SHORE BANCSHARES, INC. The following discussion compares the Company's financial condition at
PERFORMANCE OVERVIEW The Company recorded net income of$15.37 million for 2021 and net income of$15.73 million for 2020. The basic and diluted income per share was$1.17 and$1.27 for fiscal year 2021 and 2020, respectively. When comparing net income for 2021 to 2020, earnings decreased due to higher noninterest expenses, which included merger-related expenses of$8.5 million related to the acquisition of Severn. Without these merger-related expenses, noninterest expense increased$9.9 million , among all expense categories except other real-estate owned expense and general legal and professional fees (non-merger related). However, in fiscal 2021 compared to fiscal 2020, the Company recorded increases in net interest income of$11.5 million , noninterest income of$2.7 million and a decrease in provision for credit losses of$4.3 million . Total assets were$3.460 billion atDecember 31, 2021 , a$1.5 billion , or 79.0%, increase when compared to$1.933 billion at the end of 2020. The merger with Severn, added approximately$1.1 billion to total assets as ofOctober 31, 2021 . Excluding the day 1 value of acquired assets, total assets increased$406.8 million , or 21.0%, when compared to the end of 2020. This non-merger related growth in assets reflected increases in investment securities held to maturity of$214.6 million , interest-bearing deposits with other banks of$77.6 million , loans of$80.3 million and loans held for sale of$28.1 million , partially offset by a decrease in investment securities available for sale of$43.6 million . Total deposits increased$1.326 billion , or 77.9%, when compared toDecember 31, 2020 . The merger with Severn, added approximately$955.3 million to total deposits as ofOctober 31, 2021 . Excluding these assumed deposits, total deposits increased$370.2 million , or 21.8%, when compared to the end of 2020. The significant movement into deposit accounts, excluding the deposits acquired from Severn, continues to be driven by new account openings and municipal deposit inflows. Total stockholders' equity increased$155.7 million , or 79.8%, when compared toDecember 31, 2020 , primarily due to the acquisition of Severn. AtDecember 31, 2021 , the ratio of total equity to total assets was 10.14% and the ratio of total tangible equity to total tangible assets was 8.25%.
We established our process for participating in theSmall Business Administration's Paycheck Protection Program ("PPP") that enabled our clients to utilize this valuable resource beginning inApril 2020 . Loans under the PPP were designed to provide assistance for small businesses during the COVID-19 pandemic to help meet the costs associated with payroll, mortgage interest, rent and utilities. These loans are guaranteed by the SBA and forgiveness of the loans, by the SBA, is granted to the borrower if the borrower uses at least 60% of the funds to cover payroll costs and benefits. Forgiveness is also based on the small business maintaining or quickly rehiring their employees and maintaining salary levels for their employees. Loans under the PPP did not require any collateral or personal guarantees, as such, these loans are included in the Company's commercial loans segment. BetweenApril 2020 and through the date the PPP program ended we processed 1,488 PPP loans for approximately$126.7 million , which has allowed us to further strengthen and deepen our client relationships, while positively impacting thousands of individuals. We are also closely monitoring the credit quality of the loan portfolio and monitor lines of credit draws for deviation from normal activity to improve loan performance and reduce credit risk. As ofDecember 31, 2021 , the Company had 227 PPP loans totaling$27.6 million that were outstanding, inclusive of loans issued pre-merger and those acquired from Severn. The Company had no COVID related loan deferrals as of December
31,
2021.
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CRITICAL ACCOUNTING POLICIES
The Company's consolidated financial statements are prepared in accordance with GAAP and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. The most significant accounting policies that the Company follows are presented in Note 1 to the Consolidated Financial Statements. These policies, along with the disclosures presented in the notes to the financial statements and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for credit losses, accounting for loans acquired in business combinations, and goodwill are critical accounting policies. These policies are considered critical because they relate to accounting areas that require the most subjective or complex judgments, and, as such, could be most subject to revision as new information becomes available.
Loans Acquired in a Business Combination
Acquired loans are classified as either (i) purchase credit-impaired ("PCI")
loans or (ii) purchased performing loans and are recorded at fair value on the
date of acquisition.
PCI loans are those for which there is evidence of credit deterioration since
origination and for which it is probable at the date of acquisition that the
Company will not collect all contractually required principal and interest
payments. When determining fair value, PCI loans are aggregated into pools of
loans based on common risk characteristics as of the date of acquisition such as
loan type, date of origination, and evidence of credit quality deterioration
such as internal risk grades and past due and nonaccrual status. The difference
between contractually required payments at acquisition and the cash flows
expected to be collected at acquisition is referred to as the "nonaccretable
difference." Any excess of cash flows expected at acquisition over the estimated
fair value is referred to as the "accretable yield" and is recognized as
interest income over the remaining life of the loan when there is a reasonable
expectation about the amount and timing of such cash flows.
On a quarterly basis, we evaluate our estimate of cash flows expected to be
collected on PCI loans. Estimates of cash flows for PCI loans require
significant judgment. Subsequent decreases to the expected cash flows will
generally result in a provision for loan losses resulting in an increase to the
allowance for loan losses. Subsequent significant increases in cash flows may
result in a reversal of post-acquisition provision for loan losses or a transfer
from nonaccretable difference to accretable yield that increases interest income
over the remaining life of the loan, or pool(s) of loans. Disposals of loans,
which may include sale of loans to third parties, receipt of payments in full or
in part from the borrower or foreclosure of the collateral, result in removal of
the loan from the PCI loan portfolio at its carrying amount.
PCI loans are not classified as nonperforming by the Company at the time they
are acquired, regardless of whether they had been classified as nonperforming by
the previous holder of such loans, and they will not be classified as
nonperforming so long as, at quarterly re-estimation periods, we believe we will
fully collect the new carrying value of the pools of loans.
The Company accounts for purchased performing loans using the contractual cash
flows method of recognizing discount accretion based on the acquired loans'
contractual cash flows. Purchased performing loans are recorded at fair value,
including a credit discount. The fair value discount is accreted as an
adjustment to yield over the estimated lives of the loans. There is no allowance
for loan losses established at the acquisition date for purchased performing
loans. A provision for loan losses may be required for any deterioration in
these loans in future periods.
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Allowance for Credit Losses
The allowance for credit losses represents management's estimate of credit losses inherent in the loan portfolio as of the balance sheet date. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of similar loans based on historical loss experience, and consideration of current economic trends and conditions and other factors impacting the loan portfolio, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheets. Note 1 to the Consolidated Financial Statements describes the methodology used to determine the allowance for credit losses. A discussion of the allowance determination and factors driving changes in the amount of the allowance for credit losses is included in the Asset Quality - Provision for Credit Losses and Risk Management section below.
Goodwill Impairment
Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Determining fair value is subjective, requiring the use of estimates, assumptions and management judgment.Goodwill is tested at least annually for impairment, usually during the fourth quarter, and on an interim basis if circumstances dictate. Impairment testing requires a qualitative assessment or that the fair value of each of the Company's reporting units be compared to the carrying amount of its net assets, including goodwill. If the fair value of a reporting unit is less than book value, an expense may be required to write down the related goodwill to record an impairment loss. As ofDecember 31, 2021 , the Company had banking and mortgage reporting unit.
RECENT ACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS
The Notes to the Consolidated Financial Statements discuss the expected impact of accounting policies recently issued or proposed but not yet required to be adopted. To the extent the adoption of new accounting standards materially affects our financial condition, results of operations or liquidity, the impacts are discussed in the applicable section(s) of this discussion and Notes to the Consolidated Financial Statements.
RESULTS OF OPERATIONS
Net Interest Income and Net Interest Margin
Net interest income remains the most significant factor affecting our results of operations. Net interest income represents the excess of interest and fees earned on total average earning assets (loans, investment securities, federal funds sold and interest-bearing deposits with other banks) over interest owed on average interest-bearing liabilities (deposits and borrowings). Tax-equivalent net interest income is net interest income adjusted for the tax-favored status of income from certain loans and investments. As shown in the table below, tax-equivalent net interest income for 2021 was$64.3 million . This represented a$11.5 million , or 21.9%, increase from 2020. The increase in net interest income when comparing 2021 to 2020 was primarily the result of higher average balances on earnings assets of$574.1 million , or 35.6% and lower rates paid on interest-bearing deposits of 30bps, partially offset by the addition of subordinated debt from the acquisition of Severn and a full year of legacy subordinated debt issued by the Company in the third quarter of 2020. Our net interest margin (i.e., tax-equivalent net interest income divided by average earning assets) is managed through loan and deposit pricing and asset/liability strategies. The net interest margin was 2.94% for 2021 and 3.27% for 2020. The net interest margin decreased when comparing 2021 to 2020 primarily due to a decline in the average yields on total earning assets of 50bps, which was compounded by the significant increase in deposits, resulting in excess liquidity being invested in lower yielding assets. In addition, subordinated debt both issued by the Company in 2020 and acquired in the Severn merger, contributed$1.0 million in additional interest expense. Partially offsetting the decrease in average yields on earnings assets and subordinated debt, was a decline in the average rates paid on interest-bearing deposits of 30bps and the decrease in the average balance on long-term advances from the FHLB. The net interest spread, which is the difference between the average yield on earning assets and the average rate paid for interest-bearing liabilities was 2.80% for 2021 and 3.05% for 2020. 40
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The following table sets forth the major components of net interest income, on a
tax-equivalent basis, for the presented years ended
2021 2020
Average Interest Yield/ Average Interest Yield/
(Dollars in thousands) Balance (1) Rate Balance (1) Rate
Earning assets
Loans (2), (3) $ 1,568,468 $ 64,945 4.14 % $ 1,368,887 $ 56,561 4.13 %
Investment securities:
Taxable 329,890 5,006 1.52 138,391 2,997 2.16
Interest-bearing deposits 286,765 368 0.13 103,726 260 0.25
Total earning assets 2,185,123 70,319 3.21 % 1,611,004 59,818 3.71 %
Cash and due from banks 19,838 18,042
Other assets 127,704 92,575
Allowance for credit losses (15,068) (11,624)
Total assets $ 2,317,597 $ 1,709,997
Interest-bearing liabilities
Demand deposits $ 450,399 633 0.14 % $ 343,848 903 0.26 %
Money market and savings 695,056 1,433 0.21 434,781 1,172 0.27
deposits
Certificates of deposit 144,209 1,214 0.84 129,150 2,191 1.70
$100,000 or more
Other time deposits 151,429 1,181 0.78 148,823 2,174 1.46
Interest-bearing deposits 1,441,093 4,461 0.31 1,056,602 6,440 0.61
Securities sold under retail
repurchase agreements and
short-term FHLB advances 3,017 8 0.27 1,484 5 0.34
Advances from FHLB -
long-term 1,671 10 0.60 3,934 113 2.87
Subordinated debt 27,528 1,560 5.67 8,617 522 6.06
Total interest-bearing 1,473,309 6,039 0.41 % 1,070,637 7,080 0.66 %
liabilities
Noninterest-bearing deposits 574,531 431,319
Other liabilities 45,702 10,072
Stockholders' equity 224,055 197,969
Total liabilities and
stockholders' equity $ 2,317,597 $ 1,709,997
Net interest spread $ 64,280 2.80 % $ 52,738 3.05 %
Net interest margin 2.94 % 3.27 %
Tax-equivalent adjustment
Loans
Total
All amounts are reported on a tax-equivalent basis computed using the
statutory federal income tax rate of 21% for 2021 and 2020, exclusive of (1) nondeductible interest expense. The tax-equivalent adjustment amounts used in
the above table to compute yields aggregated
thousand in 2020.
(2) Average loan balances include nonaccrual loans.
Interest income on loans includes amortized loan fees, net of costs, and (3) accretion of discounts on acquired loans, which are included in the yield
calculations.
On a tax-equivalent basis, total interest income was$70.3 million for 2021 compared to$59.8 million for 2020. The increase in interest income for 2021 compared to 2020 was primarily due to the increase in the average balance in earning assets of$574.1 million which was due to both the acquisition of Severn and organic growth in 2021. The interest on loans had the most significant impact on total interest income, which increased$8.4 million in 2021, due to the increase in the average balance of loans of$199.6 million , or 14.6%, combined with accretion income of approximately$628 thousand in relation to acquired loans. In addition, PPP loan forgiveness for the year 2021 also contributed to fees, net of costs, of$3.8 million in 2021 compared to$977 thousand in 2020. The increase in interest income on taxable investment securities and interest-bearing deposits was due to increases in their respective average balances of$191.5 million and$183.0 million , the result of excess liquidity and the acquisition of Severn during the fourth quarter of 2021. As a percentage of total average earning assets, loans, investment securities, and interest-bearing deposits were 71.8%, 15.1%, and 13.1%, respectively, for 2021. The comparable percentages for 2020 were 85.0%, 8.6%, and 6.4%, respectively. 41 Table of Contents Interest expense was$6.0 million for 2021 compared to$7.1 million for 2020. The decrease in interest expense for 2021 was primarily due to the decrease in the average rates paid on interest-bearing deposits, partially offset by a full year of legacy subordinated debt and the addition of subordinated debt acquired from Severn. During 2021, money market/savings deposits, demand deposits and certificates of deposit over$100 thousand experienced the most significant growth with increases in the average balances of$260.3 million ,$106.6 million and$15.1 million , respectively, while the average rates paid on these deposits decreased 6, 12 and 86bps, respectively. The long-term advances from the FHLB declined in both the average balance and rates paid on these borrowings due to the payoff of these advances by the Company in April of 2020, partially offset by the addition of these borrowings from the acquisition of Severn, which are scheduled to mature in October of 2022. The following Rate/Volume Variance Analysis identifies the portion of the changes in tax-equivalent net interest income attributable to changes in volume of average balances or to changes in the yield on earning assets and rates paid on interest-bearing liabilities. The rate and volume variance for each category has been allocated on a consistent basis between rate and volume variances, based on a percentage of rate, or volume, variance to the sum of the absolute two variances. 2021 over (under) 2020 Total Caused By (Dollars in thousands) Variance Rate Volume Interest income from earning assets: Loans$ 8,384 $ 137 $ 8,247 Taxable investment securities 2,009 (548) 2,557 Interest-bearing deposits 108 (172) 280 Total interest income 10,501 (583) 11,084 Interest expense on deposits and borrowed funds: Interest-bearing demand deposits (270) (493)
223
Money market and savings deposits 261 (310)
571
Time deposits (1,970) (2,302)
332
Securities sold under repurchase agreements and short-term FHLB advances 3 (1)
4
Advances from FHLB - Long-term (103) (60)
(43)
Subordinated debt 1,038 (32) 1,070
Total interest expense (1,041) (3,198) 2,157
Net interest income $ 11,542 $ 2,615 $ 8,927
Noninterest Income
Noninterest income increased$2.7 million , or 25.6%, in 2021 when compared to 2020. The increase in noninterest income was largely due to the addition of the mortgage division and Mid-Maryland title from Severn. The mortgage division added$948 thousand and Mid-Maryland contributed$247 thousand in 2021. In addition, the increase in noninterest income in 2021 included increases in debit card interchange fees of$958 thousand , service charges on deposit accounts of$557 thousand and trust and investment fee income of$323 thousand , partially offset by a decrease in the gains on sales and calls of investment securities of$345 thousand . 42 Table of Contents
The following table summarizes our noninterest income from continuing operations
for the presented years ended
Years Ended Change from Prior Year
2021/ 20
(Dollars in thousands) 2021 2020 Amount Percent
Service charges on deposit accounts
19.6 %
Trust and investment fee income 1,881 1,558 323 20.7
Gains on sales and calls of
investment securities 2 347 (345) (99.4)
Interchange credits 3,964 3,006 958 31.9
Mortgage-banking revenue 948 - 948 100.0
Title Company revenue 247 - 247 100.0
Other noninterest income 3,060 2,999 61 2.0
Total $ 13,498 $ 10,749 $ 2,749 25.6
Noninterest Expense
Noninterest expense excluding merger related expenses, increased $9.9 million ,
or 25.7%, when compared to the same period in 2020. The increase was mainly the
result of increases in salaries and wages, employee related benefits, occupancy
expense, data processing, amortization of intangible assets and FDIC insurance
premium expense, which were all significantly impacted by adding Severn and its
operations in the last two months of 2021. In addition, as previously mentioned,
during 2021, the Company recorded merger-related expenses of $8.5 million due to
the acquisition of Severn.
The Company had 454 full-time equivalent employees at
The following table summarizes our noninterest expense for the years endedDecember 31 . Years Ended Change from Prior Year 2021/ 20 (Dollars in thousands) 2021 2020 Amount Percent Salaries and wages$ 21,222 $ 14,935 $ 6,287 42.1 % Employee benefits 7,262 6,461 801 12.4 Occupancy expense 3,690 2,919 771 26.4
Furniture and equipment expense 1,553 1,224
329 26.9 Data processing 5,001 4,288 713 16.6 Directors' fees 620 504 116 23.0
Amortization of intangible assets 734 533 201 37.7 FDIC insurance premium expense 1,015 485 530 109.3 Other real estate owned expenses, net 4 56
(52) (92.9) Legal and professional fees 1,742 2,296 (554) (24.1) Merger related expenses 8,530 - 8,530 100.0 Other noninterest expenses 5,433 4,698 735 15.6 Total$ 56,806 $ 38,399 $ 18,407 47.9 Income Taxes The Company reported an income tax expense of$5.8 million for 2021, compared to an income tax expense of$5.3 million for 2020. The effective tax rate was 27.4% for 2021 and 25.3% for 2020. The Company's effective tax rate increased in 2021 due to slightly higher pre-tax earnings, nondeductible expenses related to the merger and the reapportionment of assets and revenue for state income tax purposes. Please refer to Note 18 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K for further information. 43 Table of Contents
REVIEW OF FINANCIAL CONDITION
Asset and liability composition, capital resources, asset quality, market risk, interest sensitivity and liquidity are all factors that affect our financial condition. The following sections discuss each of these factors.
Assets
Interest-Bearing Deposits with Other Banks and Federal Funds Sold
The Company invests excess cash balances (i.e., the excess cash remaining after funding loans and investing in securities with deposits and borrowings) in interest-bearing accounts and federal funds sold offered by our correspondent banks. These liquid investments are maintained at a level that management believes is necessary to meet current liquidity needs. However, in recent years, due to the significant increases in deposits, both organically and through acquisition, the amounts invested exceeded then current liquidity needs. Total interest-bearing deposits with other banks increased$396.4 million from$170.3 million atDecember 31, 2020 to$566.7 million atDecember 31, 2021 . This significant increase was primarily due to the acquisition of Severn onOctober 31, 2021 which added$318.8 million in interest-bearing deposits with other banks. Organic growth in customer deposits, excluding the acquisition of Severn, which increased$370.2 million , or 21.8%, during 2021 when compared to 2020, also contributed to the increase in interest-bearing deposits with other banks.
The investment portfolio is structured to provide us with liquidity and also plays an important role in the overall management of interest rate risk. Investment securities available for sale are stated at estimated fair value based on quoted prices and may be sold as part of the asset/liability management strategy or which may be sold in response to changing interest rates. Net unrealized holding gains and losses on available for sale debt securities are reported net of related income taxes as accumulated other comprehensive income, a separate component of stockholders' equity. Investment securities in the held to maturity category are stated at cost adjusted for amortization of premiums and accretion of discounts. We have the intent and current ability to hold such securities until maturity. AtDecember 31, 2021 , 23% of the portfolio was classified as available for sale and 77% as held to maturity. AtDecember 31, 2020 , 68% of the portfolio was classified as available for sale and 32% as held to maturity. Total investment securities increased$316.8 million from$210.3 million atDecember 31, 2020 to$527.1 million atDecember 31, 2021 . The Bank acquired$146.3 million from the acquisition of Severn in the fourth quarter of 2021. Excluding acquired securities, the Bank purchased$255.5 million in securities in 2021, all of which were classified as held to maturity. The investment strategy remained relatively consistent when comparing 2021 to 2020 due to excess liquidity, which was partially utilized to purchase securities with higher average yields than current overnight Fed funds rate. The one exception to the investment strategy in 2021 was classifying new security purchases as held to maturity. This change in investment strategy was implement by management to avoid large unrealized losses in available for sale securities which are accounted for within accumulated other comprehensive income and the intention to hold such securities to maturity to avoid any realized losses. The larger percentage of securities designated as held to maturity reflects the amount that management believes is not needed to support our anticipated growth and liquidity needs. Investment securities available for sale were$117.0 million at the end of 2021 and$139.6 million at the end of 2020. The Bank did not purchase any available for sale securities in 2021 and purchased$73.5 million in available for sale securities in 2020. During 2020, the Bank purchased thirteen mortgage-backed securities and four government agency bonds aggregating$55.4 million and$18.0 million , respectively. At year-end 2021, 19.1% of the available for sale securities in the portfolio wereU.S. Government agencies, 79.2% of the securities were mortgage-backed securities and 1.7% were corporate bonds, compared to 16.9%, 83.1% and 0%, respectively, at year-end 2020. Our investments in mortgage-backed securities are issued or guaranteed byU.S. Government agencies or government-sponsored agencies. Investment securities held to maturity amounted to$404.6 million at the end of 2021 and$65.7 million at the end of 2020. The Bank purchased$255.5 million in held to maturity securities in 2021 and$57.2 million for 2020. During 2021, the Bank purchased thirty-two mortgage-backed securities totaling$177.1 million , fifteen government agency bonds totaling$75.9 million and two subordinated debt instruments from other banks amounting to$2.5 million . In 2020, the Bank purchased six mortgage-backed securities totaling$27.4 million , five government agency bonds amounting to$17.7 44
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million and seven subordinated debt instruments from other banks amounting to$12.1 million . At year-end 2021, 21.5% of the held to maturity securities in the portfolio wereU.S. Government agencies, 74.8% of the securities were mortgage-backed securities, 3.6% were subordinated debt instruments and less than 1% were community reinvestment bonds. At year-end 2020, 28.7% of the held to maturity securities in the portfolio wereU.S. Government agencies, 41.5% of the securities were mortgage-backed securities, 29.2% of the securities were subordinated debt instruments and less than 1% were community reinvestment bonds.
The following tables set forth the weighted average yields by maturity category
of the bond investment portfolio as of
1 Year or Less 1-5 Years 5-10 Years Over 10 Years
Average Average Average Average
(Dollars in thousands) Yield Yield Yield Yield
2021
Available for sale:
U.S. Government agencies - % 1.46 % 1.13 % 1.73 %
Mortgage-backed 1.60 1.68 1.94 0.83
Other Debt Securities - - 2.95 -
Total available for sale 1.60 1.66 1.64 0.85
Held to maturity:
U.S. Government agencies - % 1.05 % 1.26 % 1.79 %
Mortgage-backed - (1.01) 0.43 1.54States and political subdivisions1 5.20 -
- -
Other Debt Securities 2.68 6.50 4.21 -
Total held to maturity 3.03 1.74 1.27 1.55
1 Yields have been adjusted to reflect a tax equivalent basis using the statutory
federal tax rate of 21%.
1 Year or Less 1-5 Years 5-10 Years Over 10 Years
Average Average Average Average
(Dollars in thousands) Yield Yield Yield Yield
2020
Available for sale:
U.S. Government agencies 1.50 % - % 1.20 % - %
Mortgage-backed - 1.57 2.11 1.61
Total available for sale 1.50 1.57 1.82 1.61
Held to maturity:
U.S. Government agencies - % - % 0.91 % 1.84 %
Mortgage-backed - - - 1.34States and political subdivisions2 - 3.02
- -
Other Debt Securities - 2.68 4.51 -
Total held to maturity - 3.02 3.06 1.45
2 Yields have been adjusted to reflect a tax equivalent basis using the statutory
federal tax rate of 21%. Loans Held for Sale We originate residential mortgage loans for sale on the secondary market, which we have elected to carry at fair value. AtDecember 31, 2021 , the fair value of loans held for sale amounted to$37.7 million . AtDecember 31, 2020 , the Company had no loans held for sale. 45
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When we sell mortgage loans we make certain representations to the purchaser related to loan ownership, loan compliance and legality, and accurate documentation, among other things. If a loan is found to be out of compliance with any of the representations subsequent to the date of purchase, we may be required to repurchase the loan or indemnify the purchaser.
Loans Held for Investment
The loan portfolio is the primary source of our income. Loans totaled
The following table represents the composition of the Company's loan portfolio
for the presented years ended
2021 2020
Loans acquired from
(Dollars in thousands) Legacy Loans Severn acquisition Total Loans Total Loans
Construction $ 145,151 $ 94,202 $ 239,353 $ 106,760
Residential real estate 469,863 184,906 654,769 443,542
Commercial real estate 679,816 216,413
896,229 661,232
Commercial 128,485 47,332 175,817 88,499
Consumer 124,496 951 125,447 31,466Total loans excluding PPP loans 1,547,811 543,804
2,091,615 1,331,499
PPP loans 18,371 9,189 27,560 122,757
Total loans $ 1,566,182 $ 552,993 $ 2,119,175 $ 1,454,256
Allowance for credit losses (13,944) (13,888)
Total loans, net $ 2,105,231 $ 1,440,368
The acquisition of Severn, added $584.6 million in total loans as of the
acquisition date, of which $553.0 million in total loans remained outstanding as
of December 31, 2021 . Excluding these loans and legacy PPP loans, total legacy
loans increased $216.3 million , or 16.2% when compared to December 31, 2020 . At
December 31, 2021 and December 31, 2020 , PPP loans accounted for $27.6 million
and $122.8 million of total loans, respectively. Most of our loans, excluding
PPP loans, are secured by real estate and are classified as construction,
residential or commercial real estate loans. The increase in legacy loans,
excluding PPP loans, was comprised of increases in consumer loans of $93.0
million , or 295.7%, commercial loans of $40.0 million , or 45.2%, construction
loans of $38.4 million , or 36.0%, residential real estate loans of $26.3
million , or 5.9% and commercial real estate loans of $18.6 million , or 2.8% at
December 31, 2021 compared to December 31, 2020 . At December 31, 2021 , the
legacy loan portfolio, excluding PPP loans was comprised of 43.9% commercial
real estate, 30.4% residential real estate, 9.4% construction, 8.3% commercial
and 8.0% consumer. That compares to 49.7%, 33.3%, 8.0%, 6.6% and 2.4,
respectively, at December 31, 2020 . At December 31, 2021 , 72.6% of the loan
portfolio had fixed interest rates and 27.4% had adjustable interest rates,
compared to 78.8% and 21.2%, respectively, at December 31, 2020 . See the
discussion below under the caption "Asset Quality - Provision for Credit Losses
and Risk Management" and Note 4, "Loans and Allowance for Credit Losses", in the
Notes to Consolidated Financial Statements for additional information. We do not
engage in foreign or subprime lending activities.
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The following table below sets forth the maturities and interest rate
sensitivity of the loan portfolio at
Maturing after Maturing after
Maturing one but within five but within Maturing after
(Dollars in thousands) within one year five years fifteen years fifteen years Total
Construction $ 138,225 $ 55,360 $ 40,336 $ 5,432 $ 239,353
Residential real estate 29,777 96,309 177,044 351,639 654,769
Commercial real estate 54,857 282,475 432,647 126,250 896,229
Commercial 19,935 110,593 52,073 20,776 203,377
Consumer 918 34,729 22,711 67,089 125,447
Total $ 243,712 $ 579,466 $ 724,811 $ 571,186 $ 2,119,175
Rate terms:
Fixed-interest rate loans $ 171,937 $ 512,341
71,775 67,125 129,181 312,454 580,535
Total $ 243,712 $ 579,466 $ 724,811 $ 571,186 $ 2,119,175
Liabilities
Deposits
The Bank uses deposits primarily to fund loans and to purchase investment
securities. Total deposits increased from $1.70 billion at December 31, 2020 to
$3.03 billion at December 31, 2021 . The Severn acquisition added approximately
$955.3 million to total deposits as of October 31, 2021 . Excluding these
deposits, total deposits increased $370.2 million , or 23.7%, when compared to
December 31, 2020 . The increase in deposit products consisted of the following:
demand/money market/savings deposits of $464.4 million and other time deposits
of $9.4 million . Noninterest-bearing deposits decreased $71.5 million .
The following table sets forth the average balances of deposits and
the percentage of each category to total average deposits for the years ended
December 31 .
Average Balances
(Dollars in thousands) 2021 2020
Noninterest-bearing demand $ 574,531 28.5 % $ 431,319 29.0 %
Interest-bearing deposits
Demand 450,399 22.3 343,848 23.1
Money market and savings 695,056 34.5 434,781 29.2
Certificates of deposit, $100,000 to
$249,999 93,898 4.7 88,934 6.0
Certificates of deposit, $250,000 or
more 50,311 2.5 40,216 2.7
Other time deposits 151,429 7.5 148,823 10.0
Total $ 2,015,624 100.0 % $ 1,487,921 100.0 %
The increase in average balances in 2021 was significantly impacted by the addition of acquired Severn deposits in the fourth quarter of 2021. Average interest-bearing deposits increased$384.5 million , or 36.4%, in 2021, compared to an increase of$139.0 million , or 15.1%, in 2020. Average noninterest-bearing deposits increased$143.2 million , or 33.2%, in 2021, compared to an increase of$82.7 million , or 23.7%, in 2020. Deposits provided funding for approximately 92.2% and 92.4% of average earning assets for 2021 and 2020, respectively. 47
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The following table sets forth the maturity ranges of certificates of deposit
with balances of
(Dollars in thousands) Uninsured Three months or less$ 10,391 $ 3,391 Over three through 6 months 11,552 5,302 Over 6 through 12 months 30,683 9,933 Over 12 months 25,399 6,149 Total$ 78,025 $ 24,775
Total estimated uninsured deposits amounted to
Securities Sold Under Retail Repurchase Agreements
Securities sold under agreements to repurchase are issued in conjunction with cash management services for commercial depositors. AtDecember 31, 2021 andDecember 31, 2020 , the Company had$4.1 million and$1.1 million , respectively, in securities sold under retail repurchase agreements
Long-Term Advances from FHLB
The Company occasionally borrows from the FHLB to meet longer term liquidity needs, specifically to fund loan growth when liquidity from deposit growth is not sufficient. The acquisition of Severn added$10.1 million in long-term FHLB borrowings outstanding at the end of 2021, which carried an interest rate of 2.19%, with a maturity date ofOctober 2022 . There were no long-term FHLB borrowings at the end of 2020.
Subordinated Debt
Legacy
On
The Company has used the net proceeds of the offering for general corporate purposes, organic growth and to support the Bank's regulatory capital ratios. The Notes were structured to qualify as Tier 2 capital of the Company for regulatory capital purposes. The Notes bear an initial interest rate of 5.375% untilSeptember 1, 2025 , with interest during this period payable semi-annually in arrears. From and includingSeptember 1, 2025 , to but excluding the maturity date or early redemption date, the interest rate will reset quarterly to an annual floating rate equal to three-month SOFR, plus 526.5 basis points, with interest during this period payable quarterly in arrears. The Notes are redeemable by the Company at its option, in whole or in part, on or afterSeptember 1, 2025 . Initial debt issuance costs were$611 thousand . The debt balance of$24.6 million is presented net of unamortized issuance costs of$448 thousand atDecember 31, 2021 .
Acquired from Severn
On
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 48
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are currently redeemable, in whole or in part, by the Company.U.S. regulators have directed banks to cease offering new LIBOR-based products afterDecember 31, 2021 . Existing LIBOR contracts, per above, can continue to be serviced through theJune 30, 2023 cessation date; however, Wells Fargo will be working with customers to move to an ARR in advance of LIBOR cession, where possible. 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 of
Capital Resources Management
Total stockholders' equity was$350.7 million atDecember 31, 2021 , compared to$195.0 million atDecember 31, 2020 . The increase in stockholders' equity in 2021 was primarily due to the acquisition of Severn which added$148.8 million to common stock and additional paid in capital, partially offset by common stock repurchases in the first quarter of 2021. The ratio of period-end equity to total assets was 10.14% for 2021, as compared to 10.09% for 2020. We record unrealized holding gains (losses), net of tax, on investment securities available for sale as accumulated other comprehensive income (loss), a separate component of stockholders' equity. AtDecember 31, 2021 , the portion of the investment portfolio designated as "available for sale" had a net unrealized holding gain, net of tax, of$56 thousand compared to net unrealized holding gain, net of tax, of$1.5 million atDecember 31, 2020 . The Bank and Company are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company'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 its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum ratios of common equity Tier 1, Tier 1, and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1,250%. The Bank is also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. InJuly 2013 , federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule currently applies to all depository institutions and bank holding companies and savings and loan holding companies with total consolidated assets of more than$3 billion . The Company had total consolidated assets of more than$3 billion as ofDecember 31, 2021 , due to the acquisition of Severn in the fourth quarter of 2021. As such, the Company was required to comply with the consolidated capital requirements for the first quarterly report date following the effective date of the business combination as its total assets exceeded
$3 billion . 49 Table of Contents As ofDecember 31, 2021 , the Bank and Company were in compliance with all applicable regulatory capital requirements to which they were subject, and the Bank was classified as "well capitalized" for purposes of the prompt corrective action regulations.
The following table compares the Company's capital ratios to the minimum
regulatory requirements as of
Minimum
Regulatory
Requirements
(Dollars in thousands) 2021 2020 for 2021
Common equity Tier 1 capital
279,681 N/A
Tier 2 capital 57,015 N/A
Total risk-based capital 336,696 N/A
Net risk-weighted assets 2,191,557 N/A
Adjusted average total assets 2,966,412 N/A
Risk-based capital ratios:
Common equity Tier 1 12.76 % N/A % 7.00*
Tier 1 12.76 N/A 8.50*
Total capital 15.36 N/A 10.50*
Tier 1 leverage ratio 9.43 N/A 4.00
* includes phased in capital conservation buffer of 2.50%
See Note 20 to the Consolidated Financial Statements for further information about the regulatory capital positions of the Bank (December 31, 2021 and 2020) and Company (December 2021 ).
Asset Quality - Provision for Credit Losses and Risk Management
Originating loans involves a degree of risk that credit losses will occur in varying amounts according to, among other factors, the types of loans being made, the credit-worthiness of the borrowers over the terms of the loans, the quality of the collateral for the loans, if any, as well as general economic conditions. Through the Company's and the Bank's Asset/Liability Management Committees, the Company's Audit Committee and the Company's Board actively reviews critical risk positions, including credit, market, liquidity and operational risk. The Company's goal in managing risk is to reduce earnings volatility, control exposure to unnecessary risk, and ensure appropriate returns for risk assumed. Senior members of management actively manage risk at the product level, supplemented with corporate level oversight through the Asset/Liability Management Committee and internal audit function. The risk management structure is designed to identify risk through a systematic process, enabling timely and appropriate action to avoid and mitigate risk. Credit risk is mitigated through loan portfolio diversification, limiting exposure to any single industry or customer, collateral protection, and prudent lending policies and underwriting criteria. The following discussion provides information and statistics on the overall quality of the Company's loan portfolio. Note 1 to the Consolidated Financial Statements describes the accounting policies related to nonperforming loans (nonaccrual and delinquent 90 days or more), TDRs and loan charge-offs and describes the methodologies used to develop the allowance for credit losses, including the specific, historical formula, and qualitative formula components (also discussed below). Management believes the policies governing nonperforming loans, TDRs and charge-offs are consistent with regulatory standards. The amount of the allowance for credit losses and the resulting provision are reviewed monthly by senior members of management and approved quarterly by the Board of Directors. The allowance is increased by provisions for credit losses charged to expense and recoveries of loans previously charged off. It is decreased by loans charged off in the current period. Loans, or portions thereof, are charged off when considered uncollectible by management. Provisions for credit losses are made to bring the allowance for credit losses within the range of balances that are
considered appropriate.
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The adequacy of the allowance for credit losses is determined based on
management's estimate of the inherent risks associated with lending activities,
estimated fair value of collateral or expected future cash flows, past
experience and present indicators such as loan delinquency trends, nonaccrual
loans and current market conditions. Management believes the current allowance
is adequate to provide for probable and estimable losses inherent in our loan
portfolio; however, future changes in the composition of the loan portfolio and
financial condition of borrowers may result in additions to the allowance.
Examination of the portfolio and allowance by various regulatory agencies and
consultants engaged by the Company may result in the need for additional
provisions based on information available at the time of the examination. The
Bank's allowance for credit losses, is available to absorb losses from all loan
segments of the portfolio. The allowance set by the Bank is subject to
regulatory examination and determination as to its adequacy.
The allowance for credit losses is comprised of three parts: (i) the specific
allowance; (ii) the historical formula allowance; and (iii) the qualitative
formula allowance. The specific allowance is established against impaired loans
until charge offs are made. Loans are considered impaired when it is probable
that the Company will not collect all principal and interest payments according
to the loan's contractual terms when due. The qualitative formula allowance is
determined based on management's assessment of industry trends, economic factors
in the markets in which we operate, as well as other portfolio related factors.
The determination of the qualitative formula allowance involves a higher risk of
uncertainty and considers current risk factors that may not have yet manifested
themselves in our historical loss factors.
The specific allowance is used to individually allocate an allowance to loans
identified as impaired. An impaired loan may involve deficiencies in the
borrower's overall financial condition, payment history, support available from
financial guarantors and/or the fair market value of collateral. If it is
determined that there is a loss associated with an impaired loan, a specific
allowance is established until a charge off is made. Impaired loans, or portions
thereof, are charged off when deemed uncollectible.
The historical formula allowance is used to estimate the loss on internally
risk-rated loans, exclusive of those identified as impaired. Loans are grouped
by type (construction, residential real estate, commercial real estate,
commercial or consumer). Each loan type is assigned allowance factors based on
management's estimate of the risk, within a particular category using average
historical charge-offs by segment over the last 16 quarters.
The qualitative formula allowance is used to estimate the losses on loans
stemming from more global factors such as delinquencies, loss history, effects
of changes in lending policy, the experience and depth of management, national
and local economic trends, concentrations of credit, the quality of the loan
review system and the effect of external factors that would cause current
estimated losses to deviate from the historical loss experience. Loans that are
identified as pass-watch, special mention, substandard and doubtful are
considered to have elevated credit risk. These loans are assigned higher
allowance factors than favorably rated loans due to management's concerns
regarding collectability or management's knowledge of particular elements
regarding the borrower.
As seen in the table below, the provision for credit losses was $(358) thousand
for 2021 and $3.9 million for 2020. The reversal in the provision for credit
losses for 2021 was the result of recoveries in 2021 compared to charge-offs in
2020 and the reduction of qualitative factors established in 2020 related to the
COVID-19 pandemic. Net loan recoveries totaled $414 thousand in 2021, compared
to net loan charge-offs of $519 thousand in 2020.
The allowance for credit losses was $13.9 million , or 0.93% of period end loans,
excluding PPP loans, acquired loans and the associated purchase discount mark on
the acquired loans from both Severn and Northwest, at December 31, 2021 ,
compared to an allowance of $13.9 million , or 1.09% of period end loans,
excluding PPP loans and acquired loans from Northwest with associated purchase
discount mark at December 31, 2020 . The primary drivers for the decrease in the
percentage of the allowance for credit losses to total period end loans were
improved credit quality and the reduced impact of qualitative factors related to
the pandemic. The ratio of net (recoveries) charge-offs to average loans was
(0.03)% for 2021, compared to 0.04% for 2020.
The overall credit quality improved in 2021 compared to 2020 primarily due to a
reduction in nonaccrual loans of $3.5 million and loans 90 days and still
accruing of $296 thousand , partially offset by an increase in OREO of $532
thousand . In addition, accruing TDRs declined $1.3 million when comparing 2021
to 2020 which reflects continued workout efforts on outstanding problem loans.
When comparing 2021 to 2020 loan risk categories, substandard and special
mention loans
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decreased $8.1 million and $3.3 million , respectively. The decrease in
substandard and special mention loans was primarily due to property sales,
payoffs and credit risk rating upgrades during 2021. Pass/Watch loans increased
$12.0 million during 2021 when compared to 2020 primarily due to pass/watch
loans acquired from Severn. These loans consisted of hospitality, restaurants,
retail stores and other commercial loans. Management will continue to monitor
and charge off nonperforming assets as rapidly as possible, and focus on the
generation of healthy loan growth and new business development opportunities.
The following table sets forth a summary of our loan loss experience for
the presented years ended
2021 2020
Percentage of net Percentage of net
charge-offs (recoveries) charge-offs (recoveries)
(annualized) to (annualized) to
average loans average loans
Net(charge-offs) outstanding Net (charge-offs) outstanding (Dollars in thousands) Average balances recoveries during the year Average balances recoveries during the year Construction $ 150,669 $ 278 (0.18) % $ 108,266 $ 17 (0.02) %
Residential real estate 503,794 82 (0.02) 438,329 10 - Commercial real estate 645,595
114 (0.02) 610,296 (600) 0.10 Commercial 188,420 (42) 0.02 185,343 36 (0.02) Consumer 79,990 (18) 0.02 26,652 18 (0.07) Total $ 414 (0.03) % $ (519) 0.04 %
Average loans outstanding during the$ 1,568,468
$ 1,368,887
period
2021 2020
Allowance for credit losses at
period end as a percentage of total
period end loans (1) 0.66 % 0.95 %
Allowance for credit losses at
period end as a percentage of total
period end loans (2) 0.93 % 1.09 %
Allowance for credit losses at
period end as a percentage of
average loans (3) 0.89 % 1.01 %
Allowance for credit losses at
period end as a percentage of period
end nonaccrual loans 695.81 % 254.59 %
As of
(1) loans held for investment, including PPP loans of
million, respectively.
As of
(2) loans, acquired loans and the associated purchase discount mark on the
acquired loans from both Severn and Northwest.
As of
(3) loans held for investment, including PPP loans of
million, respectively.
The following table sets forth the allocation of the allowance for credit losses and the percentage of loans in each category to total loans for the presented years endedDecember 31 . 2021 2020 % of % of (Dollars in thousands) Amount Loans Amount Loans Construction$ 2,454 11.3 %$ 1,937 7.3 % Residential real estate 2,858 30.9 3,338 30.5 Commercial real estate 4,598 42.3 5,872 45.5 Commercial 2,070 9.6 2,089 14.5 Consumer 1,964 5.9 652 2.2 Total $$13,944 100.0 % $$13,888 100.0 % AtDecember 31, 2021 , nonperforming assets were$3.0 million , a decrease of$3.2 million , or 51.4%, when compared toDecember 31, 2020 . The decrease in nonperforming assets was due to diligent workout efforts by the Company to reduce nonaccrual loans and loans 90 days past due and still accruing, partially offset by an increase in other real estate owned properties which was significantly impacted by the acquisition of OREO from Severn. Accruing TDRs were$5.7 million atDecember 31, 2021 , a decrease of$1.3 million , or 19.0%, when compared toDecember 31, 2020 . AtDecember 31, 2021 , the ratio of nonaccrual loans to total assets was 0.06%, a decrease from 0.28% atDecember 31, 2020 . The ratio of accruing TDRs to total assets atDecember 31, 2021 was 0.16% improving from 0.36% atDecember 31, 2020 . 52
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The Company continues to focus on the resolution of its nonperforming and problem loans. The efforts to accomplish this goal include frequently contacting borrowers until the delinquency is cured or until an acceptable payment plan has been agreed upon; obtaining updated appraisals; provisioning for credit losses; charging off loans; transferring loans to other real estate owned; aggressively marketing other real estate owned; and selling loans. The reduction of nonperforming and problem loans is and will continue to be a high priority for the Company. The following table summarizes our nonperforming assets and accruing TDRs for the years endedDecember 31 . (Dollars in thousands) 2021 2020 Nonperforming assets Nonaccrual loans$ 2,004 $ 5,455
Total loans 90 days or more past due and still accruing 508 804 Other real estate owned
532 -
Total nonperforming assets $ 3,044 $ 6,259
Total accruing TDRs $ 5,667 $ 6,997
As a percent of total loans:
Nonaccrual loans 0.09 % 0.38 %
Accruing TDRs 0.27 % 0.48 %
Nonaccrual loans and accruing TDRs 0.36 % 0.86 %
As a percent of total loans and other real estate owned: Nonperforming assets
0.14 % 0.43 %
Nonperforming assets and accruing TDRs 0.41 % 0.91 %
As a percent of total assets:
Nonaccrual loans 0.06 % 0.28 %
Nonperforming assets 0.09 % 0.32 %
Accruing TDRs 0.16 % 0.36 %
Nonperforming assets and accruing TDRs 0.25 % 0.69 %
Market Risk Management and Interest Sensitivity
The Company's net income is largely dependent on its net interest income. Net
interest income is susceptible to interest rate risk to the extent that
interest-bearing liabilities mature or re-price on a different basis than
interest-earning assets. When interest-bearing liabilities mature or re-price
more quickly than interest-earning assets in a given period, a significant
increase in market rates of interest could adversely affect net interest income.
Similarly, when interest-earning assets mature or re-price more quickly than
interest-bearing liabilities, falling interest rates could result in a decrease
in net interest income. Net interest income is also affected by changes in the
portion of interest-earning assets that are funded by interest-bearing
liabilities rather than by other sources of funds, such as noninterest-bearing
deposits and stockholders' equity.
The Company's interest rate risk management goals are (1) to increase net
interest income at a growth rate consistent with the growth rate of total
assets, and (2) to minimize fluctuations in net interest margin as a percentage
of interest-earning assets. Management attempts to achieve these goals by
balancing, within policy limits, the volume of floating-rate liabilities with a
similar volume of floating-rate assets; by keeping the average maturity of
fixed-rate asset and liability contracts reasonably matched; by maintaining a
pool of administered core deposits; and by adjusting pricing rates to market
conditions on a continuing basis.
The Company's Board of Directors has established a comprehensive asset liability
management policy, which is administered by management's Asset Liability
Management Committee ("ALCO"). The policy establishes limits on risk, which are
quantitative measures of the percentage change in net interest income (a measure
of net interest income at risk) and the fair value of equity capital (a measure
of economic value of equity or "EVE" at risk) resulting from a hypothetical
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change in the yield curve ofU.S. Treasury interest rates for maturities from one day to thirty years. The Company evaluates the potential adverse impacts that changing interest rates may have on its short-term earnings, long-term value, and liquidity by outsourcing simulation analysis through the use of computer modeling. The simulation model captures optionality factors such as call features and interest rate caps and floors imbedded in investment and loan portfolio contracts. As with any method of gauging interest rate risk, there are certain shortcomings inherent in the interest rate modeling methodology used by the Company. When interest rates change, actual movements in different categories of interest-earning assets and interest-bearing liabilities, loan prepayments, and withdrawals of time and other deposits, may deviate significantly from assumptions used in the model. As an example, certain money market deposit accounts are assumed to reprice at 50% of the interest rate change in each of the up rate shock scenarios even though this is not a contractual requirement. As a practical matter, management would likely lag the impact of any upward movement in market rates on these accounts as a mechanism to manage the Company's net interest margin. Finally, the methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan customers' ability to service their debts, or the impact of rate changes on demand for loan, lease, and deposit products.
The Company presents a current base case and several alternative simulations at least once a quarter and reports the analysis to the Board of Directors. In addition, more frequent forecasts could be produced when interest rates are particularly uncertain or when other business conditions so dictate.
The statement of condition is subject to quarterly testing for six alternative
interest rate shock possibilities to indicate the inherent interest rate
risk. Average interest rates are shocked by +/- 100, 200, 300 and 400 basis
points ("bp"), although the Company may elect not to use particular scenarios
that it determines are impractical in a current rate environment. It is
management's goal to structure the balance sheet so that net interest earnings
at risk over a twelve-month period and the economic value of equity at risk do
not exceed policy guidelines at the various interest rate shock levels.
Measures of net interest income at risk produced by simulation analysis are
indicators of an institution's short-term performance in alternative rate
environments. These measures are typically based upon a relatively brief period,
usually one year. They do not necessarily indicate the long-term prospects or
economic value of the institution.
The measures of equity value at risk indicate the ongoing economic value of the
Company by considering the effects of changes in interest rates on all of the
Company's cash flows, and by discounting the cash flows to estimate the present
value of assets and liabilities. The difference between these discounted values
of the assets and liabilities is the EVE, which, in theory, approximates the
fair value of the Company's net assets.
The following tables present the projected change in the Bank's net interest
income and EVE at December 31, 2021 and 2020 that would occur upon an immediate
change in interest rates based on independent analysis, but without giving
effect to any steps that management might take to counteract that change:
Estimated Changes in Net Interest Income
Change in Interest Rates: +400 bp +300 bp +200 bp +100 bp 100 bp 200 bp Policy Limit 40 % 30 % 20 % 10 % (10) % (20) % December 31, 2021 23.5 % 18.0 % 12.6 % 6.7 % (7.0) % (10.6) % December 31, 2020 23.5 % 18.1 % 12.6 % 6.9 % (3.9) % (4.8) % Estimated Changes in Economic Value of Equity Change in Interest Rates: +400 bp +300 bp +200 bp +100 bp 100 bp 200 bp Policy Limit 25 % 20 % 15 % 10 % (20) % (35) % December 31, 2021 (2.1) % (0.5) % 1.0 % 1.1 % (10.9) % (23.0) % December 31, 2020 13.9 % 12.0 %
10.0 % 6.9 % (16.7) % (18.5) %
As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing tables. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable rate mortgage loans, have
features
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which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, if interest rates change, expected rates of prepayments on loans and early withdrawals from certificates of deposit could deviate significantly from those assumed in calculating the tables.
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 increases in our revenues correspondingly.
Off-Balance Sheet Arrangements
Credit Commitments
In the normal course of business, to meet the financing needs of its customers, the Bank is party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. The Bank's exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of the instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they use for on-balance sheet instruments. The Bank generally requires collateral or other security to support the financial instruments with credit risk. The amount of collateral or other security is determined based on management's credit evaluation of the counterparty. The Bank evaluates each customer's creditworthiness on a case-by-case basis. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Letters of credit and other commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the letters of credit and commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. Further information about these arrangements is provided in Note 23 to the Consolidated Financial Statements. Management does not believe that any of the foregoing arrangements have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
Derivatives
We maintain and account for derivatives, in the form of interest rate lock
commitments ("IRLCs") and mandatory forward contracts, in accordance with the
Financial Accounting Standards Board ("FASB") guidance on accounting for
derivative instruments and hedging activities. We recognize gains and losses on
IRLCs, mandatory forward contracts, and best effort forward contracts on the
loan pipeline through mortgage-banking revenue in the Consolidated Statements of
Income.
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 is locked in 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 120 days. For these IRLCs, we attempt to protect the Bank from
changes in interest rates through the use of to be announced ("TBA") securities,
which are forward contracts, as well as loan level commitments, on a limited
basis, in the form of best efforts and mandatory forward contracts. Mandatory
forward contracts are also considered derivatives. Best efforts forward
contracts are not derivatives, however, we have elected to measure and report
these commitments at fair value. These assets and liabilities are included in
the Consolidated Statements of Financial Condition in other assets and accrued
expenses and other liabilities, respectively. See Note 15 to the Consolidated
Financial Statements contained in this Annual Report on Form 10-K for more
information on our derivatives.
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Liquidity Management
Liquidity describes our ability to meet financial obligations that arise during
the normal course of business. Liquidity is primarily needed to meet the
borrowing and deposit withdrawal requirements of customers and to fund current
and planned expenditures. Liquidity is derived through increased customer
deposits, maturities in the investment portfolio, loan repayments and income
from earning assets. To the extent that deposits are not adequate to fund
customer loan demand, liquidity needs can be met in the short-term funds
markets. We have arrangements with correspondent banks whereby we have $15
million available in federal funds lines of credit and a reverse repurchase
agreement available to meet any short-term needs which may not otherwise be
funded by the Bank's portfolio of readily marketable investments that can be
converted to cash. The Bank is also a member of the FHLB, which provides another
source of liquidity, and had credit availability of approximately $363.7 million
from the FHLB as of December 31, 2021 .
At December 31, 2021 , our loan to deposit ratio was approximately 70.0%, lower
than the 85.5% at year-end 2020. This decrease is the result of our excess
liquidity position due to our deposits increasing $1.33 billion , or 77.9%, since
year end 2020. Investment securities available for sale totaling $117.0 million
at the end of 2021 were available for the management of liquidity and interest
rate risk, subject to certain pledging requirements, which can be easily
transitioned to held to maturity securities. The comparable amount was $139.6
million at December 31, 2020 . Cash and cash equivalents were $583.6 million at
December 31, 2021 , an increase of $396.7 million , or 212.2%, compared to the
$186.9 million at year-end 2020, which reflects the increase in deposits during
2021. Management is not aware of any demands, commitments, events or
uncertainties that will materially affect our ability to maintain liquidity at
satisfactory levels.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The information required by this item may be found in Item 7 of Part II of this annual report under the caption "Market Risk Management and Interest Sensitivity", which is incorporated herein by reference.
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