SOUND FINANCIAL BANCORP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Special Note Regarding Forward-Looking Statements
Certain matters discussed in this Form 10-Q constitute forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995. These statements relate to our financial condition, results of operations,
plans, objectives, future performance or business. Forward-looking statements
are not statements of historical fact, are based on certain assumptions and are
generally identified by use of the words "believes," "expects," "anticipates,"
"estimates," "forecasts," "intends," "plans," "targets," "potentially,"
"probably," "projects," "outlook" or similar expressions or future or
conditional verbs such as "may," "will," "should," "would" and "could."
Forward-looking statements include statements with respect to our beliefs,
plans, objectives, goals, expectations, assumptions and statements about, among
other things, expectations of the business environment in which we operate,
projections of future performance or financial items, perceived opportunities in
the market, potential future credit experience, and statements regarding our
mission and vision. These forward-looking statements are based upon current
management expectations and may, therefore, involve risks and uncertainties. Our
actual results, performance, or achievements may differ materially from those
suggested, expressed, or implied by forward-looking statements as a result of a
wide variety or range of factors including, but not limited to:
•the effect of the novel coronavirus disease 2019 ("COVID-19") pandemic,
including on our credit quality and business operations, as well as its impact
on general economic and financial market conditions and other uncertainties
resulting from the COVID-19 pandemic, such as the extent and duration of the
impact on public health, the U.S. and global economies, and consumer and
corporate clients, including economic activity, employment levels and market
liquidity;
•changes in consumer spending, borrowing and savings habits;
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•changes in economic conditions, either nationally or in our market area;
•monetary and fiscal policies of the Board of Governors of the Federal Reserve
System ("Federal Reserve") and the U.S. Government and other governmental
initiatives affecting the financial services industry;
•fluctuations in the demand for loans, the number of unsold homes, land and
other properties, and fluctuations in real estate values and both residential
and commercial and multifamily real estate market conditions in our market area;
•our ability to access cost-effective funding;
•uncertainty regarding the future of the London Interbank Offered Rate
("LIBOR"), and the potential transition away from LIBOR toward new interest rate
benchmarks;
•our ability to control operating costs and expenses;
•secondary market conditions for loans and our ability to sell loans in the
secondary market;
•fluctuations in interest rates;
•results of examinations of Sound Financial Bancorp and Sound Community Bank by
their regulators, including the possibility that the regulators may, among other
things, require us to increase our allowance for loan losses or to write-down
assets, change Sound Community Bank's regulatory capital position or affect our
ability to borrow funds or maintain or increase deposits, which could adversely
affect our liquidity and earnings;
•the risks of lending and investing activities, including changes in the level
and direction of loan delinquencies and write-offs and changes in estimates of
the adequacy of our allowance for loan losses;
•inability of key third-party providers to perform their obligations to us;
•our ability to attract and retain deposits;
•competitive pressures among financial services companies;
•our ability to successfully integrate any assets, liabilities, clients,
systems, and management personnel we may acquire into our operations and our
ability to realize related revenue synergies and expected cost savings and other
benefits within the anticipated time frames or at all;
•the use of estimates in determining fair value of certain of our assets, which
estimates may prove to be incorrect and result in significant declines in
valuation;
•our ability to keep pace with technological changes, including our ability to
identify and address cyber-security risks such as data security breaches,
"denial of service" attacks, "hacking" and identity theft, and other attacks on
our information technology systems or on the third-party vendors who perform
several of our critical processing functions;
•changes in accounting policies and practices, as may be adopted by the
financial institution regulatory agencies or the Financial Accounting Standards
Board , including additional guidance and interpretation on accounting issues and
details of the implementation of new accounting methods;
•legislative or regulatory changes such as the Dodd-Frank Wall Street Reform and
Consumer Protection Act and its implementing regulations that adversely affect
our business, and the availability of resources to address such changes;
•our ability to retain or attract key employees or members of our senior
management team;
•costs and effects of litigation, including settlements and judgments;
•our ability to implement our business strategies;
•staffing fluctuations in response to product demand or the implementation of
corporate strategies that affect our workforce and potential associated charges;
•our ability to pay dividends on our common stock;
•the possibility of other-than-temporary impairments of securities held in our
securities portfolio;
•other economic, competitive, governmental, regulatory, and technological
factors affecting our operations, pricing, products and services, including the
Coronavirus Aid, Relief, and Economic Security Act of 2020 ("CARES Act"); and
•the other risks described from time to time in our filings with the U.S.
Securities and Exchange Commission (the "SEC"), including this Form 10-Q and our
Annual Report on Form 10-K for the year ended December 31, 2019 ("2019 Form
10-K").
We wish to advise readers not to place undue reliance on any forward-looking
statements and that the factors listed above could materially affect our
financial performance and could cause our actual results for future periods to
differ materially from any such forward-looking statements expressed with
respect to future periods and could negatively affect our stock price
performance.
We do not undertake and specifically decline any obligation to publicly release
the result of any revisions which may be made to any forward-looking statements
to reflect events or circumstances after the date of such statements or to
reflect the occurrence of anticipated or unanticipated events.
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Sound Financial Bancorp , aMaryland corporation, is a bank holding company for its wholly owned subsidiary,Sound Community Bank . Substantially all ofSound Financial Bancorp's business is conducted throughSound Community Bank , aWashington state -chartered commercial bank. As aWashington commercial bank, the Bank's regulators are theWashington Department of Financial Institutions and theFederal Deposit Insurance Corporation (the "FDIC"). TheFederal Reserve is the primary federal regulator forSound Financial Bancorp . We also sell insurance products and services for clients throughSound Community Insurance Agency, Inc. , a wholly owned subsidiary of the Bank.Sound Community Bank's deposits are insured up to applicable limits by theFDIC . AtJune 30, 2020 ,Sound Financial Bancorp , on a consolidated basis, had assets of$871.7 million , net loans held-for-portfolio of$684.7 million , deposits of$694.3 million and stockholders' equity of$80.2 million . The shares ofSound Financial Bancorp are traded on NASDAQ Capital Market under the symbol "SFBC." Our executive offices are located at2400 3rd Avenue , Suite 150,Seattle, Washington , 98121. Our principal business consists of attracting retail and commercial deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one- to four- family residences (including home equity loans and lines of credit), commercial and multifamily real estate, construction and land, consumer and commercial business loans. Our commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable. We also offer a variety of secured and unsecured consumer loan products, including manufactured home loans, floating home loans, automobile loans, boat loans and recreational vehicle loans. As part of our business, we focus on residential mortgage loan originations, a significant portion of which we sell to Fannie Mae and other correspondents and the remainder of which we retain for our loan portfolio consistent with our asset/liability objectives. We sell loans which conform to the underwriting standards of Fannie Mae ("conforming") in which we retain the servicing of the loan in order to maintain the direct customer relationship and to generate noninterest income. Residential loans which do not conform to the underwriting standards of Fannie Mae ("non-conforming"), are either held in our loan portfolio or sold with servicing retained. We originate and retain a significant amount of commercial real estate loans, including those secured by owner-occupied and nonowner-occupied commercial real estate, multifamily property, mobile home parks and construction and land development loans. At the end ofMay 2020 , the branch located on 5th andVirginia inSeattle was closed. This closure was planned as the last step of the original move of the administrative offices in 2017, to2400 3rd Avenue inSeattle which is located about 5 blocks to the North of the closed branch. All client relationships, loans and deposits were successfully transferred to the Belltown Branch at2400 3rd Avenue which is adjacent to the administrative offices. The closure will result in reduced occupancy expense and a small reduction in full time equivalent employees. However no layoffs occurred as turnover and reduced branch hours due to the Covid 19 pandemic allowed us to avoid terminations. No significant client relationships were lost as a result of the branch closure. Critical Accounting Policies Certain of our accounting policies require management to make difficult, complex or subjective judgments, which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan losses, accounting for other-than-temporary impairment of securities, accounting for mortgage servicing rights, accounting for other real estate owned and accounting for deferred income taxes. Our methodologies for analyzing the allowance for loan losses, other-than-temporary impairment, mortgage servicing rights, other real estate owned and deferred tax asset accounts are described in our 2019 Form 10-K. 35 --------------------------------------------------------------------------------
COVID 19 Response
In response to the COVID-19 pandemic, the Company is offering a variety of
relief options designed to support our clients and communities, including
participating in the
Paycheck Protection Program ("PPP") Participation. The CARES Act was signed into
law on March 27, 2020 , and authorized the Small Business Administration ("SBA")
to temporarily guarantee loans under a new loan program called the Paycheck
Protection Program. As a qualified SBA lender, the Company was automatically
authorized to originate PPP loans upon commencement of the program in April
2020 . PPP loans have: (a) an interest rate of 1.0%, (b) a two-year loan term to
maturity; and (c) principal and interest payments deferred for six months from
the date of disbursement. The SBA guarantees 100% of the PPP loans made to
eligible borrowers. The entire principal amount of the borrower's PPP loan,
including any accrued interest, is eligible to be forgiven and repaid by the
SBA. The deadline for PPP loan applications to the SBA has been extended to
August 8, 2020 . The Bank is continuing to accept new PPP applications based on
this extended deadline and is assisting small businesses with other borrowing
options as they become available, including SBA and other government sponsored
lending programs, as appropriate.
As of June 30, 2020 , we have funded $73.1 million in PPP loans, with an average
loan amount of $93,000 . There were $670,000 PPP loans approved awaiting funding
as of June 30, 2020 , and 37 applications totaling $587,000 were in process. Many
of the PPP applications have been from our existing clients but we are also
serving those in our communities who have not had a banking relationship with us
in the past. In addition to the 1% interest earned on these loans, the SBA pays
us fees for processing PPP loans in the following amounts: (i) 5% for loans of
not more than $350,000 ; (ii) 3% for loans of more than $350,000 and less than
$2,000,000 ; and 1% for loans of at least $2,000,000 . We may not collect any fees
from the loan applicants. The following table summarizes our PPP participation
as of June 30, 2020 (dollars in thousands):
Funded Approved awaiting funding
Number of Number of Average Loan
Total Outstanding Loans Average Loan Amount Total Request Loans Amount
Existing clients $ 30,801 337 $ 95 $ 20 3 $ 7
New clients 42,348 445 91 650 31 21
Total PPP loans $ 73,149 782 $ 93 $ 670 34 $ 14 The SBA processing fees for the approved loans totaled
We have been utilizing theFederal Reserve's Paycheck Protection Program Liquidity Facility ("PPPLF") to retain the capital neutral treatment of PPP loans. Under the PPPLF, the Bank pledged PPP loans at face value as collateral to obtainFederal Reserve Bank non-recourse loans. PPPLF loans are risk-weighted at zero percent and have no impact on our leverage ratio and the Bank also receives a borrowing rate of 35 basis points. Loan Modifications. We received and continue to receive numerous inquiries and requests from borrowers for some form of payment relief due to the COVID-19 pandemic. We are providing payment relief for both consumer and business clients. As ofJune 30, 2020 , we have modified loans, predominantly payment deferrals of interest and/or principal for 90-180 days, aggregating$51.3 million , or 7.4% of total loans, as more fully described in the table below. In some cases, borrowerswho were granted 90-day payment deferrals for residential or consumer loans have requested payment deferral extensions. Borrowers granted payment deferrals for commercial loans have not requested extensions at this time. All loans modified due to the COVID-19 pandemic will be separately monitored and any request for continuation of relief beyond the initial modification will be reassessed at that time to determine if a further modification should be granted and if a downgrade in risk rating is appropriate. We believe the steps we are taking are necessary to effectively manage our portfolio and assist our clients through the ongoing uncertainty surrounding the duration, impact and government response to the COVID-19 pandemic. 36 --------------------------------------------------------------------------------
The following is a summary of the type and amount of loan modifications made by
the Company as of
Payment Relief
Interest only Principal & Interest Forbearance
% of Total
90 days 180 days 365 days 90 days 180 days Total Loans
Real estate loans:
One-to-four family $ 6,834 $ 333 $ - $ 5,524 $ 2,724 $ 15,415 2.2 %
Home equity - - - 98 - 98 0.01
Construction and land 153 - - 382 - 535 0.07
Commercial and multifamily 11,295 21,343 1,365 - - 34,003 4.9
Total real estate loans 18,282 21,676 1,365 6,004 2,724 50,051
Consumer loans:
Manufactured homes 53 12 - 251 688 1,004 0.1
Floating homes - - - - 282 282 0.04
Other consumer loans - - - - - -
Total consumer loans 53 12 - 251 970 1,286
Commercial business loans - - - - - - -
Total $ 18,335 $ 21,688 $ 1,365 $ 6,255 $ 3,694 $ 51,337 7.4 %
The modifications discussed above were not classified as TDRs in accordance with
the guidance of the CARES Act and related regulatory banking guidance. The CARES
Act provided that the short-term modification of loans as a result of the
COVID-19 pandemic, made on a good faith basis to borrowers who were current as
defined under the CARES Act prior to any relief, are not TDRs. This includes
short-term (e.g. six months) modifications such as payment deferrals, fee
waivers, extensions of repayment terms, or other delays in payment that are
insignificant. Borrowers are considered current under the CARES Act and related
regulatory banking guidance if they are less than 30 days past due on their
contractual payments at the time a modification program is implemented.
Support for Clients, Employees and Community during Pandemic. As various
counties where we do business began to reopen, we returned four branches on the
Olympic Peninsula to pre-pandemic lobby hours with the exception of Saturdays.
Because of the increased use of electronic services we were able to eliminate
Saturday lobby hours. By the beginning of July we expanded lobby hours in the
remaining branches. We again eliminated lobby hours on Saturday and all branches
lobby hours were shortened. The adoption of electronic /self-serve alternatives
reduces need for lobby access. We believe these shorter hours will be permanent
and tailored to individual branches based on location and demographics. We
continuously monitor and conform our practices based on updates from the Center
for Disease Control , World Health Organization , Financial Regulatory Agencies,
and local and state health departments. All retail clients and retail employees
wear masks. Lobby traffic continues to be managed to provide for social
distancing in the lobbies. The vast majority of back office workers continue to
work remotely.
We stay in constant contact with borrowers who have requested modifications and
are also working with those borrowers who were granted 90 days deferrals which
are now expiring. In addition, certain fees may be waived for clients and no
early withdrawal penalty is assessed on certificate withdrawals of up to $25,000
if needed for living or other expenses as a result of the COVID-19 pandemic.
Comparison of Financial Condition at June 30, 2020 and December 31, 2019
General. Total assets increased $151.8 million , or 21.1%, to $871.7 million at
June 30, 2020 from $719.9 million at December 31, 2019 . The increase was
primarily a result of a higher balances in loans held-for-portfolio and loans
held-for-sale, cash and cash equivalents and available-for-sale securities.
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securities, which consist of municipal bonds and agency mortgage-backed
securities increased $892,000 , or 9.6%, to $10.2 million at June 30, 2020 from
$9.3 million at December 31, 2019 as a result of investment securities purchased
during the year.
Loans. Our loans held-for-portfolio, net, increased $70.4 million , or 11.5%, to
$684.7 million at June 30, 2020 from $614.2 million at December 31, 2019 ,
primarily driven by our origination of PPP loans.
The following table reflects the changes in the loan mix of our loan portfolio
at June 30, 2020 , as compared to December 31, 2019 (dollars in thousands):
Amount Percent
June 30, 2020 December 31, 2019 Change Change
One-to-four family $ 137,988 $ 149,393 $ (11,405) (7.6) %
Home equity 19,286 23,845 (4,559) (19.1)
Commercial and multifamily 273,084 261,268 11,816 4.5
Construction and land 76,089 75,756 333 0.4
Manufactured homes 21,227 20,613 614 3.0
Floating homes 46,256 43,799 2,457 5.6
Other consumer 10,585 8,302 2,283 27.5
Commercial business 109,719 38,931 70,788 181.8
Deferred loan fees (3,531) (2,020) (1,511) 74.8
Total loans held-for-portfolio, gross 690,703 619,887 70,816 11.4
Allowance for loan losses (6,031) (5,640) (391) 6.9
Total loans held-for-portfolio, net $ 684,672 $ 614,247 $ 70,425 11.5 %
All categories of our loan portfolio increased at June 30, 2020 , compared to
December 31, 2019 , except for one-to-four family and home equity loans. The
largest increase in the loan portfolio was in commercial business loans which
increased $70.8 million , or 181.8%, to $109.7 million , at June 30, 2020 ,
compared to $38.9 million at December 31, 2019 , driven by our origination of 782
PPP loans totaling $73.1 million at June 30, 2020 . PPP loans are 100% guaranteed
by the SBA. At June 30, 2020 , our loan portfolio, net of deferred loan fees,
remained well-diversified. Commercial and multifamily real estate loans
accounted for approximately 39.3% of total loans, one-to-four family loans,
including home equity loans accounted for approximately 22.7% of total loans,
commercial business loans accounted for 15.8% of total loans, and consumer
loans, consisting of manufactured homes, floating homes, and other consumer
loans accounted for approximately 11.2% of total loans at June 30, 2020 .
Construction and land loans accounted for approximately 11.0% of total loans at
June 30, 2020 .
Allowance for Loan Losses. The allowance for loan losses is maintained to cover
losses that are probable and can be estimated
on the date of evaluation in accordance with generally accepted accounting
principles in the United States . It is our best estimate
of probable credit losses inherent in our loan portfolio. The following table
reflects the adjustments in our allowance during the periods indicated (dollars
in thousands):
Six Months Ended June
Three Months Ended June 30, 30,
2020 2019 2020 2019
Balance at beginning of period $ 5,893 $ 5,577 $ 5,640 $ 5,774
Charge-offs (311) (12) (317) (32)
Recoveries 49 5 58 28
Net recoveries/(charge-offs) (262) (7) (259) (4)
Provision (recapture) for loan losses during the period 400 (200) 650 (400)
Balance at end of period $ 6,031 Ratio of net recoveries/(charge-offs) during the period to average loans outstanding during the period
- % - % - % - %
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June 30, 2020 December 31, 2019 Allowance as a percentage of nonperforming loans (end of period)
173.30 % 121.11 %
Allowance as a percentage of total loans (end of period) 0.87 % 0.91 %
Our allowance for loan losses increased $391,000 , or 6.9%, to $6.0 million at
June 30, 2020 , from $5.6 million at December 31, 2019 . The increase in provision
for loan losses not only reflects probable credit losses based upon the
conditions that existed as of June 30, 2020 , but also considers the potential
effects from future impacts of the COVID-19 pandemic.
Specific loan loss reserves increased to $729,000 at June 30, 2020 , compared to
$724,000 at December 31, 2019 , while general loan loss reserves increased to
$4.5 million at June 30, 2020 , compared to $4.0 million at December 31, 2019 and
the unallocated reserve decreased to $800,000 at June 30, 2020 , compared to
$948,000 at December 31, 2019 . The increase in the general reserve was a result
of the higher balance on loans held-for-portfolio. Net charge-offs for the three
and six months ended June 30, 2020 were $262,000 and $259,000 respectively,
compared to net charge-offs of $7,000 and $4,000 for the three and six months
ended June 30, 2019 , respectively. At June 30, 2020 , the allowance for loan
losses as a percentage of total loans and nonperforming loans was 0.87% and
173.30%, respectively, compared to 0.91% and 121.11%, respectively, at
December 31, 2019 . Excluding the $73.1 million of PPP loans from the $690.7
million of total loans at June 30, 2020 , the allowance for loan losses to total
loans was 0.97%(1) at June 30, 2020 . PPP loans are fully guaranteed by the SBA
and management expects that the great majority of PPP borrowers will seek full
or partial forgiveness of their loan obligations from the SBA within a short
time frame, which in turn will reimburse the Bank for the amount forgiven.
Mortgage Servicing Rights. The fair value of mortgage servicing rights was $3.1
million at June 30, 2020 , a decrease of $126,000 or 3.9% from $3.2 million at
December 31, 2019 . We record mortgage servicing rights on loans sold with
servicing retained and upon acquisition of a servicing portfolio. Mortgage
servicing rights are carried at fair value. If the fair value of our mortgage
servicing rights fluctuates significantly, our financial results could be
materially impacted.
Nonperforming Assets. At June 30, 2020 , nonperforming assets totaled $4.1
million , or 0.47% of total assets, compared to $5.2 million , or 0.73% of total
assets at December 31, 2019 .
The table below sets forth the amounts and categories of nonperforming assets at
the dates indicated (dollars in thousands):
Nonperforming Assets
Amount Percent
June 30, 2020 December 31, 2019 Change Change
Nonaccrual loans $ 3,480 $ 4,657 $ (1,177) (25.3) %
OREO and repossessed assets 575 575 - -
Total nonperforming assets
Nonaccrual loans decreased$1.2 million , or 25.3%, to$3.5 million atJune 30, 2020 from$4.7 million atDecember 31, 2019 . The percentage of nonaccrual loans to total loans was 0.50% atJune 30, 2020 , compared to 0.75% of total loans atDecember 31, 2019 . OREO and repossessed assets were$575,000 at bothJune 30, 2020 andDecember 31, 2019 . AtJune 30, 2020 , OREO and repossessed assets consisted solely of a former bank branch property located inPort Angeles, Washington which was acquired in 2015 as a part of three branches purchased from another financial institution. It is currently leased to a not-for-profit organization headquartered in our market area at a below market rate. Deposits. Total deposits increased$77.6 million , or 12.6%, to$694.3 million atJune 30, 2020 from$616.7 million atDecember 31, 2019 . The increase was due primarily to disbursements of PPP loan funds into borrowers' deposit accounts as well as reduced withdrawals reflecting changes in customer spending habits due to the COVID-19 pandemic. We continue our efforts to grow noninterest-bearing deposits, which increased$45.2 million , or 46.5%, to$142.5 million atJune 30, 2020 , compared to$97.3 million atDecember 31, 2019 . (1) We have presented a non-GAAP financial measure in addition to results presented in accordance with GAAP for the allowance for loan losses to total loans excluding PPP loans. The Bank has presented this non-GAAP financial measure because it believes that it provides useful information to assess the Bank's allowance for loan losses. The non-GAAP financial measure has inherent limitations and is not required to be uniformly applied. Further, this non-GAAP financial measure should not be considered in isolation or as a substitute for the allowance for loan losses to total loans determined in accordance with GAAP and may not be comparable to similarly titled measures reported by other financial institutions. Reconciliation of the GAAP and non-GAAP financial measurement is presented in the paragraph above. 39 --------------------------------------------------------------------------------
A summary of deposit accounts with the corresponding weighted-average cost of funds at the dates indicated is presented below (dollars in thousands):
June 30, 2020 December 31, 2019
Amount Wtd. Avg. Rate Amount Wtd. Avg. Rate
Noninterest-bearing demand $ 139,919 - % $ 94,973 - %
Interest-bearing demand 185,640 0.49 159,774 0.54
Savings 73,027 0.28 57,936 0.33
Money market 54,332 0.43 50,337 0.49
Time deposits 238,842 2.51 251,387 2.23
Escrow (1) 2,562 - 2,311 -
Total deposits $ 694,322 1.11 % $ 616,718 1.16 %
(1) Escrow balances shown in noninterest-bearing deposits on the consolidated
balance sheets.
Borrowings. Total borrowings consisting of PPPLF and FHLB advances increased
$72.3 million , to $79.8 million at June 30, 2020 from $7.5 million at
December 31, 2019 . The increase in borrowing is attributable entirely to
borrowings from the PPPLF.
The maturity date of any PPPLF borrowing will be the maturity date of the PPP
loan pledged to secure such borrowing. The maturity date of any PPPLF borrowing
will be accelerated as of the date and to the extent of (i) any loan forgiveness
reimbursement by the SBA for any PPP loan securing such borrowings; or (ii) the
purchase by the SBA from the Bank of any PPP loan securing such borrowings to
realize on the SBA's guarantee of such PPP loan. In each case, the amount of our
PPPLF borrowings outstanding may not exceed the amount of PPP loans pledged to
secure such borrowings. In addition, PPPLF loans may be prepaid by borrowers in
full or in part, at any time, without penalty. The Bank must repay PPPLF
borrowings once a borrower under a PPP loan repays or prepays such PPP loan
securing such borrowings.
Stockholders' Equity. Total stockholders' equity increased $2.5 million , or
3.2%, to $80.2 million at June 30, 2020 from $77.7 million at December 31,
2019 . This increase primarily reflects $3.1 million in net income for the six
months ended June 30, 2020 , partially offset by the payment of cash dividends of
$1.3 million to common stockholders during the six months ended June 30, 2020 .
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Comparison of Results of Operation for the Three and Six Months Ended
General. Net income increased$311,000 , or 17.1%, to$2.1 million or$0.82 per diluted common share, for the three months endedJune 30, 2020 , compared to$1.8 million , or$0.71 per diluted common share, for the three months endedJune 30, 2019 . The primary reasons for the increase in net income for the three months endedJune 30, 2020 , were increases in net interest income of$368,000 and noninterest income of$724,000 , partially offset by a provision for loan losses of$400,000 for the three months endedJune 30, 2020 , compared to a$200,000 recapture from the allowance for loan losses for the three months endedJune 30, 2019 , and a$174,000 increase in noninterest expense. Net income decreased$153,000 to$3.1 million , or$1.20 per diluted common share, for the six months endedJune 30, 2020 , compared to$3.3 million , or$1.27 per diluted common share, for the same period in 2019. The primary reason for the decrease in net income for the six months endedJune 30, 2020 was a$650,000 provision for loan losses of for the six months endedJune 30, 2020 , compared to a$400,000 recapture from the allowance for loan losses for the same period in 2019, partially offset by increases in net interest income of$129,000 and noninterest income of$470,000 and a decrease of$274,000 in noninterest expense. Interest Income. Interest income increased$368,000 , or 4.4%, to$8.7 million for the three months endedJune 30, 2020 , from$8.3 million for the three months endedJune 30, 2019 . Interest income on loans increased$715,000 , or 9.0%, to$8.6 million for the three months endedJune 30, 2020 , due to higher average loan balances resulting primarily from PPP loans made by the Bank. The average balance of loans held-for-portfolio was$683.6 million for three months endedJune 30, 2020 , compared to$575.9 million for the three months endedJune 30, 2019 . The average yield on loans held-for-portfolio was 5.07% for the three months endedJune 30, 2020 , compared to 5.51% or the three months endedJune 30, 2019 . Interest income on the investment portfolio and cash and cash equivalents decreased$347,000 , or 81.8%, to$77,000 for the three months endedJune 30, 2020 , compared to$424,000 for the three months endedJune 30, 2019 . The decrease in the interest income on investment securities and cash and cash equivalents compared to the same period a year ago was due to lower average yields. The average yield on investments including interest-bearing cash was 0.46% for the three months endedJune 30, 2020 , compared to 2.64% for the three months endedJune 30, 2019 . Interest income increased$197,000 , or 1.1%, to$17.4 million for the six months endedJune 30, 2020 , from$17.2 million for the six months endedJune 30, 2019 . The increase was primarily a result of increased interest income on loans due to higher average loan balances. The average balance of loans held-for-portfolio increased$54.8 million , or 9.2%, to$648.7 million for the six months endedJune 30, 2020 , compared to$593.9 million for the six months endedJune 30, 2019 . The average yield on loans held-for-portfolio was 5.24% for the six months endedJune 30, 2020 , compared to 5.59% for the six months endedJune 30, 2019 . The average yield on net loans decreased compared to the same period in the prior year due primarily to decreases in interest rates on adjustable rate instruments following decreases to short-term rates over the last year, including the emergency 150 basis point reduction in the targeted federal funds rate inMarch 2020 due to the COVID-19 pandemic, and secondarily due to the impact of PPP loans. For the three months endedJune 30, 2020 , the average balance of PPP loans was$52.7 million and the average yield on PPP loans was 2.83%, including the recognition of the net deferred fees. Interest income included$372,000 in fees earned related to PPP loans in the quarter endedJune 30, 2020 compared to none in same period a year ago. The impact of PPP loans on loan yields will change during any period based on the volume of prepayments or amounts forgiven by the SBA as certain criteria are met, but is expected to cease completely after the two or five year maturity of the loans. Interest income on the investment portfolio and cash and cash equivalents decreased$524,000 , or 62.5%, to$314,000 during the six months endedJune 30, 2020 , compared to the same period a year ago due to was due to lower average yields. The average yield on investments including interest-bearing cash was 0.99% for the six months endedJune 30, 2020 , compared to 2.71% for the six months endedJune 30, 2019 . The average balance of investments, which included interest-bearing cash balances and available-for-sale securities increased$6.6 million , or 11.5%, compared to a year ago. Interest Expense. Interest expense decreased$66,000 , or 3.5%, to$1.8 million for the three months endedJune 30, 2020 , from$1.9 million for the three months endedJune 30, 2019 . The decrease in interest expense was as a result of lower average balance and cost of borrowings. Interest expense increased$68,000 , or 1.9%, to$3.7 million for the six months endedJune 30, 2020 , from$3.7 million for the six months endedJune 30, 2019 . The increase in interest expense was primarily due to increases in average balance of deposits, partially offset by a lower average balance of borrowings outstanding. Interest expense on deposits increased$127,000 , or 7.8%, to$1.7 million for the three months endedJune 30, 2020 , compared to$1.6 million for the same period a year ago. Interest expense on deposits increased$519,000 , or 16.8%, to$3.6 million for the six months endedJune 30, 2020 , compared to$3.1 million for the same period in 2019. The increase for both periods was 41 -------------------------------------------------------------------------------- primarily due to the increase in average balance of deposits. The average balance of deposits was$682.4 million and$651.7 million during the three and six months endedJune 30, 2020 , respectively, compared to 569.8 million and$572.2 million during the three and six months endedJune 30, 2019 , respectively. The average rate paid on deposits was 1.03% and 1.11% for the three and six months endedJune 30, 2020 , respectively, compared to 1.14% and 1.09% for the three months endedJune 30, 2019 , respectively. The average rate paid on deposits declined due to a reduction in market interest rates over the last year. The cost of borrowings for the three and six months endedJune 30, 2020 was 2.07% and 2.47%, respectively, compared to 4.25% and 2.97% for the three and six months endedJune 30, 2019 . Net Interest Income. Net interest income increased$434,000 , or 6.7%, to$6.9 million for the three months endedJune 30, 2020 , from$6.5 million for the three months endedJune 30, 2019 . Net interest income increased$129,000 , or 1.0%, to$13.6 million for the six months endedJune 30, 2020 , from$13.5 million compared to the same period a year ago. Our net interest margin was 3.69% and 3.81% for three and six months endedJune 30, 2020 , respectively, compared to 4.03% and 4.13% for the three and six months endedJune 30, 2019 , respectively. The decreases in net interest margin were primarily due to yields earned on interest-earning assets declining at a faster rate than interest rates paid on interest-bearing liabilities. The market's response to lowering deposit pricing to reflect the targeted federal funds rate decreases over the past year typically lags declines in the yield on interest earning assets. The average yield on PPP loans was 2.83% during the three and six months endedJune 30, 2020 , including the recognition of the net deferred fees, resulting in a negative impact to the net interest margin. Provision/(Recapture) for Loan Losses. We establish provisions for loan losses, which are charged to earnings, based on our review of the level of the allowance for loan losses required to reflect management's best estimate of the probable incurred credit losses in the loan portfolio. In evaluating the level of the allowance for loan losses, management considers historical loss experience, the types of loans and the amount of loans in the loan portfolio, adverse situations that may affect borrowers' ability to repay, estimated value of any underlying collateral, peer group data, prevailing economic conditions, and current factors. Large groups of smaller balance homogeneous loans, such as one- to four- family, small commercial and multifamily, home equity and consumer loans, are evaluated in the aggregate using historical loss factors adjusted for current economic conditions and other relevant data. Loans for which management has concerns about the borrowers' ability to repay, are evaluated individually and specific loss allocations are provided for these loans when necessary. The Company recorded a provision for loan losses of$400,000 and$650,000 for the three and six months endedJune 30, 2020 , respectively, compared to a recapture from the allowance for loan losses of$200,000 and$400,000 for the three and six months endedJune 30, 2019 , respectively. The increase in the provision primarily reflects potential loan losses due to credit deterioration as a result of the COVID-19 pandemic. Net charge-offs for the three and six months endedJune 30, 2020 were$262,000 and$259,000 respectively, compared to net charge-offs of$7,000 and$4,000 for the three and six months endedJune 30, 2019 , respectively. While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. A further decline in national and local economic conditions, as a result of the COVID-19 pandemic or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company's financial condition and results of operations. In addition, the determination of the amount of our allowance for loan losses is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination. 42 -------------------------------------------------------------------------------- Noninterest Income. Noninterest income increased$724,000 , or 84.7%, to$1.6 million for the three months endedJune 30, 2020 , as compared to$855,000 for the three months endedJune 30, 2019 , as reflected below (dollars in thousands): Three Months Ended June 30, Amount Percent 2020 2019 Change Change Service charges and fee income $ 429$ 479 $ (50) (10.4) % Earnings on cash surrender value of BOLI 90 78 12 15.4 Mortgage servicing income 235 256 (21) (8.2) Fair value adjustment on mortgage servicing rights (437) (162) (275) 169.8 Net gain on sale of loans 1,262 204 1,058 518.6 Total noninterest income$ 1,579 $ 855 $ 724 84.7 % The increase in noninterest income during the three months endedJune 30, 2020 compared to the same period in 2019 was primarily due to increases in gain on sale of loans, partially offset by a decrease in the mark-to-market adjustment on fair value of mortgage servicing rights. Loans sold during the three months endedJune 30, 2020 , totaled$57.3 million , compared to$9.4 million during the three months endedJune 30, 2019 , as the volume of loans originated for sale increased significantly due to refinance activity increasing as a result of the recent reductions in market interest rates. Noninterest income increased$470,000 , or 25.9%, to$2.3 million for the six months endedJune 30, 2020 , as compared to$1.8 million for the six months endedJune 30, 2019 , as reflected below (dollars in thousands): Six Months Ended June 30, Amount Percent 2020 2019 Change Change Service charges and fee income$ 923 $ 925 $ (2) (0.2) % Earnings on cash surrender value of BOLI 105 186 (81) (43.5) Mortgage servicing income 479 498 (19) (3.8) Fair value adjustment on mortgage servicing rights (800) (486) (314) 64.6 Net gain on sale of loans 1,581 695 886 127.5 Total noninterest income$ 2,288 $ 1,818 $ 470 25.9 % The increase in noninterest income during the six months endedJune 30, 2020 compared to the same period in 2019 was primarily due to increases in gain on sale of loans, partially offset by a decrease in the mark-to-market adjustment on fair value of mortgage servicing rights. Loans sold during the six months endedJune 30, 2020 , totaled$71.4 million , compared to$35.9 million during the six months endedJune 30, 2019 . 43 -------------------------------------------------------------------------------- Noninterest Expense. Noninterest expense increased$174,000 , or 3.3%, to$5.4 million during the three months endedJune 30, 2020 , compared to$5.2 million during the three months endedJune 30, 2019 , as reflected below (dollars in thousands): Three Months Ended June 30, Amount Percent 2020 2019 Change Change Salaries and benefits$ 2,818 $ 2,654 $ 164 6.2 % Operations 1,326 1,450 (124) (8.6) Regulatory assessments 120 115 5 4.3 Occupancy 497 546 (49) (9.0) Data processing 645 460 185 40.2 Net loss on OREO and repossessed assets - 7 (7) (100.0) Total noninterest expense$ 5,406 $ 5,232 $ 174 3.3 % The increase in noninterest expense during the three months endedJune 30, 2020 compared to the same period in 2019 was primarily due to increases of$185,000 in data processing and$164,000 in salaries and benefits expense, partially offset by a$124,000 decrease in operations expense. Data processing expense increased due to recording of software expenses to data processing upon renewal of existing software license agreements and technology investments made in 2020. Salaries and benefits expense increased due to increase in commissions on higher loan originations compared to a year ago. Operations expense decreased due to a lower professional and consulting fees and lower travel and conference expenses compared to the same quarter a year ago. Noninterest expense decreased$274,000 , or 2.4%, to$11.4 million during the six months endedJune 30, 2020 as compared to$11.6 million during the six months endedJune 30, 2019 , as reflected below (dollars in thousands): Six Months Ended June 30, Amount Percent 2020 2019 Change Change Salaries and benefits$ 6,053 $ 6,293 $ (240) (3.8) % Operations 2,720 3,084 (364) (11.8) Regulatory assessments 369 228 141 61.8 Occupancy 995 1,052 (57) (5.4) Data processing 1,215 960 255 26.6 Net loss on OREO and repossessed assets - 9 (9) (100.0) Total noninterest expense$ 11,352 $ 11,626 $ (274) (2.4) % The decrease in noninterest expense during the six months endedJune 30, 2020 compared to the same period in 2019 was primarily due to decreases of$240,000 in salaries and benefits and$364,000 in operations expense, partially offset by increases of$255,000 in data processing and$141,000 in regulatory assessments expense. Salaries and benefits expense decreased due to an increase in deferred loan origination costs. Operations expense decreased due to decreases in professional and consulting fees, travel and conference and marketing and advertising expense. Data processing expense increased for the same reason set forth above. Regulatory assessments increased to normal levels as the Bank utilized all of its remaining regulatory assessment credits last year and due to costs for the DFI examination paid during the six months endedJune 30, 2020 . The efficiency ratio for the quarter endedJune 30, 2020 was 63.79%, compared to 71.50% for the quarter endedJune 30, 2019 and was 71.34% for the six months endedJune 30, 2020 , compared to 75.92% for the six months endedJune 30, 2019 . The improvement in the efficiency ratio was primarily due to higher interest income and noninterest income, and, for the six month periods, lower noninterest expense. Income Tax Expense. We incurred income tax expense of$541,000 and$802,000 for the three and six months endedJune 30, 2020 , respectively, as compared$468,000 and$826,000 for the same periods in 2019, respectively. The effective tax rates for 44 --------------------------------------------------------------------------------
the three and six months ended
Liquidity
The Management Discussion and Analysis in Item 7 of the Company's 2019 Form 10-K contains an overview ofSound Financial Bancorp's and the Bank's liquidity management, sources of liquidity and cash flows. This discussion updates that disclosure for the six months endedJune 30, 2020 . The Bank's primary sources of funds are deposits, principal and interest payments on loans and borrowings. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. The Bank's primary investing activity is loan originations. The Bank maintains liquidity levels it believes to be adequate to fund loan commitments, investment opportunities, deposit withdrawals and other financial commitments. AtJune 30, 2020 , the Bank had$140.7 million in cash and investment securities available-for-sale and$7.4 million in loans held-for-sale generally available for its cash needs. Also, atJune 30, 2020 , the Bank had the ability to borrow an additional$218.7 million in FHLB advances based on existing collateral pledged, and could access$33.4 million through theFederal Reserve's Discount Window. AtJune 30, 2020 , we also had available a total of$20.0 million in credit facilities with other financial institutions, with no balance outstanding. The Bank uses these sources of funds primarily to meet ongoing commitments, pay maturing deposits and fund withdrawals and loan commitments. AtJune 30, 2020 , outstanding loan commitments, including unused lines and letters of credit totaled$136.4 million , including$37.2 million of undisbursed construction and land loans. Certificates of deposit scheduled to mature in one year or less atJune 30, 2020 , totaled$158.2 million . In addition, the Bank's is utilizingFederal Reserve's PPPLF for additional borrowing needs. AtJune 30, 2020 , the Bank had$72.3 million in borrowings from the PPPLF, with the ability to borrow an additional$800,000 based on the remaining PPP loans unpledged at that date. Cash and cash equivalents increased$74.8 million to$130.5 million as ofJune 30, 2020 , from$55.8 million as ofDecember 31, 2019 . Net cash used in operating activities was$2.5 million for the six months endedJune 30, 2020 . Net cash used in investing activities totaled$71.7 million during the six months endedJune 30, 2020 and consisted primarily of a increases in net loans and available-for-sale securities. The$149.0 million of net cash provided by financing activities during the six months endedJune 30, 2020 was primarily the result of a$77.6 million net increase in deposits and$72.3 million net increase in borrowings, all of which increase were borrowings from the PPPLF. As a separate legal entity from the Bank, the Company must provide for its own liquidity. AtJune 30, 2020 , the Company, on an unconsolidated basis, had$1.6 million in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs. The Company's principal source of liquidity is dividends and ESOP loan repayments from the Bank. Except as set forth above, management is not aware of any trends, events, or uncertainties that will have, or that are reasonably likely to have a material impact on liquidity, capital resources or operations. Off-Balance Sheet Activities In the normal course of operations, we engage in a variety of financial transactions that are not recorded in our financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage customers' requests for funding and take the form of loan commitments and lines of credit. A summary of our off-balance sheet loan commitments atJune 30, 2020 , is as follows (in thousands): June 30, 2020 Commitments to make loans$ 55,069 Unfunded construction commitments 37,235 Unused lines of credit 42,925 Irrevocable letters of credit 1,241 Total loan commitments$ 136,470 Capital 45
--------------------------------------------------------------------------------Sound Community Bank is subject to minimum capital requirements imposed by regulations of theFDIC . Capital adequacy requirements are quantitative measures established by regulation that requireSound Community Bank to maintain minimum amounts and ratios of capital. Prior toJanuary 1, 2020 ,Sound Community Bank followed theFDIC's prompt corrective actions standards. In order to be considered well-capitalized under the prompt corrective action standards, a bank must have a ratio of CET1 capital to risk-weighted assets of at least 6.5%, a ratio of Tier 1 capital to risk-weighted assets of at least 8%, a ratio of total capital to risk-weighted assets of at least 10%, and a leverage ratio of at least 5%, and the bank must not be subject to a regulatory capital requirement imposed on it as an individual bank. In order to be considered adequately capitalized, a bank must have the minimum capital ratios described above. Institutions with lower capital ratios are assigned to lower capital categories. Based on safety and soundness concerns, theFDIC may assign an institution to a lower capital category than would originally apply based on its capital ratios. TheFDIC is also authorized to requireSound Community Bank to maintain additional amounts of capital in connection with concentrations of assets, interest rate risk, and certain other items. TheFDIC has not imposed such a requirement onSound Community Bank . EffectiveJanuary 1, 2020 , a bank that elects to use the Community Bank Leverage Ratio ("CBLR") framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act will generally be considered well-capitalized and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%. As required by the CARES Act, theFDIC has temporarily lowered the CBLR to 8% beginning in the second quarter of 2020 through the end of the year. Beginning in 2021, the CBLR will increase to 8.5% for that calendar year. The CBLR will return to 9% onJanuary 1, 2022 . To be eligible to utilize the CBLR, the Bank also must have total consolidated assets of less than$10 billion , off-balance sheet exposures of 25% or less of its total consolidated assets, and trading assets and trading liabilities of 5.0% or less of its total consolidated assets, all as of the end of the most recent quarter. BeginningJanuary 2020 , the Bank elected to use the CBLR framework. AtJune 30, 2020 , the Bank's CBLR was 10.17%. Management monitors the capital levels to provide for current and future business opportunities and to maintainSound Community Bank's "well-capitalized" status. As ofJune 30, 2020 ,Sound Community Bank had CBLR in excess of theFederal Reserve's minimum and well capitalized definitions requirements. As ofDecember 31, 2019 ,Sound Community Bank had regulatory capital in excess of theFederal Reserve's minimum and well capitalized requirement. The actual regulatory capital amounts and ratios calculated forSound Community Bank atDecember 31, 2019 , were as follows (dollars in thousands): Minimum Required to be Minimum Capital Well-Capitalized Under Prompt Actual Requirements Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio Tier 1 Capital to average total adjusted assets$ 74,031 10.22 %$ 28,981 4.0 %$ 36,226 5.0 % Common Equity Tier 1 to risk-weighted assets 74,031 12.07 27,601 4.5 39,868 6.5 Tier 1 Capital to risk-weighted assets 74,031 12.07 36,801 6.0 49,068 8.0 Total Capital to risk-weighted assets$ 79,974 13.04 %$ 49,068 8.0 %$ 61,335 10.0 % Pursuant to the capital regulations of theFDIC and the other federal banking agencies, the Bank must maintain a capital conservation buffer consisting of additional CET1 capital greater than 2.5% of risk-weighted assets above the required minimum levels of risk-based CET1 capital, tier 1 capital and total capital in order to avoid limitations on paying dividends, repurchasing shares, and paying discretionary bonuses. AtDecember 31, 2019 , the Bank's CET1 capital exceeded the required capital conservation buffer. For a bank holding company with less than$3.0 billion in assets, the capital guidelines apply on a bank only basis and theFederal Reserve expects the holding company's subsidiary banks to be well capitalized under the prompt corrective action regulations. IfSound Financial Bancorp was subject to regulatory guidelines for bank holding companies with$3.0 billion or more in assets, atJune 30, 2020 ,Sound Financial Bancorp would have exceeded all regulatory capital requirements. The estimated Community Bank Leverage Ratio calculated forSound Financial Bancorp as ofJune 30, 2020 was 10.17%. 46
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