Real-time Form 4 intelligence. Smarter insider tracking.
YoY shift: Neutral
Year-over-year tone shift - average net-tone change across Risk Factors and MD&A vs the prior 10-K. This filing is -0.08pp more bearish than last year's.
Why YoY instead of absolute: the LM lexicon has ~6.6× more negative words than positive (legal/risk-disclosure language is heavy on hedging), so every 10-K reads bearish on raw tone. Year-over-year change strips that bias and surfaces the actual shift in management's framing.
Tone shift by section
The two components the gauge averages: how Risk Factors and MD&A each shifted in net tone versus last year's 10-K. The headline above is their average, so a green needle over a soft section just means the other section carried it.
Risk Factors
-0.16pp
Flat
Net-tone change vs last year's 10-K.
MD&A
-0.01pp
Flat
Net-tone change vs last year's 10-K.
Per-snippet highlights
Sentence-level sentiment highlighting with category and subcategory filters is coming once the snippet-scoring pipeline lands. For now, dig into the actual section text on the Sections tab.
Language change vs prior 10-K
Risk Factors (Item 1A) - words with the biggest YoY frequency increase
Negative rising
litigation+7
decline+7
adverse+5
loss+3
downturn+3
Positive rising
greater+4
leadership+3
success+2
successful+1
valuable+1
Risk Factors (Item 1A)
12,744 words
Item 1A. Risk Factors
You should consider carefully the following risks, along with the other information contained in and incorporated into this report. The risks and uncertainties described below are not the only ones that may affect us. Additional risks and uncertainties also may adversely affect our business and operations. If any of the following events actually occur, our business and financial results could be materially adversely affected.
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Economic and Geographic-Related Risks
The global COVID-19 pandemic has adversely affected our business, financial condition and results of operations, and the ultimate effect of the pandemic on our business, financial condition and results of operations will depend on future developments and other factors that are highly uncertain.
The global COVID-19 pandemic and related government-imposed and other measures intended to control the spread of the disease, including restrictions on travel and the conduct of business, such as stay-at-home orders, quarantines, travel bans, border closings, business and school closures and other similar measures, have had a significant impact on global economic conditions and have impacted certain aspects of our business, financial condition and results of operations, and may continue to do so in the future. The governmental and social response to the COVID-19 pandemic has resulted in an unprecedented -down in economic activity and a related increase in . The COVID-19 pandemic, and related efforts to contain it, have also caused significant in the functioning of the financial markets and have increased economic and market uncertainty and .
Language change vs prior 10-K
MD&A (Item 7) - words with the biggest YoY frequency increase
Negative rising
impairment+26
nonperforming+15
litigation+7
adversely+5
unemployment+4
Positive rising
gains+6
advances+4
benefit+4
strong+4
favorably+3
MD&A (Item 7)
24,980 words
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion provides additional information regarding our operations for the twelve-month periods ending December 31, 2020, 2019 and 2018, and financial condition at December 31, 2020 and 2019, and should be read in conjunction with our Consolidated Financial Statements and related notes that appear elsewhere in this report. Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods.
We have made, and will continue to make, various forward-looking statements with respect to financial, business and economic matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this report.
Overview
Howard Bancorp, Inc. is the holding company for Howard Bank. Howard Bank was formed in 2004. Howard Bank’s business has consisted primarily of originating both commercial and real estate loans secured by property in our market area. We are headquartered in Baltimore, Maryland. We consider our primary market area to be the Greater Baltimore Metropolitan Area. We engage in a general commercial banking business, making various types of loans and accepting deposits. We market our financial services primarily to small- and medium-sized businesses and their owners, professionals and executives, and high-net-worth individuals. Our loans are primarily funded by core deposits of customers in our market.
Given the ongoing, dynamic and unprecedented nature of the COVID-19 pandemic, it is difficult to predict the full impact the pandemic will have on our business. While certain factors point to improving economic conditions, uncertainty remains regarding the path of the economic recovery, the mitigating impacts of government interventions, the success of vaccine distribution and the efficacy of administered vaccines, as well as the effects of the change in leadership resulting from the recent elections. The COVID-19 pandemic may subject us to any of the following risks, any of which could have a material adverse effect on our business, financial condition, liquidity, results of operations, risk-weighted assets and regulatory capital:
● because the incidence of reported COVID-19 cases and related hospitalizations and deaths varies significantly by state and locality, the economic downturn caused by the pandemic may be deeper and more sustained in certain areas, including those in which we do business, relative to other areas of the country;
● our ability to market our products and services may be impaired by a variety of external factors, including a prolonged reduction in economic activity and continued economic and financial market volatility, which could cause demand for our products and services to decline, in turn making it difficult for us to grow assets and income;
● if the economy is unable to substantially reopen and high levels of unemployment continue for an extended period of time, loan delinquencies, problem assets, and foreclosures may increase, resulting in increased charges and reduced income;
● collateral for loans, especially real estate, may decline in value, which may reduce our ability to liquidate such collateral and could cause loan losses to increase and impair our ability over the long run to maintain our targeted loan origination volume;
● our allowance for loan and lease losses may have to be increased if borrowers experience financial difficulties beyond forbearance periods, which will adversely affect our net income;
● an increase in non-performing loans due to the COVID-19 pandemic would result in a corresponding increase in the risk-weighting of assets and therefore an increase in required regulatory capital;
● the net worth and liquidity of borrowers and loan guarantors may decline, impairing their ability to honor commitments to us;
● as the result of the reduction of the FRB’s target federal funds rate to near 0%, the yield on our assets may decline to a greater extent than the decline in our cost of interest-bearing liabilities, reducing our net interest margin and spread and reducing net income;
● deposits could decline if customers need to draw on available balances as a result of the economic downturn;
● the borrowing needs of our clients may increase, especially during this challenging economic environment, which could result in increased borrowing against our contractual obligations to extend credit;
● we face heightened cybersecurity risk in connection with our operation of a remote working environment, which risks include, among others, greater phishing, malware, and other cybersecurity attacks, vulnerability to disruptions of our information technology infrastructure and telecommunications systems, increased risk of unauthorized dissemination of confidential information, limited ability to restore our systems in the event of a systems failure or interruption, greater risk of a security breach resulting in destruction or misuse of valuable information, and potential impairment of our ability to perform critical functions—all of which could expose us
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to risks of data or financial loss, litigation and liability and could seriouslydisrupt our operations and the operations of any impacted customers;
● we rely on third party vendors for certain services and the unavailability of a critical service or limitations on the business capacities of our vendors for extended periods of time due to the COVID-19 pandemic could have an adverse effect on our operations; and
● as a result of the COVID-19 pandemic, there may be unexpected developments in financial markets, legislation, regulations and consumer and customer behavior.
Even after the COVID-19 outbreak has subsided, we may continue to experience materially adverse impacts to our business as a result of the virus’ global economic impact, including the availability of credit, adverse impacts on our liquidity and any recession that has occurred or may occur in the future. There are no comparable recent events that provide guidance as to the effect the spread of COVID-19 as a global pandemic may have, and, as a result, the ultimate impact of the outbreak is highly uncertain and subject to change. We do not yet know the full extent of the impacts on our business, our operations or the global economy as a whole. However, the effects could have a material impact on our results of operations and heighten many of our known risks described herein.
Our business may be adversely affected by economic conditions.
Our financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services we offer and whose success we rely on to drive our growth, is highly dependent upon the business environment in the primary markets where we operate and in the United States as a whole. Unlike larger banks that are more geographically diversified, we are a regional bank that provides banking and financial services to customers primarily in the Great Baltimore Metropolitan area. The economic conditions in this local market may be different from, and in some instances worse than, the economic conditions in the United States as a whole. In addition, due to the proximity of our primary market area to Washington, D.C., decreases in spending by the Federal government or cuts to Federal government employment could impact us to a greater degree than banks that serve a larger or a different geographical area. Such risks are beyond our control and may have a material adverse effect on our financial condition and results of operations and, in turn, the value of our common stock. Some elements of the business environment that affect our financial performance include short-term and long-term interest rates, the prevailing yield curve, inflation and price levels, monetary and trade policy, unemployment and the strength of the domestic economy and the local economy in the markets in which we operate. Unfavorable market conditions can result in a deterioration in the credit quality of our borrowers and the demand for our products and services, an increase in the number of loan delinquencies, defaults and charge-offs, additional provisions for loan losses, adverse asset values of the collateral securing our loans and an overall material adverse effect on the quality of our loan portfolio. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment; natural disasters; epidemics or pandemics (including COVID-19); or a combination of these or other factors.
The impact of the COVID-19 pandemic is fluid and continues to evolve and there is pervasive uncertainty surrounding the future economic conditions that will emerge in the months and years following the onset of the pandemic. Even after the COVID-19 pandemic subsides, the U.S. economy will likely require some time to recover from its effects, the length of which is unknown, and during which we may experience a recession. In addition, there are continuing concerns related to, among other things, the level of U.S. government debt and fiscal actions that may be taken to address that debt, depressed oil prices and a potential resurgence of economic and political tensions with China that may have a destabilizing effect on financial markets and economic activity. Economic pressure on consumers and overall economic uncertainty may result in changes in consumer and business spending, borrowing and saving habits. These economic conditions and/or other negative developments in the domestic or international credit markets or economies may significantly affect the markets in which we do business, the value of our loans and investments, and our ongoing operations, costs and profitability. Declines in real estate values and sales volumes and high unemployment or underemployment may also result in higher than expected loan delinquencies, increases in our levels of nonperforming and classified assets and a decline in demand for our products and services. These negative events may cause us to incur losses and may adversely affect our capital, liquidity and financial condition.
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Credit, Lending and Interest Rate Risks
Because our loan portfolio consists largely of commercial business and commercial real estate loans, our portfolio carries a higher degree of risk than would a portfolio composed primarily of residential mortgage loans.
Our loan portfolio is made up largely of commercial business loans and commercial real estate loans, most of which is collateralized by real estate. These types of loans generally expose a lender to a higher degree of risk of non-payment and loss than do residential mortgage loans because of several factors, including dependence on the successful operation of a business or a project for repayment, the collateral securing these loans may not be sold as easily as residential real estate, and loan terms with a balloon payment rather than full amortization over the loan term. In addition, commercial real estate and commercial loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one- to four-family residential mortgage loans. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan. Underwriting and portfolio management activities cannot completely eliminate all risks related to these loans. Any significant failure to pay on time by our customers or a significant default by our customers would materially and adversely affect us.
We make both secured and some unsecured commercial and industrial loans. Unsecured loans generally involve a higher degree of risk of loss than do secured loans because, without collateral, repayment is wholly dependent upon the success of the borrowers’ businesses. Secured commercial and industrial loans are generally collateralized by accounts receivable, inventory, equipment or other assets owned by the borrower and include a personal guaranty of the business owner. Compared to real estate, that type of collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed. Further, commercial and industrial loans generally will be serviced primarily from the operation of the business, which may not be successful, and commercial real estate loans generally will be serviced from income on the properties securing the loans.
While any declines in the value of our real estate collateral securing loans have been reflected in existing reserves, the discounts and reserves we have taken against our loan portfolio based on our internal review of economic conditions and their impact on real estate values in our market areas may be insufficient. Deterioration in the real estate market or the economy could adversely affect the value of the properties securing the loans or revenues from borrowers’ businesses, thereby increasing the risk of non-performing loans and increased portfolio losses that could materially and adversely affect us.
The small businesses that make up the majority of our commercial borrowers generally do not have the cash reserves to help cushion them from an economic slowdown to the same extent that large borrowers do and thus may be more heavily impacted by an economic downturn, including the downturn related to the COVID-19 pandemic. Any recession that has occurred due to the COVID-19 pandemic or that may occur and/or other negative developments in the domestic or international credit markets or economies may have a negative effect on the ability of our commercial borrowers to make timely repayments of their loans, which could have an adverse impact on our earnings.
Construction loans are subject to risks during the construction phase that are not present in standard residential real estate and commercial real estate loans. These risks include:
● the viability of the contractor;
● the value of the project being subject to successful completion;
● the contractor’s ability to complete the project, to meet deadlines and time schedules and to stay within cost estimates; and
● concentrations of such loans with a single contractor and its affiliates.
Real estate construction and land loans also present risks of default in the event of declines in property values or volatility in the real estate market during the construction phase. If we are forced to foreclose on a project prior to completion, we may not be able to recover the entire unpaid portion of the loan, may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate amount of time. If any of these risks were to occur, it could adversely affect our financial condition, results of operations and cash flows.
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As of December 31, 2020, our commercial real estate loans were equal to 271% of our total regulatory capital. The federal banking agencies have issued guidance regarding high concentrations of commercial real estate loans within bank loan portfolios. The guidance requires financial institutions that exceed certain levels of commercial real estate lending compared with their total capital to maintain heightened risk management practices that address the following key elements: board and management oversight and strategic planning, portfolio management, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing, and maintenance of increased capital levels as needed to support the level of commercial real estate lending. If there is any deterioration in our commercial real estate or real estate construction and land portfolios or if our regulators conclude that we have not implemented appropriate risk management practices, it could adversely affect our business and result in a requirement that we increase our capital levels, and such capital may not be available to us on acceptable terms or at all.
Because our loan portfolio includes residential real estate loans, our earnings are sensitive to the credit risks associated with these types of loans.
While we ceased originating residential first lien mortgage loans in early 2020, we will continue to originate home equity loans and home equity lines of credit within our local market area. We will also purchase residential first lien mortgage loans in order to offset portfolio runoff. While residential real estate loans are more diversified than loans to commercial borrowers, and our local real estate market and economy have historically performed better than many other markets, a prolongeddownturn related to the COVID-19 pandemic could cause higher unemployment, more delinquencies, and could adversely affect the value of properties securing loans in our portfolio. In addition, should values begin to decline again, the real estate market may take longer to recover or not recover to previous levels. These risks increase the probability of an adverse impact on our financial results as fewer borrowers would be eligible to borrow and property values could be below necessary levels required for adequate coverage on the requested loan.
If our allowance for loan and lease losses is not sufficient to cover actual loan losses, our earnings would decrease.
We are exposed to the risk that our customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans will not be sufficient to ensure full repayment. Credit losses are inherent in the lending business and could have a material adverse effect on our operating results and ability to meet our obligations. Volatility and deterioration in domestic markets may also increase our risk for credit losses. We maintain an allowance for loan and lease losses that we believe is adequate for absorbing any potential losses in our loan portfolio. Management, through a periodic review and consideration of our loan portfolio, determines the amount of the allowance for loan and lease losses. We cannot, however, predict with certainty the amount of probable losses in our portfolio or be sure that our allowance will be adequate in the future. If management’s assumptions and judgments prove to be incorrect and the allowance for loan and lease losses is inadequate to absorb future losses, our losses will increase and our earnings will suffer.
We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan and lease losses, we review our loans and our loss and delinquency experience, and we evaluate economic conditions. If our assumptions are incorrect, our allowance for loan and lease losses may not be sufficient to cover probable incurred losses in our loan portfolio, resulting in additions to the allowance and a corresponding decrease to earnings. We expect economic uncertainty to continue in 2021, and further deterioration in economic conditions may result in a significant increase to our allowance for loan losses in future periods. Material additions to the allowance could materially decrease our net income. If delinquencies and defaults should increase, we may be required to further increase our provision for loan losses.
In addition, bank regulators periodically review our allowance for loan and lease losses and may require us to increase our provision for credit losses or recognize further loan charge-offs to the allowance for loan and lease losses. Any increase in the allowance for loan and lease losses or loan charge-offs might have a material adverse effect on our financial condition and results of operations.
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Our financial condition, earnings and asset quality could be adversely affected if we are required to repurchase loans originated for sale by our former mortgage banking division.
As discussed in “Item 1. Business — Mortgage Banking,” most loans that we sold in the secondary market are with recourse. Therefore, we may be required to repurchase a previously sold mortgage loan or indemnify the purchaser if there is non-compliance with defined loan origination or documentation standards, including fraud, negligence or material misstatement in the loan documents, if the mortgagor has defaulted early in the loan term, or noncompliance with applicable law. While to date we have only had to repurchase a minimal amount of loans previously sold, should repurchases become a material issue, our earnings and asset quality could be adversely impacted, which could adversely impact the market price of our common stock.
Certain of our estimates related to accounting for acquired loans may differ from actual results.
The application of the purchase method of accounting in our prior mergers and any future mergers or acquisitions will impact our allowance for loan and lease losses. Under the purchase method of accounting, all acquired loans were recorded in our Consolidated Financial Statements at their estimated fair value at the time of acquisition and any related allowance for loan and lease loss was eliminated because credit quality, among other factors, was considered in the determination of fair value. To the extent that our estimates of fair value are too high, we will incur losses associated with the acquired loans. The allowance associated with our acquired credit impaired loans reflects deterioration in cash flows since acquisition resulting from our quarterly re-estimation of cash flows which involves complex cash flow projections and significant judgment on timing of loan resolution.
If the estimates we have made regarding the performance of loans we have acquired are inaccurate, the fair value estimates may exceed the actual collectability of the balances, and this may result in the related loans being considered by us as impaired, which would result in a reduction in interest income. The tangible book value we measure is based in part on these estimates, and if fair value estimates differ from actual collectability, then subsequent earnings may also differ from original estimates. Measures of tangible book value and earnings impact of business combinations are frequently used in evaluating the merits and value of business combinations. Numerous assumptions and estimates are integral to purchased loan accounting, and actual results could be different from prior estimates.
The small and medium-sized businesses that we lend to may have fewer resources to weather a downturn in the economy, which may impair a borrower’s ability to repay a loan to the Bank that could materially harm our operating results.
We target our business development and marketing strategy primarily to serve the banking and financial services needs of small and medium-sized businesses. These small and medium-sized businesses frequently have a smaller market share than their competition, may be more vulnerable to economic downturns, may need substantial additional capital to expand or compete and may experience significant volatility in operating results. Any one or more of these factors may impair their ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on its business and its ability to repay a loan. As a result, economic downturns and other events that negatively impact our market areas and the businesses we serve could cause us to incur substantial credit losses that could negatively affect our results of operations and financial condition.
Our profitability depends on interest rates, and changes in interest rates could have an adverse impact on our results of operations and financial condition.
Our results of operations depends to a large extent on our “net interest income,” which is the difference between the interest income received from our interest-earning assets, such as loans and investment securities, and the interest expense incurred in connection with our interest-bearing liabilities, such as interest on deposit accounts. Changes in interest rates can increase or decrease our net interest income, because different types of assets and liabilities may react differently, and at different times, to market interest rate changes. When interest bearing liabilities mature or reprice more quickly than interest earning assets in a period, an increase in interest rates could reduce net interest income. Similarly, when interest earning assets mature or reprice more quickly than interest bearing liabilities, falling interest rates could reduce net interest
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income. Additionally, an increase in interest rates may, among other things, reduce loan demand and our ability to originate loans (which would also decrease our ability to generate noninterest income through the sale of loans into the secondary market), and make it more difficult for borrowers to repay adjustable-rate loans or otherwise decrease loan repayment rates. A decrease in the general level of interest rates may affect us through, among other things, increased prepayments on our loan and mortgage-backed securities portfolios and increased competition for deposits. Accordingly, changes in the level of market interest rates affect our net yield on interest earning assets, loan origination volume, loan and mortgage-backed securities portfolios, and our overall results. Fluctuations in interest rates are highly sensitive to many factors that are not predictable or controllable. Therefore, while we attempt to manage our risk from changes in market interest rates by adjusting the rates, maturity, repricing, and balances of the different types of interest-earning assets and interest bearing liabilities, we might not be able to maintain a consistent positive spread between the interest that we receive and the interest that we pay. As a result, a rapid increase or decrease in interest rates could have an adverse effect on our net interest margin and results of operations.
In addition, as market interest rates rise, we will have competitive pressures to increase the rates we pay on deposits. Because interest rates we pay on our deposits could be expected to increase more quickly than the increase in the yields we earn on our interest-earning assets, our net interest income would be adversely affected.
Governmental economic and monetary policy will influence our results of operations. The rates of interest payable on deposits and chargeable on loans are affected by monetary policy as determined by various governmental and regulatory authorities, in particular the FRB, as well as by national, state and local economic conditions. In response to the COVID-19 pandemic, the Federal Open Market Committee cut short-term interest rates to a record low range of 0% to 0.25%, and the FRB has indicated it expects rates to remain within this range through 2023 and possibly longer. If short-term interest rates continue to remain at their historically low levels for a prolonged period and assuming longer term interest rates fall further, we could experience net interest margin compression as our interest-earning assets would continue to reprice downward while our interest-bearing liability rates could fail to decline in tandem, which would have an adverse effect on our net interest income. If rates remain relatively low it could create deflationary pressures, which while possibly lowering our operating costs, could have a negative impact on our borrowers, especially our commercial borrowers, and the values of collateral securing our loans, which could negatively affect our financial performance. If the FRB increases the federal funds rate, overall interest rates will likely rise, which may negatively impact the housing markets and U.S. economic growth.
We also are subject to reinvestment risk associated with changes in interest rates. Changes in interest rates may affect the average life of loans and mortgage-related securities. Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce borrowing costs. Under these circumstances, we are subject to reinvestment risk to the extent that we are unable to reinvest the cash received from such prepayments at rates that are comparable to the interest rates on existing loans and securities.
Capital and Liquidity Risks
We may be subject to more stringent capital requirements in the future.
We are subject to regulatory requirements specifying minimum amounts and types of capital that we must maintain. From time to time, the regulators change these regulatory capital adequacy guidelines. If we fail to meet these minimum capital guidelines and other regulatory requirements, we may be restricted in the types of activities we may conduct and we may be prohibited from taking certain capital actions, such as paying dividends and repurchasing or redeeming capital securities.
In particular, the capital requirements applicable to the Bank under the Basel III rules become fully phased-in on January 1, 2019. The Bank is now required to satisfy additional, more stringent, capital adequacy standards than it had in the past. While we expect to meet the requirements of the Basel III rules, we may fail to do so. Failure to meet minimum capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on our financial condition and results of operations. In addition, these requirements could have a negative impact on our ability to lend, grow deposit balances, make acquisitions or make capital distributions in the form of dividends or share repurchases. Higher capital levels could also lower our return on equity.
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Our investment securities portfolio is subject to credit risk, market risk, and liquidity risk.
Our investment securities portfolio is subject to risks beyond our control that may significantly influence its fair value. These include, but are not limited to, rating agency downgrades of the securities, defaults of the issuers of the securities, lack of market pricing of the securities, and instability in the credit markets. Lack of market activity with respect to some securities has, in certain circumstances, required us to base their fair market valuation on unobservable inputs. Any changes in these risk factors, in current accounting principles or interpretations of these principles could impact our assessment of fair value and thus the determination of other-than-temporary impairment of the securities in the investment securities portfolio. Investment securities that previously were determined to be other-than-temporarily impaired could require further write-downs due to continued erosion of the creditworthiness of the issuer. Write-downs of investment securities would negatively affect our earnings and regulatory capital ratios.
Further, most of our securities investment portfolio as of December 31, 2020 has been designated as available for sale pursuant to Accounting Standards Codification (“ASC”) Topic 320 – “Investments.” ASC Topic 320 requires that unrealized gains and losses in the estimated value of the available for sale portfolio be “marked to market” and reflected as a separate item in stockholders’ equity, net of tax. If the market value of the investment portfolio declines, this could cause a corresponding decline in stockholders’ equity.
We are subject to liquidity risks.
Market conditions could negatively affect the level or cost of available liquidity, which would affect our ongoing ability to accommodate liability maturities and deposit withdrawals, meet contractual obligations, and fund asset growth and new business transactions at a reasonable cost, in a timely manner, and without adverse consequences. Core deposits are our primary source of funding, but this is supplemented by overnight unsecured master notes, customer repurchase agreements, FHLB advances, the FRB Discount Window, subordinated debentures and other purchased funds. A significant decrease in our core deposits, an inability to renew FHLB advances or access the Discount Window, an inability to obtain alternative funding to core deposits or our other traditional sources of funds, or a substantial, unexpected, or prolonged change in the level or cost of liquidity could have a negative effect on our business, financial condition and results of operations.
We may be required to raise additional capital in the future, but that capital may not be available when it is needed on attractive terms, or at all.
We are required by regulatory authorities to maintain adequate levels of capital to support our operations. Our capital requirements for the foreseeable future are currently satisfied. We may at some point, however, need to raise additional capital to support our continued growth or if our liquidity is adversely affected by external factors such as a return of recessionary conditions and/or other negative developments in the domestic or international credit markets. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control. Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations could be materially impaired, or the failure to raise additional capital could have a material adverse effect on our liquidity, financial condition or results of operations. In addition, if we decide to raise additional equity capital, your interest in the Company could be diluted. Furthermore, if we raise additional capital through the issuance of debt securities, there can be no assurance that sufficient revenues or cash flow will exist to service such debt.
Risks Related to Our Industry
The phase-out of LIBOR could negatively impact our net interest income and require significant operational work.
The United Kingdom’s Financial Conduct Authority, which regulates the London Interbank Offered Rate (“LIBOR”), has announced that it will not compel panel banks to contribute to LIBOR after 2021. The discontinuance of LIBOR has resulted in significant uncertainty regarding the transition to suitable alternative reference rates and could adversely impact our business, operations, and financial results.
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The FRB, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, has endorsed replacing the U.S. dollar LIBOR with a new index calculated by short-term repurchase agreements, backed by Treasury securities (“SOFR”). SOFR is observed and backward looking, which stands in contrast with LIBOR under the current methodology, which is an estimated forward-looking rate and relies, to some degree, on the expert judgment of submitting panel members. Given that SOFR is a secured rate backed by government securities, it will be a rate that does not take into account bank credit risk (as is the case with LIBOR). In November 2020, the federal banking agencies issued a statement that says that banks may use any reference rate for its loans that the bank determines to be appropriate for its funding model and customer needs.
We have substantial exposure to LIBOR-based products, including loans, securities, derivatives and hedges, and we are preparing to transition away from the widespread use of LIBOR to alternative rates. We continue to monitor the market's progress toward an alternative to LIBOR, but are not yet comfortable that there is an efficient instrument with sufficient liquidity to begin a meaningful transition. At this time, we anticipate that a transition may occur in late 2021 or early 2022. We continue to monitor market developments and regulatory updates, including recent announcements from the ICE Benchmark Administrator to extend the cessation date for several USD LIBOR tenors to June 30, 2023, as well as collaborate with regulators and industry groups on the transition. The manner and impact of this transition, as well as the effect of these developments on our funding costs, loan and investment and trading securities portfolios, asset-liability management, and business, is uncertain.
Consumers may decide not to use banks to complete their financial transactions.
Technology and other changes are allowing consumers to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills and transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, which may increase as consumers become more comfortable with these new technologies and offerings, could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.
Strong competition within our market area may limit our growth and profitability.
Competition in the banking and financial services industry within our market area is intense. In our market area, we compete with, among others, commercial banks, savings institutions, mortgage brokerage firms, credit unions, mutual funds, insurance companies and brokerage and investment banking firms operating locally and elsewhere. There are also a number of smaller community-based banks that pursue similar operating strategies as the Bank. In addition, some of our competitors may offer loans with lower fixed rates and on more attractive terms than we are willing to offer. Our continued profitability depends on our continued ability to successfully compete in our market area. The greater resources and broader range of deposit and loan products offered by our competition may limit our ability to increase our interest earning assets and profitability. See “Item 1. Business—Competition” for more information about competition in our market area.
We expect competition to remain intense in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Increased competition among financial services companies due to the recent consolidation of certain competing financial institutions may adversely affect our ability to market our products and services. Also, technological advances have lowered barriers to entry and made it possible for banks to compete in our market without a retail footprint by offering competitive rates and for non-banks to offer products and services that have traditionally been provided by banks. Additionally, due to their size, many of our competitors may offer a broader range of products and services as well as better pricing for certain products and services than we can, which could affect our ability to grow and remain profitable on a long-term basis. Our profitability depends on our ability to successfully compete in our market area, and competition for deposits and the origination of loans could limit our ability to successfully implement our business plan, and could adversely affect our
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results of operations in the future. Further, if we must raise interest rates paid on deposits or lower interest rates charged on our loans, our net interest margin and profitability could be adversely affected.
Furthermore, competition in the banking and financial services industry is coming not only from traditional competitors but from technology-oriented financial services (“FinTech”) companies, which are subject to limited regulation. They offer user friendly front-end, quick turnaround times for loans and other benefits. While we are considering the possibility of developing relationships with FinTech companies for efficiency in processing and/or as a source of loans and other benefits, we cannot limit the possibility that our customers or future prospects will work directly with a FinTech company instead. This could impact our growth and profitability going forward.
Our lending limit may limit our growth.
We are limited in the amount we can loan to a single borrower by the amount of our capital. Generally, under current law, we may lend up to 15% of our unimpaired capital and surplus to any one borrower. Based upon our current capital levels, such amount is significantly less than that of many of our competitors and may discourage potential borrowers who have credit needs in excess of our lending limit from doing business with us. We accommodate larger loans by selling participations in those loans to other financial institutions, but this strategy may not always be available.
The failure to maintain our reputation may materially adversely affect our ability to grow and generate revenue.
Our reputation is one of the most valuable components of our business. Damage to our reputation could undermines the confidence of clients and prospects in our ability to serve them and therefore could negatively affect our earnings. Negative public opinion can result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance, mergers and acquisitions and cybersecurity incidents, and from actions taken by government regulators and community organizations in response to those activities. Damage to our reputation could affect the confidence of rating agencies, regulators, stockholders and other parties in a wide range of transactions that are important to our business. Failure to maintain our reputation ultimately would have an adverse effect on our ability to maintain and grow our business. Actions by the financial services industry generally or by other members of or individuals in the financial services industry also could impact our reputation negatively. The considerable expansion in the use of social media over recent years has increased the risk that our reputation could be negatively impacted in a short amount of time. If we are unable to quickly and effectively respond to any incidentsnegatively impacting our reputation, it could have a material and long-term negative impact on our business and, therefore, our operating results.
Risks Related to Our Strategy
Our growth strategy may not be successful, may be dilutive and may have other adverse consequences.
A key component of our growth strategy is to pursue acquisitions of other financial institutions or branches of other financial institutions, and we routinely evaluate opportunities to acquire additional financial institutions or branches or to open new branches. As consolidation of the banking industry continues, the competition for suitable acquisition candidates may increase. We compete with other banking companies for acquisition opportunities, and there are a limited number of candidates that meet our acquisition criteria. Consequently, we may not be able to identify suitable candidates for acquisitions. If we are unable to locate suitable acquisition candidates willing to sell on terms acceptable to us, our net income could decline and we would be required to find other methods to grow our business. We may also open additional branches organically and expand into new markets or offer new products and services.
Our merger and acquisition activities could be material and could require us to use a substantial amount of common stock and dilute our existing stockholders, cash, other liquid assets, and/or incur debt. In addition, if goodwill recorded in connection with our prior or potential future acquisitions were determined to be impaired, then we would be required to recognize a charge against our earnings, which could materially and adversely affect our results of operations during the period in which the impairment was recognized.
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Our expansion activities could involve a number of additional risks, including:
● the time and expense associated with identifying and evaluating potential acquisition and merger partners;
● using inaccurate estimates and judgments to evaluate credit, operations, management and market risks with respect to the target institution or its branches or assets;
● the time and expense associated with evaluating new markets for expansion, hiring experienced local management and opening new offices or branches as there may be a substantial time lag between these activities before we generate sufficient assets and deposits to support the costs of the expansion;
● operating in markets in which we have had no or only limited experience;
● taking a significant amount of time negotiating a transaction or working on expansion plans, resulting in management’s time and attention being diverted from the operation of our existing business;
● we may not be able to correctly identify profitable or growing markets for new branches;
● difficulty or unanticipated expense associated with converting the operating systems of the acquired or merged company into ours;
● the possibility that we will be unable to successfully implement integration strategies, due to challenges associated with integrating complex systems, technology, banking centers, and other assets of the acquired bank in a manner that minimizes any adverse effect on customers, suppliers, employees, and other constituencies;
● the possibility that the expected benefits of a transaction may not materialize in the timeframe expected or at all, or may be costlier to achieve;
● the ability to realize the anticipated benefits of the merger or acquisition;
● creating an adverse short-term effect on our results of operations;
● losing key employees and customers as a result of a merger or acquisition that is poorly received;
● the possibility of regulatory approval being delayed, impeded, conditioned or denied due to existing or new regulatory issues surrounding the Company, the target institution or the proposed combined entity as a result of, among other things, issues related to anti-money laundering/Bank Secrecy Act compliance, fair lending laws, fair housing laws, consumer protection laws, unfair, deceptive or abusive acts or practices regulations, or the CRA;
● delay in completing a merger or acquisition due to litigation;
● inability to obtain additional financing (including by issuing additional common equity), if necessary, on favorable terms or at all; and
● unforeseen adjustments, write-downs, write-offs or restructuring or other impairment charges.
Also, the costs to lease and start up new branch facilities or to acquire existing financial institutions or branches, and the additional costs to operate these facilities, may increase our noninterest expense. It also may be difficult to adequately and profitably manage the anticipated growth from the new branches. We can provide no assurance that any new branch sites will successfully attract a sufficient level of deposits and other banking business to offset their operating expenses.
Further, we plan to continue to make investments in our infrastructure in the future. We may in the future open additional branches in the areas where we now operate and in other markets. We anticipate that this will have the short-term effect of, at least temporarily, increasing our expenses at a faster rate than revenue growth, which will have an adverse effect on net income.
If we grow too quickly and are not able to control costs and maintain asset quality, growth could materially and adversely affect our financial condition and results of operations. Further, we may not be successful in our growth strategy, which would negatively impact our financial condition and results of operations.
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Operational Risks
A failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers or other third parties, including as a result of cyber-attacks, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses.
We rely heavily on communications and information systems to conduct our business. Information security risks for financial institutions such as ours have generally increased in recent years in part because of the proliferation of new technologies, the use of the internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. As client, public, and regulatory expectations regarding operational and information security have increased, our operational systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns. Our business, financial, accounting and data processing systems, or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors, including events that are wholly or partially beyond our control. For example, there could be electrical or telecommunications outages; natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; and, as described below, cyber-attacks.
As noted above, our business relies on our digital technologies, computer and email systems, software, and networks to conduct its operations. Although we have information security procedures and controls in place, our technologies, systems, networks, and our clients’ devices may become the target of cyberattacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our or our clients’ confidential, proprietary and other information, or otherwise disrupt our or our clients’ or other third parties’ business operations. Third parties with whom we do business or that facilitate our business activities, including financial intermediaries, or vendors that provide services or security solutions for our operations, and other third parties, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints.
While we have disaster recovery and other policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. Our risk and exposure to these matters remains heightened because of the evolving nature of these threats. As a result, cybersecurity and the continued development and enhancement of our controls, processes and practices designed to protect our systems, computers, software, data and networks from attack, damage or unauthorized access remain a focus for us. As threats continue to evolve, we may be required to expend additional resources to continue to modify or enhance our protective measures or to investigate and remediate information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and clients, or cyber-attacks or security breaches of the networks, systems or devices that our clients use to access our products and services could result in client attrition, regulatory fines, penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our results of operations or financial condition.
We depend on information technology and telecommunications systems of third-party servicers, and systems failures, interruptions or breaches of security involving these systems could have an adverse effect on our operations, financial condition and results of operations.
Our business is highly dependent on the successful and uninterrupted functioning of our information technology and telecommunications systems, third-party servicers accounting systems and mobile and online banking platforms. We outsource many of our major systems, such as data processing, deposit processing systems and online banking platforms. While we have selected these vendors carefully, we do not control their actions. The failure of these systems, or the termination of a third-party software license or service agreement on which any of these systems is based, could interrupt our operations. Financial or operational difficulties of a vendor could also hurt our operations if those difficultiesinterfere with the vendor’s ability to serve us. Furthermore, our vendors could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. Replacing these third-party vendors could also create significant delay and expense. Because our information technology and
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telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our ability to process new and renewal loans, gather deposits and provide customer service, compromise our ability to operate effectively, damage our reputation, result in a loss of customer business and/or subject us to additional regulatory scrutiny and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
We continually encounter technological change.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology driven by new or modified products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse effect on our business and, in turn, our financial condition and results of operations.
Our business may be adversely affected by increasing prevalence of fraud and other financial crimes .
As a financial institution, we are subject to risk of loss due to fraud and other financial crimes. Nationally, reported incidents of fraud and other financial crimes have increased. We believe we have controls in place to detect and prevent such losses, but in some cases multi-party collusion or other sophisticated methods of hiding fraud may not be readily detected or detectable, and could result in losses that affect our financial condition and results of operations.
Financial crime is not limited to the financial services industry. Our customers could experience fraud in their businesses, which could materially impact their ability to repay their loans, and deposit customers in all financial institutions are constantly and unwittingly solicited by others in fraud schemes that vary from easily detectable and obvious attempts to high-level and very complex international schemes that could drain an account of millions of dollars and require detailed financial forensics to unravel. While we have controls in place, contractual agreements with our customers partitioning liability, and insurance to help mitigate the risk, none of these are guarantees that we will not experience a loss, potentially a loss that could have a material adverse effect on our financial condition, reputation and results of operations.
Legal, Accounting, Regulatory and Compliance Risks
We must comply with extensive and complex governmental regulation, which could have an adverse effect on our business and our growth strategy, and we may be adversely affected by changes in laws and regulations.
We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various federal and state regulatory agencies. The Company is subject to FRB regulation, and the Bank is subject to extensive regulation, supervision and examination by the FDIC and the Commissioner.
Many of these regulations are intended to protect depositors, the public or the FDIC insurance funds, not stockholders. Regulatory requirements affect our lending practices, capital structure, investment practices, dividend policy and many other aspects of our business. These requirements may constrain our operations, and changes in regulations could adversely affect us. The burden imposed by these federal and state regulations may place banks in general, and the Bank specifically, at a competitive disadvantage compared to less regulated competitors. In addition, the cost of compliance with regulatory requirements could adversely affect our ability to operate profitably or increase profitability. See “Supervision and Regulation” for more information about applicable banking laws and regulations.
Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, classification of our assets and determination of the level of our allowance for loan and lease losses. In addition, changes to statutes, regulations or regulatory policies or supervisory guidance, including changes
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in interpretation or implementation of statutes, regulations, policies or supervisory guidance, could affect us in substantial and unpredictable ways, including, among other things, subjecting us to increased capital, liquidity and risk management requirements, creating additional costs, limiting the types of financial services and products we may offer and/or increasing the ability of non-banks to offer competing financial services and products. Failure to comply with laws, regulations or policies could also result in heightened regulatory scrutiny and in sanctions by regulatory agencies (such as a memorandum of understanding, a written supervisory agreement or a cease and desist order), civil money penalties and/or reputation damage. Any of these consequences could restrict our ability to expand our business or could require us to raise additional capital or sell assets on terms that are not advantageous to us or our stockholders and could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, such violations may occur despite our best efforts.
Further, as a public company, we incur significant legal, accounting, insurance and other expenses in connection with compliance with rules of the SEC and The Nasdaq Stock Market LLC.
We face risks related to the adoption of future legislation and potential changes in federal regulatory agency leadership, policies, and priorities.
With a new Congress taking office in January 2021, Democrats have retained control of the U.S. House of Representatives, and have gained control of the U.S. Senate, albeit with a majority found only in the tie-breaking vote of Vice President Harris. However slim the majorities, though, the net result is unified Democratic control of the White House and both chambers of Congress, and consequently Democrats will be able to set the agenda both legislatively and in the Administration. We expect that Democratic-led Congressional committees will pursue greater oversight and will also pay increased attention to the banking sector’s role in providing COVID-19-related assistance. The prospects for the enactment of major banking reform legislation under the new Congress are unclear at this time.
Moreover, the turnover of the presidential administration has produced, and likely will continue to produce, certain changes in the leadership and senior staffs of the federal banking agencies, the CFPB, SEC, and the U.S. Treasury Department. These changes could impact the rulemaking, supervision, examination and enforcement priorities and policies of the agencies. The potential impact of any changes in agency personnel, policies and priorities on the financial services sector, including the Bank, cannot be predicted at this time. Regulations and laws may be modified at any time, and new legislation may be enacted that will affect us. Any future changes in federal and state laws and regulations, as well as the interpretation and implementation of such laws and regulations, could affect us in substantial and unpredictable ways, including those listed above or other ways that could have a material adverse effect on our business, financial condition or results of operations.
We face a risk of noncompliance and enforcement action with the Patriot Act, the Bank Secrecy Act and other anti-money laundering statutes and regulations.
Financial institutions are required under the PATRIOT Act, Bank Secrecy Act and other laws and regulations to, among other duties, institute and maintain effective anti-money laundering programs and file suspicious activity and currency transaction reports as appropriate. These rules also require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. The federal Financial Crimes Enforcement Network, established by the U.S. Treasury Department to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and has engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration and Internal Revenue Service. There is also increased scrutiny of compliance with the rules enforced by the OFAC. Federal and state bank regulators also focus on compliance with Bank Secrecy Act and anti-money laundering regulations. If our policies, procedures and systems are deemed deficient or the policies, procedures and systems of the financial institutions that we have already acquired or may acquire in the future are deficient, we would be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plan, including our acquisition plans, which would negatively impact our business, financial condition and results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.
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New accounting standards could require us to increase our allowance for loan and lease losses and may have a material adverse effect on our financial condition and results of operations.
The measure of our allowance for loan and lease losses is dependent on the adoption and interpretation of accounting standards. The Financial Accounting Standards Board, or FASB, has issued a new credit impairment model, the Current Expected Credit Loss, or CECL model, which will become applicable to us in 2023. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the “incurred loss” model currently required under GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan and lease losses and could require us to significantly increase our allowance. Moreover, the CECL model may create more volatility in the level of our allowance for loan and lease losses. If we are required to materially increase our level of allowance for loan and lease losses for any reason, such increase could adversely affect our business, financial condition and results of operations.
We could be adversely affected by changes in tax laws and regulations or the interpretations of such laws and regulations.
We are subject to the income tax laws of the U.S., and its states and municipalities in which we do business. These tax laws are complex and may be subject to different interpretations. We must make judgments and interpretations about the application of these inherently complex tax laws when determining our provision for income taxes, our deferred tax assets and liabilities, and our valuation allowance. Changes to the tax laws, administrative rulings or court decisions could increase our provision for income taxes and reduce our net income.
In addition, our ability to continue to record our deferred tax assets is dependent on our ability to realize their value through future projected earnings. Future changes in tax laws or regulations could adversely affect our ability to record our deferred tax assets. Loss of part or all of our deferred tax assets would have a material adverse effect on our financial condition and results of operations.
We are party to various claims and lawsuits incidental to our business. Litigation is subject to many uncertainties such that the expenses and ultimate exposure with respect to many of these matters cannot be ascertained.
From time to time, we are the subject of various claims and legal actions by customers, employees, stockholders and others. Whether such claims and legal actions are legitimate or unfounded, if such claims and legal actions are not resolved in our favor, they may result in significant financial liability and/or adversely affect the market perception of us and our products and services as well as impact customer demand for those products and services. In light of the potential cost and uncertainty involved in litigation, we have in the past and may in the future settle matters even when we believe we have a meritorious defense. Certain claims may seek injunctive relief, which could disrupt the ordinary conduct of our business and operations or increase our cost of doing business. Our insurance or indemnities may not cover all claims that may be asserted against us. Any judgments or settlements in any pending litigation or future claims, litigation or investigation could have a material adverse effect on our business, reputation, financial condition and results of operations.
From time to time we are, or may become, involved in suits, legal proceedings, information-gatherings, investigations and proceedings by governmental and self-regulatory agencies that may lead to adverse consequences.
Many aspects of the banking business involve a substantial risk of legal liability. From time to time, we are, or may become, the subject of information-gathering requests, reviews, investigations and proceedings, and other forms of regulatory inquiry, including by bank regulatory agencies, self-regulatory agencies, the SEC and law enforcement authorities. The results of such proceedings could lead to significant civil or criminalpenalties, including monetary penalties, damages, adverse judgements, settlements, fines, injunctions, restrictions on the way we conduct our business or reputational harm.
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As a participating lender in the SBA Paycheck Protection Program (“PPP”), we are subject to additional risks of litigation from our customers or other parties regarding our processing of loans for the PPP and risks that the SBA may not fund some or all PPP loan guaranties.
On March 27, 2020, President Trump signed the CARES Act, which created a guaranteed, unsecured loan program, the Paycheck Protection Program, or PPP, to fund operational costs of eligible businesses, organizations and self-employed persons during COVID-19. Under the PPP, small businesses and other entities and individuals can apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. The Bank is participating as a lender in the PPP. The PPP commenced on April 3, 2020 and was available to qualified borrowers through August 8, 2020, and an additional stimulus package was approved on December 28, 2020, authorizing an additional $284.5 billion of PPP funds. Since the opening of the PPP, several other larger banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP. We may be exposed to the risk of litigation, from both customers and non-customers that approached us regarding PPP loans, regarding our process and procedures used in processing applications for the PPP. If any such litigation is filed against us and is not resolved in a manner favorable to us, it may result in significant financial liability or adversely affect our reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP-related litigation could have a material adverse impact on our business, financial condition and results of operations.
We also have credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by us, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by us, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from us.
Risks Related to Our Human Capital
We depend heavily on key employees, including Mary Ann Scully and Robert D. Kunisch, Jr., to continue the implementation of our long-term business strategy, and the loss of one or more of these key employees could curtail our growth, disrupt our operations and result in reduced earnings.
Ms. Scully is our Chairman and Chief Executive Officer, and Mr. Kunisch is our President and Chief Operating Officer. We believe that our continued growth and future success will depend in large part on the skills of our senior management team. We believe these two executive officers possess valuable knowledge about and experience in the banking industry and that their knowledge and relationships would be difficult to replicate. We have entered into an employment agreement with each of Ms. Scully and Mr. Kunisch and acquired key-person life insurance on each, but the existence of such agreements and insurance does not assure that we will be able to retain their services or recover losses associated with the loss of their services. The unexpectedloss of the services of Ms. Scully or Mr. Kunisch could have a material adverse effect on our business, operations, financial condition and operating results, as well as the value of our common stock.
Our success also depends, in part, on our continued ability to attract and retain experienced loan originators, as well as other management personnel. Competition for personnel is intense, and we may not be successful in attracting or retaining qualified personnel. Our failure to compete for these personnel, or the loss of the services of several of such key personnel, could adversely affect our business strategy and materially and adversely affect our business, results of operations, and financial condition.
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Risks Related to an Investment in Our Common Stock
Anti-takeover provisions in our corporate documents and in federal and state law may make it difficult and expensive to remove current management.
Anti-takeover provisions in our articles of incorporation and bylaws and federal and state banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our stockholders. For example, we have a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board. In addition, directors may only be removed from office by the affirmative vote of at least 80% of all of the votes of our stockholders entitled to be cast. Our articles of incorporation also authorize our board to classify or reclassify shares of our stock in one or more classes or series, to cause the issuance of additional shares of our stock, and to amend our articles without stockholder approval to increase or decrease the number of shares of stock that we have authority to issue. The combination of these provisions may inhibit a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock. These provisions could also discourage proxy contests and make it more difficult and expensive for holders of our common stock to elect directors other than the candidates nominated by our board of directors or otherwise remove existing directors and management, even if current management is not performing adequately.
Maryland law and our articles of incorporation limit the liability of our directors and officers and the rights of us and our stockholders to take action against our directors and officers.
Maryland law provides that a director will not have any liability as a director as long as he or she performs his or her duties in accordance with the applicable standard of conduct. In addition, our articles of incorporation eliminate our directors’ and officers’ liability to us and our stockholders for money damages to the fullest extent permitted by Maryland law. Our articles of incorporation and bylaws also require us to indemnify our directors and officers for liability resulting from actions taken by them in those capacities to the maximum extent permitted by Maryland law. As a result, we and our stockholders may have more limited rights against our directors and officers than might otherwise exist under common law. In addition, we may be obligated to fund the defense costs incurred by our directors and officers.
The market price for our common stock may be volatile.
The market price of our common stock could be subject to significant fluctuations due to changes in sentiment in the market regarding our operations or business prospects. Factors that may affect market sentiment include:
● operating results that vary from the expectations of our management or of securities analysts and investors;
● developments in our business or in the financial service sector generally;
● regulatory or legislative changes affecting our industry generally or our business and operations in particular;
● operating and securities price performance of companies that investors consider to be comparable to us;
● changes in estimates or recommendations by securities analysts;
● announcements of strategic developments, acquisitions, dispositions, financings and other material events by us or our competitors; and
● changes in financial markets and national and local economies and general market conditions, such as interest rates and stock, commodity, credit or asset valuations or volatility.
While the U.S. and other governments continue efforts to restore confidence in financial markets and promote economic growth, market and economic turmoil could still occur in the near- or long-term, negatively affecting our business, financial condition and results of operations, as well as the price, trading volume and volatility of our common stock.
We may be unable to, or may continue to choose not to, pay dividends on our common stock.
We have never paid cash dividends to holders of our common stock. Although we may pay cash dividends in the future, we currently intend to retain a large majority of any earnings to help fund our growth. Our ability to pay cash dividends
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may be limited by regulatory restrictions, by our Bank’s ability to pay cash dividends to the Company and by our need to maintain sufficient capital to support our operations. The FRB has issued a policy statement regarding the payment of dividends by bank holding companies. In general, the FRB’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition. The FRB’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. Under the prompt corrective action regulations, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.
Since the Company is a legal entity separate and distinct from the Bank and does not conduct stand-alone operations, its ability to pay dividends depends on the ability of the Bank to pay dividends to it. As a Maryland-chartered trust company, the Bank is subject to limitations on the amount of dividends that it is permitted to pay. The federal banking agencies have also issued policy statements which provide that bank holding companies and insured banks should generally only pay dividends out of current earnings.
If our Bank is not permitted to pay cash dividends to the Company, it is unlikely that we would be able to pay cash dividends on our common stock. Moreover, holders of our common stock are entitled to receive dividends only when, and if declared by our board of directors. If we fail to pay dividends in the future, capital appreciation, if any, of our common stock may be the sole opportunity for gains on an investment in our common stock. In addition, in the event the Bank becomes unable to pay dividends to the Company, we may not be able to service our debt or pay our other obligations. Accordingly, the Company’s inability to receive dividends from the Bank could also have a material adverse effect on our business, financial condition and results of operations.
We can sell additional shares of common stock without consulting stockholders and without offering shares to existing stockholders, which would result in dilution of our stockholders’ interests and could depress our stock price.
Our articles of incorporation currently authorize an aggregate of 20,000,000 shares of common stock, 18,782,399 of which are outstanding as of March 15, 2021. As permitted by Maryland law, our articles of incorporation provide that our board of directors can amend our articles of incorporation, without stockholder approval, to increase or decrease the aggregate number of shares of stock or the number of shares of any class of stock that we have the authority to issue. Our board of directors is further authorized to issue additional shares of common stock and preferred stock, at such times and for such consideration as it may determine, without stockholder action. Because our common stockholders do not have preemptive rights to purchase shares of our capital stock (that is, the right to purchase a stockholder’s pro rata share of any securities issued by us), any future offering of capital stock could have a dilutive effect on holders of our common stock.
Recent Business Developments
We completed the exit of our mortgage banking activities in early 2020. On December 18, 2019, we entered into an agreement to release certain management members of our mortgage division from their employment contracts and allow those individuals to create a limited liability company (“LLC”) for the purpose of hiring our remaining mortgage employees. We also agreed to transfer ownership of the domain name “VAmortgage.com” to the newly created LLC. In consideration of the release of the employment agreements, the transfer of our mortgage employees, and the sale of the domain name, the LLC paid us $750 thousand. Under the agreement, we agreed to cease originating residential first lien mortgage loans and exit all our mortgage banking activities in 2020. Accordingly, all of our residential first lien mortgage pipeline loans were processed by the end of the first quarter of 2020 and our remaining mortgage loans held for sale were sold in the second quarter of 2020. In order to manage future loan run-off within our residential mortgage loan portfolio, we began (and plan to continue) buying first lien residential mortgage loans, on a servicing released basis, from third-party originators. The exit of our mortgage banking activities is discussed in Note 2 to the Consolidated Financial Statements.
COVID-19 Pandemic
Our business, financial condition and results of operations generally rely upon the ability of our borrowers to repay their loans, the value of collateral underlying our secured loans, and demand for loans and other products and services we offer, which are highly dependent on the business environment in our primary market and in the United States as a whole. The COVID-19 pandemic continues to create extensive disruptions to the global economy and financial markets and to businesses and the lives of individuals throughout the world. Federal and state governments have taken, and may continue to take, unprecedented actions to contain the spread of the disease, including quarantines, travel bans, shelter-in-place orders, closures of businesses and schools, fiscal stimulus, and legislation designed to deliver monetary aid and other relief to businesses and individuals impacted by the pandemic. Although in various locations certain activity restrictions have been relaxed and businesses and schools have reopened with some level of success, in many states and localities the number of individuals diagnosed with COVID-19 has increased significantly, which may cause a freezing or, in certain cases, a reversal of previously announced relaxation of activity restrictions and may prompt the need for additional aid and other forms of relief.
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The impact of the COVID-19 pandemic is fluid and continues to evolve. The unprecedented and rapid spread of COVID-19 and its associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities has resulted in less economic activity, lower equity market valuations and significant volatility and disruption in financial markets. In addition, due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling below 1.00% on March 3, 2020 for the first time, then declining further to a low of 0.52% in early August. Since that time, intermediate and long-term bond yields have risen, with a sharper rise in 2021; the yield on the 10-year Treasury bond is now nearing where it was before the start of the pandemic in February 2020. On March 3, 2020, the Federal Open Market Committee reduced the targeted federal funds interest rate range by 50 basis points to 1.00% to 1.25%. This range was further reduced to 0% to 0.25% percent on March 16, 2020 and remained at that level throughout the remainder of 2020. These reductions in interest rates and the other effects of the COVID-19 pandemic have had, and are expected to continue to have, possibly materially, an adverse effect on our business, financial condition, and results of operations. The ultimate extent of the impact of the COVID-19 pandemic on our business, financial condition and results of operations is currently uncertain and will depend on various developments and other factors, including the effect of governmental, regulatory and private sector initiatives, the effect of the recent rollout of vaccinations for the virus, whether such vaccinations will be effectiveagainst any resurgence of the virus, including any new strain, and the ability for customers and businesses to return to their pre-pandemic routine.
Our COVID-19 Operational Response
In response to the pandemic, we have taken a number of steps to protect our employees, customers and communities. Our response has continued to evolve since the first confirmed case of COVID-19 was reported in Maryland on March 5, 2020. We have implemented the following measures in an effort to ensure the safety of both our customers and employees while continuing to serve our customers during this challenging period:
● Twelve of the Bank’s fifteen branches remain accessible to customers – nine through drive thru capabilities and all twelve through pre-scheduled meetings.
● Encouraged utilization of our mobile, online, ATM, and other banking channels to limit personal contact.
● Implemented a work-from-home policy for substantially all employees other than branch personnel.
● Added one week of paid time off to all full-time employees to be used in either 2020 or 2021, to acknowledge long hours devoted to providing extraordinary customer service.
● Implemented deep cleaning procedures at all branch locations and other bank facilities.
● Instituted mandatory social distancing policies and wearing of masks for employees working in bank facilities.
Lending Operations and Accommodations to Borrowers
We actively participated in the Small Business Administration’s (“SBA”) Paycheck Protection Program (“PPP”) established under the Coronavirus Aid, Relief and Economic Security Act (“CARES” Act), as amended and extended. Lending under the PPP commenced on April 3, 2020 and the SBA notified lenders that PPP funds were exhausted on or around April 16, 2020. On April 24, 2020, additional funds were allocated to the PPP and were available through August 8, 2020. An additional stimulus package, approved on December 27, 2020, authorized additional PPP funds. We are continuing to monitor the potential development of additional legislation and further actions taken by the U.S. government with respect to the PPP.
The Paycheck Protection Program Flexibility Act of 2020 (the “PPPF Act”) was enacted in June 2020 and modified the PPP as follows: (i) established a minimum maturity of five years for all loans made after the enactment of the PPPF Act and permits an extension of the maturity of existing loans to five years if the borrower and lender agree; (ii) extended the “covered period” of the CARES Act from June 30, 2020, to December 31, 2020; (iii) extended the eight-week “covered period” for expenditures that qualify for forgiveness to the earlier of 24 weeks following loan origination or December 31, 2020; (iv) extended the deferral period for payment of principal, interest and fees to the date on which the forgiveness amount is remitted to the lender by the SBA; (v) requires the borrower to use at least 60% (down from 75%) of the proceeds of the loan for payroll costs, and up to 40% (up from 25%), for other permitted purposes, as a condition to obtaining forgiveness of the loan; (vi) delayed from June 30, 2020 to December 31, 2020 the date by which employees must be rehired to avoid a reduction in the amount of forgiveness of a loan, and created a “rehiring safe harbor” that allows
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businesses to remain eligible for loan forgiveness if they make a good-faith attempt to rehire employees or hire similarly qualified employees, but are unable to do so, or are able to document an inability to return to pre-COVID-19 levels of business activity due to compliance with social distancing measures; and (vii) allows borrowers to receive both loan forgiveness under the PPP and the payroll tax deferral permitted under the CARES Act, rather than having to choose which of the two would be more advantageous.
In July 2020, the CARES Act was amended to extend, through August 8, 2020, the SBA’s authority to make commitments under the PPP. The SBA’s existing authority had previously expired on June 30, 2020. We are continuing to monitor the potential development of additional legislation and further actions taken by the U.S. government.
At December 31, 2020, we had originated $201.0 million of loans under the PPP. During the first phase of the program, which commenced on April 3, we funded 777 loans totaling $178.7 million. During the second phase, which commenced on April 24 and ended with applications submitted to the SBA by August 8, 2020, we funded an additional 285 loans totaling $22.5 million. The average loan size under the first and second phase of the PPP program was $230 thousand and $78 thousand, respectively. We will continue to support our customers throughout the forgiveness process. We received processing fees from the SBA for the originated PPP loans totaling $6.7 million, which were deferred. In addition, we deferred $782 thousand of origination costs. The net deferred fees are being accreted as a yield adjustment over the contractual term of the underlying PPP loans. PPP lending generated pretax income of $3.8 million, or $0.16 after tax per share in 2020. PPP loans, net of unearned income, totaled $167.6 million at December 31, 2020. A total of $30.1 million of PPP loans were forgiven during 2020.
During this unprecedented situation, we have also established client assistance programs, including offering loan modifications, on a case by case basis, in the form of payment deferrals for periods up to six months, to both commercial and retail customers as discussed in the “Nonperforming and Problem Assets” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”). We have also temporarily ceased making collection calls, are temporarily waiving a higher proportion of late fees assessed for consumer loans, and have paused new foreclosure and repossession actions. We will continue to re-evaluate these temporary actions based on the ongoing COVID-19 pandemic. These programs may negatively impact our revenue and other results of operations in the near term and, if not effective in mitigating the effect of COVID-19 on our customers, may adversely affect our business and results of operations more substantially over a longer period of time. Current and future governmental actions may require these and other types of customer-related responses.
The CARES Act also permits financial institutions to suspend requirements under GAAP for certain loan modifications to borrowers affected by COVID-19 that would otherwise be characterized as TDRs, as discussed in the “Nonperforming and Problem Assets” section of this MD&A.
Impact on Our Results of Operation and Financial Condition
We continue to monitor the impact of the COVID-19 pandemic on our results of operation and financial condition. While the pandemic did not have a significant impact on our financial condition as of December 31, 2020, in the form of significant incurred losses or any communications from our borrowers that significant losses were imminent, we nevertheless determined it prudent to increase our allowance for loan and lease losses (the “allowance”) by $8.8 million in 2020, related to changes in qualitative factors, primarily as a result of the abruptslowdown in commercial economic activity related to COVID-19, as well as the dramatic rise in the unemployment rate in our market area. Our allowance may also be materially impacted in future periods by the COVID-19 pandemic.
In addition, due to the pandemic and the related economic fallout, including most specifically, declining stock prices at both the Company and peer banks, the Federal Reserve’s significant reduction in interest rates, and other business and market considerations, we performed an interim goodwill impairment analysis as of June 30, 2020. Based on this analysis, the estimated fair value of the Company was less than book value, resulting in a $34.5 million impairment charge, recorded in noninterest expense, in the second quarter of 2020. This was a non-cash charge to earnings and had no impact on our regulatory capital ratios, cash flows, or liquidity position.
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Capital and Liquidity
As of December 31, 2020, all of our capital ratios were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession brought about by the COVID-19 pandemic, our reported and regulatory capital ratios could be adversely impacted by loan and lease losses.
We anticipated potential stresses on liquidity management as a result of the COVID-19 pandemic and our participation in the PPP. We built on-balance sheet liquidity during the first quarter of 2020 in anticipation of a possible increase in the utilization of existing lines of credit or decreases in customer deposits. Since these events didn’t materialize, in part due to the various actions initiated by the Federal Reserve to provide market liquidity, we reduced this on-balance sheet liquidity to pre-COVID-19 levels during the second quarter of 2020 while continuing to build our contingent funding availability during 2020.
The Federal Reserve created the Paycheck Protection Program Lending Facility (“PPPLF”), a lending facility that allows us to obtain funding specifically for loans that we make under the PPP, and allows us to retain existing sources of liquidity for our traditional operations. While we had originally planned to use the PPPLF as the funding source for all PPP loans, strong customer deposit growth and the availability of alternative short-term funding sources at a lower cost resulted in our limited usage of the PPPLF and no borrowings outstanding at December 31, 2020.
Use of Non-GAAP Financial Measures and Related Reconciliations
This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of our tangible book value per share, portfolio loans, and portfolio loan-related asset quality ratios.
Management believes that the presentation of these non-GAAP financial measures (a) provides important supplemental information that contributes to a proper understanding of our operating performance and provides a meaningful comparison to our peers, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation to investors of our performance. However, non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently. These disclosures should not be considered in isolation or as an alternative to our GAAP results. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented below.
Certain information in this report is presented with respect to “portfolio loans,” a non-GAAP financial measure defined as total loans and leases, but excluding PPP loans. Portfolio loans is calculated by subtracting PPP loans (net of unamortized deferred fees and origination costs) from total loans and leases. We also provide certain asset quality ratios such as nonperforming loans and the allowance for loan and lease losses as a percentage of portfolio loans. We believe that the presentation of portfolio loans and the related asset quality measures provide additional useful information for purposes of evaluating our results of operations and financial condition with respect to the year 2020 when comparing to other periods, since the PPP loans are 100% guaranteed, were not subject to traditional loan underwriting standards, and a substantial portion of these loans are expected to be forgiven and repaid by the SBA within the next 12-18 months.
We also present “tangible book value per common share.” We believe that this measure is consistent with the treatment by bank regulatory agencies, which exclude intangible assets from the calculation of risk-based capital ratios. Accordingly, we believe that this non-GAAP financial measure provides information that is important to investors and that is useful in understanding our capital position and ratios. In addition, tangible book value per share is the key metric used by bank analysts in evaluating bank stock price performance. Tangible book value per common share is calculated by dividing tangible common stockholders' equity by total common shares outstanding. Tangible common stockholders' equity is calculated by subtracting goodwill and our net core deposit intangible from total stockholders' equity.
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The tables below provide a reconciliation of these non-GAAP financial measures with financial measures defined under GAAP.
Tangible Book Value per Common Share
December 31,
($ in thousands except per share data)
$Change
% Change
Total stockholders' equity (GAAP)
Subtract:
Goodwill
Core deposit intangible, net of deferred tax liability
Total subtractions
Tangible common stockholders' equity (non-GAAP)
Total common shares outstanding at end of period
Book value per common share (GAAP)
Tangible book value per common share (non-GAAP)
Portfolio Loans and Related Asset Quality Ratios
December 31,
($in thousands)
$Change
% Change
Total loans and leases (GAAP)
Subtract PPP loans, net
Total portfolio loans (non-GAAP)
Nonperformng loans
Total loans and leases (GAAP)
Portfolio loans (non-GAAP)
Allowance for loan and lease losses
Total loans and leases (GAAP)
Portfolio loans (non-GAAP)
Financial Highlights
Financial highlights for 2020 are as follows:
● We reported a net loss of $17.0 million, or a loss of $0.91 per diluted common share for the year ended December 31, 2020 compared to net income of $16.9 million, or $0.89 per diluted common share for the year ended December 31, 2019.
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● We recorded a goodwill impairment charge of $34.5 million (or a loss of $1.84 per share) in the second quarter of 2020, which was a non-cash charge that did not affect regulatory capital ratios, liquidity, or our overall financial strength.
● We recorded a provision for credit losses of $9.8 million in 2020, a $5.7 million increase from the $4.2 million we recorded in 2019.
● The allowance for loan and lease losses (the “allowance”) was $19.2 million at December 31, 2020, an increase of $8.8 million from $10.4 million at December 31 2019.
● The allowance was 1.03% of total loans and leases and 1.13% of portfolio loans (a non-GAAP financial measure – refer to the section “Use of Non-GAAP Financial Measures and Related Reconciliations” for additional detail) at December 31, 2020, compared to 0.60% of total loans and leases at December 31, 2019.
● Our net interest margin was 3.27% in 2020, a decrease of 23 basis points (“bp”) from 2019; due primarily to a 78 bp decrease in the average yield on our earning assets, partially offset by a 66 bp decrease in the average rate paid on interest-bearing liabilities.
● Total assets were $2.54 billion at December 31, 2020, up $163.4 million from year end 2019 with this asset growth primarily attributable to securities available for sale, up $159.9 million, and loans and leases, net of unearned income, up $120.4 million. Offsetting this growth were decreases in interest bearing deposits with banks, down $31.8 million, loans held for sale, down $30.7 million, and goodwill, down $34.5 million.
● Total loans and leases, net of unearned income, were $1.87 billion at December 31, 2020, up $120.4 million from December 31, 2019. Portfolio loans were $1.70 billion at December 31, 2020, a decrease of $47.0 million from December 31, 2019.
● Total deposits were $1.98 billion at December 31, 2020, up $261.0 million from year end 2019, with customer deposits up $221.9 million from year end 2019.
● Our borrowings of $242.1 million at December 31, 2020 decreased by $77.3 million since year end 2019 as strong customer and institutional deposit growth reduced our utilization of this source of funds.
● We completed our $7.0 million stock repurchase program on February 24, 2020; a total of 372,801 shares were repurchased during the first quarter for $6.7 million.
● We remained “well capitalized” by all regulatory measures in 2020.
● Our book value per common share was $15.72 at December 31, 2020, down $0.73 per share from December 31, 2019. The decrease in book value per share was driven by the goodwill impairment charge in 2020 of $1.84 per common share.
● Our tangible book value per common share (a non-GAAP financial measure – refer to the “Use of Non-GAAP Financial Measures” for additional detail) was $13.81 per share at December 31, 2020, an increase of 8.8%, or $1.13 per share since at December 31, 2019. The goodwill impairment charge did not impact tangible book value per share.
Critical Accounting Policies
Our accounting and financial reporting policies conform to the accounting principles generally accepted in the United States of America (“GAAP”) and general practice within the banking industry. Application of these principles requires management to make estimates, assumptions and complex judgements that affect the amounts reported in our Consolidated Financial Statements and accompanying notes. These estimates, assumptions and judgments are based on historical experience and various assumptions that we believe to be reasonable as of the date of the financial statements; accordingly, as this information changes, our Consolidated Financial Statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from those estimates.
Certain accounting measurements inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. The accounting policies we view as critical accounting policies are those relating to the allowance for loan and lease losses, the valuation of goodwill and other intangible assets, and income taxes.
In reviewing and understanding our financial information, we also encourage you to review our significant accounting policies used in preparing our financial statements. See Note 1 to our Consolidated Financial Statements for further discussion of our significant accounting policies.
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Allowance for Loan and Lease Losses
Our allowance for loan and lease losses (the “allowance”) is established through a provision for credit losses charged against income. Loans are charged against the allowance when we believe that the collectability of the principal is unlikely. Subsequent recoveries are added to the allowance. The allowance is an amount that represents the amount of probable and reasonably estimable known and inherent incurred losses in the loan portfolio, based on evaluations of the collectability of loans. The evaluations take into consideration such factors as changes in the types and amount of loans in the loan portfolio, historical loss experience, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, estimated losses relating to specifically identified loans, and current economic conditions. Based on our estimate of the level of allowance required, we record a provision for loan losses to maintain the allowance at an appropriate level.
Our evaluation of the allowance is inherently subjective as it requires material estimates including, among others, exposure at default, the amount and timing of expected future cash flows on impaired loans, value of collateral, and estimated losses on our loan portfolios as well as consideration of general loss experience. The allowance is also influenced by factors outside of our control such as such as industry and business trends, geopolitical events and the effects of laws and regulations as well as economic conditions such as trends in housing prices, interest rates, GDP, inflation, energy prices and unemployment.
We cannot predict with certainty the amount of loan charge-offs that we will incur. We do not currently determine a range of loss with respect to the allowance. In addition, our regulatory agencies, as an integral part of their examination processes, periodically review our allowance. Such agencies may require that we recognize additions to the allowance based on their judgments about information available to them at the time of their examination. To the extent that actual outcomes differ from management’s estimates, additional provisions to the allowance may be required that would adversely impact earnings in future periods. Note 7 to our Consolidated Financial Statements describes the methodology used to determine the allowance.
Goodwill, Other Intangible Assets and Long-Lived Assets
Goodwill represents the excess of the purchase price over the sum of the estimated fair values of tangible and identifiable intangible assets acquired less the estimated fair value of the liabilities assumed. Core deposit intangibles represent the estimated value of long-term deposit relationships acquired in a business combination. The core deposit intangible is amortized over the estimated useful lives of the long-term deposits acquired, and the remaining amounts of the core deposit intangible are periodically reviewed for impairment. Goodwill has an indefinite useful life and is evaluated for impairment annually or more frequently if events and circumstances indicate that the asset might be impaired. Long-lived assets are those that provide the Company with a future economic benefit beyond the current year or operating period. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset is greater than the fair value of the asset. Assets to be disposed of are reported at the lower of the cost or the fair value, less costs to sell.
Effective April 1, 2020, the Company adopted ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment , which simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. The goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge would be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value, to the extent that the loss recognized does not exceed the amount of goodwill allocated to that reporting unit.
Management has determined that we have one reporting unit. The sudden and continuing decline in economic conditions triggered by the pandemic included a significant decline in stock market valuations and the stock price of both the Company and our peer banks. These events indicated that goodwill may be impaired and resulted in us performing a goodwill impairment assessment. Based on this assessment, the Company's estimated fair value was less than its book value, resulting in a goodwill impairment charge of $34.5 million recorded in the second quarter of 2020.
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Based on the results of our annual impairment analysis, performed in the fourth quarter of 2020, we determined that there was no additional impairment of the carrying value of either the goodwill or core deposit intangible at December 31, 2020.
Income Taxes
We account for income taxes under the asset/liability method. We recognize deferred tax assets and liabilities for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carry-forwards. We measure deferred tax assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We recognize the effect on deferred tax assets and liabilities of a change in tax rates in income in the period indicated by the enactment date. We establish a valuation allowance for deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. The judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part, be beyond our control. It is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.
Balance Sheet Analysis and Comparison of Financial Condition
A comparison between December 31, 2020 and December 31, 2019 balance sheets is presented below.
General
Total assets increased $163.4 million, or 6.9%, to $2.54 billion at December 31, 2020 compared to $2.37 billion at December 31, 2019. Our asset growth consisted primarily of increases in our total loans of $120.4 million, which included $167.6 million of PPP loans, and investment securities available for sale of $159.9 million. The growth in these assets was partially offset by decreases in interest-bearing deposits with banks of $31.8 million, goodwill of $34.5 million, and loans held for sale of $30.7 million as we exited our mortgage banking activities. The primary source of funding our net asset growth was deposits. Total deposits increased by $261.0 million, including an increase in customer deposits of $221.9 million. Borrowings decreased by $77.3 million, primarily as a result of a decrease of $85.0 million in Federal Home Loan Bank of Atlanta (“FHLB”) borrowings. Total stockholders’ equity decreased by $19.5 million due primarily to the goodwill impairment charge to earnings.
Investment Securities
The following table sets forth the composition of our investment securities portfolio at the dates indicated.
December 31,
(in thousands)
Amortized
Estimated
Amortized
Estimated
Amortized
Estimated
$ Change in
Cost
Fair Value
Cost
Fair Value
Cost
Fair Value
Fair Value
% Change
Available for sale
U.S. Government
Agencies
Mortgage-backed
Other investments
Held to maturity
Corporate debentures
Available for sale
Our available for sale securities are reported at fair value. At December 31, 2020 and 2019, we held U.S. agency debentures, mortgage backed securities, and corporate debentures. This portfolio is used primarily to provide sufficient liquidity to fund our loans and provide funds for withdrawals of deposits. In addition, this portfolio is used as collateral
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for borrowings such as commercial customer overnight securities sold under agreements to repurchase (“repurchase agreements”) and as a source of earnings. At December 31, 2020 and 2019, $226.2 million and $11.6 million in fair value of available for sale securities, respectively, were pledged as collateral. These securities were pledged at the FRB Discount Window as well as for repurchase agreements and deposits of local government entities that require pledged collateral as a condition of maintaining these deposit accounts.
During 2020, we embarked on a strategy to monetize certain unrealized gains in our mortgage-backed securities (“MBS”) portfolio by selling $105 million of MBS with high prepayment speeds, resulting in net gains of $3.0 million. We then purchased $125 million of lower coupon MBS in order to replace both the MBS sold as well as other available for sale securities runoff. We also executed a leveraging strategy that increased the MBS portfolio by $102.4 million from the prior-year level. The leveraging strategy was designed to replace the decrease in the MBS portfolio’s net interest income that resulted from the completion of the strategy to monetize certain unrealized gains in the MBS portfolio. Our portfolio growth, consisting primarily of MBS, was part of our overall earnings and interest rate risk management strategies.
Our available for sale securities portfolio contained eight securities with unrealized losses of $58 thousand at December 31, 2020, and 16 securities with unrealized losses of $166 thousand at December 31, 2019. Changes in the fair value of these securities resulted primarily from interest rate fluctuations. We neither intend to sell these securities nor is it more likely than not that we would be required to sell these securities before their anticipated recovery. Furthermore, we believe the collection of the investment and related interest is probable. Based on this analysis, we do not consider any of the unrealized losses to be other-than-temporary impairment.
Average investment securities available for sale were $309.5 million for the year 2020, an increase of $127.1 million, or 69.7%, from the year 2019 average balance.
Held to maturity
Held to maturity securities are reported at amortized cost. The only investments that we have classified as held to maturity are certain corporate debentures. These investments are intended to be held until maturity. Our held to maturity securities balances were $7.3 million at December 31, 2020 and $7.8 million at December 31, 2019.
There were three held to maturity securities in an unrealized loss position totaling $32 thousand at December 31, 2020, and none at December 31, 2019. Based on our analysis of these securities, we do not consider the unrealized losses to be other-than-temporary impairment. Note 4 to our Consolidated Financial Statements provides more detail concerning the composition of our portfolio and our process for evaluating the portfolio for other-than-temporary impairment.
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Portfolio Maturities and Yields
The composition and maturities of the investment securities portfolio (with respect to those securities that have a fixed maturity date) at December 31, 2020 is summarized in the following table. Maturities are based on the final contractual payment dates, and do not reflect the impact of prepayments or early redemptions that may occur.
As of December 31, 2020
After one
After five
(in thousands)
One year or less
through five years
through ten years
After ten years
Total
Weighted
Weighted
Weighted
Weighted
Weighted
Amortized
Average
Amortized
Average
Amortized
Average
Amortized
Average
Amortized
Average
Cost
Yield
Cost
Yield
Cost
Yield
Cost
Yield
Cost
Yield
U.S. Government
Agencies
Mortgage-backed
Other investments
Held to maturity
Corporate debentures
Nonmarketable Equity Securities
At December 31, 2020 and 2019, we held an investment in stock of the Federal Home Loan Bank of Atlanta (“FHLB”) of $10.6 million and $14.2 million, respectively. This investment is required for continued FHLB membership and is based partially upon the amount of borrowings outstanding from the FHLB. This FHLB stock is carried at cost which approximates fair value.
Loan and Lease Portfolio
Total loans and leases (hereinafter referred to as “loans”) increased $120.4 million, or 6.9%, to $1.87 billion at December 31, 2020 from $1.75 billion at December 31, 2019. We originated $196.4 million of PPP loans, net of unamortized deferred fees and origination costs, during the second and third quarters of 2020. At December 31, 2020, PPP loans totaled $167.6 million. Our portfolio loans, which exclude PPP loans (a non-GAAP financial measure – refer to the “Use of Non-GAAP Financial Measures” section for additional detail), decreased by $47.0 million, or 2.7%, to $1.70 billion at December 31, 2020 from $1.75 billion at December 31, 2019.
The $47.0 million decrease in portfolio loans was primarily driven by residential real estate loans, which decreased by $70.7 million, or 13.8%. Despite $42.1 million of loan originations and purchases in 2020 ($11.4 million of portfolio originations prior to our exit of mortgage banking activities and $30.7 million of secondary market loan purchases), the net decrease in residential real estate loans was the result of a continued substantially higher level of prepayments due to lower interest rates that led to strong mortgage refinancing. The commercial lending portfolio modestly increased with commercial real estate loans up $56.8 million, or 8.3%, commercial and industrial (“C&I”) loans down $38.8 million, or 10.4%, primarily due to lower line utilization, and construction and land loans down $11.6 million, or 9.1% due primarily to transfers to other loan portfolios. Consumer loans were up $17.1 million, or 36.4%, primarily driven by growth in our marine lending portfolio.
Average loans were $1.85 billion for the year 2020, an increase of $166.8 million, or 9.9%, over average loans for the year 2019. Average portfolio loans were $1.72 billion for the year 2020, an increase of $35.3 million, or 2.1%, from average loans for the year 2019. The year over year growth was primarily in commercial real estate loans, partially offset by decreased residential real estate loans.
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The following table sets forth the composition of our loan portfolio at the dates indicated.
December 31,
(dollars in thousands)
Amount
Percent
Amount
Percent
Amount
Percent
Amount
Percent
Amount
Percent
Real Estate
Construction and land
Residential – first lien
Residential – junior lien
Total residential real estate
Commercial – owner occupied
Commercial – non-owner occupied
Total commercial real estate
Total real estate loans
Commercial loans and leases 1
Consumer
Total portfolio loans and leases
Paycheck protection program (PPP)
Total loans and leases
Includes equipment financing leases of $3,597, $6,382, $7,607, $8,759, and $2,847 at December 31, 2020, 2019, 2018, 2017, and 2016, respectively.
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Loan Portfolio Maturities
The following table summarizes the scheduled repayments of our loan portfolio and sets forth the scheduled repayments of fixed and adjustable rate loans in our portfolio at December 31, 2020.
At December 31, 2020
After one
(dollars in thousands)
One year or less
through five years
After five years
Total
Real Estate
Construction and land
Residential - first lien
Residential - junior lien
Total residential real estate
Commercial - owner occupied
Commercial - non-owner occupied
Total commercial real estate
Total real estate loans
Commercial loans and leases 1
Consumer
Total portfolio loans and leases
Paycheck protection program (PPP)
Total loans and leases
Rate terms:
Fixed rate
Adjustable rate
Total
Includes equipment financing leases of $3,597 at December 31, 2020
Loans Held for Sale
In connection with exiting of our mortgage banking activities, we completed the processing of our remaining residential first lien mortgage loan pipeline during the first quarter of 2020 and sold the remaining loans held for sale during the second quarter of 2020. As a result, we did not have any loans held for sale at December 31, 2020 compared to $30.7 million at December 31, 2019.
Interest-Bearing Deposits with Banks
Interest-bearing deposits with banks, primarily with the Federal Reserve Bank of Richmond, were $65.2 million at December 31, 2020, a decrease of $31.8 million from the December 31, 2019 balance of $97.0 million. On March 15, 2020, the Board of Governors of the Federal Reserve System reduced the reserve requirement to zero percent due to the COVID-19 pandemic; this action and our active management of cash levels were the primary drivers of the lower balance.
Goodwill, Other Intangible Assets and Long-Lived Assets
Goodwill represents the excess of the purchase price over the sum of the estimated fair value of tangible and identifiable intangible assets acquired less the estimated fair value of the liabilities assumed. Goodwill has an indefinite useful life and is evaluated for impairment annually or more frequently if events and circumstances indicate that the asset might be impaired.
Due to the pandemic and the related economic fallout, including most specifically, declining stock prices at both the Company and peer banks, the Federal Reserve’s significant reduction in interest rates, and other business and market considerations, we performed an interim goodwill impairment analysis as of June 30, 2020. Based on this analysis, the estimated fair value of the Company was less than book value, resulting in a $34.5 million goodwill impairment charge,
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recorded in noninterest expense, in the second quarter of 2020. This was a non-cash charge to earnings and had no impact on our regulatory capital ratios, cash flows, or liquidity position. As a result, goodwill decreased to $31.4 million at December 31, 2020 compared to $65.9 million at December 31, 2019.
Core deposit intangibles represent the estimated value of long-term deposit relationships acquired in a business combination. The core deposit intangible is amortized over the estimated useful lives of the long-term deposits acquired, and the remaining amounts of the core deposit intangible are periodically reviewed for impairment. The unamortized balance of our core deposit intangible was $5.8 million at December 31, 2020, compared to $8.5 million at December 31, 2019. Amortization expense reflected in noninterest expense totaled $2.7 million, $3.0 million and $2.9 million for the years ended December 31, 2020, 2019 and 2018, respectively.
Deposits
We accept deposits primarily from the areas in which our branches and offices are located. We have consistently focused on building broader customer relationships and targeting small business customers to increase our core deposits. We also rely on our customer service to attract and retain deposits. We offer a variety of deposit accounts with a range of interest rates and terms. Our deposit accounts consist of commercial and retail checking accounts, savings accounts, certificates of deposit, money market accounts, and individual retirement accounts. In addition, we utilize brokered deposits, primarily through IntraFi Network’s certificate of deposit account registry service (“CDARS”) program. Customer deposits, which exclude brokered deposits and other non-customer deposits, have historically provided us with a sizeable source of relatively stable and low-cost funds to support asset growth.
We review and update interest rates paid, maturity terms, service fees and withdrawal penalties on a periodic basis. Deposit rates and terms are based primarily on current operating strategies and market interest rates, liquidity requirements, anticipated short term loan demand and our deposit growth goals.
Total deposits were $1.98 billion at December 31, 2020, an increase of $261.0 million, or 15.2%, from $1.71 billion at December 31, 2019. Customer deposits were $1.70 billion at December 31, 2020, an increase of $221.9 million, or 15.0%, from $1.47 billion at December 31, 2019. The increase in customer deposits was primarily the result of strong growth in low-cost, non-maturity deposits, which increased by $317.7 million, or 27.8%. $239.1 million of this non-maturity deposit growth was in transaction accounts, with $207.8 million of the transaction account growth in noninterest-bearing deposits. Offsetting this growth was a decline of $86.6 million, or 15.2%, in customer certificates of deposit. Brokered and other non-customer deposits were $279.2 million at December 31, 2020, compared to $240.0 million at December 31, 2019. Non-customer deposits are currently our lowest-cost incremental funding source.
Average customer deposits for the year 2020 were $1.60 billion, an increase of $124.2 million, or 8.4%, from the year 2019 average balance. Customer non-maturity deposit balances increased by $193.6 million, or 17.2%, with transaction accounts up $161.5 million; $170.4 million of the transaction account growth was in noninterest-bearing deposits.
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The following table sets forth the distribution of total deposits, by account type, at the dates indicated:
December 31, 2020
December 31, 2019
(dollars in thousands)
Amount
Total
Amount
Total
$ Change
% Change
Noninterest-bearing demand
Interest-bearing checking
Money market accounts
Savings
Certificates of deposit $250 and over
Certificates of deposit under $250
Total deposits
By deposit source:
Customer deposits
Brokered and other non-customer deposits
Total deposits
The following table sets forth the maturity of certificates of deposit of $100,000 or more at December 31, 2020.
(in thousands)
Three months or less
Over three to six months
Over six to twelve months
Over twelve months
FHLB Advances
Our primary source of non-deposit funding is FHLB advances. We use a variety of term structures in order to manage liquidity and interest rate risk. FHLB advances were $200.0 million at December 31, 2020, a decrease of $85.0 million from December 31, 2019. As of December 31, 2020, all FHLB advances have maturities beyond one year. In the second quarter of 2020, we repaid $5.0 million of long-term FHLB borrowings, recording a prepayment penalty of $224 thousand in other operating expenses. The early repayment of these advances were primarily for asset/liability management purposes and a result of the current rate environment.
Additional information regarding FHLB borrowings with final maturities of less than one year are presented in the following table:
Maximum
Maximum
Maximum
Month-End
Month-End
Month-End
(dollars in thousands)
Amount
Rate
Balance
Amount
Rate
Balance
Amount
Rate
Balance
Balance at December 31
Averages for the year
Stockholders’ Equity
Total stockholders’ equity was $294.6 million at December 31, 2020, a $19.5 million decrease from $314.1 million at December 31, 2019. Our decrease in stockholders’ equity was primarily the result of our $17.0 million net loss in 2020, which included the $34.5 million goodwill impairment charge. On February 24, 2020, we completed our stock repurchase program authorized by the Board of Directors on April 24, 2019. A cumulative total of 392,565 shares, at an average price
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paid per share of $17.83, for an aggregate amount of $7.0 million, were repurchased under the program. A total of 372,801 shares were repurchased during the first quarter of 2020 for an aggregate amount of $6.7 million.
Our book value per common share was $15.72 at December 31, 2020, down $0.73 per share from December 31, 2019. The decrease in book value per share was driven by the goodwill impairment charge in 2020 of $1.84 per common share.
Our tangible book value per common share (a non-GAAP financial measure – refer to the “Use of Non-GAAP Financial Measures” section for additional detail) was $13.81 per share at December 31, 2020, an increase of 8.8%, or $1.13 per share since December 31, 2019. The goodwill impairment charge had no impact on our tangible book value per common share.
Comparison of Results of Operations
General
Our results of operations depend mainly on our net interest income, which is the difference between the interest income we earn on our loan and investment portfolios, as well as accretion income on acquired loans, and the interest expense we pay on deposits and borrowings. Our net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans and acquired credit impaired loans, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction.
Our results of operations are also affected by provisions for credit losses, noninterest income and noninterest expense. Our noninterest expense consists primarily of compensation and employee benefits, as well as office occupancy, data processing, deposit insurance, and general administrative expenses.
A discussion of our results of operations for the years ended December 31, 2020, 2019 and 2018 follows.
Average Balance and Yields
The following tables set forth average balances, average yields and costs, and certain other information for the periods indicated. No tax-equivalent yield adjustments were made, as the effect thereof was not material. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, and have been
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reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.
December 31,
Average
Income
Yield
Average
Income
Yield
Average
Income
Yield
(dollars in thousands)
Balance
/ Expense
/ Rate
Balance
/ Expense
/ Rate
Balance
/ Expense
/ Rate
Earning assets
Loans and leases: (1)
Commercial loans and leases
Commercial real estate
Construction and land
Residential real estate
Consumer
Paycheck Protection Program (PPP)
Total loans and leases
Securities available for sale: (2)
U.S. Treasury
U.S Gov agencies
Mortgage-backed
Corporate debentures
Total available for sale securities
Securities held to maturity: (2)
FHLB Atlanta stock, at cost
Interest bearing deposit in banks
Loans held for sale
Total earning assets
Cash and due from banks
Bank premises and equipment, net
Goodwill
Core deposit intangible
Other assets
Less: allowance for credit losses
Total assets
Interest-bearing liabilities
Deposits:
Interest-bearing demand accounts
Money market
Savings
Time deposits
Total interest-bearing deposits
Borrowings:
FHLB advances
Fed funds and other borrowings
Subordinated debt
Total borrowings
Total interest-bearing funds
Noninterest-bearing deposits
Other liabilities
Total liabilities
Stockholders’ equity
Total liabilities & equity
Net interest rate spread (3)
Effect of noninterest-bearing funds
Net interest margin on earning assets (4)
Loan fee income is included in the interest income calculation, and non-accrual loans are included in the average loan balance; they have been reflected as loans carrying a zero yield.
Available for sale securities are presented at fair value; held to maturity securities are presented at amortized cost.
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Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities.
Net interest margin represents net interest income divided by average total interest-earning assets.
Rate/Volume Analysis
The following table presents the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate) as well as any impact of number of days and mix.
The total of the changes set forth in the rate and volume columns are presented in the total column.
For the year ended December 31,
Due to variances in
Due to variances in
(in thousands)
Total
Rates
Volumes
Total
Rates
Volumes
Effect on interest income on earning assets:
Loans and leases:
Commercial loans and leases
Commercial real estate
Construction and land
Residential real estate
Consumer
Paycheck Protection Program (PPP)
Total interest on loans and leases
Securities available for sale:
U.S. Treasury
U.S. Gov agencies
Mortgage-backed
Corporate debentures
Total interest on available for sale securities
Securities held to maturity
FHLB Atlanta stock, at cost
Interest bearing deposit in banks
Loans held for sale
Total interest income
Effect on interest expense on interest-bearing liabilities: Deposits:
Interest-bearing demand accounts
Money market
Savings
Time deposits
Total deposit on deposits
Borrowings:
FHLB advances
Fed funds and other borrowings
Subordinated debt
Total interest on borrowings
Total interest expense
Effect on net interest earned
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The Federal Reserve’s Federal Open Market Committee’s target for federal funds increased 125 bp in 2017 and 100 bp in 2018 to a range of 2.25% to 2.50% for the year ended December 31, 2018. During 2019, the federal funds target rate remained at the 2.25% to 2.50% range until July 2019 when the Federal Reserve began to drop the federal funds target rate. In the last half of 2019, the Federal Reserve dropped the federal funds target rate 75 bp to the range of 1.50% to 1.75% at December 31, 2019. In March 2020, in response to the COVID19 pandemic, the Federal Reserve then dropped the federal funds target rate 150 bp to a range of 0.00% to 0.25% where it remained at December 31, 2020.
Comparison of the years ended December 31, 2020 and December 31, 2019
General
We reported a net loss of $17.0 million, or a loss of $0.91 per both basic and diluted common share for the year ended December 31, 2020, compared to net income of $16.9 million, or $0.89 per both basic and diluted common share for the year ended December 31, 2019. The $33.9 million, or $1.80 per diluted common share, decrease in net income for 2020 compared to 2019, was driven primarily by the $34.5 million goodwill impairment charge ($1.84 per diluted common share) in 2020, which was not tax deductible. Outside of the goodwill impairment, net income increased by $628 thousand, or $0.03 per diluted common share, in 2020 compared to 2019, primarily as a result of the following:
Increase in securities gains of $2.4 million ($0.10 after tax per diluted common share) in 2020;
Income tax benefit of $1.3 million ($0.07 per diluted common share) in 2020 resulting from a net operating loss carryback provision in the CARES Act;
Decrease in prepayment penalties on FHLB advances of $427 thousand ($0.02 after tax per diluted common share) in 2020;
Decrease in branch optimization charges of $2.7 million ($0.11 after tax per diluted common share) in 2020;
PPP loan pretax income of $3.8 million ($0.16 after tax per diluted common share) in 2020; and
Litigation settlement charge of $700 thousand ($0.03 after tax per diluted common share) in 2019 stemming from certain mortgages originated by First Mariner Bank before its merger with Howard Bank.
These items were partially offset by:
Higher provision for credit losses in 2020 when compared to 2019 of $5.7 million (or $0.23 after tax per diluted common share) as we increased our allowance for loan and lease losses due to the current economic environment;
Decrease in pretax income from our now exited mortgage banking activities of $2.1 million (or $0.08 after tax per diluted common share) in 2020;
Litigation settlement charge of $2.0 million (or $0.08 after tax per diluted common share) in 2020 stemming from certain mortgages originated by First Mariner Bank before its merger with Howard Bank. This settlement was not related to the litigation accrual recorded in 2019; and
Expenses attributable to the departure of our former CFO of $788 thousand (or $0.03 after tax per diluted common share) in 2020.
Net Interest Income
Net interest income is our largest source of operating revenue. Net interest income is affected by various factors including changes in interest rates and the composition of interest-earning assets and interest-bearing liabilities and maturities. Net interest income is determined by the interest rate spread (i.e., the difference between the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.
Net interest income for 2020 was $73.6 million, an increase of $4.3 million, or 6.2%, from 2019. Our net interest margin was 3.27% in 2020, a decrease of 23 bp from the net interest margin of 3.50% in 2019. We continue to experience compression in our net interest margin as market interest rates, after falling to historically low levels as a result of the COVID-19 pandemic through the second quarter of 2020, have generally stabilized. Average earning assets for 2020 of $2.25 billion increased by $267.3 million, or 13.5%, while total interest income decreased by $5.1 million when compared to 2019, as the impact of the 78 bp decrease in the average yield on our earning assets more than offset the interest income
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benefit attributable to the growth in earning assets. Our average interest-bearing liabilities for 2020 increased by $62.6 million while interest expense decreased by $9.4 million compared 2019, as the impact of the 66 bp decrease in the average rate paid on our interest-bearing liabilities more than offset the increase in interest expense attributable to the growth in interest-bearing liabilities.
The net accretion of fair value adjustments on acquired loans added ten bp to our net interest margin in 2020, unchanged from 2019. We expect the impact of this net accretion to continue declining in future periods. PPP loans, with an average yield of 3.06% and an interest spread (net of an assumed funding cost at 0.35%) of 2.71%, reduced our net interest margin by four bp in 2020. The PPP program commenced in the second quarter of 2020; therefore, we had no PPP loans in 2019.
Interest Income
Interest income decreased by $5.1 million, or 5.6%, to $86.4 million in 2020, compared to $91.4 million in 2019. Interest income on loans and leases decreased by $3.7 million, or 4.5%, in 2020 compared to 2019, while average loans and leases increased by 9.9% to $1.85 billion in 2020 when compared to 2019. The average yield on loans and leases of 4.25% for 2020 was down 64 bp from 2019, primarily driven by the lower interest rate environment and, to a lesser extent, the impact of the lower-yielding PPP loans. PPP loans reduced the average loan yield by nine bp in 2020. The net accretion of fair value adjustments on acquired loans added 13 bp to our average yield on loans in 2020, unchanged from 2019.
The average yield on available for sale securities decreased by 104 bp to 1.99%, in 2020 compared to 2019, with the yield on the MBS portfolio, which represents 74.5% and 51.3% of the average available for sale securities portfolio in 2020 and 2019, respectively, down 143 bp to 1.66% in 2020 compared to 2019. Average MBS were up $137.3 million in 2020 (refer to the “Balance Sheet Analysis and Comparison of Financial Condition, Investment Securities” section for additional detail), with net purchases in 2020 at lower yields. In addition, higher prepayment speeds within this portfolio adversely impacted the portfolio yield in 2020. Reflective of the significant decline in the federal funds target rate, the average yield on our interest-bearing deposits in banks fell 128 bp to 0.43% in 2020 compared to 2019.
Interest Expense
Interest expense decreased $9.4 million, or 42.3%, to $12.8 million, in 2020, compared to $22.1 million in 2019. The average rate on interest-bearing liabilities decreased by 66 bp to 0.82% in 2020 compared to 2019. Driving this decrease was a $5.0 million decrease in average interest-bearing deposits which included a 56 bp reduction in the average rate paid on total interest-bearing deposits. We lowered the interest rates paid on interest-bearing deposits in response to the lower prevailing competitive market rates starting in late February 2020, with the full impact of those rate reductions expected as maturing time deposits reprice at lower market interest rates. In addition, our interest expense on FHLB advances decreased $2.3 million in 2020 compared to 2019, while the average balance increased by $54.4 million. The average rate paid on FHLB advances of 0.94% for 2020 decreased by 135 bp when compared to 2019.
Provision for Credit Losses
We recorded a provision for credit losses of $9.8 million in 2020, compared to $4.2 million in 2019, an increase of $5.7 million. The higher provision for credit losses reflects the changing economic environment driven by COVID-19. The provision for credit losses included $320 thousand attributable to our reserve for unfunded commitments, with the remaining $9.5 million attributable to loan and lease losses. For 2020, the portion of the provision for credit losses attributable to loan and lease losses, less net charge-offs of $764 thousand, resulted in an increase in the allowance for loan and lease losses of $8.8 million. For 2019, the provision for credit losses, less net charge-offs of $3.7 million, resulted in an increase in the allowance of $528 thousand. The increase in our allowance is more fully discussed below under the sections of this MD&A entitled “Nonperforming and Problem Assets; COVID-Related Loan Deferrals” and “Allowance for Loan and Lease Losses.”
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Noninterest Income
The following table presents the major categories of noninterest income for the years ended December 31, 2020 and 2019:
(in thousands)
$ Change
% Change
Service charges on deposit accounts
Realized and unrealized gains on mortgage banking activity
Gain on the sale of securities
Gain (loss) on the disposal of bank premises & equipment
Income from bank owned life insurance
Loan related fees and service charges
Other operating income
Total noninterest income
Noninterest income for the year 2020 was $12.4 million, a decrease of $8.7 million, or 41.2%, compared to $21.0 million for 2019. The primary drivers of this decrease were the $9.2 million decrease in noninterest income attributable to exiting our mortgage banking activities, which was partially offset by a $3.0 million increase in gains on the sale of investment securities. Noninterest income other than from mortgage banking activities and securities gains, decreased by $1.9 million, or 19.1%, in 2020 compared to 2019.
Noninterest income from our mortgage banking activities consisted of realized and unrealized gains on mortgage banking activity as well as a portion of the line item “loan related fees and service charges.” Noninterest income attributable to our mortgage banking activities was $1.4 million in 2020, compared to $10.6 million in 2019. We completed the exit of our mortgage banking activities during the second quarter of 2020.
During the second quarter of 2020, we embarked on a strategy to monetize certain unrealized gains in our MBS portfolio. We identified and sold $105 million of MBS with high prepayment speeds, resulting in net gains on the sale of securities of $3.0 million in 2020.
Service charges on deposit accounts, which consisted of account activity fees such as nonsufficient funds (”NSF”) and overdraft fees in addition to other traditional banking fees, decreased by $631 thousand in 2020 when compared to 2019. While the traditional banking fee component was up $150 thousand, NSF and overdraft fees were down $781 thousand in 2020 from 2019 levels, with a portion of this reduction representing accommodations to COVID-19 impacted customers.
Loan related fees and service charges decreased by $2.6 million in 2020 when compared to 2019, which included $389 thousand and $2.8 million attributable to our now exited mortgage banking activities in 2020 and 2019, respectively. Outside of our mortgage banking activities, loan related fees and service charges were down $126 thousand in 2020. 2019 included an early payoff fee of $308 thousand while 2020 included an interest rate swap arrangement fee of $217 thousand.
Other operating income, which consisted mainly of non-depository account fees such as wire, merchant card and ATM services, decreased by $1.1 million in 2020 when compared to 2019. Interchange income declined by $238 thousand in 2020, with a portion of the decline in transaction volumes attributable to the COVID-19 related drop in economic activity. Additionally, 2019 included $750 thousand in revenue associated with the exit of our mortgage banking activities.
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Noninterest Expenses
The following table presents the major categories of noninterest expense for the years ended December 31, 2020 and 2019:
(in thousands)
$ Change
% Change
Compensation and benefits
Occupancy and equipment
Marketing and business development
Professional fees
Data processing fees
FDIC assessment
Other real estate owned
Loan production expense
Amortization of core deposit intangible
Other operating expense
Total noninterest expense before goodwill impairment
Goodwill impairment
Total noninterest expense
N/M - not meaningful
Noninterest expenses increased by $25.4 million to $89.5 million in 2020, compared to $64.1 million in 2019. The increase in noninterest expenses was primarily driven by a $34.5 million goodwill impairment charge in 2020. Partially offsetting this increase was a reduction in noninterest expenses attributable to our now exited mortgage banking activities, which were $1.4 million in 2020, down $7.6 million from 2019. Noninterest expenses other than from our goodwill impairment charge and mortgage banking activities, were down $1.5 million, or 2.8%, in 2020 compared to 2019.
Compensation and benefits expense is the largest component of our noninterest expenses, and decreased by $3.5 million in 2020, compared to 2019. Compensation and benefits expense attributable to our now exited mortgage banking activities was $928 thousand in 2020, compared to $6.4 million 2019, a $5.5 million decrease. Compensation and benefits expense other than from our mortgage banking activities increased $2.0 million, or 7.7%, in 2020 compared to 2019. Included within this increase was $698 thousand of compensation expense attributable to the departure of our former CFO in the first quarter of 2020, $214 thousand related to higher claims experience in our self-insured healthcare plan, an increase of $171 thousand resulting from a lower level of loan origination cost deferrals driven by a decline in lending activities, $360 thousand attributable to an accrual for compensated absences related to additional PTO with a carryover provision granted in light of COVID-19, and $527 thousand attributable to increased staff costs.
Occupancy and equipment expense decreased by $3.6 million in 2020 compared to 2019. In 2020, we continued to evaluate our branch delivery system and further optimized our branch locations, resulting in a $1.1 million branch optimization charge in the fourth quarter of 2020 associated with our decision to close two branches in early 2021. Both of these branches have been temporarily closed since March 2020 due to the pandemic. This $1.1 million charge was partially offset by the partial reversal of a $538 thousand branch closing liability, initially recorded in 2019, as a result of securing a sublease on the former branch location. In 2019, we reported a branch optimization charge of $3.6 million, as we closed three branch locations in 2019 and consolidated two other existing branch locations into a new smaller branch location in 2020. The projected cost savings from our 2019 branch optimization initiative have been realized. Occupancy and equipment expense also decreased by $334 thousand in 2020 due to the exit of our mortgage banking activities.
Marketing and business development expenses decreased by $940 thousand, to $1.4 million in 2020. Lower marketing and business development expenses were driven primarily by the impact of COVID-19 and non-customer direct contact, although our corporate sponsorships were up $195 thousand in 2020 as we increased our level of community support in response to the pandemic.
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Data processing fees consist of core system processors and banking network costs. These expenses decreased by $935 thousand to $4.0 million in 2020, from $4.9 million in 2019, as we realize the benefits from our renegotiated core processing contract.
Loan production expenses decreased by $1.6 million in 2020 compared to 2019, with $1.2 million attributable to our now exited mortgage banking activities.
Our FDIC insurance expense increased by $657 thousand in 2020 compared to 2019. Our second and third quarter 2020 FDIC assessment rate increased due to the impact of the goodwill impairment charge on the assessment calculation. We received small bank assessment credits from the FDIC of $522 thousand in 2019 that did not reoccur in 2020.
Other operating expenses increased by $1.2 million in 2020 compared to 2019. Other operating expenses consisted mainly of a variety of general expenses such as telephone and data lines, supplies and postage, courier services, general insurance, director fees, and miscellaneous losses. Also included in other operating expenses in 2020 was a $2.0 million litigation settlement charge associated with potential litigationclaims stemming from certain mortgages originated by First Mariner Bank before its merger with Howard Bank. The settlement agreement was executed in January 2021. Prepayment penalties on FHLB advances were $224 thousand in 2020, a decrease of $427 thousand from 2019. Included in other operating expenses in 2019 was a $700 thousand litigation settlement charge stemming from certain mortgages originated by First Mariner Bank before its merger with Howard Bank. That settlement was not related to the $2.0 million litigation settlement charge recorded in 2020.
Income Tax Expense
Income tax expense for 2020 was $3.6 million compared to $5.2 million in 2019. Our effective tax rate (income tax expense as a percentage of pretax income) was -27.3% in 2020 and 23.5% in 2019. The effective tax rate is influenced by sources of non-taxable income, such as the income from Bank Owned Life Insurance (“BOLI”) as well as certain non-deductible expense items. The $34.5 million goodwill impairment charge in 2020 was not tax deductible. Income tax expense for 2020 was favorably impacted by certain provisions of the CARES Act. The CARES Act permits corporate taxpayers to recover prior period taxes paid by carrying back net operating losses incurred in tax years ending after December 31, 2017 to tax years ending up to five years earlier. As a result, we will be able to carryback the 2018 tax net operating loss of $9.8 million to tax years 2013-2017. The $1.3 million tax benefit represents the difference between the current federal statutory tax rate of 21% and the 34% statutory federal tax rate applicable during the carryback years. Excluding the impact of the goodwill impairment charge and the $1.3 million benefit from the CARES Act, the effective tax rate for 2020 would have been 23.2%.
Income tax expense for 2019 was favorably impacted by a 2019 U.S. Treasury Department change in tax regulations that provided for retroactive application to the taxability of income from BOLI contracts that were acquired in certain tax-free merger transactions. As a result of the change in tax regulations, we recognized a $232 thousand net reduction of tax expense in 2019 pertaining to BOLI income that was earned, and initially treated as subject to income tax, in 2018. Excluding the impact of the $232 thousand of BOLI income, the effective tax rate for 2019 would have been 24.5%.
Comparison of the years ended December 31, 2019 and December 31, 2018
General
Our net income increased $20.7 million to $16.9 million in 2019, compared to a net loss of $3.8 million in 2018. The net loss in 2018 was primarily driven by $15.5 million of merger and restructuring expenses related to our March 1, 2018 merger with First Mariner, which were not repeated in 2019. The increase in net income in 2019 was also driven by an $11.0 million increase in interest income, compared to 2018, primarily from an increase in interest and fees earned on loans and leases as a result of organic growth and a full-year impact of our merger with First Mariner, partially offset by an $8.4 million increase in interest expense. In 2019, net income was also partially offset by $3.6 million of expense, included within occupancy and equipment expense, related to our branch optimization initiative that resulted in three branch closures in 2019, and the expected consolidation of two additional branches in the first quarter of 2020. Our results
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for 2019 also included the proceeds from our agreement to exit our mortgage banking activities (net of expenses recorded) of $462 thousand.
Both our basic and diluted earnings per common share were $0.89 in 2019, compared to both a basic and diluted loss per common share of $0.22 in 2018.
Net Interest Income
Net interest income increased $2.7 million in 2019, compared to 2018. The increase in net interest income, while up $7.3 million due to favorable volume variances, was offset by unfavorable rate variances of $4.6 million. Our net interest margin was 3.50% in 2019, a decline of 28 bp, compared to 3.78% in 2018. This decrease was primarily driven by a 44 bp increase in the average rate paid on interest bearing liabilities, which more than offset the six bp increase in the average yield on interest earning assets. The net accretion of fair value adjustments added eight bp to our net interest margin in 2019, compared to 18 bp in 2018.
Interest Income
Interest income increased $11.0 million, or 13.7%, to $91.4 million in 2019, compared to $80.4 million in 2018. $8.9 million of this increase was attributable to interest and fees on loans and leases (excluding loans held for sale) and was primarily attributable to organic loan growth with the average balance of our loans and leases up $170.6 million, or 11.3%, in 2019. Interest income was further aided by a four bp increase in the average yield on our loans and leases, with increases in yields in all categories of loans other than consumer loans. The accretion of fair value adjustments in our loan portfolio added ten bp to the average yield on loans in 2019, compared to 15 bp in 2018. Interest and dividends on investment securities increased $2.5 million in 2019 as a result of both an increase in average balances of $59.1 million and a 36 bp increase in the average yield.
Interest Expense
Interest expense increased $8.4 million, or 60.7%, to $22.1 million, in 2019, compared to $13.8 million in 2018. Interest expense on deposits increased by $6.9 million in 2019, compared to 2018, with $3.9 million of the increase resulting from increases in average volumes and $3.0 million resulting from increases in rates paid on interest-bearing deposits. These increases were influenced by a $129.4 million increase in the average balance of time deposits and a corresponding 75 bp increase in the rate paid on such deposits. Average non-maturity interest bearing deposits increased $43.7 million with a 12 bp increase in the average rate paid on such deposits. We increased the interest rates on our interest-bearing deposits in response to the prevailing competitive rates in our market. The amortization of fair value adjustments in our interest-bearing liabilities, primarily in time deposits, reduced the rate on interest bearing liabilities by one bp in 2019, compared to six bp in 2018. Overall, the average interest rate paid on interest bearing deposits increased 45 bp in 2019. In addition, interest expense on short- and long-term borrowings increased an aggregate of $1.4 million in 2019, compared to 2018, resulting from a 148 bp increase in the average rate paid on such borrowings. The increase in average rates paid on borrowings more than offset the $4.9 million decrease in our average balance of short- and long-term borrowings in 2019, compared to 2018.
Provision for Credit Losses
We recorded a provision for credit losses of $4.2 million for 2019, compared to $6.1 million for 2018, a decrease of $1.9 million. The decrease included the impact of a decrease in specific reserves from $2.4 million at December 31, 2018 to $500 thousand at December 31, 2019. The trend in our asset quality metrics indicate year over year improvement. Our nonperforming loans, as a percentage of gross loans, declined to 1.10% at 2019, from 1.50% at 2018, and nonperforming assets, as a percentage of total assets, declined to 0.94% at 2019 from 1.28% at 2018.
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Noninterest Income
The following table presents the major categories of noninterest income for the years ended December 31, 2019 and 2018:
(in thousands)
$ Change
% Change
Service charges on deposit accounts
Realized and unrealized gains on mortgage banking activity
Gain (loss) on the sale of securities
Loss on the disposal of bank premises & equipment
Income from bank owned life insurance
Loan related fees and service charges
Other operating income
Total noninterest income
Noninterest income was $21.0 million for 2019, compared to $17.9 million for 2018. This increase was primarily driven by a $2.6 million increase in realized and unrealized gains on mortgage banking activity and the net $1.0 million increase in gain (loss) on the sale of securities. While our mortgage loans originated for sale were down 2.2% in 2019, compared to 2018, our increase in realized and unrealized gains was up 48.7%. This represents an average gain on loans originated for sale of 1.36% in 2019, compared to 0.89% in 2018. The improvement in our average gain on loans originated for sale was the result of a stronger management focus on originating a more profitable product mix. The gain/(loss) on the sale of securities in 2019 and 2018, respectively, were both due to our interest rate positioning strategies at the time of the respective sales.
Service charges on deposit accounts, which consisted of account activity fees such as overdraft fees and other traditional banking fees, increased $531 thousand in 2019, compared to 2018, primarily as a result of increased overdraft activities resulting from deposit growth during 2019.
Other operating income, which consisted mainly of non-depository account fees such as wire, merchant card and ATM services increased $252 thousand in 2019, compared to 2018. Reflected in 2019 other operating income was $750 thousand in revenue associated with the previously disclosed exit of our mortgage banking activities. In 2018, other operating income included a $750 thousand insurance refund.
Partially offsetting the above increases was a $1.7 million decrease in loan related fees and service charges. This decrease was primarily due to a $2.0 million reduction in underwriting and processing fees in 2019. Underwriting and processing fees from our mortgage banking activities decreased $2.3 million in 2019, compared to 2018. This reduction resulted from our decision to discontinue our national consumer direct origination channel in mid-2018. The loans originated from this channel generated substantially higher underwriting and processing fees per loan than comparable fees on loans originated from our retail origination channel.
Our mortgage banking activities generated total noninterest income of $10.6 million in 2019 and $10.2 million in 2018.
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Noninterest Expenses
The following table presents the major categories of noninterest expense for the years ended December 31, 2019 and 2018:
(in thousands)
$ Change
% Change
Compensation and benefits
Occupancy and equipment
Marketing and business development
Professional fees
Data processing fees
Merger and restructuring expense
FDIC assessment
Other real estate owned
Loan production expense
Amortization of core deposit intangible
Other operating expense
Total noninterest expense
Noninterest expenses decreased $19.0 million, or 22.9%, to $64.1 million for 2019, compared to $83.1 million for 2018. This decrease was primarily driven by $15.5 million of merger and restructuring expenses related to our merger with First Mariner in 2018, which were not repeated in 2019.
Compensation and benefits expense decreased $1.6 million in 2019, compared to 2018. The primary driver of this decrease was decreases in staff related to our branch optimization initiative in 2019.
Occupancy and equipment expense decreased $1.6 million in 2019, compared to 2018. Following our merger with First Mariner in 2018, we evaluated our retail branch network, which resulted in the closing of several acquired and existing locations that we deemed to be redundant. In 2019, we continued to evaluate our branch delivery system and further optimized our branch locations. Because of our branch optimization efforts, we incurred $3.6 million and $2.7 million in lease termination and location closing costs in 2019 and 2018, respectively, partially offset by a reduction in lease liability expense on one branch location closed in 2019. These efficiencies also reduced general operating expenses (rent, janitorial, utilities, and depreciation) by $2.0 million in 2019, and equipment expenses (hardware and maintenance contracts and real estate taxes) by $281 thousand in 2019.
Marketing and business development expenses decreased by $1.0 million, or 29.9%, to $2.3 million in 2019. The 2018 expense level included $1.1 million of costs associated with mortgage lead generation from our former national leads-based consumer direct residential first lien mortgage origination channel that we discontinued in mid-2018. Data processing costs increased by $877 thousand to $4.9 million in 2019, from $4.0 million in 2018, resulting from the large growth in loan and deposit accounts primarily resulting from our merger with First Mariner, which increased our core processing cost, as well as improved technology to enhance product deliveries. Our FDIC insurance expense was down $601 thousand in 2019. We received small bank assessment credits from the FDIC of $522 thousand in 2019, resulting from the Deposit Insurance Fund ratio exceeding 1.38%.
Other operating expenses increased $268 thousand in 2019, compared to 2018, primarily as a result of a $700 thousand charge related to the settlement of a litigation claim related to mortgages originated by First Mariner before our acquisition of the bank and $692 thousand of prepayment penalties resulting from our early redemption of FHLB advances. Partially offsetting these increases was a $1.4 million reduction in various categories of other expense, due primarily to merger integration and branch optimization efficiencies.
Income Tax Expense
Income tax expense for 2019 was $5.2 million, compared to an income tax benefit in 2018 of $897 thousand. Our effective tax rate (income tax expense as a percentage of pretax income) was 23.5% in 2019 and 19.0% in 2018. The effective tax rate is influenced by sources of non-taxable income, such as the income from Bank Owned Life Insurance (“BOLI”) as
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well as certain non-deductible expense items. Certain merger and acquisition costs are deemed not deductible for income tax purposes, which impacted the effective tax rate for 2018. Income tax expense for 2019 was favorably impacted by a 2019 U.S. Treasury Department change in tax regulations that provided for retroactive application to the taxability of income from BOLI contracts that were acquired in certain tax-free merger transactions. As a result of the change in tax regulations, we recognized a $232 thousand net reduction of tax expense in 2019 pertained to BOLI income that was earned, and initially treated as subject to income tax, in 2018. Excluding the impact of the $232 thousand of BOLI income, the effective tax rate for 2019 would have been 24.5%.
Nonperforming and Problem Assets; COVID–Related Loan Deferrals
We perform reviews of all delinquent loans and our loan officers contact customers to attempt to resolve potential credit issues in a timely manner. Loans are placed on non-accrual status when payment of principal or interest is 90 days or more past due and the value of the collateral securing the loan, if any, is less than the outstanding balance of the loan. Loans are also placed on non-accrual status if we have seriousdoubt about further collectability of principal or interest on the loan, even though the loan is currently performing. When loans are placed on non-accrual status, unpaid accrued interest is fully reversed, and subsequent income, if any, is recognized only to the extent received. The loan may be returned to accrual status if the loan is brought current, has performed in accordance with the contractual terms for a reasonable period of time and ultimate collectability of the total contractual principal and interest is no longer in doubt.
Under GAAP we are required to account for certain loan modifications or restructurings as troubled debt restructurings (“TDRs”). In general, the modification or restructuring of a debt constitutes a TDR if we, for economic or legal reasons related to the borrower’s financial difficulties, grant a concession, such as a reduction in the effective interest rate, to the borrower that we would not otherwise consider. However, all debt restructurings or loan modifications for a borrower do not necessarily constitute TDRs. We believe loan modifications will potentially result in a lower level of loan losses and loan collection costs than if we proceeded immediately through the foreclosure process with these borrowers.
The CARES Act, as extended by certain provisions of the Consolidated Appropriations Act, 2021, permits banks to suspend requirements under GAAP for loan modifications to borrowers affected by COVID-19 that may otherwise be characterized as TDRs and suspend any determination related thereto if (i) the borrower was not more than 30 days past due as of December 31, 2019, (ii) the modifications are related to COVID-19, and (iii) the modification occurs between March 1, 2020 and the earlier of 60 days after the date of termination of the national emergency or January 1, 2022. Federal bank regulatory authorities also issued guidance to encourage banks to make loan modifications for borrowers affected by COVID-19 and confirmed in working with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not TDRs.
Our level of COVID-19-related loan deferrals has generally continued to trend favorably. As of December 31, 2020, a total of $56.1 million of loans, representing 3.0% of total loans and 3.3% of portfolio loans, were performing under some form of deferral or other payment relief. By comparison, $291.4 million of loans, representing 15.3% of total loans and 17.1% of portfolio loans, were performing under some form of deferral or other payment relief as of June 30, 2020; June 30, 2020 represented our highest level of loan deferrals at any quarter-end in 2020. As of March 12, 2021, loan deferrals were $55.8 million, representing 3.0% of total loans and 3.3% of portfolio loans. We expect that some requests for payment deferral extensions will continue while other borrowers currently on payment deferral will resume payments.
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The table below sets forth the amounts and categories of our nonperforming assets, which consist of non-accrual loans, TDRs and OREO (which includes real estate acquired through, or in lieu of, foreclosure), at the dates indicated.
December 31,
(in thousands)
Non-accrual loans:
Real estate loans:
Construction and land
Residential - first lien
Residential - junior lien
Commercial owner occupied
Commercial non-owner occupied
Commercial and leases
Consumer
Total non-accrual loans
Accruing troubled debt restructured loans:
Real estate loans:
Construction and land
Residential - first lien
Commercial non-owner occupied
Commercial and leases
Total accruing troubled debt restructured loans
Total nonperforming loans
Other real estate owned:
Land
Residential - first lien
Commercial non-owner occupied
Total other real estate owned
Total nonperforming assets
Ratios:
Nonperforming loans to total loans and leases
Nonperforming loans to portfolio loans (1)
Nonperforming assets to total assets
Loans past due 90 days still accruing:
Real estate loans:
Construction and land
Residential - first lien
Residential - junior lien
Commercial owner occupied
Commercial non-owner occupied
Commercial and leases
Consumer
Denotes a non-GAAP measure; refer to the section “Use of Non-GAAP Financial Measures and Related Reconciliations” for additional detail.
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Nonperforming Loans
The government fiscal stimulus and relief programs appear to have delayed any materially adverse financial impact to our loan portfolio. Once these stimulus programs have been exhausted, however, we believe our credit metrics could worsen and loan losses could ultimately materialize. Any potential loan losses will be contingent upon a number of factors beyond our control, such as the resurgence of the virus, including any new strains, offset by the potency of the vaccine along with its extensive distribution, and the ability for customers and businesses to return to their pre-pandemic routines.
Nonperforming loans were $19.4 million, or 1.04% of total loans and leases and 1.14% of portfolio loans, at December 31, 2020. Nonperforming loans were up $288 thousand from the December 31, 2019 level, which represented 1.10% of total loans. The $288 thousand increase in 2020 was due primarily to $6.9 million in new nonaccrual loans offset by $5.2 million in payoffs, $1.0 million of charge-offs and $369 thousand of returns to accruing status. $564 thousand of the 2020 nonperforming loan charge-offs were attributable to the full charge-off of loans to one borrower during the first quarter of 2020 where we had recorded a specific allocation of the allowance for loan and lease losses of $500 thousand at December 31, 2019.
Included in non-accrual loans at December 31, 2020 are three troubled debt restructured loans (“TDRs”) with a new carrying balance totaling $498 thousand that were not performing in accordance with their modified terms, and the accrual of interest has ceased. In addition, there were five TDRs totaling $1.5 million that were performing in accordance with their modified terms. There were no additional TDRs in 2020.
The composition of our nonperforming loans at December 31, 2020 is further described below:
Non-Accrual Loans
● Two construction and land loans
● 55 residential first lien loans, three with a combined fair value of $2.5 million in the process of foreclosure
● 22 residential junior lien loans, one with a fair value of $25 thousand in the process of foreclosure
● Two commercial real estate owner-occupied loans, one with a fair value of $294 thousand in the process of foreclosure
● Four commercial real estate non-owner-occupied loans
● Nine commercial loans representing five separate relationships, one with an SBA guarantee, and two loans to one relationship with specific reserves totaling $894 thousand
Accruing Troubled Debt Restructured Loans
● Three residential real estate loans
● Two commercial loans
Nonperforming Assets
Nonperforming assets consist of nonperforming loans and other real estate owned (“OREO”). Our nonperforming assets were $20.2 million, or 0.79% of total assets, at December 31, 2020 compared to $22.2 million, or 0.94% of total assets, at December 31, 2019. Nonperforming assets decreased by $2.1 million at December 31, 2020, compared to December 31, 2019, with OREO down $2.4 million, partially offset by a $288 thousand increase in nonperforming loans.
Other Real Estate Owned
Real estate we acquire as a result of foreclosure is classified as OREO. When a property is acquired as a result of foreclosure, it is recorded at fair value less the anticipated cost to sell at the date of foreclosure. If there is a subsequent change in the value of OREO, we record a valuation allowance to adjust the carrying value of the real estate to its current fair value less estimated disposal costs. Costs relating to holding such real estate are expensed in the current period while
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costs relating to improving such real estate are capitalized up to the property’s net realizable value until a saleable condition is reached. Costs in excess of the property’s net realizable value would be expensed in the current period.
Our OREO totaled $743 thousand at December 31, 2020, a $2.4 million decrease from $3.1 million at December 31, 2019. Included in noninterest expenses were $257 thousand, $473 thousand and $352 thousand for 2020, 2019 and 2018, respectively, attributable to net increases in valuation allowances as the current appraised value of OREO properties, less estimated cost to sell, was insufficient to cover the recorded OREO amount. In addition, we sold several parcels of land, one commercial real estate property, and three residential real estate properties with a combined net carrying balance of $2.1 million in 2020, which resulted in a $98 thousand net loss on the disposition of OREO in 2020. We added one new residential real estate property with a carrying balance of $51 thousand in 2020.
OREO at December 31, 2020 consisted of:
● Several parcels of unimproved land.
● Two residential 1-4 family properties.
Classification of Loans
Our policies, consistent with regulatory guidelines, provide for the classification of loans and other assets that are considered to be of lesser quality as Substandard, Doubtful, or Loss assets. An asset is considered Substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Substandard assets include those assets characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Assets classified as Doubtful have all of the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable or improbable. Assets (or portions of assets) classified as Loss are those considered uncollectible and of such little value that their continuance as assets is not warranted. Assets that do not expose us to risk sufficient to warrant classification in one of the aforementioned categories, but which possess potential weaknesses that deserve our close attention, are required to be designated as Special Mention.
We maintain an allowance for loan and lease losses at an amount estimated to equal all loan losses incurred in our loan portfolio that are both probable and reasonable to estimate at a balance sheet date. Our determination as to the classification of our assets is subject to review by the Commissioner and the FDIC. We regularly review our asset portfolio to determine whether any assets require classification in accordance with applicable regulations.
The $22.2 million increase in special mention loans at December 31, 2020, is primarily due to COVID-related downgrades. The following table sets forth our amounts of classified loans and criticized loans (classified loans plus loans designated as Special Mention) at the dates indicated.
December 31,
(in thousands)
Classified loans:
Substandard
Doubtful
Total classified loans
Special mention
Total criticized loans
Allowance for Loan and Lease Losses
Our allowance for loan and lease losses (the “allowance”) at December 31, 2020 was $19.2 million, up $8.8 million or 84.2% from $10.4 million at December 31, 2019. Net charge-offs in 2020 were $764 thousand and we recorded a $9.5 million provision for credit losses attributable to loan and lease losses. The allowance was 1.03% of total loans and leases and 1.13% of portfolio loans (a non-GAAP financial measure – refer to the “Use of Non-GAAP Financial Measures” section for additional detail) at December 31, 2020, compared to 0.60% of total loans and leases at December 31, 2019.
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The allowance was also 98.62% of nonperforming loans at December 31, 2020, an increase of 44.28% from 54.34% of nonperforming loans at December 31, 2019. The $8.8 million increase in our allowance was primarily the result of management’s response to the COVID-19 pandemic and changes in the qualitative factors discussed below.
COVID-19 and Our Evaluation of the Allowance
The December 31, 2020 allowance reflects our assessment of the impact of COVID-19 on the national and local economies and the impact on various categories of our loan portfolio. Management’s evaluation of COVID-19’s impact on the allowance identified the following qualitative factors for further review:
● Changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments;
● The existence and effect of any concentrations of credit, and changes in the level of such concentrations;
● Changes in the value of underlying collateral for collateral-dependent loans; and
● Changes in the volume and severity of past due, nonaccrual, and adversely classified loans.
Our evaluation of changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments, considered the abruptslowdown in commercial economic activity and the dramatic rise in the unemployment rate in our market area. Initially, stay-at-home orders, travel restrictions and closure of non-essential businesses resulted in significant business and operational disruptions, including business closures, supply chain disruptions, mass layoffs, and furloughs. Although many of those restrictions have been lifted or eased, continuing capacity restrictions and health and safety recommendations that discourage travel and encourage continued physical distancing and teleworking have limited the ability of businesses to return to pre-pandemic levels of activity and employment. Therefore, this qualitative factor was increased during 2020 in response to this potential risk, and represents $6.0 million, or 0.35%, of the increase in the allowance.
We also evaluated the existence and effect of any concentrations of credit, and changes in the level of such concentrations, with a focus on the identification of our exposure to industry segments that may potentially be the most highly impacted by COVID-19. The following table identifies those industry segments within our loan portfolio that we believe may potentially be most highly impacted by COVID-19. All balances are as of December 31, 2020; note that the column “Initial SBA PPP Loan Relief” indicates the original balance of PPP loans received by our borrowers in each of the identified loan segments. The potentially highly impacted loan segments total $352.0 million, or 18.9% of total loans and leases, at December 31, 2020. However, the table presents each of these loan segments as a percentage of portfolio loans, which we believe is a more meaningful measure of our potentially highly impacted loan concentration. The definition of our potentially highly impacted (“PHI”) loan segments has remained unchanged through December 31, 2020.
Total Credit
Balance
Initial SBA
($in millions)
Loan
Portfolio
Exposure
Total Credit
with
Loan
PPP Loan
Loan Category
Balance
Loans (1)
Exposure
Deferrals
Category
Relief
Loan Category
CRE - retail
Hotels
CRE - residential rental
Nursing and residential care
Retail trade
Restaurants and caterers
Religious and similar organizations
Arts, entertainment, and recreation
Total - selected categories
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A non-GAAP financial measure – refer to the section “Use of Non-GAAP Financial Measures and Related Reconciliation” for additional detail
Includes unused lines of credit, unfunded commitments, and letters of credit
The PHI breakdown by loan portfolio segment is as follows:
($in millions)
Loan
Portfolio
Total
Loan Portfolio Segment
Balance
Total Loans
Loans (1)
"High Impacts"
Commercial real estate - non-owner occupied
Commercial real estate - owner occupied
Construction and land
Commercial loans and leases
Other
Total
A non-GAAP financial measure – refer to the section “Use of Non-GAAP Financial Measures and Related Reconciliation” for additional detail
PHI loan exposures at December 31, 2020 were concentrated in non-owner-occupied commercial real estate (62.1% of total PHI), owner-occupied commercial real estate (19.4% of total PHI), construction and land (9.6% of total PHI), and C&I loans (8.4% of total PHI). Therefore, this qualitative factor within these PHI loan portfolio segments was increased during 2020 in response to this potential risk, and represents $1.3 million, or 0.08%, of the increase in the allowance.
Our evaluation of potential changes in the value of underlying collateral for collateral-dependent loans considered the potential impact of the economic fallout from COVID-19 on commercial property values due to rent relief and possible business failures resulting in vacancies. In addition, the need for office space may diminish in the future as work from home policies have allowed much office-oriented business activity to continue. We concluded that 53% of our non-owner-occupied commercial real estate portfolio at December 31, 2020 was not included in a PHI loan segment. Therefore, this qualitative factor was increased during 2020 in response to this potential risk, and represents $1.0 million, or 0.06%, of the increase in the allowance.
Our evaluation of changes in the volume and severity of past due, nonaccrual, and adversely classified loans identified three loan portfolio segments where adverse risk rating migration warranted an upward revision to this qualitative factor during 2020; these portfolio segments were both non-owner-occupied and owner-occupied commercial real estate loans as well as C&I loans. The increase in this qualitative factor represents $1.3 million, or 0.08%, of the increase in the allowance.
Credit Risk Management and Allowance Methodology
We provide for loan and lease losses (hereinafter referred to as “loan losses”) based upon the consistent application of our documented allowance methodology. All loan losses are charged to the allowance and all recoveries are credited to it. Additions to the allowance are provided by charges to income based on various factors that, in our judgment, deserve current recognition in estimating probable losses. We regularly review the loan portfolio and make provisions for credit losses in order to maintain the allowance in accordance with GAAP.
In accordance with accounting guidance for business combinations, there was no allowance brought forward on any acquired loans in our acquisitions. For acquired performing loans, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value and the discount is accreted to interest income over the life of the loan. Subsequent to the purchase date, the method used to evaluate the sufficiency of the credit discount is similar to originated loans, and if necessary, additional reserves are recognized in the allowance.
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We recorded acquired credit impaired loans in our acquisitions net of purchase accounting adjustments. Subsequent to the acquisition date, management continues to monitor cash flows on a quarterly basis, to determine the performance of each acquired credit impaired loan in comparison to management’s initial performance expectations. Subsequent decreases in the present value of expected cash flows will be recorded as an increase in the allowance through a provision for credit losses. Subsequent significant increases in cash flows result in a reversal of the provision for credit losses to the extent of prior provisions or a reclassification of amount from non-accretable difference to accretable yield, with a positive impact on the accretion of interest income in future periods.
The allowance consists of two components – specific and general allowances:
Specific allowances are established for loans classified as Substandard or Doubtful. For loans classified as impaired, the allowance is established when the net realizable value (collateral value less costs to sell) of the impaired loan is lower than the carrying amount of the loan. The amount of impairment provided for as a specific allowance is represented by the deficiency, if any, between the underlying collateral value and the carrying value of the loan. Impaired loans for which the estimated fair value of the loan, or the loan’s observable market price or the fair value of the underlying collateral, if the loan is collateral dependent, exceeds the carrying value of the loan are not considered in establishing specific allowances; and
General allowances established for loan losses on a portfolio basis for loans that do not meet the definition of impaired loans. The portfolio is grouped into similar risk characteristics, primarily loan type and regulatory classification. We apply an estimated loss rate to each loan group. The loss rates applied are based upon our loss experience adjusted, as appropriate, for the qualitative factors discussed below. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant revisions based upon changes in economic and real estate market conditions.
The allowance is maintained at a level to provide for loan losses that are probable and can be reasonably estimated. Our periodic evaluation of the adequacy of the allowance is based on past credit loss experience, known and inherent losses in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans.
A loan is considered past due or delinquent when a contractual payment is not paid on the day it is due. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. We determine the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. The impairment of a loan may be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if repayment is expected to be provided by the collateral. Generally, our impairment on such loans is measured by reference to the fair value of the collateral. Interest income on impaired loans is recognized on the cash basis.
Our loan policies state that after all collection efforts have been exhausted, and the loan is deemed to be a loss, then the remaining loan balance will be charged off against the allowance. All loans are evaluated for loss potential once it has been determined by our Watch Committee that the likelihood of repayment is in doubt. When a loan is past due for at least 90 days or a deterioration in debt service coverage ratio, guarantor liquidity, or loan-to-value ratio has occurred that would cause concern regarding the likelihood of the full repayment of principal and interest, and the loan is deemed not to be well secured, the loan is moved to non-accrual status and a specific reserve is established if the net realizable value is less than the principal value of the loan balance(s). Once the actual loss value has been determined, this amount is charged off against the allowance. Each loss is evaluated on its specific facts regarding the appropriate timing to recognize the loss.
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The adjustments to historical loss experience are based on our evaluation of several qualitative factors, including:
● changes in lending policies, procedures, and practices;
● changes in international, national, state and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments;
● changes in the nature and volume of the loan portfolio;
● changes in the experience, ability and depth of the lending staff;
● changes in the volume and severity of past due, nonaccrual, and adversely classified loans;
● changes in the quality of our loan review system;
● changes in the value of underlying collateral for collateral-dependent loans;
● the existence of any concentrations of credit, and changes in the level of such concentrations;
● the effect of other external factors such as competition and legal and regulatory requirements; and
● any other factors that management considers relevant to the quality or performance of the loan portfolio.
We evaluate the allowance based upon the combined total of the specific and general components. Generally when the loan portfolio increases, absent other factors, the allowance methodology results in a higher dollar amount of estimated probable losses than would be the case without the increase. Generally when the loan portfolio decreases, absent other factors, the allowance methodology results in a lower dollar amount of estimated probable losses than would be the case without the decrease.
Commercial and commercial real estate loans generally have greater credit risks compared to the one- to four-family residential mortgage loans in our loan portfolio, as they typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. In addition, the payment experience on loans secured by income-producing properties typically depends on the successful operation of the related business and thus may be subject to a greater extent to adverse conditions in the real estate market and in the general economy. Actual loan and lease losses may be significantly more than the allowance we have established, which could have a material negative effect on our financial results.
Generally, we underwrite commercial loans based on cash flow and business history and receive personal guarantees from the borrowers where appropriate. We generally underwrite commercial real estate loans and residential real estate loans at a loan-to-value ratio of 85% or less at origination. In the event that a loan becomes significantly past due, we will conduct visual inspections of collateral properties and/or review publicly available information, such as online databases, to ascertain property values. We will also obtain formal appraisals on a regular basis even if we are not considering liquidation of the property to repay a loan. It is our practice to obtain updated appraisals if there is a material change in market conditions or if we become aware of new or additional facts that indicate a potential material reduction in the value of any individual property collateral.
For impaired loans, we utilize the appraised value or present value of expected cash flows in determining the appropriate specific allowance attributable to the loan. In addition, changes in the appraised value of multiple properties securing our loans may result in an increase or decrease in our general allowance as an adjustment to our historical loss experience due to qualitative and environmental factors, as described above.
Nonperforming loans are evaluated and valued at the time the loan is identified as impaired on a case by case basis, at the lower of cost or market value. Market value is measured based on the value of the collateral securing the loan. The value of real estate collateral is determined based on an appraisal by qualified licensed appraisers hired by us. Appraised values may be discounted based on management’s historical experience, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. The difference between the appraised value and the principal balance of the loan will determine the specific allowance valuation required for the loan, if any. Nonperforming loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly.
We evaluate the loan portfolio on at least a quarterly basis, more frequently if conditions warrant, and the allowance is adjusted accordingly. While we use the best information available to make evaluations, future adjustments to the
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allowance may be necessary if conditions differ substantially from the information used in making the evaluations. In addition, as an integral part of their examination process, the Commissioner and the FDIC will periodically review the allowance. The Commissioner and the FDIC may require us to recognize additions to the allowance based on their analysis of information available to them at the time of their examination.
The following table sets forth activity in our allowance for loan and lease losses for the periods ended:
December 31,
(in thousands)
Balance at beginning of year
Charge-offs:
Real estate
Construction and land loans
Residential first lien loans
Residential junior lien loans
Commercial owner occupied loans
Commercial non-owner occupied loans
Commercial loans and leases
Consumer loans
Total charge-offs
Recoveries:
Real estate
Construction and land loans
Residential first lien loans
Residential junior lien loans
Commercial owner occupied loans
Commercial non-owner occupied loans
Commercial loans and leases
Consumer loans
Total recoveries
Net charge-offs
Provision for credit losses (1)
Balance at end of year
Allowance as a % of total loans and leases
Allowance as a % of portfolio loans (2)
Allowance as a % of nonperforming loans
Net charge-offs to average loans and leases
Provision for credit losses to average loans and leases
Portion attributable to loan and lease losses
Denotes a non-GAAP measure - refer to the section “Use of Non-GAAP Financial Measures and Related Reconciliations” for additional detail
Allocation of Allowance for Loan and Lease Losses
The following table sets forth the allocation of the allowance by loan category and the percent of loans in each category to total loans at the dates indicated. The allowance allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories. Loans funded through the PPP program are fully guaranteed by the U.S. government and we anticipate that the majority of these loans
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will ultimately be forgiven by the SBA in accordance with the terms of the program. Therefore, no allowance for loan and lease losses is attributable to this loan portfolio segment.
December 31,
(in thousands)
Amount
Percent (1)
Amount
Percent (1)
Amount
Percent (1)
Amount
Percent (1)
Amount
Percent (1)
Real estate loans:
Construction and land loans
Residential first lien loans
Residential junior lien loans
Commercial owner occupied loans
Commercial non-owner occupied loans
Total real estate loans
Commercial loans and leases
Consumer loans
Paycheck Protection Program (PPP)
Total
Represents the percent of loans in each category to total loans and leases.
Liquidity and Capital Resources
Liquidity is the ability to meet current and future financial obligations. Our primary sources of funds consist of deposit inflows, loan repayments, advances from the FHLB, and the sale of securities available for sale. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. Our Asset/Liability Committee (“ALCO”) is responsible for establishing and monitoring our liquidity targets and strategies in order to ensure that sufficient liquidity exists for meeting the borrowing needs and deposit withdrawals of our customers as well as unanticipated contingencies. We believe that we had enough sources of liquidity to satisfy our short- and long-term liquidity needs as of December 31, 2020 and December 31, 2019.
We regularly monitor and adjust our investments in liquid assets based upon our assessment of:
● Expected loan demand;
● Expected deposit flows and borrowing maturities;
● Yields available on interest-earning deposits and securities; and
● The objectives of our asset/liability management program.
The most liquid of all assets are cash and cash equivalents. The level of these assets is dependent on our operating, financing, lending and investing activities during any given period. At December 31, 2020 and 2019, cash and cash equivalents totaled $74.6 million and $110.0 million, respectively. Our excess liquid assets were invested in interest-bearing deposits in banks (primarily the Federal Reserve Bank of Richmond). The level of these assets is dependent on our operating, financing, lending and investing activities during any given period.
Our cash flows are derived from operating activities, investing activities and financing activities as reported in our statements of cash flows included in our financial statements.
Our total commitments to extend credit and available credit lines are discussed in the “Commitments and Off-Balance Sheet Arrangements” section of this MD&A, including a table presenting our comparative exposure at December 31, 2020 and 2019.
CDs due within one year totaled $416.1 million, or 21.1% of total deposits, and $458.9 million, or 26.8% of total deposits, at December 31, 2020 and 2019, respectively. If we do not retain these deposits, we may be required to seek other sources of funds, including loan and securities sales and FHLB advances. Based on current market conditions, a substantial portion of our customer CDs with maturities of one year or less are at significantly higher rates than current market rates for both customer CDs and other funding sources. As a result, we do not expect to retain some portion of our customer CDs with maturities of one year or less as of December 31, 2020.
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Our primary investing activity is originating loans. During the years ended December 31, 2020 and December 31, 2019, cash used to fund net loan growth was $119.5 million and $99.2 million, respectively. PPP loans accounted for $167.6 million of the net loan growth in 2020. During 2020, we purchased $340.4 million of securities which partially offset $80.1 million of securities maturities / calls / paydowns and $105.0 million of securities sales. In 2019, we purchased $102.7 million of securities which partially offset $80.4 million of securities maturities / calls / paydowns and $35.4 million of securities sales.
Financing activities consist primarily of activity in deposit accounts and FHLB advances. We experienced a net increase in cash provided from deposits of $261.0 million and $28.6 million, respectively, during the years ended December 31, 2020 and 2019. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our local competitors, and by other factors, including the pandemic which caused significant growth in deposit balances held by both households and businesses.
Liquidity management is both a daily and long-term function of business management. If we require funds beyond our ability to generate them internally, borrowing agreements exist with the FHLB, which provide an additional source of funds. FHLB advances decreased to $200.0 million at December 31, 2020 compared to $285.0 million at December 31, 2019. At December 31, 2020, we had an available line of credit for $639.7 million at the FHLB, with borrowings limited to a total of $475.0 million based on pledged collateral. At December 31, 2019, this available line of credit at the FHLB was $573.3 million, with borrowings limited to a total of $435.4 million based on pledged collateral. Additionally, we participated in and continue to have access to borrowing availability under the FRB’s PPPLF. At December 31, 2020 there were no outstanding PPPLF advances.
The Bank is subject to various regulatory capital requirements, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At December 31, 2020 and 2019, we exceeded all regulatory capital requirements and are considered “well capitalized” under regulatory guidelines. See “Item 1. Business—Supervision and Regulation—Howard Bank—Capital Requirements” and Note 20 of our Consolidated Financial Statements.
Commitments and Off-Balance Sheet Arrangements
We are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our customers. These financial instruments are limited to commitments to originate loans and involve, to varying degrees, elements of credit, interest rate, and liquidity risk. These do not represent unusual risks, and management does not anticipate any losses that would have a material effect on us.
Outstanding loan commitments and lines of credit at December 31, 2020 and December 31, 2019 are as follows:
December 31,
(in thousands)
Unfunded loan commitments
Unused lines of credit
Letters of credit
Total commitments to extend credit and available credit lines
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. We generally require collateral to support financial instruments with credit risk on the same basis as we do for balance sheet instruments. Management generally bases the collateral required on the credit evaluation of the counterparty. Commitments generally have interest rates at current market rates, expiration dates or other termination clauses and may require payment of a fee. Available credit lines represent the unused portion of lines of credit previously extended and available to the customer so long as there is no violation of any contractual condition. These lines generally have variable interest rates. Since we expect many of the commitments to expire without being drawn upon, and since it is unlikely that all customers will draw upon their lines of credit in full at any one time, the total commitment amount or line of credit amount does not necessarily represent future cash requirements. We evaluate each
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customer’s credit-worthiness on a case-by-case basis. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.
The credit risk involved in these financial instruments is essentially the same as that involved in extending loan facilities to customers. At December 31, 2020 we had a $320 thousand reserve for potential credit losses related to these commitments, recorded in other liabilities on the consolidated balance sheet. We did not have a reserve for potential credit losses related to these commitments at December 31, 2019.
We have contractual obligations to make future payments on debt and lease agreements. In the normal course of business, we enter into contractual arrangements whereby we commit to future purchases of products or services from unaffiliated parties. These purchase obligations are legally binding agreements whereby we agree to purchase products or services with a specific minimum quantity at a fixed, minimum or variable price over a specified period of time. Purchase obligations may include vendor contracts, communication services, processing services and software contracts. We also have contractual obligations under real property leases for certain facilities we utilize.
Payments due by period for our contractual obligations at December 31, 2020 are as follows:
Within
One to
Three to
Over
(in thousands)
one year
three years
five years
five years
Total
Certificates of deposit
FHLB borrowings
Estimated interest due on certificates of deposit and long-term borrowings
Contractual service obligations
Future lease payments
Impact of Inflation and Changing Prices
Our financial statements and related notes have been prepared in accordance with GAAP. GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration of changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on performance than the effects of inflation.
