SEVERN BANCORP When used in this report, the terms "the Company," "we," "us," and "our" refer toSevern Bancorp and, unless the context requires otherwise, its consolidated subsidiaries. The following discussion should be read and reviewed in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations set forth inSevern Bancorp's Annual Report on Form 10-K as of and for the year endedDecember 31, 2019 .
The Company
The Company is a savings and loan holding company chartered as a corporation in the state ofMaryland in 1990. It conducts business primarily through three subsidiaries,Severn Savings Bank , FSB (the "Bank"),Mid-Maryland Title Company, Inc. (the "Title Company "), andSBI Mortgage Company ("SBI").The Title Company is a real estate settlement company that handles commercial and residential real estate settlements inMaryland . SBI holds mortgages that do not meet the underwriting criteria of the Bank, and is the parent company ofCrownsville Development Corporation ("Crownsville"), which is doing business asAnnapolis Equity Group and acquires real estate for syndication and investment purposes. The Bank's principal subsidiary,Louis Hyatt, Inc. ("Hyatt Commercial"), conducts business as Hyatt 30
Table of Contents
Commercial, a commercial real estate brokerage and property management company. We maintained seven branches inAnne Arundel County, Maryland atJune 30, 2020 . The branches offer a full range of deposit products and we originate mortgages in the Bank's primary market ofAnne Arundel County, Maryland and, to a lesser extent, in other parts ofMaryland ,Delaware , andVirginia . As ofJune 30, 2020 , we had 173 full-time equivalent employees.
Significant Developments - COVID-19
OnMarch 11, 2020 , theWorld Health Organization declared the outbreak of a novel coronavirus ("COVID-19") as a global pandemic, which continues to spread throughoutthe United States of America ("U.S.") and around the world. The declaration of a global pandemic indicates that almost all public commerce and related business activities must be, to varying degrees, curtailed with the goal of decreasing the rate of new infections. The COVID-19 pandemic in theU.S. has had and is expected to continue to have a complex and significant adverse impact on the economy, the banking industry, and the Company in future fiscal periods, all subject to a high degree of uncertainty.
Effects on Our Market Areas
Our commercial and consumer banking products and services are offered primarily inMaryland , where individual and governmental responses to the COVID-19 pandemic have led to a broad curtailment of economic activity beginning inMarch 2020 . InMaryland , the Governor issued a series of orders, including ordering schools to close for an indefinite period of time and an order that, subject to limited exceptions, all individuals stay at home and nonessential businesses cease all activities for an indeterminate amount of time. InJune 2020 , many of these restrictions were removed and some non-essential businesses were allowed to re-open in a limited capacity, adhering to social distancing and disinfection guidelines. The Bank has remained open during these orders because banks have been identified as essential services. The Bank has been serving its customers through its drive-ups, ATMs, and in all of its branch offices by appointment only. Locally, as well as nationally, we have experienced an increase in unemployment levels in our market area as a result of the curtailment of business activities, the levels of which are expected to remain elevated for the foreseeable future.
Policy and Regulatory Developments
Federal, state and local governments and regulatory authorities have enacted and issued a range of policy responses to the COVID-19 pandemic, including the following:
The
? target rate by 0.5% on
reaching the current range of 0.0% - 0.25%.
On
Economic Security Act ("CARES Act"), which established a
stimulus package, including cash payments to individuals, supplemental
unemployment insurance benefits and a
subsequent legislation) administered through the
Administration ("SBA"), referred to as the paycheck protection program ("PPP").
Under the PPP, small businesses, sole proprietorships, independent contractors
and self-employed individuals may apply for loans from existing SBA lenders and
? other approved regulated lenders that enroll in the program, subject to
numerous limitations and eligibility criteria. PPP loans have an interest rate
of 1.0%, a two-year or five-year loan term to maturity, and principal and
interest payments deferred until the lender receives the applicable forgiven
amount or ten months after the period the business has used such funds. The
Bank is participating as a lender in the PPP. In addition, the CARES Act
provides financial institutions the option to temporarily suspend certain
requirements under accounting principles generally accepted in the
("GAAP") related to troubled debt restructure loans ("TDR" or "TDRs") for a
limited period of time to account for the effects of COVID-19.
On
Statement on Loan Modifications and Reporting for Financial Institutions,
? which, among other things, encouraged financial institutions to work prudently
with borrowers
obligations because of the effects of COVID-19, and stated that institutions
generally do not need to categorize COVID-19-
31
Table of Contents
related modifications as TDRs and that the agencies will not direct supervised
institutions to automatically categorize all COVID-19 related loan modifications
as TDRs.
On
small and mid-sized businesses, as well as state and local governments impacted
by COVID-19. The FRB announced the Main Street Business Lending Program, which
establishes two new loan facilities intended to facilitate lending to small and
mid-sized businesses: (1) the Main Street New Loan Facility ("MSNLF") and (2)
the Main Street Expanded Loan Facility ("MSELF"). MSNLF loans are unsecured
term loans originated on or after
as upsized tranches of existing loans originated before
combined size of the program will be up to
designed for businesses with up to 10,000 employees or
? revenues. To obtain a loan, borrowers must confirm that they are seeking
financial support because of COVID-19 and that they will not use proceeds from
the loan to pay off debt. The FRB also stated that it would provide additional
funding to banks offering PPP loans to help struggling small businesses. The
PPP Loan Facility ("PPPLF") was created by the FRB on
facilitate lending by participating financial institutions to small businesses
under the PPP of the CARES Act. Under the facility, the FRB lends to
participating financial institutions on a non-recourse basis, taking PPP loans
as collateral. Lenders participating in the PPP will be able to exclude loans
financed by the facility from their leverage ratio. To date, due to our high
liquidity levels, we have not participated in the PPPLF.
The FRB also created a Municipal Liquidity Facility to support state and local governments with up to$500.0 billion in lending, with theTreasury Department backing$35.0 billion for the facility using funds appropriated by the CARES Act. The facility will make short-term financing available to cities with a population of more than one million or counties with a population of greater than two million. The FRB expanded both the size and scope of its Primary and Secondary Market Corporate Credit Facilities to support up to$750.0 billion in credit to corporate debt issuers. This will allow companies that were investment grade before the onset of COVID-19 but then subsequently downgraded afterMarch 22, 2020 to gain access to the facility. Finally, the FRB announced that its Term Asset-Backed Securities Loan Facility will be scaled up in scope to include the triple A-rated tranche of commercial mortgage-backed securities and newly issued collateralized loan obligations. The size of the facility is$100.0 billion .
Effects on Our Business
The COVID-19 pandemic and the specific developments referred to above could have and are expected to continue to have a significant impact on our business. The outbreak of COVID-19 could continue to adversely impact a broad range of industries in which the Company's customers operate and impair their ability to fulfill their financial obligations to the Company. In particular, we anticipate that a significant portion of the Bank's borrowers in the hotel, restaurant, and retail industries will continue to endure significant economic distress, which has caused, and may continue to cause, them to draw on their existing lines of credit and adversely affect their ability to repay existing indebtedness, and is expected to adversely impact the value of collateral. These developments, together with economic conditions generally, are also expected to impact our commercial real estate portfolio, particularly with respect to real estate with exposure to these industries, and the value of certain collateral securing our loans. As a result, we anticipate that our financial condition, capital levels, and results of operations could be adversely affected. As ofJune 30, 2020 , we held$4.1 million ,$14.0 million , and$39.4 million in hotel, restaurant, and retail industry loans, respectively.
Our Response
We have taken numerous steps in response to the COVID-19 pandemic, including the following:
? actively working with loan customers to evaluate prudent loan modification
terms;
continuing to promote our digital banking options through our website.
? Customers are encouraged to utilize online and mobile banking tools, and our
customer service and retail departments are fully staffed and available to
assist customers remotely;
32
Table of Contents
acting as a participating lender in the PPP. We believe it is ourresponsibility as a community bank to assist the SBA in the distribution of
funds authorized under the CARES Act to our customers and communities, which we
? are carrying out in a prudent and responsible manner. As of
held
diligently with the SBA to qualify customers to receive such loans (see Note 3
to the Consolidated Financial Statements for more information regarding PPP
loans and loan modifications under the CARES Act); and
closing all branches to customer activity indefinitely, except for drive-up and
appointment only services. We continue to pay all employees according to their
normal work schedule, even if their work has been reduced. No employees have
? been furloughed. Employees whose job responsibilities can be effectively
carried out remotely are working from home. Employees whose critical duties
require their continued presence on-site are observing social distancing and
cleaning protocols. Overview The Company provides a wide range of personal and commercial banking services. Personal services include mortgage lending and various other lending services as well as deposit products such as personal Internet banking and online bill pay, checking accounts, individual retirement accounts, money market accounts, and savings and time deposit accounts. Commercial services include commercial secured and unsecured lending services as well as business Internet banking, corporate cash management services, and deposit services to commercial customers, including those in the medical-use cannabis industry. The Company also provides ATMs, credit cards, debit cards, safe deposit boxes, and telephone banking, among other products and services. We have experienced a decline in profitability for the three and six months endedJune 30, 2020 , primarily due to a decrease in net interest income, an increased provision for loan losses, and increased noninterest expenses (for the six month period), slightly offset by increased noninterest income. Net interest income decreased primarily due to a declining interest rate environment, resulting from rate reductions by the FRB in response to the COVID-19 pandemic (see additional information on COVID-19 above and in Item 1A - Risk Factors of Part II of this Quarterly Report on Form 10-Q). We recognized increased revenue from mortgage-banking activities. We recorded a$750,000 provision for loan losses for the six months endedJune 30, 2020 . Noninterest expenses increased for the six months endedJune 30, 2020 due to increased investments in staff, property, and systems to enhance production and efficiency, as well as to increased commissions corresponding to the increased mortgage production. The Company expects to experience similar market conditions during the remainder of 2020, provided interest rates do not increase or decrease rapidly. If interest rates change rapidly, demand for loans may fluctuate and our interest rate spread could change significantly. We continue to manage loan and deposit pricing against the potential risks of rising costs of our deposits and borrowings. Interest rates are outside of our control, so we must attempt to balance the pricing and duration of the loan portfolio against the risks of rising or declining costs of our deposits and borrowings. The continued success and attraction ofAnne Arundel County, Maryland , and vicinity, will also be important to our ability to originate and grow loans and deposits, as will our continued focus on maintaining a low overhead. If volatility in the market and the economy continues to occur, our business, financial condition, results of operations, access to funds, and the price of our stock could be materially and adversely impacted. Despite our declining profitability in the first half of 2020, we believe the Company is well prepared for the economic and social consequences of the COVID-19 global pandemic in future periods.
Critical Accounting Policies
Our accounting and financial reporting policies conform to GAAP and prevailing
practices within the banking industry. Accordingly, preparation of the financial
statements requires management to exercise significant judgment or discretion or
make significant assumptions and estimates based on the information available
that have, or could have, a material impact on the carrying value of certain
assets or on income. These estimates and assumptions affect the reported amounts
of assets and liabilities at the date of the financial statements and the
reported amounts of income and expenses during the periods presented. The
accounting policies we view as critical are those relating to the allowance for
loan losses ("Allowance"), the valuation of real estate acquired through
foreclosure, and the valuation of deferred tax assets and
33
Table of Contents
liabilities. Significant accounting policies are discussed in detail in "Notes to Consolidated Financial Statements - Note 1 - Summary of Significant Account Policies" in our Annual Report on Form 10-K as of and for the year endedDecember 31, 2019 . There have been no material changes to the significant accounting policies as described in the Annual Report other than those that may be mentioned in Note 1 to the financial statements in this Quarterly Report on Form 10-Q. Disclosures regarding the effects of new accounting pronouncements are included in Note 1 to our Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. Results of OperationsNet Income Three Months EndedJune 30
Net income decreased by
Six Months Ended
Net income decreased by$2.5 million , or 51.9%, to$2.3 million for the six months endedJune 30, 2020 compared to$4.8 million for the six months endedJune 30, 2019 . Basic and diluted income per share were$0.18 for the six months endedJune 30, 2020 , compared to$0.37 for the six months endedJune 30, 2019 . The decrease in net income reflected decreased net interest income, an increased provision for loan losses, and increased noninterest expense, partially offset by increased noninterest income.
Net Interest Income
Net interest income was significantly impacted by a declining interest rate environment directly related to the COVID-19 pandemic. The abrupt decline in interest rates during the first half of 2020 not only reduced interest income on floating-rate commercial loans and other liquid assets, but it also reduced competitive pressures and depositor expectations concerning deposit interest rates. Because of the need to maintain higher levels of liquidity and delays in business investment activity due to COVID-19 disruptions, some further compression of our net interest margin is likely in future periods, but a reasonably robust recovery in business conditions could enable us to deploy our additional asset generation resources and thus reallocate some of our excess liquidity. Additionally, atJune 30, 2020 , we held$46.5 million in low-yielding PPP loans, which reduced our net interest margin.
Three Months Ended
Net interest income decreased by$1.2 million or 15.3%, to$6.6 million for the three months endedJune 30, 2020 , compared to$7.8 million for the same period of 2019. Our net interest margin decreased from 3.55% for the three months endedJune 30, 2019 to 3.22% for the three months endedJune 30, 2020 . Our net interest spread decreased from 3.20% for the three months endedJune 30, 2019 to 2.81% for the three months endedJune 30, 2020 .
Six Months Ended
Net interest income decreased by$2.5 million or 15.9%, to$13.4 million for the six months endedJune 30, 2020 , compared to$15.9 million for the same period of 2019. Our net interest margin decreased from 3.60% for the six months endedJune 30, 2019 to 3.30% for the six months endedJune 30, 2020 . Our net interest spread decreased from 3.27% for the six months endedJune 30, 2019 to 2.87% for the six months endedJune 30, 2020 . Interest Income Three Months EndedJune 30 34 Table of Contents Interest income decreased by$1.9 million , or 18.2%, to$8.4 million for the three months endedJune 30, 2020 , compared to$10.2 million for the three months endedJune 30, 2019 , due to both a low interest rate environment created by the COVID-19 pandemic and a decreased level of average interest-earning assets in the second quarter of 2020. Average interest-earning assets decreased from$885.5 million for the three months endedJune 30, 2019 to$830.4 million for the three months endedJune 30, 2020 , due primarily to a decline in average other interest-earning assets of$30.0 million and a decline in average loans of$24.0 million . The decrease in average other interest-earning assets resulted primarily from decreased average interest-earning deposits in banks, which was the result of decreased deposits from our medical-use cannabis customers. The decrease in average loans was the result of significant loan payoffs in the second quarter of 2020. The average yield on interest-earning assets decreased 58 basis points to 4.05% for the three months endedJune 30, 2020 from 4.63% for the three months endedJune 30, 2019 . The average yield on other interest-earning assets decreased to 0.12% for the three months endedJune 30, 2020 from 1.95% for the three months endedJune 30, 2019 , primarily due to a change in the mix of other interest-earning asset types and the decreased rate environment. We held less certificates of deposit held for investment during the three months endedJune 30, 2020 than during the three months endedJune 30, 2019 . The average yield on loans held for investment decreased from 5.42% for the three months endedJune 30, 2019 to 4.89% for the three months endedJune 30, 2020 as a result of the decreased interest rate environment in the second quarter of 2020 compared to the second quarter of 2019.
Six Months Ended
Interest income decreased by$3.5 million , or 16.8%, to$17.3 million for the six months endedJune 30, 2020 , compared to$20.8 million for the six months endedJune 30, 2019 , due to both a low interest rate environment created by the COVID-19 pandemic and a decreased level of average interest-earning assets in the first half of 2020. Average interest-earning assets decreased from$892.0 million for the six months endedJune 30, 2019 to$816.8 million for the six months endedJune 30, 2020 , due primarily to a decline in average other interest-earning assets of$43.0 million and a decline in average loans of$29.1 million . The decrease in average other interest-earning assets resulted primarily from decreased average interest-earning deposits in banks, which was the result of decreased deposits from our medical-use cannabis customers. The decrease in average loans outstanding was a result of significant loan payoffs in the first half of 2020. The average yield on interest-earning assets decreased 44 basis points to 4.25% for the six months endedJune 30, 2020 from 4.69% for the six months endedJune 30, 2019 . The average yield on other interest-earning assets decreased to 0.66% for the six months endedJune 30, 2020 from 2.32% for the six months endedJune 30, 2019 , primarily due to a change in the mix of other interest-earning asset types and the decreased rate environment. We held less certificates of deposit held for investment during the six months endedJune 30, 2020 than during the six months endedJune 30, 2019 . The average yield on loans held for investment decreased from 5.44% for the six months endedJune 30, 2019 to 5.02% for the six months endedJune 30, 2020 as a result of the decreased interest rate environment in the first half of 2020 compared to the first half of 2019.
Interest Expense
Three Months Ended
Total interest expense was$1.7 million for the three months endedJune 30, 2020 and$2.4 million for the three months endedJune 30, 2019 . We experienced a decrease in deposit interest expense, due to both a decrease in the average balance of interest-bearing deposits from$591.1 million for the three months endedJune 30, 2019 to$501.2 million for the three months endedJune 30, 2020 and a decrease in the average rate paid on interest-bearing liabilities from 1.43% for the three months endedJune 30, 2019 to 1.24% for the same period of 2020. The average balance of interest-bearing checking and savings accounts decreased from$385.1 million for the three months endedJune 30, 2019 to$307.4 million for the three months endedJune 30, 2020 , primarily due to decreases in our medical-use cannabis related accounts. The average balance of certificates of deposit decreased from$206.0 million for the three months endedJune 30, 2019 to$193.8 million for the same period of 2020 due to runoff from maturing certificates of deposit. Average borrowings decreased$20.3 million during the three months endedJune 30, 2020 compared to the same period of 2019, due to payoffs ofFederal Home Loan Bank of Atlanta ("FHLB") advances. Six Months EndedJune 30 35 Table of Contents Total interest expense was$3.9 million for the six months endedJune 30, 2020 and$4.8 million for the six months endedJune 30, 2019 . We experienced a decrease in deposit interest expense, primarily due to a decrease in the average balance of interest-bearing deposits from$606.8 million for the six months endedJune 30, 2019 to$510.3 million for the six months endedJune 30, 2020 . The average balance of interest-bearing checking and savings accounts decreased significantly from$398.2 million for the six months endedJune 30, 2019 to$315.5 million for the six months endedJune 30, 2020 , primarily due to decreases in our medical-use cannabis related accounts. The average balance of certificates of deposit decreased from$208.6 million for the six months endedJune 30, 2019 to$194.8 million for the same period of 2020 due to runoff from maturing certificates of deposit. Average borrowings decreased$23.7 million during the six months endedJune 30, 2020 compared to the same period of 2019, due to payoffs of FHLB advances. The following tables set forth, for the periods indicated, information regarding the average balances of interest-earning assets and interest-bearing liabilities and the resulting yields on average interest-earning assets and average rates paid on
average interest-bearing liabilities. Average balances are also provided for noninterest-earning assets and noninterest-bearing liabilities.
Three Months Ended June 30,
2020 2019
Average Yield/ Average Yield/
Balance Interest (2) Rate (4) Balance Interest (2) Rate (4)
ASSETS (dollars in thousands)
Loans (1) $ 655,366 $ 7,972 4.89 % $ 679,334 $ 9,176 5.42 %
Mortgage loans held for sale
("LHFS") 18,463 106 2.31 % 10,184 50 1.97 %
Available-for-sale ("AFS")
securities 16,021 94 2.36 % 11,553 50 1.74 %
Held-to-maturity ("HTM")
securities 23,222 122 2.11 % 36,410 191 2.10 %
Other interest-earning assets
(3) 114,973 35 0.12 % 144,974 705 1.95 %
Restricted stock investments, at
cost 2,364 32 5.44 % 3,077 52 6.80 %
Total interest-earning assets 830,409 8,361 4.05 % 885,532 10,224 4.63 %
Allowance (7,593) (8,082)
Cash and other
noninterest-earning assets 44,868 42,753
Total assets $ 867,684 8,361 $ 920,203 10,224
LIABILITIES AND STOCKHOLDERS'
EQUITY
Interest-bearing deposits:
Checking and savings $ 307,363 372 0.49 % $ 385,084 807 0.84 %
Certificates of deposit 193,846 1,011 2.10 % 206,022 1,091 2.12 %
Total interest-bearing deposits 501,209 1,383 1.11% 591,106 1,898 1.29 % Borrowings 55,619 333 2.41 % 75,887 481 2.54 % Total interest-bearing liabilities 556,828 1,716 1.24 % 666,993 2,379 1.43 %
Noninterest-bearing deposit accounts 195,283 146,832 Other noninterest-bearing liabilities 8,243 4,382 Stockholders' equity 107,330 101,996 Total liabilities and stockholders' equity$ 867,684 1,716$ 920,203 2,379 Net interest income/net interest spread$ 6,645 2.81 %$ 7,845 3.20 % Net interest margin 3.22 % 3.55 %
(1) Nonaccrual loans are included in average loans.
(2) There are no tax equivalency adjustments.
(3) Other interest-earning assets include interest-earning deposits, federal
funds sold, and certificates of deposit held for investment.
(4) Annualized.
36
Table of Contents
Six Months Ended June 30,
2020 2019
Average Yield/ Average Yield/
Balance Interest (2) Rate (4) Balance Interest (2) Rate (4)
ASSETS (dollars in thousands)
Loans (1) $ 649,726 $ 16,212 5.02 % $ 678,846 $ 18,327 5.44 %
LHFS 15,996 204 2.56 % 8,378 66 1.59 %
AFS securities 15,134 175 2.33 % 11,805 102 1.74 %
HTM securities 23,744 260 2.20 % 37,016 398 2.17 %
Other interest-earning assets
(3) 109,794 360 0.66 % 152,756 1,758 2.32 %
Restricted stock investments, at
cost 2,398 66 5.53 % 3,189 116 7.34 %
Total interest-earning assets 816,792 17,277 4.25 % 891,990 20,767 4.69 %
Allowance (7,374) (8,075)
Cash and other
noninterest-earning assets 45,182 42,305
Total assets $ 854,600 17,277 $ 926,220 20,767
LIABILITIES AND STOCKHOLDERS'
EQUITY
Interest-bearing deposits:
Checking and savings $ 315,536 1,033 0.66 % $ 398,214 1,624 0.82 %
Certificates of deposit 194,784 2,147 2.22 % 208,561 2,143 2.07 %
Total interest-bearing deposits 510,320 3,180 1.25% 606,775 3,767 1.25 % Borrowings 55,619 697 2.52 % 79,309 1,070 2.72 % Total interest-bearing liabilities 565,939 3,877 1.38 % 686,084 4,837 1.42 %
Noninterest-bearing deposits 172,955 134,845 Other noninterest-bearing liabilities 8,165 3,750 Stockholders' equity 107,541 101,541 Total liabilities and stockholders' equity$ 854,600 3,877$ 926,220 4,837 Net interest income/net interest spread$ 13,400 2.87 %$ 15,930 3.27 % Net interest margin 3.30 % 3.60 %
(1) Nonaccrual loans are included in average loans.
(2) There are no tax equivalency adjustments.
(3) Other interest-earning assets include interest-earning deposits, federal
funds sold, and certificates of deposit held for investment.
(4) Annualized.
The "Rate/Volume Analysis" below indicates the changes in our net interest
income as a result of changes in volume and rates. We maintain an asset and
liability management policy designed to provide a proper balance between
rate-sensitive assets and rate-sensitive liabilities to attempt to optimize
interest margins while providing adequate liquidity for our anticipated needs.
Changes in interest income and interest expense that result from variances in
both volume and rates have been allocated to rate and volume changes in
proportion to the absolute dollar amounts of the change in each.
37
Table of Contents
Three Months Ended June 30, 2020 vs. 2019 Six Months Ended June 30, 2020 vs. 2019
Due to Variances in Due to Variances in
Rate Volume Total Rate Volume Total
Interest earned on: (dollars in thousands)
Loans $ (882) $ (322) $ (1,204) $ (1,367) $ (748) $ (2,115)
LHFS 10 46 56 56 82 138
AFS securities 23 21 44 41 32 73
HTM Securities (1) (68) (69) 15 (153) (138)Other interest-earning assets (549) (121) (670) (1,004) (394) (1,398) Restricted stock investments, at cost (9) (11)
(20) (24) (26) (50)
Total interest income (1,408) (455) (1,863) (2,283) (1,207) (3,490)
Interest paid on:
Interest-bearing deposits:
Checking and savings (295) (140) (435) (290) (301) (591)
Certificates of deposit (13) (67) (80) 295 (291) 4
Total interest-bearing deposits (308) (207)
(515) 5 (592) (587)
Borrowings (25) (123) (148) (75) (298) (373)
Total interest expense (333) (330) (663) (70) (890) (960)
Net interest income $ (1,075) $ (125) $ (1,200) $ (2,213) $ (317) $ (2,530) Provision for Loan Losses Our loan portfolio is subject to varying degrees of credit risk and an Allowance is maintained to absorb losses inherent in our loan portfolio. Credit risk includes, but is not limited to, the potential for borrower default and the failure of collateral to be worth what we determined it was worth at the time of the granting of the loan. We monitor loan delinquencies at least monthly. All loans that are delinquent and all loans within the various categories of our portfolio as a group are evaluated. Management, with the advice and recommendation of the Company's Board of Directors, estimates an Allowance to be set aside for loan losses. Included in determining the calculation are such factors as historical losses for each loan portfolio, current market value of the loan's underlying collateral, inherent risk contained within the portfolio after considering the state of the general economy, economic trends, consideration of particular risks inherent in different kinds of lending and consideration of known information that may affect loan collectability. We recorded$750,000 in provision for loan losses for the six months endedJune 30, 2020 primarily due to economic factors related to the COVID-19 pandemic. We did not record any provision for loan losses during the three months endedJune 30, 2020 or the three or six months endedJune 30, 2019 .
See additional information about the provision for loan losses under "Credit Risk Management and the Allowance" later in this Item.
Noninterest Income
Three Months Ended
Total noninterest income increased by$622,000 or 23.8%, to$3.2 million for the three months endedJune 30, 2020 , compared to$2.6 million for the three months endedJune 30, 2019 , with the majority of the increase from mortgage-banking revenue. Mortgage-banking revenue increased$903,000 , or 83.1%, due to the increased volume of loans originated from$69.4 million during the three months endedJune 30, 2019 to$80.6 million during the three months endedJune 30, 2020 . A significant portion of the originations were refinances due to the drop in interest rates.The Title Company generated$226,000 in revenue during the three months endedJune 30, 2020 compared to$262,000 for the three months endedJune 30, 2019 due to a decline in loan closings and related title work. Real estate commissions decreased$248,000 primarily due to the lack of activity in real estate sales as a result of the COVID-19 pandemic. 38 Table of Contents Six Months EndedJune 30 Total noninterest income increased by$1.4 million or 28.5%, to$6.3 million for the six months endedJune 30, 2020 , compared to$4.9 million for the six months endedJune 30, 2019 , with the majority of the increase from mortgage-banking revenue. Mortgage-banking revenue increased$1.8 million , or 100.5%, due to the increased volume of loans originated from$88.9 million during the six months endedJune 30, 2019 to$123.8 million during the six months endedJune 30, 2020 . A significant portion of the originations were refinances due to the drop in interest rates. Deposit service charges increased$75,000 for the six months endedJune 30, 2020 compared to the same period of 2019 primarily due to increased onboarding and monthly fees associated with medical-use cannabis customer accounts.The Title Company generated$464,000 in revenue during the six months endedJune 30, 2020 compared to$479,000 for the six months endedJune 30, 2019 due to a decline in loan closings and related title work. Real estate commissions decreased$420,000 primarily due to the lack of activity in real estate sales as a result of the COVID-19 pandemic.
Noninterest Expense
Three Months Ended
Total noninterest expense remained relatively stable at$7.5 million for both the three months endedJune 30, 2020 and 2019. Professional fees decreased$272,000 primarily due to less consulting fees for SOX related matters. Compensation and related expenses increased by$262,000 , or 5.3%, to$5.2 million for the three months endedJune 30, 2020 , compared to$4.9 million for the three months endedJune 30, 2019 . This increase was primarily due to annual salary increases, additional hirings for theCrofton branch, and increased commission expense that corresponds with our increased mortgage-banking volumes. Occupancy expenses increased$56,000 , or 14.4%, primarily due to the addition of theCrofton branch. We also incurred additional expenses related to COVID-19 protocols. Six Months EndedJune 30 Total noninterest expense increased$1.5 million , or 10.3%, to$15.7 million for the six months endedJune 30, 2020 , compared to$14.3 million for the six months endedJune 30, 2019 , primarily due to increases in compensation and related expenses, occupancy expenses, legal fees, and data processing fees. Compensation and related expenses increased by$1.2 million , or 12.7%, to$10.6 million for the six months endedJune 30, 2020 , compared to$9.4 million for the six months endedJune 30, 2019 . This increase was primarily due to annual salary increases, additional hirings for our new branch, and increased commission expense that corresponds with our increased mortgage-banking volumes. Occupancy expenses increased$159,000 , or 19.8%, primarily due to the addition of theCrofton branch. We also incurred additional expenses related to COVID-19 protocols. Data processing fees increased$160,000 due to additional efficiency and security enhancements to our core and related systems, as well as the implementation in late 2019 of a new customer relationship management ("CRM") system. Legal fees increased$108,000 . We recognized a$76,000 loss on disposal of premises and equipment when we terminated a lease agreement. We experienced a$109,000 decrease in professional fees as we were no longer utilizing consultants in
2020 for SOX related matters. Income Tax Provision Three Months EndedJune 30 We recorded a$658,000 tax provision on net income before income taxes of$2.4 million for the three months endedJune 30, 2020 for an effective tax rate of 27.5%, compared to an income tax provision of$771,000 on net income before income taxes of$2.9 million for the three months endedJune 30, 2019 , for
an effective tax rate of 26.2%. Six Months EndedJune 30 We recorded a$871,000 tax provision on net income before income taxes of$3.2 million for the six months endedJune 30, 2020 for an effective tax rate of 27.4%, compared to an income tax provision of$1.8 million on net income before income taxes of$6.5 million for the six months endedJune 30, 2019 , for an
effective tax rate of 26.9%.
39
Table of Contents
Financial Condition
Total assets increased $96.7 million to $923.7 million at June 30, 2020 ,
compared to $826.9 million at December 31, 2019 . This increase was primarily due
to a $80.3 million , or 91.0%, increase in cash and cash equivalents, to $168.5
million at June 30, 2020 from $88.2 million at December 31, 2019 due primarily
to increased deposits. We experienced an increase in loans of $15.7 million , or
2.4%, to $661.4 million at June 30, 2020 from $645.7 million at December 31,
2019 . Additionally, we had approximately $6.2 million of securities that had not
yet settled at June 30, 2020 , which grossed up total assets. Total deposits
increased $87.9 million , or 13.3%, to $748.9 million at June 30, 2020 compared
to $661.0 million at December 31, 2019 . Stockholders' equity increased $1.5
million to $107.0 million at June 30, 2020 compared to $105.5 million at
December 31, 2019 , due to net income for the first half of the year and
increased accumulated comprehensive income, partially offset by dividends paid
to stockholders.
Securities
We utilize the securities portfolio as part of our overall asset/liability management practices to enhance interest revenue while providing necessary liquidity for the funding of loan growth or deposit withdrawals. We continually monitor the credit risk associated with investments and diversify the risk in the securities portfolios. We held$15.8 million and$12.9 million in securities classified as AFS as ofJune 30, 2020 andDecember 31, 2019 , respectively. We held$21.3 million and$26.0 million , respectively, in securities classified as HTM as ofJune 30, 2020 andDecember 31, 2019 , respectively. Changes in current market conditions, such as interest rates and the economic uncertainties in the mortgage, housing, and banking industries impact the securities market. Quarterly, we review each security in our portfolio to determine the nature of any decline in value and evaluate if any impairment should be classified as other-than-temporary impairment ("OTTI"). For the three and six months endedJune 30, 2020 , we determined that no OTTI charges were required. All of the AFS and HTM securities that are temporarily impaired as ofJune 30, 2020 were so due to declines in fair values resulting from changes in interest rates or decreased credit/liquidity spreads compared to the time they were purchased. We have the intent to hold these securities to maturity (including those designated as AFS) and it is more likely than not that we will not be required to sell the securities before recovery of value. As such, management considers the impairments to be temporary.
Our securities portfolio composition is as follows:
AFS HTM
June 30, 2020 December 31, 2019 June 30, 2020 December 31, 2019
(dollars in thousands)
U.S. Treasury securities $ - $ - $ 998 $ 994
U.S. government agency notes 3,067 5,019 2,985 4,986
Corporate obligations 1,984 - - -
Mortgage-backed securities 10,755 7,887 17,327 19,980
$ 15,806 $ 12,906 $ 21,310 $ 25,960
LHFS
We originate residential mortgage loans for sale on the secondary market. Such
LHFS, which are carried at fair value, amounted to $11.4 million at June
30, 2020 and $10.9 million at December 31, 2019 , the majority of which are
subject to purchase commitments from investors. The increase in LHFS was
primarily due to increased originations and to the timing of loans pending
sale
on the secondary market.
Loans
Our loan portfolio is expected to produce higher yields than investment
securities and other interest-earning assets; the absolute volume and mix of
loans and the volume and mix of loans as a percentage of total interest-earning
assets is an important determinant of our net interest margin.
40
Table of Contents
The following table sets forth the composition of our loan portfolio:
June 30, 2020 December 31, 2019
Percent Percent
Amount of Total Amount of Total
(dollars in thousands)
Residential Mortgage $ 237,266 35.7 % $ 269,654 41.6 %
Commercial 87,931 13.2 % 43,127 6.7 %
Commercial real estate 225,588 33.9 % 229,257 35.3 %
Land acquisition, development, and
construction ("ADC") 100,812 15.2 % 92,822 14.3 %
Home equity/2nds 12,027 1.8 % 12,031 1.9 %
Consumer 1,384 0.2 % 1,541 0.2 %
Loans receivable, before net unearned
fees $ 665,008 100.0 % $ 648,432 100.0 %
Total loans increased by$15.7 million , or 2.4%, to$661.4 million atJune 30, 2020 , compared to$645.7 million atDecember 31, 2019 . This increase was due primarily to the origination of PPP loans, partially offset by increased payoffs of residential real estate and commercial real estate loans.
Credit Risk Management and the Allowance
Credit risk is the risk of loss arising from the inability of a borrower to meet his or her obligations and entails both general risks, which are inherent in the process of lending, and risks specific to individual borrowers. Our credit risk is mitigated through portfolio diversification, which limits exposure to any single customer, industry, or collateral type. We manage credit risk by evaluating the risk profile of the borrower, repayment sources, the nature of the underlying collateral, and other support given current events, conditions, and expectations. We attempt to manage the risk characteristics of our loan portfolio through various control processes, such as credit evaluation of borrowers, establishment of lending limits, and application of lending procedures, including the holding of adequate collateral and the maintenance of compensating balances. However, we seek to rely primarily on the cash flow of our borrowers as the principal source of repayment. Although credit policies and evaluation processes are designed to minimize our risk, management recognizes that loan losses will occur and the amount of these losses will fluctuate depending on the risk characteristics of our loan portfolio, as well as general and regional economic conditions. Management has an established methodology to determine the adequacy of the Allowance that assesses the risks and losses inherent in the loan portfolio. Our Allowance methodology employs management's assessment as to the level of future losses on existing loans based on our internal review of the loan portfolio, including an analysis of the borrowers' current financial position, and the consideration of current and anticipated economic conditions and their potential effects on specific borrowers and/or lines of business. In determining our ability to collect certain loans, we also consider the fair value of any underlying collateral. In addition, we evaluate credit risk concentrations, including trends in large dollar exposures to related borrowers, industry and geographic concentrations, and economic and environmental factors. Our risk management practices are designed to ensure timely identification of changes in loan risk profiles; however, undetected losses may inherently exist within the loan portfolio. The assessment aspects involved in analyzing the quality of individual loans and assessing collateral values can also contribute to undetected, but probable, losses. In the first half of 2020, we adjusted our economic risk factors to incorporate the current economic implications and
rising unemployment rate from
41
Table of Contents
the COVID-19 pandemic. For more detailed information about our Allowance methodology and risk rating system, see Note 3 to the Consolidated Financial Statements.
The following table summarizes the activity in our Allowance by portfolio
segment:
Three Months Ended June 30, Six Months Ended June 30,
2020 2019 2020 2019
(dollars in thousands)
Allowance, beginning of period $ 7,918 $ 8,085 $ 7,138 $ 8,044
Charge-offs:
Residential mortgage - (20) - (20)
Commercial - - - -
Commercial real estate - - - -
ADC - - - -
Home equity/2nds - - - -
Consumer - (12) (15) (12)
Total charge-offs - (32) (15) (32)
Recoveries:
Residential mortgage 177 3 180 8
Commercial 3 - 8 -
Commercial real estate 70 33 102 67
ADC - - - -
Home equity/2nds 1 4 3 6
Consumer - - 3 -
Total recoveries 251 40 296 81
Net recoveries 251 8 281 49
Provision for loan losses - - 750 -
Allowance, end of period $ 8,169 $ 8,093 $ 8,169 $ 8,093
Loans:
Period-end balance $ 661,372 $ 679,573 $ 661,372 $ 679,573
Average balance during period 655,366 679,334 649,726 678,846
Allowance as a percentage of
period-end loan balance (1) 1.24 % 1.19 % 1.24 % 1.19 %
Percent of average loans (annualized):
Provision for loan losses - % - % 0.23 % - %
Net recoveries 0.15 % - % 0.09 % 0.01 %
(1) The Allowance at
The following table summarizes our allocation of the Allowance by loan segment:
June 30, 2020 December 31, 2019
Percent Percent
of Loans of Loans
Percent to Total Percent to Total
Amount of Total Loans Amount of Total Loans
(dollars in thousands)
Residential mortgage $ 2,422 29.7 % 35.7 % $ 2,264 31.7 % 41.6 %
Commercial 1,677 20.5 % 13.2 % 1,421 19.9 % 6.7 %
Commercial real estate 1,078 13.2 % 33.9 % 984 13.8 % 35.3 %
ADC 2,789 34.1 % 15.2 % 2,286 32.0 % 14.3 %
Home equity/2nds 165 2.0 % 1.8 % 134 1.9 % 1.9 %
Consumer - - % 0.2 % - - % 0.2 %
Unallocated 38 0.5 % - % 49 0.7 % - %
Total $ 8,169 100.0 % 100.0 % $ 7,138 100.0 % 100.0 %
42
Table of Contents
Based upon management's evaluation, provisions are made to maintain the
Allowance as a best estimate of inherent losses within the portfolio. The
Allowance totaled $8.2 million at June 30, 2020 and $7.1 million at December 31,
2019 . Any changes in the Allowance from period to period reflect management's
ongoing application of its methodologies to establish the Allowance, which, for
the six months ended June 30, 2020 , resulted in increased allocated Allowances
for the majority of the loan segments, primarily due to economic factors related
to the COVID-19 pandemic.
As result of our Allowance analysis, we recorded a provision for loan losses of
$750,000 during the six months ended June 30, 2020 . We did not record any
provision for loan losses for the three months ended June 30, 2020 or the three
or six months ended June 30, 2019 . We recorded net recoveries of $251,000 and
$281,000 , respectively, during the three and six months ended June 30, 2020 and
net recoveries of $8,000 and $49,000 , respectively, during the three and six
months ended June 30, 2019 . During the three and six months ended June 30, 2020 ,
annualized net recoveries as a percentage of average loans outstanding amounted
to 0.15% and 0.09%, respectively. During the three and six months ended June
30, 2019 , annualized net recoveries as a percentage of average loans outstanding
amounted to 0.00% and 0.01%, respectively. The Allowance as a percentage of
outstanding loans was 1.24% as of June 30, 2020 compared to 1.11% as
of December 31, 2019 , the increase in which was primarily the result of the net
recoveries recognized in 2020 as well as the decrease in outstanding loans, net
of PPP loans. PPP loans are fully guaranteed by the SBA and, therefore, not
required to have an allocated Allowance. The Allowance as a percentage of
outstanding loans less PPP loans amounted to 1.33% at June 30, 2020 .
Although management uses available information to establish the appropriate
level of the Allowance, future additions or reductions to the Allowance may be
necessary based on estimates that are susceptible to change as a result of
changes in economic conditions, and other factors. As a result, our Allowance
may not be sufficient to cover actual loan losses, and future provisions for
loan losses could materially adversely affect our operating results. In
addition, various regulatory agencies, as an integral part of their examination
process, periodically review our Allowance and related methodology. Such
agencies may require us to recognize adjustments to the Allowance based on their
judgments about information available to them at the time of their examination.
Management believes the Allowance is adequate as of June 30, 2020 and is
sufficient to address the credit losses inherent in the current loan portfolio.
Management will continue to evaluate the adequacy of the Allowance as more
economic data becomes available and as changes within our portfolio are known.
The effects of the COVID-19 pandemic may require us to fund additional increases
in the Allowance in future periods.
Nonperforming Assets ("NPAs")
Given the volatility of the real estate market, it is very important for us to have current valuations on our NPAs. Generally, we obtain appraisals or alternative valuations on NPAs annually. In addition, as part of our asset monitoring activities, we maintain a Loss Mitigation Committee that meets monthly. During these Loss Mitigation Committee meetings, all NPAs and loan delinquencies are reviewed. We also produce an NPA report which is distributed monthly to senior management and is also discussed and reviewed at the Loss Mitigation Committee meetings. This report contains all relevant data on the NPAs, including the latest appraised value (or alternative valuation vehicle) and valuation date. Accordingly, these reports identify which assets will require an updated valuation. As a result, we have not experienced any internal delays in identifying which loans/credits require updated valuations. With respect to the ordering process of appraisals, we have not experienced any delays in turnaround time nor has this been an issue over the past three years. Furthermore, we have not had any delays in turnaround time or variances thereof in our specific loan operating markets.
NPAs, expressed as a percentage of total assets, totaled 0.79% at
43
Table of Contents
The distribution of our NPAs is illustrated in the following table. We did not
have any loans greater than 90 days past due and still accruing at
June 30, 2020 December 31, 2019
Nonaccrual Loans: (dollars in thousands)
Residential mortgage $ 5,676 $ 3,766
Commercial real estate 307 237
ADC 131 89
Home equity/2nds 131 150
6,245 4,242
Real Estate Acquired Through Foreclosure:
Residential mortgage - 1,377
Commercial real estate 452 452
ADC 558 558
1,010 2,387
Total NPAs $ 7,255 $ 6,629
Nonaccrual loans totaled
Real estate acquired through foreclosure decreased$1.4 million to$1.0 million atJune 30, 2020 compared to$2.4 million atDecember 31, 2019 , primarily due to the sale of three residential mortgage properties existing atDecember 31, 2019 .
The activity in our real estate acquired through foreclosure was as follows:
Three Months Ended June 30, Six Months Ended June 30,
2020 2019 2020 2019
(dollars in thousands)
Balance at beginning of period $ 1,684 $ 1,601 $ 2,387 $ 1,537
Real estate acquired in satisfaction of
loans - - - 171
Write-downs and losses on real estate
acquired through foreclosure (471) (64) (551) (171)
Proceeds from sales of real estate
acquired through foreclosure (203) (107) (826) (107)
Balance at end of period $ 1,010 $ 1,430 $ 1,010 $ 1,430
TDRs
In situations where, for economic or legal reasons related to a borrower's financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a TDR. See Significant Developments - COVID-19 for information regarding the CARES Act and its effect on modifications.
44
Table of Contents
The composition of our TDRs is illustrated in the following table:
June 30, 2020 December 31, 2019
Residential mortgage: (dollars in thousands)
Nonaccrual $ 82 $ 85
<90 days past due/current 6,966 7,675
Commercial real estate:
Nonaccrual - -
<90 days past due/current 971 984
ADC:
Nonaccrual - - <90 days past due/current 129 130
Consumer:
Nonaccrual - - <90 days past due/current 65 69
Totals:
Nonaccrual 82 85
<90 days past due/current 8,131 8,858
$ 8,213 $ 8,943
See additional information on TDRs in Note 3 to the Consolidated Financial Statements herein.
Deposits
Deposits totaled$748.9 million atJune 30, 2020 and$661.0 million atDecember 31, 2019 . The$87.9 million increase was primarily the result of short-term medical-use cannabis related funds (funds that have not yet actually been used in the medical-use cannabis industry) that account holders have placed at the Bank temporarily while looking for desired investments in the industry. Management is aware of the short-term nature of such medical-use cannabis related deposits and offset those funds by maintaining short-term liquidity to meet any deposit outflows.
The deposit breakdown is as follows:
June 30, 2020 December 31, 2019
Percent Percent
Balance of Total Balance of Total
(dollars in thousands)
NOW $ 92,806 12.4 % $ 83,612 12.6 %
Money market 61,353 8.2 % 162,621 24.6 %
Savings 167,031 22.3 % 61,514 9.3 %
Certificates of deposit 225,872 30.1 % 230,401 34.9 %Total interest-bearing deposits 547,062 73.0 % 538,148
81.4 % Noninterest-bearing deposits 201,854 27.0 % 122,901 18.6 % Total deposits$ 748,916 100.0 %$ 661,049 100.0 % Borrowings
Our borrowings consist of advances from the FHLB.
The FHLB advances are available under a specific collateral pledge and security
agreement, which requires that we maintain collateral for all of our borrowings
equal to 30% of total assets. Our advances from the FHLB may be in the form of
short-term or long-term obligations. Short-term advances have maturities for
one year or less and may contain prepayment penalties. Long-term borrowings
through the FHLB have original maturities up to 15 years and generally contain
prepayment penalties.
45
Table of Contents
At June 30, 2020 , our total credit line with the FHLB was $256.1 million . The
Bank, from time to time, utilizes the line of credit when interest rates are
more favorable than obtaining deposits from the public. Our outstanding FHLB
advance balance at both June 30, 2020 and December 31, 2019 was $35.0 million .
The following table sets forth information concerning the interest rates and
maturity dates of the advances from the FHLB as of
Principal
Amount (in thousands) Rate Maturity
$ 25,000 1.75% to 1.92% 2020
10,000 2.19% 2022
$ 35,000
Subordinated Debentures
As of bothJune 30, 2020 andDecember 31, 2019 , the Company had outstanding$20.6 million in principal amount ofJunior Subordinated Debt Securities , due in 2035 (the "2035 Debentures"). The 2035 Debentures were issued pursuant to an Indenture dated as ofDecember 17, 2004 (the "2035 Indenture") between the Company andWells Fargo Bank, National Association as Trustee. The 2035 Debentures pay interest quarterly at a floating rate of interest of 3-month LIBOR plus 200 basis points, and mature onJanuary 7, 2035 . Payments of principal, interest, premium and other amounts under the 2035 Debentures are subordinated and junior in right of payment to the prior payment in full of all senior indebtedness of the Company, as defined in the 2035 Indenture. The 2035 Debentures became redeemable, in whole or in part, by the Company onJanuary 7, 2010 . The 2035 Debentures were issued and sold to Severn Capital Trust I (the "Trust"), of which 100% of the common equity is owned by the Company. The Trust was formed for the purpose of issuing corporation-obligated mandatorily redeemable Capital Securities ("Capital Securities") to third-party investors and using the proceeds from the sale of such Capital Securities to purchase the 2035 Debentures. The 2035 Debentures held by the Trust are the sole assets of the Trust. Distributions on the Capital Securities issued by the Trust are payable quarterly at a rate per annum equal to the interest rate being earned by the Trust on the 2035 Debentures.The Capital Securities are subject to mandatory redemption, in whole or in part, upon repayment of the 2035 Debentures. We have entered into an agreement which, taken collectively, fully and unconditionally guarantees the Capital Securities subject to the terms of the guarantee. Under the terms of the 2035 Debentures, we are permitted to defer the payment of interest on the 2035 Debentures for up to 20 consecutive quarterly periods, provided that no event of default has occurred and is continuing. As ofJune 30, 2020 , we were current on all interest due on the 2035 Debentures.
Capital Resources
Total stockholders' equity increased$1.5 million to$107.0 million atJune 30, 2020 compared to$105.5 million as ofDecember 31, 2019 . The increase was the result of 2020 net income to date and an increase in accumulated other comprehensive income, partially offset by dividends paid to stockholders during the six months endedJune 30, 2020 .
Capital Adequacy
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. As ofJune 30, 2020 andDecember 31, 2019 , the Bank exceeded all capital adequacy requirements to which it is subject
and
meets the qualifications
46
Table of Contents
to be considered "well capitalized." As of January 1, 2020 , the Bank elected to
follow the Community Bank Leverage Ratio. See details of our capital ratios in
Note 4 of the Consolidated Financial Statements.
Liquidity
Liquidity describes our ability to meet financial obligations, including lending commitments and contingencies, which arise during the normal course of business. Liquidity is primarily needed to meet the borrowing and deposit withdrawal requirements of our customers, to fund the operations of our mortgage-banking business, as well as to meet current and planned expenditures. These cash requirements are met on a daily basis through the inflow of deposit funds, the maintenance of short-term overnight investments, maturities and calls in our securities portfolio, and available lines of credit with the FHLB, which requires pledged collateral. Fluctuations in deposit and short-term borrowing balances may be influenced by the interest rates paid, general consumer confidence, and the overall economic environment. There can be no assurances that deposit withdrawals and loan fundings will not exceed all available sources of liquidity on a short-term basis. Such a situation would have an adverse effect on our ability to originate new loans and maintain reasonable loan and deposit interest rates, which would negatively impact earnings. Our principal sources of liquidity are loan repayments, maturing investments, deposits, borrowed funds, and proceeds from loans sold on the secondary market. The levels of such sources are dependent on the Bank's operating, financing, and investing activities at any given time. We consider core deposits stable funding sources and include all deposits, except time deposits of$100,000 or more. The Bank's experience has been that a substantial portion of certificates of deposit renew at time of maturity and remain on deposit with the Bank. Additionally, loan payments, maturities, deposit growth, and earnings contribute to our flow of funds. In addition to our ability to generate deposits, we have external sources of funds, which may be drawn upon when desired. The primary source of external liquidity is an available line of credit with the FHLB. The Bank's total credit availability under the FHLB's credit availability program was$256.1 million atJune 30, 2020 , of which$35.0 million was outstanding. The borrowing requirements of customers include commitments to extend credit and the unused portion of lines of credit (collectively "commitments"), which totaled$108.1 million atJune 30, 2020 . Historically, many of the commitments expire without being fully drawn; therefore, the total commitment amounts do not necessarily represent future cash requirements. We expect to fund these commitments from the sources of liquidity described above. Customer withdrawals are also a principal use of liquidity, but are generally mitigated by growth in customer funding sources, such as deposits and short-term borrowings. In addition to the foregoing, the payment of dividends is a use of cash, but is not expected to have a material effect on liquidity. As ofJune 30, 2020 , we had no material commitments for capital expenditures. Our ability to acquire deposits or borrow could be impaired by factors that are not specific to us, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole. Additionally, the origination volume of PPP loans could be a drain on our liquidity. As ofJune 30, 2020 , we have not yet experienced any negative impact on our liquidity due to COVID-19. AtJune 30, 2020 , management considered the Company's liquidity level to be sufficient for the purposes of meeting our cash flow requirements. We are not aware of any undisclosed known trends, demands, commitments, or uncertainties that are reasonably likely to result in material changes in our liquidity. We anticipate that our primary sources of liquidity over the next twelve months will be from loan repayments, maturing investments, deposit growth, and borrowed funds. We believe that these sources of liquidity will be sufficient for us to meet our liquidity needs over the next twelve months.
Off-Balance Sheet Arrangements and Derivatives
We enter into off-balance sheet arrangements in the normal course of business. These arrangements consist primarily of commitments to extend credit, lines of credit, and letters of credit. In addition, we have certain operating lease
obligations.
47
Table of Contents
Credit Commitments
Credit commitments are agreements to lend to a customer as long as there is no violation of any condition to the contract. Loan commitments generally have interest rates fixed at current market amounts, fixed expiration dates, and may require payment of a fee. Lines of credit generally have variable interest rates. Such lines do not represent future cash requirements because it is unlikely that all customers will draw upon their lines in full at any time. Letters of credit are commitments issued to guarantee the performance of a customer to a third party. Our exposure to credit loss in the event of nonperformance by the borrower is the contract amount of the commitment. Loan commitments, lines of credit, and letters of credit are made on the same terms, including collateral, as outstanding loans. We are not aware of any accounting loss we would incur by funding our commitments.
See detailed information on credit commitments above under "Liquidity."
Derivatives
We maintain and account for derivatives, in the form of interest-rate lock
commitments ("IRLCs") and mandatory forward contracts, in accordance with the
IRLCs on mortgage loans that we intend to sell in the secondary market are considered derivatives. We are exposed to price risk from the time a mortgage loan closes until the time the loan is sold. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 14 days to 60 days. For these IRLCs, we attempt to protect the Bank from changes in interest rates through the use of best efforts and mandatory forward contracts.
See Note 8 to the consolidated financial statements for more detailed information on our derivatives.
Inflation
The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with GAAP and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. As a financial institution, virtually all of our assets and liabilities are monetary in nature and interest rates have a more significant impact on our performance than the effects of general levels of inflation. A prolonged period of inflation could cause interest rates, wages, and other costs to increase and could adversely affect our results of operations unless mitigated by a corresponding increase in our revenues. However, we believe that the impact of inflation on our operations was not material for the three and six months endedJune 30, 2020 and 2019.
© Edgar Online, source
