Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with U. S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. In particular, the Company has identified the determination of the ALLL, OREO, fair value measurements, the evaluation of deferred tax assets, the other-than-temporary impairment evaluation of securities, and the valuation of our derivative positions to be critical because management must make subjective and/or complex judgments about matters that are inherently uncertain and could be most subject to revision as new information becomes available. Note 2 to our audited consolidated financial statements contains a summary of our significant accounting policies. Management believes our policy with respect to the methodology for the determination of the allowance for loan losses involves more complexity and requires management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could materially impact results of operations. This critical policy and its application are periodically reviewed with the Audit Committee and our Board of Directors.
The Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Such estimates include ALLL, fair value of financial estimates, along with assumptions used in the calculation of income taxes, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using loss experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods. There can be no assurances that actual results will not differ from those estimates.
Operating, Accounting and Reporting Considerations related to COVID-19
The COVID-19 pandemic has negatively impacted the global economy. In response to the crisis, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was passed by Congress and signed into law on March 27, 2020. The CARES Act provided an estimated $2.2 trillion to fight the COVID-19 pandemic and stimulate the economy by supporting individuals and businesses through loans, grants, tax changes, and other types of relief. Under Section 4013 of the CARES Act and based upon regulatory guidance promulgated by federal banking regulators, qualifying short-term loan modifications resulting in payment deferrals that are attributable to the adverse impact of COVID-19 are not considered to be troubled debt restructurings (“TDRs”). Some of the provisions applicable to the Company include, but are not limited to:
Accounting for Loan Modifications – The CARES Act provides that a financial institution may elect to suspend (1) the requirements under GAAP for certain loan modifications that would otherwise be categorized as a TDR and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes. The suspension is applicable for the term of the loan modification that occurs during the applicable period for a loan that was not more than 30 days past due as of December 31, 2019. The suspension is not applicable to any adverse impact on the credit of a borrower that is not related to the pandemic.
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Paycheck Protection Program – The CARES Act established the Paycheck Protection Program (“PPP”), an expansion of the Small Business Administration’s 7(a) loan program and the Economic Injury Disaster Loan Program (“EIDL”), administrated directly by the Small Business Administration (“SBA”).
Also in response to the COVID-19 pandemic, the Board of Governors of the Federal Reserve System (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”), the National Credit Union Administration (“NCUA”), the Office of the Comptroller of the Currency (“OCC”), and the Consumer Financial Protection Bureau (“CFPB”), in consultation with the state financial regulators (collectively, the “agencies”) issued a joint interagency statement (issued March 22, 2020; revised statement issued April 7, 2020). Some of the provisions applicable to the Company include, but are not limited to:
Accounting for Loan Modifications – Loan modifications that do not meet the conditions of the CARES Act may still qualify as a modification that does not need to be accounted for as a TDR. The agencies confirmed with FASB staff that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who are current on payments prior to any relief granted to them are not TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or insignificant delays in payments. Loan modifications were made in accordance with Section 4013 of the CARES Act and the Interagency Statement on Loan Modifications and Reporting for Financial Institutions working with customers affected by COVID-19 and therefore were not classified as TDRs.
Past Due Reporting – With regard to loans not otherwise reportable as past due, financial institutions are not expected to designate loans with deferrals granted due to COVID-19 as past due because of the deferral. A loan’s payment date is governed by the due date stipulated in the legal agreements. If a financial institution agrees to a payment deferral, these loans would not be considered past due during the period of the deferral.
Nonaccrual Status and Charge-offs – During short-term COVID-19 modifications, these loans generally should not be reported as nonaccrual or as classified.
On December 27, 2020, the 2021 Consolidated Appropriations Act was signed into law. The $900 billion relief package includes legislation that extends certain relief provisions of the CARES Act that were set to expire on December 31, 2020. This new legislation extends this relief to the earlier of 60 days after the national emergency declared by the President is terminated or January 1, 2022.
Paycheck Protection Program
The CARES Act established the PPP, an expansion of the EIDL, administrated directly by the SBA.
The Company started accepting and processing applications for loans under the PPP in early April 2020, when the program was officially launched by the SBA and Treasury Department under the CARES Act. The Company sold the entirety of its PPP loan portfolio in December 2020.
Liquidity Sources
Management has reviewed all primary and secondary sources of liquidity in preparation for any unforeseen funding needs due to the COVID-19 pandemic and prioritized based on available capacity, term flexibility, and cost. As of September 30, 2022, the Company had adequate sources of liquidity.
Capital Strength
The Bank’s capital ratios continue to exceed the highest required regulatory benchmark levels. As of September 30, 2022, common equity Tier 1 capital ratio was 19.27 percent, Tier 1 leverage ratio was 16.30 percent, Tier 1 risk-based capital ratio was 19.27 percent and the total risk-based capital ratio was 20.34 percent.
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Deferral and Modification Requests
The CARES Act provided guidance around the modification of loans as a result of the COVID-19 pandemic, which outlined, among other criteria, that short-term modifications made on a good faith basis to borrowers who were current as defined under the CARES Act prior to any relief, are not TDRs. This includes short-term modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers are considered current under the CARES Act and related regulatory guidance if they are less than 30 days past due on their contractual payments at the time a modification program is implemented. As of September 30, 2022, the Company had three COVID-19 pandemic related loan modification agreements totaling $32.0 million representing 4.1 percent of gross loans outstanding. Further details regarding these modifications are provided in the table below. At September 30, 2021, the Company had eight COVID-19-related modified loan deferrals totaling $61.2 million or 6.7% of total loans. Of the remaining $32.0 million deferrals, none of the deferrals are paying the contractual interest payments. For loans subject to the program, each borrower is required to resume making regularly scheduled loan payments at the end of the modification period and the deferred amounts will be moved to the end of the loan term. Management anticipates this activity will continue beyond fiscal year 2022.
September 30, 2022
Number of Loans
Loan Modified Exposure
Gross Loans September 30, 2022
Percentage of Gross Loans Modified
(Dollars in thousands)
Residential mortgage
Construction and Development:
Residential and commercial
Land loans
Total Construction and Development
Commercial:
Commercial real estate
Farmland
Multi-family
Commercial and industrial
Other
Total Commercial
Consumer:
Home equity lines of credit
Second mortgages
Other
Total Consumer
Total loans
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September 30, 2021
Number of Loans
Loan Deferment Exposure
Gross Loans September 30, 2021
Percentage of Gross Loans Modified
(Dollars in thousands)
Residential mortgage
Construction and Development:
Residential and commercial
Land loans
Total Construction and Development
Commercial:
Commercial real estate
Farmland
Multi-family
Commercial and industrial
Other
Total Commercial
Consumer:
Home equity lines of credit
Second mortgages
Other
Total Consumer
Total loans
Allowance for Loan Losses
The allowance for loan losses represents management’s estimate of probable loan losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the Company’s Consolidated Statements of Financial Condition.
The evaluation of the adequacy of the allowance for loan losses includes, among other factors, an analysis of historical loss rates by loan category applied to current loan totals and qualitative factors. However, actual loan losses may be higher or lower than historical trends, which vary. Actual losses on specified problem loans, which also are provided for in the evaluation, may vary from estimated loss percentages, which are established based upon a limited number of potential loss classifications. The allowance for loan losses is established through a provision for loan losses charged to expense. Management believes that the current allowance for loan losses will be adequate to absorb loan losses on existing loans that may become uncollectible based on the evaluation of known and inherent risks in the loan portfolio. The evaluation takes into consideration such factors as changes in the nature and size of the portfolio, overall portfolio quality, and specific loans and current economic conditions which may affect our borrowers’ ability to pay.
The evaluation also details historical losses by loan category and the resulting loan loss rates which are projected for current loan total amounts. Loss estimates for specified problem loans are also detailed. In addition, the OCC, as an integral part of its examination process, periodically reviews our allowance for loan losses. The OCC may require us to make additional provisions for loan losses based upon information available at the time of the examination. All of the factors considered in the analysis of the adequacy of the allowance for loan losses may be subject to change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required that could materially adversely impact earnings in future periods.
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Qualitative or environmental factors that may result in further adjustments to the quantitative analyses include items such as changes in lending policies and procedures, economic and business conditions, nature and volume of the portfolio, changes in delinquency, concentration of credit trends, and value of underlying collateral. The total net adjustments due to qualitative factors, pay-offs and charge-offs decreased the allo wance for loan losses by approximately $2.4 million to $9.1 million from $11.5 million at September 30, 2022 and September 30, 2021, respectively.
An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
Fair Value Measurements
The Company uses fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Investment securities available for sale, equity securities and interest rate swap agreements are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans, other real estate owned and certain other assets. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or write-downs of individual assets.
Under the FASB Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements, the Company groups its assets at fair value in three levels, based on the markets in which the assets are traded and the reliability of the assumptions used to determine fair value. These levels are:
Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.
Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s own estimates of assumptions that market participants would use in pricing the asset.
Under FASB ASC Topic 820, the Company bases its fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is our policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in FASB ASC Topic 820.
Fair value measurements for assets where there exists limited or no observable market data and, therefore, are based primarily upon the Company’s or other third-party’s estimates, are often calculated based on the characteristics of the asset, the economic and competitive environment and other such factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, that could significantly affect the results of current or future valuations. At September 30, 2022, the Company had $14.0 million of assets that were measured at fair value on a non-recurring basis using Level 3 measurements.
Income Taxes
We make estimates and judgments to calculate some of our tax liabilities and determine the realizability of some of our DTAs, which arise from temporary differences between the tax and financial statement recognition of revenues and expenses. We also estimate a reserve for DTAs if, based on the available evidence, it is more likely than not that some portion of the recorded DTAs will not be realized in future periods. These estimates and judgments are inherently subjective. Historically, our estimates and judgments to calculate our deferred tax accounts have not required significant revision to our initial estimates.
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In evaluating our ability to recover DTAs, we consider all available positive and negative evidence, including our past operating results and our forecast of future taxable income. In determining future taxable income, we make assumptions for taxable income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require us to make judgments about our future taxable income and are consistent with the plans and estimates we use to manage our business. Any reduction in estimated future taxable income may require us to record a valuation allowance against our DTAs. An increase in the valuation allowance would result in additional income tax expense in the period and could have a significant impact on our future earnings.
Realization of a DTA requires us to exercise significant judgment and is inherently uncertain because it requires the prediction of future occurrences. Our net DTA amounted to $3.7 million and $3.5 million at September 30, 2022 and at September 30, 2021, respectively. In accordance with ASC Topic 740, the Company evaluates on a quarterly basis, all evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance for DTAs is needed. In conducting this evaluation, management explores all possible sources of taxable income available under existing tax laws to realize the net DTA beginning with the most objectively verifiable evidence first, including available carry back claims and viable tax planning strategies. If needed, management will look to future taxable income as a potential source. Management reviews the Company’s current financial position and its results of operations for the current and preceding years. That historical information is supplemented by all currently available information about future years. The Company understands that projections about future performance are subjective. The Company did not have a DTA valuation allowance as of September 30, 2022 and September 30, 2021.
Other-Than-Temporary Impairment of Securities
Securities are evaluated on a quarterly basis, and more frequently when market conditions warrant such an evaluation, to determine whether declines in their value are other-than-temporary. To determine whether a loss in value is other-than-temporary, management utilizes criteria such as the reasons underlying the decline, the magnitude and duration of the decline and whether management intends to sell or expects that it is more likely than not that it will be required to sell the security prior to an anticipated recovery of the fair value. The term “other-than-temporary” is not intended to indicate that the decline is permanent but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value for a debt security is determined to be other-than-temporary, the other-than-temporary impairment is separated into (a) the amount of the total other-than-temporary related to a decrease in cash flows expected to be collected from the debt security (the credit ) and (b) the amount of the total other-than-temporary related to all other factors. The amount of the total other-than-temporary related to the credit is recognized in earnings. The amount of the total other-than-temporary related to all other factors is recognized in other comprehensive income.
Derivatives
The Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the payment of future uncertain cash amounts, the value of which are determined by interest rates. The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its debt funding and the use of derivative financial instruments. The Company primarily uses interest rate swaps as part of its interest rate risk management strategy.
Interest rate swaps are valued by a third party, using models that primarily use market observable inputs, such as yield curves, and are validated by comparison with valuations provided by the respective counterparties. The credit risk associated with derivative financial instruments that are subject to master netting agreements is measured on a net basis by counterparty portfolio. The significant assumptions used in the models, which include assumptions for interest rates, are independently verified against observable market data where possible. Where observable market data is not available, the estimate of fair value becomes more subjective and involves a high degree of judgment. In this circumstance, fair value is estimated based on management’s judgment regarding the value that market participants would assign to the asset or liability. This valuation process takes into consideration factors such as market illiquidity. Imprecision in estimating these factors can impact the amount recorded on the balance sheet for an asset or liability with related impacts to earnings or other comprehensive income.
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Other assets increased from $13.9 million at September 30, 2021, to $18.7 million at September 30, 2022, due to current year gains on our cash flow hedge and an increase in receivables related to an OREO sale. Other liabilities decreased from $12.3 million at September 30, 2021, to $6.0 million at September 30, 2022, primarily due to the payments related to prior year participation loans purchased settled during fiscal year 2022.
Results of Operations
Net income for the year ended September 30, 2022, was $7.0 million as compared to a net loss of ($92,000) in fiscal year 2021. For fiscal year 2022, the fully diluted earnings per common share was $0.92 as compared with fully diluted loss per common share of ($0.01) in fiscal year 2021.
The increase in net income and diluted earnings per share were primarily due to no provision recorded in fiscal year 2022 compared to a $11.2 million provision for the same period ending 2021.
For the year ended September 30, 2022, the Company’s return on average equity (‘‘ROAE’’) was 4.79 percent and its return on average assets (‘‘ROAA’’) was 0.63 percent. The comparable ratios for the year ended September 30, 2021 were ROAE of (0.06) percent and ROAA of (0.01) percent.
Net Interest Income and Margin
Net interest income is the difference between the interest earned on the portfolio of earning assets (principally loans and investments) and the interest paid for deposits and borrowings, which support these assets.
The following table presents the components of net interest income for the periods indicated.
Net Interest Income
Year Ended September 30,
Increase
Increase
(Decrease)
(Decrease)
from Prior
Percent
from Prior
Percent
(In thousands)
Amount
Year
Change
Amount
Year
Change
Interest income:
Loans, including fees
Investment securities
Dividends, restricted stock
Interest-bearing cash accounts
Total interest income
Interest expense:
Deposits
Short-term borrowings
Long-term borrowings
Subordinated debt
Total interest expense
Net interest income
Net interest income is directly affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, which support those assets, as well as changes in the rates earned and paid.
Net interest income for the year ended September 30, 2022 increased $1.3 million, or 4.47 percent, to $29.3 million, from $28.1 million for fiscal year 2021. The Company’s net interest margin increased 33 basis points to 2.95 percent in fiscal year ended September 30, 2022, from 2.62 percent for the fiscal year ended September 30, 2021. During fiscal year 2022, our net interest margin was impacted by a decrease in the costs of money market and interest-bearing demand deposit accounts.
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As previously mentioned, the increase in net interest income during fiscal year 2022 was attributable in part to decrease in costs on money market and interest-bearing demand deposit accounts. The Company experienced an increase of $5.3 million in average noninterest-bearing deposits during fiscal year 2022 and a decrease of $67.0 million in average interest-bearing demand, savings, money market and time deposits during fiscal year 2022. During the fiscal year ended September 30, 2022, the Company’s net interest spread increased by 33 basis points reflecting a decrease in both the average yield on interest-earning assets and the average interest rates paid on interest-bearing liabilities of 6 basis points and 39 basis points, respectively.
For the fiscal year ended September 30, 2022, average interest-earning assets decreased by $78.8 million to $1.0 billion, as compared with the fiscal year ended September 30, 2021. The change in average interest-earning asset volume was primarily due to decreased loan volume. Average interest-bearing liabilities decreased by $114.4 million in fiscal year 2022 compared to fiscal year 2021, primarily due to a decrease in average interest-bearing deposits.
The factors underlying the year-to-year changes in net interest income are reflected in the tables presented above. The table on page 36 presents the Average Statements of Condition with Interest and Average Rates shows the Company’s consolidated average balance of assets, liabilities and shareholders’ equity, the amount of income produced from interest-earning assets and the amount of expense incurred from interest-bearing liabilities, and net interest income as a percentage of average interest-earning assets.
Total Interest Income
Interest income for the year ended September 30, 2022, decreased by $3.4 million, or 8.9 percent, as compared with the year ended September 30, 2021. This decrease was primarily due to a decrease in loan volume, partially offset by an increase in investments.
The average balance of the Company’s loan portfolio decreased $129.3 million in fiscal year 2022 to $854.8 million from $984.1 million in fiscal year 2021, primarily driven by a decrease in loan volume.
The average loan portfolio represented 86.1 percent of the Company’s interest-earning assets (on average) during fiscal year 2022 and 91.8 percent for fiscal year 2021. Average investment securities increased during fiscal year 2022 by $38.4 million compared to fiscal year 2021. Interest-bearing cash increased in fiscal year 2022 by $14.3 million compared to fiscal year 2021. The average yield on interest-earning assets decreased from 3.58 percent in fiscal year 2021 to 3.52 percent in fiscal year 2022.
Interest Expense
Interest expense for the year ended September 30, 2022, was impacted by both rate related and volume related factors. The changes resulted in decreased expense of $4.7 million primarily due to a decrease in rates paid on money market and other interest-bearing deposits from fiscal year 2021 to fiscal year 2022.
The cost of total average interest-bearing liabilities decreased to 0.64 percent for the year ended September 30, 2022, a decrease of 39 basis points, from 1.03 percent for the year ended September 30, 2021.
The Company’s net interest spread, (i.e., the average yield on average interest-earning assets minus the average rate paid on interest-bearing liabilities) increased 33 basis points to 2.88 percent in fiscal year 2022 from 2.55 percent for fiscal year 2021. The increase in fiscal year 2022 reflected a decreased cost in interest-bearing liabilities.
Rate/Volume Analysis
The following table quantifies the impact on net interest income and margin resulting from volume changes in average balances of interest earning assets, interest bearing liabilities, and average related yields and associated funding costs over the past two years. Any change in interest income or expense attributable to both changes in volume and changes in rate has been allocated in proportion to the relationship of the absolute dollar amount of change in each category.
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Analysis of Variance in Net Interest Income Due to Volume and Rates
Fiscal Year 2022/2021
Increase (Decrease)
Due to Change in:
Average
Average
Net
(In thousands)
Volume
Rate
Change
Interest-earning assets:
Loans, including fees
Investment securities
Interest-bearing cash accounts
Dividends, restricted stock
Total interest-earning assets
Interest-bearing liabilities:
Money market deposits
Savings deposits
Certificates of deposit
Other interest-bearing deposits
Total interest-bearing deposits
Borrowings
Total interest-bearing liabilities
Change in net interest income
The following table, ‘‘Average Statements of Condition with Interest and Average Rates’’ presents for the years ended September 30, 2022 and 2021, the Company’s average assets, liabilities, and shareholders’ equity. The Company’s net interest income, net interest spreads and net interest income as a percentage of interest-earning assets (net interest margin) are also reflected. No tax equivalent adjustments have been made as the amounts are not material.
Year Ended September 30,
Average
Interest
Average
Average
Interest
Average
Outstanding
Earned
Yield
Outstanding
Earned
Yield/
Balance
/Paid
/Rate
Balance
/Paid
Rate
(In thousands)
ASSETS
Interest earning assets:
Loans receivable (1)
Investment securities
Deposits in other banks
FHLB stock
Total interest earning assets (1)
Non-interest earning assets
Cash and due from banks
Bank owned life insurance
Other assets
Other real estate owned
Allowance for loan losses
Total non-interest earning assets
Total assets
LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest bearing liabilities:
Money Market accounts
Savings accounts
Certificate accounts
Other interest-bearing deposits
Total deposits
Borrowed funds
Total interest-bearing liabilities
Non-interest bearing liabilities
Demand deposits
Other liabilities
Total non-interest-bearing liabilities
Shareholders’ equity
Total liabilities and shareholders’ equity
Net interest spread
Net interest margin
Net interest income
Includes non-accrual loans during the respective periods. Calculated net of unamortized deferred loan fees, loan discounts, undisbursed portions of loans-in-process, and allowance for loan losses.
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Other Income
The following table presents the principal categories of other (“non-interest”) income for each of the years in the two-year period ended September 30, 2022.
Year Ended September 30,
Increase
(Decrease)
Change
(In thousands)
Service charges and other fees
Rental income-other
Net gains on sale and call of available for sale securities
Net gains on sale of loans
Earnings on bank-owned life insurance
Total other income
For the fiscal year ended September 30, 2022, total other income decreased $1.4 million compared to the fiscal year ended September 30, 2021. This decrease was primarily a result of decreases of $779,000 in net gain on sale and call of available for sale securities and $688,000 in net gain on sale of loans, partially offset by an increase of $138,000 in excess of death benefit on banked-owned life insurance.
The increase on the sale of investments resulted from managing and optimizing normal portfolio activity during 2021. The decrease in the gain on sale of loans was primarily the result of a strategic effort to originate and sell residential loans in the low interest rate environment throughout fiscal year 2021 and the gain on sale of PPP loans during 2021.
Other Expense
The following table presents the principal categories of other expense for each of the years in the two-year period ended September 30, 2022.
Year Ended September 30,
Increase
(Decrease)
Change
(In thousands)
Salaries and employee benefits
Occupancy expense
Federal deposit insurance premium
Advertising
Data processing
Professional fees
Other real estate owned expense, net
Pennsylvania shares tax
Other operating expense
Total other expense
Total other expense for the fiscal year ended September 30, 2022 increased $1.8 million, or 8.7%, to $22.8 when compared to the fiscal year ended September 30, 2021. The increase was primarily due to an increase of $1.6 million, or a 51.4% increase in other operating expenses. The increase in other operating expenses was mainly due to $1.5 million of real estate tax expense and $359,000 valuation allowance adjustment related to a $13.3 million loan held for sale. In addition, professional fees increased by $653,000 to $3.8 million at September 30, 2022, from $3.2 million at September 30, 2021, primarily due to legal fees associated with loan workouts and related matters concerning nonperforming loans. These increases were offset by a decrease in other real estate owned (“OREO”) expenses of $561,000 to $305,000 at September 30, 2022, when compared to $866,000 for the fiscal year ended September 30, 2021.
Financial Condition
Investment Portfolio
For the year ended September 30, 2022, the average volume of investment securities increased by $38.4 million to approximately $96.0 million or 9.7 percent of average interest-earning assets, from $57.7 million or 5.4 percent of average interest-earning assets, for the year ended September 30, 2021. At September 30, 2022, the total investment portfolio amounted to $110.0 million, an increase of $39.2 million from September 30, 2021. The increase in the investment portfolio was primarily due to purchases in the investment portfolio of $53.8 million, partially offset by maturities, calls and principal repayments in the amount of $6.1 during fiscal year 2022. At September 30, 2022, the principal components of the investment portfolio were government agency obligations, federal agency obligations, including mortgage-backed securities, obligations of U.S. states and political subdivision, corporate bonds and notes, a trust preferred security and equity securities.
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During the year ended September 30, 2022, volume related factors increased investment revenue by $1.0 million. The yield on investments was relatively flat decreasing by two basis points to 2.68 percent from a yield of 2.70 percent during the year ended September 30, 2021.
As of September 30, 2022, the estimated fair value of the available-for-sale securities disclosed below was primarily dependent upon the movement in market interest rates, particularly given the negligible inherent credit risk associated with these securities. These investment securities are comprised of securities that are rated investment grade by at least one bond credit rating service. Although the fair value will fluctuate as the market interest rates move, management believes that these fair values will recover as the underlying portfolios mature and are reinvested in market rate yielding investments. The Company does not intend to sell and expects that it is not more likely than not that it will be required to sell these securities until such time as the value recovers or the securities mature. Management does not believe any individual unrealized loss as of September 30, 2022, represents other-than-temporary impairment.
Securities available-for-sale are a part of the Company’s interest rate risk management strategy and may be sold in response to changes in interest rates, changes in prepayment risk, liquidity management and other factors. The Company continues to reposition the investment portfolio as part of an overall corporate-wide strategy to produce reasonable and consistent margins where feasible, while attempting to limit risks inherent in the Company’s balance sheet.
For fiscal year 2022, there were no sales of available-for-sale investment securities. For fiscal year 2021, proceeds of available-for-sale investment securities sold amounted to $17.3 million and gross realized gains on investment securities sold amounted to $779,000,
The varying amount of sales from the available-for-sale portfolio reflects the significant volatility present in the market. Given the historic low interest rates prevalent in the market, it is necessary for the Company to protect itself from interest rate exposure. Securities that once appeared to be sound long-term investments can, after changes in the market, become securities that the Company wishes to sell to avoid losses and mismatches of interest-earning assets and interest-bearing liabilities at a later time.
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The table below illustrates the maturity distribution and weighted average yield for investment securities at September 30, 2022, based on a contractual maturity.
More than Five
More than One Year
Years through Ten
More than Ten
One year or less
through Five Years
Years
Years
Total
Weighted
Weighted
Weighted
Weighted
Weighted
Amortized
Average
Amortized
Average
Amortized
Average
Amortized
Average
Amortized
Fair
Average
Cost
Yield
Cost
Yield
Cost
Yield
Cost
Yield
Cost
Value
Yield
(In thousands)
Available for Sale Securities:
U.S. government agencies
State and municipal obligations
Single issuer trust preferred security
Corporate debt securities
US Treasury Note
Mortgage- backed securities ("MBS")
MBS
Total
Held to Maturity Securities:
U.S. government agencies and obligations
State and municipal obligations
Corporate debt securities
Mortgage- backed securities
Mortgage Backed Security ("MBS"), fixed-rate
Collateralized mortgage obligations ("CMO"), fixed-rate
Total
Equity Securities:
Mutual fund
Total
Total Investment Securities
For information regarding the carrying value of the investment portfolio, see Note 6 and Note 12 of the Notes to the Consolidated Financial Statements.
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The following table sets forth the carrying value of the Company’s investment securities, as of September 30, for each of the last two years.
(In thousands)
Investment Securities Available-for-Sale:
U.S. government agencies
State and municipal obligations
Single issuer trust preferred security
Corporate debt securities
MBS Securities
U.S. Treasury Note
Total available-for-sale
Investment Securities Held-to-Maturity:
U.S. government agencies
State and municipal obligations
Corporate debt securities
Mortgage-backed securities:
Mortgage Backed Security ("MBS"), fixed-rate
Collateralized mortgage obligations ("CMO"), fixed-rate
Total held-to-maturity
Equity Securities:
Mutual fund
Total equity securities
Total investment securities
For additional information regarding the Company’s investment portfolio, see Note 6 and Note 12 of the Notes to the Consolidated Financial Statements.
Loan Portfolio
Lending is the Company’s primary business activity. The Company’s loan portfolio consists of residential, construction and development, commercial and consumer loans, serving the diverse customer base in its market area. The composition of the Company’s portfolio continues to change due to the local economy. Factors such as the economic climate, interest rates, real estate values and employment all contribute to these changes in the composition of the Company’s portfolio. Growth is generated through business development efforts, repeat customer requests for new financings, penetration into existing markets and entry into new markets.
The Company seeks to create growth in commercial lending, which primarily includes commercial real estate, multi-family, farmland, and commercial and industrial lending, by offering customer-focused products and competitive pricing and by capitalizing on the positive trends in its market area. Products offered are designed to meet the financial requirements of the Company’s customers. It is the objective of the Company’s credit policies to diversify the commercial loan portfolio to limit concentrations in any single industry.
At September 30, 2022, total gross loans amounted to $810.4 million, a decrease of $103.4 million or 11.3 percent as compared to September 30, 2021. At September 30, 2022, total net loans amounted to $801.9 million, a decrease of $101.1 million or 11.2 percent as compared to September 30, 2021. For the fiscal year ended September 30, 2022, the gross loan portfolio saw declines of $22.8 million in residential mortgage loans, $40.0 million in commercial loans, and $38.8 million in construction and land loans.
The average balance of our total loans decreased $129.3 million, or 13.1 percent, for the fiscal year ended September 30, 2022, as compared to the fiscal year ended September 30, 2021, while the average yield on loans increased 2 basis points to 3.72 percent for the fiscal year ended September 30, 2022, from 3.70 percent for the fiscal year ended September 30, 2021. During fiscal year 2022 compared to fiscal year 2021, the volume-related factors contributed to a decrease of interest income on loans of $4.8 million, while the rate-related changes increased interest income by $247,000.
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The following table presents information regarding the components of the Company’s loan portfolio (which does not include loans held for sale, except as noted below) on the dates indicated.
September 30,
(In thousands)
Residential mortgage
Construction and Development:
Residential and commercial
Land
Total construction and development
Commercial:
Commercial real estate
Farmland
Multi-family
Commercial and industrial
Other
Total commercial
Consumer:
Home equity lines of credit
Second mortgages
Other
Total consumer
Total loans
Deferred loan fees and costs, net
Allowance for loan losses
Loans receivable, net
At September 30, 2022, our net loan portfolio totaled $801.9 million or 76.8 percent of total assets. Our principal lending activity has been the origination of residential, commercial, and commercial real estate loans. Through our loan policy, we utilize strict underwriting guidelines to maintain low average loan-to-value (“LTV”) ratios and require maximum gross debt ratios and minimum debt coverage ratios.
Loans are subject to federal and state law and regulations. Interest rates charged by us on loans are affected principally by the demand for such loans and the supply of money available for lending purposes and the rates offered by our competitors. These factors are, in turn, affected by general and economic conditions, the monetary policy of the federal government, including the Federal Reserve Bank, legislative tax policies and governmental budgetary matters.
The loans receivable portfolio is segmented into residential mortgage loans, construction and development loans, commercial loans and consumer loans. The residential mortgage loan segment has one class, one- to four-family first lien residential mortgage loans. The construction and development loan segment consists of the following classes: residential and commercial construction loans and land loans. Residential construction loans are made for the acquisition of and/or construction on a lot or lots on which a residential dwelling is to be built and occupied by the homeowner. Commercial construction loans are made for the purpose of acquiring, developing, and constructing a commercial use structure and for acquisition, development, and construction of residential properties by residential developers. The commercial loan segment consists of the following classes: commercial real estate loans, multi-family real estate loans, and other commercial loans, which are also generally known as commercial and industrial loans or commercial business loans. The consumer loan segment consists of the following classes: home equity lines of credit, second mortgage loans and other consumer loans, primarily unsecured consumer lines of credit.
Residential Lending. Residential mortgage originations are secured primarily by properties located in the Company’s market areas and surrounding areas. At September 30, 2022, $176.0 million, or 21.7 percent, of our total loans in our portfolio consisted of single-family residential mortgage loans.
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Our single-family residential mortgage loans generally are underwritten on terms and documentation conforming to guidelines issued by Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal National Mortgage Association (“Fannie Mae”). Applications for one- to four-family residential mortgage loans are taken by our loan origination officers and are accepted at any of our banking offices and are then referred to the lending department in order to process the loan, which consists primarily of obtaining all documents required by Freddie Mac and Fannie Mae underwriting standards, and completing the underwriting, which includes making a determination whether the loan meets our underwriting standards such that the Bank can extend a loan commitment to the customer. We generally have retained for our portfolio a substantial portion of the single-family residential mortgage loans that we originate. We currently originate fixed-rate, fully amortizing mortgage loans with maturities of 10 to 30 years. We also offer adjustable rate mortgage (“ARM”) loans where the interest rate either adjusts on an annual basis or is fixed for the initial one, three, five or seven years and then adjusts annually. However, due to the low interest rate environment and demand for fixed rate products, we have not originated a significant amount of ARM loans in recent years. At September 30, 2022, $49.8 million, or 28.3 percent, of our one- to four-family residential mortgage loans consisted of ARM loans.
In prior years, the Company purchased single-family residential mortgage loans and consumer loans from a network of mortgage brokers. The Company now has correspondent lending relationships, but the Bank independently underwrites these loans.
We underwrite one- to four-family residential mortgage loans with loan-to-value ratios of up to 95 percent, provided that the borrower obtains private mortgage insurance on loans that exceed 80 percent of the appraised value or sales price, whichever is less, of the secured property. We also require that title insurance, hazard insurance and, if appropriate, flood insurance be maintained on all properties securing real estate loans. We require that a licensed appraiser from our list of approved appraisers perform and submit to us an appraisal on all properties secured by a first mortgage on one- to four-family first mortgage loans. Our mortgage loans generally include due-on-sale clauses, which provide us with the contractual right to deem the loan immediately due and payable in the event the borrower transfers ownership of the property. Due-on-sale clauses are an important means of adjusting the yields of fixed-rate mortgage loans in portfolio and we generally exercise our rights under these clauses.
Construction and Development Loans . The amount of our outstanding construction and development loans in our portfolio decreased to $24.9 million or 3.0 percent of gross loans at September 30, 2022 from $63.7 million or 7.0 percent of gross loans as of September 30, 2021. We generally limit construction loans to builders and developers with whom we have an established relationship, or who are otherwise known to officers of the Bank. Our construction loans also include single-family residential construction loans which may, if approved, convert to permanent, long-term mortgage loans upon completion of construction (“construction/perm” loans). During the initial or construction phase, these construction/perm loans require payment of interest only, which generally is tied to the prime rate, as the home is being constructed. On residential construction to perm loans the final interest rate is approved upon the earlier of the completion of construction or one year. These loans if approved by the appropriate approving authority, convert to long-term (generally 30 years), amortizing, fixed-rate single-family mortgage loans.
Our portfolio of construction loans generally have a maximum term as approved based upon the underwriting (for individual, owner-occupied dwellings), and loan-to-value ratios less than 80 percent. Residential construction loans to developers are made on either a pre-sold or speculative (unsold) basis. Limits are placed on the number of units that can be built on a speculative basis based upon the reputation and financial position of the builder, his/her present obligations, the location of the property and prior sales in the development and the surrounding area. Generally, a limit of two unsold homes (one model home and one speculative home) is placed per project.
Prior to committing to a construction loan, we require that an independent appraiser prepare an appraisal of the property. Each project also is reviewed and inspected at its inception and prior to every disbursement of loan proceeds. Disbursements are made after inspections based upon a percentage of project completion and monthly payment of interest is required on all construction loans.
Our construction loans also include loans for the acquisition and development of land for sale (i.e., roads, sewer and water lines). We typically make these loans only in conjunction with a commitment for a construction loan for the units to be built on the site. These loans are secured by a lien on the property and are limited to a loan-to-value ratio not exceeding 75 percent of the appraised value at the time of origination. The loans have a variable rate of interest and require monthly payments of interest. The principal of the loan is repaid as units are sold and released. We limit loans of this type to our market area and to developers with whom we have established relationships. In most cases, we also obtain personal guarantees from the borrowers.
Our loan portfolio included one loan secured by unimproved real estate and lots (“land loan”), with an outstanding balance of $550,000, constituting 0.1 percent of total loans, at September 30, 2022.
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In order to mitigate some of the risks inherent to construction lending, we inspect properties under construction, review construction progress prior to advancing funds, work with builders with whom we have established relationships, require annual updating of tax returns and other financial data of developers and obtain personal guarantees from the principals. At September 30, 2022, approximately $134,000, or 1.5 percent, of our allowance for loan losses was attributed to construction and development loans. We had no construction and development loans that were non-performing at September 30, 2022 or September 30, 2021. We had no construction and development loans that were performing TDRs at September 30, 2022 or September 30, 2021.
Commercial Lending. At September 30, 2022, our loans secured by commercial real estate amounted to $406.9 million and constituted 50.2 percent of our gross loans at such date. During the fiscal year ended September 30, 2022, the commercial real estate loan portfolio decreased by $20.0 million, or 4.7 percent. During fiscal year 2022, we had no charge-offs of commercial real estate loans, as compared to $11.9 million of charge-offs of commercial real estate loans for fiscal year 2021.
Our commercial real estate loan portfolio consists primarily of loans secured by office buildings, retail and industrial use buildings, strip shopping centers, mixed-use and other properties used for commercial purposes located in our market area.
Although terms for commercial real estate and multi-family loans vary, our underwriting standards generally allow for terms up to 10 years with the interest rate being reset in the fifth year and with amortization typically not greater than 25 years and loan-to-value ratios of not more than 80 percent. Interest rates are either fixed or adjustable, based upon the index rate plus a margin, and fees ranging from 0.5 percent to 1.50 percent are charged to the borrower at the origination of the loan. Prepayment fees are charged on most loans in the event of early repayment. Generally, we obtain personal guarantees of the principals as additional collateral for commercial real estate and multi-family real estate loans.
Commercial and multi-family real estate loans generally present a higher level of risk than loans secured by one- to four-family residences. This greater risk is due to several factors, including the concentration of principal in a limited number of loans and borrowers, the effect of general economic conditions on income producing properties and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by commercial and multi-family real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced (for example, if leases are not obtained or renewed, a bankruptcy court modifies a lease term, or a major tenant is unable to fulfill its lease obligations), the borrower’s ability to repay the loan may be impaired. As of September 30, 2022, there were no non-accruing commercial real estate mortgage loans, other than one commercial real estate mortgage loan held-for-sale that was non-accruing in the amount of $13.3 million. As of September 30, 2022, $6.1 million, or 67.2 percent of our allowance for loan losses, was allocated to commercial real estate mortgage loans. As of September 30, 2022, our commercial real estate loans held in our portfolio that were deemed performing debt decreased to $594,000 from $12.2 million as of September 30, 2021.
At September 30, 2022, our multi-family loan portfolio included 23 loans with an aggregate book value of $55.3 million secured by multi-family (more than four units) properties, constituting 6.8 percent of our gross loans at such date. As of September 30, 2022, we had no non-accruing multi-family loans.
At September 30, 2022, we had $102.7 million in commercial business loans, or 12.7 percent of gross loans outstanding, in our portfolio. Our commercial business loans generally have been made to small to mid-sized businesses located in our market area. The commercial business loans in our portfolio assist us in our asset/liability management since they generally provide shorter maturities and/or adjustable rates of interest in addition to generally having higher rates of return which are designed to compensate for the additional credit risk associated with these loans. The commercial business loans which we have originated may be either a revolving line of credit or for a fixed term of generally 10 years or less. Interest rates are adjustable, indexed to a published prime rate of interest, or fixed. Generally, equipment, machinery, real property or other corporate assets secure such loans. Personal guarantees from the business principals are generally obtained as additional collateral.
Generally, commercial business loans are characterized as having higher risks associated with them than single-family residential mortgage loans. As of September 30, 2022, we had no non-accruing commercial loans in our loan portfolio. At such date, approximately $1.0 million, or 10.5 percent of the allowance for loan losses was allocated to commercial business loans. At September 30, 2022, one commercial business loan totaling $625,000 was deemed a performing troubled debt restructuring loan.
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In our underwriting procedures, consideration is given to the stability of the property’s cash flow history, future operating projections, current and projected occupancy levels, location, and physical condition. Generally, our practice is to impose a debt service ratio (the ratio of net cash flows from operations before the payment of debt service/debt service) of not less than 120 percent. We also evaluate the credit and financial condition of the borrower, and if applicable, the guarantor. Appraisal reports prepared by independent appraisers are obtained on each loan to substantiate the property’s market value and are reviewed by us prior to the closing of the loan.
Consumer Lending. In our efforts to provide a full range of financial services to our customers, we offer various types of consumer loans. Our consumer loans amounted to $19.8 million or 2.4 percent of our total loan portfolio at September 30, 2022. The largest components of our consumer loans are home equity lines of credit, which amounted to $13.2 million at September 30, 2022, and loans secured by second mortgages, consisting primarily of home equity loans, which amounted to $4.4 million at September 30, 2022. Our consumer loans also include automobile loans, unsecured personal loans and loans secured by deposits. Consumer loans are originated primarily through existing and walk-in customers and direct advertising.
Our home equity lines of credit are variable rate loans tied to LIBOR, treasury, and prime rates. Our second mortgages may have fixed or variable rates, although they generally have had fixed rates in recent periods. Our second mortgages have a maximum term to maturity of 15 years. Both our second mortgages and our home equity lines of credit generally are secured by the borrower’s primary residence. However, our security generally consists of a second lien on the property. Our lending policy provides that the maximum loan-to-value ratio on our home equity lines of credit is 80 percent when the Bank has the first mortgage. However, the maximum loan-to-value ratio on our home equity lines of credit is reduced to 75 percent when the Bank does not have the first mortgage. At September 30, 2022, the unused portion of our home equity lines of credit was $27.9 million.
Consumer loans generally have higher interest rates and shorter terms than residential loans; however, they have additional credit risk due to the type of collateral securing the loan or in some cases the absence of collateral. In the year ended September 30, 2022, we recovered $57,000 of previously charged-off consumer loans mostly consisting of second mortgage loans, as compared to $129,000 of recoveries, mostly consisting of second mortgage loans during the year ended September 30, 2021. As of September 30, 2022, we had $148,000 of non-accruing second mortgage loans and $20,000 of non-accruing home equity lines of credit, representing a decrease of $133,000 over the amount of non-accruing second mortgage loans and home equity lines of credit at September 30, 2021. At September 30, 2022, $317,000 of our consumer loans were classified as substandard consumer loans. At September 30, 2022, an aggregate of $88,000 of our allowance for loan losses was allocated to second mortgages and home equity lines of credit.
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The following table presents the contractual maturity of our loans held in our portfolio at September 30, 2022. The table does not include the effect of prepayments or scheduled principal amortization. Loans having no stated repayment schedule or maturity and overdraft loans are reported as being due in one year or less.
At September 30, 2022, Maturing
After One
Years
After Five
In One Year
Through
Through
After
or Less
Five Years
Fifteen Years
Fifteen Years
Total
(In thousands)
Residential mortgage
Construction and Development:
Residential and commercial
Land
Total construction and development
Commercial:
Commercial real estate
Farmland
Multi-family
Commercial and industrial
Other
Total commercial
Consumer:
Home equity lines of credit
Second mortgages
Other
Total consumer
Total
Loans with:
Fixed rates
Variable rates
Total
For additional information regarding loans, see Note 7 of the Notes to the Consolidated Financial Statements.
Allowance for Loan Losses and Related Provision
The purpose of the allowance for loan losses (“ALLL” or “allowance”) is to absorb the impact of probable losses inherent in the loan portfolio. Additions to the allowance are made through provisions charged against current operations and through recoveries made on loans previously charged-off. The allowance is maintained at an amount considered adequate by management to provide for potential loan losses based upon a periodic evaluation of the risk characteristics of the loan portfolio. In establishing an appropriate allowance, an assessment of the individual borrowers, a determination of the value of the underlying collateral, a review of historical loss experience and an analysis of the levels and trends of loan categories, delinquencies and problem loans are considered. Such qualitative factors as changes in lending policies and procedures, economic and business conditions, nature and volume of the portfolio, changes in delinquency, concentration of credit trends, value of underlying collateral, the level and trend of interest rates, and peer group statistics are also reviewed. At September 30, 2022, the level of the allowance was $9.1 million as compared to a level of $11.5 million at September 30, 2021. The Company made no loan provisions in fiscal year 2022 compared with $11.2 million in fiscal year 2021. Provision expense was higher during the fiscal year ended September 30, 2021, due primarily to four commercial loans that were transferred to held-for-sale. The level of the allowance during the fiscal years of 2022 and 2021 reflects the change in average volume, credit quality within the loan portfolio, the level of charge-offs, and loan volume recorded during the periods and the Company’s focus on the changing composition of the commercial and residential real estate loan portfolios.
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At September 30, 2022, the allowance amounted to 1.12 percent of total gross loans. In management’s view, the level of the allowance at September 30, 2022 is adequate to cover losses inherent in the loan portfolio. Management’s judgment regarding the adequacy of the allowance constitutes a ‘‘Forward Looking Statement’’ under the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from management’s analysis, based principally upon the factors considered by management in establishing the allowance.
Although management uses the best information reasonably available to it, the level of the allowance remains an estimate, which is subject to significant judgment and short-term change. The OCC, as an integral part of its examination process, periodically reviews the Company’s allowance. The OCC may require the Company to increase the allowance based on its analysis of information available to it at the time of its examination. Furthermore, the majority of the Company’s loans are secured by real estate in the State of New Jersey and the State of Pennsylvania. Future adjustments to the allowance may be necessary due to economic factors impacting real estate in the Bank’s market areas and a deterioration of the economic climate, as well as, operating, regulatory and other conditions beyond the Company’s control, including those as a result of COVID-19. The allowance as a percentage of total loans amounted to 1.12 percent and 1.21 percent at September 30, 2022 and 2021, respectively. Net charge-offs were $2.4 million in fiscal year 2022, compared to net charge-offs of $12.1 million in fiscal year 2021. Charge-offs were higher primarily in the commercial and industrial loan portfolio segment in fiscal year 2022.
At September 30, 2022, the Company held one non-accrual commercial real estate loan transferred to held-for-sale with an aggregate book balance of $13.3 million, for which the Company continues to evaluate a sale of this loan.
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Five-Year Statistical Allowance for Loan Losses
The following table reflects the relationship of loan volume, the provision and allowance for loan losses and net charge-offs for the past five years.
September 30,
(In thousands)
Average loans outstanding
Total loans at end of period
Analysis of the Allowance of Loan Losses
Balance at beginning of year
Charge-offs:
Residential mortgage
Commercial:
Commercial real estate
Commercial and industrial
Consumer:
Home equity lines of credit
Second mortgages
Other
Total charge-offs
Recoveries:
Residential mortgage
Construction and Development:
Residential and commercial
Commercial:
Commercial real estate
Commercial and industrial
Consumer:
Home equity lines of credit
Second mortgages
Other
Total recoveries
Net charge-offs
Provision for loan losses
Balance at end of year
Ratio of net charge-offs during the year to average loans outstanding during the year
Allowance for loan losses as a percentage of total loans at end of year
Balance includes loans held for sale.
For additional information regarding loans, see Note 7 of the Notes to the Consolidated Financial Statements.
Implicit in the lending function is the fact that loan losses will be experienced and that the risk of loss will vary with the type of loan being made, the creditworthiness of the borrower and prevailing economic conditions. The allowance for loan losses has been allocated in the table below according to the estimated amount deemed to be reasonably necessary to provide for the possibility of losses being incurred within the following categories of loans at September 30, for each of the past five years.
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The table below shows, by type of loan, the amounts of the allowance allocable to such loans and the percentage of such loans to total loans.
September 30,
Loans
Loans
Loans
Loans
Loans
Total
Total
Total
Total
Total
Amount
Loans
Amount
Loans
Amount
Loans
Amount
Loans
Amount
Loans
(In thousands)
Residential mortgage
Construction and Development:
Residential and commercial
Land loans
Commercial:
Commercial real estate
Farmland
Multi-family
Commercial and industrial
Other
Consumer:
Home equity lines of credit
Second mortgages
Other
Total allocated
Unallocated
Balance at end of period
In assessing the adequacy of the allowance, it is recognized that the process, methodology and underlying assumptions require a significant degree of judgment and uncertainty. The estimation of loan losses is not precise; the range of factors considered is wide and is significantly dependent upon management’s judgment, including the outlook and potential changes in the economic environment and general market conditions. At present, components of the commercial loan segments of the portfolio are new originations and the associated volumes continue to see increased growth. At the same time, historical loss levels have decreased as factors utilized in assessing the portfolio. Any unallocated portion of the allowance reflects management’s estimate of probable inherent but undetected losses within the portfolio due to uncertainties in economic conditions, delays in obtaining information, including unfavorable information about a borrower’s financial condition, the difficulty in identifying triggering events that correlate perfectly to subsequent loss rates, and risk factors that have not yet manifested in allocation factors.
Asset Quality
The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and mix. The Company strives to identify loans experiencing difficulty early enough to attempt to correct the problems, to record charge-offs promptly based on realistic assessments of current collateral values, and to maintain an adequate allowance for loan losses at all times.
It is generally the Company’s policy to discontinue interest accruals once a loan is past due as to interest or principal payments for a period of 90 days. When a loan is placed on non-accrual status, interest accruals cease and uncollected accrued interest is reversed and charged against current income. Payments received on non-accrual loans are applied against principal. A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection or all past due amounts have been collected and a satisfactory period of ongoing repayment exists. Accruing loans past due 90 days or more are generally well secured and in the process of collection. For additional information regarding loans, see Note 7 of the Notes to the Consolidated Financial Statements.
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Non-Performing, Past Due Loans and OREO
Non-performing loans include non-accrual loans and accruing loans which are contractually past due 90 days or more. Non-accrual loans represent loans on which interest accruals have been suspended. It is the Company’s general policy to consider the charge-off of loans at the point they become past due in excess of 90 days, with the exception of loans that are both well-secured and in the process of collection. Troubled debt restructurings represent loans on which a concession was granted to a borrower, such as a reduction in interest rate to a rate lower than the current market rate for new debt with similar risks, and which are currently performing in accordance with the modified terms. For additional information regarding loans, see Note 7 of the Notes to the Consolidated Financial Statements.
The following table sets forth, as of the dates indicated, the amount of the Company’s non-accrual loans, accruing loans past due 90 days or more, OREO and troubled debt restructurings.
At September 30,
(In thousands)
Non-accrual loans:
Residential mortgage
Commercial:
Commercial real estate
Commercial and industrial
Total commercial
Consumer:
Home equity lines of credit
Second mortgages
Other
Total consumer
Total non-accrual loans
Accruing loans past due 90 days or more
Total non-performing loans
Other real estate owned
Total non-performing assets
Troubled debt restructured loans — performing
Non-accrual loans, excluding loans held-for-sale, totaled $753,000 at September 30, 2022, and $3.7 million at September 30, 2021. The decrease in non-accrual loans was primarily due a charge-off of $2.4 million related to one non-accrual commercial and industrial loan during the fiscal year and then transferred to OREO at a carrying value of $259,000. The decrease in OREO of $4.7 million at September 30, 2022, compared to September 30, 2021, was attributed to a sale at carrying value and the transfer of a new commercial and industrial loan to OREO during fiscal year 2022 totaling $259,000. Non-accrual loans to total loans were 0.09% and 0.39% at September 30, 2022 and 2021, respectively. The allowance for loan losses to non-accrual loans were 1,207.2% at September 30, 2022 compared to 310.3% at September 30, 2021.
Performing TDR loans were $5.0 million at September 30, 2022, and $17.6 million at September 30, 2021. The decrease is primarily related to two TDR commercial real estate loans totaling $17.1 million that were sold during the fiscal year 2021.
At September 30, 2022, non-performing assets ("NPAs") totaled $1.3 million, or 0.12% of total assets, as compared with $8.7 million, or 0.72% of total assets, at September 30, 2021. The decrease in NPAs is due to the decrease in non-accrual loans and OREO as described above.
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Provision for Income Taxes
The Company recorded a $1.9 million income tax expense in fiscal year 2022 compared to a $212,000 income tax benefit in fiscal year 2021. For a more detailed description of income taxes see Note 13 of the Notes to Consolidated Financial Statements.
Recent Accounting Pronouncements
Please refer to the note on Recent Accounting Pronouncements in Note 2 to the consolidated financial statements in Item 8 for a detailed discussion of new accounting pronouncements.
Asset and Liability Management
Asset and liability management encompasses an analysis of market risk, the control of interest rate risk (interest sensitivity management) and the ongoing maintenance and planning of liquidity and capital. The composition of the Company’s statement of condition is planned and monitored by the Company’s Asset and Liability Committee (“ALCO”). In general, management’s objective is to optimize net interest income and minimize market risk and interest rate risk by monitoring the components of the statement of condition and the interaction of interest rates.
Short-term interest rate exposure analysis is supplemented with an interest sensitivity gap model. The Company utilizes interest sensitivity analysis to measure the responsiveness of net interest income to changes in interest rate levels. Interest rate risk arises when an earning asset matures or when its interest rate changes in a time period different than that of a supporting interest-bearing liability, or when an interest-bearing liability matures or when its interest rate changes in a time period different than that of an earning asset that it supports. While the Company matches only a small portion of specific assets and liabilities, total earning assets and interest-bearing liabilities are grouped to determine the overall interest rate risk within a number of specific time frames. The difference between interest-sensitive assets and interest-sensitive liabilities is referred to as the interest sensitivity gap. At any given point in time, the Company may be in an asset-sensitive position, whereby its interest-sensitive assets exceed its interest-sensitive liabilities, or in a liability-sensitive position, whereby its interest-sensitive liabilities exceed its interest-sensitive assets, depending in part on management’s judgment as to projected interest rate trends.
The Company’s interest rate sensitivity position in each time frame may be expressed as assets less liabilities, as liabilities less assets, or as the ratio between rate sensitive assets (“RSA”) and rate sensitive liabilities (“RSL”). For example, a short-funded position (liabilities repricing before assets) would be expressed as a net negative position, when period gaps are computed by subtracting repricing liabilities from repricing assets. When using the ratio method, an RSA/RSL ratio of 1 indicates a balanced position, a ratio greater than 1 indicates an asset-sensitive position and a ratio less than 1 indicates a liability-sensitive position.
A negative gap and/or a rate sensitivity ratio less than 1 tends to expand net interest margins in a falling rate environment and reduce net interest margins in a rising rate environment. Conversely, when a positive gap occurs, generally margins expand in a rising rate environment and contract in a falling rate environment. From time to time, the Company may elect to deliberately mismatch liabilities and assets in a strategic gap position.
At September 30, 2022, the Company reflected a positive interest sensitivity gap with an interest sensitivity ratio of 1.20:1.00 at the cumulative one-year position. Based on current rising interest rate environment, that at the current time is estimated to continue through the first half of 2023, emphasis will be on controlling liability costs and duration in our efforts to insulate the net interest spread for a potential future decline in rates.
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The following table sets forth the amounts of our interest-earning assets and interest-bearing liabilities outstanding at September 30, 2022, which we expect, based upon certain assumptions, to reprice or mature in each of the future time periods shown (the “GAP Table”). Except as stated below, the amount of assets and liabilities shown which reprice or mature during a particular period were determined in accordance with the earlier of term to repricing or the contractual maturity of the asset or liability. The GAP Table sets forth approximation of the projected repricing of assets and liabilities at September 30, 2022, on the basis of contractual maturities, anticipated prepayments, and scheduled rate adjustments within a three-month period and subsequent selected time intervals. The loan amounts in the GAP Table reflect principal balances expected to be redeployed and/or repriced as a result of contractual amortization and anticipated prepayments of adjustable-rate loans and fixed-rate loans, and as a result of contractual rate adjustments on adjustable-rate loans.
More than
More than
More than
6 Months
6 Months
1 Year
3 Year
More than
Total
or Less
to 1 Year
to 3 Years
to 5 Years
5 Years
Amount
(In thousands)
Interest-earning assets (1) :
Loans receivable (2)
Investment securities and restricted securities
Other interest-earning assets
Total interest-earning assets
Interest-bearing liabilities:
Demand and NOW accounts
Money market accounts
Savings accounts
Certificate accounts
Borrowings
Total interest-bearing liabilities
Interest-earning assets less interest- bearing liabilities
Cumulative interest-rate sensitivity gap (3)
Cumulative interest-rate gap as a percentage of total assets at September 30, 2022
Cumulative interest-earning assets as a percentage of cumulative interest-bearing liabilities at September 30, 2022
Interest-earning assets are included in the period in which the balances are expected to be redeployed and /or repriced as a result of anticipated prepayments, scheduled rate adjustments and contractual maturities.
For purposes of the gap analysis, loans receivable excludes non-accrual loans gross of the allowance for loan losses, undisbursed loan funds, unamortized discounts and deferred loans fees.
Interest-rate sensitivity gap represents the net cumulative difference between interest-earning assets and interest-bearing liabilities.
Net Portfolio Value and Net Interest Income Analysis. Our interest rate sensitivity is also monitored by management through the use of models which generate estimates of the change in its net portfolio value (“NPV”) and net interest income (“NII”) over a range of interest rate scenarios. NPV is the present value of expected cash flows from assets, liabilities, and off-balance sheet contracts. The NPV ratio, under any interest rate scenario, is defined as the NPV in that scenario divided by the market value of assets in the same scenario.
The table below sets forth as of September 30, 2022 and 2021 the estimated changes in our NPV that would result from designated instantaneous changes in the United States Treasury yield curve. Computations of prospective effects of hypothetical interest rates changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.
As of September 30, 2022
As of September 30, 2021
Dollar
Percentage
Dollar
Percentage
Changes in Interest Rates
Change from
Change from
Change from
Change from
(basis points) (1)
Amount
Base
Base
Amount
Base
Base
(In thousands)
Assumes an instantaneous uniform change in interest rates. A basis point equals 0.01%.
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In addition to modeling changes in NPV, we also analyze potential changes to NII for a twelve-month period under rising and falling interest rate scenarios. The following table shows our NII model as of September 30, 2022.
Net Interest
Changes in Interest Rates in Basis Points (Rate Shock)
Income
$ Change
% Change
(In thousands)
Static
As is the case with the GAP Table, certain shortcomings are inherent in the methodology used in the above interest rate risk measurements. Modeling changes in NPV and NII require the making of certain assumptions which may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the models presented assume that the composition of our interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Accordingly, although the NPV measurements and net interest income models provide an indication of interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on net interest income and will differ from actual results.
Estimates of Fair Value
The estimation of fair value is significant to a number of the Company’s assets, including loans held for sale, investment securities available-for-sale and interest rate swaps. These are all recorded at either fair value or the lower of cost or fair value. Fair values are volatile and may be influenced by a number of factors. Circumstances that could cause estimates of the fair value of certain assets and liabilities to change include a change in prepayment speeds, discount rates, or market interest rates. Fair values for most available-for-sale investment securities are based on quoted market prices. If quoted market prices are not available, fair values are based on judgments regarding future expected loss experience, current economic condition risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature, involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Liquidity
The liquidity position of the Company is dependent primarily on successful management of the Bank’s assets and liabilities to meet the needs of both deposit and credit customers. Liquidity needs arise principally to accommodate possible deposit outflows and to meet customers’ requests for loans. Scheduled principal loan repayments, maturing investments, short-term liquid assets and deposit inflows, can satisfy such needs. The objective of liquidity management is to enable the Company to maintain sufficient liquidity to meet its obligations in a timely and cost-effective manner.
Management monitors current and projected cash flows and adjusts positions as necessary to maintain adequate levels of liquidity. Under its liquidity risk management program, the Company regularly monitors correspondent bank funding exposure and credit exposure in accordance with guidelines issued by the banking regulatory authorities. Management uses a variety of potential funding sources and staggering maturities to reduce the risk of potential funding pressure. Management also maintains a detailed contingency funding plan designed to respond adequately to situations which could lead to stresses on liquidity. Management believes that the Company has the funding capacity to meet the liquidity needs arising from potential events. The Company maintains borrowing capacity through the Federal Home Loan Bank of Pittsburgh secured with loans and marketable securities.
The Company’s primary sources of short-term liquidity consist of cash and cash equivalents and investment securities available-for-sale.
At September 30, 2022, the Company had $53.3 million in cash and cash equivalents compared to $136.6 million at September 30, 2021. The decrease in cash and cash equivalents year over year was due to decreased deposits to $785.3 million at September 30, 2022 from $938.2 million at September 30, 2021 combined with an increase in investment securities to $110.0 million at September 30, 2022 from $70.8 million at September 30, 2021. In fiscal year 2021,
t he Company decided to build liquidity during the economic downturn, with the cash received from loan paydowns and payoffs throughout the year.
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Deposits
Total deposits decreased to $785.3 million at September 30, 2022, from $938.2 million at September 30, 2021. Total interest-bearing deposits decreased from $884.3 million at September 30, 2021, to $727.3 million at September 30, 2022, a decrease of $157.0 million or 17.8 percent. Time deposits $250,000 and over increased $46.5 million at September 30, 2022, as compared to September 30, 2021, and represented 41.6 percent of total time deposits at September 30, 2022, compared to 14.8 percent at September 30, 2021. We had brokered deposits totaling $9.1 million at September 30, 2022, compared to $6.1 million at September 30, 2021.
The Company continues to place the main focus of its deposit gathering efforts in the maintenance, development, and expansion of its core deposit base.
The following table depicts the Company’s deposits classified by interest rates with percentages to total deposits at September 30, 2022 and 2021:
September 30,
September 30,
Dollar
Amount
Percentage
Amount
Percentage
Change
(In thousands)
Balances by types of deposit:
Savings
Money market accounts
Interest bearing demand
Non-interest bearing demand
Certificates of deposit
Total
At September 30, 2022, our certificates of deposit and other time deposits with a balance of $250,000 or more amounted to $63.0 million, of which $47.7 million are scheduled to mature within twelve months. At September 30, 2022, the weighted average remaining maturity of our certificate of deposit accounts was 7.9 months. The following table presents the maturity of our certificates of deposit and other time deposits with balances of $250,000 or more at September 30, 2022.
Amount
(In thousands)
Maturity Period:
Three months or less
Over three months through six months
Over six months through twelve months
Over twelve months
Total
Borrowings
Borrowings from the FHLB of Pittsburgh are available to supplement the Company’s liquidity position and, to the extent that maturing deposits do not remain with the Company, management may replace such funds with advances. As of September 30, 2022 and 2021, the Company’s outstanding balance of FHLB advances totaled $80.0 million and $90.0 million, respectively. The $80.0 million in advances as of September 30, 2022 represents two short-term FHLB advances of fixed-rate borrowing with rollover of 90 days and three additional short term-borrowings.
During both fiscal year 2022 and 2021, the Company did not purchase any securities sold under agreements to repurchase as a short-term funding source.
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Cash Flows
The Consolidated Statements of Cash Flows present the changes in cash and cash equivalents resulting from the Company’s operating, investing and financing activities. During the fiscal year ended September 30, 2022, cash and cash equivalents decreased by $83.3 million from the balance at September 30, 2021 of $136.6 million. Net cash of $5.9 million was provided by operating activities in fiscal year 2022 compared to net cash of $14.8 million provided by operating activities in fiscal year 2021. Net cash provided by investing activities amounted to $73.6 million in fiscal year 2022 compared to net cash provided by investing activities of $58.0 million in fiscal year 2021. Net cash of $162.9 million was used in financing activities in fiscal year 2022 compared to net cash of $2.4 million provided by financing activities in fiscal year 2021.
In the normal course of operations, the Company engages in a variety of financial transactions that, in accordance with GAAP, are not recorded in its financial statements. These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments, lines of credit and letters of credit.
The contractual amounts of commitments to extend credit represent the amounts of potential accounting loss should the contract be fully drawn upon, the customer defaults and the value of any existing collateral becomes worthless. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. Financial instruments whose contract amounts represent credit risk at September 30, 2022 and 2021 were as follows:
September 30,
(In thousands)
Commitments to extend credit: (1)
Future loan commitments
Undisbursed construction loans
Undisbursed home equity lines of credit
Undisbursed commercial lines of credit
Overdraft protection lines
Standby letters of credit
Total commitments
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. Commitments may require payment of a fee and generally have fixed expiration dates or other termination clauses.
We anticipate that we will continue to have sufficient funds and alternative funding sources to meet our current commitments.
Shareholders ’ Equity
Total shareholders’ equity amounted to $146.4 million, or 14.0 percent of total assets at September 30, 2022, compared to $142.2 million, or 11.8 percent of total assets at September 30, 2021. Book value per common share was $19.18 at September 30, 2022, compared to $18.65 at September 30, 2021.
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Capital
The Bank’s capital ratios as of September 30, 2022 and September 30, 2021, are as follows:
To Be Well
Capitalized
Under Prompt
Excess Over
Required for Capital
Corrective
Well-Capitalized
Actual
Adequacy Purposes
Action Provisions
Provision
Amount
Ratio
Amount
Ratio
Amount
Ratio
Amount
Ratio
As of September 30, 2022:
(Dollars in thousands)
Tier 1 leverage (core) capital (to adjusted tangible assets)
Common equity Tier 1 (to risk-weighted assets)
Tier 1 risk-based capital (to risk-weighted assets)
Total risk-based capital (to risk-weighted assets)
As of September 30, 2021:
Tier 1 leverage (core) capital (to adjusted tangible assets)
Common equity Tier 1 (to risk-weighted assets)
Tier 1 risk-based capital (to risk-weighted assets)
Total risk-based capital (to risk-weighted assets)
Looking Forward
One of the Company’s primary objectives is the improvement of asset quality and capital preservation. Additional objectives are balancing asset and revenue growth, while at the same time expanding market presence and diversifying the Company’s financial products. However, it is recognized that objectives, no matter how focused, are subject to factors beyond the control of the Company, which can impede its ability to achieve these goals. The following factors should be considered when evaluating the Company’s ability to achieve its objectives:
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The financial market place is rapidly changing. Banks are no longer the only place to obtain loans, nor the only place to keep financial assets. The banking industry has lost market share to other financial service providers. The future is predicated on the Company’s ability to adapt its products, provide superior customer service and compete in an ever-changing marketplace. Net interest income, the primary source of earnings, is impacted favorably or unfavorably by changes in interest rates. Although the impact of interest rate fluctuations is mitigated by ALCO strategies, significant changes in interest rates can have a material adverse impact on profitability.
The ability of customers to repay their obligations is often impacted by changes in the regional and local economy. Although the Company sets aside loan loss provisions toward the allowance for loan losses when management determines such action to be appropriate, significant unfavorable changes in the economy could impact the assumptions used in the determination of the adequacy of the allowance.
Technological changes will have a material impact on how financial service companies compete for and deliver services and products. It is recognized that these changes will have a direct impact on how the marketplace is approached and ultimately on profitability. The Company has taken steps to improve its traditional delivery channels. However, continued success will likely be measured by the Company’s ability to anticipate and react to future technological changes.
This ‘‘Looking Forward’’ discussion constitutes a forward-looking statement under the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those projected in the Company’s forward-looking statements due to numerous known and unknown risks and uncertainties, including the factors referred to above, on the first page of this Report and in other sections of this Report.
