Real-time Form 4 intelligence. Smarter insider tracking.
YoY shift: Lean +
Year-over-year tone shift - average net-tone change across Risk Factors and MD&A vs the prior 10-K. This filing is 0.15pp more bullish than last year's.
Why YoY instead of absolute: the LM lexicon has ~6.6× more negative words than positive (legal/risk-disclosure language is heavy on hedging), so every 10-K reads bearish on raw tone. Year-over-year change strips that bias and surfaces the actual shift in management's framing.
Tone shift by section
The two components the gauge averages: how Risk Factors and MD&A each shifted in net tone versus last year's 10-K. The headline above is their average, so a green needle over a soft section just means the other section carried it.
Risk Factors
+0.25pp
Flat
Net-tone change vs last year's 10-K.
MD&A
+0.05pp
Flat
Net-tone change vs last year's 10-K.
Per-snippet highlights
Sentence-level sentiment highlighting with category and subcategory filters is coming once the snippet-scoring pipeline lands. For now, dig into the actual section text on the Sections tab.
Language change vs prior 10-K
Risk Factors (Item 1A) - words with the biggest YoY frequency increase
Negative rising
adversely+26
adverse+12
failure+10
delay+10
decline+6
Positive rising
greater+5
able+3
successfully+3
opportunities+3
achieve+3
Risk Factors (Item 1A)
17,969 words
Item 1A. Risk Factors
The summary below provides an overview of many of the risks we are exposed to in the normal course of our business activities. As a result, the below summary risks do not contain all of the information that may be important to you. Additional risks, beyond those summarized below or discussed in this section, may also materially and adversely impact our business, financial conditions and results of operation, and you should read the summary risks together with the more detailed discussion of risks set forth following this section as well as elsewhere in this Annual Report. The occurrence of one or more of the events or circumstances described in this section "Risk Factors," alone or in combination with other events or circumstances, may materially adversely affect our business, financial condition and operating results. In that event, the trading price of our securities could decline, and you could lose all or part of your investment. Consistent with the foregoing, the risks we face include, but are not limited to, the following:
Risks Related to the COVID-19 Pandemic
The global COVID-19 pandemic could harm our business and results of operations.
Language change vs prior 10-K
MD&A (Item 7) - words with the biggest YoY frequency increase
Negative rising
declines+3
discontinued+2
impaired+1
against+1
penalties+1
Positive rising
gain+4
strength+1
proactive+1
improve+1
strong+1
MD&A (Item 7)
20,307 words
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Historical Consolidated Financial Data” and our consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements that are subject to certain risks and uncertainties and are based on certain assumptions that we believe are reasonable but may prove to be inaccurate. Certain risks, uncertainties and other factors, including those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this Annual Report on Form 10-K, may cause actual results to differ materially from those projected results discussed in the forward-looking statements appearing in this discussion and analysis. Except as required by law, we assume no obligation to update any of these forward-looking statements.
Overview
We are a Texas corporation and a registered bank holding company located in the Houston metropolitan area with headquarters in Conroe, Texas. We offer a broad range of commercial and retail banking services through our wholly-owned bank subsidiary, Spirit of Texas Bank SSB. We operate through 35 full-service branches located primarily in the Houston, Dallas/Fort Worth, Bryan/College Station, San Antonio-New Braunfels, Corpus Christi, Tyler, and Austin metropolitan areas metropolitan areas. As of December 31, 2021, we had total assets of $3.27 billion, loans held for investment of $2.32 billion, total deposits of $2.78 billion and total stockholders’ equity of $393.82 million.
We are subject to increasing credit risk as a result of the COVID-19 pandemic.
Changes in market interest rates or capital markets could affect our revenues and expenses, the value of assets and obligations, and the availability and cost of capital or liquidity.
Unpredictable future developments related to or resulting from the COVID-19 pandemic could materially and adversely affect our business.
Risks Relating to the Proposed Merger
The value of the per share merger consideration to be received by Spirit shareholders is uncertain.
Regulatory approvals may not be received, may take longer than expected or may impose conditions that are not presently anticipated or cannot be met.
Failure of the Proposed Merger to be completed could negatively impact Simmons and Spirit.
We will be subject to business uncertainties and contractual restrictions while the Proposed Merger is pending.
Our directors and executive officers have interests in the Proposed Merger that may be different from our shareholders.
The merger agreement contains provisions that may discourage other companies from pursuing a business combination with Spirit that might result in greater value to Spirit shareholders.
Shares of Simmons common have different rights from the shares of Spirit common stock.
The Proposed Merger is expected to, but may not, qualify as a reorganization under Section 368(a) of the Code.
Litigationagainst Spirit or Simmons could result in significant costs, distraction, and/or a delay.
The COVID-19 pandemic may delay and adversely affect the completion of the Proposed Merger.
Risks Relating to the Combined Company’s Business Following the Proposed Merger
The market price of the common stock of the combined company after the Proposed Merger may be affected by factors different from those currently affecting the shares of Simmons or Spirit common stock.
Sales of Simmons common stock in the open market could depress Simmons’ stock price.
Combining the two companies may be difficult, costly or time consuming.
The combined company expects to incur substantial expenses related to the Proposed Merger.
Holders of Spirit common stock will have a reduced ownership after the Proposed Merger.
Risks Relating to Our Business
We conduct our operations exclusively in Texas, which imposes risks and may magnify the consequences of any regional or local economic downturn affecting its Texas markets.
We may not be able to implement aspects of our growth strategy.
Our SBA lending program is dependent upon the federal government and we face specific risks associated with originating SBA loans.
We face specific risks associated with foreign nationals.
Our ability to develop, retain and recruit bankers is critical to the success of our business strategy, and any failure to do so could adversely affect our business.
The small- to medium-sized businesses to which we lend to may have fewer resources to weather adverse business developments, which may impair a borrower’s ability to repay a loan.
If our allowance for loan and lease losses is insufficient, our earnings may be affected.
A large portion of our loan portfolio is comprised of commercial loans secured by collateral, the deterioration in value of which could increase the potential for future losses.
A portion of our loan portfolio is comprised of 1-4 single family residential real estate loans, and negative changes in the economy affecting real estate could impair the value of collateral.
Our commercial real estate and construction, land and development loan portfolios expose us to credit risks that could be greater than the risks related to other types of loans.
Climate change and related legislative and regulatory initiatives may materially affect our business.
Our primary markets are susceptible to severe weather events that could negatively impact our markets.
A failure in or breach of our operational or security systems could disrupt our business and cause losses.
We have a concentration of loans outstanding to a limited number of borrowers.
A lack of liquidity could impair our ability to fund operations and jeopardize our business.
Fluctuations in interest rates could reduce net interest income and otherwise negatively impact us.
Uncertainty related to the LIBOR may adversely affect our results of operations.
We could recognize losses on investment securities held in its securities portfolio, particularly if interest rates increase or economic and market conditions deteriorate.
We face strong competition from financial services companies and companies that offer banking services.
Negative public opinion regarding us could adversely affect our business.
The obligations associated with being a public company require significant resources and attention.
We could be subject to harm due to acts on the part of our loan customers, employees or vendors.
Our operations could be interrupted if our third-party service providers experience difficulty, terminate their services or fail to comply with banking regulations.
We are subject to environmental liability risk associated with lending activities.
Changes in U.S. trade policies and other factors beyond our control may adversely impact our business.
Risks Related to Our Industry and Regulation
We operate in a highly regulated environment and the laws and regulations that govern our operations could adversely affect us.
Legislative and regulatory actions taken now or in the future may increase impact our business.
As a regulated entity, we and the Bank must maintain certain required levels of regulatory capital that may limit our and the Bank’s operations and potential growth.
State and federal banking agencies periodically conduct examinations of our business and our failure to comply with any supervisory actions could adversely affect us.
We face a risk of noncompliance with the Bank Secrecy Act and other anti-money laundering statutes.
We are subject to numerous lending laws designed to protect consumers and failure to comply with these laws could lead to material sanctions and penalties and restrictions on our expansion opportunities.
The Federal Reserve may require us to commit capital resources to support the Bank.
We could be adversely affected by the soundness of other financial institutions.
Monetary policies and regulations of the Federal Reserve could adversely affect our business.
Risks Related to Our Common Stock
An active trading market for our common stock may not be sustained.
The market price of our common stock could be volatile and may fluctuate significantly.
If securities or industry analysts change their recommendations regarding our common stock or if our operating results do not meet their expectations, our stock price could decline.
We are an “emerging growth company,” and we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.
Our shareholders may be deemed to be in control of us, which could impose notice, approval and ongoing regulatory requirements and result in adverse regulatory consequences.
Our directors and executive officers could have the ability to influence shareholder actions in a manner that may be adverse to your personal investment objectives.
Investing in our common stock involves a significant degree of risk. The material risks and uncertainties that management believes affect us are described below. Before investing in our common stock, you should carefully consider the risks and uncertainties described below, in addition to the other information contained in this Annual Report on Form 10-K. Any of the following risks, as well as risks that we do not know or currently deem immaterial, could have a material adverse effect on our business operations and/or financial condition. As a result, the trading price of our common stock could decline, and you could lose some or all of your investment. Further, to the extent that any of the information in this report, or in other reports we file with the SEC, constitutes forward-looking statements, the risk factors below are cautionary statements identifying important factors that could cause actual results to differ materially from those expressed in any forward-looking statements made by us or on our behalf. See “Cautionary Note Regarding Forward-Looking Statements.”
Risks Related to the COVID-19 Pandemic
The global COVID-19 pandemic has led to periods of significant volatility in financial, real estate, commodities and other markets and could harm our business and results of operations.
In December 2019, a COVID-19 outbreak was reported in China, and, in March 2020, the World Health Organization declared it a pandemic. Since that time, the coronavirus has spread throughout the United States, including in the regions and communities in which the Company operates. In response, many state and local governments, including the State of Texas, instituted various emergency restrictions that substantially limited the operation of non-essential businesses and the activities of individuals. Although many of these restrictions have eased or been lifted, these restrictions have resulted in significant adverse effects on our customers and business partners, particularly those in the retail, hospitality and food and beverage industries, among many others, including a significant number of layoffs and furloughs of employees nationwide, and in the regions and communities in which we operate. These measures may be implemented again in the event of another COVID-19 outbreak or any current or future variant thereof and could adversely affect our business, operations and financial condition, as well as the business, operations and financial conditions of our customers and business partners. There is no certainty that such measures will be sufficient to mitigate the risks posed by the virus or otherwise be satisfactory to government authorities.
The ultimate effect of COVID-19 and related events, including those described above and those not yet known or knowable, could have a negative effect on the stock price, business prospects, financial condition and results of operations of the Company, including as a result of quarantines, market volatility, market downturns, changes in consumer behavior, business closures, deterioration in the credit quality of borrowers or the inability of borrowers to satisfy their obligations to the Company (and any related forbearances or restructurings that may be implemented), declines in the value of collateral securing outstanding loans, branch or office closures and business interruptions.
We are subject to increasing credit risk as a result of the COVID-19 pandemic, which could adversely impact our profitability.
Our business depends on our ability to successfully measure and manage credit risk. We are exposed to the risk that the principal of, or interest on, a loan will not be paid timely or at all or that the value of any collateral supporting a loan will be insufficient to cover our outstanding exposure. In addition, we are exposed to risks resulting from changes in economic and industry conditions and risks inherent in dealing with loans and borrowers. As the overall economic climate in the U.S., generally, and in our market areas specifically, experience material disruption due to the COVID-19 pandemic, our borrowers have had, and may have again, difficulties in repaying their loans. Governmental actions providing payment relief to borrowers affected by COVID-19 could preclude our ability to initiate foreclosure proceedings in certain circumstances and, as a result, the collateral we hold may decrease in value or become illiquid, and the level of our nonperforming loans, charge-offs and delinquencies could rise and require significant additional provisions for loan losses. Additional factors related to the credit quality of certain commercial real estate and multifamily residential loans include the duration of state and local moratoriums on evictions for non-payment of rent or other fees. The payment on these loans that are secured by income producing properties are typically dependent on the successful operation of the related real estate property and may subject us to risks from adverse conditions in the real estate market or the general economy.
Bank regulatory agencies and various governmental authorities are urging financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations because of the effects of COVID-19. We have been actively working to support our borrowers to mitigate the impact of the COVID-19 pandemic on them and on our loan portfolio, including through loan modifications that defer payments for those who experienced a hardship as a result of the COVID-19 pandemic. Although loans on deferral related to the COVID-19 pandemic at December 31, 2021 were only $13.9 million, we cannot predict whether any such future loan modifications may ultimately have an adverse impact on our profitability in future periods. Our inability to successfully manage the increased credit risk caused by the COVID-19 pandemic could have a material adverse effect on our business, financial condition and results of operations.
Changes in market interest rates or capital markets, including volatility resulting from the COVID-19 pandemic, could affect our revenues and expenses, the value of assets and obligations, and the availability and cost of capital or liquidity.
The COVID-19 pandemic has significantly affected the financial markets and has resulted in a number of Federal Reserve actions. Market interest rates declined significantly in 2020 and have remained at such levels over the past year. We expect that these reductions in interest rates, especially if prolonged, could adversely affect our net interest income and margins and our profitability.
Given our business mix, and the fact that most of our assets and liabilities are financial in nature, we tend to be sensitive to market interest rate movements and the performance of the financial markets. Our primary source of income is net interest income. Prevailing economic conditions, fiscal and monetary policies and the policies of various regulatory agencies all affect market rates of interest and the availability and cost of credit, which, in turn, significantly affect financial institutions' net interest income. If the interest we pay on deposits and other borrowings increases at a faster rate than increases in the interest we receive on loans and investments, net interest income, and, therefore, our earnings, could be affected. Earnings could also be affected if the interest we receive on loans and other investments falls more quickly than the interest we pay on deposits and other borrowings.
In addition, the continued spread of COVID-19, and any current or future variant thereof, has also led to disruption and volatility in financial markets, which could increase our cost of capital and adversely affect our ability to access financial markets. This market volatility could result in a significant decline in our stock price and market capitalization, which could result in goodwill impairment charges.
Unpredictable future developments related to or resulting from the COVID-19 pandemic could materially and adversely affect our business and results of operations.
Given the ongoing and dynamic nature of the circumstances, it is not possible to predict the ultimate impact of the coronavirus outbreak on our stock price, business prospects, financial condition or results of operations. Any future development is highly uncertain and cannot be predicted, including the scope and duration of the pandemic, third party providers’ ability to support our operation, and any actions taken by governmental authorities and other third parties in response to the pandemic. We are continuing to monitor the COVID-19 pandemic and related risks, although the rapid development and fluidity of the situation precludes any specific prediction as to its ultimate impact on us. However, if the pandemic continues to spread or otherwise results in a continuation or worsening of the current economic and commercial environments, our business, financial condition, results of operations and cash flows as well as our regulatory capital and liquidity ratios could be materially adversely affected and many of the risks described herein will be heightened.
Risks Relating to the Proposed Merger
Because the market price of Simmons common stock and the amount of fully diluted shares of Spirit common stock outstanding will both fluctuate, the value of the per share merger consideration to be received by Spirit shareholders is uncertain.
On November 18, 2021, we entered into a merger agreement with Simmons First National Corporation, pursuant to and subject to the terms of which we will merge with and into Simmons, with Simmons as the surviving corporation. Based on the assumptions set forth herein, upon completion of the Proposed Merger, each share of outstanding Spirit common stock (except for shares of Spirit common stock held directly or indirectly by Spirit or Simmons and any dissenting shares) will be converted into the right to receive the per share merger consideration, with cash paid in lieu of any resulting fractional shares. Any change in the market price of Simmons common stock prior to the completion of the Proposed Merger will affect the market value of the per share merger consideration that Spirit shareholders will receive upon completion of the Proposed Merger. The value of the per share merger consideration could also change if the amount of fully diluted shares of Spirit common stock outstanding changes after the date hereof. Stock price changes may result from a variety of factors, including general market and economic conditions, changes in the respective businesses, operations and prospects of Simmons or Spirit, and regulatory considerations, among other things. Many of these factors are beyond the control of Simmons and Spirit.
There will be no adjustment to the per share merger consideration based upon changes in the market price of Simmons common stock or Spirit common stock prior to the time the Proposed Merger is completed, and the merger agreement cannot be terminated due to a change in the price of Simmons common stock.
Regulatory approvals may not be received, may take longer than expected or may impose conditions that are not presently anticipated or cannot be met.
Before the transactions contemplated by the merger agreement, including the Proposed Merger and the bank merger, may be completed, various approvals must be obtained from bank regulatory authorities. In determining whether to grant these approvals, the applicable regulatory authorities consider a variety of factors, including the competitive impact of the proposal in the relevant geographic markets; financial, managerial and other supervisory considerations, including the future prospects, of each party; potential effects of the Proposed Merger on the convenience and needs of the communities to be served and the record of the insured depository institution subsidiaries under the Community Reinvestment Act of 1977 and the regulations promulgated thereunder, which we refer to as the Community Reinvestment Act, including the subsidiaries’ overall compliance records and recent fair lending examinations; effectiveness of the parties in combatting money laundering activities; the extent to which the proposal would result in greater or more concentrated risks to the stability of the United States banking or financial system; and whether Simmons controls or would after consummation of the Proposed Merger control deposits in excess of certain limits. These regulatory authorities may impose conditions on the granting of such approvals. Such conditions or changes and the process of obtaining pending regulatory approvals could have the effect of delaying completion of the Proposed Merger or of imposing additional costs or limitations on the combined company following the Proposed Merger. While some regulatory approvals have been received, pending regulatory approvals may not be received at all, may not be received in a timely fashion, or may contain conditions on the completion of the Proposed Merger that are not anticipated or cannot be met. Furthermore, such conditions or changes may constitute a burdensome condition that may allow Simmons to terminate the merger agreement and Simmons may exercise its right to terminate the merger agreement. If the consummation of the Proposed Merger is delayed, including by a delay in receipt of necessary regulatory approvals, the business, financial condition and results of operations of each party may also be adversely affected.
Failure of the Proposed Merger to be completed, the termination of the merger agreement or a significant delay in the consummation of the Proposed Merger could negatively impact Simmons and Spirit.
The merger agreement is subject to a number of conditions which must be fulfilled in order to complete the Proposed Merger. These conditions to the consummation of the Proposed Merger may not be fulfilled and, accordingly, the Proposed Merger may not be completed. In addition, if the merger is not completed by November 30, 2022, either Simmons or Spirit may choose to terminate the merger agreement at any time after such date if the failure to consummate the transactions contemplated by the merger agreement is not caused by any breach of the merger agreement by the party electing to terminate the merger agreement, before or after Spirit shareholder approval of the Proposed Merger.
If the Proposed Merger is not consummated, the ongoing business, financial condition and results of operations of each party may be adversely affected and the market price of Simmons common stock and Spirit common stock may decline significantly, particularly to the extent that the current market price reflects a market assumption that the Proposed Merger will be consummated. If the consummation of the Proposed Merger is delayed, including by the receipt of a competing acquisition proposal, the business, financial condition and results of operations of each party may be adversely affected.
In addition, each party has incurred and will incur substantial expenses in connection with the negotiation and completion of the transactions contemplated by the merger agreement, as well as the costs and expenses of filing, printing and mailing our proxy statement/prospectus and all filing and other fees paid to the SEC and other regulatory agencies in connection with the Proposed Merger. If the Proposed Merger is not completed, the parties would have to recognize these expenses without realizing the expected benefits of the merger. Any of the foregoing, or other risks arising in connection with the failure of or delay in consummating the Proposed Merger, including the diversion of management attention from pursuing other opportunities and the constraints in the merger agreement on the ability to make significant changes to each party’s ongoing business during the pendency of the Proposed Merger, could have an adverse effect on each party’s business, financial condition and results of operations.
Additionally, Simmons’ or Spirit’s business may have been adversely impacted by the failure to pursue other beneficialopportunities due to the focus of management on the Proposed Merger, without realizing any of the anticipated benefits of completing the Proposed Merger, and the market price of Simmons’ or Spirit’s common stock might decline to the extent that the current market price reflects a market assumption that the Proposed Merger will be completed. If the merger agreement is terminated and a party’s board of directors seeks another Proposed Merger or business combination, such party’s shareholders cannot be certain that such party will be able to find a party willing to engage in a transaction on more attractive terms than the Proposed Merger.
Some of the conditions to the Proposed Merger may be waived by Simmons or Spirit without resoliciting Spirit shareholder approval of the merger agreement.
Some of the conditions to the Proposed Merger set forth in the merger agreement may be waived by Spirit or Simmons, subject to the agreement of the other party in specific cases. If any such conditions are waived, Spirit and Simmons will evaluate whether an amendment of our proxy statement/prospectus and resolicitation of proxies is warranted. In the event that the Spirit board of directors determines that resolicitation of Spirit shareholders is not warranted, Simmons and Spirit will have the discretion to complete the Proposed Merger without seeking further Spirit shareholder approval.
Simmons and Spirit will be subject to business uncertainties and contractual restrictions while the Proposed Merger is pending.
Uncertainty about the effect of the Proposed Merger on employees, customers (including depositors and borrowers), suppliers and vendors may have an adverse effect on the business, financial condition and results of operations of the parties to the Proposed Merger. These uncertainties may impair Simmons’ or Spirit’s ability to attract, retain and motivate key personnel and customers (including depositors and borrowers) pending the consummation of the Proposed Merger, as such personnel and customers may experience uncertainty about their future roles and relationships following the consummation of the Proposed Merger. Additionally, these uncertainties could cause customers (including depositors and borrowers), suppliers, vendors and others who deal with Simmons and/or Spirit to seek to change existing business relationships with Simmons and/or Spirit or fail to extend an existing relationship with Simmons and/or Spirit. In addition, competitors may target each party’s existing customers by highlighting potential uncertainties and integration difficulties that may result from the Proposed Merger.
The pursuit of the Proposed Merger and the preparation for the integration may place a burden on each company’s management and internal resources. Any significant diversion of management attention away from ongoing business concerns and any difficulties encountered in the transition and integration process could have an adverse effect on each party’s business, financial condition and results of operations.
In addition, the merger agreement restricts each party from taking certain actions without the other party’s consent while the Proposed Merger is pending. These restrictions could have an adverse effect on each party’s business, financial condition and results of operations.
Spirit’s directors and executive officers have interests in the Proposed Merger that may be different from the interests of the Spirit shareholders.
Spirit’s directors and executive officers have interests in the Proposed Merger that may be different from, or in addition to, the interests of the Spirit shareholders generally. The Spirit board of directors was aware of these interests and considered them, among other matters, in approving the merger agreement and the transactions contemplated by the merger agreement and recommending to Spirit shareholders that they vote to approve the Proposed Merger.
The merger agreement contains provisions that may discourage other companies from pursuing, announcing or submitting a business combination proposal to Spirit that might result in greater value to Spirit shareholders.
The merger agreement contains provisions that may discourage a third party from pursuing, announcing or submitting a business combination proposal to Spirit that might result in greater value to the Spirit shareholders than the Proposed Merger. These provisions include a general prohibition on Spirit from soliciting or entering into discussions with any third party regarding any acquisition proposal or offers for competing transactions. Furthermore, if the merger agreement is terminated, under certain circumstances, Spirit may be required to pay Simmons a termination fee equal to $22,750,000. Spirit also has an unqualified obligation to submit its merger-related proposals to a vote by its shareholders, including if Spirit receives an unsolicited proposal that the Spirit board of directors has determined in good faith is superior to the Proposed Merger.
In connection with entering into the merger agreement, each member of the Spirit board of directors and Spirit’s named executive officers, in their capacities as individuals, have separately entered into a Spirit voting agreement pursuant to which they agreed to vote their beneficially owned shares of Spirit common stock in favor of the merger proposal and certain related matters and against alternative transactions. Shares constituting approximately 24.7% of the Spirit common stock entitled to vote at the Spirit special meeting are subject to Spirit voting agreements.
The shares of Simmons common stock to be received by holders of Spirit common stock as a result of the Proposed Merger will have different rights from the shares of Spirit common stock.
The rights of Spirit shareholders are currently governed by the second amended and restated certificate of formation of Spirit, which we refer to as the Spirit charter, and the second amended and restated bylaws of Spirit, as amended, which we refer to as the Spirit bylaws. Upon completion of the Proposed Merger, the rights of former holders of Spirit common stock will be governed by the Simmons charter and the Simmons bylaws. Simmons is organized under Arkansas law, while Spirit is organized under Texas law. The rights associated with Spirit common stock are different from the rights associated with Simmons common stock.
The Proposed Merger is expected to, but may not, qualify as a reorganization under Section 368(a) of the Code.
The parties expect the Proposed Merger to be treated as a “reorganization” within the meaning of Section 368(a) of the Code, and the obligations of Simmons and Spirit to complete the Proposed Merger are conditioned upon the receipt of U.S. federal income tax opinion to that effect from Covington & Burling LLP, which we refer to as Covington. This tax opinion represents the legal judgment of counsel rendering the opinion and is not binding on the United States Internal Revenue Service, which we refer to as the IRS, or the courts. The expectation that the Proposed Merger will be treated as a “reorganization” within the meaning of Section 368(a) of the Code reflects assumptions and takes into account the relevant information available to Simmons and Spirit at the time. However, this information is not a fact and should not be relied upon as necessarily indicative of future results. Furthermore, such expectation constitutes a forward-looking statement. For information on forward-looking statements, see the section entitled “Cautionary Statement Regarding Forward-Looking Statements.”
If the Proposed Merger does not qualify as a “reorganization” within the meaning of Section 368(a) of the Code, then the exchange of Spirit common stock for Simmons common stock pursuant to the Proposed Merger may be treated as a taxable transaction to holders of Spirit common stock. Consequently, a holder of Spirit common stock may be required to recognize gain or loss equal to the difference between (1) the sum of the fair market value of Simmons common stock received by the Spirit shareholder in the Proposed Merger and the amount of cash, if any, received by the Spirit shareholder, and (2) the Spirit shareholder’s adjusted tax basis in the shares of Spirit common stock exchanged therefor. You should consult your tax advisor to determine the particular tax consequences to you.
The opinion of Stephens Inc. delivered to the Spirit board of directors prior to the signing of the merger agreement will not reflect changes in circumstances after the date of the opinion.
The Spirit board of directors received a fairness opinion from Stephens Inc., Spirit’s financial advisor, dated November 18, 2021. Such opinion has not been updated as of the date of our proxy statement/prospectus and will not be updated at, or prior to, the time of the completion of the Proposed Merger. Changes in the operations and prospects of Simmons or Spirit, general market and economic conditions and other factors that may be beyond the control of Simmons and Spirit may alter the value of Simmons or Spirit or the prices of shares of Simmons common stock or Spirit common stock by the time the Proposed Merger is completed. The opinion does not speak as of the time the Proposed Merger is completed or as of any other date than the date of the opinion.
Litigationagainst Spirit or Simmons, or the members of the Spirit or Simmons board of directors, could result in significant costs, management distraction, and/or a delay of or injunctionagainst the Proposed Merger.
While Simmons and Spirit believe that any claims that may be asserted by purported shareholder plaintiffs related to the Proposed Merger would be without merit, the results of any such potential legal proceedings are difficult to predict and could delay or prevent the Proposed Merger from being competed in a timely manner. The existence of litigation related to the Proposed Merger could affect the likelihood of obtaining the required approval from Spirit shareholders. Moreover, any litigation could be time consuming and expensive, could divert Simmons and Spirit management’s attention away from their regular business and, any lawsuit adversely resolved against Spirit, Simmons or members of the Spirit or Simmons board of directors, could have an adverse effect on each party’s business, financial condition and results of operations.
If the actions remain unresolved, they could prevent or delay the completion of the Proposed Merger. One of the conditions to the consummation of the Proposed Merger is the absence of any law or order (whether temporary, preliminary or permanent) by any court or regulatory authority of competent jurisdiction prohibiting, restricting or making illegal consummation of the consummation of the transactions contemplated by the merger agreement (including the Proposed Merger). Consequently, if a settlement or other resolution is not reached in any lawsuit that is filed or any regulatory proceeding and a claimant secures injunctive or other relief or a regulatory authority issues an order or other directive prohibiting, restricting or making illegal consummation of the consummation of the transactions contemplated by the merger agreement (including the Proposed Merger), then such injunctive or other relief may prevent the Proposed Merger from becoming effective in a timely manner or at all.
The COVID-19 pandemic may delay and adversely affect the completion of the Proposed Merger.
The COVID-19 pandemic has created economic and financial disruptions that have adversely affected, and are likely to continue to adversely affect, the business, financial condition, liquidity, capital and results of operations of Simmons and Spirit. If the effects of the COVID-19 pandemic, or any current or future variant of COVID-19, cause continued or extended decline in the economic environment and the financial results of Simmons or Spirit, or the business operations of Simmons or Spirit are disrupted as a result of the COVID-19 pandemic, efforts to complete the Proposed Merger and integrate the businesses of Simmons and Spirit may also be delayed and adversely affected. Additional time may be required to obtain the requisite regulatory approvals, and regulatory authorities may impose additional requirements on Simmons or Spirit that must be satisfied prior to completion of the Proposed Merger, which could delay and adversely affect the completion of the Proposed Merger.
Risks Relating to the Combined Company’s Business Following the Proposed Merger
The market price of the common stock of the combined company after the Proposed Merger may be affected by factors different from those currently affecting the shares of Simmons or Spirit common stock.
Upon the completion of the Proposed Merger, Simmons shareholders and Spirit shareholders will become shareholders of the combined company. Simmons’ business differs from that of Spirit, and, accordingly, the results of operations of the combined company and the market price of the combined company’s shares of common stock
may be affected by factors different from those currently affecting the independent results of operations of each of Simmons and Spirit.
Sales of substantial amounts of Simmons common stock in the open market by former Spirit shareholders could depress Simmons’ stock price.
Shares of Simmons common stock that are issued to Spirit shareholders in the Proposed Merger will be freely tradable without restrictions or further registration under the Securities Act. Simmons currently expects to issue 18,325,000 shares of Simmons common stock in connection with the Proposed Merger based on the assumptions described herein. If the Proposed Merger is completed and if Spirit’s former shareholders sell substantial amounts of Simmons common stock in the public market following completion of the Proposed Merger, the market price of Simmons common stock may decrease. These sales might also make it more difficult for Simmons to sell equity or equity-related securities at a time and price that it otherwise would deem appropriate.
Combining the two companies may be more difficult, costly or time consuming than expected and the anticipated benefits and cost savings of the Proposed Merger may not be realized.
The success of the Proposed Merger will depend on, among other things, the combined company’s ability to combine the businesses of Simmons and Spirit. If the combined company is not able to successfullyachieve this objective, the anticipated benefits of the merger may not be realized fully, or at all, or may take longer to realize than expected.
Simmons and Spirit have operated and, until the completion of the Proposed Merger, will continue to operate, independently. The success of the Proposed Merger, including anticipated benefits and cost savings, will depend, in part, on the successful combination of the businesses of Simmons and Spirit. To realize these anticipated benefits and cost savings, after the completion of the Proposed Merger, Simmons expects to integrate Spirit’s business into its own. It is possible that the integration process could result in the loss of key employees, the disruption of each company’s ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect the combined company’s ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits and cost savings of the Proposed Merger. The loss of key employees could have an adverse effect on the companies’ financial results and the value of their common stock. If Simmons experiences difficulties with the integration process, the anticipated benefits of the Proposed Merger may not be realized fully, or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be business disruptions that cause Simmons or Spirit to lose current customers or cause current customers to remove their accounts from Simmons or Spirit and move their business to competing financial institutions. Integration efforts between the two companies will also divert management attention and resources. These integration matters could have an adverse effect on each of Simmons or Spirit during this transition period and for an undetermined period after consummation of the Proposed Merger.
The combined company expects to incur substantial expenses related to the Proposed Merger.
The combined company expects to incur substantial expenses in connection with consummation of the Proposed Merger and combining the business, operations, networks, systems, technologies, policies and procedures of the two companies. Although Simmons and Spirit have assumed that a certain level of transaction and combination expenses would be incurred, there are a number of factors beyond their control that could affect the total amount or the timing of their combination expenses. Many of the expenses that will be incurred, by their nature, are difficult to estimate accurately at the present time. Due to these factors, the transaction and combination expenses associated with the Proposed Merger could, particularly in the near term, exceed the savings that the combined company expects to achieve from the elimination of duplicative expenses and the realization of economies of scale and cost savings related to the combination of the businesses following the consummation of the Proposed Merger. As a result of these expenses, both Simmons and Spirit expect to take charges against their earnings before and after the completion of the Proposed Merger. The charges taken in connection with the Proposed Merger are expected to be significant, although the aggregate amount and timing of such charges are uncertain at present.
Holders of Simmons and Spirit common stock will have a reduced ownership and voting interest after the Proposed Merger and will exercise less influence over management.
Holders of Simmons and Spirit common stock currently have the right to vote for the election of the directors and on other matters affecting Simmons and Spirit, respectively. Upon the completion of the Proposed Merger, each Spirit shareholder who receives shares of Simmons common stock will become a shareholder of Simmons with a
percentage ownership of Simmons common stock that is smaller than such shareholder’s percentage ownership of Spirit common stock. Following completion of the Proposed Merger , it is currently expected that former holders of Spirit common stock as a group will own approximately 14.0 % of the combined company’s common stock and existing Simmons common shareholders as a group will own approximately 86.0 % of the combined company’s common stock. As a result, Spirit shareholders will have less influence on the management and policies of the combined company than they now have on the management and policies of Spirit, and existing Simmons shareholders may have less influence than they now have on the management and policies of Simmons.
Risks Related to Our Business
We conduct our operations exclusively in Texas, specifically in the Houston, Dallas/Fort Worth and Bryan/College Station, San Antonio-New Braunfels, Corpus Christi, Tyler and Austin metropolitan areas and North Central Texas, which imposes risks and may magnify the consequences of any regional or local economic downturn affecting its Texas markets, including any downturn in the energy, technology or real estate sectors.
As of December 31, 2021, the substantial majority of the loans in our loan portfolio were made to borrowers who live and/or conduct business in our Texas markets. Likewise, as of such date, the substantial majority of our secured loans were secured by collateral located in Texas. Accordingly, we are exposed to risks associated with a lack of geographic diversification. The economic conditions in Texas significantly affect our business, financial condition, results of operations and future prospects, and any adverse economic developments, among other things, could negatively affect the volume of loan originations, increase the level of non-performing assets, increase the rate of foreclosurelosses on loans and reduce the value of our loans and loan servicing portfolio.
The economies in our markets are also highly dependent on the energy sector as well as the technology and real estate sectors. In particular, a decline in or volatility of the prices of crude oil or natural gas could adversely affect many of our customers. Any downturn or adverse development in our Texas markets, including as a result of a downturn in the energy, technology or real estate sectors, could result in increases in loan delinquencies, increases in non-performing assets and foreclosures, decreases in demand for our products and services, which could adversely affect our liquidity position, and decreases in the value of the collateral securing our loans, especially real estate, which could reduce customers’ borrowing power and repayment ability, all of which, in turn, would adversely affect our business, financial condition and results of operations.
In addition, the inflationary outlook in the United States remains uncertain. The consumer price index increased 7 percent year-over-year in December 2021. The risks to our business from inflation depends on the durability of the current inflationary pressures in our markets. Transitory increases in inflation are unlikely to have a material impact on our business or earnings. However, more persistent inflation could lead to tighter-than-expected monetary policy which could, in turn, increase the borrowings costs of our customers, making it more difficult for them to repay their loans or other obligations. High interest rates may be needed to tame persistent inflationary price pressures, which could also push down asset prices and weaken economic activity. A deterioration in economic conditions in the United States and our markets could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values and a decrease in demand for our products and services, all of which, in turn, would adversely affect our business, financial condition and results of operations.
We may not be able to implement aspects of our growth strategy, which may affect our ability to maintain our historical earnings trends.
Our strategy focuses on organic growth and acquisitions. We may not be able to execute on aspects of our growth strategy to sustain our historical rate of growth or may not be able to grow at all. More specifically, we may not be able to generate sufficient new loans and deposits within acceptable risk and expense tolerances, obtain the personnel or funding necessary for additional growth or find suitable acquisition candidates. Various factors, such as economic conditions and competition, may impede or prohibit the growth of our operations, the opening of new branches and the consummation of acquisitions. Further, we may be unable to attract and retain experienced bankers, which could adversely affect our growth. The success of our strategy also depends on our ability to effectively manage growth, which is dependent upon a number of factors, including our ability to adapt our existing credit, operational, technology and governance infrastructure to accommodate expanded operations. If we fail to implement one or more aspects of our strategy, we may be unable to maintain our historical earnings trends, which could have an adverse effect on our business.
Our strategy of pursuing acquisitions exposes us to financial, execution and operational risks that could have a material adverse effect on our business, financial condition, results of operations and future prospects.
We intend to continue pursuing a strategy that includes acquisitions. We face significant competition in pursuing acquisition targets from other banks and financial institutions, many of which possess greater financial, human, technical and other resources than we do. Our ability to compete in acquiring target institutions will depend on our available financial resources to fund the acquisitions, including the amount of cash and cash equivalents we have and the liquidity and market price of our common stock. In addition, increased competition may also drive up the acquisition consideration that we will be required to pay in order to successfully capitalize on attractive acquisition opportunities. To the extent that we are unable to find suitable acquisition targets, an important component of our growth strategy may not be realized.
Acquisitions of financial institutions also involve operational risks and uncertainties, such as unknown or contingent liabilities with no available manner of recourse, exposure to unexpectedproblems such as asset quality, the retention of key employees and customers and other issues that could negatively affect our business. We may not be able to complete future acquisitions or, if completed, we may not be able to successfully integrate the operations, technology platforms, management, products and services of the entities that we acquire or successfully eliminate redundancies. The integration process may also require significant time and attention from our management that would otherwise be directed toward servicing existing business and developing new business. Failure to successfully integrate the entities we acquire into our existing operations in a timely manner may increase our operating costs significantly and adversely affect our business, financial condition and results of operations. Further, acquisitions in Texas typically involve the payment of a premium over book and market values. Therefore, some dilution of our tangible book value and earnings per share may occur in connection with any future acquisition, and the carrying amount of any goodwill that we currently maintain or may acquire may be subject to impairment in future periods.
SBA lending is an important part of our business. Our SBA lending program is dependent upon the federal government and our status as a participant in the SBA’s Preferred Lenders Program, and we face specific risks associated with originating SBA loans and selling the guaranteed portion thereof.
We have been approved by the SBA to participate in the SBA’s Preferred Lenders Program. As an SBA Preferred Lender, we enable our clients to obtain SBA loans without being subject to the potentially lengthy SBA approval process necessary for lenders that are not SBA Preferred Lenders. If we lose our status as an SBA Preferred Lender, we may lose some or all of our customers to lenders who are SBA Preferred Lenders, which could adversely affect our business, financial condition and results of operations.
SBA lending programs typically guarantee 75.0% of the principal on an underlying loan. We generally sell the guaranteed portion of our SBA 7(a) loans in the secondary market. These sales have resulted in both premium income for us at the time of sale, and created a stream of future servicing income. There can be no assurance that we will be able to continue originating these loans, that a secondary market for these loans will continue to exist or that we will continue to realize premiums upon the sale of the guaranteed portion of these loans. When we sell the guaranteed portion of our SBA 7(a) loans, we incur credit risk on the non-guaranteed portion of the loans, and if a customer defaults on the non-guaranteed portion of a loan, we share any loss and recovery related to the loan pro-rata with the SBA. Furthermore, if our employees do not follow the SBA guidelines in originating loans and if our loan review and audit programs fail to identify and rectify such failures, the SBA may reduce or, in some cases, refuse to honor its guarantee obligations and we may incur losses as a result.
The laws, regulations and standard operating procedures that are applicable to SBA loan products may change in the future. In addition, the aggregate amount of SBA 7(a) and 504 loan guarantees by the SBA must be approved each fiscal year by the federal government. We cannot predict the effects of these changes or decisions on our business and profitability. If the federal government were to reduce the amount of SBA loan guarantees, such reduction could adversely impact our SBA lending program, including making and selling the guaranteed portion of fewer SBA 7(a) and 504 loans. In addition, any default by the U.S. government on its obligations or any prolonged government shutdown could, among other things, impede our ability to originate SBA or U.S. Department of Agriculture loans or sell such loans in the secondary market, which could materially and adversely affect our business, financial condition and results of operations.
Loans to and deposits from foreign nationals are an important part of our business and we face specific risks associated with foreign nationals.
As of December 31, 2021, loans to foreign nationals of $143.3 million comprised 6.2% of our loan portfolio and deposits from foreign nationals of $30.8 million comprised 1.1% of our total deposits. We define foreign nationals as those who derive more than 50.0% of their personal income from non-U.S. sources. We intend to grow this segment of its loan and deposit portfolio in the future. These borrowers typically lack a U.S. credit history and have a potential to leave the United States without fulfilling their mortgage obligation and leaving us with little
recourse to them personally. Additionally, transactions with foreign nationals place additional pressure on our policies, procedures and systems for complying with the Bank Secrecy Act and other AML statutes and regulations.
Our ability to develop bankers, retain bankers and recruit additional successful bankers is critical to the success of our business strategy, and any failure to do so could adversely affect our business, financial condition, results of operations and future prospects.
Our ability to retain and grow our loans, deposits and fee income depends upon the business generation capabilities, reputation and relationship management skills of our bankers, many of whom we develop internally. If we lose the services of any of our bankers, including successful bankers employed by financial institutions that we may acquire, to a new or existing competitor or otherwise, or fail to successfully recruit bankers or develop bankers internally, we may not be able to implement our growth strategy, retain valuable relationships and some of our customers could choose to use the services of a competitor instead of our services. Additionally, we may incur significant expenses and expend significant time and resources on training, integration and business development before it is able to determine whether a new banker will be profitable or effective. If we are unable to develop, attract or retain successful bankers, or if our bankers fail to meet our expectations in terms of customer relationships and profitability, we may be unable to execute our business strategy and our business, financial condition, results of operations and future prospects may be adversely affected.
The small- to medium-sized businesses to which we lend to may have fewer resources to weather adverse business developments, which may impair a borrower’s ability to repay a loan, and such impairment could adversely affect our results of operations and financial condition.
We focus our business development and marketing strategy primarily on small- to medium-sized businesses, which we define as commercial borrowing relationships with customers with revenues of $3.0 million to $30.0 million. Small- to medium-sized businesses frequently have smaller market shares than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management skills, talents and efforts of one or two people or a small group of people, and the death, disability or resignation of one or more of these people could have a material adverse impact on the business and its ability to repay its loan. If general economic conditions negatively impact our primary service areas specifically or Texas generally and small- to medium-sized businesses are adversely affected or our borrowers are otherwise affected by adverse business developments, our business, financial condition and results of operations could be adversely affected.
If our allowance for loan and lease losses is not sufficient to cover actual loan losses, our earnings may be affected.
We establish our allowance for loan and lease losses and maintain it at a level considered adequate by management to absorb probable loan losses based on our analysis of our loan portfolio and market environment. Although we believe that the allowance for loan and lease losses is adequate, there can be no assurance that the allowance will prove sufficient to cover future losses. The amount of future loan losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates.
We may be required to take additional provisions for loan and lease losses in the future to further supplement the allowance for loan and lease losses, either due to management’s decision to do so or requirements by our banking regulators, which would result in a decrease in our net income and our capital balance. These adjustments could adversely affect our business, financial condition and results of operations.
In the aftermath of the 2008 financial crisis, the FASB decided to review how banks estimate losses in the allowance calculation, and it issued the final current expected credit loss standard (“CECL”) in June 2016. The current allowance model will be replaced by the new CECL model that will become effective for us, as an emerging growth company, for the first interim and annual reporting periods beginning after December 15, 2022. Under the new CECL model, financial institutions will be required to use historical information, current conditions and reasonable forecasts to estimate the expected loss over the life of the loan. The transition to the CECL model will bring with it significantly greater data requirements and changes to methodologies to accurately account for expected losses under the new parameters, and there is the potential for an increase in the allowance at adoption date. We expect to continue developing and implementing processes and procedures to ensure we are fully compliant with the CECL requirements at its adoption date.
A large portion of our loan portfolio is comprised of commercial loans secured by receivables, promissory notes, inventory, equipment or other commercial collateral, the deterioration in value of which could increase the potential for future losses.
As of December 31, 2021, $464.7 million, or 20.0% of our loans held for investment, were comprised of commercial loans to businesses. These commercial loans are typically larger in amount than loans to individuals and, therefore, have the potential for larger losses on a single loan basis. Additionally, the repayment of commercial loans is subject to the ongoing business operations of the borrower. The collateral securing such loans generally includes moveable property such as equipment and inventory, which may decline in value more rapidly than we anticipate exposing us to increased credit risk. A portion of our commercial loans are secured by promissory notes that evidence loans made by us to borrowers that in turn make loans to others that are secured by real estate. Accordingly, significant adverse changes in the economy or local market conditions in which our commercial lending customers operate could cause rapid declines in loan collectability and the values associated with general business assets resulting in inadequate collateral coverage that may expose us to credit losses and could adversely affect our business, financial condition and results of operations.
Because a portion of our loan portfolio is comprised of 1-4 single family residential real estate loans, negative changes in the economy affecting real estate values and liquidity could impair the value of collateral securing our real estate loans and result in loan and other losses.
As of December 31, 2021, $362.2 million, or 15.6% of our loans held for investment, were comprised of loans with 1-4 single family residential real estate as a primary component of collateral. As a result, adverse developments affecting real estate values in our primary markets could increase the credit risk associated with our real estate loan portfolio. Negative changes in the economy affecting real estate values and liquidity in our market areas could significantly impair the value of property pledged as collateral on loans and affect our ability to sell the collateral upon foreclosure without a loss or additional losses. Collateral may have to be sold for less than the outstanding balance of the loan, which could result in losses on such loans. Such declines and losses could have a material adverse impact on our business, results of operations and growth prospects. If real estate values decline, it is also more likely that we would be required to increase our allowance for loan and lease losses, which could adversely affect our business, financial condition and results of operations.
Our commercial real estate and construction, land and development loan portfolios expose us to credit risks that could be greater than the risks related to other types of loans.
As of December 31, 2021, $1.03 billion, or 44.4% of our loans held for investment, were comprised of commercial real estate loans (including owner-occupied commercial real estate loans and multifamily loans) and $401 million, or 17.3% of our loans held for investment, were comprised of construction, land and development loans. These loans typically involve repayment dependent upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service. The availability of such income for repayment may be adversely affected by changes in the economy or local market conditions. These loans expose a lender to greater credit risk than loans secured by other types of collateral because the collateral securing these loans is typically more difficult to liquidate due to the fluctuation of real estate values. Additionally, nonowner-occupied commercial real estate loans generally involve relatively large balances to single borrowers or related groups of borrowers. Unexpecteddeterioration in the credit quality of our nonowner-occupied commercial real estate loan portfolio could require us to increase our allowance for loan and lease losses, which would reduce our profitability and could have a material adverse effect on our business, financial condition and results of operations.
Construction, land and development loans also involve risks attributable to the fact that loan funds are secured by a project under construction and the project is of uncertain value prior to its completion. It can be difficult to accurately evaluate the total funds required to complete a project, and this type of lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If we are forced to foreclose on a project prior to completion, we may be unable to recover the entire unpaid portion of the loan. In addition, we may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time, any of which could adversely affect our business, financial condition and results of operations.
Climate change and related legislative and regulatory initiatives may materially affect the Company’s business and results of operations.
The effects of climate change continue to create an alarming level of concern for the state of the global environment. As a result, the global business community has increased its political and social awareness surrounding the issue. Further, the U.S. Congress, state legislatures and federal and state regulatory agencies continue to propose numerous initiatives to supplement the global effort to combat climate change. Similar and even more expansive initiatives are expected under the current administration, including potentially increasing supervisory expectations with respect to banks’ risk management practices, accounting for the effects of climate change in stress testing scenarios and systemic risk assessments, revising expectations for credit portfolio concentrations based on climate-related factors and encouraging investment by banks in climate-related initiatives and lending to communities disproportionately impacted by the effects of climate change. The lack of empirical data surrounding the credit and other financial risks posed by climate change render it impossible to predict how specifically climate change may impact our financial condition and results of operations; however, the physical effects of climate change may also directly impact us. Specifically, unpredictable and more frequent weather disasters may adversely impact the value of real property securing the loans in our portfolios. Additionally, if insurance obtained by our borrowers is insufficient to cover any losses sustained to the collateral, or if insurance coverage is otherwise unavailable to our borrowers, the collateral securing our loans may be negatively impacted by climate change, which could impact our financial condition and results of operations. Further, the effects of climate change may negatively impact regional and local economic activity, which could lead to an adverse effect on our customers and impact the communities in which we operate. Overall, climate change, its effects and the resulting, unknown impact could have a material adverse effect on our financial condition and results of operations.
Our primary markets are susceptible to severe weather events that could negatively impact the economies of our markets, our operations or our customers, any of which impacts could have a material adverse effect on our business, financial condition and results of operations.
Our primary markets are susceptible to tornadoes, hurricanes, tropical storms and other natural disasters and severe weather conditions. Future severe weather events in our markets could potentially result in extensive and costly property damage to businesses and residences, force the relocation of residents and significantly disrupt economic activity in our markets. If the economies in our primary markets experience an overall decline as a result of a catastrophic event, demand for loans and our other products and services could decline. In addition, the rates of delinquencies, foreclosures, bankruptcies and losses on our loan portfolios may increase substantially after events such as hurricanes, as uninsured property losses, interruptions of our customers’ operations or sustained job interruption or loss may materially impair the ability of borrowers to repay their loans. Moreover, the value of real estate or other collateral that secures our loans could be materially and adversely affected by a catastrophic event. A severe weather event, therefore, could have a materially adverse impact on our financial condition, results of operations and business, as well as potentially increase our exposure to credit and liquidity risks.
A failure in or breach of our operational or security systems, or those of our third-party service providers, including as a result of cyber-attacks, could disrupt our business, result in unintentional disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses.
As a financial institution, our operations rely heavily on the secure data processing, storage and transmission of confidential and other information on our computer systems and networks. Any failure, interruption or breach in security or operational integrity of these systems could result in failures or disruptions in our online banking system, customer relationship management, general ledger, deposit and loan servicing and other systems. The security and integrity of our systems could be threatened by a variety of interruptions or information security breaches, including those caused by computer hacking, cyber-attacks, electronic fraudulent activity or attempted theft of financial assets. We may be required to expend significant additional resources in the future to modify and enhance our protective measures.
Additionally, we face the risk of operational disruption, failure, termination or capacity constraints of any of the t hird parties that facilitate our business activities, including exchanges, clearing agents, clearing houses or other financial intermediaries. Such parties could also be the source of an a ttack on, or breach of, our operational systems. Any failures, interruptions or security breaches in our informati on systems could damage our reputation, result in a loss of customer business, result in a violation of privacy or other laws, or expose us to civil litigation, regulatory fines or losses not covered by insurance.
We may be subject to additional credit risk with respect to loans that we make to other lenders.
As a part of our commercial lending activities, we may make loans to customers that, in turn, make commercial and residential real estate loans to other borrowers. When we make a loan of this nature, we take as collateral the promissory notes issued by the end borrowers to our customer, which are themselves secured by the underlying real estate. Because we are not lending directly to the end borrower, and because our collateral is a promissory note rather than the underlying real estate, we may be subject to risks that are different from those we are exposed to when it makes a loan directly that is secured by commercial or residential real estate. Because the ability of the end borrower to repay its loan from our customer could affect the ability of our customer to repay its loan from us, our inability to exercise control over the relationship with the end borrower and the collateral, except under limited circumstances, could expose us to credit losses that adversely affect our business, financial condition and results of operations.
We have a concentration of loans outstanding to a limited number of borrowers, which may increase our risk of loss.
We have extended significant amounts of credit to a limited number of borrowers, and as of December 31, 2021, the aggregate amount of loans to our 10 and 20 largest borrowers (including related entities) amounted to $227.1 million, or 9.8% of loans held for investment, and $392.0 million, or 16.9% of loans held for investment, respectively. In the event that one or more of these borrowers is not able to make payments of interest and principal in respect of such loans, the potential loss to us is more likely to have a material adverse effect on our business, financial condition and results of operations.
A lack of liquidity could impair our ability to fund operations and adversely affect our operations and jeopardize our business, financial condition and results of operations.
Liquidity is essential to our business. We rely on our ability to generate deposits and effectively manage the repayment and maturity schedules of our loans and investment securities, respectively, to ensure that we have adequate liquidity to fund our operations. Our most important source of funds is deposits. If customers move money out of bank deposits and into other investments such as money market funds, we would lose a relatively low-cost source of funds, increasing its funding costs and reducing its net interest income and net income.
Our access to funding sources in amounts adequate to finance or capitalize our activities, or on terms that are acceptable to us, could be impaired by factors that affect us specifically or the financial services industry or economy generally, such as disruptions in the financial markets or negative views and expectations about the prospects for the financial services industry. Our access to funding sources could also be affected by a decrease in the level of our business activity as a result of a downturn in our primary markets, or by one or more adverse regulatory actions against us. Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses or fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could have a material adverse impact on our liquidity and could, in turn, adversely affect our business, financial condition and results of operations.
An inability to raise additional capital in the future or otherwise could adversely affect our financial condition, liquidity and results of operations, as well as our ability to maintain regulatory compliance.
We face significant capital and other regulatory requirements as a financial institution. Importantly, regulatory capital requirements could increase from current levels, which could require us to raise additional capital or reduce our operations. Our ability to raise additional capital depends on conditions in the capital markets, economic conditions, investor perceptions regarding the banking industry, market conditions and governmental activities, and our financial condition and performance. Accordingly, we may not be able to raise additional capital if needed or on terms acceptable to us. If we fail to maintain capital to meet regulatory requirements, our liquidity, business, financial condition and results of operations could be adversely affected.
Fluctuations in interest rates could reduce net interest income and othe rwise negatively impact our financial condition and results of operations.
Our profitability depends to a great extent upon the level of our net interest income. Changes in interest rates can increase or decrease our net interest income because different types of assets and liabilities may react differently and at different times to market interest rate changes. When interest-bearing liabilities mature or reprice more quickly, or to a greater degree than interest-earning assets in a period, an increase in interest rates could reduce net interest income. Similarly, when interest-earning assets mature or reprice more quickly, or to a greater degree than interest-bearing liabilities, falling interest rates could reduce net interest income. Our interest sensitivity profile was asset sensitive as of December 31, 2021, meaning that we estimate our net interest income would increase more from rising interest rates than from falling interest rates.
Additionally, an increase in interest rates may, among other things, reduce the demand for loans and our ability to originate loans and decrease loan repayment rates. A decrease in the general level of interest rates may affect us through, among other things, increased prepayments on its loan portfolio and increased competition for deposits. Accordingly, changes in the level of market interest rates affect our net yield on interest-earning assets, loan origination volume, loan portfolio and our overall results. Although our asset-liability management strategy is designed to control and mitigate exposure to the risks related to changes in market interest rates, those rates are affected by many factors outside of our control, including governmental monetary policies, inflation, deflation, recession, changes in unemployment, the money supply, international disorder and instability in domestic and foreign financial markets.
Uncertainty related to the LIBOR determination process and LIBOR discontinuance may adversely affect our results of operations.
In July 2017, the Financial Conduct Authority (the authority that regulates LIBOR) announced it intends to stop compelling banks to submit rates for the calculation of LIBOR after December 31, 2021. While there is no consensus on what rate or rates may become accepted alternatives to LIBOR, the Alternative Reference Rates Committee (the “ARRC”) has proposed the Secured Overnight Financing Rate (“SOFR”) as the alternative rate for use in derivatives and other financial contracts currently being indexed to LIBOR. SOFR is a daily index of the interest rate banks and hedge funds pay to borrow money overnight, secured by U.S. Treasury securities. At this time, it is not possible to predict whether SOFR will attain market traction as a LIBOR replacement tool, and the future of LIBOR is still uncertain.
In October 2021, the federal bank regulatory agencies issued a Joint Statement on Managing the LIBOR Transition. In that guidance, the agencies offered their regulatory expectations and outlined potential supervisory and enforcement consequences for banks that fail to adequately plan for and implement the transition away from LIBOR. The failure to properly transition away from LIBOR may result in increased supervisory scrutiny. In addition, the implementation of LIBOR reform proposals may result in increased compliance costs and operational costs, including costs related to continued participation in LIBOR and the transition to a replacement reference rate or rates. We cannot reasonably estimate the expected cost.
We could recognize losses on investment securities held in its securities portfolio, particularly if interest rates increase or economic and market conditions deteriorate .
While we attempt to invest a significant majority of our total assets in loans, we invest a percentage of our total assets (13.0% as of December 31, 2021) in investment securities with the primary objectives of providing a source of liquidity, providing an appropriate return on funds invested, managing interest rate risk, meeting pledging requirements and meeting regulatory capital requirements. Factors beyond our control can significantly and adversely influence the fair value of securities in our portfolio. Such factors include, but are not limited to, rating agency downgrades of the securities, defaults by the issuer or individual borrowers with respect to the underlying securities, and instability in the credit markets. Any of the foregoing factors could cause other-than-temporary impairment in future periods and result in realized losses. Because of changing economic and market conditions affecting interest rates, the financial condition of issuers of the securities and the performance of the underlying collateral, we may incur realized or unrealized losses in future periods, which could have an adverse effect on our business, financial condition and results of operations.
We face strong competition from financial services companies and other companies that offer banking services, which could adversely affect our business, financial condition and results of operations.
Many of our competitors offer the same, or a wider variety of, banking services within our primary market areas. These competitors include banks with nationwide operations, regional banks and other community banks. We also face competition from many other types of financial institutions, including savings banks, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking firms, asset-based non-bank lenders and certain other non-financial entities, such as retail stores which may maintain their own credit programs and certain governmental organizations which may offer more favorable financing or deposit terms than we can. In addition, a number of out-of-state financial intermediaries have production offices or otherwise solicit loan and deposit products in our market areas. Furthermore, our legal lending limit is significantly less than the limits for many of our competitors, and this may hinder our ability to establish relationships with larger businesses in our primary service area. If we are unable to attract and retain banking customers, we may be unable to continue to grow our loan and deposit portfolios, and our business, financial condition and results of operations could be adversely affected.
Negative public opinion regarding us or failure to maintain our reputation in the communities we serve could adversely affect our business and prevent us from growing our business.
As a community bank, our reputation within the communities we serve is critical to our success. If our reputation is negatively affected by the actions of our employees or otherwise, we may be less successful in attracting new customers, and our business, financial condition, results of operations and future prospects could be materially and adversely affected. Further, negative public opinion can expose us to litigation and regulatory action or delay in acting as we seek to implement our growth strategy.
Companies are facing increasing scrutiny from customers, regulators, investors, and other stakeholders related to their environmental, social and governance (“ESG”) practices and disclosure. Investor advocacy groups, investment funds and influential investors are also increasingly focused on these practices, especially as they relate to the environment, health and safety, diversity, labor conditions and human rights. For example, certain investors are beginning to incorporate the business risks of climate change and the adequacy of companies’ responses to climate change and other ESG matters as part of their investment theses. These shifts in investing priorities may result in adverse effects on the trading price of the Company’s common stock if investors determine that the Company has not made sufficient progress on ESG matters. In addition, n ew government regulations could also result in new or more stringent forms of ESG oversight and expanding mandatory and voluntary reporting, diligence, and disclosure. Increased ESG related compliance costs could result in increases to our overall operational costs.
If we fail to maintain an effective system of disclosure controls and procedures and internal control over financial reporting, we may not be able to accurately report its financial results or prevent fraud.
Our management may conclude that our internal control over financial reporting is not effective due to our failure to cure any identified material weakness or otherwise. Moreover, even if our management concludes that its internal control over financial reporting is effective, our independent registered public accounting firm may not conclude that our internal control over financial reporting is effective. In addition, during the course of the evaluation, documentation and testing of our internal control over financial reporting, we may identify deficiencies
that we may not be able to remediate in time to meet the deadline imposed by the FDIC for compliance with the requirement of FDICIA. Any such defi ciencies may also subject us to adverse re gulatory consequences. If we fail to achieve and maintain the adequ acy of our internal control over financial reporting, as these standards are modified, supplemented or a mended from time to time, we may be unable to report our financial infor mation on a timely basis, we may not be able to conc lude on an ongoing basis that we have effective internal control over financial reporting in accordance with the Sarbanes -Oxley Act or FDICIA, and we may sufferadverse regulatory consequences or violations of listing standards. There could also be a negative reaction in the financial markets due to a loss of investor confidenc e in the reliability of our financial statements.
The obligations associated with being a public company require significant resources and management attention.
We expect to incur significant incremental costs related to operating as a public company, particularly when we no longer qualify as an emerging growth company. We are subject to the reporting requirements of the Exchange Act, which require that we file annual, quarterly and current reports with respect to our business and financial condition and proxy and other information statements, and the rules and regulations implemented by the SEC, the Sarbanes-Oxley Act, the Dodd-Frank Act, the Public Company Accounting Oversight Board (the “PCAOB”) and NASDAQ, each of which imposes additional reporting and other obligations on public companies.
We expect these rules and regulations and changes in laws, regulations and standards relating to corporate governance and public disclosure to increase legal and financial compliance costs and make some activities more time consuming and costly. These laws, regulations and standards are subject to varying interpretations, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. Our investment in compliance with existing and evolving regulatory requirements will result in increased administrative expenses and a diversion of management’s time and attention from revenue-generating activities to compliance activities, which could have a material adverse effect on our business, financial condition and results of operations.
We could be subject to losses, regulatory action or reputational harm due to fraudulent, negligent or other acts on the part of our loan customers, employees or vendors.
Employee errors or employee or customer misconduct could subject us to financial losses or regulatory sanctions and seriouslyharm our reputation. Misconduct by our employees could include hiding from us unauthorized activities, improper or unauthorized activities on behalf of our customers or improper use of confidential information. It is not always possible to prevent employee errors or employee or customer misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee errors could also subject us to financial claims for negligence.
In addition, in deciding whether to extend credit or enter into other transactions with customers and counterparties, we may rely on information furnished by or on behalf of customers and counterparties, including representations and warranties, financial statements, property appraisals, title information, employment and income documentation, account information and other financial information. Any such misrepresentation or incorrect or incomplete information may not be detected prior to funding a loan or during our ongoing monitoring of outstanding loans. Any of these developments could have a material adverse effect on our business, financial condition, results of operations and future prospects.
We have a continuing need for technological change, and we may not have the resources to effectively implement new technology, or we may experience operational challenges when implementing new technology.
Our future success will depend, at least in part, upon our ability to respond to future technological changes and our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations as we continue to grow and expand our product and service offerings. We may experience operational challenges as we implement these new technology enhancements or products, which could result in us not fully realizing the anticipated benefits from such new technology or require it to incur significant costs to remedy any such challenges in a timely manner.
In addition, changes may be more difficult or expensive than we anticipate. Many of our larger competitors may be able to offer additional or superior products compared to those that we will be able to provide. Accordingly, we may lose customers seeking new technology-driven products and services to the extent it is unable to provide such products and services.
Our operat ions could be interrupted if our third-party service providers experience difficulty, terminate their services or fail to comply with banking regulations.
We depend on a number of relationships with third-party service providers. Specifically, we receive certain third-party services including, but not limited to, core systems processing, essential web hosting and other Internet systems, online banking services, deposit processing and other processing services. If these third-party service providers experience difficulties or terminate their services, and we are unable to replace them with other service providers, particularly on a timely basis, our operations could be interrupted. If an interruption were to continue for a significant period of time, our business, financial condition and results of operations could be adversely affected, perhaps materially. Even if we are able to replace third-party service providers, it may be at a higher cost to us, which could adversely affect our business, financial condition and results of operations.
We are subject to environmental liability risk associated with lending activities.
A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. The remediation costs and any other financial liabilities associated with an environmental hazard could adversely affect our business, financial condition and results of operations.
Changes in U.S. trade policies and other factors beyond our control, including the imposition of tariffs and retaliatory tariffs and the impacts of epidemics or pandemics, may adversely impact our business, financial condition and results of operations.
There have been changes and discussions with respect to U.S. trade policies, legislation, treaties and tariffs. Tariffs, retaliatory tariffs or other trade restrictions on products and materials that our customers import or export could cause the prices of our customers’ products to increase which could reduce demand for such products, or reduce our customer margins, and adversely impact their revenues, financial results and ability to service debt; which, in turn, could adversely affect our financial condition and results of operations. In addition, to the extent changes in the political environment have a negative impact on us or on the markets in which we operate our business, results of operations and financial condition could be materially and adversely impacted in the future. It remains unclear what the U.S. Administration or foreign governments will or will not do with respect to tariffs already imposed, additional tariffs that may be imposed, or international trade agreements and policies. A trade war or other governmental action related to tariffs or international trade agreements or policies, as well as coronavirus or other potential epidemics or pandemics, have the potential to negatively impact our and/or our customers’ costs, demand for our customers’ products, and/or the U.S. economy or certain sectors thereof and, thus, adversely affect our business, financial condition, and results of operations.
Risks Related to Our Industry and Regulation
We operate in a highly regulated environment and the laws and regulations that govern our operations, corporate governance, executive compensation and accounting principles, or changes in them, or our failure to comply with them, could adversely affect us.
We are subject to extensive regulation, supervision and legal requirements that govern almost all aspects of our operations. These laws and regulations are not intended to protect our shareholders. Rather, these laws and regulations are intended to protect customers, depositors, the DIF and the overall financial stability of the banking system in the United States. Compliance with laws and regulations can be difficult and costly, and changes to laws and regulations often impose additional compliance costs. Our failure to comply with these laws and regulations, even if the failure follows good faith effort or reflects a difference in interpretation, could subject us to restrictions on our business activities, fines and other penalties, any of which could adversely affect our results of operations, capital base and the price of our securities. Further, any new laws, rules and regulations could make compliance more difficult or expensive or otherwise adversely affect our business, financial condition and results of operations.
Legislative and regulatory actions taken now or in the future may increase our costs and impact our business, governance structure, financial condition or results of operations.
New proposals for legislation continue to be introduced in the U.S. Congress that could further substantially increase regulation of the financial services industry, impose restrictions on the operations and general ability of firms within the industry to conduct business consistent with historical practices, including in the areas of compensation, interest rates, financial product offerings and disclosures, and have an effect on bankruptcy proceedings with respect to consumer residential real estate mortgages, among other things.
Certain aspects of current or proposed regulatory or legislative changes, including laws applicable to the financial industry and federal and state taxation, if enacted or adopted, may impact the profitability of our business activities, require more oversight or change certain of our business practices, including the ability to offer new products, obtain financing, attract deposits, make loans and achievesatisfactory interest spreads, and could expose us to additional costs, including increased compliance costs. These changes also may require us to invest significant management attention and resources to make any necessary changes to operations to comply, and could have a material adverse effect on our business, financial condition and results of operations. In addition, any proposed legislative or regulatory changes, including those that could benefit our business, financial condition and results of operations, may not occur on the timeframe that is proposed, or at all, which could result in additional uncertainty for our business.
As a regulated entity, we and the Bank must maintain certain required levels of regulatory capital that may limit our and the Bank’s operations and potential growth.
We and the Bank are subject to various regulatory capital requirements administered by the Federal Reserve and the FDIC, respectively. See “Supervision and Regulation—Regulatory Capital Requirements.”
Many factors affect the calculation of our risk-based assets and our ability to maintain the level of capital required to achieve acceptable capital ratios. For example, any increases in our risk-weighted assets will require a corresponding increase in our capital to maintain the applicable ratios. In addition, recognized loan losses in excess of amounts reserved for such losses, loan impairments, impairmentlosses on securities and other factors will decrease our capital, thereby reducing the level of the applicable ratios. Our failure to remain well-capitalized for bank regulatory purposes could affect customer confidence, our ability to grow, our costs of funds and FDIC insurance costs, our ability to pay dividends to the Company and the Company’s ability to pay dividends on its common stock, the Company’s ability to make acquisitions and on our and the Company’s business, results of operations and financial condition. Under regulatory rules, if we cease to be a well-capitalized institution for bank regulatory purposes, the interest rates that we pay on deposits and our ability to accept brokered deposits may be restricted.
State and federal banking agencies periodically conduct examinations of our business, including compliance with laws and regulations, and our failure to comply with any supervisory actions to which we become subject as a result of such examinations could adversely affect it.
Texas and federal bank regulatory agencies periodically conduct examinations of our business, including compliance with laws and regulations. If, as a result of an examination, a regulatory agency were to determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of any of our operations had become unsatisfactory, or that we, the Bank or our respective management, were in violation of any law or regulation, it may take a number of different remedial actions as it deems appropriate. These actions include the power to enjoin “unsafe or unsound” practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital levels, to restrict our growth, to assess civil monetary penaltiesagainst us, the Bank or our respective officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate the Bank’s deposit insurance, with the result that the Bank would be closed. If we become subject to such regulatory actions, our business, financial condition, results of operations and reputation could be adversely affected.
Many of our new activities and expansion plans require regulatory approvals, and failure to obtain them may restrict our growth.
Generally, we must receive federal and state regulatory approval before we can acquire an FDIC-insured depository institution or related business. Such regulatory approvals may not be granted on terms that are acceptable to us, or at all. We may also be required to sell branches or other business lines as a condition to receiving regulatory approval, which condition may not be acceptable to us or, if acceptable to us, may reduce the benefit of any acquisition.
Financ ial institutions, such as the Bank, face a risk of noncompliance with the Bank Secrecy Act and other anti-money laundering statutes and regulations, and associated enforcement actions.
The Bank Secrecy Act, the USA PATRIOT Act and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and file suspicious activity and currency transaction reports as appropriate. The Financial Crimes Enforcement Network is authorized to impose significant civil money penalties for violations of those requirements, and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice (the “Justice Department”), the Drug Enforcement Administration and the IRS. There is also increased scrutiny of compliance with the sanctions programs and rules administered and enforced by OFAC.
If our policies, procedures and systems are deemed deficient, we could be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and on expansion opportunities, including acquisitions.
We are subject to numerous lending laws designed to protect consumers, including the CRA and fair lending laws, and failure to comply with these laws could lead to material sanctions and penalties and restrictions on our expansion opportunities.
The CRA, the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations impose nondiscriminatory lending requirements on financial institutions. The CFPB, the FDIC, the Justice Department and other federal agencies are responsible for enforcing these laws and regulations. A successfulchallenge to an institution’s performance under the CRA or fair lending laws and regulations could result in a wide variety of sanctions, including the required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on mergers and acquisitions activity, and restrictions on expansion activity. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation.
The Federal Reserve may require us to commit capital resources to support the Bank.
The Dodd-Frank Act and Federal Reserve require a bank holding company to act as a source of financial and managerial strength to its subsidiary banks and to commit resources to support its subsidiary banks. Accordingly, we could be required to provide financial assistance to the Bank if it experiences financial distress.
Such a capital injection may be required at a time when our resources are limited and we may be required to raise capital or borrow the funds to make the required capital injection. Any borrowing that must be done by the holding company in order to make the required capital injection may be difficult and expensive and may adversely impact the holding company’s business, financial condition and results of operations.
We could be adversely affected by the soundness of other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when our collateral cannot be foreclosed upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due. Any such losses could adversely affect our business, financial condition and results of operations.
Monetary policies and regulations of the Federal Reserve could adversely affect our business, financial condition and results of operations.
In addition to being affected by general economic conditions, our earnings and growth are affected by the policies of the Federal Reserve. An important function of the Federal Reserve is to regulate the U.S. money supply and credit conditions. Among the instruments used by the Federal Reserve to implement these objectives are open market operations in U.S. government securities, adjustments of both the discount rate and the federal funds rate and changes in reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits.
Although we cannot determine the effects of such policies on it at this time, such policies could adversely affect our business, financial condition and results of operations.
Risks Related to Our Common Stock
An active trading market for our common stock may not be sustained.
We completed the initial public offering of our common stock and the Company’s common stock began trading on NASDAQ in May 2018. An active trading market for shares of our common stock may not be sustained. If an active trading market is not sustained, you may have difficulty selling your shares of our common stock at an attractive price, or at all. Consequently, you may not be able to sell your shares of our common stock at or above an attractive price at the time that you would like to sell.
The market price of our common stock could be volatile and may fluctuate significantly, which could cause the value of an investment in our common stock to decline.
The market price of our common stock could fluctuate significantly due to a number of factors, many of which are beyond our control, including the realization of any of the risks described in this “Risk Factors” section. In addition, the stock market in general, and the market for banks and financial services companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Securities class action litigation has often been instituted against companies following periods of volatility in the overall market and in the market price of a company’s securities. This litigation, if instituted against us, could result in substantial costs, divert our management’s attention and resources and harm our business, operating results and financial condition.
If securities or industry analysts change their recommendations regarding our common stock or if our operating results do not meet their expectations, its stock price could decline.
The trading market for our common stock could be influenced by the research and reports that industry or securities analysts may publish about us or our business. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline and our common stock to be less liquid. Moreover, if one or more of the analysts who cover us downgrade our stock or if our operating results do not meet their expectations, either absolutely or relative to our competitors, the price of our common stock could decline significantly.
Future sales or the possibility of future sales of a substantial amount of our common stock may depress the price of shares of our common stock.
We may seek to raise additional funds, finance acquisitions or develop strategic relationships by issuing additional shares of our common stock.
We may also grant registration rights covering those shares of our common stock or other securities in connection with any such acquisitions and investments. We cannot predict the size of future issuances of our common stock or the effect, if any, that future issuances and sales of our common stock will have on the market price of our common stock. Future sales or the availability for sale of substantial amounts of our common stock in the public market could adversely affect the prevailing market price of our common stock and could impair our ability to raise capital through future sales of equity securities.
We may issue shares of preferred stock in the future, which could make it difficult for another company to acquire us or could otherwise materially adversely affect our shareholders, which could depress the price of our common stock.
Our certificate of formation authorizes us to issue up to 5,000,000 shares of one or more series of preferred stock. Our board of directors has the authority to determine the preferences, limitations and relative rights of shares of preferred stock and to fix the number of shares constituting any series and the designation of such series, without any further vote or action by our shareholders. Our preferred stock could be issued with voting, liquidation, dividend and other rights superior to the rights of our common stock. The potential issuance of preferred stock may delay or prevent a change in control of us, discourage bids for our common stock at a premium over the market price and materially adversely affect the market price and the voting and other rights of our shareholders.
We are dependent upon the Bank for cash flow, and the Bank’s ability to make cash distributions is restricted, which could impact our ability to satisfy our obligations.
Our primary asset is the Bank. As such, we depend upon the Bank for cash distributions through dividends on the Bank’s stock to pay our operating expenses and satisfy our obligations, including debt obligations. There are numerous laws and banking regulations that limit the Bank’s ability to pay dividends to us. If the Bank is unable to pay dividends to us, we will not be able to satisfy our obligations or pay dividends.
We are an “emer ging growth company,” and we cannot be certain if the reduced disclosure requirements applicable to emerging g rowth companies will make our common stock less attractive to investors.
We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act (the “JOBS Act”) and we have taken advantage of certain disclosure exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies. We will remain an emerging growth company for up to five years, though we may cease to be an emerging growth company earlier under certain circumstances, including if, before the end of such five years, it is deemed to be a large accelerated filer under the rules of the SEC. Investors and securities analysts may find it more difficult to evaluate our common stock because we may rely on one or more of these exemptions, and, as a result, investor confidence and the market price of our common stock may be materially and adversely affected.
Our shareholders may be deemed to be acting in concert or otherwise in control of us, which could impose notice, approval and ongoing regulatory requirements and result in adverse regulatory consequences for such holders.
We are subject to the BHC Act, and federal and state banking regulation, that will impact the rights and obligations of owners of our common stock. Any bank holding company or foreign bank that is subject to the BHC Act may need approval to acquire or retain 5.0% or more of the then outstanding shares of our common stock, and any holder (or group of holders deemed to be acting in concert) may need regulatory approval to acquire or retain 10.0% or more of the shares of our common stock. A holder or group of holders may also be deemed to control us if they own 25.0% or more of its total equity. Under certain limited circumstances, a holder or group of holders acting in concert may exceed the 25.0% threshold and not be deemed to control us until they own 33.3% or more of our total equity. The amount of total equity owned by a holder or group of holders acting in concert is calculated by aggregating all shares held by the holder or group, whether as a combination of voting or non-voting shares or through other positions treated as equity for regulatory or accounting purposes and meeting certain other conditions. Holders deemed to be in “control” of us will be subject to certain reporting and other obligations with the Federal Reserve. Our shareholders should consult their own counsel with regard to regulatory implications.
Our directors and executive officers could have the ability to influence shareholder actions in a manner that may be adverse to your personal investment objectives.
Due to the significant ownership interests of our directors and executive officers, our directors and executive officers are able to exercise significant influence over our management and affairs. For example, our directors and executive officers may be able to influence the outcome of director elections or block significant transactions, such as a merger or acquisition, or any other matter that might otherwise be approved by the shareholders.
An investment in our common stock is not an insured deposit and is not guaranteed by the FDIC, so you could lose some or all of your investment.
An investment in our common stock is not a bank deposit and, therefore, is not insured againstloss or guaranteed by the FDIC, any other deposit insurance fund or by any other public or private entity. An investment in our common stock is inherently risky for the reasons described herein. As a result, if you acquire our common stock, you could lose some or all of your investment.
Our corporate organizational documents and certain corporate and banking provisions of Texas law to which it is subject contain certain provisions that could have an anti-takeover effect and may delay, make more difficult or prevent an attempted acquisition of us that you may favor.
Our certificate of formation and bylaws contain certain provisions that may have an anti-takeover effect and may delay, discourage or prevent an attempted acquisition or change of control of us. These provisions include (i) staggered terms for directors, who may only be removed for cause; (ii) authorization for our board of directors to issue shares of one or more series of preferred stock without shareholder approval and upon such terms as our board of directors may determine; (iii) a prohibition of shareholder action by less than unanimous written consent; (iv) a prohibition of cumulative voting in the election of directors; (v) a provision establishing certain advance notice procedures for nomination of candidates for election of directors and for shareholder proposals; and (vi) a limitation on the ability of shareholders to call special meetings to those shareholders or groups of shareholders owning at least 50.0% of the shares of our common stock that are issued, outstanding and entitled to vote. In addition, certain provisions of Texas law, including a provision which restricts certain business combinations between a Texas corporation and certain affiliated shareholders, may delay, discourage or prevent an attempted acquisition or change in control. Moreover, banking laws impose notice, approval, and ongoing regulatory requirements on any shareholder or other party that seeks to acquire direct or indirect “control” of an FDIC-insured depository institution. These laws could delay or prevent an acquisition.
Our certificate of formation contains an exclusive forum provision that limits the judicial forums where our shareholders may initiate derivative actions and certain other legal proceedings against us and our directors and officers.
Our certificate of formation provides that the state and federal courts located in Montgomery County, Texas will, to the fullest extent permitted by law, be the sole and exclusive forum for certain causes of action, which may limit our shareholders’ ability to obtain a favorable judicial forum for disputes with us. Alternatively, if a court were to find the choice of forum provision contained in our certificate of formation to be inapplicable or unenforceable in an action, we may incur additional costs associated with resolving such action in other jurisdictions, which could harm our business, operating results and financial condition.
As a bank holding company, we generate most of our revenues from interest income on loans, gains on sale of the guaranteed portion of SBA loans, customer service and loan fees, brokerage fees derived from secondary mortgage originations and interest income from investments in securities. We incur interest expense on deposits and other borrowed funds and noninterest expenses, such as salaries and employee benefits and occupancy expenses. Our goal is to maximize income generated from interest earning assets, while also minimizing interest expense associated with our funding base to widen net interest spread and drive net interest margin expansion. Net interest margin is a ratio calculated as net interest income divided by average interest-earning assets. Net interest income is the difference between interest income on interest-earning assets, such as loans and securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings that are used to fund those assets. Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities.
Changes in market interest rates and the interest rates we earn on interest-earning assets or pay on interest-bearing liabilities, as well as the volume and types of interest-earning assets, interest-bearing and noninterest-bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest spread, net interest margin and net interest income. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Texas, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and energy sectors within our target markets and throughout Texas.
Pending Merger of Simmons First National Corporation and Spirit of Texas Bancshares, Inc.
On November 18, 2021, we entered into an Agreement and Plan of Merger (the “merger agreement”) with Simmons First National Corporation (“Simmons”), parent company of Simmons Bank, pursuant to which the companies will combine in an all‐stock transaction. Under the terms of the merger agreement, which was approved by both companies’ Boards of Directors, Spirit will merge with and into Simmons, with Simmons surviving (the “Proposed Merger”), and the combined holding company and bank will operate under the Simmons name and brand with the company’s headquarters remaining in Little Rock, Arkansas. Pending regulatory approvals and the satisfaction of the closing conditions set forth in the merger agreement, the Proposed Merger is expected to close during the second calendar quarter of 2022.
COVID-19 Pandemic
In December 2019, a novel strain of coronavirus (“COVID-19”) was reported to have surfaced in Wuhan, China, and has since spread worldwide. In March 2020, the World Health Organization declared COVID-19 a global pandemic and the United States declared a National Public Health Emergency. In addition, the “Delta” and “Omicron” variants of COVID-19, which are the most transmissible variants identified to date, have spread in the United States in 2021. The impact of these variants, or any other new variants of COVID-19, cannot be predicted at this time, and could depend on numerous factors, including vaccination rates among the population, the effectiveness of COVID-19 vaccines against variants, and the response by governmental bodies and regulators. The ongoing COVID-19 pandemic has severely impacted the level of economic activity in the local, national and global economies and financial markets. As a result, the Company and certain of its customers have been adversely affected by the COVID-19 pandemic. The extent to which the COVID-19 pandemic, or any current or future variant thereof, negatively impacts the Company's business, results of operations, and financial condition, as well as its regulatory capital and liquidity ratios, is unknown at this time and will depend on future developments, including the scope and duration of the pandemic and actions taken by governmental authorities and other third parties in response to the pandemic, or any current or future variant thereof. If the pandemic is sustained for a prolonged period of time, it may further adversely impact the Company and impair the ability of the Company's customers to fulfill their contractual obligations to the Company. This could cause the Company to experience a material adverse effect on its business operations, asset valuations, financial condition, and results of operations. Please refer to Part I, Item 1A, “Risk Factors” of this Annual Report on Form 10-K.
In April 2020, we began originating loans to qualified small businesses under the PPP administered by the SBA under the provisions of the CARES Act. Loans covered by the PPP may be eligible for loan forgiveness for certain costs incurred related to payroll, group health care benefit costs and qualifying mortgage, rent and utility payments. The remaining loan balance after forgiveness of any amounts is still fully guaranteed by the SBA. Terms of the PPP loans include the following (i) maximum amount limited to the lesser of $10 million or an amount calculated using a payroll-based formula, (ii) maximum loan term of two years, (iii) interest rate of 1.00%, (iv) no collateral or personal guarantees are required, (v) no payments are required for six months following the loan disbursement date and (vi) loan forgiveness up to the full principal amount of the loan and any accrued interest, subject to certain requirements including that no more than 25% of the loan forgiveness amount may be attributable to non-payroll costs. In return for processing and booking the loan, the SBA will pay the lender a processing fee tiered by the size of the loan (5% for loans of not more than $350 thousand; 3% for loans more than $350 thousand and less than $2 million; and 1% for loans of at least $2 million). At December 31, 2021, PPP loans totaled $43.9 million which are included in commercial and industrial loans.
The Economic Aid Act, signed into law on December 27, 2020, authorized new PPP funding and extended the authority of lenders to make PPP loans through March 31, 2021. Under the revised terms of the PPP, loans may be made to first time borrowers as well as certain businesses that previously received a PPP loan and experienced a significant reduction in revenue.
During the year ended December 31, 2021, we also participated in the Federal Reserve's PPPLF, which expired on July 30, 2021. As of December 31, 2021, we had no borrowings under the PPPLF. The maturity date of a borrowing under the PPPLF was equal to the maturity date of the PPP loan pledged to secure the borrowing and would be accelerated (i) if the underlying PPP loan goes into default and is sold to the SBA to realize on the SBA guarantee or (ii) to the extent that any PPP loan forgiveness reimbursement is received from the SBA. Borrowings under the PPPLF bear interest at a rate of 0.35% and there were no fees to us.
Federal bank regulatory agencies have issued an interim final rule that permits banks to neutralize the regulatory capital effects of participating in the PPP and, if applicable, the PPPLF. Specifically, all PPP loans have a zero percent risk weight under applicable risk-based capital rules. Additionally, a bank may exclude all PPP loans pledged as collateral to the PPPLF from its average total consolidated assets for the purposes of calculating its leverage ratio, while PPP loans that are not pledged as collateral to the PPPLF will be included.
Simmons Branch Acquisition
On February 28, 2020, Spirit completed its acquisition of certain assets and assumption of certain liabilities associated with five banking offices of Simmons Bank. The offices are located in Austin, San Antonio and Tilden, Texas. The Company paid total consideration of $131.6 million in the Simmons branch acquisition. For more information about the acquisition, see “Note 3. Business Combinations” in the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
Results of Operations
Our results of operations depend substantially on net interest income and noninterest income. Other factors contributing to our results of operations include our level of noninterest expenses, such as salaries and employee benefits, occupancy and equipment and other miscellaneous operating expenses.
Net Interest Income
Net interest income represents interest income less interest expense. We generate interest income from interest, dividends and fees received on interest-earning assets, including loans and investment securities we own. We incur interest expense from interest paid on interest-bearing liabilities, including interest-bearing deposits and borrowings. To evaluate net interest income, we measure and monitor (1) yields on our loans and other interest-earning assets, (2) the costs of our deposits and other funding sources, (3) our net interest spread, (4) our net interest margin and (5) our provisions for loan losses. Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities. Net interest margin is calculated as the annualized net interest income divided by average interest-earning assets. Because noninterest-bearing sources of funds, such as noninterest-bearing deposits and stockholders’ equity, also fund interest-earning assets, net interest margin includes the benefit of these noninterest-bearing sources.
Changes in market interest rates and the interest rates we earn on interest-earning assets or pay on interest-bearing liabilities, as well as the volume and types of interest-earning assets, interest-bearing and noninterest-bearing deposits and stockholders’ equity, are usually the largest drivers of periodic changes in net interest spread, net interest margin and net interest income. We measure net interest income before and after provision for loan losses required to maintain our allowance for loan and lease losses at acceptable levels.
Noninterest Income
Our noninterest income includes the following: (1) service charges and fees; (2) SBA loan servicing fees; (3) mortgage referral fees; (4) gain on the sales of loans, net; (5) gain (loss) on sales of investment securities; (6) swap fees; (7) swap referral fees; and (8) other.
Noninterest Expense
Our noninterest expense includes the following: (1) salaries and employee benefits; (2) occupancy and equipment expenses; (3) professional services; (4) data processing and network; (5) regulatory assessments and insurance; (6) amortization of core deposit intangibles; (7) advertising; (8) marketing; (9) telephone expenses; (10) conversion expense; and (11) other.
Financial Condition
The primary factors we use to evaluate and manage our financial condition include liquidity, asset quality and capital.
Liquidity
We manage liquidity based upon factors that include the amount of core deposits as a percentage of total deposits, the level of diversification of our funding sources, the allocation and amount of our deposits among deposit types, the short-term funding sources used to fund assets, the amount of non-deposit funding used to fund assets, the availability of unused funding sources, off-balance sheet obligations, the availability of assets to be readily converted into cash without undueloss, the amount of cash and liquid securities we hold, and the repricing characteristics and maturities of our assets when compared to the repricing characteristics of our liabilities, the ability to securitize and sell certain pools of assets and other factors.
Asset Quality
We manage the diversification and quality of our assets based upon factors that include the level, distribution, severity and trend of problem, classified, delinquent, nonaccrual, nonperforming and restructured assets, the adequacy of our allowance for loan and lease losses, discounts and reserves for unfunded loan commitments, the diversification and quality of loan and investment portfolios and credit risk concentrations.
Capital
We manage capital based upon factors that include the level and quality of capital and our overall financial condition, the trend and volume of problem assets, the adequacy of discounts and reserves, the level and quality of earnings, the risk exposures in our balance sheet, the levels of tier 1 (core), risk-based and tangible common equity capital, the ratios of tier 1 (core), risk-based and tangible common equity capital to total assets and risk-weighted assets and other factors.
Analysis of Results of Operations
Net income for the year ended December 31, 2021 totaled $42.1 million, which generated diluted earnings per common share of $2.38 and adjusted diluted earnings per common share, which is a non-GAAP financial measure that excludes gain on sale of securities and expenses related to the Proposed Merger, of $2.42 for the year ended December 31, 2021. Net income for the year ended December 31, 2020 totaled $31.3 million, which generated diluted earnings per common share of $1.77 and adjusted diluted earnings per common share of $1.79 for the year ended December 31, 2020. The increase in net income was driven by an increase in interest income of $2.0 million that was primarily attributable to organic loan growth and origination fees net of costs recognized on Paycheck Protection Program loans. In addition, interest expense decreased $6.2 million primarily due to market rate resets which occurred on all products during the year ended December 31, 2021. Increased interest income was partially offset by a decrease of non-interest income of $4.8 million primarily due to a decrease in gain on sale of loans of $4.4 million offset by an increase in Swap fees of $1.0 million. Our results of operations for the year ended December 31, 2021 produced a return on average assets of 1.34% compared to a return on average assets of 1.11% for the year ended December 31, 2020. We had a return on average stockholders’ equity of 11.17% compared to a return on average stockholders’ equity of 8.98% for the year ended December 31, 2020.
Net income for the year ended December 31, 2020 totaled $31.3 million, which generated diluted earnings per common share of $1.77 and adjusted diluted earnings per common share, which is a non-GAAP financial measure that excludes gain on sale of securities and acquisition-related expenses, of $1.79 for the year ended December 31, 2020. Net income for the year ended December 31, 2019 totaled $21.1 million, which generated diluted earnings per common share of $1.40 and adjusted diluted earnings per common share of $1.43 for the year ended December 31, 2019. The increase in net income was driven by an increase in interest income of $37.9 million that was primarily attributable to acquired loan growth, partially offset by an increase in interest expense of $7.0 million, which was mainly the result of increased deposit balances from acquisitions. Our results of operations for the year ended December 31, 2020 produced a return on average assets of 1.11% compared to a return on average assets of 1.14% for the year ended December 31, 2019. We had a return on average stockholders’ equity of 8.98% compared to a return on average stockholders’ equity of 8.38% for the year ended December 31, 2019.
Net Interest Income and Net Interest Margin
The following table presents, for the periods indicated, information about (1) average balances, the total dollar amount of interest income from interest-earning assets and the resultant average yields; (2) average balances, the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rates; (3) the interest rate spread; (4) net interest income and margin; and (5) net interest income and margin (tax equivalent). Interest earned on loans that are classified as nonaccrual is not recognized in income, however the balances are reflected in
average outstanding balances for that period. Any nonaccrual loans have been included in the table as loans carrying a zero yield.
Years Ended December 31,
Average
Balance(1)
Interest/
Expense
Yield/ Rate
Average
Balance(1)
Interest/
Expense
Yield/ Rate
Average
Balance(1)
Interest/
Expense
Yield/ Rate
(Dollars in thousands)
Interest-earning assets:
Interest-earning deposits in
other banks
Loans, including loans held
for sale(2)
Investment securities and
other
Total interest-earning
assets
Noninterest-earning assets
Total assets
Interest-bearing liabilities:
Interest-bearing demand
deposits
Interest-bearing NOW
accounts
Savings and money market
accounts
Time deposits
FHLB advances and other
borrowings
Total interest-bearing
liabilities
Noninterest-bearing liabilities
and shareholders' equity
Noninterest-bearing
demand deposits
Other liabilities
Stockholders' equity
Total liabilities and
stockholders' equity
Net interest rate spread
Net interest income and margin
Net interest income and margin
(tax equivalent)(3)
Average balances presented are derived from daily average balances.
Includes loans on nonaccrual status.
In order to make pretax income and resultant yields on tax-exempt loans comparable to those on taxable loans, a tax-equivalent adjustment has been computed using a federal tax rate of 21% for the years ended December 31, 2021, 2020 and 2019, which is a non-GAAP financial measure. See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Non-GAAP Financial Measures.”
Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and liabilities, as well as changes in average interest rates. The following table shows the effect that these factors had on the interest earned on our interest-earning assets and the interest incurred on our interest-bearing liabilities for the periods indicated. The effect of changes in volume is determined by multiplying the change in volume by the prior period’s average rate. Similarly, the effect of rate changes is calculated by multiplying the change in average rate by the previous period’s volume.
A summary of increases and decreases in interest income and interest expense resulting from changes in average balances (volume) and average interest rates follows:
Years Ended December 31, 2021
Compared to 2020
Years Ended December 31, 2020
Compared to 2019
Increase (Decrease)
Due to
Increase (Decrease)
Due to
Volume(1)
Rate(1)
Total
Volume(1)
Rate(1)
Total
(Dollars in thousands)
Interest-earning assets:
Interest-earning deposits in other banks
Loans, including loans held for sale(2)
Investment securities and other
Total change in interest income
Interest-bearing liabilities:
Interest-bearing demand deposits
Interest-bearing NOW accounts
Savings and money market accounts
Time deposits
FHLB advances and other borrowings
Total change in interest expenses
Total change in net interest income
Variances attributable to both volume and rate are allocated on a consistent basis between rate and volume based on the absolute value of the variances in each category.
Includes loans on nonaccrual status.
Year ended December 31, 2021 compared to Year ended December 31, 2020
Net interest income was $114.1 million for the year ended December 31, 2021 compared to $105.9 million for the year ended December 31, 2020, representing an increase of 8.2 million, or 7.7%. The increase in net interest income was primarily due to an increase in interest income of $2.0 million due to organic loan growth and origination fees net of costs recognized on Paycheck Protection Program loans and by a decrease in interest expense of $6.2 million due to market rate resets which occurred on all products during the year ended December 31, 2021. Interest income on loans decreased by $982 thousand for the year ended December 31, 2021. The effects of growth in average loans of $59.0 million, including loans held for sale, for the year ended December 31, 2021 was more than offset by declines in interest rates during the year.
Interest expense was $11.4 million for the year ended December 31, 2021 compared to $17.6 million for the year ended December 31, 2020, representing a decrease of $6.2 million, or 35.2%. This decrease was mainly due to a decrease in interest expense on deposits. Interest expense on FHLB advances and other borrowings totaled $3.7 million for the year ended December 31, 2021 compared to $3.0 million for the year ended December 31, 2020, representing an increase of $642 thousand, resulting primarily from interest expense on subordinated debt issued during the year ended December 31, 2020 which yields 6.0%. Interest on subordinated debt was offset by declines in interest expense on deposits related to lower overall market interest rates.
Interest expense on deposits decreased by $6.8 million for the year ended December 31, 2021 compared to the year ended December 31, 2020. The decrease was primarily attributable to a decrease in overall market rates offset by an increase in the average balance of interest bearing deposits of $228.0 million. The average cost of deposits for the year ended December 31, 2021 was 0.30% compared to the average cost of deposits of 0.64% for the year ended December 31, 2020. The decrease in cost of deposits was primarily attributable to the decrease in interest rates by the Federal Open Market Committee during the year ended December 31, 2020. For the year ended December 31, 2021, the average rate paid on time deposits was 0.75% compared to 1.54% for the year ended December 31, 2020.
N et interest margin was 3.95 % for the year ended December 31, 202 1 , compared to 4. 14 % for the year ended December 31, 20 20 , representing a decrease of 19 basis points . The tax equivalent net inter est margin (which is a non-GAAP measure) was 3.96 % for the year ended December 31, 202 1 compared to 4. 21 % for the year ended December 31, 20 20 , representing a decr ease of 25 basis points . See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures under the caption “Management ’s Discussion and Analysis of Financial Condition and Results of Operations—Non-GAAP Financial Measures.” The average yield on interes t-earning assets decreased by 49 basis points for the year ended December 31, 202 1 , compared to the year ended December 31, 20 20 and the average rate paid on interest-bea ring liabilities decreased by 4 0 basis points, resulting in 8 basis point decrease in the interest rate spread.
We currently expect volatility within our net interest income and net interest margin throughout the year ending December 31, 2022 as competition for loans places downward pressure on loan yields offset by any Federal Rate hikes during the year ending December 31, 2022 and the deployment of excess cash into higher yielding loans.
Year ended December 31, 2020 compared to Year ended December 31, 2019
Net interest income was $105.9 million for the year ended December 31, 2020, compared to $77.9 million for the year ended December 31, 2019, representing an increase of $28.0 million, or 36.0%. The increase in net interest income was primarily due to an increase in interest income of $28.3 million partially offset by an increase in interest expense of $240 thousand. Interest income on loans increased by $32.4 million for the year ended December 31, 2020. The effects of growth in average loans of $843.7 million, including loans held for sale, for the year ended December 31, 2020 was more than offset by declines in interest rates during the year and the primary driver of the increase in interest income on loans of $6.8 million was origination fees recognized in conjunction with the PPP.
Interest expense was $17.6 million for the year ended December 31, 2020 compared to $17.4 million for the year ended December 31, 2019, representing an increase of $240 thousand, or 1.4%. This increase was mainly due to an increase in interest expense on FHLB advances and other borrowings. Interest expense on FHLB advances and other borrowings totaled $3.0 million for the year ended December 31, 2020 compared to $1.8 million for the year ended December 31, 2019, representing an increase of $1.2 million, resulting primarily from interest expense on subordinated debt issued during the year ended December 31, 2020 which yields 6.0%. Interest on subordinated debt was offset by declines in interest expense on deposits related to lower overall market interest rates.
Interest expense on deposits decreased by $970 thousand for the year ended December 31, 2020 compared to the year ended December 31, 2019. The decrease was primarily attributable to a decrease in overall market rates offset by an increase in the average balance of interest bearing deposits of $433.6 million. The average cost of deposits for the year ended December 31, 2020 was 0.64% compared to the average cost of deposits of 1.01% for the year ended December 31, 2019. The decrease in cost of deposits was primarily attributable to the decrease in interest rates by the Federal Open Market Committee during the year ended December 31, 2020. For the year ended December 31, 2020, the average rate paid on time deposits was 1.54% compared to 1.90% for the year ended December 31, 2019.
Provision for Loan Losses
The provision for loan losses represents the amount determined by management to be necessary to maintain the allowance for loan and lease losses at a level capable of absorbing inherent losses in the loan portfolio. See the discussion under “—Critical Accounting Policies—Allowance for Loan and Lease Losses.” Our management and board of directors review the adequacy of the allowance for loan and lease losses on a quarterly basis. The allowance for loan and lease losses calculation is segregated by call report code and then further segregated into various segments that include classified loans, loans with specific allocations and pass rated loans. A pass rated loan is generally characterized by a very low to average risk of default and in which management perceives there is a minimal risk of loss. Loans are rated using a nine-point risk grade scale by loan officers that are subject to validation by a third-party loan review or our internal credit committee. Risk ratings are categorized as pass, watch, special mention, substandard, doubtful and loss, with some general allocation of reserves based on these grades. Impaired loans are reviewed specifically and separately under the FASB’s Accounting Standards Codification (“ASC”) 310, “Receivables”, to determine the appropriate reserve allocation. Management compares the investment in an impaired loan with the present value of expected future cash flow discounted at the loan’s effective interest rate, the loan’s
observable market price or the fair value of the collateral, if the loan is collateral-dependent, to determine the specific reserve allowance. Reserve percentages assigned to non-impaired loans are based on historical charge-off experience adjusted for other risk factors. To evaluate the overall adequacy of the allowance to absorb losses inherent in our loan portfolio, our management considers historical loss experience based on volume and types of loans, trends in classifications, volume and trends in delinquencies and nonaccruals, economic conditions and other pertinent information. Loan s egments negatively impact ed by COVID-19 and deferrals granted to customers impacted by the COVID-19 pandemic do not have a direct impact on the provision; however, adjustments to qualitative factors and loan downgrades within these populations have been made which do impact the provision. Based on future evaluations, additional provisions for loan losses may be necessary to maintain the allowance for loan and lease losses at an appropriate level.
Year ended December 31, 2021 compared to Year ended December 31, 2020
The provision for loan losses was $3.7 million for the year ended December 31, 2021 and $11.3 million for the year ended December 31, 2020. The decrease of the provision for the year ended December 31, 2021 was primarily due to decreased qualitative reserves in response to improved economic indicators. Currently, the qualitative reserve calculation is based upon ten external and internal factors. The COVID-19 pandemic did not significantly impact internal qualitative factors via changes to underwriting guidelines, staffing, and compliance; however, external factors which are developed based upon GDP growth, unemployment, and oil prices were significantly impacted. It was the rebound in these macroeconomic conditions during the year ended December 31, 2021 which translated into lower qualitative scores and thus lower reserves.
Our management maintains a proactive approach in managing nonperforming loans, which were $5.1 million, or 0.22% of loans held for investment, at December 31, 2021, and $8.6 million, or 0.36% of loans held for investment, at December 31, 2020. During the year ended December 31, 2021, we had net charged-off loans totaling $3.3 million, compared to net charged-off loans of $2.0 million for the year ended December 31, 2020. The ratio of net charged-off loans to average loans was 0.15% for 2021, compared to 0.09% for 2020. The allowance for loan and lease losses totaled $16.4 million, or 0.71% of loans held for investment, at December 31, 2021, compared to $16.0 million, or 0.67% of loans held for investment, at December 31, 2020. The ratio of allowance for loan and lease losses to nonperforming loans was 318.4% at December 31, 2021, compared to 186.4% at December 31, 2020.
Year ended December 31, 2020 compared to Year ended December 31, 2019
The provision for loan losses was $11.3 million for the year ended December 31, 2020 and $2.9 million for the year ended December 31, 2019. The increase of the provision for the year ended December 31, 2020 was primarily due to increased qualitative reserves in response to the global COVID-19 pandemic. Currently, the qualitative reserve calculation is based upon ten external and internal factors. The COVID-19 pandemic did not significantly impact internal qualitative factors via changes to underwriting guidelines, staffing, and compliance; however, external factors which are developed based upon GDP growth, unemployment, and oil prices were significantly impacted. It was the deterioration in these macroeconomic conditions which translated into higher qualitative scores and thus higher reserves.
Our management maintains a proactive approach in managing nonperforming loans, which were $8.6 million, or 0.36% of loans held for investment, at December 31, 2020, and $6.5 million, or 0.37% of loans held for investment, at December 31, 2019. During the year ended December 31, 2020, we had net charged-off loans totaling $2.0 million, compared to net charged-off loans of $2.4 million for the year ended December 31, 2019. The ratio of net charged-off loans to average loans was 0.09% for 2020, compared to 0.17% for 2019. The allowance for loan and lease losses totaled $16.0 million, or 0.67% of loans held for investment, at December 31, 2020, compared to $6.7 million, or 0.38% of loans held for investment, at December 31, 2019. The ratio of allowance for loan and lease losses to nonperforming loans was 186.4% at December 31, 2020, compared to 104.18% at December 31, 2019.
Noninterest Income
Our noninterest income includes the following: (1) service charges and fees; (2) SBA loan servicing fees; (3) mortgage referral fees; (4) gain on the sales of loans, net; (5) gain (loss) on sales of investment securities; (6) swap fees; (7) swap referral fees; and (8) other.
The following table presents a summary of noninterest income by category, including the percentage change in each category, for the periods indicated:
Years Ended December 31, 2021
Compared to 2020
Years Ended December 31, 2020
Compared to 2019
Change
from the
Prior Year
Change
from the
Prior Year
(Dollars in thousands)
Noninterest income:
Service charges and fees
SBA loan servicing fees
Mortgage referral fees
Gain on sales of loans, net
Gain (loss) on sales of investment securities
Swap Fees
Swap Referral Fees
Other noninterest income
Total noninterest income
Year ended December 31, 2021 compared to Year ended December 31, 2020
For the year ended December 31, 2021, noninterest income totaled $14.1 million, a $4.8 million, or 25.5%, decrease from $18.9 million for the prior year. This decrease was primarily due to a decrease in gain on sales of loans of $4.4 million. During the year ended December 31, 2020, the Company recorded a gain on sale of Main Street loans of $3.6 million compared to only $99 thousand in the year ended December 31, 2021. Lower gain on sale of loans was partially offset by an increase in swap fees of $1.0 million. We currently expect noninterest income to show signs of strength in the coming quarters as borrowers get ready for possible rate hikes.
Service charges and fees were $6.3 million for the year ended December 31, 2021, compared to $5.7 million for the year ended December 31, 2020. The $1.6 million increase was due to increased deposit accounts associated with government lending programs.
Gain on sales of loans, net, was $1.1 million for the year ended December 31, 2021, compared to $5.5 million for the year ended December 31, 2020, a decrease of $4.4 million. The decrease was due to declines in gain on sale of SBA loans.
Year ended December 31, 2020 compared to Year ended December 31, 2019
For the year ended December 31, 2020, noninterest income totaled $18.9 million, a $4.3 million, or 29.6%, increase from $14.6 million for the prior year. This increase was primarily due to fees on two new swap products offered to commercial loan customers, increased service charges related to an increase in number of accounts, and an increase in gain on sale of loans recorded in conjunction with the Main Street Lending Program. This was partially offset by a decrease in gains on sale of investment securities of $3.6 million. We currently expect noninterest income to remain at reduced levels due to less loan sales and fewer swap agreements in response to the COVID-19 pandemic; however, these revenue streams are beginning to show signs of improvement.
Both swap fees and swap referral fees represented new product offerings in 2020. The decision to offer these products was based upon customer demand and the need to structure some lending deals in a manner that is as competitive as other financial institutions in our market. Depending on the pace of the economic recovery and prevailing views regarding when interest rates might rise, demand for these products will increase or decrease accordingly.
SBA loans servicing fees were $1.2 million for the year ended December 31, 2020, compared to $929 thousand for the year ended December 31, 2019. The $263 thousand increase was primarily due to fair value market adjustments on the SBA servicing asset.
Service charges and fees were $5.7 million for the year ended December 31, 2020 , compared to $3.7 million for the year ended December 31, 2019. The $2.0 million increase was due to increased deposit accounts associated with acquired institutions and accounts related to government lending programs .
Gain on sales of loans, net, was $5.5 million for the year ended December 31, 2020, compared to $4.0 million for the year ended December 31, 2019, an increase of $1.5 million. The increase was due to gain on sale of Main Street Lending Program loans of $3.7 million offset by declines in gain on sale of SBA loans.
Noninterest Expense
Our noninterest expense includes the following: (1) salaries and employee benefits; (2) occupancy and equipment expenses; (3) professional services; (4) data processing and network; (5) regulatory assessments and insurance; (6) amortization of core deposit intangibles; (7) advertising; (8) marketing; (9) telephone expense; (10) conversion expense; and (11) other.
The following table presents a summary of noninterest expenses by category, including the percentage change in each category, for the periods indicated:
Years Ended December 31, 2021
Compared to 2020
Years Ended December 31, 2020
Compared to 2019
Change
from the
Prior Year
Change
from the
Prior Year
(Dollars in thousands)
Noninterest expense:
Salaries and employee benefits
Occupancy and equipment expenses
Professional services
Data processing and network
Regulatory assessments and insurance
Amortization of intangibles
Advertising
Marketing
Telephone expense
Conversion expenses
Other operating expenses
Total noninterest expense
Year ended December 31, 2021 compared to Year ended December 31, 2020
For the year ended December 31, 2021, noninterest expense totaled $71.8 million, a $3.0 million, or 4.1%, decrease from $74.8 million for the prior year. This decrease was primarily due to lack of conversion expenses in the year ended December 31, 2021 compared to conversion expenses of $1.8 million in the year ended December 31, 2020, a decrease in other operating expenses of $772 thousand, a decrease in amortization on intangibles of 596 thousand, partially offset by increases in professional services of $306 thousand and telephone expense of $237 thousand.
Professional services increased $306 thousand to $3.0 million for the year ended December 31, 2021, compared to $2.7 million for the year ended December 31, 2020. The increase was primarily due to increase professional fees associated with the Proposed Merger with Simmons.
Telephone expense increased $237 thousand or 11.8% during the year ended December 31, 2021 primarily due to expenses related to communications upgrades at various branches. These upgrades should help to improve reliability and connectivity while lowering telephone expense in future years.
Other operating expense decreased $ 772 thousand for the yea r ended December 31, 202 1 , compared to the year ended December 31, 2020, primarily due to prepayment penalties paid on FHLB advances which were incurred as part of an overall balance sheet strateg y in 2020 .
Year ended December 31, 2020 compared to Year ended December 31, 2019
For the year ended December 31, 2020, noninterest expense totaled $74.8 million, an $11.7 million, or 18.6%, increase from $63.0 million for the prior year. This increase was primarily due to increases in salaries and employee benefits of $5.6 million, occupancy and equipment expenses of $3.2 million, regulatory assessments and insurance of $1.4 million, other operating expenses of $1.3 million, and telephone expense of $1.0 million.
Salaries and employee benefits totaled $41.8 million for the year ended December 31, 2020, which included $979 thousand of stock-based compensation expense. By comparison, salaries and employee benefits totaled $36.2 million for the year ended December 31, 2019, which included $665 thousand of stock-based compensation expense. During the year ended December 31, 2020, we experienced higher salary and employee benefit costs primarily due to increased employee count resulting from the Simmons branch acquisition and acquisition-related and Paycheck Protection Program bonuses paid.
Professional services decreased $1.4 million to $2.7 million for the year ended December 31, 2020, compared to $4.1 million for the year ended December 31, 2019. The decrease was primarily due to increased legal and consulting expenses in 2019 related to the Beeville and Citizens acquisitions compared to expenses in 2020 related to only the Simmons branch acquisition.
Increases in occupancy and equipment, regulatory assessments and insurance, and telephone expense are all related to a larger branch network due to our merger activity.
Other operating expense increased $1.3 million for the year ended December 31, 2020, compared to the year ended December 31, 2019, primarily due to prepayment penalties paid on FHLB advances which were incurred as part of an overall balance sheet strategy.
Income Tax Expense
The provision for income taxes includes both federal and state taxes. Fluctuations in effective tax rates reflect the differences in the inclusion or deductibility of certain income and expenses for income tax purposes. Our future effective income tax rate will fluctuate based on the mix of taxable and tax-free investments we make, periodic increases in surrender value of bank-owned life insurance policies for certain former executive officers and our overall taxable income.
Year ended December 31, 2021 compared to Year ended December 31, 2020
Income tax expense was $10.7 million, an increase of $3.2 million for the year ended December 31, 2021, compared to income tax expense of $7.5 million for the year ended December 31, 2020. Our effective tax rates for the years ended December 31, 2021 and 2020 were 20.16% and 19.24%, respectively. The effective tax rate was favorably impacted in the year ended December 31, 2020 due to the income tax benefit associated with a net operating loss carryback claim that was allowed under the CARES Act. The effective tax rate for December 31, 2021 represents a more normalized rate based on recurring permanent differences.
Year ended December 31, 2020 compared to Year ended December 31, 2019
Income tax expense was $7.5 million, an increase of $2.0 million for the year ended December 31, 2020, compared to income tax expense of $5.4 million for the year ended December 31, 2019. Our effective tax rates for the years ended December 31, 2020 and 2019 were 19.24% and 20.41%, respectively. The effective tax rate was lower at December 31, 2020 due to the income tax benefit associated with a net operating loss carryback claim that was allowed under the CARES Act. The effective tax rate for December 31, 2019 represents a more normalized rate based on recurring permanent differences.
Financial Condition
Our total assets increased $181.3 million, or 5.9%, from $3.08 billion as of December 31, 2020 to $3.27 billion as of December 31, 2021. Our asset growth was mainly due to organic loan demand.
Investment Securities
We use our securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk, meet collateral requirements and meet regulatory capital requirements. The securities portfolio grew to $424.4 million during the year ended December 31, 2021 as a result of deploying excess liquidity resulting from PPP loan forgiveness. The average balance of the securities portfolio including FHLB, FRB and The Independent BankersBank (“TIB”) stock for the years ended December 31, 2021 and 2020 was $429.1 million and $117.9 million, respectively, with a pre-tax yield of 1.48% and 1.98%, respectively. We held 105 securities classified as available for sale with an amortized cost of $407.6 million as of December 31, 2021. Additionally, we held one equity security carried at fair value totaling $23.7 million.
Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. No securities were determined to be OTTI as of December 31, 2021 or 2020.
The following table summarizes our available for sale securities portfolio as of the dates presented.
As of December 31,
Fair
Value
Fair
Value
Available for sale:
State and municipal obligations
Residential mortgage-backed securities
Corporate bonds and other debt securities
Total available for sale
The following table shows contractual maturities and the weighted average yields on our investment securities as of the date presented. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Weighted average yields are not presented on a taxable equivalent basis:
Maturity as of December 31, 2021
One Year or Less
One to Five Years
Five to Ten Years
After Ten Years
Amortized
Cost
Weighted
Average
Yield
Amortized
Cost
Weighted
Average
Yield
Amortized
Cost
Weighted
Average
Yield
Amortized
Cost
Weighted
Average
Yield
(Dollars in thousands)
Available for sale:
State and municipal obligations
Residential mortgage-
backed securities
Corporate bonds and other debt
securities
Total available for sale
As a member institution of the FHLB and TIB, the Bank is required to own capital stock in the FHLB and TIB. As of December 31, 2021 and 2020, the Bank held approximately $3.7 million and $5.7 million, respectively, in FHLB and TIB stock. No market exists for this stock, and the Bank’s investment can be liquidated only through repurchase by the FHLB or TIB. Such repurchases have historically been at par value. We monitor our investment in FHLB and TIB stock for impairment through review of recent financial results, dividend payment history and information from credit agencies. As of December 31, 2021 and 2020, management did not identify any indicators of impairment of FHLB or TIB stock.
Equity investments at fair value consist of an investment in the CRA Qualified Investment Fund. Investment in the fund allows the Bank to earn a return on invested funds while obtaining CRA credit. At December 31, 2021, the fair value of equity securities totalled $23.7 million.
Our securities portfolio had a weighted average life of 5.3 years and an effective duration of 4.7 years as of December 31, 2021 and a weighted average life of 5.11 years and an effective duration of 4.58 years as of December 31, 2020.
Loans Held for Sale
Loans held for sale consist of the guaranteed portion of SBA loans that we intend to sell after origination. Our loans held for sale were $3.5 million as of December 31, 2021 and $1.5 million as of December 31, 2020.
Loan Concentrations
Our primary source of income is interest on loans to individuals, professionals, small and medium-sized businesses and commercial companies located in the Houston, Dallas/Fort Worth, Bryan/College Station, San Antonio/New Braunfels, Corpus Christi, Tyler and Austin metropolitan areas. Our loan portfolio consists primarily of commercial and industrial loans, 1-4 single family residential real estate loans and loans secured by commercial real estate properties located in our primary market areas. Our loan portfolio represents the highest yielding component of our earning asset base.
Our loans of $2.32 billion as of December 31, 2021 represented a decrease of $66.4 million, or 2.8%, compared to $2.39 billion as of December 31, 2020. This decrease was primarily due to a reduction of PPP loans from $277.8 million at December 31, 2020 to $43.9 million at December 31, 2021 offset by organic loan growth.
Our loans as a percentage of assets were 71.1% and 77.4% as of December 31, 2021 and 2020, respectively.
The current concentrations in our loan portfolio may not be indicative of concentrations in our loan portfolio in the future. We plan to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral. The following table summarizes the allocation of loans by type as of the dates presented.
As of December 31,
Amount
Total
Amount
Total
Commercial and industrial loans(1)
Real estate:
1-4 single family residential loans
Construction, land and development loans
Commercial real estate loans (including multifamily)
Consumer loans and leases
Municipal and other loans
Total loans held in portfolio
Balance includes $53.5 million and $70.8 million of the unguaranteed portion of SBA loans as of December 31, 2021 and 2020, respectively.
Commercial and Industrial Loans
Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to repay the loan through operating profitably and effectively growing its business. Our management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial loans are primarily made based on the credit quality and cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee to add strength to the credit and reduce the risk on a transaction to an acceptable level; however, some short-term loans may be made on an unsecured basis to the most credit worthy borrowers.
In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Due to the nature of accounts receivable and inventory secured loans, we closely monitor credit availability and collateral through the use of various tools, including but not limited to borrowing-base formulas, periodic accounts receivable agings, periodic inventory audits, and/or collateral inspections.
Commercial and industrial loans, including SBA and PPP loans discussed below, totaled $464.7 million as of December 31, 2021 and represented a decrease of $110.3 million, or 19.2%, from $575.0 million as of December 31, 2020. This decrease was primarily due to loans outstanding related to the PPP decreasing to $43.9 million at December 31, 2021 from $277.8 million at December 31, 2020.
SBA Loans
SBA loans are included in commercial and industrial loans. The primary focus of our SBA lending program is financing well-known national franchises for which the United States generally will guarantee between 75% and 85% of the loan. We are an SBA preferred lender, and originate SBA loans to national franchises in Texas and nationwide. We routinely sell the guaranteed portion of SBA loans to third parties for a premium and retain the servicing rights, for which we earn a 1% fee, and maintain the nonguaranteed portion in our loan portfolio.
SBA loans held in our loan portfolio totaled $53.5 million and $70.8 million at December 31, 2021 and 2020, respectively. We intend to continue to lend under the SBA lending program at volumes determined by market demand.
Paycheck Protection Program
In April 2020, we began originating loans to qualified small businesses under the PPP administered by the SBA under the provisions of the CARES Act. These loans are included in commercial and industrial loans and may be eligible for loan forgiveness for certain costs incurred related to payroll, group health care benefit costs and qualifying mortgage, rent and utility payments. The remaining loan balance after forgiveness of any amounts is still fully guaranteed by the SBA. Terms of the PPP loans include the following (i) maximum amount limited to the lesser of $10 million or an amount calculated using a payroll-based formula, (ii) maximum loan term of two years, (iii) interest rate of 1.00%, (iv) no collateral or personal guarantees are required, (v) no payments are required for six months following the loan disbursement date and (vi) loan forgiveness up to the full principal amount of the loan and any accrued interest, subject to certain requirements including that no more than 25% of the loan forgiveness amount may be attributable to non-payroll costs. In return for processing and booking the loan, the SBA will pay the lender a processing fee tiered by the size of the loan (5% for loans of not more than $350 thousand; 3% for loans more than $350 thousand and less than $2 million; and 1% for loans of at least $2 million). At December 31, 2021, PPP loans totaled $43.9 million which are included in commercial and industrial loans compared to $277.8 million at December 31, 2020.
We also participated in the Federal Reserve's PPPLF, which expired on July 30, 2021. At December 31, 2021, all amounts outstanding under PPPLF had been repaid compared to $149.8 million outstanding at December 31, 2020. The maturity date of a borrowing under the PPPLF was equal to the maturity date of the PPP loan pledged to secure the borrowing and would be accelerated (i) if the underlying PPP loan goes into default and is sold to the SBA to realize on the SBA guarantee or (ii) to the extent that any PPP loan forgiveness reimbursement is received from the SBA. Borrowings under the PPPLF bear interest at a rate of 0.35% and there were no fees to us.
Federal bank regulatory agencies have issued an interim final rule that permits banks to neutralize the regulatory capital effects of participating in the PPP and, if applicable, the PPPLF . Specifically, all PPP loans have a zero percent risk weight under applicable risk-based capital rules. Additionally, a bank may exclude all PPP loans pledged as collateral to the PPPLF from its average total consolidated assets for the purposes of calculating its leverage ratio, while PPP loans that are not pledged as collateral to the PPPLF will be included.
Real estate loans
1-4 single family residential real estate loans (including loans to foreign nationals)
1-4 single family residential real estate loans, including foreign national loans, are subject to underwriting standards and processes similar to commercial and industrial loans. We provide mortgages for the financing of 1-4 single family residential homes for primary occupancy, vacation or rental purposes. The borrowers on these loans generally qualify for traditional market financing. We also specialize in 1-4 single family residential real estate loans to foreign national customers, in which the borrower does not qualify for traditional market financing.
We define our foreign national loans as loans to borrowers who derive more than 50% of their personal income from outside the United States. We provide mortgages for these foreign nationals in Texas for primary occupancy or secondary homes while travelling to the United States. Because more than 50 percent of the borrower’s income is derived from outside of the United States, they do not qualify for traditional market financing. We have developed an enhanced due diligence process for foreign national loans that includes larger down payments than a traditional mortgage, as well as minimum reserves equal to an amount of mortgage payments over a specified period held in the Bank and monthly escrows for taxes and insurance.
1-4 single family residential real estate loans totaled $362.2 million as of December 31, 2021 and represented a decrease of $1.9 million, or 0.54%, from $364.1 million as of December 31, 2020. Foreign national loans comprised $143.3 million, or 39.6%, of 1-4 single family residential real estate loans as of December 31, 2021, compared to $124.6 million, or 34.2%, of 1-4 single family residential real estate loans as of December 31, 2020. The decrease was primarily due to refinance competition in response to overall lower interest rates.
Construction, land and development loans
With respect to loans to developers and builders, we generally require the borrower to have a proven record of success and expertise in the building industry. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment primarily dependent on the success of the ultimate project.
Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from us until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing. Due to the nature of the real estate industry, we evaluate the borrower’s ability to service the interest of the debt from other sources other than the sale of the constructed property.
Construction loans totaled $401.0 million as of December 31, 2021 and represented a decrease of $14.5 million, or 3.5%, from $415.5 million as of December 31, 2020. The decrease was primarily due the transition of loans into permanent financing.
Commercial real estate loans
Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan.
Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. Management monitors and evaluates commercial real estate loans based on collateral and risk grade criteria. As a general rule, we avoid financing special use projects unless strong secondary support is present to help mitigate risk.
Commercial real estate loans consist of owner and nonowner-occupied commercial real estate loans, multifamily loans and farmland. Total commercial real estate loans of $1.03 billion as of December 31, 2021 represented an increase of $74.1 million, or 7.8%, from $956.7 million as of December 31, 2020. The increase was primarily due to strong loan demand in the second half of 2021.
Owner and nonowner-occupied commercial real estate loans
Owner-occupied commercial real estate loans totaled $257.0 million as of December 31, 2021 and $243.1 million as of December 31, 2020. Owner-occupied real estate loans comprised 24.9% and 25.4% of total commercial real estate loans as of December 31, 2021 and 2020, respectively.
Nonowner-occupied commercial real estate loans totaled $663.2 million as of December 31, 2021 and $600.6 million as of December 31, 2020. Nonowner-occupied commercial real estate loans comprised 64.3% and 62.8% of total commercial real estate loans as of December 31, 2021 and 2020, respectively.
Multifamily loans and farmland
Multifamily loans totaled $42.9 million at December 31, 2021 and $55.3 million at December 31, 2020. Multifamily loans comprised 4.2% and 5.8% of total commercial real estate loans as of December 31, 2021 and 2020, respectively.
Multifamily loans are not a focus of the Bank, and we do not expect this portion of the portfolio to represent a large portion of our growth going forward. Farmland loans totaled $68.3 million at December 31, 2021 and $57.8 million at December 31, 2020.
Consumer loans and leases
Our non-real estate consumer loans are based on the borrower’s proven earning capacity over the term of the loan. We monitor payment performance periodically for consumer loans to identify any deterioration in the borrower’s financial strength. To monitor and manage consumer loan risk, management develops and adjusts policies and procedures as needed. This activity, coupled with a relatively small volume of consumer loans, minimizes risk.
All of our leases are related to the financing of vehicle leases to individuals. These loans are originated by a well-known third - party leasing company and subsequently purchased by us after our final credit review. We limit our exposure to individuals living in Texas, within our defined local markets. We do not intend on growing this portfolio going forward as we believe current pricing on these loans does not adequately cover the inherent risk.
Consumer loans and leases totaled $6.3 million as of December 31, 2021 and represented a decrease of $5.4 million, or 46.3%, from $11.7 million as of December 31, 2020. Leases comprised $182 thousand and $1.8 million of total consumer loans and leases at December 31, 2021 and 2020, respectively.
Municipal and other loans
Municipal and other loans consist primarily of loans made to municipalities and emergency service, hospital and school districts as well as agricultural loans.
We make loans to municipalities and emergency service, hospital and school districts primarily throughout Texas. The majority of these loans have tax or revenue pledges and in some cases are additionally supported by collateral. Municipal loans made without a direct pledge of taxes or revenues are usually made based on some type of collateral that represents an essential service. Lending money directly to these municipalities allows us to earn a higher yield for similar durations than we could if we purchased municipal securities. Total loans to municipalities and emergency service, hospital and school districts and others were $57.1 million and $65.4 million as of December 31, 2021 and 2020, respectively.
For a more detailed discussion of the type of loans in our loan portfolio, see “Business—Lending Activities.”
The following table summarizes the loan contractual maturity distribution by type and by related interest rate characteristics as of the date indicated:
As of December 31, 2021
One Year
or Less
After One but
Within Five Years
Five to
Fifteen
Years
After
Fifteen
Years
Total
(Dollars in thousands)
Commercial and industrial loans
Real estate:
1-4 single family residential loans
Construction, land and development loans
Commercial real estate loans (including
multifamily)
Consumer loans and leases
Municipal and other loans
Total loans held in portfolio
Predetermined (fixed) interest rates
Floating interest rates
Total
The information in the table above is limited to contractual maturities of the underlying loans. The expected life of our loan portfolio will differ from contractual maturities because borrowers may have the right to curtail or prepay their loans with or without prepayment penalties.
Asset Quality
The following table sets forth the composition of our nonperforming assets, including nonaccrual loans, accruing loans 90 days or more days past due, other real estate owned and repossessed assets and restructured loans as of the dates indicated:
For the Years Ended December 31,
Asset and Credit Quality Ratios:
Nonaccrual loans
Accruing loans 90 days or more past due
Total nonperforming loans
Other real estate owned and repossessed assets
Total nonperforming assets
Loans held for investment
Total Assets
Allowance for Loan Lease
Nonperforming loans to loans held for investment(1)
Nonperforming assets to loans plus OREO
Nonperforming assets to total assets(2)
Allowance for loan and lease losses to nonperforming loans
Allowance for loan and lease losses to loans held for investment
Net charge-offs (recoveries) to average loans:
Commercial and industrial loans
Net charge offs
Average loans
1-4 single family residential
Net charge offs (recoveries)
Average loans
Construction, land and development
Net charge offs
Average loans
Commercial real estate (including multifamily)
Net charge offs
Average loans
Consumer loans and leases
Net charge offs (recoveries)
Average loans
Municipal and other loans
Net charge offs (recoveries)
Average loans
Total loans held in portfolio
Net charge offs
Average loans
Performing troubled debt restructurings represent the balance at the end of the respective period for those performing loans modified in a troubled debt restructuring that are not already presented as a nonperforming loan.
Nonperforming loans include loans on nonaccrual status and accruing loans 90 or more days past due.
Nonperforming assets include loans on nonaccrual status, accruing loans 90 days or more past due and other real estate owned and repossessed assets.
Nonperforming loans tot aled $ 5.1 million at December 31, 20 2 1 , a decrease of $ 3.5 million , or 67.0 %, from $ 8.6 million at December 31, 20 20 . N on performing assets totaled $ 5.3 million at December 31, 20 2 1 , a de crease of $ 3.4 million, or 38.9 %, from $ 8.7 million at December 31, 20 20 . This decrea s e was primarily due to charge offs on previously impaired loans .
We classify loans as past due when the payment of principal or interest is greater than 30 days delinquent based on the contractual next payment due date. Our policies related to when loans are placed on nonaccrual status conform to guidelines prescribed by bank regulatory authorities. Loans are placed on nonaccrual status when it is probable that principal or interest is not fully collectible, or when principal or interest becomes 90 days past due, whichever occurs first. Loans are removed from nonaccrual status when they become current as to both principal and interest and concern no longer exists as to the collectability of principal and interest.
Loans are identified for restructuring based on their delinquency status, risk rating downgrade, or at the request of the borrower. Borrowers that are 90 days delinquent and/or have a history of being delinquent, or experience a risk rating downgrade, are contacted to discuss options to bring the loan current, cure credit risk deficiencies, or other potential restructuring options that will reduce the inherent risk and improve collectability of the loan. In some instances, a borrower will initiate a request for loan restructure. We require borrowers to provide current financial information to establish the need for financial assistance and satisfy applicable prerequisite conditions required by us. We may also require the borrower to enter into a forbearance agreement.
Modification of loan terms may include the following: reduction of the stated interest rate; extension of maturity date or other payment dates; reduction of the face amount or maturity amount of the loan; reduction in accrued interest; forgiveness of past-due interest; or a combination of the foregoing.
We engage an external consulting firm to complete an independent loan review and validate our credit risk program on a periodic basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk ratings and credit quality assessment decisions made by lenders and credit personnel, as well as our policies and procedures.
Throughout the year ended December 31, 2021, certain borrowers were unable to meet their contractual payment obligations because of the effects of the ongoing COVID-19 pandemic. In an effort to mitigate the adverse effects of the COVID-19 pandemic on our loan customers, we have provided certain customers the opportunity to defer payments, or portions thereof, for up to 90 days, should they so request. As of December 31, 2021, we had $13.9 million of loans with active COVID-related deferrals, all of which the Company expects to return to active payment status at the end of their respective deferral periods. In the absence of other intervening factors, such short-term modifications made on a good faith basis are not categorized as troubled debt restructurings, nor are loans granted payment deferrals related to the COVID-19 pandemic reported as past due or placed on non-accrual status (provided the loans were not past due or on non-accrual status prior to the deferral. We continue to monitor industries that have experienced more lasting effects from the COVID-19 pandemic. At December 31, 2021 no alterations were made to the allowance for loan loss calculation specifically for any industry.
For a more detailed discussion of nonperforming loans, see “Business—Lending Activities—Nonperforming Loans.”
Analysis of the Allowance for Loan and Lease Losses
Allowance for loan and lease losses reflects management’s estimate of probable credit losses inherent in the loan portfolio. The computation of the allowance for loan and lease losses includes elements of judgment and high levels of subjectivity.
In determining the allowance for loan and lease losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan and lease losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates.
On November 14, 2018, we closed the Comanche acquisition. At the date of acquisition, Comanche had $117.2 million in loans. In accordance with ASC 805 , “ Business Combinations ” , we utilized a third party to value the loan portfolio as of the acquisition date. Based upon the third party valuation, the fair value of the loans was approximately $116. 2 million at the acquisition date. The overall discount calculated was $946 thousand and is being accreted into interest inc ome over the life of the loans.
On April 2, 2019, we completed the acquisition of First Beeville Financial Corporation and its subsidiary, The First National Bank of Beeville. At the date of acquisition, Beeville had $298.9 million in loans. Based upon a third party valuation the fair value of the loan portfolio was approximately $296.4 million. The overall discount calculated was $2.5 million and is being accreted into interest income over the life of the loans.
On November 5, 2019, the Company completed its acquisition of Chandler Bancorp Inc. and its subsidiary, Citizens State Bank. At the date of acquisition, Citizens had $253.1 million in loans. Based upon a third party valuation the fair value of the loan portfolio was approximately $252.0 million. The overall discount calculated was $1.1 million and is being accreted into interest income over the life of the loans.
On February 28, 2020, the Company completed its acquisition of certain assets and assumption of certain liabilities associated with five branch offices of Simmons Bank. At the date of acquisition, Simmons had $260.3 million in loans. Based upon a third party valuation the fair value of the loan portfolio was approximately $255.5 million. The overall discount calculated was $4.8 million and is being accreted into interest income over the life of the loans.
Purchased credit impaired loans related to the Comanche acquisition were insignificant, and the Bank did no t identify any purchased credit impaired loans related to the Beeville acquisition or the Simmons branch acquisition. Management identified purchased credit impaired loans related to the Citizens of approximately $ 3.2 million and estimated that expected cash flows were equal to contractual cash flows at the acquisition date. The remaining recorded investment in purchased credit impaired loans related to the Citizens acquisition was $455 thousand at December 31, 2021 and the Company believes that all contractual principal and interest will be received.
The allowance for loan and lease losses increased $369 thousand to $16.4 million at December 31, 2021 from $16.0 million at December 31, 2020, primarily due to organic loan growth. The allowance for loan and lease losses as a percentage of nonperforming loans and allowance for loan and lease losses as a percentage of loans held for investment was 318.4% and 0.71%, respectively, as of December 31, 2021, compared to 186.4% and 0.67%, respectively, as of December 31, 2020.
Net loan charge-offs for the year ended December 31, 2021 totaled $3.3 million, an increase from $2.4 million of net loan charge-offs for the same period of 2020. The increase in net charge-offs for the year ended December 31, 2021 primarily related to charge-offs in our SBA loan portfolio. The ratio of net loan charge-offs to average loans outstanding during the years ended December 31, 2021 and 2020 was 0.14% and 0.09%, respectively.
The following table provides the allocation of the allowance for loan and lease losses as of the dates presented:
As of December 31,
Amount
% Loans
in each
category
Amount
% Loans
in each
category
Commercial and industrial loans
Real estate:
1-4 single family residential loans
Construction, land and development loans
Commercial real estate loans (including multifamily)
Consumer loans and leases
Municipal and other loans
Ending allowance balance
Bank-owned Life Insurance (“BOLI”)
BOLI policies are held in order to insure key, active employees and former directors the Bank. Policies are recorded at the cash surrender value adjusted for other charges or other amounts due that are probable at settlement, if applicable.
The following table summarizes the changes in the cash surrender value of BOLI for the periods presented:
For the Years Ended December 31,
(Dollars in thousands)
Balance at beginning of period
Additions from premium payments
Net gain in cash surrender value
Balance at end of period
As of December 31, 2021 and 2020, the BOLI cash surrender value was $36.6 million and $16.0 million, respectively. We recognized $675 thousand, $359 thousand and $306 thousand of BOLI income for the years ended December 31, 2021, 2020 and 2019, respectively. The total death benefit of the BOLI policies at December 31, 2021 was $80.7 million.
Deposits
We expect deposits to be our primary funding source in the future as we optimize our deposit mix by continuing to shift our deposit composition from higher cost time deposits to lower cost demand deposits. Non-time deposits include demand deposits, NOW accounts, and savings and money market accounts.
The following table shows the deposit mix as of the dates presented:
As of December 31,
Amount
Total
Amount
Total
(Dollars in thousands)
Noninterest-bearing demand deposits
Interest-bearing demand deposits
Interest-bearing NOW accounts
Savings and money market accounts
Time deposits
Total deposits
Total deposits at December 31, 2021 were $2.78 billion, an increase of $323.3 million, or 13.1%, from total deposits at December 31, 2020 of $2.46 billion.
The average cost of deposits for the year ended December 31, 2021 was 0.30%. This represents a decrease of 34 basis points compared to the average cost of deposits of 0.64% for the year ended December 31, 2020. The decrease in cost of deposits was primarily attributable to the decrease in interest rates by the Federal Open Market Committee during the year ended December 31, 2020. For the year ended December 31, 2021, the average rate paid on time deposits was 0.75% compared to 1.54% for the year ended December 31, 2020.
Total deposits that exceeded the FDIC insurance limit of $250 thousand at December 31, 2021 were $1.2 billion. The maturities of time deposits that exceeded the FDIC insurance limit of $250 thousand at December 31, 2021 are as follows:
As of December 31,
(Dollars in thousands)
Three months or less
After three months through six months
After six months through twelve months
After twelve months
Total time deposits in excess of FDIC insurance limit
Borrowings
In addition to deposits, we utilize advances from the FHLB and other borrowings as a supplementary funding source to finance our operations.
FHLB borrowings : The FHLB allows us to borrow, both short and long-term, on a blanket floating lien status collateralized by certain securities and loans. As of December 31, 2021 and 2020, total remaining borrowing capacity of $841.9 million and $654.9 million, respectively, was available under this arrangement. As of December 31, 2021 we had no short-term FHLB borrowings. As of December 31, 2020, we had short-term FHLB borrowings of $10 million, with an average interest rate of 0.70%. We had long-term FHLB borrowings of $38.5 million and $51.9 million as of December 31, 2021 and 2020, respectively, with an average interest rate of 2.44% and 2.29%, respectively.
PPPLF: In conjunction with the PPP, we also participated in the Federal Reserve's PPPLF, which expired on July 30, 2021. At December 31, 2021, all amounts outstanding under PPPLF had been repaid compared to $149.8 million outstanding at December 31, 2020. The maturity date of a borrowing under the PPPLF was equal the maturity date of the PPP loan pledged to secure the borrowing and would be accelerated (i) if the underlying PPP loan goes into default and is sold to the SBA to realize on the SBA guarantee or (ii) to the extent that any PPP loan forgiveness reimbursement is received from the SBA. Borrowings under the PPPLF bear interest at a rate of 0.35% and there were no fees to us.
Subordinated Notes: On July 24, 2020, the Company issued $37 million aggregate principal amount of 6.00% fixed-to-floating rate subordinated notes due 2030. The Notes will initially bear interest at a fixed annual rate of 6.00%, payable quarterly, in arrears, to, but excluding, July 31, 2025. From and including July 31, 2025, to, but excluding, the maturity date or earlier redemption date, the interest rate will reset quarterly to an interest rate per annum equal to a benchmark rate, which is expected to be the then-current three-month Secured Overnight Financing Rate, as published by the Federal Reserve Bank of New York (provided, that in the event the benchmark rate is less than zero, the benchmark rate will be deemed to be zero) plus 592 basis points, payable quarterly, in arrears. The amount outstanding at December 31, 2021 and 2020 was $37.0 million .
Secured borrowings : Due to the rights retained on certain loan participations sold, the Company is deemed to have retained effective control over these loans under ASC Topic 860, “Transfers and Servicing”, and therefore these participations sold must be accounted for as a secured borrowing. At December 31, 2021, the Company had no secured borrowings. At December 31, 2020, total secured borrowings were $4.0 million representing an increase in loans held for investment and matching increase in long-term borrowings.
Line of credit : We entered into a line of credit with a third party lender in May 2017 that allows us to borrow up to $20 .0 million. The interest rate on this line of credit is based upon 90-day LIBOR plus 4.0%, and unpaid principal and interest is due at the stated maturity of May 12, 2022. This line of credit is secured by a pledge of all of the common stock of the Bank. This line of credit may be prepaid at any time without penalty, so long as such prepayment includes the payment of all interest accrued through the date of the repayments, and, in the case of prepayment of the entire loan, the amount of attorneys’ fees and disbursements of the lender. During 2019, the line of credit was increased to a total borrowing capacity of $50.0 million all of which wa s available at December 31, 202 1 and at December 31, 20 20 .
Total borrowings consisted of the following as of the dates presented:
As of December 31,
(Dollars in thousands)
Short-term FHLB borrowings
Long-term FHLB borrowings
PPPLF
Subordinated Notes
Secured borrowings
Total borrowings
At December 31, 2021, total borrowings were $74.9 million, a decrease of $177.1 million, or 70.3%, from $252.0 million at December 31, 2020. The decrease in total borrowings was primarily driven by repayment of Paycheck Protection Program Liquidity Facility advances.
Short-term borrowings consist of debt with maturities of one year or less. Our short-term borrowings consist of FHLB borrowings and a third party line of credit. The following table is a summary of short-term borrowings as of and for the periods presented:
As of and for the years ended
December 31,
(Dollars in thousands)
Short-term borrowings:
Maximum outstanding at any month-end during the period
Balance outstanding at end of period
Average outstanding during the period
Average interest rate during the period
Average interest rate at the end of the period
We maintained five, unsecured Federal Funds lines of credit with commercial banks which provide for extensions of credit with an availability to borrow up to an aggregate $115.0 million as of December 31, 2021. We maintained five, unsecured Federal Funds lines of credit with commercial banks with an availability to borrow up to an aggregate $105.0 million as of December 31, 2020. There were no advances under these lines of credit outstanding as of December 31, 2021 or 2020.
Stockholders’ Equity
The following table summarizes the changes in our stockholders’ equity for the periods indicated:
Years Ended December 31,
(Dollars in thousands)
Balance at beginning of period
Net income
Common stock dividends declared ($0.42 and $0.16 per share, respectively)
Shares issued in offering, net(1)
Shares issued in business combination
Exercise of stock options and warrants
Stock-based compensation
Treasury Stock Purchases
Other comprehensive income (loss)
Balance at end of period
Shares issued in offering were net of expenses of $442 thousand for 2019.
Net income totaled $42.1 million for the year ended December 31, 2021, an increase of $10.7 million, compared to $31.3 million for the year ended December 31, 2020. Our results of operations for the year ended December 31, 2021, produced a return on average assets of 1.13% compared to 1.11% for the prior year. Our results of operations for the year ended December 31, 2021 produced a return on average stockholders’ equity of 9.25% compared to 8.98% for the prior year.
Stockholders’ equity was $393.8 million as of December 31, 2021, an increase of $33.0 million from $360.8 million as of December 31, 2020. The increase was primarily driven by net income of $42.1 million offset by dividends of $7.2 million and other comprehensive loss of $5.1 million.
Net income totaled $31.3 million for the year ended December 31, 2020, an increase of $10.2 million, compared to $21.1 million for the year ended December 31, 2019. Our results of operations for the year ended December 31, 2020 produced a return on average assets of 1.11% compared to 1.14% for the prior year. Our results of operations for the year ended December 31, 2020 produced a return on average stockholders’ equity of 8.98% compared to 8.38% for the prior year.
Stockholders’ equity was $360.8 million as of December 31, 2020, an increase of $15.1 million from $345.7 million as of December 31, 2019. The increase was primarily driven by net income of $31.3 million offset by share repurchases of $15.5 million.
Capital Resources and Liquidity
Capital Resources
We are required to comply with certain “risk-based” capital adequacy guidelines issued by the Federal Reserve and the FDIC. The risk-based capital guidelines assign varying risk weights to the individual assets held by a bank. The guidelines also assign weights to the “credit-equivalent” amounts of certain off-balance sheet items, such as letters of credit and interest rate and currency swap contracts.
Under the Basel III Capital Rules, we are required to maintain the following minimum capital to risk-adjusted assets requirements: (i) a common equity tier 1 capital ratio of 4.5% (6.5% to be considered “well capitalized”); (ii) a tier 1 capital ratio of 6.0% (8.0% to be considered “well capitalized”), and (iii) a total capital ratio of 8.0% (10.0% to be considered “well capitalized”). Under the Basel III rules there is a requirement for a common phased-in equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not maintain this required capital buffer will become subject
to progressively more stringentlimitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement effectively raises the minimum required common equity tier 1 capital ratio to 7.0%, the tier 1 capital ratio to 8.5%, and the total capital ratio to 10. 5% on a fully phased-in basis as of January 1, 2019.
The risk-based capital ratios measure the adequacy of a bank’s capital against the riskiness of its assets and off-balance sheet activities. Failure to maintain adequate capital is a basis for “prompt corrective action” or other regulatory enforcement action. In assessing a bank’s capital adequacy, regulators also consider other factors such as interest rate risk exposure; liquidity, funding and market risks; quality and level of earnings; concentrations of credit, quality of loans and investments; risks of any nontraditional activities; effectiveness of bank policies; and management’s overall ability to monitor and control risks.
The following table sets forth the regulatory capital ratios, excluding the impact of the capital conservation buffer, as of the dates indicated:
Minimum
Capital
Requirement
Minimum
Capital
Requirement
with
Capital
Buffer
Minimum
to Be Well
Capitalized
December 31,
Capital ratios (Company):
Tier 1 leverage ratio
Common equity tier 1 capital ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
Capital ratios (Bank):
Tier 1 leverage ratio
Common equity tier 1 capital ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
At December 31, 2021, both we and the Bank met all the capital adequacy requirements to which we and the Bank were subject. At December 31, 2021, the Bank was “well capitalized” under the regulatory framework for prompt corrective action. Management believes that no conditions or events have occurred since December 31, 2020 that would materially adversely change such capital classifications. From time to time, we may need to raise additional capital to support our and the Bank’s further growth and to maintain our “well capitalized” status.
As of December 31, 2021, we had a tier 1 leverage ratio of 10.64 %. As of December 31, 2021, the Bank had a tier 1 leverage ratio of 10.65%, which provided $178.9 million of excess capital relative to the minimum requirements to be considered well capitalized.
For a discussion of the changes in our total stockholders’ equity at December 31, 2021 as compared with December 31, 2020, please see the discussion under “—Stockholders’ Equity” above.
Liquidity
Liquidity involves our ability to raise funds to support asset growth and acquisitions or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate on an ongoing basis and manage unexpected events. For the years ended December 31, 2021 and 2020, our liquidity needs were primarily met by core deposits, security and loan maturities and amortizing investment and loan portfolios. Although access to brokered deposits, purchased funds from correspondent banks and overnight advances from the FHLB are available and have been utilized on occasion to take advantage of investment opportunities, we do not generally rely on these external funding sources. The Bank maintained five unsecured Federal Funds lines of credit
with commercial banks which provide for extensions of credit with an availability to borrow up to an aggregate $ 115.0 million as of December 31, 202 1 . We maintained five , unsecured Federal Funds lines of credit with commercial banks with an availability to borrow up to an aggregate $ 105.0 million as of December 31, 20 20 . The Company drew $ 10 million on the line of credit during the year ended December 31, 20 20 to fund general corporate needs and repaid the outstanding amount plus interest in July 20 20 . There were no advances under these lines of credit outstanding as of December 31, 202 1 or 2019 .
The following table illustrates, during the periods presented, the mix of our funding sources and the average assets in which those funds are invested as a percentage of our average total assets for the periods indicated. Average assets were $3.15 billion for the year ended December 31, 2021 and $2.82 billion for the year ended December 31, 2020.
As of and for the Years Ended
December 31,
Sources of funds:
Deposits:
Noninterest-bearing
Interest-bearing
Advances from FHLB and other borrowings
Other liabilities
Stockholders' equity
Total
Uses of funds:
Loans
Investment securities and other
Interest-bearing deposits in other banks
Other noninterest-earning assets
Total
Average noninterest-bearing deposits to average deposits
Average loans to average deposits
Our primary source of funds is deposits and our primary use of funds is loans. We do not expect a change in the primary source or use of our funds in the foreseeable future. Our average loans, including loans held for sale, increased 2.6% for the year ended December 31, 2021 compared to the year ended December 31, 2020. We predominantly invest excess deposits in overnight deposits with the Federal Reserve, securities, interest-bearing deposits at other banks or other short-term liquid investments until needed to fund loan growth. Our securities portfolio had a weighted average life of 5.3 years and an effective duration of 4.7 years as of December 31, 2021.
In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included on our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and commercial and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized on our consolidated balance sheets.
We enter into contractual loan commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Since a portion of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent our future cash requirements. Substantially all of our commitments to extend credit are contingent upon customers maintaining specific credit standards until the time of loan funding. We seek to minimize our exposure to loss under these commitments by subjecting them to prior credit approval and ongoing monitoring procedures. We assess the credit risk associated with certain commitments to extend credit and establish a liability for probable credit losses. As of December 31, 2021 and 2020, our reserve for unfunded commitments totaled $76 thousand and $90 thousand, respectively.
Commercial and standby letters of credit are written conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek recovery from the customer. Our policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.
The following table summarizes our commitments as of the dates presented:
December 31,
(Dollars in thousands)
Unfunded loan commitments
Commercial and standby letters of credit
Total
Management believes that we have adequate liquidity to meet all known contractual obligations and unfunded commitments, including loan commitments over the next twelve months. Additionally, management believes that our off-balance sheet arrangements have not had or are not reasonably likely to have a current or future material effect on our financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources.
As of December 31, 2021, we had outstanding $550.6 million in commitments to extend credit and $3.4 million in commitments associated with outstanding commercial and standby letters of credit. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the total outstanding may not necessarily reflect the actual future cash funding requirements.
As of December 31, 2021, we believe we had no exposure to future cash requirements associated with known uncertainties. Capital expenditures, including buildings and construction in process, for the years ended December 31, 2021 and 2020 were $2.0 million and $10.2 million, respectively.
We had cash and cash equivalents of $305.8 million and $263.0 million as of December 31, 2021 and 2020, respectively. The increase was primarily due to PPP loan forgiveness received during the year ended December 31, 2021.
Interest Rate Sensitivity and Market Risk
As a financial institution, our primary component of market risk is interest rate volatility. Our asset liability and funds management policy provides management with the guidelines for effective funds management, and we have established a measurement system for monitoring our net interest rate sensitivity position. We manage our sensitivity position within our established guidelines.
Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of our assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which have a short term to maturity. Interest rate risk is the potential for economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income.
We manage our exposure to interest rates by structuring our balance sheet in the ordinary course of business. We do not enter into instruments such as leveraged derivatives, interest rate swaps, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk. Based upon the nature of our operations, we are not subject to foreign exchange or commodity price risk. We do not own any trading assets.
Our exposure to interest rate risk is managed by the Asset-Liability Management Committee of the Bank in accordance with policies approved by its board of directors. The committee formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, the committee
considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The committee meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, the committee reviews liquidity, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity. Management employs methodologies to manage interest rate risk which include an analysis of relationships between interest-earning assets and interest-bearing liabilities, and an interest rate shock simulation model.
We use interest rate risk simulation models and shock analysis to test the interest rate sensitivity of net interest income and fair value of equity, and the impact of changes in interest rates on other financial metrics. Contractual maturities, prepayment assumptions and repricing opportunities of loans are incorporated in the model as are prepayment assumptions, maturity data and call options within the investment portfolio. Average life of our non-maturity deposit accounts are based on standard regulatory decay assumptions and are incorporated into the model. The assumptions used are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.
On a quarterly basis, we run two simulation models including a static balance sheet and dynamic growth balance sheet. These models test the impact on net interest income and fair value of equity from changes in market interest rates under various scenarios. Under the static and dynamic growth models, rates are shocked instantaneously and ramped rate changes over a 12-month horizon based upon parallel and non-parallel yield curve shifts. Parallel shock scenarios assume instantaneous parallel movements in the yield curve compared to a flat yield curve scenario. Non-parallel simulation involves analysis of interest income and expense under various changes in the shape of the yield curve. Internal policy regarding internal rate risk simulations currently specifies that for instantaneous parallel shifts of the yield curve, estimated net income at risk for the subsequent one-year period should not decline by more than 5.0% for a 100 basis point shift, 10.0% for a 200 basis point shift, and 15.0% for a 300 basis point shift.
The following table summarizes the simulated change in net interest income over a 12-month horizon:
December 31,
Change in interest rates (basis points)
% Change
in Net
Interest Income
Base
The following table summarizes an immediate shock in the fair value of equity as of the date indicated:
December 31,
Change in interest rates (basis points)
% Change
in Fair
Value of Equity
Base
The results are primarily due to behavior of demand, money market and savings deposits during such rate fluctuations. We have found that, historically, interest rates on these deposits change more slowly than changes in
the discount and federal funds rates. This assumption is incorporated into the simulation model and is generally not fully reflected in a gap analysis. The assumptions incorporated into the model are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various strategies.
Some of our financial instruments are currently tied to LIBOR. LIBOR is a benchmark interest rate referenced in a variety of agreements that are used by numerous entities. On March 5, 2021, the U.K. Financial Conduct Authority (“FCA”) announced that the majority of LIBOR rates will no longer be published after December 31, 2021, although a number of key settings will continue until June 2023, to support the rundown of legacy contracts only. As a result, LIBOR should be discontinued as a reference rate. Other interest rates used globally could also be discontinued for similar reasons.
In response to reference rate reform, the Company formed a LIBOR Transition Team in 2020, has created standard LIBOR replacement language for new and modified loan notes, and is monitoring the remaining loans with LIBOR rates monthly to ensure progress in updating these loans with acceptable LIBOR replacement language or converting them to other interest rates. The Company has not been offering LIBOR-indexed rates originated by other banks, subject to the Company’s determination that the LIBOR replacement language in the loan documents meets the Company’s standards. Pursuant to the Interagency Statement on LIBOR Transition issued in November 2020, the Company will not enter into any new LIBOR-based credit agreements after December 31, 2021.
Impact of Inflation
Our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K have been prepared in accordance with GAAP. These require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession.
Unlike many industrial companies, substantially all of our assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, other operating expenses do reflect general levels of inflation.
Non-GAAP Financial Measures
Our accounting and reporting policies conform to GAAP, and the prevailing practices in the banking industry. However, we also evaluate our performance based on certain additional financial measures discussed in this Annual Report on Form 10-K as being non-GAAP financial measures. We classify a financial measure as being a non-GAAP financial measure if that financial measure excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, that are included or excluded, as the case may be, in the most directly comparable measure calculated and presented in accordance with GAAP as in effect from time to time in the United States in our statements of income, balance sheets or statements of cash flows. Non-GAAP financial measures do not include operating and other statistical measures or ratios or statistical measures calculated using exclusively financial measures calculated in accordance with GAAP.
The non-GAAP financial measures that we discuss in this Annual Report on Form 10-K should not be considered in isolation or as a substitute for the most directly comparable or other financial measures calculated in accordance with GAAP. Moreover, the manner in which we calculate the non-GAAP financial measures that we discuss in this Annual Report on Form 10-K may differ from that of other banking organizations reporting measures with similar names. You should understand how such other banking organizations calculate their financial measures similar or with names similar to the non-GAAP financial measures we have discussed in this Annual Report on Form 10-K when comparing such non-GAAP financial measures.
Adjusted Earnings per Common Share – Basic and Diluted
Adjusted earnings per common share – basic and diluted is a non-GAAP financial measure that excludes gains on security sales, merger related expenses, and non-recurring tax benefits related to recently enacted legislation. In our judgment, the adjustments made to net income allow investors and analysts to better assess our basic and diluted earnings per common share by removing the volatility that is associated with items that are unrelated to our core business.
The following table reconciles, as of the date set forth below, basic and diluted earnings per common share and presents our basic and diluted earnings per common share exclusive of the impact of non-core transactions:
As of or for the Years Ended December 31,
(Dollars in thousands, except per share data)
Basic and diluted earnings per share - GAAP basis:
Net income
Less:
Participated securities share of undistributed earnings
Net income available to common stockholders
Weighted average number of common shares - basic
Weighted average number of common shares - diluted
Basic earnings per common share
Diluted earnings per common share
Basic and diluted earnings per share - Non-GAAP basis:
Net income available to common stockholders
Pre-tax adjustments:
Noninterest income
Gain on sale of investment securities
Noninterest expense
Merger related expenses
Taxes:
NOL carryback claim
Tax effect of adjustments
Adjusted net income
Weighted average number of common shares - basic
Weighted average number of common shares - diluted
Basic earnings per common share
Diluted earnings per common share
Tangible Book Value Per Share
Tangible book value per share is a non-GAAP financial measure generally used by investors, financial analysts and investment bankers to evaluate financial institutions. We calculate (1) tangible book value per share as tangible equity divided by shares of common stock outstanding at the end of the respective period, and (2) tangible equity as common stockholders’ equity less goodwill and other intangible assets, net of accumulated amortization. The most directly comparable GAAP financial measure for tangible book value per share is book value per share.
We believe that this measure is important to many investors in the marketplace who are interested in changes from period to period in book value per share exclusive of changes in intangible assets. Goodwill and other intangible assets have the effect of increasing total book value while not increasing our tangible book value.
The following table reconciles, as of the dates set forth below, total stockholders’ equity to tangible equity and presents our tangible book value per share compared to our book value per share:
As of December 31,
(Dollars in thousands, except per share
data)
Total stockholders' equity
Less:
Goodwill and other intangible assets
Tangible stockholders' equity
Shares outstanding(1)
Book value per share(1)(2)
Less:
Goodwill and other intangible assets per share(1)(3)
Tangible book value per share
Reflects the issuance of 170,236 shares of common stock to our holders of Series A preferred stock in connection with the conversion of 170,236 shares of our issued and outstanding Series A preferred stock into common stock on February 23, 2017 and the one-for-two reverse stock split that occurred on March 16, 2017.
We calculate book value per share as total stockholders’ equity at the end of the relevant period divided by the outstanding number of shares of our common stock at the end of the relevant period.
We calculate goodwill and other intangible assets per share as total goodwill and other intangible assets at the end of the relevant period divided by the outstanding number of shares of our common stock at the end of the relevant period.
Tangible Equity to Tangible Assets
Tangible equity to tangible assets is a non-GAAP financial measure generally used by investors, financial analysts and investment bankers to evaluate financial institutions. We calculate tangible equity, as described above in “—Tangible Book Value Per Share”, and tangible assets as total assets less goodwill and core deposit intangibles and other intangible assets, net of accumulated amortization. The most directly comparable GAAP financial measure for tangible equity to tangible assets is total common stockholders’ equity to total assets.
We believe that this measure is important to many investors in the marketplace who are interested in the relative changes from period to period in common equity and total assets, each exclusive of changes in intangible assets. Goodwill and other intangible assets have the effect of increasing both total stockholders’ equity and assets while not increasing our tangible equity or tangible assets.
The following table reconciles, as of the dates set forth below, total stockholders’ equity to tangible equity and total assets to tangible assets:
As of December 31,
(Dollars in thousands)
Total stockholders' equity to total assets - GAAP basis:
Total stockholders' equity (numerator)
Total assets (denominator)
Total stockholders' equity to total assets
Tangible equity to tangible assets - Non-GAAP basis:
Tangible equity:
Total stockholders' equity
Less:
Goodwill and other intangible assets
Total tangible common equity (numerator)
Tangible assets:
Total assets
Less:
Goodwill and other intangible assets
Total tangible assets (denominator)
Tangible equity to tangible assets
Net Interest Margin
We show net interest margin on a fully taxable equivalent basis, which is a non-GAAP financial measure.
We believe the fully tax equivalent basis is the preferred industry measurement basis for net interest margin and that it enhances comparability of net interest income arising from taxable and tax-exempt sources.
The following table reconciles, as of the dates set forth below, net interest margin on a fully taxable equivalent basis:
As of and for the Years Ended
December 31,
(Dollars in thousands)
Net interest margin - GAAP basis:
Net interest income
Average interest-earning assets
Net interest margin
Net interest margin - Non-GAAP basis:
Net interest income
Plus:
Impact of fully taxable equivalent adjustment
Net interest income on a fully taxable equivalent basis
Average interest-earning assets
Net interest margin on a fully taxable equivalent basis -
Non-GAAP basis
Critical Accounting Policies and Estimates
Our financial reporting and accounting policies conform to GAAP. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Our accounting policies and estimates are described in greater detail in “Note 1. Summary of Significant Accounting Policies” in the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. See “Risk Factors” for a discussion of information that should be considered in connection with an investment in our securities.
We have identified the following accounting policies and estimates that, due to the difficult, subjective or complex judgments and assumptions inherent in those policies and estimates and the potential sensitivity of our financial statements to those judgments and assumptions, are critical to an understanding of our financial condition and results of operations. We believe that the judgments, estimates and assumptions used in the preparation of our financial statements are appropriate. Our accounting policies are integral to understanding our results of operations.
Allowance for Loan and Lease Losses
Management’s ongoing evaluation of the adequacy of the allowance for loan and lease losses is based on our past loan loss experience, the volume and composition of our lending, adverse situations that may affect a borrower’s ability to repay, the estimated value of any underlying collateral, current economic conditions and other factors affecting the known and inherent risk in the portfolio. The allowance for loan and lease losses is increased by charges to income through the provision for loan and lease losses and decreased by charge-offs (net of recoveries). The allowance is maintained at a level that management, based upon its evaluation, considers adequate to absorb losses inherent in the loan portfolio. This evaluation is inherently subjective as it requires material estimates including, among others, the amount and timing of expected future cash flows on impacted loans, exposure at default, value of collateral, and estimated losses on our loan portfolio. All of these estimates may be susceptible to significant change.
The allowance consists of specific allowances for impaired loans and a general allowance on the remainder of the portfolio. Although management determines the amount of each element of the allowance separately, the allowance for loan and lease losses is available for the entire loan portfolio.
Management establishes an allowance on certain impaired loans for the amount by which the discounted cash flows, observable market price, or fair value of collateral if the loan is collateral dependent, is lower than the carrying value of the loan. A loan is considered to be impaired when, based upon current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan. A delay or shortfall in amount of payments does not necessarily result in the loan being identified as impaired.
Management also establishes a general allowance on non-impaired loans to recognize the inherent losses associated with lending activities, but which, unlike specific allowances, have not been allocated to particular loans. This general valuation allowance is determined by segregating the loans by loan category and assigning allowance percentages based on our historical loss experience, delinquency trends, and management’s evaluation of the collectability of the loan portfolio.
The allowance is adjusted for significant factors that, in management’s judgment, affect the collectability of the portfolio as of the evaluation date. These significant factors may include changes in lending policies and procedures, changes in existing general economic and business conditions affecting its primary lending areas, credit quality trends, collateral value, loan volumes and concentrations, seasoning of the loan portfolio, loss experience in particular segments of the portfolio, duration of the current business cycle, and bank regulatory examination results. The applied loss factors are re-evaluated each reporting period to ensure their relevance in the current economic environment.
While management uses the best information known to it in order to make loan loss allowance valuations, adjustments to the allowance may be necessary based on changes in economic and other conditions, changes in the composition of the loan portfolio, or changes in accounting guidance. In times of economic slowdown, either regional or national, the risk inherent in the loan portfolio could increase resulting in the need for additional provisions to the allowance for loan and lease losses in future periods. An increase could also be necessitated by an increase in the size of the loan portfolio or in any of its components even though the credit quality of the overall portfolio may be improving. Historically, the estimates of the allowance for loan and lease losses have provided adequate coverage against actual losses incurred.
Goodwill and Other Intangible Assets
Goodwill represents the excess of consideration transferred in business combinations over the fair value of tangible and identifiable intangible assets acquired. Goodwill is assessed annually for impairment or more frequently if events or circumstances indicate that impairment may have occurred.
Goodwill acquired in a purchase business combination that is determined to have an indefinite useful life, is not amortized, but tested for impairment as described above. We perform our annual impairment test in the fourth quarter. Goodwill is the only intangible asset with an indefinite life on our balance sheet.
Core deposit intangible (“CDI”) is a measure of the value of checking and savings deposit relationships acquired in a business combination. The fair value of the CDI stemming from any given business combination is based on the present value of the expected cost savings attributable to the core deposit funding relative to an alternative source of funding. CDI is amortized over the estimated useful lives of the existing deposit relationships acquired, but does not exceed 12 years. We evaluate such identifiable intangibles for impairment when events and circumstances indicate that its carrying amount may not be recoverable.
Income Taxes
Management makes estimates and judgments to calculate various tax liabilities and determine the recoverability of various deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenues and expenses. Management also estimates a reserve for deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. These estimates and judgments are inherently subjective. Historically, management’s estimates and judgments to calculate the deferred tax accounts have not required significant revision.
In evaluating our ability to recover deferred tax assets, management considers all available positive and negative evidence, including the past operating results and forecasts of future taxable income. In determining future taxable income, management makes assumptions for the amount of taxable income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require management to make judgments about the future taxable income and are consistent with the plans and estimates used to manage the business. Any reduction in estimated future taxable income may require management to record a valuation allowance against the deferred tax assets. An increase in the valuation allowance would result in additional income tax expense in the period and could have a significant impact on future earnings.
SBA Servicing Asset
A servicing asset related to SBA loans is initially recorded when these loans are sold and the servicing rights are retained. The servicing asset is recorded on the balance sheet. An updated fair value of the servicing asset is obtained from an independent third party on a quarterly basis and any necessary adjustments are included in SBA loan servicing fees on the consolidated statements of income. The valuation begins with the projection of future cash flows for each asset based on their unique characteristics, market-based assumptions for prepayment speeds and estimated losses and recoveries. The present value of the future cash flows are then calculated utilizing market-based discount ratio assumptions. In all cases, we model expected payments for every loan for each quarterly period in order to create the most detailed cash flow stream possible. We use various assumptions and estimates in determining the impairment of the SBA servicing asset. These assumptions include prepayment speeds and discount rates commensurate with the risks involved and comparable to assumptions used by participants to value and bid serving rights available for sale in the market.
Recently Issued Accounting Pronouncements
See “Note 1. Summary of Significant Accounting Policies” in the notes to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K regarding the impact of new accounting pronouncements which we have adopted.
