls, and overall operational readiness for our adoption of the ASU 2016-13, which will continue until adoption, including parallel runs for CECL alongside our current allowance process. We are in the process of developing, validating, and implementing models used to estimate credit losses under CECL. We have completed substantially all of our loss forecasting models, and we expect to complete the validation process for our loan models during 2020. Our current planned approach for estimating expected life-time credit losses for loans includes the following key components: • An initial loss forecast period of one year for all loan portfolio
segments and classes of financing receivables and off-balance-sheet credit
exposures. This period reflects management's expectation of losses based
on forward-looking economic scenarios over that time.
• A historical loss forecast period covering the remaining contractual life,
adjusted for prepayments, by segment and class of financing receivables
based on the change in key historical economic variables during
representative historical expansionary and recessionary periods.
• A reversion period of up to two years connecting the initial loss forecast
to the historical loss forecast based on economic conditions at the
measurement date.
• Utilization of discounted cash flow ("DCF") methods to measure credit
impairment for loans modified in a troubled debt restructuring, unless
they are collateral dependent and measured at the fair value of
collateral. The DCF methods would obtain estimated life-time credit losses
using the conceptual components described above.
As aSmaller Reporting Company , the Company is not required to adopt CECL beforeJanuary 1, 2023 , and we have elected not to early adopt as ofJanuary 1, 2020 . However, we have the option to early adopt CECL as of eitherJanuary 1, 2021 , orJanuary 1, 2022 . Based on our loan portfolio composition atDecember 31, 2019 , and the Company's current economic forecast, had we elected to early adopt CECL as ofJanuary 1, 2020 , we estimate the impact of adoption to be an overall decrease in our allowance for credit losses ("ACL") for loans between$7.5 million and$9 million . The reduction reflects an expected decrease for all loan segments given their short contractual maturities. The Company does not hold a material amount of residential mortgage loans with long or indeterminate maturities as ofDecember 31, 2019 . In most instances the Company believes that the ACL for these types of loans would lead to an increase in the ACL. We will continue to evaluate and refine the results of our loss estimates until adoption of ASU 2016-13. The ultimate effect of CECL on our ACL will depend on the size and composition of our loan portfolio, the loan portfolio's credit quality and economic conditions at the time of adoption, as well as any refinements to our models, methodology and other key assumptions. At adoption, we will have a cumulative-effect adjustment to retained earnings for our change in the ACL. We currently estimate an overall decrease in our ACL, which will result in an increase to our retained earnings and regulatory capital amounts and ratios. 34
-------------------------------------------------------------------------------- RESULTS OF OPERATIONS Income Statement Net Income Our results of operations are dependent to a large degree on our net interest income. We also generate other income primarily through mortgage banking income, purchased receivables products, sales of employee benefit plans (through August of 2017, when we sold our interest in the assets of NBG), service charges and fees, and bankcard fees. Our operating expenses consist in large part of salaries and other personnel costs, occupancy, data processing, marketing, and professional services expenses. Interest income and cost of funds, or interest expense, are affected significantly by general economic conditions, particularly changes in market interest rates, by government policies and the actions of regulatory authorities, and by competition in our markets. We earned net income attributable to the Company of$20.7 million in 2019, compared to net income of$20.0 million in 2018. During these periods, net income per diluted share was$3.04 and$2.86 , respectively. The increase in net income in 2019 compared to 2018 was primarily due to increases in other operating income, net interest income, and the benefit for loan losses. Net Interest Income / Net Interest Margin Net interest income is the difference between interest income from loan and investment securities portfolios and interest expense on customer deposits and borrowings. Changes in net interest income result from changes in volume and spread, which in turn affect our margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Changes in net interest income are influenced by yields and the level and relative mix of interest-earning assets and interest-bearing liabilities. Net interest income in 2019 was$64.4 million , compared to$61.2 million in 2018. The increase in 2019 as compared to 2018 was the result of higher net average interest-earning asset balances as well as higher average interest rates. During 2019 and 2018, net interest margins were 4.65% and 4.55%, respectively. The increase in net interest margin in 2019 as compared to 2018 is the result of increases in the spread between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. 35 -------------------------------------------------------------------------------- The following table sets forth for the periods indicated information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities. Average yields or costs, net interest income, and net interest margin are also presented: Years ended December 31, 2019 2018 2017 Average Interest Average Average Interest Average Average Interest Average outstanding income / Yield /
outstanding income / Yield / outstanding income / Yield / (In Thousands)
balance expense Cost balance expense Cost balance expense Cost Loans (1),(2)
$1,010,098 $59,919 5.93 %
56,344 2,231 3.96 % 46,089 2,016 4.37 % 44,047 1,740 3.95 %
Long-term Investments(3) 273,711 7,011 2.56 % 286,426 5,829 2.04 %
305,211 4,634 1.52 %
Short-term investments(4) 46,404 922 1.99 % 42,386 806 1.90 % 36,944 433 1.17 %
Total interest-earning
assets $1,386,557 $70,083 5.05 % $1,346,449 $64,177 4.77 % $1,367,203 $60,108 4.40 %
Noninterest-earning assets 169,150 146,936 143,849
Total $1,555,707 $1,493,385 $1,511,052
Interest-bearing deposits
33,730 680 2.02 % 47,570 662 1.37 % 50,523 723 1.43 %
Total
interest-bearing liabilities$883,932 $5,641 0.64 %$857,378 $2,969 0.35 %$880,441 $2,430 0.28 % Noninterest-bearing demand deposits 426,205 417,464 418,415 Other liabilities 36,968 17,521 19,067 Equity 208,602 201,022 193,129 Total$1,555,707 $1,493,385 $1,511,052 Net interest income$64,442 $61,208 $57,678 Net interest margin 4.65 % 4.55 % 4.22 % Average portfolio loans to average-earnings assets 72.85 % 72.16 % 71.75 % Average portfolio loans to average total deposits 79.14 % 79.16 % 78.58 % Average non-interest deposits to average total deposits 33.39 % 34.02 % 33.52 % Average interest-earning assets to average interest-bearing liabilities 156.86 % 157.04 % 155.29 % 1Interest income includes loan fees. Loan fees recognized during the period and included in the yield calculation totaled$3.3 million ,$3.0 million and$3.2 million for 2019, 2018 and 2017, respectively. 2Nonaccrual loans are included with a zero effective yield. Average nonaccrual loans included in the computation of the average loans were$16.9 million ,$17.5 million , and$18.1 million in 2019, 2018 and 2017, respectively. 3Consists of investment securities available for sale, investment securities held to maturity, marketable equity securities, and investment inFederal Home Loan Bank stock. 4Consists of interest bearing deposits in other banks and domestic CDs. 36 -------------------------------------------------------------------------------- The following table sets forth the changes in consolidated net interest income attributable to changes in volume and to changes in interest rates. Changes attributable to the combined effect of volume and interest rate have been allocated proportionately to the changes due to volume and the changes due to interest rate: 2019 compared to 2018 2018 compared to 2017 Increase (decrease) due to Increase (decrease) due to (In Thousands) Volume Rate Total Volume Rate Total Interest Income: Loans$2,246 $2,147 $4,393 ($508 )$2,733 $2,225 Loans held for sale 374 (159 ) 215 83 193 276 Long-term investments (245 ) 1,427 1,182 (264 ) 1,459 1,195 Short term investments 79 37 116 71 302 373 Total interest income$2,454 $3,452 $5,906 ($618 )$4,687 $4,069 Interest Expense: Interest-bearing deposits$120 $2,534 $2,654 ($40 )$640 $600 Borrowings (29 ) 47 18 (35 ) (26 ) (61 ) Total interest expense$91 $2,581 $2,672 ($75 )$614 $539 Provision for Loan Losses We recorded a benefit for loan losses in 2019 of$1.2 million , compared to a benefit for loan losses of$500,000 in 2018. The loan loss provision decreased in 2019 compared to 2018 primarily due to an improvement in credit quality as nonperforming loans and adversely classified loans decreased, the Alaskan economy improved, and the Company recorded net recoveries for the year. See the "Allowance for Loan Losses" section under "Financial Condition" and Note 6 of the Notes to Consolidated Financial Statements included in Item 8 of this report for further discussion of these decreases and changes in the Company's Allowance. Other Operating Income The following table details the major components of other operating income for the years endedDecember 31 : (In Thousands) 2019 $ Change % Change 2018 $ Change % Change 2017 Other Operating Income Mortgage banking income$24,201 $3,357 16 %$20,844 ($2,443 ) (10 )%$23,287 Purchased receivable income 3,271 16 - % 3,255 280 9 % 2,975 Bankcard fees 2,976 165 6 % 2,811 214 8 % 2,597 Service charges on deposit accounts 1,557 49 3 % 1,508 (106 ) (7 )% 1,614 Interest rate swap income 964 880 1,048 % 84 58 223 % 26 Gain (loss) on marketable equity securities 911 1,536 246 % (625 ) (625 ) (100 )% - Commercial servicing revenue 624 (798 ) (56 )% 1,422 1,050 282 % 372 Rental income 497 (195 ) (28 )% 692 160 30 % 532 Other loan fees 269 77 40 % 192 (2 ) (1 )% 194 Gain on loans acquired - APB 30 (227 ) (88 )% 257 68 36 % 189 Gain (loss) on sale of securities 23 23 100 % - (11 ) (100 )% 11 Gain on sale of Northrim Benefits Group - - - % - (4,445 ) (100 )% 4,445 Employee benefit plan income - - - % - (2,506 ) (100 )% 2,506 Other income 2,023 296 17 % 1,727
1 - % 1,726
Total other operating income$37,346 $5,179 16 %$32,167 ($8,307 ) (21 )%$40,474 37
-------------------------------------------------------------------------------- 2019 Compared to 2018 The most significant changes in other operating income in 2019 were increases in mortgage banking income and gains on marketable equity securities, as well as higher interest rate swap income. Mortgage banking income consists of gross income from the origination and sale of mortgages as well as mortgage loan servicing fees and is the largest component of other operating income at 65% of total other operating income in 2019. Mortgage banking income increased in 2019 compared to 2018 mainly due to an increase in mortgage loans originated and sold as this volume increased to$684 million in 2019 from$528 million in 2018. The overall increase in mortgage originations is primarily the result of the decrease in interest rates during the year. The Company recognized$964,000 in interest rate swap income in 2019 on the execution of five interest rate swaps which totaled$40.6 million in notional value compared to the execution of two interest rate swaps with a total notional value of$2.8 million in 2018. These interest rate swaps are related to the Company's commercial lending operations. Lastly, commercial servicing revenue decreased in 2019 because in 2018 the Company recorded for the first time in other operating income the fair value of its commercial loan servicing portfolio of$1.0 million . In 2019, only changes in the fair value of the Company's commercial loan servicing portfolio are reflected in other operating income, which comprised a portion of the decrease in other income in 2019 as compared to 2018. Other Operating Expense The following table details the major components of other operating expense for the years endedDecember 31 : (In Thousands) 2019 $ Change % Change 2018 $ Change % Change 2017 Other Operating Expense Salaries and other personnel expense$51,317 $6,667 15 %$44,650 ($71 ) - %$44,721 Data processing expense 7,128 1,093 18 % 6,035 486 9 % 5,549 Occupancy expense 6,607 471 8 % 6,136 (616 ) (9 )% 6,752 Professional and outside services 2,531 78 3 % 2,453 88 4 % 2,365 Marketing expense 2,373 55 2 % 2,318 (248 ) (10 )% 2,566 Insurance expense 557 (305 ) (35 )% 862 (299 ) (26 )% 1,161 Compensation expense - RML acquisition payments 468 468 100 % - (130 ) (100 )% 130 Intangible asset amortization 60 (10 ) (14 )% 70 (30 ) (30 )% 100 Loss on sale of premise and equipment - (2 ) (100 )% 2 (1 ) (33 )% 3 OREO (income) expense, net rental income and gains on sale: OREO operating expense 693 (109 ) (14 )% 802 382 91 % 420 Impairment on OREO - - - % - (904 ) (100 )% 904 Rental income on OREO (506 ) 35 6 % (541 ) (425 ) (366 )% (116 ) Gains on sale of OREO (380 ) (377 ) NM (3 ) 368 99 % (371 ) Subtotal (193 ) (451 ) (175 )% 258 (579 ) (69 )% 837 Other expenses 5,990 (1,026 ) (15 )% 7,016
47 1 % 6,969
Total other operating expense$76,838 $7,038 10 %$69,800 ($1,353 ) (2 )%$71,153 38
-------------------------------------------------------------------------------- 2019 Compared to 2018 Other operating expense increased in 2019 as compared to the prior year primarily due to increases in salaries and other personnel expense, data processing expense, occupancy expense, and compensation expense related to RML acquisition payments. These increases were only partially offset by a decrease in other expenses. The fourth quarter of 2019 marked the end of the five-year period following the acquisition of RML during which the Company was required to make additional payments to the former owners of RML when profitability hit certain targets. Per the terms of the purchase agreement, no further payments are scheduled, and therefore no additional expense for RML acquisition payments will be recorded in the future. The$6.7 million increase in salaries and other personnel expense is the result of the following items. Salaries increased$2.2 million , or approximately 8% in 2019 compared to 2018 due to salary increases as total FTE remained consistent from 2018 to 2019. Profit sharing expense increased$1.5 million , or 112%, in 2019 as compared to 2018. While a portion of this increase is due to improvement in the Company's financial results in 2019, the majority of the increase is due to a redesign of the profit sharing plan that results in a higher payout to employees when the Company's financial results are higher. Commission expense for mortgage originations increased$1.4 million , or 27%, as a result of higher mortgage production in 2019. Lastly, group medical expense increased$1.1 million , or 23%, due to higher claims in the Company's self-insured medical benefit plan in 2019 compared to 2018. Data processing expense increased$1.1 million in 2019 as compared to 2018 due to costs associated with the addition of two new branches in 2019, costs for improved functionality for digital products and services, and the addition of various software applications related to our lending activities. Occupancy expense increased in 2019 as compared to 2018 primarily due to a one-time technical correction that decreased depreciation expense by$670,000 in 2018. The reserve for purchased receivable losses decreased$87,000 and employee recruitment expense decreased$76,000 in 2019 as compared to 2018. Income Taxes The provision for income taxes increased$1.4 million or 33%, to$5.4 million in 2019 as compared to 2018. The increase in 2019 is primarily due to higher pretax income, less tax exempt income, and fewer low income housing tax credits as a percentage of pre-tax income as compared to 2018. Additionally, in 2018 the Company finalized its valuation of net deferred tax assets related to the decrease in the federal tax rate after completing a fixed asset cost segregation study for tax planning purposes which resulted in a$470,000 decrease in tax expense that was not repeated in 2019. The Company's effective tax rates were 21% and 17% in 2019 and 2018, respectively. The changes in the Company's effective tax rates for 2019 and 2018 are primarily due to the items discussed regarding the changes in tax expense for these periods. FINANCIAL CONDITIONInvestment Securities The composition of our investment securities portfolio, which includes securities available for sale and marketable equity securities, reflects management's investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of interest income. The investment securities portfolio also mitigates interest rate and credit risk inherent in the loan portfolio, while providing a vehicle for the investment of available funds, a source of liquidity (by pledging as collateral or through repurchase agreements), and collateral for certain public funds deposits. Investment securities designated as available for sale comprised 97% of the portfolio as ofDecember 31, 2019 and are available to meet liquidity requirements. Our investment portfolio consists primarily of government sponsored entity securities, corporate securities, collateralized loan obligations, and municipal securities. Investment securities atDecember 31, 2019 increased$5.2 million , or 2%, to$284.1 million from$278.9 million atDecember 31, 2018 . The increase atDecember 31, 2019 as compared toDecember 31, 2018 is primarily due to investment of funds received as deposit balances increased, as well as proceeds from sales, maturities, and security calls being reinvested as ofDecember 31, 2019 . The average maturity of the investment portfolio was approximately one and a half years atDecember 31, 2019 . Investment securities may be pledged as collateral to secure public deposits or borrowings. AtDecember 31, 2019 and 2018,$30.6 million and$58.4 million in securities were pledged for deposits and borrowings, respectively. Pledged securities decreased atDecember 31, 2019 as compared toDecember 31, 2018 because the Company had decreased balances in securities sold under agreements to repurchase accounts atDecember 31, 2019 . 39 -------------------------------------------------------------------------------- The following tables set forth the composition of our investment portfolio atDecember 31 for the years indicated: (In Thousands) Amortized Cost Fair
Value
Securities Available for Sale: 2019: U.S. Treasury and government sponsored entities$210,756 $211,852 Municipal Securities 3,288 3,297 Corporate Bonds 34,764 35,066 Collateralized Loan Obligations 25,980
25,923
Total $274,788 2018:
U.S. Treasury and government sponsored entities$209,908 $208,860 Municipal Securities 9,089 9,084 Corporate Bonds 40,139 39,780 Collateralized Loan Obligations 13,990
13,886
Total $273,126 2017:
U.S. Treasury and government sponsored entities$250,794 $249,461 Municipal Securities 14,395 14,421 Corporate Bonds 36,654 37,132 Collateralized Loan Obligations 6,000 6,005 Preferred Stock 5,422 5,731 Total$313,265 $312,750 Marketable Equity Securities : 2019: Preferred Stock$7,349 $7,945 Total$7,349 $7,945 2018: Preferred Stock$7,580 $7,265 Total$7,580 $7,265 40
--------------------------------------------------------------------------------
The following table sets forth the market value, maturities, and weighted
average pretax yields of our investment portfolio as of
Maturity
Within Over
(In Thousands) 1 Year 1-5 Years 5-10 Years 10 Years Total
Securities Available for Sale:
U.S. Treasury and government
sponsored entities
Balance $52,668 $159,184 $- $- $211,852
Weighted average yield 2.30 % 2.07 % - % - % 2.13 %
Municipal securities
Balance $994 $2,303 $- $- $3,297
Weighted average yield 2.15 % 3.97 % - % - % 3.42 %
Corporate bonds
Balance $12,027 $17,975 $5,064 $- $35,066
Weighted average yield 2.74 % 2.95 % 2.91 % - % 2.87 %Collateralized loan obligations
Balance $- $- $5,999 $19,924 $25,923
Weighted average yield - % - % 3.88 % 3.64 % 3.70 %
Total
Balance $65,689 $179,462 $11,063 $19,924 $276,138
Weighted average yield 2.38 % 2.18 % 3.44 % 3.64 % 2.38 %
Marketable Equity Securities
Preferred Stock
Balance $- $- $- $7,945 $7,945
Weighted average yield - % - % - % 4.70 % 4.70 %
The Company's investment in marketable equity securities does not have a
maturity date but it has been included in the over 10 years column above. At
December 31, 2019 , we held no securities of any single issuer (other than
government sponsored entities) that exceeded 10% of our shareholders' equity.
Loans
Our loan products include short and medium-term commercial loans, commercial
credit lines, construction and real estate loans, and consumer loans. To a
lesser extent, through our wholly-owned subsidiary RML, we also originate
mortgage loans which we sell to the secondary market. We retain servicing rights
on mortgage loans originated by RML and sold to the Alaska Housing Finance
Corporation ("AHFC"). We emphasize providing financial services to small and
medium-sized businesses and to individuals. From our inception, we have
emphasized commercial, land development and home construction, and commercial
real estate lending. These types of lending have provided us with needed market
opportunities and generally provide higher net interest margins compared to
other types of lending such as consumer lending. However, they also involve
greater risks, including greater exposure to changes in local economic
conditions.
All of our loans and credit lines are subject to approval procedures and amount
limitations. These limitations apply to the borrower's total outstanding
indebtedness and commitments to us, including the indebtedness of any
guarantor. Generally, we are permitted to make loans to one borrower of up to
15% of the unimpaired capital and surplus of the Bank. The loan-to-one-borrower
limitation for the Bank was $27.8 million at December 31, 2019 . At December 31,
2019 , the Company had two relationships whose total direct and indirect
commitments exceeded $27.8 million ; however, no individual direct relationship
exceeded the loans-to-one borrower limitation. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Provision for Loan
Losses" for further discussion of the Company's concentration of loans to large
borrowers.
Our lending operations are guided by loan policies, which outline the basic
policies and procedures by which lending operations are conducted. Generally,
the policies address our desired loan types, target markets, underwriting and
collateral requirements, terms, interest rate and yield considerations, and
compliance with laws and regulations. The policies are reviewed and approved
annually by the board of directors of the Bank. Our Quality Assurance Department
provides a detailed financial
41
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analysis of our largest, most complex loans. In addition, the Quality Assurance
Department , along with the Chief Credit Officer of the Bank, have developed
processes to analyze and manage various concentrations of credit within the
overall loan portfolio. The Credit Administration Department monitors the
procedures and processes for both the analysis and reporting of problem loans,
and also develops strategies to resolve problem loans based on the facts and
circumstances for each loan. Finally, our Internal Audit Department also
performs an independent review of each loan portfolio for compliance with loan
policy as well as a review of credit quality. The Internal Audit review follows
the FDIC sampling guidelines, and a review of each portfolio is performed on an
annual basis.
The following table sets forth the composition of our loan portfolio by loan
segment:
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
(In Thousands) Dollar Amount Total Dollar Amount Total Dollar Amount Total Dollar Amount Total Dollar Amount Total
Commercial $412,690 39.5 % $342,420 34.8 % $313,514 32.8 % $277,802 28.5 % $271,946 27.8 %
Real estate construction
one-to-four family 38,818 3.7 % 37,111 3.8 % 31,201 3.3 % 26,061 2.7 % 44,488 4.5 %
Real estate construction other 61,808 5.9 % 72,256 7.3 % 80,093 8.4 % 72,159 7.4 % 74,956 7.7 %
Real estate term owner occupied 138,891 13.3 % 126,414 12.8 % 132,042 13.8 % 152,112 15.6 % 143,667 14.7 %
Real estate term non-owner
occupied 312,960 30.0 % 325,720 33.1 % 319,313 33.4 % 356,411 36.6 % 347,284 35.4 %
Real estate term other 42,506 4.1 % 42,039 4.3 % 40,411 4.2 % 45,402 4.7 % 46,672 4.8 %
Consumer secured by 1st deeds
of trust 16,198 1.6 % 19,228 2.0 % 22,616 2.4 % 23,280 2.4 % 26,369 2.7 %
Consumer other 24,585 2.4 % 23,645 2.4 % 19,919 2.1 % 25,281 2.6 % 28,912 3.0 %
Subtotal $1,048,456 $988,833 $959,109 $978,508 $984,294
Less: Unearned origination fee,
net of origination costs (5,085 ) (0.5 )% (4,487 ) (0.5 )% (4,156 ) (0.4 )% (4,434 ) (0.5 )% (4,612 ) (0.5 )%
Total portfolio loans $1,043,371 $984,346 $954,953 $974,074 $979,682
Commercial Loans: Our commercial loan portfolio includes both secured and
unsecured loans for working capital and expansion. Short-term working capital
loans generally are secured by accounts receivable, inventory, or equipment. We
also make longer-term commercial loans secured by equipment and real estate. We
also make commercial loans that are guaranteed in large part by the Small
Business Administration or the Bureau of Indian Affairs and to a lesser extent
guaranteed by the United States Department of Agriculture , as well as commercial
real estate loans that are purchased by the Alaska Industrial Development and
Export Authority ("AIDEA"). Commercial loans increased to $412.7 million at
December 31, 2019 from $342.4 million at December 31, 2018 and represented
approximately 39% and 35% of our total loans outstanding as of December 31, 2019
and December 31, 2018 , respectively. Commercial loans reprice more frequently
than other types of loans, such as real estate loans. More frequent repricing
means that interest cash flows from commercial loans are more sensitive to
changes in interest rates. In a rising interest rate environment, our philosophy
is to emphasize the pricing of loans on a floating rate basis, which allows
these loans to reprice more frequently and to contribute positively to our net
interest margin.
Commercial Real Estate : We are an active lender in the commercial real estate
market. At December 31, 2019 , commercial real estate loans increased slightly to
$494.4 million from $494.2 million at December 31, 2018 , and represented
approximately 47% and 50% of our loan portfolio as of December 31, 2019 and
December 31, 2018 , respectively. These loans are typically secured by office
buildings, apartment complexes or warehouses. Loan amortization periods range
from 10 to 25 years and generally have a maximum maturity of 10 years.
We may sell all or a portion of a commercial real estate loan to two State of
Alaska entities, AIDEA and AHFC, which were both established to provide
long-term financing in the State of Alaska . The loans that AIDEA purchases
typically feature a maturity twice that of the loans retained by us and bear a
lower interest rate. The blend of our and AIDEA's loan terms allows us to
provide competitive long-term financing to our customers, while reducing the
risk inherent in this type of lending. We also originate and sell to AHFC loans
secured by multifamily residential units. Typically, 100% of these loans are
sold to AHFC and we provide ongoing servicing of the loans for a fee. AIDEA and
AHFC make it possible for us to originate these commercial real estate loans and
enhance fee income while reducing our exposure to interest rate risk.
Construction Loans: We provide construction lending for commercial real estate
projects. Such loans generally are made only when the Company has also committed
to finance the completed project with a commercial real estate loan, or if there
is a firm take-out commitment upon completion of the project by a third party
lender. Additionally, we provide land development and residential subdivision
construction loans. We also originate one-to-four-family residential and
condominium construction loans
42
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to builders for construction of homes. The Company's construction loans
decreased in 2019 to $100.6 million , down from $109.4 million in 2018, and
represented approximately 10% and 11% of our loan portfolio in December 31, 2019
and December 31, 2018 , respectively. As of December 31, 2019 , approximately
$24.0 million or 24%, of the Company's construction loans were for low income
housing tax credit projects as compared to $43.1 million or 39% as of December
31, 2018 .
Consumer Loans: We provide personal loans for automobiles, recreational
vehicles, boats, and other larger consumer purchases. We provide both secured
and unsecured consumer credit lines to accommodate the needs of our individual
customers, with home equity lines of credit serving as the major product in this
area.
Loans Directly Exposed to the Oil and Gas Industry: The Company defines "direct
exposure" to the oil and gas industry as companies that it has identified as
significantly reliant upon activity related to the oil and gas industry, such as
oil producers or drilling and exploration companies, and companies who provide
oilfield services, lodging, equipment rental, transportation, and other logistic
services specific to the industry. The Company estimates that $79.2 million , or
approximately 8% of loans as of December 31, 2019 have direct exposure to the
oil and gas industry as compared to $62.3 million , or approximately 6% of loans
as of December 31, 2018 . The Company has no loans to oil producers or drilling
and exploration companies as of the end of 2019 or 2018, but the $79.2 million
outstanding as of December 31, 2019 noted above does include $14.2 million
related to the construction of an oil rig. The Company's unfunded commitments to
borrowers that have direct exposure to the oil and gas industry were $31.1
million and $32.5 million at December 31, 2019 and 2018, respectively. The
portion of the Company's allowance for loan losses that related to the loans
with direct exposure to the oil and gas industry was estimated at $1.6 million
and $1.4 million as of December 31, 2019 and 2018, respectively.
The following table details loan balances by loan segment asset quality rating
("AQR") and class of financing receivable for loans with direct oil and gas
exposure as of the dates indicated:
Real estate
Real estate Real estate term Consumer
(In construction Real estate term owner non-owner Real estate secured by 1st Consumer
Thousands) Commercial one-to-four family construction other occupied occupied term other deeds of trust other Total
December
31, 2019
AQR Pass $62,345 $- $- $4,153 $- $- $- $361 $66,859
AQR Special
Mention 450 - - 1,900 6,916 - - - 9,266
AQR
Substandard 3,070 - - - - - - - 3,070
Total
loans $65,865 $- $- $6,053 $6,916 $- $- $361 $79,195
December
31, 2018
AQR Pass $44,512 $- $- $5,216 $- $- $- $399 $50,127
AQR Special
Mention 857 - - 2,242 7,364 - - - 10,463
AQR
Substandard $1,723 $- $- $- $- $- $- $- $1,723
Total
loans $47,092 $- $- $7,458 $7,364 $- $- $399 $62,313
43--------------------------------------------------------------------------------
Maturities and Sensitivities of Loans to Change in Interest Rates: The following
table presents the aggregate maturity data of our loan portfolio, excluding
loans held for sale, at
Maturity
(In Thousands) Within 1 Year 1-5 Years Over 5 Years Total
Commercial $133,784 $117,941 $160,965 $412,690
Real estate construction one-to-four family 36,153 2,665 - 38,818
Real estate construction other 40,331 10,300 11,177 61,808
Real estate term owner occupied 7,469 37,064 94,358 138,891
Real estate term non-owner occupied 18,657 88,581 205,722 312,960
Real estate term other 3,993 14,622 23,891 42,506
Consumer secured by 1st deeds of trust 119 1,269 14,810 16,198
Consumer other 819 5,676 18,090 24,585
Total $241,325 $278,118 $529,013 $1,048,456
Fixed interest rate $89,162 $118,274 $88,693 $296,129
Floating interest rate 152,163 159,844 440,320 752,327
Total $241,325 $278,118 $529,013 $1,048,456
At December 31, 2019 , 57% of the portfolio was scheduled to mature or reprice
in 2020 with 39% scheduled to mature or reprice between 2021 and 2024.
As of December 31, 2019 , approximately 73% of commercial loans are variable rate
loans, of which 66% reprice within one year. The majority of these loans reprice
to an index based upon the prime rate of interest or the respective Federal Home
Loan Bank of Boston (the "Boston FHLB") rate. The Company also uses floors in
its commercial loan pricing as loans are originated or renewed during the year.
At December 31, 2019 , the interest rates for approximately 81% of commercial
real estate loans are variable, of which 46% reset within one year.
Approximately 40% of commercial real estate variable rate loans reprice in
greater than one year but within three years. The indices for these loans
include the prime rate of interest or the respective Treasury or FHLB-Boston
rate. The Company also uses floors in its commercial real estate loan pricing as
loans are originated or renewed during the year.
Loans Held for Sale and Mortgage Servicing Rights: The Company originates
residential mortgage loans and sells them in the secondary market through our
wholly-owned subsidiary, RML. All residential mortgage loans originated and sold
in 2019 and 2018 were newly originated loans that did not affect nonperforming
loans. The Company also has a mortgage servicing portfolio which is comprised of
1-4 family loans serviced for Freddie Mac Home Loan Corporation ("FHLMC") and
AHFC. The Company retains servicing rights on all mortgage loans originated by
RML and sold to AHFC. Mortgages originated by RML and sold to AHFC represent
approximately 23% and 32% of the mortgages originated by RML in 2019 and 2018,
respectively. MSRs are adjusted to fair value quarterly with the change recorded
in mortgage banking income. The value of MSRs at December 31, 2019 and 2018 were
$11.9 million and $10.8 million , respectively. The value of MSRs is impacted by
market rates for mortgage loans primarily due to how changes in interest rates
affect prepayments of mortgage loans. To the extent loans are prepaid sooner
than estimated at the time servicing assets are originally recorded, it is
possible that certain residential MSR assets may decrease in value. Generally,
the fair value of our residential MSRs are expected to increase as market rates
for mortgage loans rise and decrease if market rates fall.
44
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Credit Quality and Nonperforming Assets
Nonperforming assets consist of nonaccrual loans, accruing loans that are 90
days or more past due, repossessed assets and OREO. The following table sets
forth information regarding our nonperforming loans and total nonperforming
assets:
(In Thousands) 2019 2018 2017 2016 2015
Nonperforming loans
Nonaccrual loans $15,356 $15,210 $21,626 $13,893 $3,686
Loans 90 days past due and accruing - - 252 456 -
Government guarantees on nonperforming loans (1,405 ) (516 ) (467 ) (1,413 ) (1,561 ) Net nonperforming loans
$13,951 $14,694 $21,411 $12,936 $2,125 Other real estate owned 7,043 7,962 8,651 6,574 3,053 Repossessed assets 231 1,242 - - - Other real estate owned guaranteed by government (1,279 ) (1,279 ) (1,333 ) (195 ) - Net nonperforming assets$19,946 $22,619
Nonperforming loans, net of government guarantees to portfolio loans 1.34 % 1.49 % 2.24 % 1.33 % 0.22 % Nonperforming assets, net of government guarantees to total assets 1.21 % 1.50 % 1.89 % 1.27 % 0.35 % Performing restructured loans$1,448 $3,413 $7,668 $6,131 $11,804 Nonperforming loans plus performing restructured loans, net of government guarantees$15,399 $18,107 $29,079 $19,067 $13,929 Nonperforming loans plus performing restructured loans to portfolio loans, net of government guarantees 1.48 % 1.84 % 3.05 % 1.96 % 1.42 % Nonperforming assets plus performing restructured loans to total assets, net of government guarantees 1.30 % 1.73 % 2.40 % 1.67 % 1.13 % Adversely classified loans, net of government guarantees$22,330 $27,217 $33,845 $35,634 $30,825 Loans 30-89 days past due and accruing, net of government guarantees to portfolio loans 0.15 % 0.36 % 0.22 % 0.22 % 0.12 % Allowance for loan losses to portfolio loans 1.83 % 1.98 % 2.25 % 2.02 % 1.85 % Allowance for loan losses to nonperforming loans, net of government guarantees 137 % 133 %
100 % 152 % 854 %
The Company's nonperforming loans, net of government guarantees decreased in 2019 to$14.0 million as compared to$14.7 million in 2018. This decrease was mostly due to a large nonaccrual loan payoff, as well as principal paydowns and charge-offs on nonaccrual loans in 2019. There was interest income of$301,000 and$159,000 recognized in net income for 2019 and 2018, respectively, related to interest collected on nonaccrual loans whose principal has been paid down to zero. The Company had three relationships that represented more than 10% of nonaccrual loans as ofDecember 31, 2019 . The Company had$1.4 million and$3.4 million in loans classified as troubled debt restructuring loans ("TDRs") that were performing as ofDecember 31, 2019 and 2018, respectively. Additionally, there were$8.7 million and$11.4 million in TDRs included in nonaccrual loans atDecember 31, 2019 and 2018 for total TDRs of$10.1 million and$14.8 million atDecember 31, 2019 and 2018, respectively. The decrease in TDRs atDecember 31, 2019 as compared to 2018 was primarily due to payoffs and paydowns on loans classified as TDRs that were only partially offset by additions to TDRs in 2019. See Note 5 of the Notes to Consolidated Financial Statements included in Item 8 of this report for further discussion of TDRs. AtDecember 31, 2019 , management had identified potential problem loans of$9.0 million as compared to potential problem loans of$17.1 million atDecember 31, 2018 . Potential problem loans are loans which are currently performing that have developed negative indications that the borrower may not be able to comply with present payment terms and which may later be included in nonaccrual, past due, or impaired loans. The$8.1 million decrease in potential problem loans atDecember 31, 2019 fromDecember 31, 2018 was primarily due to the transfer of eight relationships totaling$7.0 million to nonaccrual loans, the payoff of two relationships totaling$3.8 million and$1.7 million of other loan paydowns. These decreases were partially offset by the addition of several relationships totaling$3.5 million in 2019. 45 -------------------------------------------------------------------------------- The Company acquired other assets consisting of aircraft totaling$1.2 million in the fourth quarter of 2018 through foreclosure proceedings related to one lending relationship. These assets were sold in the third quarter of 2019. The Company acquired a vessel totaling$231,000 in the third quarter of 2019 through foreclosure proceedings related to one lending relationship. The following summarizes OREO activity for the periods indicated: (In Thousands) 2019 2018
2017
Balance, beginning of the year$7,962 $8,651
Transfers from loans - 686
5,912
Investment in other real estate owned - 144
-
Proceeds from the sale of other real estate owned (1,299 ) (1,522 ) (3,302 ) Gain on sale of other real estate owned, net
380 3 371
Impairment on other real estate owned - - (904 ) Balance, end of year 7,043 7,962 8,651 Government guarantees (1,279 ) (1,279 )
(1,333 )
Balance, end of year, net of government guarantees
AtDecember 31, 2019 and 2018 the Company held$5.8 million and$6.7 million , respectively, of OREO assets, net of government guarantees. AtDecember 31, 2019 , OREO consists of$1.4 million in residential lots in various stages of development and a$5.6 million commercial building. All OREO property is located inAlaska . The Bank initiates foreclosure proceedings to recover and sell collateral pledged by a debtor to secure a loan based on various events of default and circumstances related to loans that are secured by either commercial or residential real property. These events and circumstances include delinquencies, the Company's relationship with the borrower, and the borrower's ability to repay the loan via a source other than the collateral. If the loan has not yet matured, the debtors may cure the events of default up to the time of sale to retain their interest in the collateral. Failure to cure the defaults will result in the debtor losing ownership interest in the property, which is taken by the creditor, or high bidder at a foreclosure sale. During 2019, the Company had no additions to OREO. During 2019, the Company received approximately$1.3 million in proceeds from the sale of OREO which included$1.1 million from the sale of lots and land and$214,000 from the sale of single-family residences. The Company recognized$380,000 and$144,000 in gains and$0 and$141,000 in losses on the sale of OREO properties in 2019 and 2018, respectively, for net gains of$380,000 and$3,000 in 2019 and 2018, respectively. The Company had remaining accumulated deferred gains on the sale of OREO properties of$231,000 and$262,000 atDecember 31, 2019 and 2018, respectively. The Company did not make any loans to facilitate the sale of OREO in 2019 or 2018. Our underwriting policies and procedures for loans to facilitate the sale of OREO are no different than our standard loan policies and procedures. The Company recognized impairments of zero in both 2019 and 2018 due to adjustments to the Company's estimate of the fair value of certain properties based on changes in estimated costs to complete the projects, decrease in expected sales prices, and changes in theAnchorage and theSoutheastern Alaska real estate markets. Allowance for Loan Losses The Company maintains an Allowance to reflect management's assessment of probable, estimable losses inherent in the loan portfolio. The Allowance is increased by provisions for loan losses and loan recoveries and decreased by loan charge-offs. The size of the Allowance is determined through quarterly assessments of probable estimated losses in the loan portfolio. Our methodology for making such assessments and determining the adequacy of the Allowance includes the following key elements: • A specific allocation for impaired loans. Management determines the
fair value of the majority of these loans based on the underlying
collateral values. This analysis is based upon a specific analysis for
each impaired loan, including external appraisals on loans secured by
real property, management's assessment of the current market, recent
payment history, and an evaluation of other sources of
repayment. In-house evaluations of fair value are used in the
impairment analysis in some situations. Inputs to the in-house
evaluation process include information about sales of comparable
properties in the appropriate markets and changes in tax assessed
values. The Company obtains appraisals on real and personal propertythat secure its loans during the loan origination process in accordance
with regulatory guidance and its loan policy. The Company obtains
updated appraisals on loans secured by real or personal property based
46
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upon its assessment of changes in the current market or particular projects or
properties, information from other current appraisals, and other sources of
information. Appraisals may be adjusted downward by the Company based on its
evaluation of the facts and circumstances on a case by case basis. External
appraisals may be discounted when management believes that the absorption period
used in the appraisal is unrealistic, when expected liquidation costs exceed
those included in the appraisal, or when management's evaluation of
deteriorating market conditions warrants an adjustment. Additionally, the
Company may also adjust appraisals in the above circumstances between appraisal
dates. The Company uses the information provided in these updated appraisals
along with its evaluation of all other information available on a particular
property as it assesses the collateral coverage on its performing and
nonperforming loans and the impact that may have on the adequacy of its
Allowance. The specific allowance for impaired loans, as well as the overall
Allowance, may increase based on the Company's assessment of updated
appraisals. See Note 26 of the Notes to Consolidated Financial Statements
included in Item 8 of this report for further discussion of the Company's
estimation of impaired loans measured at fair value.
When the Company determines that a loss has occurred on an impaired loan, a
charge-off equal to the difference between carrying value and fair value is
recorded. If a specific allowance is deemed necessary for a loan, and then that
loan is partially charged off, the loan remains classified as a nonperforming
loan after the charge-off is recognized.
• A general allocation - The Company has identified segments and classes
of loans not considered impaired for purposes of establishing the
general allocation allowance. The Company disaggregates the loan
portfolio into segments and classes based on its assessment of howdifferent pools of loans with like characteristics in the portfolio
behave over time. This determination is based on historical experience
and management's assessment of how current facts and circumstances are
expected to affect the loan portfolio.
The Company first disaggregates the loan portfolio into the following eight
segments: commercial, real estate construction one-to-four family, real estate
construction other, real estate term owner occupied, real estate term non-owner
occupied, real estate term other, consumer secured by 1st deeds of trust, and
other consumer loans.
After division of the loan portfolio into segments, the Company then further
disaggregates each of the segments into classes. The Company has a total of five
classes, which are based off of the Company's loan risk grading system known as
the Asset Quality Rating ("AQR") system. The risk ratings are discussed in Note
5 to the Consolidated Financial Statements included in Item 8 of this
report. There are five loan classes: pass (pass AQR grades, which are grades 1 -
6), special mention, substandard, doubtful, and loss. There have been no changes
to these loan classes in 2019.
After the portfolio has been disaggregated into segments and classes, the
Company calculates a general reserve for each segment and class based on the
average loss history for each segment and class. The Company utilizes a
look-back period of five years in the calculation of average historical loss
rates.
After the Company calculates a general allocation using our loss history, the
general reserve is then adjusted for qualitative factors by segment and
class. Qualitative factors are based on management's assessment of current
trends that may cause losses inherent in the current loan portfolio to differ
significantly from historical losses. Some factors that management considers in
determining the qualitative adjustment to the general reserve include our
concentration of large borrowers; national and local economic trends; general
business conditions; trends in local real estate markets; economic, political,
and industry specific factors that affect resource development in Alaska ;
effects of various political activities; peer group data; and internal factors
such as underwriting policies and expertise of the Company's employees.
• An unallocated reserve - The unallocated portion of the Allowance
provides for other credit losses inherent in our loan portfolio that
may not have been contemplated in the specific and general components
of the Allowance, and it acknowledges the inherent imprecision of all
loss prediction models. The unallocated component is reviewed
periodically based on trends in credit losses and overall economic
conditions. At
as a percentage of the total Allowance was 11% and 13%, respectively.
47
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The following table shows the allocation of the Allowance for the years
indicated:
2019 2018 2017 2016 2015
(In Thousands) Amount % of Loans(1) Amount % of Loans(1) Amount % of Loans(1) Amount % of Loans(1) Amount % of Loans(1)
Commercial $6,604 39 % $5,660 35 % $6,172 34 % $5,535 28 % $5,906 28 %
Real estate construction
one-to-four family 643 4 % 675 4 % 629 3 % 550 3 % 854 4 %
Real estate construction
other 1,017 6 % 1,275 7 % 1,566 8 % 1,465 7 % 1,439 8 %
Real estate term owner
occupied 2,188 13 % 2,027 13 % 2,194 14 % 2,358 16 % 1,657 15 %
Real estate term non-owner
occupied 5,180 30 % 5,799 33 % 6,043 33 % 6,853 37 % 5,515 35 %
Real estate term other 671 4 % 716 4 % 725 4 % 819 5 % 628 4 %
Consumer secured by 1st
deeds of trust 270 2 % 306 2 % 315 2 % 313 2 % 264 3 %
Consumer other 436 2 % 426 2 % 307 2 % 408 2 % 397 3 %
Unallocated 2,079 - % 2,635 - % 3,510 - % 1,396 - % 1,493 - %
Total $19,088 100 % $19,519 100 % $21,461 100 % $19,697 100 % $18,153 100 %
1Represents percentage of this category of loans to total portfolio loans.
The following table sets forth information regarding changes in our Allowance for the years indicated: (In Thousands) 2019 2018 2017 2016 2015 Balance at beginning of year$19,519 $21,461 $19,697 $18,153 $16,723 Charge-offs: Commercial (195 ) (1,716 ) (1,611 ) (903 ) (616 ) Real estate construction one-to-four family - - - (535 ) - Real estate term other - (28 ) (5 ) - (81 ) Consumer secured by 1st deeds of trust (4 ) (143 ) (85 ) (36 ) (28 ) Consumer other (18 ) (39 ) (43 ) (8 ) (101 ) Total charge-offs (217 ) (1,926 ) (1,744 ) (1,482 ) (826 ) Recoveries: Commercial 908 442 293 699 379 Real estate term other 28 3 2 - 107 Consumer secured by 1st deeds of trust - 12 2 - 3 Consumer other 25 27 11 29 13 Total recoveries 961 484 308 728 502 Net, recoveries (charge-offs) 744 (1,442 ) (1,436 ) (754 ) (324 ) Provision (benefit) for loan losses (1,175 ) (500 ) 3,200 2,298 1,754 Balance at end of year$19,088 $19,519 $21,461 $19,697 $18,153 Ratio of net (recoveries) charge-offs to average loans outstanding during the period (0.07 )% 0.15 % 0.15
% 0.08 % 0.03 %
In accordance with GAAP, loans acquired in connection with our acquisition of Alaska Pacific onApril 1, 2014 were recorded at their fair value at the acquisition date. Credit discounts were included in the determination of fair value; therefore, an allowance for loan losses was not recorded at the acquisition date. Purchased credit impaired loans were evaluated on a loan by loan basis and the valuation allowance for these loans was netted against the carrying value. Loans acquired from Alaska Pacific have been classified as impaired loans and evaluated for specific impairment using the same methodology as all other loans sinceApril 1, 2014 . A general allowance for loans acquired from Alaska Pacific was established if there was deterioration in credit quality of the acquired loans subsequent to acquisition fromApril 1, 2014 throughDecember 31, 2017 . As ofDecember 31, 2019 and 2018, loans acquired fromAlaska Pacific are included in the Company's general allowance using the same methodology as all other loans as described above due to the amount of time that has passed since the loans were purchased. There was no specific 48 -------------------------------------------------------------------------------- impairment on acquired loans atDecember 31, 2019 or 2018. The purchase discount related to acquired credit impaired loans was$345,000 and$375,000 as ofDecember 31, 2019 and 2018, respectively. The provision for loan losses in 2019 as compared to 2018 decreased$675,000 to a benefit of$1.2 million compared to a benefit of$500,000 in 2018. This decrease is primarily due to net recoveries on loans and a decrease in qualitative factors mostly due to strengthening in theAlaska economy in 2019. The Company determined that an Allowance of$19.1 million , or 1.83% of portfolio loans, is appropriate as ofDecember 31, 2019 based on our analysis of the current credit quality of the portfolio and current economic conditions. The provision for loan losses in 2018 as compared to 2017 decreased$3.7 million to a benefit of$500,000 compared to a provision of$3.2 million in 2017. This decrease is primarily due to a decrease in nonperforming loans and the portion of the Allowance specific to impaired loans. The provision for loan losses in 2017 as compared to 2016 increased$902,000 to$3.2 million compared to$2.3 million in 2016. This increase was primarily due to an increase in nonperforming loans and the portion of the Allowance specific to impaired loans. The provision for loan losses in 2016 as compared to 2015 increased$544,000 to$2.3 million compared to$1.8 million in 2015. This increase was primarily due to an increase in nonperforming loans in 2016 compared to the prior year as well as an increase in qualitative factors mostly due to softening in theAlaska economy in 2016. While management believes that it uses the best information available to determine the Allowance, unforeseen market conditions and other events could result in an adjustment to the Allowance, and net income could be significantly affected if circumstances differed substantially from the assumptions used in making the final determination of the Allowance. Purchased Receivables We purchase accounts receivable from our business customers and provide them with short-term working capital. We provide this service to our customers inAlaska ,Washington ,Oregon , and some other states through NFS. Our purchased receivable activity is guided by policies that outline risk management, documentation, and approval limits. The policies are reviewed and approved annually by the Company's Board of Directors. Purchased receivables are recorded on the balance sheet net of a reserve for purchased receivable losses. Purchased receivable balances increased atDecember 31, 2019 to$24.4 million from$14.4 million atDecember 31, 2018 , and year-to-date average purchased receivable balances were$18.8 million and$17.4 million in 2019 and 2018, respectively. Purchased receivable income was$3.3 million in both 2019 and 2018. Purchased receivable income in 2019 remained consistent with 2018 despite an increase in average balances due to a decrease in average yield which varies depending on the makeup of the purchased receivable portfolio. The following table sets forth information regarding changes in the purchased receivable reserve for the years indicated: (In Thousands) 2019 2018 2017 Balance at beginning of year$190 $200 $171 Charge-offs - - - Recoveries - - - Net recoveries (charge-offs) - - - Reserve for (recovery from) purchased receivables (96 ) (10 ) 29 Balance at end of year$94
- % - % - %
Deposits
Deposits are our primary source of funds. Total deposits increased 12% to
49
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2019 2018 2017
Average Average Average
(In Thousands) Average balance rate paid Average balance rate paid Average balance rate paid Interest-bearing demand accounts
$272,895 0.17 %$243,000 0.07 %$220,449 0.03 % Money market accounts 209,245 0.55 % 225,014 0.31 % 238,830 0.17 % Savings accounts 233,057 0.46 % 241,807 0.31 % 249,641 0.21 % Certificates of deposit 135,005 1.67 % 99,987 0.70 % 120,998 0.57 % Total interest-bearing accounts 850,202 0.58 % 809,808 0.28 % 829,918 0.21 % Noninterest-bearing demand accounts 426,205 417,464 418,415 Total average deposits$1,276,407 $1,227,272 $1,248,333 Certificates of Deposit: The only deposit category with stated maturity dates is certificates of deposit. AtDecember 31, 2019 , we had$164.5 million in certificates of deposit, of which$90.5 million , or 55%, are scheduled to mature in 2020. The Company's certificates of deposit increased to$164.5 million during 2019 as compared to$113.3 million atDecember 31, 2018 . The aggregate amount of certificates of deposit in amounts of$100,000 or more atDecember 31, 2019 and 2018, was$118.9 million and$70.7 million , respectively. The following table sets forth the amount outstanding of certificates of deposits in amounts of$100,000 or more by time remaining until maturity and percentage of total deposits as ofDecember 31, 2019 : Time Certificates of Deposits of$100,000 or More (In Thousands) Amount Percent of Total Deposits Amounts maturing in: Three months or less$14,779 12 % Over 3 through 6 months 4,631 4 % Over 6 through 12 months 41,545 35 % Over 12 months 57,940 49 % Total$118,895 100 % The Company offers the Certificate of Deposit Account Registry Service® (CDARS®) as a member ofPromontory Interfinancial Network , LLCSM (Network). When a Network member places a deposit using CDARS, that certificate of deposit is divided into amounts under the standardFDIC insurance maximum ($250,000 ) and is allocated among member banks, making the large deposit eligible forFDIC insurance. The Company had$1.2 million CDARS certificates of deposits atDecember 31, 2019 and no CDARS certificates of deposits atDecember 31, 2018 .
Borrowings
FHLB: The Bank is a member of theFederal Home Loan Bank of Des Moines (the "FHLB"). As a member, the Bank is eligible to obtain advances from the FHLB. FHLB advances are dependent on the availability of acceptable collateral such as marketable securities or real estate loans, although all FHLB advances are secured by a blanket pledge of the Company's assets. AtDecember 31, 2019 , our maximum borrowing line from the FHLB was$734.0 million , approximately 45% of the Bank's assets, subject to the FHLB's collateral requirements. The Company has outstanding advances of$8.9 million as ofDecember 31, 2019 which were originated to match fund low income housing projects that qualify for long term fixed interest rates. The first advance is a$1.9 million FHLB Community Investment Program advance which was originated onMarch 22, 2013 . It has an eighteen year term with a 30 year amortization period, which mirrors the term of the term real estate loan made to the borrower, and a fixed rate of 3.12%. The second advance is a$2.1 million FHLB Community Investment Cash Advance Program advance that was originated in the second quarter of 2016. This advance has a 20 year term with a 30 year amortization period, which mirrors the term of the term real estate loan made to the borrower, and a fixed interest rate of 2.61%. The third advance is a$3.0 million FHLB Community Investment Cash Advance Program advance that was originated in the third quarter of 2017. This advance has a 20 year term with a 30 year amortization period and a fixed interest rate of 3.25%, which mirrors the term of the loan made to the borrower. The fourth advance 50 -------------------------------------------------------------------------------- is a$1.0 million FHLB Community Investment Cash Advance Program advance that was originated in the third quarter of 2019. This advance has a 20 year term with a 30 year amortization period and a fixed interest rate of 2.69%, which mirrors the term of the loan made to the borrower. The last advance is a$769,000 FHLB Community Investment Cash Advance Program advance that was originated in the third quarter of 2019. This advance has a 20 year term with a 30 year amortization period and a fixed interest rate of 2.69%, which mirrors the term of the loan made to the borrower. All of these FHLB advances are included in borrowings.Federal Reserve Bank : TheFederal Reserve Bank of San Francisco (the "FederalReserve Bank ") is holding$79.5 million of loans as collateral to secure advances made through the discount window as ofDecember 31, 2019 . There were no discount window advances outstanding atDecember 31, 2019 or 2018. Other Short-term Borrowings: Securities sold under agreements to repurchase were zero and$34.3 million , as ofDecember 31, 2019 and 2018, respectively. The average balance outstanding of securities sold under agreements to repurchase during 2019 and 2018 was$15.2 million and$29.9 million , respectively, and the maximum outstanding at any month-end was$36.6 million and$36.5 million , respectively, during the same time periods. The securities sold under agreements to repurchase are held by the FHLB under the Company's control. The Company is subject to provisions underAlaska state law which generally limit the amount of outstanding debt to 15% of total assets or$244.7 million and$222.6 million atDecember 31, 2019 and 2018, respectively. Long-term Borrowings: The Company had no long-term borrowings outstanding other than the FHLB advances noted above as ofDecember 31, 2019 or 2018. Contractual Obligations The following table references contractual obligations of the Company for the periods indicated. This table does not include interest payments: Payments Due by Period (In Thousands) Within 1 Year 1-3 Years 3-5 Years Over 5 Years Total December 31, 2019: Certificates of deposit$90,554 $70,734 $1,390 $1,794 $164,472 Short-term borrowings - - - - - Long-term borrowings 187 444 471 7,789 8,891 Junior subordinated debentures - - - 10,310 10,310 Operating lease obligations 2,665 4,718 3,592 6,453 17,428 Other long-term liabilities(1) 2,937 9,484 1,341 4,001 17,763 Capital commitments 1,389 - - - 1,389 Total$97,732 $85,380 $6,794 $30,347 $220,253 December 31, 2018: Certificates of deposit$57,451 $52,529 $1,494 $1,799 $113,273 Short-term borrowings 34,278 - - - 34,278 Long-term borrowings 167 351 373 6,350 7,241 Junior subordinated debentures - - - 10,310 10,310 Operating lease obligations 2,668 4,908 3,750 8,121 19,447 Other long-term liabilities 1,010 1,703 1,453 3,196 7,362 Capital commitments 57 - - - 57 Total$95,631 $59,491 $7,070 $29,776 $191,968 (1) Includes principal payments related to employee benefit plans. If a benefit payment schedule is established, payments are recorded in the corresponding dates listed in the table above. Unscheduled payments for all remaining benefits are recorded "Over 5 Years". Additional information about employee benefit plans is provided in Note 19 of the Notes to the Consolidated Financial Statements in Item 8 below. 51
-------------------------------------------------------------------------------- Short and long-term borrowings included in the table above are described in the "Borrowings" section above. Junior subordinated debentures include$10.3 million that was originated onDecember 16, 2005 , matures onMarch 15, 2036 , and bears interest at a rate of 90-day LIBOR plus 1.37%, adjusted quarterly. The Company entered into an interest rate swap in the third quarter of 2017 to hedge the variability in cash flows arising out of its junior subordinated debentures, by swapping the cash flows with an interest rate swap which receives floating and pays fixed. The Company has designated this interest rate swap as a hedging instrument. The interest rate swap effectively fixes the Company's interest payments on the$10 million of junior subordinated debentures held underNorthrim Statutory Trust 2 ("NST2") at 3.72% through its maturity date. Operating lease obligations are more fully described in Note 12 of the Company's Consolidated Financial Statements included in Item 8 of this report. Other long-term liabilities consist of amounts that the Company owes for its investments inDelaware limited partnerships that develop low-income housing projects throughoutthe United States . Additional information about these partnerships is included at Note 8. The Company purchased a$10.7 million interest inR4 Frontier Housing Partners L.P. ,Coronado Park Senior Village L.P. ("R4-Coronado") inMarch 2013 . The investment in R4-Coronado was 95% funded at the end of 2019 and is expected to be fully funded in 2029. The Company purchased an$8.5 million interest inR4 Frontier Housing Partners L.P. ,Mountain View Village V L.P. ("R4-MVV") inMay 2014 . The investment in R4-MVV was 97% funded at the end of 2019 and is expected to be fully funded in 2030. The Company purchased a$6.8 million interest inR4 Frontier Housing Partners L.P. ,PJ33 L.P. ("R4-PJ33") inJune 2016 . The investment in R4-PJ33 was 94% funded at the end of 2019 and is expected to be fully funded in 2032. The Company purchased a$7.3 million interest inR4 Frontier Housing Partners L.P. ,Parkscape L.P. ("R4-Coronado II") inJune 2019 . The investment in R4-Coronado II was 5% funded at the end of 2019 and is expected to be fully funded in 2035. The Company also purchased a$4.0 million interest inR4 Frontier Housing Partners L.P. ,Duke Apartments L.P. ("R4-Duke") inNovember 2019 . The investment in R4-Duke was 9% funded at the end of 2019 and is expected to be fully funded in 2035. Off-Balance Sheet Arrangements The Company is a party to financial instruments with off-balance sheet risk. Among the off-balance sheet items entered into in the ordinary course of business are commitments to extend credit, commitments to originate loans held for sale and the issuance of letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized on the balance sheet. Certain commitments are collateralized. We apply the same credit standards to these commitments as in all of our lending activities and include these commitments in our lending risk evaluations. As ofDecember 31, 2019 , we had commitments to extend credit of$301.9 million , which were not reflected on our balance sheet, compared to$260.6 million as ofDecember 31, 2018 . Commitments to extend credit are agreements to lend to customers. These commitments have specified interest rates and generally have fixed expiration dates but may be terminated by the Company if certain conditions of the contract are violated. Collateral held relating to these commitments varies, but generally includes real estate, inventory, accounts receivable, and equipment. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. Since many of the commitments are expected to expire without being drawn upon, these total commitment amounts do not necessarily represent future cash requirements. As ofDecember 31, 2019 , we had commitments to originate loans held for sale of$48.8 million , which were not reflected in the balance sheet compared to$45.0 million as ofDecember 31, 2018 . Mortgage loans sold to investors may be sold with servicing rights released, for which the Company makes only standard legal representations and warranties as to meeting certain underwriting and collateral documentation standards. In the past two years, the Company has had to repurchase one loan due to deficiencies in underwriting or loan documentation and has not realized significant losses related to this repurchase. Management currently believes that any liabilities that may result from such recourse provisions are not significant. As ofDecember 31, 2019 , we had standby letters of credit of$2.0 million , which were not reflected on our balance sheet compared to$3.2 million as ofDecember 31, 2018 . Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Credit risk arises in these transactions from the possibility that a customer may not be able to repay the Company upon default of performance. Collateral held for standby letters of credit is based on an individual evaluation of each customer's creditworthiness. Our total unfunded lending commitments atDecember 31, 2019 , which includes commitments to extend credit, commitments to originate loans held for sale and standby letters of credit, were$352.7 million , compared to$308.8 million as ofDecember 31, 2018 . We do not expect that all of these commitments are likely to be fully drawn upon at any one time. The Company has established reserves of$152,000 and$130,000 atDecember 31, 2019 and 2018, respectively, for estimated losses related to these commitments that are recorded in other liabilities on the consolidated balance sheet. Additional information regarding Off-Balance Sheet Arrangements is included in Notes 20 and 21 of the Notes to Consolidated Financial Statements included in Item 8 of this report. 52 -------------------------------------------------------------------------------- Liquidity and Capital Resources Our shareholders' equity atDecember 31, 2019 , was$207.1 million , as compared to$205.9 million atDecember 31, 2018 . The Company earned net income of$20.7 million , issued 23,269 shares of common stock through the exercise of stock options, and repurchased 347,676 shares during 2019. AtDecember 31, 2019 , the Company had approximately 6.6 million shares of its common stock outstanding. The Company is a single bank holding company and its primary ongoing source of liquidity is from dividends received from the Bank. Such dividends arise from the cash flow and earnings of the Bank. Banking regulations and regulatory authorities may limit the amount of, or require the Bank to obtain certain approvals before paying, dividends to the Company. Given that the Bank currently meets and the Bank anticipates that it will continue to meet, all applicable capital adequacy requirements for a "well-capitalized" institution by regulatory standards, including the conservation buffer that is now in full effect, the Company expects to continue to receive dividends from the Bank during 2020. The Bank manages its liquidity through itsAsset and Liability Committee . Our primary sources of funds are customer deposits and advances from the FHLB. These funds, together with loan repayments, loan sales, other borrowed funds, retained earnings, and equity are used to make loans, to acquire securities and other assets, and to fund deposit flows and continuing operations. The primary sources of demands on our liquidity are customer demands for withdrawal of deposits and borrowers' demands that we advance funds against unfunded lending commitments. Our total unfunded commitments to fund loans, loans held for sale, and letters of credit atDecember 31, 2019 , were$352.7 million . We do not expect that all of these loans are likely to be fully drawn upon at any one time. Additionally, as noted above, our total deposits atDecember 31, 2019 , were$1.4 billion . As shown in the Consolidated Statements of Cash Flows, net cash used by operating activities was$821,000 in 2019 and net cash provided by operating activities was$25.2 million in 2018. The primary source of cash provided by operating activities for all periods presented was positive net income; however, in 2019 the origination of loans held for sale exceeded proceeds from the sale of loans held for sale which is the primary reason that operating cash flow is negative in 2019. Net cash used by investing activities was$71.9 million in 2019 and primarily due to the fact that purchases of investment securities and net investment in loans and purchased receivables exceeded proceeds from sales and maturities of securities available for sale. Net cash provided by investing activities was$5.6 million in 2018 as the Company's proceeds from sales and maturities of securities available for sale were greater than funds used to purchase additional investment securities in those years. Financing activities provided cash of$90.6 million in 2019 and used cash of$31.1 million in 2018. Financing activities provided cash in 2019 due to an increase in deposits that was only partially offset by a decrease in securities sold under repurchase agreements, repurchase of 347,676 shares of the Company's common stock for$12.6 million , and the payment of cash dividends to shareholders. Financing activities used net cash in 2018 primarily as a result of a decrease in deposit balances and payment of cash dividends to shareholders. The sources by which we meet the liquidity needs of our customers are current assets and borrowings available through our correspondent banking relationships and our credit lines with theFederal Reserve Bank and the FHLB. AtDecember 31, 2019 , our current assets were$431.3 million and our funds available for borrowing under our existing lines of credit were$800.7 million . Given these sources of liquidity and our expectations for customer demands for cash and for our operating cash needs, we believe our sources of liquidity to be sufficient in the foreseeable future. During 2019, the Company's Board of Directors approved a quarterly cash dividend of$0.30 per common share for the first and second quarters and$0.33 per common share for the third and fourth quarters. These dividends were made pursuant to our existing dividend policy and in consideration of, among other things, earnings, regulatory capital levels, liquidity, asset quality, and the overall payout ratio. We expect that dividend payments will be reassessed on a quarterly basis by the Board of Directors in accordance with the dividend policy. The payment of cash dividends is subject to regulatory limitations as described under the Supervision and Regulation section of Part I of this report. There is no assurance that future cash dividends on common shares will be declared or increased. OnFebruary 27, 2020 , the Board of Directors approved payment of a$0.34 per share dividend onMarch 20, 2020 , to shareholders of record onMarch 12, 2020 . This dividend is$0.01 , or 3%, higher than the Company's dividend of$0.33 that was paid in the fourth quarter of 2019. InSeptember 2002 , our Board of Directors approved a plan whereby we would periodically repurchase for cash up to approximately 5% of our shares of common stock in the open market. We purchased an aggregate of 688,442 shares of our common stock under this program throughDecember 31, 2009 at a total cost of$14.2 million at an average price of$20.65 per share, which left a balance of 227,242 shares available under the stock repurchase program. The Company did not repurchase any of its shares in 2010 through 2016. In 2017, we purchased an aggregate of 58,341 shares at an average price of$27.56 per share. In 2018, we purchased an aggregate of 15,468 shares at an average price of$31.90 per share. InApril 2019 , the Company's Board of Directors 53 -------------------------------------------------------------------------------- approved a plan whereby it would periodically repurchase for cash up to approximately 5% of its shares of common stock in the open market where 340,000 shares were available for repurchase. In 2019 we purchased an aggregate of 347,676 shares at an average price of$36.15 per share. At December, 31, 2019, there were zero shares available under the stock repurchase program. However, onJanuary 27, 2020 , the Board authorized the repurchase of up to an additional 327,000 shares of common stock. We intend to continue to repurchase our stock from time-to-time depending upon market conditions, but we can make no assurances that we will continue this program or that we will authorize additional shares for repurchase. The table below shows this effect on diluted earnings per share. Diluted EPS as Years Ending: Reported Diluted EPS without Stock Repurchase 2019$3.04 $2.59 2018$2.86 $2.56 2017$1.88 $1.69 2016$2.06 $1.87 2015$2.56 $2.31 OnMay 8, 2003 , the Company's subsidiary, NCT1, issued trust preferred securities in the principal amount of$8 million . These securities carried an interest rate of 90-day LIBOR plus 3.15% per annum that was initially set at 4.45% adjusted quarterly. The securities had a maturity date ofMay 15, 2033 , and were callable by the Company on or afterMay 15, 2008 . These securities were treated as Tier 1 capital by the Company's regulators for capital adequacy calculations. The Company redeemed these trust preferred securities onAugust 15, 2017 . OnDecember 16, 2005 , the Company's subsidiary, NST2, issued trust preferred securities in the principal amount of$10 million . These securities carry an interest rate of 90-day LIBOR plus 1.37% per annum that was initially set at 5.86% adjusted quarterly. The securities have a maturity date ofMarch 15, 2036 , and are callable by the Company on or afterMarch 15, 2011 . These securities are treated as Tier 1 capital by the Company's regulators for capital adequacy calculations. The interest cost to the Company of these securities was$398,000 in 2019. AtDecember 31, 2019 , the securities had an interest rate of 3.26%. The Company entered into an interest rate swap in the third quarter of 2017 to hedge the variability in cash flows arising out of its junior subordinated debentures, by swapping the cash flows with an interest rate swap which receives floating and pays fixed. The Company has designated this interest rate swap as a hedging instrument. The interest rate swap effectively fixes the Company's interest payments on the$10 million of junior subordinated debentures held under NST2 at 3.72% through its maturity date. Net of the impact of the interest rate swap, interest expense on these securities was$389,000 in 2019 and 2018. We are subject to minimum capital requirements. Federal banking agencies have adopted regulations establishing minimum requirements for the capital adequacy of banks and bank holding companies. The requirements address both risk-based capital and leverage capital. We believe as ofDecember 31, 2019 , that the Company and the Bank met all applicable capital adequacy requirements for a "well-capitalized" institution by regulatory standards. The table below illustrates the capital requirements in effect in 2019 for the Company and the Bank and the actual capital ratios for each entity that exceed these requirements. Management intends to maintain capital ratios for the Bank in 2020, exceeding theFDIC's new requirements for the "well-capitalized" classification. The capital ratios for the Company exceed those for the Bank primarily because the$10 million trust preferred securities offering that the Company completed in the fourth quarter of 2005 is included in the Company's capital for regulatory purposes, although they are accounted for as a long-term debt in our financial statements. The trust preferred securities are not accounted for on the Bank's financial statements nor are they included in its capital. As a result, the Company has$10 million more in regulatory capital than the Bank atDecember 31, 2019 and 2018, respectively, which explains most of the difference in the capital ratios for the two entities. Minimum Actual Required Ratio Actual December 31, 2019 Capital Well-Capitalized Company Ratio Bank Total risk-based capital 8.00% 10.00% 15.63% 13.24% Tier 1 risk-based capital 6.00% 8.00% 14.38% 11.98% Common equity tier 1 capital 4.50% 6.50% 13.69% 11.98% Leverage ratio 4.00% 5.00% 12.41% 10.36% 54
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See Note 24 of the Consolidated Financial Statements for a detailed discussion of the capital ratios. The requirements for "well-capitalized" come from the Prompt Correction Action rules. See Item 1 Supervision and Regulation. These rules apply to the Bank but not to the Company. Under the rules of theFederal Reserve Bank , a bank holding company such as the Company is generally defined to be "well capitalized" if its Tier 1 risk-based capital ratio is 8.0% or more and its total risk-based capital ratio is 10.0% or more. Effects of Inflation and Changing Prices: The primary impact of inflation on our operations is increased operating costs. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution's performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates, which could affect the degree and timing of the repricing of our assets and liabilities. In addition, inflation has an impact on our customers' ability to repay their loans. See additional discussion below in Item 7A regarding how various market risks affect the Company.
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