Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of our operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. In addition to historical consolidated financial information, this discussion contains forward-looking statements that involve risks uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this Form 10-K, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements.
Principal Factors Affecting Our Results of Operations
Net Income. Net income is calculated by taking interest and noninterest income and subtracting our costs to do business, such as interest, salaries, taxes and other operational expenses. We evaluate our net income based on measures that include net interest margin, return on average assets and return on average equity.
Net Interest Income. Net interest income represents interest income, less interest expense. We generate interest income from interest, dividends and fees received on interest earning assets, including loans, interest earning deposits in other banks and investment securities we own. We incur interest expense from interest paid on interest bearing liabilities, including interest bearing deposits, borrowings and other forms of indebtedness. Net interest income typically is the most significant contributor to our net income. To evaluate net interest income, we measure and monitor: (i) yields on our loans, securities, interest earning deposits in other banks and other interest earning assets; (ii) the costs of our deposits and other funding sources; (iii) our net interest spread; and (iv) our net interest margin. Net interest spread is the difference between rates earned on interest earning assets and rates paid on interest bearing liabilities. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Because noninterest bearing sources of funds, such as noninterest bearing deposits and shareholders’ equity, also fund interest earning assets, net interest margin includes the benefit of these noninterest bearing sources.
Changes in market interest rates and interest we earn on interest earning assets or pay on interest bearing liabilities, as well as the volume and types of our interest earning assets, interest bearing and noninterest bearing liabilities and shareholders’ equity, usually have the largest impact on periodic changes in our net interest spread, net interest margin and net interest income. We measure net interest income before and after our provision for loan losses.
Provision for Loan Losses. Provision for loan losses is the amount of expense that, based on our management’s judgment, is required to maintain our allowance for loan losses at an adequate level to absorb probable losses inherent in our loan portfolio at the applicable balance sheet date and that, in our management’s judgment, is appropriate under relevant accounting guidance. Determination of the allowance for loan losses is complex and involves a high degree of judgment and subjectivity. For a description of the factors considered by our management in determining the allowance for loan losses see “—Financial Condition—Allowance for Loan Losses.”
Noninterest Income. Noninterest income consists of, among other things: (i) deposit related fees; (ii) mortgage warehouse fee income; (iii) gain on sale of securities; (iv) other gain and losses; and (v) other noninterest income. Deposit related fees include cash management fees, such as analyzed checking fees, account maintenance fees, insufficient funds fees, overdraft fees, stop payment fees, foreign exchange fee income, domestic and foreign wire transfer fees, SEN related fees and card processing fee income. Mortgage warehouse fee income consists of transaction fees collected as the funded loans are sold or settled.
Noninterest Expense. Noninterest expense includes, among other things: (i) salaries and employee benefits; (ii) occupancy and equipment expense; (iii) communications and data processing fees; (iv) professional services fees; (v) federal deposit insurance; (vi) correspondent bank charges; (vii) other loan expense and (viii) other general and administrative expenses.
Salaries and employee benefits include compensation, stock-based compensation, employee benefits and tax expenses for our personnel. Occupancy and equipment expense includes depreciation expense, lease expense on our leased properties and other occupancy-related expenses. Equipment expense includes expenses related to our furniture, fixtures, equipment and software. Communications expense includes costs for telephone and internet. Data processing fees include expenses paid to our third-party data processing system provider and other data service providers. Professional fees include legal, accounting, consulting and other outsourcing arrangements. Federal deposit insurance expense relates to FDIC assessments based on the level of our deposits. Correspondent bank charges include wire transfer fees, transaction fees and service charges related to transactions settled with correspondent relationships. Other loan expense includes custodial fees for our digital currency collateralized loans and loan servicing related expenses. Other general and administrative expenses include expenses associated with travel, meals, advertising, promotions, sponsorships, training, supplies, postage, insurance, board of director expenses and other expenses related to being a public company. Noninterest expenses generally increase as we grow our business.
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Financial Condition
The primary factors we use to evaluate and manage our financial condition include asset quality, capital and liquidity.
Asset Quality. We manage the diversification and quality of our assets based on factors that include the level, distribution, severity and trend of problem, classified, delinquent, nonaccrual, nonperforming and restructured assets, the adequacy of our allowance for loan losses, the diversification and quality of our loan and investment portfolios, the extent of counterparty risks, credit risk concentrations and other factors.
Capital. Financial institution regulators have established guidelines for minimum capital ratios for banks and bank holding companies. The Company and the Bank’s capital ratios at December 31, 2021 exceeded all current well capitalized regulatory requirements.
We manage capital primarily based upon: (i) the level and quality of capital, our growth rate and our overall financial condition; (ii) the level and quality of earnings; (iii) the risk exposures in our balance sheet; and (iv) general economic conditions.
Liquidity. We manage liquidity based on factors that include the amount of core deposits as a percentage of total deposits, the level of diversification of our funding sources, the allocation and amount of our deposits among deposit types, the short-term funding sources used to fund assets, the amount of non-deposit funding used to fund assets, the availability of unused funding sources, off-balance sheet obligations, the availability of assets to be readily converted into cash without undue loss, the amount of cash, interest earning deposits in other banks and liquid securities we hold, the re-pricing characteristics and maturities of our assets when compared to the re-pricing characteristics of our liabilities and other factors.
We maintain high levels of liquidity for our customers who operate in the digital currency industry, as these deposits are subject to potentially dramatic fluctuations due to certain factors that may be outside of our control. As a result, the Bank deploys its customer deposits into interest earning deposits in other banks and securities, as well as into specialized lending opportunities.
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Selected Historical Financial Data
Information as of and for the years ended December 31, 2021 and 2020 is derived from audited financial statements presented separately herein, while information as of and for the years ended December 31, 2019, 2018 and 2017 is derived from audited financial statements not included herein. Our historical results are not necessarily indicative of any future period. The performance ratios and asset quality and capital ratios are unaudited and derived from our audited financial statements and other financial information as of and for the periods presented. Average balances have been calculated using daily averages.
Year Ended December 31,
(In thousands, except per share data)
Statement of Operations Data:
Interest income
Interest expense
Net interest income
Provision for (reversal of) loan losses
Net interest income after provision
Noninterest income
Noninterest expense
Income before income taxes
Income tax expense (1)
Net income
Dividends on preferred stock
Net income available to common shareholders
Financial Ratios:
Return on average assets (ROAA)
Return on average equity (ROAE)
Return on average common equity (ROACE)
Net interest margin (2)
Noninterest income to average assets
Noninterest expense to average assets
Efficiency ratio (3)
Loan yield (4)
Cost of deposits
Cost of funds
Share Data:
Basic earnings per common share
Diluted earnings per common share
Common stock shares issued and outstanding at end of period
Basic weighted average shares outstanding
Diluted weighted average shares outstanding
Book value per common share at end of period
(1) The year ended December 31, 2017 included a $1.2 million increase in income tax expense related to the revaluation of our deferred tax assets resulting from the reduction in the corporate income tax rate as a result of the Tax Cuts and Jobs Act of 2017.
(2) Net interest margin is a ratio calculated as net interest income, on a fully taxable equivalent basis for interest income on tax-exempt securities using the federal statutory tax rate of 21.0%, divided by average interest earning assets for the same period.
(3) Efficiency ratio is calculated by dividing noninterest expenses by net interest income plus noninterest income.
(4) Includes nonaccrual loans and loans 90 days and more past due.
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December 31,
(Dollars in thousands)
Statement of Financial Condition Data:
Cash and cash equivalents
Securities available-for-sale, at fair value
Loans held-for-sale
Loans held-for-investment, net
Other
Total assets
Deposits
Borrowings
Other liabilities
Total liabilities
Total shareholders’ equity
Total liabilities and shareholders' equity
Nonperforming Assets:
Nonaccrual loans
Troubled debt restructurings
Other real estate owned, net
Nonperforming assets
Asset Quality Ratios:
Nonperforming assets to total assets
Nonaccrual loans to total loans (1)
Net charge-offs (recoveries) to average total loans (1)
Allowance for loan losses to total loans (1)
Allowance for loan losses to nonaccrual loans
Company Capital Ratios:
Tier 1 leverage ratio
Common equity tier 1 capital ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
Common equity to total assets
Bank Capital Ratios:
Tier 1 leverage ratio
Common equity tier 1 capital ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
(1) Loans exclude loans held-for-sale at each of the dates presented.
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Results of Operations
Net Income
The following table sets forth the principal components of net income for the periods indicated.
Year Ended December 31,
$ Increase/
(Decrease)
% Increase/
(Decrease)
(Dollars in thousands)
Interest income
Interest expense
Net interest income
Provision for loan losses
Net interest income after provision
Noninterest income
Noninterest expense
Net income before income taxes
Income tax expense
Net income
N/M—Not meaningful
Net income for the year ended December 31, 2021 was $78.5 million, an increase of $52.5 million, or 201.6%, from net income of $26.0 million for the year ended December 31, 2020. The increase was primarily due to an increase of $56.9 million, or 78.6%, in net interest income, and an increase of $26.1 million, or 136.0%, in noninterest income, partially offset by an increase of $1.7 million, or 33.3%, in income tax expense and a $29.5 million, or 49.5%, increase in noninterest expense, all as described below.
Net Interest Income and Net Interest Margin Analysis (Taxable Equivalent Basis)
We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest income is the difference between the interest and fees earned on interest earning assets, such as loans, interest earning deposits in other banks and securities, and the interest expense incurred on interest bearing liabilities, such as deposits and borrowings, which are used to fund those assets.
Changes in market interest rates and the interest rates we earn on interest earning assets or pay on interest bearing liabilities, as well as in the volume and types of interest earning assets, interest bearing and noninterest bearing liabilities and shareholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Our ability to respond to changes in these factors by using effective asset-liability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings.
The following tables show the average outstanding balance of each principal category of our assets, liabilities and shareholders’ equity, together with the average yields on our assets and the average costs of our liabilities for the periods indicated. Such yields and costs are calculated by dividing income or expense by the average daily balances of the associated assets or liabilities for the same period.
Tax-exempt income from securities is calculated on a taxable equivalent basis. Net interest income, net interest spread and net interest margin are presented on a taxable equivalent basis to consistently reflect income from taxable securities and tax-exempt securities based on the federal statutory tax rate of 21.0%.
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AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS
Year Ended December 31,
Average
Outstanding
Balance
Interest
Income/
Expense
Average
Yield/
Rate
Average
Outstanding
Balance
Interest
Income/
Expense
Average
Yield/
Rate
(Dollars in thousands)
Assets
Interest earning assets:
Interest earning deposits in other banks
Taxable securities
Tax-exempt securities (1)
Loans (2)(3)
Other
Total interest earning assets
Noninterest earning assets
Total assets
Liabilities and Shareholders’ Equity
Interest bearing liabilities:
Interest bearing deposits
FHLB advances and other borrowings
Subordinated debentures and other
Total interest bearing liabilities
Noninterest bearing liabilities:
Noninterest bearing deposits
Other liabilities
Shareholders’ equity
Total liabilities and shareholders’ equity
Net interest spread (4)
Net interest income, taxable equivalent basis
Net interest margin (5)
Reconciliation to reported net interest income:
Adjustments for taxable equivalent basis
Net interest income, as reported
(1) Interest income on tax-exempt securities is presented on a taxable equivalent basis using the federal statutory tax rate of 21.0% for all periods presented.
(2) Loans include nonaccrual loans and loans held-for-sale, net of deferred fees and before allowance for loan losses.
(3) Interest income includes amortization of deferred loan fees, net of deferred loan costs.
(4) Net interest spread is the difference between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities.
(5) Net interest margin is a ratio calculated as net interest income, on a taxable equivalent basis, divided by average interest earning assets for the same period.
Information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and interest bearing liabilities and distinguishes between the changes
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attributable to changes in volume and changes attributable to changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been proportionately allocated to both volume and rate.
ANALYSIS OF CHANGES IN NET INTEREST INCOME
For the Year Ended
December 31, 2021 Compared to 2020
Change Due To
Interest
Variance
Volume
Rate
(Dollars in thousands)
Interest Income:
Interest earning deposits in other banks
Taxable securities
Tax-exempt securities (1)
Loans
Other
Total interest income
Interest Expense:
Interest bearing deposits
FHLB advances and other borrowings
Subordinated debentures and other
Total interest expense
Net interest income, taxable equivalent basis
(1) Interest income on tax-exempt securities is presented on a taxable equivalent basis using the federal statutory tax rate of 21.0% for all periods presented.
Net interest income on a taxable equivalent basis increased $60.2 million to $133.9 million for the year ended December 31, 2021 compared to $73.7 million for the year ended December 31, 2020, due to an increase of $54.1 million in interest income and a decrease of $6.1 million in interest expense. Average total interest earning assets increased $8.7 billion, or 355.0%, from $2.5 billion for the year ended December 31, 2020 to $11.2 billion for the year ended December 31, 2021. This increase was primarily due to an increase in the average balance of interest earning deposits in other banks and securities. The average yield on total interest earning assets decreased from 3.29% for the year ended December 31, 2020 to 1.21% for the year ended December 31, 2021 primarily due to interest earning deposits in other banks being a greater percentage of interest earning assets, and lower yields on securities and interest earning deposits.
Average interest bearing liabilities decreased $190.5 million, or 63.8%, for the year ended December 31, 2021 as compared to 2020 primarily due to calling the remaining balance of brokered certificates of deposit in the second quarter of 2020 and lower FHLB advances. The average rate on total interest bearing liabilities decreased to 1.04% for the year ended December 31, 2021 compared to 2.42% for 2020 primarily due to the impact of calling the remaining balance of brokered certificates of deposit in the first half of 2020. The total interest expense, including accelerated premium amortization, related to the brokered certificates was $5.4 million for the year ended December 31, 2020.
For the year ended December 31, 2021, the net interest spread was 0.17% and the net interest margin was 1.20% compared to 0.87% and 3.00%, respectively, for 2020. The decrease in the net interest spread for the year ended December 31, 2021 was primarily due to lower yields on securities and interest earning deposits due to a declining interest rate environment. The decrease in the net interest margin was primarily due to a greater proportion of lower yielding interest earning deposits as a percentage of total interest earning assets, which was driven by the increase in noninterest bearing digital currency customer deposits. The decrease in the net interest margin was also due to lower yields on securities and interest earning deposits.
Provision for Loan Losses
The provision for loan losses is a charge to income to bring our allowance for loan losses to a level deemed appropriate by management. For a description of the factors considered by our management in determining the allowance for loan losses see “—Financial Condition—Allowance for Loan Losses” and “—Critical Accounting Policies—Allowance for Loan Losses.”
We recorded no provision for loan losses for the year ended December 31, 2021 compared to a provision of $0.7 million for the year ended December 31, 2020. The allowance for loan losses to total loans held-for-investment was 0.77% at December 31, 2021 compared to 0.92% at December 31, 2020. Management determined that no provision was necessary for the year ended December 31, 2021, based on the mix of our loan portfolio, our historically strong credit quality and minimal loan
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charge-offs, and the loan-to-value ratios in the low- to mid-50% range in our commercial, multi-family and one-to-four family residential real estate held-for-investment loan portfolios.
Noninterest Income
The following table presents, for the periods indicated, the major categories of noninterest income:
NONINTEREST INCOME
Year Ended December 31,
$ Increase/
(Decrease)
% Increase/
(Decrease)
(Dollars in thousands)
Noninterest income:
Mortgage warehouse fee income
Deposit related fees
Gain on sale of securities, net
Gain on sale of loans, net
Gain on extinguishment of debt
Other income
Total noninterest income
N/M—Not meaningful
Noninterest income for the year ended December 31, 2021 was $45.3 million, an increase of $26.1 million, or 136.0%, compared to noninterest income of $19.2 million for the year ended December 31, 2020. This increase was primarily due to a $24.6 million increase in deposit related fees, substantially all of which are fees from our digital currency customers, and a $1.5 million increase in gain on sale of securities. The $24.6 million increase in deposit related fees was primarily due to increases in cash management, foreign exchange, and SEN related fees associated with our digital currency initiative. During the year ended December 31, 2021, we sold a total of $1.5 billion of securities and realized a net gain on sale of $5.2 million, compared to a total of $216.4 million in sales of securities and net gain on sale of $3.8 million during the year ended December 31, 2020. During the year ended December 31, 2020, the Company initiated and settled a $64.0 million FHLB five-year term advance. Due to an increase in FHLB advance rates after settlement, the Company repaid the advance and recorded a gain of $0.9 million. Other income for the year ended December 31, 2021 included a $0.9 million gain on sale of assets related to the sale of interest rate swaps.
Noninterest Expense
The following table presents, for the periods indicated, the major categories of noninterest expense:
NONINTEREST EXPENSE
Year Ended December 31,
$ Increase/
(Decrease)
% Increase/
(Decrease)
(Dollars in thousands)
Noninterest expense:
Salaries and employee benefits
Occupancy and equipment
Communications and data processing
Professional services
Federal deposit insurance
Correspondent bank charges
Other loan expense
Other general and administrative
Total noninterest expense
N/M—Not meaningful
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Noninterest expense increased $29.5 million, or 49.5%, for the year ended December 31, 2021 compared to the year ended December 31, 2020 primarily due to increases in federal deposit insurance, salaries and employee benefits, professional services and other general and administrative.
The increase of $9.3 million, or 25.5%, in salaries and employee benefits was primarily due to an increase in headcount and an increase in cost per full-time equivalent employee, including a $1.0 million increase in employee related stock-based compensation expense. The Company’s average full-time equivalent employees increased from 210 for the year ended December 31, 2020 to 235 for 2021. Occupancy and equipment decreased $3.2 million, or 56.7%, due to a reduction in costs related to our leased office space and fixed assets no longer in use that were written off during the year ended December 31, 2020. Communications and data processing increased $1.7 million, or 30.8%, primarily due to additional core processing expense due to higher transaction volumes, continued investment in scalable cloud-based software solutions and investments in compliance software to support our digital currency related customers. Professional services increased $5.3 million, or 119.2%, primarily due to consulting and legal fees for projects related to our strategic growth initiatives, including expenses related to our stablecoin project. In addition, professional services increased due to legal settlements and higher audit expense. Federal deposit insurance increased $12.4 million due to a rate increase driven by the significant growth in assets. Correspondent bank charges increased $1.0 million, or 64.1%, due to increased wire volumes and expanded correspondent relationships. Other loan expense increased $0.8 million, or 242.6%, due to increased custodial fees related to the growth of our SEN Leverage loans. Other general and administrative expense increased $2.3 million, or 51.3%, primarily due to an increase for expanded insurance coverage and an increase in the provision for commitments related to the increase in SEN Leverage loans total lines of credit.
Income Tax Expense
Income tax expense was $6.9 million for the year ended December 31, 2021 compared to $5.2 million for the year ended December 31, 2020. The increase in income tax expense was primarily related to an increase in pre-tax income. Our effective tax rates for the years ended December 31, 2021 and 2020 were 8.1% and 16.5%, respectively. The decrease in the Company’s effective tax rate in 2021 was primarily related to higher excess tax benefit from stock-based compensation and tax-exempt income earned on certain municipal bonds.
Financial Condition
As of December 31, 2021, our total assets increased to $16.0 billion compared to $5.6 billion as of December 31, 2020. Shareholders’ equity increased $1.3 billion, or 446.7%, to $1.6 billion at December 31, 2021 compared to $294.3 million at December 31, 2020. A summary of the individual components driving the changes in total assets, total liabilities and shareholders' equity is set forth below.
Interest Earning Deposits in Other Banks
Interest earning deposits in other banks increased from $2.9 billion at December 31, 2020 to $5.2 billion at December 31, 2021. The majority of the Company’s interest earning deposits in other banks is cash held at the Federal Reserve Bank. The increase in interest earning deposits was due to growth in total deposits exceeding growth in total loans and securities.
Securities Available-for-sale
We use our securities portfolio to primarily provide a source of liquidity, provide a return on funds invested and manage interest rate risk.
Management classifies investment securities primarily as either held-to-maturity or available-for-sale based on our intentions and the Company’s ability to hold such securities until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held to maturity and carried at amortized cost. All other securities are designated as available-for-sale and carried at estimated fair value with unrealized gains and losses included in shareholders’ equity on an after-tax basis. For the years presented, substantially all securities were classified as available-for-sale.
Our securities available-for-sale increased $7.7 billion, or 818.5%, from $939.0 million at December 31, 2020 to $8.6 billion at December 31, 2021. To supplement interest income earned on our loan portfolio, we invest in high quality mortgage-backed securities, collateralized mortgage obligations, other asset backed securities and municipal bonds. During the year ended December 31, 2021, the Company purchased $9.6 billion of securities, including $4.1 billion of agency residential mortgage-backed securities, $2.5 billion of municipal bonds, $2.4 billion of U.S. agency securities, $333.2 million of U.S. Treasury securities, $220.0 million of agency commercial mortgage-backed securities, and $133.1 million of private-label commercial mortgage-backed securities. In addition, we sold U.S. Treasury and longer duration securities for $1.5 billion and recognized a gain of $5.2 million.
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The following tables summarize the contractual maturities and weighted-average yields of investment securities at December 31, 2021 and the amortized cost and carrying value of those securities as of the indicated dates. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Residential and commercial mortgage-backed securities are classified below based on the final maturity date, however these are amortizing securities with expected average lives primarily less than ten years. The weighted average yield is a prospective yield computed using the amortized cost of fixed income investment securities. Actual yields earned may differ significantly based upon actual prepayments.
SECURITIES
One Year or
Less
More Than One
Year Through
Five Years
More Than Five
Years Through
10 Years
More Than
10 Years
Total
Amortized
Cost
Weighted
Average
Yield
Amortized
Cost
Weighted
Average
Yield
Amortized
Cost
Weighted
Average
Yield
Amortized
Cost
Weighted
Average
Yield
Amortized
Cost
Fair
Value
Weighted
Average
Yield
(Dollars in thousands)
December 31, 2021
Securities Available-for-Sale:
U.S. agency securities - excluding mortgage-backed securities
Residential mortgage-backed securities:
Government agency mortgage-backed securities
Government agency collateralized mortgage obligation
Private-label collateralized mortgage obligation
Commercial mortgage-backed securities:
Government agency mortgage-backed securities
Government agency collateralized mortgage obligation
Private-label collateralized mortgage obligation
Municipal bonds:
Tax-exempt
Taxable
Asset backed securities:
Government sponsored student loan pools
Total securities
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Loan Portfolio
Our loan portfolio consists primarily of mortgage warehouse loans, loans secured by real estate and loans secured by bitcoin which are included in the commercial and industrial loan segment. The following table summarizes our loan portfolio by loan segment as of the dates indicated:
COMPOSITION OF LOAN PORTFOLIO
As of December 31,
Amount
Percent
Amount
Percent
(Dollars in thousands)
Real estate:
One-to-four family
Multi-family
Commercial
Construction
Commercial and industrial (1)
Reverse mortgage and other
Mortgage warehouse
Total gross loans held-for-investment
Deferred fees, net
Total loans held-for-investment
Allowance for loan losses
Total net loans held-for-investment
Loans held-for-sale (2)
(1) Commercial and industrial loans includes $335.9 million and $77.2 million of SEN Leverage loans as of December 31, 2021 and 2020, respectively.
(2) Loans held-for-sale are comprised entirely of mortgage warehouse loans for all periods presented.
The repayment of loans is a source of additional liquidity for the Bank. The following table details maturities and sensitivity to interest rate changes for our loans held-for-investment at December 31, 2021:
LOAN MATURITY AND SENSITIVITY TO CHANGES IN INTEREST RATES
December 31, 2021
Due in One Year
or Less
Due in One to
Five Years
Due After Five
Years to 15 Years
Due After
15 Years
Total
(Dollars in thousands)
Real estate:
One-to-four family
Multi-family
Commercial
Construction
Commercial and industrial
Reverse mortgage and other
Mortgage warehouse
Total loans held-for-investment
Amounts with fixed rates
Amounts with floating rates
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Nonperforming Assets
Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether such loans are actually past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. When interest accrual is discontinued, all unpaid accrued interest is reversed from income. Interest income is subsequently recognized only to the extent cash payments received exceed principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, reasonably assured. Any loan which the Bank deems to be uncollectible, in whole or in part, is charged off to the extent of the anticipated loss. Loans that are past due for 180 days or more are charged off unless the loan is well secured and in the process of collection.
We believe our disciplined lending approach and focused management of nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. We have several procedures in place to assist us in maintaining the overall quality of our loan portfolio. We have established underwriting guidelines to be followed by our loan officers, and we also monitor our delinquency levels for any negative or adverse trends. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions.
Nonaccrual loans decreased to $4.0 million, or 0.45% of total loans, at December 31, 2021 compared to $5.0 million, or 0.66% of total loans, at December 31, 2020. The decrease in nonaccrual loans during the year ended December 31, 2021 was primarily due to loan principal repayments on one-to-four family real estate loans.
Total nonperforming assets were $4.0 million and $5.0 million at December 31, 2021 and 2020, respectively, or 0.03% and 0.09%, respectively, of total assets.
The following table presents information regarding nonperforming assets at the dates indicated:
NONPERFORMING ASSETS
December 31,
(Dollars in thousands)
Nonaccrual loans
Real estate:
One-to-four family
Reverse mortgage and other
Total nonaccrual loans
Accruing loans 90 or more days past due
Total nonperforming loans
Other real estate owned, net
Total nonperforming assets
Ratio of nonaccrual loans to total loans (1)
Ratio of allowance for loan losses to nonaccrual loans
Ratio of nonperforming assets to total assets
Troubled debt restructurings:
Restructured loans-nonaccrual
Restructured loans-accruing
Total troubled debt restructurings
(1) Total loans exclude loans held-for-sale at each of the dates presented.
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Impaired Loans and TDRs.
Impaired loans also include certain loans that have been modified as troubled debt restructurings, or TDRs. As of December 31, 2021, the Company held eight loans totaling $1.7 million that were TDRs, compared to seven loans totaling $1.5 million at December 31, 2020.
A loan is identified as a TDR when a borrower is experiencing financial difficulties and, for economic or legal reasons related to these difficulties, the Company grants a concession to the borrower in the restructuring that it would not otherwise consider. The Company has granted a concession when, as a result of the restructuring, it does not expect to collect all amounts due or within the time periods originally due under the original contract, including one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a temporary forbearance with regard to the payment of principal or interest. All TDRs are reviewed for potential impairment. Generally, a nonaccrual loan that is restructured remains on nonaccrual status for a minimum period of six months to demonstrate that the borrower can perform under the restructured terms. If the borrower’s performance under the new terms is not reasonably assured, the loan remains classified as a nonaccrual loan. Loans classified as TDRs are reported as loans.
Loans Grading
From a credit risk standpoint, we grade watchlist and problem loans into one of five categories: pass, special mention, substandard, doubtful or loss. The classifications of loans reflect a judgment about the risks of default and loss associated with the loan. We review the ratings on credits regularly. Ratings are adjusted regularly to reflect the degree of risk and loss that our management believes to be appropriate for each credit. Our methodology is structured so that specific reserve allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss).
The following table presents the loan balances by segment as well as risk rating. No assets were classified as loss during the periods presented.
LOAN CLASSIFICATION
Credit Risk Grades
Pass
Special Mention
Substandard
Doubtful
Total
(Dollars in thousands)
December 31, 2021
Real estate loans:
One-to-four family
Multi-family
Commercial
Construction
Commercial and industrial
Reverse mortgage and other
Mortgage warehouse
Total loans held-for-investment
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Credit Risk Grades
Pass
Special Mention
Substandard
Doubtful
Total
(Dollars in thousands)
December 31, 2020
Real estate loans:
One-to-four family
Multi-family
Commercial
Construction
Commercial and industrial
Reverse mortgage and other
Mortgage warehouse
Total loans held-for-investment
Allowance for Loan Losses
We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts, or at all. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of our loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. See “Critical Accounting Policies—Allowance for Loan .”
The following table presents a summary of changes in the allowance for loan losses for the periods and dates indicated:
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
For the Years Ended December 31,
(Dollars in thousands)
Allowance for loan losses at beginning of period
Charge-offs:
Real estate:
One-to-four family
Total charge-offs
Total recoveries
Net charge-offs
Provision for loan losses
Allowance for loan losses at period end
Total loans outstanding (end of period)
Average loans outstanding
Allowance for loan losses to period end loans
Net charge-offs to average loans
Net charge-offs to average loans by segment:
Real estate:
One-to-four family
Our allowance for loan losses at December 31, 2021 and 2020 was $6.9 million, or 0.77% and 0.92% of loans for each respective period-end. The overall level of the allowance was based on Silvergate’s historically strong credit quality and
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minimal loan charge-offs, and the loan-to-values ratios in the low- to mid-50% range, based on last required appraisal value, in the Company’s commercial, multi-family and one-to-four family real estate loans as of December 31, 2021. The decrease in the ratio of the allowance for loan losses to loans held-for-investment from December 31, 2020 was due to the changes in loan product and segment mix.
We had no charge-offs and no recoveries for the year ended December 31, 2021 compared to charge-offs of $17,000 and no recoveries for the year ended December 31, 2020.
Although we believe that we have established our allowance for loan losses in accordance with GAAP and that the allowance for loan losses was adequate to provide for known and inherent losses in the portfolio at all times shown above, future provisions for loan losses will be subject to ongoing evaluations of the risks in our loan portfolio.
The following table shows the allocation of the allowance for loan losses among loan categories and certain other information as of the dates indicated. The total allowance is available to absorb losses from any loan category.
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
As of December 31,
Amount
Percent (1)
Amount
Percent (1)
(Dollars in thousands)
Real estate:
One-to-four family
Multi-family
Commercial
Construction
Commercial and industrial
Reverse mortgage and other
Mortgage warehouse
Total allowance for loan losses
(1) Loan amount as a percentage of total loans.
Deposits
Deposits are the major source of funding for the Company, substantially all of which are derived from our digital currency customer base. Deposits increased $9.0 billion, or 172.3%, to $14.3 billion at December 31, 2021 compared to $5.2 billion at December 31, 2020. Noninterest bearing deposits totaled $14.2 billion (representing approximately 99.5% of total deposits) at December 31, 2021, compared to $5.1 billion (representing approximately 97.8% of total deposits) at December 31, 2020. The increase in total deposits from the prior year end was driven by an increase in deposits from digital currency exchanges, institutional investors in digital assets and other fintech related customers.
At December 31, 2021, deposits by foreign depositors amounted to $4.0 billion, or 28.0% of total deposits, compared to $1.4 billion, or 27.6% of total deposits, at December 31, 2020.
Deposits that meet or exceed the FDIC insurance limit of $250,000 and over totaled $14.1 billion at December 31, 2021. The amounts stated for uninsured deposits as of the reported period are estimates due to the impracticability of precisely measuring amounts of uninsured deposits for accounts held through fiduciary relationships, some portion of which may qualify for “pass-through” insurance coverage under FDIC regulations. Accordingly, a portion of our reported uninsured deposits may be eligible for pass-through deposit insurance coverage. There were no uninsured certificates of deposit at December 31, 2021.
Our continued growth has been accompanied by significant fluctuations in the level of our deposits, in particular our deposits from customers in the digital currency industry, as our customers in this industry typically carry higher balances over the weekend to take advantage of the 24/7 availability of the SEN, and carry lower balances during the business week. The Bank’s average total digital currency deposits during the year ended December 31, 2021 amounted to $10.2 billion and the high and low daily total digital currency deposit levels during such time were $16.0 billion and $4.6 billion, respectively, compared to an average of $1.9 billion during the year ended December 31, 2020, and a high and low daily deposit levels of $5.0 billion and $1.1 billion, respectively.
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Demand for new deposit accounts is generated by the Company’s banking platform for innovators that includes the SEN, which is enabled through Silvergate’s proprietary API, and other cash management solutions. These tools enable Silvergate’s clients to grow their business and scale operations. The following table presents a breakdown of our digital currency customer base and the deposits held by such customers at the dates noted below:
December 31,
December 31,
Number of Customers
Total Deposits (1)
Number of Customers
Total Deposits (1)
(Dollars in millions)
Digital currency exchanges
Institutional investors
Other customers
Total
(1) Total deposits may not foot due to rounding.
Our cost of total deposits and our cost of funds was 0.00% and 0.01%, respectively, for the year ended December 31, 2021 as compared to 0.27% and 0.32%, respectively, for the year ended December 31, 2020. The decrease in the weighted average cost of deposits and cost of funds compared to the prior period was driven by the absence of any interest expense associated with brokered certificates of deposit, which were called in the second quarter of 2020, and due to higher balances of noninterest bearing deposits.
The following table presents the average balances and average rates paid on deposits for the periods indicated:
COMPOSITION OF DEPOSITS
Year Ended December 31,
Average
Balance
Average
Rate
Average
Balance
Average
Rate
(Dollars in thousands)
Noninterest bearing demand accounts (1)
Interest bearing accounts:
Interest bearing demand accounts
Money market and savings accounts (2)
Certificates of deposit:
Brokered certificates of deposit
Other
Total interest bearing deposits
Total deposits
(1) Noninterest bearing demand accounts includes an average balance of $3.1 billion of foreign deposits for the year ended December 31, 2021. Data is not available for 2020.
(2) Money market and savings accounts includes an average balance of $0.5 million of foreign deposits with an average rate paid of 0.05% for the year ended December 31, 2021. Data is not available for 2020.
Borrowings
We primarily utilize short-term and long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below.
FHLB Advances . The FHLB allows us to borrow up to 35% of the Bank’s assets on a blanket floating lien status collateralized by certain securities and loans. As of December 31, 2021, approximately $1.4 billion in real estate loans were pledged as collateral for our FHLB borrowings. We may use these borrowings to meet liquidity needs and to fund certain loans in our portfolio. As of December 31, 2021, we had no outstanding FHLB advances and had an additional $973.9 million in available borrowing capacity from the FHLB.
Federal Reserve Bank of San Francisco . The FRB has an available borrower in custody arrangement that allows us to borrow on a collateralized basis. The Banks’s borrowing capacity under the Federal Reserve’s discount window program was
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$5.2 million as of December 31, 2021. Certain commercial loans are pledged under this arrangement. We maintain this borrowing arrangement to meet liquidity needs pursuant to our contingency funding plan. No advances were outstanding under this facility as of December 31, 2021.
The Company has also issued subordinated debentures and has access to borrow federal funds or lines of credit with correspondent banks. At December 31, 2021, these borrowings amounted to $15.8 million.
Subordinated Debentures. A trust formed by the Company issued $12.5 million of floating rate trust preferred securities in July 2001 as part of a pooled offering of such securities. The Company issued subordinated debentures to the trust in exchange for its proceeds from the offering. The debentures and related accrued interest represent substantially all the assets of the trust. The subordinated debentures bear interest at six-month London Interbank Offered Rate (or “LIBOR”) plus 375 basis points, which adjusts every six months in January and July of each year. Interest is payable semiannually. At December 31, 2021, the interest rate for the Company’s next scheduled payment was 3.91%, based on six-month LIBOR of 0.16%. On any January 25 or July 25 the Company may redeem the 2001 subordinated debentures at 100% of principal amount plus accrued interest. The 2001 subordinated debentures mature on July 25, 2031.
A second trust formed by the Company issued $3.0 million of trust preferred securities in January 2005 as part of a pooled offering of such securities. The Company issued subordinated debentures to the trust in exchange for its proceeds from the offering. The debentures and related accrued interest represent substantially all the assets of the trust. The subordinated debentures bear interest at three-month LIBOR plus 185 basis points, which adjusts every three months. Interest is payable quarterly. At December 31, 2021, the interest rate for the Company’s next scheduled payment was 2.05%, based on three-month LIBOR of 0.20%. On the 15th day of any March, June, September, or December, the Company may redeem the 2005 subordinated debentures at 100% of principal amount plus accrued interest. The 2005 subordinated debentures mature on March 15, 2035.
The Company also retained a 3% minority interest in each of these trusts which is included in subordinated debentures. The balance of the equity in the trusts is comprised of mandatorily redeemable preferred securities. The subordinated debentures may be included in Tier I capital (with certain limitations applicable) under current regulatory guidelines and interpretations. The Company has the right to defer interest payments on the subordinated debentures from time to time for a period not to exceed five years.
Other Borrowings . At December 31, 2021, the Company had no outstanding balance of federal funds purchased and had available lines of credit of $108.0 million with other correspondent banks.
Liquidity and Capital Resources
Liquidity
Liquidity is defined as the Bank’s capacity to meet its cash and collateral obligations at a reasonable cost. Maintaining an adequate level of liquidity depends on the Bank’s ability to meet both expected and unexpected cash flows and collateral needs efficiently without adversely affecting either daily operations or the financial condition of the Bank. Liquidity risk is the risk that we will be unable to meet our obligations as they become due because of an inability to liquidate assets or obtain adequate funding. The Bank’s obligations, and the funding sources used to meet them, depend significantly on our business mix, balance sheet structure and the cash flow profiles of our on- and off-balance sheet obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints on the ability to convert assets into cash or in accessing sources of funds (i.e., market liquidity) and contingent liquidity events. Changes in economic conditions or exposure to credit, market, operation, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity and asset/liability management.
We maintain high levels of liquidity for our customers who operate in the digital currency industry, as these deposits are subject to potentially dramatic fluctuations due to certain factors that may be outside of our control. As a result, we have a significant amount of interest earning deposits in other banks and our investment portfolio is comprised primarily of mortgage-backed securities backed by government-sponsored entities, collateralized mortgage obligations, municipal bonds and asset-backed securities.
Management has established a comprehensive management process for identifying, measuring, monitoring and controlling liquidity risk. Because of its critical importance to the viability of the Bank, liquidity risk management is fully integrated into our risk management processes. Critical elements of our liquidity risk management include: effective corporate governance consisting of oversight by the board of directors and active involvement by management; appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; comprehensive liquidity risk measurement and monitoring systems (including assessments of the current and prospective cash flows or sources and uses of funds) that are commensurate with the complexity and business activities of the Bank; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of cash and cash equivalents and
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highly liquid marketable securities free of legal, regulatory or operational impediments, that can be used to meet liquidity needs in stressful situations; comprehensive contingency funding plans that sufficiently address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes sufficient to determine the adequacy of the institution’s liquidity risk management process.
The movement of funds on our balance sheet among different SEN deposit customers does not reduce the Bank’s deposits and thus does not result in liquidity issues or require any borrowing by the Company or the Bank. In addition, to the extent that SEN participants fully withdraw funds from the Bank, no material liquidity issues or borrowing needs would arise since the majority of SEN participants deposits are held in liquid assets, such as available-for-sale securities and cash, or used to fund short-term mortgage warehouse loans.
We expect funds to be available from basic banking activity sources, including the core deposit base, the repayment and maturity of loans and investment security cash flows. Other potential funding sources include borrowings from the FHLB, the FRB, other lines of credit and brokered certificates of deposit. As of December 31, 2021, we had $973.9 million of available borrowing capacity from the FHLB, $5.2 million of available borrowing capacity from the FRB and available lines of credit of $108.0 million with other correspondent banks. Cash and cash equivalents at December 31, 2021 were $5.4 billion. Accordingly, our liquidity resources were at sufficient levels to fund loans and meet other cash needs as necessary.
Off-Balance Sheet Items
In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated statements of financial condition. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and issue letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk exceeding the amounts recognized in our consolidated statements of financial condition. Our exposure to credit loss is represented by the contractual amounts of these commitments. The same credit policies and procedures are used in making these commitments as for on-balance sheet instruments. We are not aware of any accounting loss to be incurred by funding these commitments; however, we maintain an allowance for off-balance sheet credit risk which is recorded in other liabilities on the consolidated statements of financial condition. At December 31, 2021, we had $248.6 million of credit extension commitments. For details of our commitments to extend credit, and commercial and standby letters of credit, please refer to “Note 10—Commitments and Contingencies—Off-Balance Sheet Items” of the “Notes to Consolidated Financial Statements” under Part II, Item 8 of this Annual Report on Form 10-K.
Capital Resources
Shareholders’ equity increased $1.3 billion to $1.6 billion at December 31, 2021 compared to $294.3 million at December 31, 2020. The increase in shareholders’ equity was primarily due to three common equity offerings, which resulted in the issuance of a total of 11,164,214 shares of Class A common stock for net proceeds of $1.1 billion after deducting underwriting discounts, commissions and offering expenses, as applicable, and a $200.0 million preferred equity offering that resulted in net proceeds of $193.6 million. In addition, net income available to common shareholders after payment of $3.0 million in preferred stock dividends, for the year ended December 31, 2021 amounted to $75.5 million, which was partially offset by a decrease in accumulated other comprehensive income of $53.0 million, due to the decrease in unrealized gains on available-for-sale securities portfolio and derivative assets.
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and 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.
As of December 31, 2021, the Bank was in compliance with all applicable regulatory capital requirements to which it was subject, and was classified as “well capitalized” for purposes of the prompt corrective action regulations. As we deploy our capital and continue to grow our operations, our regulatory capital levels may decrease depending on our level of earnings. However, we intend to monitor and control our growth to remain in compliance with all regulatory capital standards applicable to us.
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The following table presents the regulatory capital ratios for the Company and the Bank as of the dates indicated:
Actual
Minimum capital
adequacy (1)
To be well
capitalized
Amount
Ratio
Amount
Ratio
Amount
Ratio
(Dollars in thousands)
December 31, 2021
The Company
Tier 1 leverage ratio
Common equity tier 1 capital ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
The Bank
Tier 1 leverage ratio
Common equity tier 1 capital ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
Actual
Minimum capital
adequacy
To be well
capitalized
Amount
Ratio
Amount
Ratio
Amount
Ratio
(Dollars in thousands)
December 31, 2020
The Company
Tier 1 leverage ratio
Common equity tier 1 capital ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
The Bank
Tier 1 leverage ratio
Common equity tier 1 capital ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
Critical Accounting Estimates
The preparation of our consolidated financial statements in accordance with GAAP requires us to make estimates and judgments that affect our reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under current circumstances, results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. We evaluate our estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.
Accounting policies, as described in detail in the notes to our consolidated financial statements, included elsewhere in this Annual Report on Form 10-K, are an integral part of our financial statements. A thorough understanding of these accounting policies is essential when reviewing our reported results of operations and our financial position. We believe that the critical accounting policies and estimates discussed below require us to make difficult, subjective or complex judgments about matters that are inherently uncertain. Changes in these estimates, which are likely to occur from period to period, or use of different estimates that we could have reasonably used in the current period, would have a material impact on our financial position, results of operations or liquidity.
See “Note 1—Nature of Business and Summary of Significant Accounting Policies” in our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information.
Allowance for Loan Losses. The allowance for loan losses is a valuation allowance for probable incurred credit losses. Management groups loans into different categories based on loan type to determine the appropriate allowance for each loan
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group. Management estimates the allowance balance required using past loan loss experience, current economic conditions, the nature and volume of the portfolio, information about specific borrower situations, estimated collateral values and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Amounts are charged off when available information confirms that specific loans, or portions thereof, are uncollectible. This methodology for determining charge-offs is consistently applied to each group of loans. Loans that are deemed to be uncollectible are charged off and deducted from the allowance for loan losses. The provision for loan losses and recoveries on loans previously charged off are credited to the allowance for loan losses.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered TDRs and classified as impaired.
The general component covers loans that are collectively evaluated for impairment and loans that are not individually identified for impairment evaluation. The general component is based on historical loss experience adjusted for current factors and includes actual loss history experienced for the preceding rolling twelve year period or less, if twelve years of data is not available. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment using a qualitative scorecard model.
Management’s determination of the adequacy of the level of the allowance for loan losses is based on periodic evaluations of the loan portfolio and other relevant factors which are inherently subjective as it requires significant estimates by management. These factors may be susceptible to significant change. Specific reserves reflect estimated losses on impaired loans from managements analyses which involve a high degree of judgement in estimating the amount of loss associated with specific loans, including the amount and timing of future cash flows and collateral values. The general reserve is based on estimate losses of homogeneous loans based historical loss experience, qualitative factors and consideration of current economic trends and conditions. The allowance for loan losses at December 31, 2021 and 2020 was $6.9 million.
Securities. Management determines the appropriate classification of debt securities at the time of purchase. The fair values of securities available-for-sale and trading securities are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2), using matrix pricing. Matrix pricing is a mathematical technique commonly used to price debt securities that are not actively traded, which values debt securities without relying exclusively on quoted prices for specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). Securities to be held for indefinite periods of time, but not necessarily to be held-to-maturity or on a long-term basis, are classified as available-for-sale and carried at fair value, with unrealized gains or losses, net of applicable deferred income taxes, reported as a separate component of shareholders’ equity in accumulated other comprehensive income.
The valuation of debt securities involves significant judgment, is subject to variability, is established using management's best estimate, and is revised as additional information becomes available. Due to the subjective nature of the valuation process, it is possible that the actual fair values of these investments could differ from the estimated amounts, thereby affecting our financial position, results of operations and cash flows.
The fair values of investment securities are generally determined by various pricing models. Our procedures include initial and ongoing review of pricing methodologies and trends. We perform an analysis on the pricing of investment securities to ensure that the prices represent a reasonable estimate of the fair value. Depending upon the type of security, management employs various techniques to analyze the pricing it receives from third-parties, such as reviewing model inputs, reviewing comparable trades, analyzing changes in market yields and, in certain instances, reviewing the underlying collateral of the security. Management reviews changes in fair values from period to period and performs testing to ensure that the prices received from third parties are consistent with their expectation of the market.
