Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(MARK ONE)
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2022
OR
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 000-23877
Heritage Commerce Corp
(Exact name of Registrant as Specified in its Charter)
California(State or Other Jurisdiction ofIncorporation or Organization)
77-0469558(I.R.S. Employer Identification No.)
224 Airport Parkway, San Jose, California(Address of Principal Executive Offices)
95110(Zip Code)
(408) 947-6900
(Registrant’s Telephone Number, Including Area Code)
N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class:
Trading Symbol:
Name of each exchange on which registered:
Common Stock, No Par Value
HTBK
The NASDAQ Stock Market LLC
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ☒ NO ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). YES ☒ NO ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐
Accelerated filer ☒
Non-accelerated filer ☐
Smaller reporting company ☐
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ☐ NO ☒
The Registrant had 60,668,794 shares of Common Stock outstanding on July 29, 2022
HERITAGE COMMERCE CORP
QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS
Page No.
Cautionary Note on Forward-Looking Statements
3
Part I. FINANCIAL INFORMATION
Item 1.
Consolidated Financial Statements (unaudited)
5
Consolidated Balance Sheets
Consolidated Statements of Income
6
Consolidated Statements of Comprehensive Income
7
Consolidated Statements of Changes in Shareholders’ Equity
8
Consolidated Statements of Cash Flows
9
Notes to Unaudited Consolidated Financial Statements
10
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
43
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
74
Item 4.
Controls and Procedures
PART II. OTHER INFORMATION
Legal Proceedings
75
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
76
SIGNATURES
77
2
Cautionary Note Regarding Forward-Looking Statements
This Report on Form 10-Q contains various statements that may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, Rule 3b-6 promulgated thereunder and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These forward-looking statements often can be, but are not always, identified by the use of words such as “assume,” “expect,” “intend,” “plan,” “project,” “believe,” “estimate,” “predict,” “anticipate,” “may,” “might,” “should,” “could,” “goal,” “potential” and similar expressions. We base these forward-looking statements on our current expectations and projections about future events, our assumptions regarding these events and our knowledge of facts at the time the statements are made. These statements include statements relating to our projected growth, anticipated future financial performance, and management’s long-term performance goals, as well as statements relating to the anticipated effects on results of operations and financial condition.
These forward-looking statements are subject to various risks and uncertainties that may be outside our control and our actual results could differ materially from our projected results. Risks and uncertainties that could cause our financial performance to differ materially from our goals, plans, expectations and projections expressed in forward-looking statements include those set forth in our filings with the Securities and Exchange Commission (“SEC”), Item 1A of the Heritage Commerce Corp’s (“the Company”) Annual Report on Form 10-K for the year ended December 31, 2021, and including, but not limited to the following:
Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. You should consider any forward looking statements in light of this explanation, and we caution you about relying on forward-looking statements.
4
Part I—FINANCIAL INFORMATION
ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(Unaudited)
June 30,
December 31,
2022
2021
(Dollars in thousands)
Assets
Cash and due from banks
$
35,764
15,703
Other investments and interest-bearing deposits in other financial institutions
840,821
1,290,513
Total cash and cash equivalents
876,585
1,306,216
Securities available-for-sale, at fair value
332,129
102,252
Securities held-to-maturity, at amortized cost, net of allowance for credit losses of $39 at June 30, 2022
and $43 at December 31, 2021 (fair value of $650,829 at June 30, 2022 and $657,649 at December 31, 2021)
723,716
658,397
Loans held-for-sale - SBA, at lower of cost or fair value, including deferred costs
2,281
2,367
Loans, net of deferred fees
3,082,452
3,087,326
Allowance for credit losses on loans
(45,490)
(43,290)
Loans, net
3,036,962
3,044,036
Federal Home Loan Bank, Federal Reserve Bank stock and other investments, at cost
32,513
32,504
Company-owned life insurance
77,972
77,589
Premises and equipment, net
9,593
9,639
Goodwill
167,631
Other intangible assets
12,351
13,668
Accrued interest receivable and other assets
85,108
85,110
Total assets
5,356,841
5,499,409
Liabilities and Shareholders' Equity
Liabilities:
Deposits:
Demand, noninterest-bearing
1,846,365
1,903,768
Demand, interest-bearing
1,218,538
1,308,114
Savings and money market
1,387,003
1,375,825
Time deposits - under $250
36,691
38,734
Time deposits - $250 and over
98,760
94,700
CDARS - interest-bearing demand, money market and time deposits
26,287
38,271
Total deposits
4,613,644
4,759,412
Subordinated debt, net of issuance costs
39,274
39,925
Accrued interest payable and other liabilities
96,699
102,044
Total liabilities
4,749,617
4,901,381
Shareholders' equity:
Preferred stock, no par value; 10,000,000 shares authorized; none issued and outstanding
at June 30, 2022 and December 31, 2021
—
Common stock, no par value; 100,000,000 shares authorized;
60,666,794 shares issued and outstanding at June 30, 2022 and
60,339,837 shares issued and outstanding at December 31, 2021
499,832
497,695
Retained earnings
123,310
111,329
Accumulated other comprehensive loss
(15,918)
(10,996)
Total shareholders' equity
607,224
598,028
Total liabilities and shareholders' equity
See notes to consolidated financial statements (unaudited).
CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended
Six Months Ended
(Dollars in thousands, except per share amounts)
Interest income:
Loans, including fees
36,538
33,439
71,639
67,275
Securities, taxable
4,407
1,944
7,851
3,672
Securities, exempt from Federal tax
271
404
568
833
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold
2,340
845
3,404
1,613
Total interest income
43,556
36,632
83,462
73,393
Interest expense:
Deposits
1,146
1,179
2,260
2,411
Subordinated debt
531
577
1,102
1,148
Total interest expense
1,677
1,756
3,362
3,559
Net interest income before provision for credit losses on loans
41,879
34,876
80,100
69,834
Provision for (recapture of) credit losses on loans
(181)
(493)
(748)
(2,005)
Net interest income after provision for credit losses on loans
42,060
35,369
80,848
71,839
Noninterest income:
Service charges and fees on deposit accounts
867
659
1,479
1,260
Increase in cash surrender value of life insurance
480
458
960
914
Servicing income
139
104
245
286
Termination fees
45
57
147
Gain on sales of SBA loans
27
83
183
633
Gain on proceeds from company-owned life insurance
396
462
Gain on warrants
637
Other
513
412
982
768
Total noninterest income
2,098
2,169
4,558
4,470
Noninterest expense:
Salaries and employee benefits
13,476
12,572
27,297
26,530
Occupancy and equipment
2,277
2,247
4,714
4,521
Professional fees
1,291
1,771
2,371
3,490
6,146
9,185
12,060
14,478
Total noninterest expense
23,190
25,775
46,442
49,019
Income before income taxes
20,968
11,763
38,964
27,290
Income tax expense
6,147
2,950
11,277
7,273
Net income
14,821
8,813
27,687
20,017
Earnings per common share:
Basic
0.24
0.15
0.46
0.33
Diluted
0.45
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Other comprehensive income (loss):
Change in net unrealized holding (losses) gains on available-for-sale
securities and I/O strips
(2,724)
(640)
(7,129)
(1,489)
Deferred income taxes
790
186
2,067
433
Change in net unamortized unrealized gain on securities available-for-
sale that were reclassified to securities held-to-maturity
(13)
(26)
Change in unrealized (losses) gains on securities and I/O strips, net of
deferred income taxes
(1,934)
(463)
(5,062)
(1,074)
Change in net pension and other benefit plan liability adjustment
103
283
207
372
(33)
(84)
(67)
(113)
Change in pension and other benefit plan liability, net of
70
199
140
259
Other comprehensive loss
(1,864)
(264)
(4,922)
(815)
Total comprehensive income
12,957
8,549
22,765
19,202
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Accumulated
Total
Common Stock
Retained
Comprehensive
Shareholders’
Shares
Amount
Earnings
Loss
Equity
Balance, January 1, 2021
59,917,457
493,707
94,899
(10,717)
577,889
11,204
(551)
Issuance (forfeitures) of restricted stock awards, net
(34,358)
Amortization of restricted stock awards,
net of forfeitures and taxes
Cash dividend declared $0.13 per share
(7,789)
Stock option expense, net of forfeitures and taxes
132
Stock options exercised
49,235
320
Balance March 31, 2021
59,932,334
494,617
98,314
(11,268)
581,663
Issuance of restricted stock awards, net
187,325
438
(7,816)
146
83,107
464
Balance, June 30, 2021
60,202,766
495,665
99,311
(11,532)
583,444
Balance, January 1, 2022
60,339,837
12,866
(3,058)
518
(7,848)
149
68,009
401
Balance March 31, 2022
60,407,846
498,763
116,347
(14,054)
601,056
189,305
477
(7,858)
144
69,643
448
Balance June 30, 2022
60,666,794
CONSOLIDATED STATEMENTS OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of discounts and premiums on securities
910
1,969
Gain on sale of SBA loans
(183)
(633)
Proceeds from sale of SBA loans originated for sale
2,452
6,676
SBA loans originated for sale
(2,663)
(8,688)
(960)
(914)
Depreciation and amortization
508
Amortization of other intangible assets
1,317
1,487
Stock option expense, net
293
278
Amortization of restricted stock awards, net
995
896
Amortization of subordinated debt issuance costs
96
92
(27)
(462)
Effect of changes in:
1,954
(1,574)
(5,159)
3,472
Net cash provided by operating activities
26,532
21,119
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of securities available-for-sale
(250,997)
Purchase of securities held-to-maturity
(119,447)
(181,805)
Maturities/paydowns/calls of securities available-for-sale
14,056
87,503
Maturities/paydowns/calls of securities held-to-maturity
53,201
56,797
Purchase of mortgage loans
(74,544)
(140,030)
Net change in loans
82,846
(63,944)
Changes in Federal Home Loan Bank stock and other investments
(9)
1,027
Purchase of premises and equipment
(522)
(89)
Proceeds from redemption of company-owned life insurance
604
1,506
Net cash (used in) investing activities
(294,812)
(239,035)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits
(145,768)
429,986
Exercise of stock options
849
784
Payment of cash dividends
(15,706)
(15,605)
Redemption of subordinated debt
(40,000)
Issuance of subordinated debt, net of issuance costs
Net cash (used-in) provided by financing activities
(161,351)
415,165
Net increase in cash and cash equivalents
(429,631)
197,249
Cash and cash equivalents, beginning of period
1,131,073
Cash and cash equivalents, end of period
1,328,322
Supplemental disclosures of cash flow information:
Interest paid
3,321
3,464
Income taxes paid, net
12,153
9,192
Supplemental schedule of non-cash activity:
Transfer of loans held-for-sale to loan portfolio
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2022
1) Basis of Presentation
The unaudited consolidated financial statements of Heritage Commerce Corp (the “Company” or “HCC”) and its wholly owned subsidiary, Heritage Bank of Commerce (the “Bank” or “HBC”), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company’s Form 10-K for the year ended December 31, 2021.
HBC is a commercial bank serving customers primarily located in Alameda, Contra Costa, Marin, San Benito, San Francisco, San Mateo, and Santa Clara counties of California. CSNK Working Capital Finance Corp. a California corporation, dba Bay View Funding (“Bay View Funding”) is a wholly owned subsidiary of HBC, and provides business-essential working capital factoring financing to various industries throughout the United States. No customer accounts for more than 10% of revenue for HBC or the Company. The Company reports its results for two segments: banking and factoring. The Company’s management uses segment results in its operating and strategic planning.
In management’s opinion, all adjustments necessary for a fair presentation of these consolidated financial statements have been included and are of a normal and recurring nature. All intercompany transactions and balances have been eliminated.
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 periods. Actual results could differ significantly from these estimates. Material estimates that are particularly susceptible to significant change include the determination of the allowance for credit losses and any impairment of goodwill or intangible assets. It is reasonably possible the Company’s estimate of the allowance for credit losses and evaluation of impairment of goodwill or intangible assets could change as a result of the continued impact of the COVID-19 pandemic on the economy. The resulting change in these estimates could be material to the Company’s consolidated financial statements.
The results for the three and six months ended June 30, 2022 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2022.
Reclassifications
Certain reclassifications of prior year balances have been made to conform to the current year presentation. These reclassifications had no impact on the Company’s consolidated financial position, results of operations or net change in cash and cash equivalents.
Accounting Guidance Issued But Not Yet Adopted
In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The ASU provides optional expedients and exceptions for applying GAAP to loan and lease agreements, derivative contracts, and other transactions affected by the anticipated transition away from London Inter-Bank Offered Rate (“LIBOR”) toward new interest rate benchmarks. For transactions that are modified because of reference rate reform and that meet certain scope guidance (i) modifications of loan agreements should be accounted for by prospectively adjusting the effective interest rate and the modification will be considered "minor" so that any existing unamortized origination fees/costs would carry forward and continue to be amortized and (ii) modifications of lease agreements should be accounted for as a continuation of the existing agreement with no reassessments of the lease classification and the discount rate or remeasurements of lease payments that otherwise would be required for modifications not accounted for as separate contracts. ASU 2020-04 also provides numerous optional expedients for derivative accounting. ASU 2020-04 is effective March 12, 2020 through December 31, 2022. An
entity may elect to apply ASU 2020-04 for contract modifications as of January 1, 2020, or prospectively from a date within an interim period that includes or is subsequent to March 12, 2020, up to the date that the financial statements are available to be issued. Once elected for a Topic or an Industry Subtopic within the Codification, the amendments in this ASU must be applied prospectively for all eligible contract modifications for that Topic or Industry Subtopic. The Company does not expect any material impact on its consolidated financial statements since the Company has an insignificant number of financial instruments applicable to this ASU.
In March 2022, the FASB issued ASU No. 2022-02 Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restrucurings and Vintage Disclosures, which 1) eliminates the accounting guidance for troubled debt restructurings ("TDRs") by creditors while enhancing the disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty; and 2) requires that an entity disclose current-period gross writeoffs by year of origination for financing receivables and net investments in leases. ASU 2022-02 is effective for fiscal years beginning after December 15, 2022 and the amendments should be applied prospectively, although the entity has the option to apply a modified retrospective transition method for the recognition and measurement of TDRs, resulting in a cumulative-effect adjustment to retained earnings in the period of adoption. The Company is currently evaluating the impact of adopting the new guidance on its consolidated financial statements.
2) Earnings Per Share
Basic earnings per common share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflect potential dilution from outstanding stock options using the treasury stock method. There were 1,389,250 weighted average stock options outstanding for both the three months and six months ended June 30, 2022 considered to be antidilutive and excluded from the computation of diluted earnings per share. There were 1,057,945 weighted average stock options outstanding for the three months ended June 30, 2021 considered to be antidilutive and excluded from the computation of diluted earnings per share, and 1,072,945 for the six months ended June 30, 2021. A reconciliation of these factors used in computing basic and diluted earnings per common share is as follows:
Weighted average common shares outstanding for basic
earnings per common share
60,542,170
60,089,327
60,468,027
60,008,071
Dilutive potential common shares
426,984
640,814
477,684
564,386
Shares used in computing diluted earnings per common share
60,969,154
60,730,141
60,945,711
60,572,457
Basic earnings per share
Diluted earnings per share
11
3) Accumulated Other Comprehensive Income (Loss) (“AOCI”)
The following table reflects the changes in AOCI by component for the periods indicated:
Three Months Ended June 30, 2022 and 2021
Unamortized
Unrealized
Gain on
Gains (Losses) on
Available-
for-Sale
Defined
Securities
Benefit
Reclassified
Pension
and I/O
to Held-to-
Plan
Strips
Maturity
Items(1)
Beginning balance April 1, 2022, net of taxes
(975)
(13,079)
Other comprehensive (loss) before reclassification,
net of taxes
(3)
(1,937)
Amounts reclassified from other comprehensive income,
73
Net current period other comprehensive income (loss),
Ending balance June 30, 2022, net of taxes
(2,909)
(13,009)
Beginning balance April 1, 2021, net of taxes
3,327
252
(14,847)
Other comprehensive income (loss) before reclassification,
(454)
51
(403)
Amounts reclassified from other comprehensive income (loss),
148
Ending balance June 30, 2021, net of taxes
2,873
243
(14,648)
12
Six Months Ended June 30, 2022 and 2021
Beginning balance January 1, 2022, net of taxes
2,153
(13,149)
Other comprehensive loss before reclassification,
(6)
(5,068)
Beginning balance January 1, 2021, net of taxes
3,929
261
(14,907)
(1,056)
(2)
(1,058)
(18)
13
Amounts Reclassified from
AOCI
Affected Line Item Where
Details About AOCI Components
Net Income is Presented
Amortization of unrealized gain on securities available-
for-sale that were reclassified to securities
held-to-maturity
Interest income on taxable securities
(4)
Net of tax
Amortization of defined benefit pension plan items (1)
Prior transition obligation and actuarial losses (2)
1
Prior service cost and actuarial losses (3)
(114)
(211)
(104)
(210)
Other noninterest expense
31
62
Income tax benefit
(73)
(148)
Total reclassification from AOCI for the period
(139)
Amortization of unrealized gain on securities
available-for-sale that were reclassified to securities
26
(8)
18
21
(228)
(372)
(207)
(370)
61
109
(146)
(261)
(243)
14
4) Securities
The amortized cost and estimated fair value of securities were as follows for the periods indicated:
Gross
Allowance
Estimated
Amortized
for Credit
Fair
Cost
Gains
(Losses)
Losses
Value
Securities available-for-sale:
U.S. Treasury
251,365
224
(1,463)
250,126
Agency mortgage-backed securities
84,952
(2,951)
82,003
336,317
226
(4,414)
Unrecognized
Securities held-to-maturity:
683,779
(72,491)
611,289
Municipals - exempt from Federal tax
39,976
86
39,540
(39)
723,755
87
(73,013)
650,829
December 31, 2021
99,359
2,893
607,377
3,157
(4,752)
605,782
51,063
804
51,867
(43)
658,440
3,961
657,649
Securities with unrealized losses at June 30, 2022 and December 31, 2021, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are as follows:
Less Than 12 Months
12 Months or More
218,960
81,550
300,510
580,869
(66,582)
29,473
(5,909)
610,342
Municipals — exempt from Federal tax
23,120
603,989
(67,104)
633,462
15
408,856
(3,319)
27,997
(1,433)
436,853
There were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders’ equity. At June 30, 2022, the Company held 430 securities (144 available-for-sale and 286 held-to-maturity), of which 366 had fair value below amortized cost. At June 30, 2022, there were $218,960,000 of U.S. Treasury securities available-for-sale, and $81,550,000 of agency mortgage-backed securities available-for-sale, carried with an unrealized loss for less than 12 months. At June 30, 2022, there were $580,869,000 of agency mortgage-backed securities held-to-maturity, and $23,120,000 of municipal securities, carried with an unrealized loss for less than 12 months, and $29,473,000 of agency mortgage-backed securities held-to-maturity, carried with an unrealized loss for 12 months or more. The total unrealized loss for securities carried less than 12 months was ($71,518,000), and the total unrealized loss for securities carried for 12 months or more was ($5,909,000) at June 30, 2022. The unrealized loss was due to higher interest rates in comparison to when the security was purchased. The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline. The Company does not believe that it is more likely than not that the Company will be required to sell a security in an unrealized loss position prior to recovery in value. Therefore, the Company does not consider the agency mortgage-backed securities and U.S. Treasury securities to have credit-related losses as of June 30, 2022.
The amortized cost and estimated fair values of securities as of June 30, 2022 are shown by contractual maturity below. The expected maturities will differ from contractual maturities if borrowers have the right to call or pre-pay obligations with or without call or pre-payment penalties. Securities not due at a single maturity date are shown separately.
Available-for-sale
Fair Value
Due after one through five years
Held-to-maturity
Due after three months through one year
549
550
7,496
7,523
Due after five through ten years
26,335
25,970
Due after ten years
5,596
5,497
Securities with amortized cost of $63,885,000 and $42,473,000 as of June 30, 2022 and December 31, 2021 were pledged to secure public deposits and for other purposes as required or permitted by law or contract.
The table below presents a roll-forward by major security type for the six months ended June 30, 2022 of the allowance for credit losses on debt securities held-to-maturity held at period end:
Municipals
Beginning balance January 1, 2022
Provision for (recapture of) credit losses
Ending balance June 30, 2022
39
16
For the six months ended June 30, 2022, there was a reduction of $4,000 to the allowance for credit losses on the Company’s held-to-maturity municipal investment securities portfolio. This reduction was the result of a reduction in municipal securities amortized balances resulting from regular payments. The bond ratings for the Company’s municipal investment securities at June 30, 2022 were consistent with the ratings at December 31, 2021.
5) Loans and Allowance for Credit Losses on Loans
On January 1, 2020, the Company adopted the current expected credit loss (“CECL”) model under ASU 2016-13 (Topic 326) using the modified retrospective approach. The allowance for credit losses on loans is an estimate of the current expected credit losses in the loan portfolio. Loans are charged-off against the allowance when management determines that a loan balance has become uncollectible. Subsequent recoveries, if any, are credited to the allowance for credit losses on loans.
Management’s methodology for estimating the allowance balance consists of several key elements, which include pooling loans with similar characteristics into segments and using a discounted cash flow calculation to estimate losses. The discounted cash flow model inputs include loan level cash flow estimates for each loan segment based on peer and bank historic loss correlations with certain economic factors. Management uses a four quarter forecast of each economic factor that is used for each loan segment and the economic factors are assumed to revert to the historic mean over an eight quarter period after the forecast period. The economic factors management has selected include the California unemployment rate, California gross domestic product, California home price index, and a national CRE value index. These factors are evaluated and updated occasionally and as economic conditions change. Additionally, management uses qualitative adjustments to the discounted cash flow quantitative loss estimates in certain cases when management has assessed an adjustment is necessary. These qualitative adjustments are applied by pooled loan segment and have been made for increased risk due to loan quality trends, collateral risk, or other risks management determines are not adequately captured in the discounted cash flow loss estimation. Specific allowances on individually evaluated loans are combined to the allowance on pools of loans with similar risk characteristics to derive to total allowance for credit losses on loans.
Management has also considered other qualitative risks such as collateral values, concentrations of credit risk (geographic, large borrower, and industry), economic conditions, changes in underwriting standards, experience and depth of lending staff, trends in delinquencies, and the level of criticized loans to address asset-specific risks and current conditions that were not fully considered by the macroeconomic variables driving the quantitative estimate.
The allowance for credit losses on loans was calculated by pooling loans of similar credit risk characteristics and credit monitoring procedures. The loan portfolio is classified into eight segments of loans - commercial, commercial real estate – owner occupied, commercial real estate – non-owner occupied, land and construction, home equity, multifamily, residential mortgages and consumer and other.
The risk characteristics of each loan portfolio segment are as follows:
Commercial
Commercial loans primarily rely on the identified cash flows of the borrower for repayment and secondarily on the underlying collateral provided by the borrower. However, the cash flows of the borrowers 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, inventory or equipment and may incorporate a personal guarantee; however, some loans may be unsecured. Included in commercial loans are $8,153,000 of Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) loans at June 30, 2022, and $88,726,000 at December 31, 2021. No allowance for credit losses has been recorded for PPP loans as they are fully guaranteed by the SBA.
Commercial Real Estate (“CRE”)
CRE loans rely primarily on the cash flows of the properties securing the loan and secondarily on the value of the property that is securing the loan. CRE loans comprise two segments differentiated by owner occupied CRE and non-owner CRE. Owner occupied CRE loans are secured by commercial properties that are at least 50% occupied by the borrower or borrower affiliate. Non-owner occupied CRE loans are secured by commercial properties that are less than
17
50% occupied by the borrower or borrower affiliate. CRE loans may be adversely affected by conditions in the real estate markets or in the general economy.
Land and Construction
Land and construction loans are generally based on estimates of costs and value associated with the complete project. Construction loans usually involve the disbursement of funds with repayment substantially dependent on the success of the completion of the project. Sources of repayment for these loans may be permanent loans from HBC or other lenders, or proceeds from the sales of the completed project. These loans are monitored by on-site inspections and are considered to have higher risk than other real estate loans due to the final repayment dependent on numerous factors including general economic conditions.
Home Equity
Home equity loans are secured by 1-4 family residences that are generally owner occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily on the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values. These loans are generally revolving lines of credit.
Multifamily
Multifamily loans are loans on residential properties with five or more units. These loans rely primarily on the cash flows of the properties securing the loan for repayment and secondarily on the value of the properties securing the loan. The cash flows of these borrowers can fluctuate along with the values of the underlying property depending on general economic conditions.
Residential Mortgages
Residential mortgage loans are secured by 1-4 family residences which are generally owner-occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily on the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values. These are generally term loans and are acquired.
Consumer and Other
Consumer and other loans are secured by personal property or are unsecured and rely primarily on the income of the borrower for repayment and secondarily on the collateral value for secured loans. Borrower income and collateral values can vary depending on economic conditions.
Loan Distribution
Loans by portfolio segment and the allowance for credit losses on loans were as follows for the periods indicated:
Loans held-for-investment:
531,421
682,834
Real estate:
CRE - owner occupied
597,521
595,934
CRE - non-owner occupied
993,621
902,326
Land and construction
155,389
147,855
Home equity
116,641
109,579
221,938
218,856
Residential mortgages
448,958
416,660
Consumer and other
18,354
16,744
Loans
3,083,843
3,090,788
Deferred loan fees, net
(1,391)
(3,462)
Changes in the allowance for credit losses on loans were as follows for the periods indicated:
Three Months Ended June 30, 2022
CRE
Owner
Non-owner
Land &
Home
Multi-
Residential
Consumer
Occupied
Construction
Family
Mortgage
and Other
Beginning of period balance
6,801
6,397
19,413
2,006
722
2,544
4,757
42,788
Charge-offs
(355)
Recoveries
79
3,124
3,238
Net recoveries
(276)
2,883
(392)
2,061
492
(58)
280
475
(3,116)
End of period balance
6,602
6,009
21,474
2,498
695
2,824
5,232
156
45,490
Three Months Ended June 30, 2021
11,600
8,368
16,431
2,754
1,171
2,751
918
303
44,296
(105)
115
68
55
258
153
(753)
(166)
54
(686)
(118)
1,050
10,857
8,206
16,485
2,136
1,069
1,968
285
43,956
Six Months Ended June 30, 2022
8,414
7,954
17,125
1,831
864
2,796
4,132
174
43,290
(371)
133
3,319
(238)
2,948
(1,952)
4,349
667
(224)
28
1,100
(3,142)
19
Six Months Ended June 30, 2021
11,587
8,560
16,416
2,509
1,297
2,804
943
284
44,400
(368)
928
884
1,929
Net (charge-offs) recoveries
560
1,561
(1,290)
(362)
69
(1,257)
(267)
1,025
(69)
The following tables present the amortized cost basis of nonperforming loans and loans past due over 90 days and still accruing at the periods indicated:
Restructured
Nonaccrual
and Loans
with no Specific
with Specific
over 90 Days
Allowance for
Past Due
Credit
and Still
Accruing
222
418
1,558
CRE - Owner Occupied
1,094
63
1,316
981
2,715
94
1,028
1,400
1,126
84
1,128
2,432
3,738
20
The following tables present the aging of past due loans by class for the periods indicated:
30 - 59
60 - 89
90 Days or
Days
Greater
Current
6,449
1,691
991
9,130
522,291
596,427
CRE - Non-Owner Occupied
2,085
10,224
3,073,619
2,714
168
408
3,290
679,544
594,808
599
416,061
3,313
1,534
5,015
3,085,773
Past due loans 30 days or greater totaled $10,224,000 and $5,015,000 at June 30, 2022 and December 31, 2021, respectively, of which $1,316,000 and $1,258,000 were on nonaccrual, at June 30, 2022 and December 31, 2021, respectively. At June 30, 2022, there were also $418,000 of loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2021, there were also $2,202,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. Management’s classification of a loan as “nonaccrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt.
Credit Quality Indicators
Concentrations of credit risk arise when a number of customers are engaged in similar business activities, or activities in the same geographic region, or have similar features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. The Company’s loan portfolio is concentrated in commercial (primarily manufacturing, wholesale, and service) and real estate lending, with the remaining balance in consumer loans. While no specific industry concentration is considered significant, the Company’s lending operations are located in the Company’s market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company’s borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers’ ability to repay their loans.
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, and other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis is performed on a quarterly basis. Nonclassified loans generally include those loans
that are expected to be repaid in accordance with their contractual loan terms. Loans categorized as special mention have potential weaknesses that may, if not checked or corrected, weaken the credit or inadequately protect the Company’s position at some future date. These loans pose elevated risk, but their weaknesses do not yet justify a substandard classification. Classified loans are those loans that are assigned a substandard, substandard-nonaccrual, or doubtful risk rating using the following definitions:
Special Mention. A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in a deterioration of the repayment prospects for the asset or in the credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that will jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Substandard-Nonaccrual. Loans classified as substandard-nonaccrual are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any, and it is probable that the Company will not receive payment of the full contractual principal and interest. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. In addition, the Company no longer accrues interest on the loan because of the underlying weaknesses.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loss. Loans classified as loss are considered uncollectable or of so little value that their continuance as assets is not warranted. This classification does not necessarily mean that a loan has no recovery or salvage value; but rather, there is much doubt about whether, how much, or when the recovery would occur. Loans classified as loss are immediately charged off against the allowance for credit losses on loans. Therefore, there is no balance to report as of June 30, 2022 and December 31, 2021.
Loans may be reviewed at any time throughout a loan’s duration. If new information is provided, a new risk assessment may be performed if warranted.
The following tables present term loans amortized cost by vintage and loan grade classification, and revolving loans amortized cost by loan grade classification at June 30, 2022 and December 31, 2021. The loan grade classifications are based on the Bank’s internal loan grading methodology. Loan grade categories for doubtful and loss rated loans are not included on the tables below as there are no loans with those grades at June 30, 2022 and December 31, 2021. The vintage year represents the period the loan was originated or in the case of renewed loans, the period last renewed. The amortized balance is the loan balance less any purchase discounts, plus any loan purchase premiums. The loan categories are based on the loan segmentation in the Company's CECL reserve methodology based on loan purpose and type.
22
Revolving
Term Loans Amortized Cost Basis by Originated Period as of June 30, 2022
2017 and
06/30/2022
12/31/2021
12/31/2020
12/31/2019
12/31/2018
Prior
Basis
Commercial:
Pass
95,919
53,413
45,686
9,416
9,239
9,031
270,442
493,146
Special Mention
2,500
5,660
479
111
400
318
22,197
31,665
Substandard
463
223
610
4,584
5,970
Substandard-Nonaccrual
-
474
640
98,423
60,010
46,445
10,137
9,675
9,508
297,223
CRE - Owner Occupied:
68,066
162,615
123,243
57,289
45,689
112,933
8,080
577,915
5,738
5,924
409
12,278
825
3,138
1,458
813
6,234
68,891
168,353
133,399
47,354
114,155
CRE - Non-Owner Occupied:
194,717
363,614
126,203
110,251
15,443
171,247
2,601
984,076
353
757
2,712
6,076
8,788
129,319
177,676
Land and construction:
77,361
68,164
7,778
2,080
Home equity:
35
116,370
116,405
236
116,462
Multifamily:
19,789
99,389
27,610
26,351
15,362
22,280
50
210,831
1,099
4,263
5,362
5,745
106,233
30,614
Residential mortgage:
79,470
318,949
16,733
7,534
2,934
23,116
448,736
23,338
Consumer and other:
514
23
1,395
872
15,477
Total loans
538,724
1,085,837
361,284
217,928
92,198
347,973
439,899
Risk Grades:
535,395
1,066,658
347,253
212,944
90,097
339,479
413,026
3,004,852
12,497
6,807
4,374
607
1,080
50,062
829
6,208
6,073
1,468
7,331
4,676
27,195
1,151
1,734
Grand Total
Term Loans Amortized Cost Basis by Originated Period as of December 31, 2021
2020
2019
2018
2017
Prior Periods
208,645
65,257
15,086
12,281
7,311
5,507
349,717
663,804
2,210
512
219
764
204
4,024
8,176
3,709
930
302
4,776
9,732
595
442
37
48
1,122
215,159
67,141
15,342
13,058
7,856
5,761
358,517
170,504
135,103
65,596
57,017
31,657
107,203
14,486
581,566
2,254
672
355
3,849
985
6,042
1,477
889
9,393
172,057
144,499
66,268
58,494
108,473
374,470
141,404
115,170
45,959
68,125
134,454
2,068
881,650
5,388
1,133
3,816
10,337
5,842
4,497
10,339
152,634
69,258
142,767
125,844
11,401
4,385
1,300
3,566
146,496
1,359
127,203
46
106,738
106,784
1,931
726
780
109,395
102,535
27,955
30,820
16,151
16,261
13,895
207,617
5,804
4,307
10,111
109,467
35,127
360,424
17,875
8,065
3,070
6,015
19,967
415,416
1,244
21,211
491
40
1,426
1,000
13,756
16,729
506
1,359,286
421,591
244,397
138,204
131,061
294,461
501,788
Risk Grades:.
1,342,913
398,997
239,162
135,950
129,383
283,326
490,331
3,020,062
9,941
8,154
5,198
1,376
5,619
5,955
37,007
4,709
12,814
1,490
5,442
5,502
30,259
1,723
1,626
3,460
24
The amortized cost basis of collateral-dependent loans by business assets was $446,000 and $1,028,000 at June 30, 2022 and December 31, 2021, respectfully.
When management determines that foreclosures are probable, expected credit losses for collateral-dependent loans are based on the fair value of the collateral at the reporting date, adjusted for selling costs as appropriate. For loans for which foreclosure is not probable, but for which repayment is expected to be provided substantially through the operation or sale of the collateral and the borrower is experiencing financial difficulty, management has elected the practical expedient under ASC 326 to estimate expected credit losses based on the fair value of collateral, adjusted for selling costs as appropriate. The class of loan represents the primary collateral type associated with the loan. Significant quarter over quarter changes are reflective of changes in nonaccrual status and not necessarily associated with credit quality indicators like appraisal value.
The book balance of troubled debt restructurings at June 30, 2022 was $177,000 of accruing loans. The book balance of troubled debt restructurings at December 31, 2021 was $500,000 which included $372,000 of nonaccrual loans and $128,000 of accruing loans. There were no specific reserves established with respect to these loans as of June 30, 2022, and approximately $290,000 in specific reserves were established with respect to these loans as of December 31, 2021.
There were no loans modified as a troubled debt restructuring during the six months ended June 30, 2022. There was one new loan with total recorded investment of $3,000 that was modified as a troubled debt restructuring during the six months ended June 30, 2021.
The following table presents loans by class modified as troubled debt restructurings for the period indicated:
During the Six Months Ended
June 30, 2021
Pre-modification
Post-modification
Number
Outstanding
of
Recorded
Troubled Debt Restructurings:
Contracts
Investment
A loan is considered to be in payment default when it is 30 days contractually past due under the modified terms. There were no defaults on troubled debt restructurings, within twelve months following the modification, during the six months ended June 30, 2022 and 2021.
A loan that is a troubled debt restructuring on nonaccrual status may return to accruing status after a period of at least six months of consecutive payments in accordance with the modified terms.
6) Goodwill and Other Intangible Assets
At June 30, 2022, the carrying value of goodwill was $167,631,000, which included $13,044,000 of goodwill related to its acquisition of Bay View Funding, $32,619,000 from its acquisition of Focus Business Bank, $13,819,000 from its acquisition of Tri-Valley Bank, $24,271,000 from its acquisition of United American Bank and $83,878,000 from its acquisition of Presidio Bank.
Goodwill impairment exists when a reporting unit’s carrying value exceeds its fair value, which is determined through a qualitative assessment whether it is more likely than not that the fair value of equity of the reporting unit exceeds the carrying value (“Step Zero”). If the qualitative assessment indicates it is more likely than not that the fair value of equity of a reporting unit is less than book value, then a quantitative two-step impairment test is required. Step 1
25
includes the determination of the carrying value of the Company’s reporting units, including the existing goodwill and intangible assets, and estimating the fair value of each reporting unit.
The Company completed its annual goodwill impairment analysis as of November 30, 2021 with the assistance of an independent valuation firm. The goodwill related to the acquisition of Bay View Funding was tested separately for impairment under this analysis. No events or circumstances since the November 30, 2021 annual impairment test were noted that would indicate it was more likely than not that a goodwill impairment exists, for either the Company’s banking or factoring reporting units.
The following table summarizes the carrying amount of goodwill by segment for the periods indicated:
Banking
154,587
Factoring
13,044
Total Goodwill
Other Intangible Assets
The Company’s intangible assets are summarized as follows for the periods indicated:
Carrying
Amortization
Core deposit intangibles
25,023
(13,205)
11,818
Customer relationship and brokered relationship intangibles
1,900
(1,456)
444
Below market leases
110
(21)
89
27,033
(14,682)
(11,982)
13,041
(1,361)
539
(22)
88
(13,365)
As of June 30, 2022, the estimated amortization expense for future periods is as follows:
Customer &
Below/
Core
Brokered
(Above)
Deposit
Relationship
Market
Year
Intangible
Lease
Expense
2022 remaining
1,224
95
(1)
1,318
2023
2,217
190
2,405
2024
2,023
159
2,187
2025
1,795
1,813
2026
1,512
1,530
2027
1,438
1,456
Thereafter
1,609
33
1,642
Impairment testing of the intangible assets is performed at the individual asset level. Impairment exists if the carrying amount of the asset is not recoverable and exceeds its fair value at the date of the impairment test. For intangible assets, estimates of expected future cash flows (cash inflows less cash outflows) that are directly associated with an
intangible asset are used to determine the fair value of that asset. Management makes certain estimates and assumptions in determining the expected future cash flows from core deposit and customer relationship intangibles including account attrition, expected lives, discount rates, interest rates, servicing costs and other factors. Significant changes in these estimates and assumptions could adversely impact the valuation of these intangible assets. If an impairment loss exists, the carrying amount of the intangible asset is adjusted to a new cost basis. The new cost basis is then amortized over the remaining useful life of the asset. Based on its assessment, management concluded that there was no impairment of intangible assets at June 30, 2022 and December 31, 2021.
7) Income Taxes
Some items of income and expense are recognized in one year for tax purposes, and another when applying generally accepted accounting principles, which leads to timing differences between the Company’s actual current tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the “deferred” portion of the Company’s tax expense or benefit, which is accumulated on the Company’s books as a deferred tax asset or deferred tax liability until such time as they reverse.
Under generally accepted accounting principles, a valuation allowance is required if it is “more likely than not” that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.
The Company had net deferred tax assets of $29,657,000 and $28,757,000, at June 30, 2022 and December 31, 2021, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax assets at June 30, 2022 and December 31, 2021 will be fully realized in future years.
The following table reflects the carrying amounts of the low income housing investments included in accrued interest receivable and other assets, and the future commitments included in accrued interest payable and other liabilities for the periods indicated:
Low income housing investments
3,959
4,380
Future commitments
The Company expects $55,000 of the future commitments to be paid in 2022, and $513,000 in 2023 through 2025.
For tax purposes, the Company had low income housing tax credits of $210,000 for both the three months ended June 30, 2022 and the three months ended June 30, 2021, and low income housing investment expense of $211,000 and $209,000, respectively. For tax purposes, the Company had low income housing tax credits of $420,000 for both the six months ended June 30, 2022 and for the six months ended June 30, 2021, and low income housing investment expense of $421,000 and $418,000, respectively. The Company recognized low income housing investment expense as a component of income tax expense.
8) Benefit Plans
Supplemental Retirement Plan
The Company has a supplemental retirement plan (the “Plan”) covering some current and some former key employees and directors. The Plan is a nonqualified defined benefit plan. Benefits are unsecured as there are no Plan assets. The following table presents the amount of periodic cost recognized for the periods indicated:
Components of net periodic benefit cost:
Service cost
120
240
Interest cost
216
432
380
Amortization of prior service cost
100
Amortization of net actuarial loss
114
136
228
272
Net periodic benefit cost
417
521
834
992
The components of net periodic benefit cost other than the service cost component are included in the line item “other noninterest expense” in the Consolidated Statements of Income.
Split-Dollar Life Insurance Benefit Plan
The Company maintains life insurance policies for some current and former directors and officers that are subject to split-dollar life insurance agreements. The following table sets forth the funded status of the split-dollar life insurance benefits for the periods indicated:
Change in projected benefit obligation:
Projected benefit obligation at beginning of year
9,244
9,689
123
Actuarial loss
(664)
Projected benefit obligation at end of period
9,367
Net actuarial loss
4,666
4,601
Prior transition obligation
835
879
5,501
5,480
Amortization of prior transition obligation and actuarial losses
(10)
102
108
9) Fair Value
Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data (for example, interest rates and yield curves observable at commonly quoted intervals, prepayment speeds, credit risks, and default rates).
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
Financial Assets and Liabilities Measured on a Recurring Basis
The fair values of securities available-for sale-are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).
The fair value of interest-only (“I/O”) strip receivable assets is based on a valuation model used by a third party. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs).
Fair Value Measurements Using
Significant
Quoted Prices in
Active Markets for
Observable
Unobservable
Identical Assets
Inputs
Balance
(Level 1)
(Level 2)
(Level 3)
Assets at June 30, 2022
Available-for-sale securities:
I/O strip receivables
173
Assets at December 31, 2021
221
There were no transfers between Level 1 and Level 2 during the period for assets measured at fair value on a recurring basis.
Assets and Liabilities Measured on a Non-Recurring Basis
The fair value of collateral dependent loans individually evaluated with specific allocations of the allowance for credit losses on loans is generally based on recent real estate appraisals. The appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. There were no material collateral dependent loans carried at fair value on a non-recurring basis at June 30, 2022 or December 31, 2021.
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Foreclosed assets are valued at the time the loan is foreclosed upon and the asset is transferred to foreclosed assets. The fair value is based primarily on third party appraisals, less costs to sell. The appraisals may utilize a single valuation approach or a combination of approaches including the comparable sales and income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. At June 30, 2022 and December 31, 2021, there were no foreclosed assets on the balance sheet.
The carrying amounts and estimated fair values of financial instruments at June 30, 2022 are as follows:
Estimated Fair Value
Amounts
Assets:
Cash and cash equivalents
Securities available-for-sale
Securities held-to-maturity
Loans (including loans held-for-sale), net
3,039,243
2,945,005
2,947,286
FHLB stock, FRB stock, and other
investments
Accrued interest receivable
11,679
587
1,724
9,368
I/O strips receivables
Time deposits
139,625
139,912
Other deposits
4,474,019
38,424
Accrued interest payable
423
The carrying amounts and estimated fair values of the Company’s financial instruments at December 31, 2021:
3,046,403
3,061,558
3,063,925
10,781
1,719
9,062
139,834
140,086
4,619,578
40,425
10) Equity Plan
The Company maintained an Amended and Restated 2004 Equity Plan (the “2004 Plan”) for directors, officers, and key employees. The 2004 Plan was terminated on May 23, 2013. On May 23, 2013, the Company’s shareholders approved the 2013 Equity Incentive Plan (the “2013 Plan”). On May 21, 2020, the shareholders approved an amendment
30
to the Heritage Commerce Corp 2013 Equity Incentive Plan to increase the number of shares available from 3,000,000 to 5,000,000 shares. The equity plans provide for the grant of incentive and nonqualified stock options and restricted stock. The equity plans provide that the option price for both incentive and nonqualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally, options vest over four years. All options expire no later than ten years from the date of grant. Restricted stock is subject to time vesting. For the six months ended June 30, 2022, the Company granted 370,000 shares of nonqualified stock options and 201,811 shares of restricted stock for the six months ended June 30, 2022. There were 1,433,941 shares available for the issuance of equity awards under the 2013 Plan as of June 30, 2022.
Stock option activity under the equity plans is as follows:
Weighted
Average
Remaining
Aggregate
Exercise
Contractual
Intrinsic
Total Stock Options
of Shares
Price
Life (Years)
Outstanding at January 1, 2022
2,584,632
10.00
Granted
370,000
11.03
Exercised
(137,652)
6.17
Forfeited or expired
(52,410)
12.78
Outstanding at June 30, 2022
2,764,570
10.27
5.79
4,134,577
Vested or expected to vest
2,598,696
3,886,502
Exercisable at June 30, 2022
1,954,421
4.46
3,905,368
Information related to the equity plans for the periods indicated:
Intrinsic value of options exercised
706,376
679,403
Cash received from option exercise
848,739
784,264
Tax benefit (expense) realized from option exercises
52,952
57,215
Weighted average fair value of options granted
2.18
2.33
As of June 30, 2022, there was $1,629,000 of total unrecognized compensation cost related to nonvested stock options granted under the equity plans. That cost is expected to be recognized over a weighted-average period of approximately 2.98 years.
Restricted stock activity under the equity plans is as follows:
Average Grant
Date Fair
Total Restricted Stock Award
Nonvested shares at January 1, 2022
298,566
201,811
11.09
Vested
(173,347)
11.98
(12,506)
10.93
Nonvested shares at June 30, 2022
314,524
11.04
As of June 30, 2022, there was $3,261,000 of total unrecognized compensation cost related to nonvested restricted stock awards granted under the equity plans. The cost is expected to be recognized over a weighted-average period of approximately 2.15 years.
11) Subordinated Debt
On May 11, 2022, the Company completed a private placement offering of $40,000,000 aggregate principal amount of its 5.00% fixed-to-floating rate subordinated notes due May 15, 2032 (“Sub Debt due 2032”). The Company used the net proceeds of the Sub Debt due 2032 for general corporate purposes, including the repayment on June 1, 2022
of the Company’s $40,000,000 aggregate principal amount of 5.25% fixed-to-floating rate subordinated notes due June 1, 2027 (“Sub Debt due 2027”). The Sub Debt due 2032, net of unamortized issuance costs of $726,000, totaled $39,274,000 at June 30, 2022, and qualifies as Tier 2 capital for the Company under the guidelines established by the Federal Reserve Bank
On May 26, 2017, the Company completed an underwritten public offering of $40,000,000 aggregate principal amount of its Sub Debt due 2027. The Sub Debt due 2027 had a fixed interest rate of 5.25% per year through June 1, 2022. On June 1, 2022, the Company completed the redemption of all of its outstanding $40,000,000 of Sub Debt due 2027, prior to resetting to a floating rate. The Sub Debt due 2027 was redeemed pursuant to the terms of the Subordinated Indenture, as supplemented by the First Supplemental Indenture, each dated as of May 26, 2017, between the Company and Wilmington Trust, National Association, as Trustee, at the redemption price of 100% of its principal amount, plus accrued and unpaid interest of $1,100,000.
.
12) Capital Requirements
The Company and its subsidiary bank are subject to various regulatory capital requirements administered by the banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory—and possibly additional discretionary—actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements and operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and HBC must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off balance sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
The Company’s consolidated capital ratios and the HBC’s capital ratios exceeded the regulatory guidelines for a well-capitalized financial institution under the Basel III regulatory requirements at June 30, 2022. There are no conditions or events since June 30, 2022, that management believes have changed the categorization of the Company or HBC as “well-capitalized.”
As permitted by the interim final rule issued on March 27, 2020 by our federal regulatory agency, we elected the option to delay the estimated impact of the adoption of the CECL Standard in our regulatory capital for two years. This two-year delay is in addition to the three-year transition period the agency had already made available. The adoption delayed the effects of CECL on our regulatory capital through the end of 2021. The effects are being phased-in over a three-year period from January 1, 2022 through December 31, 2024, with 75% recognized in 2022, 50% recognized in 2023, and 25% recognized in 2024. Under the interim final rule, the amount of adjustments to regulatory capital deferred until the phase-in period includes both the initial impact of adoption of the CECL Standard at January 1, 2020 and 25% of subsequent changes in our allowance for credit losses during each quarter of the two-year period ending December 31, 2021.
Quantitative measures established by regulation to help ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios (set forth in the tables below) of total, Tier 1 capital, and common equity Tier 1 capital (as defined in the regulations) to risk weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of June 30, 2022 and December 31, 2021, the Company and HBC met all capital adequacy guidelines to which they were subject.
32
The Company’s consolidated capital amounts and ratios are presented in the following table, together with capital adequacy requirements, under the Basel III regulatory requirements for the periods indicated:
Required For
Capital
Adequacy
Purposes
Actual
Under Basel III
Ratio
Ratio (1)
As of June 30, 2022
Total Capital
524,149
14.6
%
375,873
10.5
(to risk-weighted assets)
Tier 1 Capital
447,045
12.5
304,278
8.5
Common Equity Tier 1 Capital
250,582
7.0
8.7
206,102
4.0
(to average assets)
As of December 31, 2021
506,209
14.4
369,711
433,488
12.3
299,290
246,474
7.9
220,193
HBC’s actual capital amounts and ratios are presented in the following table, together with capital adequacy requirements, under the Basel III regulatory requirements for the periods indicated:
To Be Well-Capitalized
Under Basel III PCA Regulatory
Requirements
502,872
14.1
357,789
10.0
375,679
465,042
13.0
286,232
8.0
304,121
232,563
6.5
250,453
9.0
257,537
5.0
206,030
484,382
13.8
351,839
369,431
451,586
12.8
281,471
299,063
228,695
246,287
8.2
275,109
220,087
The Subordinated Debt, net of unamortized issuance costs, totaled $39,274,000 at June 30, 2022, and qualifies as Tier 2 capital for the Company under the guidelines established by the Federal Reserve Bank.
Under California General Corporation Law, the holders of common stock are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available. The California Financial Code provides that a state licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank’s retained earnings; or (ii) the bank’s net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Commissioner of the California Department of Financial Protection and Innovation (“DFPI”) may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank’s retained earnings; (ii) its net income for its last fiscal year; or (iii) its net income for the current fiscal year. Also with the prior approval of the Commissioner of the DFPI and the shareholders of the bank, the bank may make a distribution to its shareholders, as a reduction in capital of the bank. In the event that the Commissioner determines that the shareholders’ equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Commissioner may order a bank to refrain from making such a proposed distribution. As June 30, 2022, HBC would not be required to obtain regulatory approval, and the amount available for cash dividends is $33,140,000. HBC distributed to HCC dividends of $8,000,000, during the second and first quarters of 2022, for a total of $16,000,000.
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13) Commitments and Loss Contingencies
Loss Contingencies
Within the ordinary course of our business, we are subject to private lawsuits, government audits, administrative proceedings and other claims. A number of these claims may exist at any given time, and some of the claims may be pled as class actions. We could be affected by adverse publicity and litigation costs resulting from such allegations, regardless of whether they are valid or whether we are legally determined to be liable. A summary of proceedings outstanding at June 30, 2022 follows:
DC Solar Related:
Employee Related:
The Company makes a provision for a liability relating to legal matters when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, estimated settlements, legal rulings, advice of legal counsel and other information and events pertaining to a particular matter. The outcomes of legal proceedings and other contingencies are, however, inherently unpredictable and subject to significant uncertainties. As a result, the Company is not able to reasonably estimate the amount or range of possible losses, including losses that could arise as a result of application of non-monetary remedies, with respect to the contingencies it faces, and the Company’s estimates may not prove to be accurate.
At this time, we believe that the amount of reasonably possible losses resulting from final disposition of any pending lawsuits, audits, proceedings and claims will not have a material adverse effect individually or in the aggregate on our financial position, results of operations or liquidity. It is possible, however, that our future results of operations for a particular quarter or fiscal year could be impacted by changes in circumstances relating to lawsuits, proceedings or claims. Legal costs related to such claims are expensed as incurred.
Off-Balance Sheet Arrangements
In the normal course of business the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in the contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, but are not reflected on the Company’s consolidated balance sheets. Total unused commitments to extend credit were $1,149,568,000 at June 30, 2022, and $1,150,811,000 at December 31, 2021. Unused commitments represented 37% outstanding gross loans at both June 30, 2022, and December 31, 2021, 41% at June 30, 2021.
The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted because there is no certainty that lines of credit and letters of credit will ever be fully utilized. The following table presents the Company’s commitments to extend credit for the periods indicated:
Fixed
Variable
Rate
Unused lines of credit and commitments
to make loans
129,214
1,008,654
1,137,868
119,071
1,015,588
1,134,659
Standby letters of credit
3,902
7,798
11,700
3,084
13,068
16,152
133,116
1,016,452
1,149,568
122,155
1,028,656
1,150,811
For the six months ended June 30, 2022, there was an increase of $6,000 to the allowance for credit losses on the Company’s off-balance sheet credit exposures. The increase in the allowance for credit losses for off-balance sheet credit exposures in the first six months of 2022 was driven by higher loss factors as a result of a deteriorating economic outlook. The allowance for credit losses on the Company’s off-balance sheet credit exposures was $821,000 at June 30, 2022 and $815,000 at December 31, 2021.
14) Revenue Recognition
On January 1, 2018, the Company adopted ASU No. 2014-09 (Topic 606) and all subsequent ASUs that modified Topic 606. Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and securities. In addition, certain noninterest income streams such as fees associated with mortgage servicing rights, financial guarantees, gain on sale of securities, bank-owned life insurance, gain on sales of SBA loans, and certain credit card fees are also not in scope of the new guidance. Topic 606 is applicable to noninterest revenue streams such as deposit related fees, interchange fees, and merchant income. However, the recognition of these revenue streams did not change significantly upon adoption of Topic 606. Substantially all of the Company’s revenue is generated from contracts with customers. The following noninterest income revenue streams are in-scope of Topic 606:
36
Service charges and fees on deposit accounts consist of account analysis fees (i.e., net fees earned on analyzed business and public checking accounts), monthly service fees, check orders, and other deposit account related fees. We sometimes charge customers fees that are not specifically related to the customer accessing its funds, such as account maintenance or dormancy fees. The amount of deposit fees assessed varies based on a number of factors, such as the type of customer and account, the quantity of transactions, and the size of the deposit balance. We charge, and in some circumstances do not charge, fees to earn additional revenue and influence certain customer behavior. An example would be where we do not charge a monthly service fee, or do not charge for certain transactions, for customers that have a high deposit balance. Deposit fees are considered either transactional in nature (such as wire transfers, nonsufficient fund fees, and stop payment orders) or non-transactional (such as account maintenance and dormancy fees). These fees are recognized as earned or as transactions occur and services are provided. Check orders and other deposit account related fees are largely transactional based and, therefore, the Company’s performance obligation is satisfied, and related revenue recognized, at a point in time. Payment for service charges on deposit accounts is primarily received immediately or in the following month through a direct charge to customers’ accounts.
The Company currently accounts for sales of foreclosed assets in accordance with Topic 360-20. In most cases the Company will seek to engage a real estate agent for the sale of foreclosed assets immediately upon foreclosure. However, in some cases, where there is clear demand for the property in question, the Company may elect to allow for a marketing period on no more than six months to attempt a direct sale of the property. We generally recognize the sale, and any associated gain or loss, of a real estate property when control of the property transfers. Any gains or losses from the sale are recorded to noninterest income/expense.
The following presents noninterest income, segregated by revenue streams in-scope and out-of-scope of Topic 606, for the periods indicated:
Noninterest Income In-scope of Topic 606:
Total noninterest income in-scope of Topic 606
Noninterest Income Out-of-scope of Topic 606
1,231
1,510
3,079
3,210
15) Noninterest Expense
The following table sets forth the various components of the Company’s noninterest expense for the periods indicated:
Insurance expense
1,043
661
2,086
1,324
Data processing
681
583
1,332
1,117
Amortization of intangible assets
658
754
Client services
530
348
938
652
Software subscriptions
501
874
977
Reserve for litigation
4,000
2,772
2,338
5,513
4,921
16) Leases
The Company recognizes the following for all leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use (“ROU”) asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. The Company is impacted as a lessee of the offices and real estate used for operations. The Company's lease agreements include options to renew at the Company's option. No lease extensions are reasonably certain to be exercised, therefore it was not considered in the calculation of the ROU asset and lease liability. As of June 30, 2022, operating lease ROU assets, included in other assets, and lease liabilities, included in other liabilities, totaled $32,434,000.
The following table presents the quantitative information for the Company’s leases for the periods indicated:
Operating Lease Cost (Cost resulting from lease payments)
1,620
1,621
3,240
3,292
Operating Lease - Operating Cash Flows (Fixed Payments)
1,235
1,220
2,445
2,406
Operating Lease - ROU assets
32,434
36,601
Operating Lease - Liabilities
Weighted Average Lease Term - Operating Leases
7.03 yrs
7.79 yrs
Weighted Average Discount Rate - Operating Leases
4.50%
4.48%
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The following maturity analysis shows the undiscounted cash flows due on the Company’s operating lease liabilities as of June 30, 2022:
3,170
5,724
5,340
4,929
4,357
14,654
Total undiscounted cash flows
38,174
Discount on cash flows
(5,740)
Total lease liability
17) Business Segment Information
The following presents the Company’s operating segments. The Company operates through two business segments: Banking segment and Factoring segment. Transactions between segments consist primarily of borrowed funds. Intersegment interest expense is allocated to the Factoring segment based on the Company’s prime rate and funding costs. The provision for credit losses on loans is allocated based on the segment’s allowance for loan loss determination which considers the effects of charge-offs. Noninterest income and expense directly attributable to a segment are assigned to it. Taxes are paid on a consolidated basis and allocated for segment purposes. The Factoring segment includes only factoring originated by Bay View Funding.
Banking (1)
Consolidated
Interest income
40,427
3,129
Intersegment interest allocations
321
(321)
Net interest income
39,071
2,808
(328)
Net interest income after provision
39,399
2,661
Noninterest income
1,974
124
Noninterest expense
21,559
1,631
Intersegment expense allocations
128
(128)
19,942
1,026
5,844
14,098
723
5,280,953
75,888
3,019,076
63,376
(1) Includes the holding company’s results of operations
33,860
202
(202)
32,306
2,570
Provision (recapture) for credit losses on loans
(486)
(7)
32,792
2,577
2,049
24,331
1,444
127
(127)
10,637
2,617
333
8,020
793
5,003,894
68,981
5,072,875
2,777,685
47,111
2,824,796
77,540
5,922
558
(558)
74,736
5,364
(867)
119
75,603
5,245
4,372
43,326
3,116
242
(242)
36,891
2,073
10,664
613
26,227
1,460
67,971
5,422
413
(413)
64,825
5,009
(1,949)
(56)
66,774
5,065
4,209
46,228
2,791
233
(233)
24,988
2,302
6,593
680
18,395
1,622
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18) Subsequent Events
On July 28, 2022, the Company announced that its Board of Directors declared a $0.13 per share quarterly cash dividend to holders of common stock. The dividend will be payable on August 25, 2022, to shareholders of record at the close of the business day on August 11, 2022.
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ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of Heritage Commerce Corp (the “Company” or “HCC”), its wholly-owned subsidiary, Heritage Bank of Commerce (“HBC” or the “Bank”), and HBC’s wholly-owned subsidiary, CSNK Working Capital Finance Corp., a California Corporation, dba Bay View Funding (“Bay View Funding”). This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of operations. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this report. Unless we state otherwise or the context indicates otherwise, references to the “Company,” “Heritage,” “we,” “us,” and “our,” in this Report on Form 10-Q refer to Heritage Commerce Corp and its subsidiaries.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are discussed in our Form 10-K for the year ended December 31, 2021. There have been no changes in the Company's application of critical accounting policies since December 31, 2021.
EXECUTIVE SUMMARY
This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company’s evaluation includes comparisons with peer group financial institutions and its own performance objectives established in the internal planning process.
The primary activity of the Company is commercial banking. The Company’s operations are located entirely in the general San Francisco Bay Area of California in the counties of Alameda, Contra Costa, Marin, San Benito, San Francisco, San Mateo, and Santa Clara. The Company’s market includes the cities of Oakland, San Francisco and San Jose and the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company’s customers are primarily closely held businesses and professionals.
Performance Overview
For the three months ended June 30, 2022, net income was $14.8 million, or $0.24 per average diluted common share, compared to $8.8 million, or $0.15 per average diluted common share, for the three months ended June 30, 2021. The Company’s annualized return on average tangible assets was 1.15% and annualized return on average tangible equity was 14.06% for the three months ended June 30, 2022, compared to 0.73% and 8.84%, respectively, for the three months ended June 30, 2021.
For the six months ended June 30, 2022, net income was $27.7 million, or $0.45 per average diluted common share, compared to $20.0 million, or $0.33 per average diluted common share, for the six months ended June 30, 2021. The Company’s annualized return on average tangible assets was 1.07% and annualized return on average tangible equity was 13.28% for the six months ended June 30, 2022, compared to 0.85% and 10.16%, respectively, for the six months ended June 30, 2021.
Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”)
In response to economic stimulus laws passed by Congress in 2020 and 2021, the Bank funded two rounds of SBA PPP loans totaling $530.8 million. At June 30, 2022, after accounting for loan payoffs and SBA loan forgiveness, Round 1 PPP loans were $43,000 and Round 2 PPP loans were $8.1 million. In total, the Bank had $8.2 million in outstanding PPP loan balances at June 30, 2022. The following table shows interest income, fee income and deferred origination costs generated by the PPP loans, and the PPP loan outstanding balances and related deferred fees and costs for the periods indicated:
At or For the Quarter Ended:
At or For the Six Months Ended:
PPP LOANS
(in $000’s, unaudited)
53
831
1,615
Fee income, net
493
2,211
1,876
1,839
5,276
546
2,529
2,707
2,038
6,891
PPP loans outstanding at period end:
Round 1
1,717
91,849
Round 2
8,110
87,009
194,612
8,153
88,726
286,461
Deferred fees outstanding at period end
(337)
(2,342)
(7,747)
Deferred costs outstanding at period end
189
869
(313)
(2,153)
(6,878)
Factoring Activities - Bay View Funding
Based in San Jose, California, Bay View Funding provides business-essential working capital factoring financing to various industries throughout the United States. The following table reflects selected financial information for Bay View Funding for the periods indicated:
Total factored receivables at period-end
Average factored receivables:
For the three months ended
64,085
48,993
For the six months ended
60,940
48,546
Total full time equivalent employees at period-end
Second Quarter 2022 Highlights
The following are important factors that impacted the Company’s results of operations:
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The following are important factors in understanding our current financial condition and liquidity position:
Well-capitalized
Heritage
Financial Institution
Basel III Minimum
Commerce
Bank of
Basel III PCA Regulatory
Regulatory
Capital Ratios
Corp
Guidelines
Requirement(1)
Tier 1 Leverage
RESULTS OF OPERATIONS
The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is noninterest income, which primarily consists of gains on the sale of loans, loan servicing fees, customer service charges and fees, the increase in the cash surrender value of life insurance, and gains on the sale of securities. The majority of the Company’s noninterest expenses are operating costs that relate to providing a full range of banking and lending services to our customers.
Net Interest Income and Net Interest Margin
The level of net interest income depends on several factors in combination, including yields on earning assets, the cost of interest-bearing liabilities, the relative volumes of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. To maintain its net interest margin the Company must manage the relationship between interest earned and paid.
The following Distribution, Rate and Yield table presents the average amounts outstanding for the major categories of the Company’s balance sheet, the average interest rates and amounts earned or paid thereon, and the resulting net interest margin on average interest earning assets for the periods indicated. Average balances are based on daily averages.
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Distribution, Rate and Yield
Interest
Income /
Yield /
Loans, gross (1)(2)
3,050,177
4.80
2,794,421
Securities — taxable
912,408
1.94
479,419
1.63
Securities — exempt from Federal tax (3)
40,447
343
3.40
62,257
511
3.29
982,579
0.96
1,341,987
0.25
Total interest earning assets
4,985,611
43,628
3.51
4,678,084
36,739
3.15
37,172
42,449
9,666
10,147
Goodwill and other intangible assets
180,391
183,283
Other assets
121,796
133,134
5,334,636
5,047,097
Liabilities and shareholders’ equity:
1,836,350
1,808,638
1,249,875
468
1,139,090
0.17
1,327,665
1,179,321
528
0.18
Time deposits — under $100
12,643
0.13
15,335
0.21
Time deposits — $100 and over
125,258
0.37
133,935
164
0.49
CDARS — interest-bearing demand, money
market and time deposits
27,645
0.03
31,236
Total interest-bearing deposits
2,743,086
2,498,917
0.19
4,579,436
0.10
4,307,555
0.11
48,425
4.40
39,802
5.81
Short-term borrowings
0.00
Total interest-bearing liabilities
2,791,527
2,538,747
0.28
Total interest-bearing liabilities and demand,
noninterest-bearing / cost of funds
4,627,877
4,347,385
0.16
Other liabilities
103,577
116,703
4,731,454
4,464,088
Shareholders’ equity
603,182
583,009
Total liabilities and shareholders’ equity
Net interest income / margin
41,951
3.38
34,983
3.00
Less tax equivalent adjustment
(72)
(107)
3,039,443
4.75
2,707,858
5.01
847,409
1.87
458,256
1.62
42,647
719
64,373
1,053
3.30
1,109,933
0.62
1,319,249
Total interest earning assets (3)
5,039,432
83,613
3.35
4,549,736
73,613
3.26
37,400
41,640
9,636
10,257
180,726
183,648
121,444
125,961
5,388,638
4,911,242
1,846,699
1,761,035
1,264,849
927
1,082,962
956
1,361,014
1,101
1,158,693
12,937
0.14
15,616
0.22
122,187
220
0.36
132,397
335
0.51
30,274
0.02
28,265
2,791,261
2,417,933
0.20
4,637,960
4,178,968
0.12
44,211
5.03
39,780
5.82
2,835,495
2,457,749
0.29
4,682,194
4,218,784
105,165
111,364
4,787,359
4,330,148
601,279
581,094
Net interest income (3) / margin
80,251
3.21
70,054
3.10
Less tax equivalent adjustment (3)
(151)
(220)
49
Volume and Rate Variances
The Volume and Rate Variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are equal to the change in rate times the change in average balance and are included below in the average volume column.
Three Months Ended June 30,
2022 vs. 2021
Increase (Decrease)
Due to Change in:
Net
Volume
Change
Income from the interest earning assets:
Loans, gross
3,097
3,099
2,088
375
2,463
Securities — exempt from Federal tax (1)
(185)
(168)
(872)
1,495
Total interest income on interest-earning assets
4,128
2,761
6,889
Expense from the interest-bearing liabilities:
(51)
58
(28)
(40)
(50)
CDARS — interest-bearing demand, money market
and time deposits
(140)
(46)
Total interest expense on interest-bearing liabilities
(262)
(79)
3,945
3,023
6,968
7,003
Six Months Ended June 30,
(3,492)
4,364
3,602
4,179
(366)
(334)
(652)
2,443
1,791
10,440
(440)
10,000
121
(150)
(29)
182
(16)
(99)
(115)
(156)
395
(592)
(197)
10,045
152
10,197
10,266
The Company’s FTE net interest margin, expressed as a percentage of average earning assets, increased 38 basis points to 3.38% for the second quarter of 2022, from 3.00% for the second quarter of 2021, primarily due to a shift in the mix of earning assets into higher yielding loans and investment securities, higher average yields on overnight funds, an increase in the accretion of the loan purchase discount into interest income from acquired loans, and a decline in the cost of funds, partially offset by lower interest and fees on PPP loans.
For the first six months of 2022, the FTE net interest margin increased 11 basis points to 3.21%, compared to 3.10% for the first six months of 2021, primarily due to higher average balances of loans and investment securities, higher average yields on investment securities and overnight funds, and a lower cost of funds, partially offset by lower interest and fees on PPP loans.
The following tables present the average balance of loans outstanding, interest income, and the average yield for the periods indicated:
For the Quarter Ended
Income
Yield
Loans, core bank
2,530,836
27,402
4.34
2,246,030
25,036
4.47
Prepayment fees
0.09
504
PPP loans
21,479
0.99
334,604
1.00
PPP fees, net
9.21
2.25
Asset-based lending
49,667
7.06
35,125
5.30
Bay View Funding factored receivables
19.58
22.69
Purchased residential mortgages
381,988
2,711
2.85
125,710
3.13
Purchased commercial ("CRE") loans
8,425
3.67
14,602
3.02
Loan fair value mark / accretion
(6,303)
1,250
(10,643)
865
Total loans (includes loans held-for-sale)
The average yield on the total loan portfolio remained flat at 4.80% for both the second quarter of 2022 and the second quarter of 2021, as an increase in the accretion of the loan purchase discount into interest income from acquired loans and higher yields on the asset-based lending portfolio, was offset by lower interest and fees on PPP loans, higher average balances of lower yielding purchased residential mortgages, declines in the average yields of the core bank loans and Bay View Funding factored receivables.
2,507,403
53,498
4.30
2,222,135
49,729
4.51
1,059
1,021
40,764
0.98
326,928
9.10
3.25
59,587
1,825
6.18
31,268
838
5.40
19.60
22.52
368,880
5,139
2.81
74,238
2.99
Purchased CRE loans
8,469
154
15,875
281
3.57
(6,600)
2,004
(11,132)
1,994
The average yield on the total loan portfolio decreased to 4.75% for the six months ended June 30, 2022, compared to 5.01% for the six months ended June 30, 2021, primarily due to an increase in the average balance of lower yielding purchased residential mortgages, and a decrease in interest and fees on PPP loans.
In aggregate, the remaining net purchase discount on total loans acquired from Focus, Tri-Valley, United American, and Presidio was $5.3 million at June 30, 2022.
52
The average cost of total deposits was 0.10% for the second quarter of 2022, compared to 0.11% for the second quarter of 2021. The average cost of total deposits was 0.10% for the six months ended June 30, 2022, compared to 0.12% for the six months ended June 30, 2021.
Net interest income, before provision for credit losses on loans, increased 20% to $41.9 million for the second quarter of 2022, compared to $34.9 million for the second quarter of 2021, primarily due to higher average balances of loans and investment securities, higher average yields on investment securities and overnight funds, an increase in the accretion of the loan purchase discount into interest income from acquired loans, and a lower cost of funds, partially offset by lower interest and fees on PPP loans. Net interest income increased 15% to $80.1 million for the first six months of 2022, compared to $69.8 million for the first six months of 2021, primarily due to higher average balances of loans and investment securities, higher average yields on investment securities and overnight funds, and a lower cost of funds, partially offset by lower interest and fees on PPP loans.
Provision for Credit Losses on Loans
Credit risk is inherent in the business of making loans. The Company establishes an allowance for credit losses on loans through charges to earnings, which are presented in the statements of income as the provision for credit losses on loans. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for credit losses on loans is determined by conducting a quarterly evaluation of the adequacy of the Company’s allowance for credit losses on loans and charging the shortfall or excess, if any, to the current quarter’s expense. This has the effect of creating variability in the amount and frequency of charges to the Company’s earnings. The provision for credit losses on loans and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company’s market area. The provision for credit losses on loans and level of allowance for each period are also dependent on forecast data for the state of California including GDP and unemployment rate projections.
During the second quarter of 2022, there was a negative provision for credit losses on loans of $181,000, compared to a $493,000 negative provision for credit losses on loans for the second quarter of 2021. There was a negative provision for credit losses on loans of $748,000 for the six months ended June 30, 2022, compared to a $2.0 million negative provision for credit losses on loans for the six months ended June 30, 2021. Provisions for credit losses on loans are charged to operations to bring the allowance for credit losses on loans to a level deemed appropriate by the Company based on the factors discussed under “Credit Quality and Allowance for Credit Losses on Loans.”
Noninterest Income
Increase
(decrease)
2022 versus 2021
Percent
208
(12)
(369)
(93)
101
(71)
(41)
(14)
(102)
(450)
Gain on proceeds from company owned life insurance
(435)
(94)
214
Total noninterest income remained relatively flat at $2.1 million for the second quarter of 2022, compared to $2.2 million for the second quarter of 2021, primarily due to a lower gain on proceeds from company-owned life insurance, partially offset by higher service charges and fees on deposit accounts during the second quarter of 2022. For the six months ended June 30, 2022, total noninterest income remained relatively flat at $4.6 million, compared to $4.5 million for the six months ended June 30, 2021, primarily due to a $637,000 gain on warrants and higher service charges and fees on deposit accounts during the first six months of 2022, partially offset by a lower gain on proceeds from company-owned life insurance and a lower gain on sale of SBA loans during the first six months of 2022.
A portion of the Company’s noninterest income has been associated with its SBA lending activity, as gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing rights retained. For the second quarter of 2022, SBA loan sales resulted in a $27,000 gain, compared to a $83,000 gain on sales of SBA loans for the second quarter of 2021. For the six months ended June 30, 2022, SBA loan sales resulted in a $183,000 gain, compared to a $633,000 gain on sales of SBA loans for the first six months of 2021.
The servicing assets that result from the sales of SBA loans with servicing retained are amortized over the expected term of the loans using a method approximating the interest method. Servicing income generally declines as the respective loans are repaid.
Noninterest Expense
The following table sets forth the various components of the Company’s noninterest expense:
(Decrease)
904
(480)
382
98
(96)
(4,000)
(100)
434
(2,585)
767
193
(1,119)
(32)
762
215
(170)
(11)
(103)
592
(2,577)
(5)
The following table indicates the percentage of noninterest expense in each category for the periods indicated:
Percent of
of Total
59
Total noninterest expense for the second quarter of 2022 decreased to $23.2 million, compared to $25.8 million for the second quarter of 2021, primarily due to a $4.0 million reserve for a legal settlement and higher professional fees during the second quarter of 2021, partially offset by higher salaries and employee benefits, insurance expense and client services expense during the second quarter of 2022. Noninterest expense for the six months ended June 30, 2022 decreased to $46.4 million, compared to $49.0 million for the six months ended June 30, 2021, primarily due to a reserve for a legal settlement and higher professional fees during the first six months of 2021, partially offset by higher salaries and employee benefits, insurance expense and client services expense during the first six months of 2022.
Full time equivalent employees was 332 at June 30, 2022, and 330 at June 30, 2021, and 326 at December 31, 2021.
Income Tax Expense
The Company computes its provision for income taxes on a monthly basis. The effective tax rate is determined by applying the Company’s statutory income tax rates to pre-tax book income as adjusted for permanent differences between pre-tax book income and actual taxable income. These permanent differences include, but are not limited to, increases in the cash surrender value of life insurance policies, interest on tax-exempt securities, certain expenses that are not allowed as tax deductions, and tax credits.
The following table shows the Company’s effective income tax rates for the periods indicated:
Effective income tax rate
29.3
25.1
28.9
26.7
The difference in the effective tax rate for the periods reported compared to the combined Federal and state statutory tax rate of 29.6% is primarily the result of the Company’s investment in life insurance policies whose earnings are not subject to taxes, tax credits related to investments in low income housing limited partnerships (net of low income housing investment losses), and tax-exempt interest income earned on municipal bonds.
The Company’s Federal and state income tax expense for the second quarter of 2022 was $6.1 million, compared to $3.0 million for the second quarter of 2021. The Federal and state income tax expense for the first six months of 2022 was $11.3 million, compared to $7.3 million for the first six months of 2021.
Some items of income and expense are recognized in one year for tax purposes, and another when applying generally accepted accounting principles, which leads to timing differences between the Company’s actual tax liability, and the amount accrued for this liability based on book income. These temporary differences comprise the “deferred” portion of the Company’s tax expense or benefit, which is accumulated on the Company’s books as a deferred tax asset or deferred tax liability until such time as they reverse.
56
Realization of the Company’s deferred tax assets is primarily dependent upon the Company generating sufficient future taxable income to obtain benefit from the reversal of net deductible temporary differences and the utilization of tax credit carryforwards and the net operating loss carryforwards for Federal and state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under generally accepted accounting principles a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax assets will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.
The Company had net deferred tax assets of $29.7 million at June 30, 2022, $26.9 million at June 30, 2021, and $28.8 million at December 31, 2021. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax assets at June 30, 2022, June 30, 2021, and December 31, 2021 will be fully realized in future years.
FINANCIAL CONDITION
At June 30, 2022, total assets increased 6% to $5.357 billion, compared to $5.073 billion at June 30, 2021, and decreased (3%) from $5.499 billion at December 31, 2021.
Securities available-for-sale, at fair value, were $332.1 million at June 30, 2022, an increase of 128% from $146.0 million at June 30, 2021, and an increase of 225% from $102.3 million at December 31, 2021. Securities held-to-maturity, at amortized cost, were $723.7 million at June 30, 2022, an increase of 72% from $421.3 million at June 30, 2021, and an increase of 10% from $658.4 million at December 31, 2021.
Loans, excluding loans held-for-sale, increased $257.7 million, or 9%, to $3.082 billion at June 30, 2022, compared to $2.825 billion at June 30, 2021, and decreased ($4.9) million from $3.087 billion at December 31, 2021. The decrease in loans at June 30, 2022 from December 31, 2021, was primarily due to forgiveness of PPP loans. Total loans at June 30, 2022 included $8.2 million of PPP loans, compared to $286.5 million at June 30, 2021 and $88.7 million at December 31, 2021. Total loans at June 30, 2022 included $449.0 million of residential mortgages, compared to $205.9 million at June 30, 2021, and $416.7 million at December 31, 2021. Loans, excluding loans held-for-sale, PPP loans and residential mortgages, increased $286.3 million, or 12%, to $2.626 billion at June 30, 2022, compared to $2.339 billion at June 30, 2021, and increased $41.6 million, or 2%, from $2.584 billion at December 31, 2021.
Total deposits increased $269.2 million, or 6%, to $4.613 billion at June 30, 2022, compared to $4.344 billion at June 30, 2021, and decreased ($145.8) million, or (3%), from $4.759 billion at December 31, 2021. The decrease in total deposits at June 30, 2022, compared to December 31, 2021, was primarily due to a decline in temporary deposits from two customers. The deposits from those two customers decreased ($153.9) million to $149.3 million at June 30, 2022, compared to $303.2 million at December 31, 2021. Deposits, excluding all time deposits and CDARS deposits, increased $295.9 million, or 7%, to $4.452 billion at June 30, 2022, compared to $4.156 billion at June 30, 2021, and decreased ($135.8) million, or (3%), compared to $4.588 billion at December 31, 2021.
Securities Portfolio
The following table reflects the balances for each category of securities at the dates indicated:
Securities available-for-sale (at fair value):
15,063
130,892
145,955
Securities held-to-maturity (at amortized cost):
361,184
60,153
421,337
The following table summarizes the weighted average life and weighted average yields of securities at June 30, 2022:
Weighted Average Life
After One and
After Five and
Within One
Within Five
Within Ten
After Ten
Year or Less
Years
2.76
291
80,202
2.44
330,328
2.66
2.65
113,439
1.89
514,010
1.75
56,330
1.99
1.80
Municipals — exempt from Federal tax (1)
14,172
3.50
5,936
3.56
16,873
3.24
2,995
3.39
119,375
1.97
530,883
59,325
2.06
1.88
The securities portfolio serves the following purposes: (i) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (ii) it provides liquidity to even out cash flows from the loan and deposit activities of customers; (iii) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; and (iv) it is an alternative interest-earning use of funds when loan demand is weak or when deposits grow more rapidly than loans.
The Company’s portfolio may include: (i) U.S. Treasury securities and U.S. Government sponsored entities’ debt securities for liquidity and pledging; (ii) mortgage-backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (iii) municipal obligations, which provide tax free income and limited pledging potential; (iv) single entity issue trust preferred securities, which generally enhance the yield on the portfolio; (v) corporate bonds, which also enhance the yield on the portfolio; (vi) money market mutual funds; (vii) certificates of deposit; (viii) commercial paper; (ix) bankers acceptances; (x) repurchase agreements; (xi) collateralized mortgage obligations; and (xii) asset-backed securities.
The Company classifies its securities as either available-for-sale or held-to-maturity at the time of purchase. Accounting guidance requires available-for-sale securities to be marked to fair value with an offset to accumulated other comprehensive income (loss), a component of shareholders’ equity. Monthly adjustments are made to reflect changes in the fair value of the Company’s available-for-sale securities. All other factors remaining the same, when market interest rates are increasing, the Company will experience a higher unrealized loss on the securities portfolio.
The pre-tax unrealized loss on U.S. Treasury securities available-for-sale at June 30, 2022 was ($1.2) million, compared to a pre-tax unrealized gain of $94,000 at June 30, 2021. There were no U.S. Treasury securities available-for-sale at December 31, 2021. The pre-tax unrealized loss on mortgage-backed securities available-for-sale at June 30, 2022 was ($2.9) million, compared to a pre-tax unrealized gain of $4.2 million at June 30, 2021, and a pre-tax unrealized gain of $2.9 million at December 31, 2021. The pre-tax unrealized loss on total securities available-for-sale at June 30, 2022 was ($4.2) million, compared to a pre-tax unrealized gain of $4.3 million at June 30, 2021, and a pre-tax unrealized gain of $2.9 million at December 31, 2021.
The pre-tax unrealized loss on mortgage-backed securities held-to-maturity at June 30, 2022 was ($72.5) million, compared to a pre-tax unrealized gain of $4.2 million at June 30, 2021, and a pre-tax unrealized loss ($1.6) million at December 31, 2021. The pre-tax unrealized loss on municipal bonds held-to-maturity at June 30, 2022 was ($436,000), compared to a pre-tax unrealized gain of $1.2 million at June 30, 2021, and a pre-tax unrealized gain of $805,000 at December 31, 2021. The pre-tax unrealized loss on total securities held-to-maturity at June 30, 2022 was ($72.9) million, compared to a pre-tax unrealized gain of $5.4 million at June 30, 2021, and a pre-tax unrealized loss of ($790,000) at December 31, 2021.
During the second quarter of 2022, the Company purchased $229.3 million of U.S. Treasury securities available-for-sale, with a book yield of 2.80% and an average life of 2.58 years. During the first six months of 2022, the Company purchased $251.0 million of U.S. Treasury securities available-for-sale, with a book yield of 2.75% and an average life of 2.57 years.
During the second quarter of 2022, the Company purchased $9.8 million of agency mortgage-backed securities held-to-maturity, with a book yield of 3.26% and an average life of 6.92 years. During the first six months of 2022, the Company purchased $119.4 million of agency mortgage-backed securities held-to-maturity, with a book yield of 2.21% and an average life of 6.55 years.
The Company’s loans represent the largest portion of invested assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing the Company’s financial condition. Gross loans, excluding loans held-for-sale, represented 58% of total assets at June 30, 2022, and represented 56% at both June 30, 2021 and December 31, 2021. The loan to deposit ratio was 66.81% at June 30, 2022, compared to 65.02% at June 30, 2021, and 64.87% at December 31, 2021.
The Loan Distribution table that follows sets forth the Company’s gross loans, excluding loans held-for-sale, outstanding and the percentage distribution in each category at the dates indicated:
% to Total
523,268
557,686
594,108
PPP loans(1)
0
583,091
742,135
129,426
107,873
198,771
205,904
21,519
Total Loans
2,832,866
(8,070)
(43,956)
2,780,840
The Company’s loan portfolio is concentrated in commercial loans, (primarily manufacturing, wholesale, and services oriented entities), and CRE, with the remaining balance in land development and construction, home equity, purchased residential mortgages, and consumer loans. The Company does not have any concentrations by industry or group of industries in its loan portfolio, however, 82% of its gross loans were secured by real property at June 30, 2022, compared to 69% at June 30, 2021, and 77% at December 31, 2021. While no specific industry concentration is considered significant, the Company’s bank lending operations are substantially located in areas that are dependent on the technology and real estate industries and their supporting companies.
The Company has established concentration limits in its loan portfolio for CRE loans, commercial loans, construction loans and unsecured lending, among others. The Company uses underwriting guidelines to assess the borrower’s historical cash flow to determine debt service, and we further stress test the debt service under higher interest rate scenarios. Financial and performance covenants are used in commercial lending to allow the Company to react to a borrower’s deteriorating financial condition should that occur.
The Company’s commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Commercial loans include loans with maturities ranging from thirty days to one year and “term
loans” with maturities normally ranging from one to five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.
The Company is an active participant in the SBA and U.S. Department of Agriculture guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes such guaranteed loans (collectively referred to as “SBA loans”). The guaranteed portion of these loans is typically sold in the secondary market depending on market conditions. When the guaranteed portion of an SBA loan is sold, the Company retains the servicing rights for the sold portion. During the six months ended June 30, 2022 and 2021, loans were sold resulting in a gain on sales of SBA loans of $183,000 and $633,000, respectively.
The Company’s factoring receivables are from the operations of Bay View Funding whose primary business is purchasing and collecting factored receivables. Factored receivables are receivables that have been transferred by the originating organization and typically have not been subject to previous collection efforts. These receivables are acquired from a variety of companies, including but not limited to service providers, transportation companies, manufacturers, distributors, wholesalers, apparel companies, advertisers, and temporary staffing companies. The portfolio of factored receivables is included in the Company’s commercial loan portfolio. The average life of the factored receivables was 38 days for the first six months of 2022, compared to 36 days for the first six months of 2021. The balance of the purchased receivables was $63.4 million at June 30, 2022, compared to $47.1 million at June 30, 2021, and $53.2 million at December 31, 2021.
The commercial loan portfolio, excluding PPP loans, decreased ($34.4) million, or (6%), to $523.3 million at June 30, 2022, from $557.7 million at June 30, 2021, and decreased ($70.8) million, or (12%), from $594.1 million at December 31, 2021. Commercial and industrial (“C&I”) line usage was 28% at June 30, 2022, compared to 27% at June 30, 2021, and 31% at December 31, 2021. In addition, the Company had $8.2 million in PPP loans at June 30, 2022, compared to $286.5 million at June 30, 2021, and $88.7 million at December 31, 2021.
The Company’s CRE loans consist primarily of loans based on the borrower’s cash flow and are secured by deeds of trust on commercial property to provide a secondary source of repayment. The Company generally restricts real estate term loans to no more than 75% of the property’s appraised value or the purchase price of the property depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities for CRE loans are generally between five and ten years (with amortization ranging from fifteen to twenty five years and a balloon payment due at maturity), however, SBA and certain other real estate loans that can be sold in the secondary market may be granted for longer maturities.
The CRE owner-occupied loan portfolio increased $14.4 million, or 2%, to $597.5 million at June 30, 2022, from $583.1 million at June 30, 2021, and increased $1.6 million from $595.9 million at December 31, 2021. CRE non-owner occupied loans increased $251.5 million, or 34%, to $993.6 million, compared to $742.1 million at June 30, 2021, and increased $91.3 million, or 10% from $902.3 million at December 31, 2021. At June 30, 2022, 38% of the CRE loan portfolio was secured by owner-occupied real estate.
The Company’s land and construction loans are primarily to finance the development and construction of commercial and single family residential properties. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or availability of permanent mortgage financing prior to making the construction loan. Construction loans are provided only in our market area, and the Company has extensive controls for the disbursement process. Land and construction loans increased $26.0 million, or 20%, to $155.4 million at June 30, 2022, compared to $129.4 million at June 30, 2021, and increased $7.5 million, or 5%, from $147.9 million at December 31, 2021.
The Company makes home equity lines of credit available to its existing customers. Home equity lines of credit are underwritten initially with a maximum 75% loan to value ratio. Home equity lines of credit increased $8.8 million, or 8%, to $116.6 million at June 30, 2022, compared to $107.8 million at June 30, 2021, and increased $7.1 million, or 6%, from $109.6 million at December 31, 2021.
Multifamily loans increased $23.2 million, or 12%, to $221.9 million, at June 30, 2022, compared to $198.8 million at June 30, 2021, and increased $3.1 million, or 1%, from $218.8 million at December 31, 2021.
60
From time to time the Company has purchased single family residential mortgage loans. Residential mortgage loans increased $243.1 million, or 118%, to $449.0 million at June 30, 2022, compared to $205.9 million at June 30, 2021, and increased $32.3 million, or 8% from $416.7 million at December 31, 2021. During the second quarter of 2022, the Company purchased single family residential mortgage loans totaling $74.5 million, tied to homes all located in California, with average principal balances of approximately $821,000 and a weighted average yield of approximately 3.14%. During the second quarter of 2021, the Company purchased single family residential mortgage loans totaling $140.0 million, tied to homes all located in California, with average principal balances of approximately $585,000 and a weighted average yield of approximately 3.39% (excluding servicing costs, which are netted against interest income contributing to a lower overall average yield). Purchases of residential loans have been an attractive alternative for replacing mortgage-backed security paydowns in the investment securities portfolio.
Consumer and other loans decreased ($3.2) million, or (15%), to $18.3 million at June 30, 2022, compared to $21.5 million at June 30, 2021, and increased $1.6 million, or 10% from $16.7 million at December 31, 2021.
Additionally, the Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company’s consumer loans are secured by the personal property being purchased or, in the instances of home equity loans or lines, real property.
With certain exceptions, state chartered banks are permitted to make extensions of credit to any one borrowing entity totaling up to 15% of the bank’s capital and reserves for unsecured loans and up to 25% of the bank’s capital and reserves for secured loans. For HBC, these lending limits were $100.6 million and $167.7 million at June 30, 2022, respectively.
Loan Maturities
The following table presents the maturity distribution of the Company’s loans (excluding loans held-for-sale) as of June 30, 2022. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the Western Edition of The Wall Street Journal. As of June 30, 2022, approximately 36% of the Company’s loan portfolio consisted of floating interest rate loans.
Over One
Due in
Year But
One Year
Less than
Over
or Less
Five Years
295,287
169,203
58,778
25,618
121,661
450,242
24,674
260,101
708,846
139,131
6,075
10,183
116,576
65
13,046
82,103
126,789
11,264
18,577
419,117
10,020
6,738
1,596
635,659
672,568
1,775,616
Loans with variable interest rates
574,413
228,677
293,653
1,096,743
PPP loans with fixed interest rates
Other loans with fixed interest rates
61,203
435,781
1,481,963
1,978,947
Loan Servicing
As of June 30, 2022 and 2021, $66.4 million and $73.6 million, respectively, in SBA loans were serviced by the Company for others. Activity for loan servicing rights was as follows:
606
655
Additions
141
(49)
(136)
(144)
562
Loan servicing rights are included in accrued interest receivable and other assets on the unaudited consolidated balance sheets and reported net of amortization. There was no valuation allowance as of June 30, 2022 and 2021, as the fair value of the assets was greater than the carrying value.
Activity for the I/O strip receivable was as follows:
296
305
Unrealized holding gain loss
(35)
(48)
(31)
274
Credit Quality and Allowance for Credit Losses on Loans
Financial institutions generally have a certain level of exposure to credit quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company’s management of credit quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines as a result of customers’ inability to generate sufficient cash flow to service their debts, downturns in national and regional economies and declines in overall asset values including real estate collateral values. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor’s financial capacity to repay deteriorates.
The Company’s policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations. In addition, these policies establish the Company’s underwriting standards and the methods of monitoring ongoing credit quality. The Company’s internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan customers as well as the relative diversity and geographic concentration of our loan portfolio.
The Company’s credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets. As an independent community bank serving a specific geographic area, the Company must contend with the unpredictable changes in the general California market and, particularly, primary local markets. The Company’s asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, and depressed real estate values.
Nonperforming assets are comprised of the following: loans for which the Company is no longer accruing interest; restructured loans which have been current under six months; loans 90 days or more past due and still accruing interest (although they are generally placed on nonaccrual when they become 90 days past due, unless they are both well-secured and in the process of collection); and foreclosed assets. Past due loans 30 days or greater totaled $10.2 million and $5.0 million at June 30, 2022 and December 31, 2021, respectively, of which $1.3 million were on nonaccrual at both June 30, 2022 and December 31, 2021. At June 30, 2022, there were also $418,000 loans less than
30 days past due included in nonaccrual loans held-for-investment. At December 31, 2021, there were also $2.2 million loans less than 30 days past due included in nonaccrual loans held-for-investment.
Management’s classification of a loan as “nonaccrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued on all nonaccrual loans. Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. Foreclosed assets consist of properties acquired by foreclosure or similar means that management is offering or will offer for sale.
The following table summarizes the Company’s nonperforming assets at the dates indicated:
Nonaccrual loans — held-for-investment
5,291
Restructured and loans 90 days past due and
still accruing
Total nonperforming loans
6,180
Foreclosed assets
Total nonperforming assets
Nonperforming assets as a percentage of loans
plus foreclosed assets
Nonperforming assets as a percentage of total assets
0.05
0.07
Nonperforming assets were $2.7 million, or 0.05% of total assets, at June 30, 2022, compared to $6.2 million, or 0.12% of total assets, at June 30, 2021, and $3.7 million, or 0.07% of total assets, at December 31, 2021.
The following table presents the amortized cost basis of nonperforming loans and loans past due over 90 days and still accruing at the periods indicated:
with no Special
with Special
Loans with a well-defined weakness, which are characterized by the distinct possibility that the Company will sustain a loss if the deficiencies are not corrected, are categorized as “classified.” Classified loans include all loans considered as substandard, substandard-nonaccrual, and doubtful and may result from problems specific to a borrower’s business or from economic downturns that affect the borrower’s ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate). Loans held-for-sale are carried at the lower of cost or estimated fair value, and are not allocated an allowance for loan losses.
The amortized cost basis of collateral-dependent commercial loans collateralized by business assets totaled $446,000 and $1.0 million at June 30, 2022 and December 31, 2021, respectively.
Classified loans decreased to $28.9 million, or 0.54% of total assets, at June 30, 2022, compared to $32.4 million, or 0.64% of total assets, at June 30, 2021, and $33.7 million, or 0.61% of total assets at December 31, 2021.
In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed in accordance with the Company’s underwriting policy.
Beginning January 1, 2020, the ACLL is calculated by using the current expected credit loss (“CECL”) methodology. The ACLL estimation process involves procedures to appropriately consider the unique characteristics of loan portfolio segments. These segments are further disaggregated into loan classes, the level at which credit risk is monitored. When computing the level of expected credit losses, credit loss assumptions are estimated using a model that categorizes loan pools based on loss history, delinquency status, and other credit trends and risk characteristics, including current conditions and reasonable and supportable forecasts about the future. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. In future periods, evaluations of the overall loan portfolio in light of the factors and forecasts then prevailing, may result in significant changes in the allowance and credit loss expense in those future periods.
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The allowance level is influenced by loan volumes, loan risk rating migration or delinquency status, changes in historical loss experience, and other conditions influencing loss expectations, such as reasonable and supportable forecasts of economic conditions. The methodology for estimating the amount of expected credit losses reported in the allowance for credit losses has two basic components: first, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans; and second, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics.
Loans are charged-off against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance for credit losses on loans.
The following provides a summary of the risks associated with various segments of the Company’s loan portfolio, which are factors management regularly considers when evaluating the adequacy of the allowance:
Commercial loans primarily rely on the identified cash flows of the borrower for repayment and secondarily on the value of underlying collateral provided by the borrower. However, the cash flows of the borrowers may not be as expected and the collateral securing these loans may vary in value. Most commercial loans are secured by the assets being financed or on other business assets such as accounts receivable, inventory or equipment and may incorporate a personal guarantee; however, some loans may be unsecured. Included in commercial loans are $8.2 million of PPP loans at June 30, 2022, $286.5 million at June 30, 2021, and $88.7 million at December 31, 2021. No allowance for credit losses has been recorded for PPP loans as they are fully guaranteed by the SBA at June 30, 2022, June 30, 2021, and December 31, 2021.
CRE loans rely primarily on the cash flows of the properties securing the loan and secondarily on the value of the property that is securing the loan. CRE loans comprise two segments differentiated by owner occupied CRE and non-owner CRE. Owner occupied CRE loans are secured by commercial properties that are at least 50% occupied by the borrower or borrower affiliate. Non-owner occupied CRE loans are secured by commercial properties that are less than 50% occupied by the borrower or borrower affiliate. CRE loans may be adversely affected by conditions in the real estate markets or in the general economy.
Home equity loans are secured by 1-4 family residences that are generally owner occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily on the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values.
Residential mortgage loans are secured by 1-4 family residences which are generally owner-occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily by the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values.
Consumer and other loans are secured by personal property or are unsecured and rely primarily on the income of the borrower for repayment and secondarily on the collateral value for secured loans. Borrower income and collateral value can vary dependent on economic conditions.
Allocation of Allowance for Credit Losses on Loans
As a result of the matters mentioned above, changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the condition of the various markets in which collateral may be sold may all affect the required level of the allowance for credit losses on loans and the associated provision for credit losses on loans.
On an ongoing basis, we have engaged an outside firm to perform independent credit reviews of our loan portfolio. The Federal Reserve Board and the California Department of Financial Protection and Innovation (“DFPI”) also review the allowance for credit losses on loans as an integral part of the examination process. Based on information currently available, management believes that the allowance for credit losses on loans is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company’s market area were to weaken further. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company’s future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.
Mortgages
66
The increase in the allowance for credit losses on loans on loans for the six months ended June 30, 2022, was primarily attributed to a net increase of $2.6 million in the reserve for pooled loans, driven by deterioration in forecasted macroeconomic conditions and an increase in the loan portfolio, partially offset by a $413,000 decrease in specific reserves for individually evaluated loans compared to December 31, 2021. The increase in the allowance for credit losses for pooled loans from December 31, 2021 is largely the result of deterioration in the economic factors used in our methodology and increases in loan balances.
The following table provides a summary of the allocation of the allowance for credit losses on loans by class at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for credit losses on loans will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each category represents the total amount available for charge-offs that may occur within these classes.
of Loans
in each
category
to total
loans
The ACLL totaled $45.5 million, or 1.48% of total loans at June 30, 2022, compared to $44.0 million, or 1.56% of total loans at June 30, 2021, and $43.3 million, or 1.40% of total loans at December 31, 2021. The ACLL was 1,675.51% of nonperforming loans at June 30, 2022, compared to 711.26% of nonperforming loans at June 30, 2021, and 1,158.11% of nonperforming loans at December 31, 2021. The Company had net recoveries of $2.9, or (0.38%) of average loans, for the second quarter of 2022, compared to net recoveries of $153,000 or (0.02%) of average loans, for the second quarter of 2021, and net recoveries of $225,000, or (0.03%) of average loans for the fourth quarter of 2021.
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The following table shows the drivers of change in ACLL under CECL for each of the second quarter of 2022:
Drivers of Change in ACLL Under CECL
ACLL at December 31, 2021
Portfolio changes during the first quarter of 2022
including net recoveries
Qualitative and quantitative changes during the first
quarter of 2022 including changes in economic forecasts
(469)
ACLL at March 31, 2022
Portfolio changes during the second quarter of 2022
1,383
Qualitative and quantitative changes during the second
1,319
ACLL at June 30, 2022
Leases
The Company recognizes the following for all leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use (“ROU”) asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. While the new standard impacts lessors and lessees, the Company is impacted as a lessee of the offices and real estate used for operations. The Company's lease agreements include options to renew at the Company's discretion. The extensions are not reasonably certain to be exercised, therefore it was not considered in the calculation of the ROU asset and lease liability. Total assets and total liabilities were $32.4 million on its consolidated statement of financial condition at June 30, 2022, as a result of recognizing right-of-use assets, included in other assets, and lease liabilities, included in other liabilities, related to non-cancelable operating lease agreements for office space.
The composition and cost of the Company’s deposit base are important components in analyzing the Company’s net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. The Company’s liquidity is impacted by the volatility of deposits from the propensity of that money to leave the institution for rate-related or other reasons. Deposits can be adversely affected if economic conditions weaken in California, and the Company’s market area in particular. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $250,000, as customers with balances of that magnitude are typically more rate-sensitive than customers with smaller balances.
The following table summarizes the distribution of deposits and the percentage of distribution in each category of deposits for the periods indicated:
1,840,516
1,140,867
1,174,587
Time deposits — under $250
42,118
Time deposits — $250 and over
110,111
CDARS — interest-bearing demand,
money market and time deposits
36,273
4,344,472
The Company obtains deposits from a cross-section of the communities it serves. The Company’s business is not generally seasonal in nature. Public funds were less than 1% of deposits at June 30, 2022, June 30, 2021, and December 31, 2021.
Total deposits increased $269.2 million, or 6%, to $4.613 billion at June 30, 2022, compared to $4.344 billion at June 30, 2021, and decreased ($145.8) million, or (3%), from $4.759 billion at December 31, 2021. The decrease in total deposits at June 30, 2022, compared to December 31, 2021, was primarily due to a decline in temporary deposits from two customers. The deposits from those two customers decreased ($153.9) million to $149.3 million at June 30, 2022, compared to $303.2 million at December 31, 2021. Deposits, excluding all time deposits and CDARS deposits, increased
$295.9 million, or 7%, to $4.452 billion at June 30, 2022, compared to $4.156 billion at June 30, 2021, and decreased ($135.8) million, or (3%), compared to $4.588 billion at December 31, 2021.
At June 30, 2022, the $26.3 million CDARS deposits comprised $20.4 million of interest-bearing demand deposits, $1.7 million of money market accounts and $4.2 million of time deposits. At June 30, 2021, the $36.3 million CDARS deposits comprised $29.4 million of interest-bearing demand deposits, $441,000 of money market accounts and $6.4 million of time deposits. At December 31, 2021, the $38.3 million CDARS deposits comprised $30.9 million of interest-bearing demand deposits, $1.0 million of money market accounts and $6.4 million of time deposits.
The following table indicates the contractual maturity schedule of the Company’s uninsured time deposits in excess of $250,000 as of June 30, 2022:
% of Total
Three months or less
21,550
Over three months through six months
12,374
Over six months through twelve months
18,253
Over twelve months
11,333
63,510
The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $250,000 in average balance per account. As a result, certain types of business clients that the Company serves typically carry average deposits in excess of $250,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to help ensure its ability to fund deposit withdrawals.
Return on Equity and Assets
The following table indicates the ratios for return on average assets and average equity, and average equity to average assets for the periods indicated:
Return on average assets
1.11
0.70
1.04
0.82
Return on average tangible assets
1.15
0.73
1.07
0.85
Return on average equity
9.86
6.06
9.29
6.95
Return on average tangible equity
14.06
8.84
13.28
10.16
Average equity to average assets ratio
11.31
11.55
11.16
11.83
Liquidity and Asset/Liability Management
The Company’s liquidity position supports its ability to maintain cash flows sufficient to fund operations, meet all of its financial obligations and commitments, and accommodate unexpected sudden changes in balances of loans and deposits in a timely manner. At various times the Company requires funds to meet short term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or repayment of liabilities. An integral part of the Company’s ability to manage its liquidity position appropriately is derived from its large base of core deposits which are generated by offering traditional banking services in its service area and which have historically been a stable source of funds.
The Company manages liquidity to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity. Excess balance sheet liquidity can negatively impact the Company’s net interest margin. In order to meet short term liquidity needs the Company utilizes overnight Federal funds purchase arrangements and other borrowing arrangements with correspondent banks, solicits brokered deposits if cost effective deposits are not available from local sources, and maintains collateralized lines of credit with the Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”). In addition, the Company can raise cash for temporary needs by selling securities under agreements to repurchase and selling securities available for sale.
One of the measures of liquidity is the loan to deposit ratio. The loan to deposit ratio was 66.81% at June 30, 2022, compared to 65.02% at June 30, 2021, and 64.87% at December 31, 2021.
FHLB and FRB Borrowings and Available Lines of Credit
HBC has off-balance sheet liquidity in the form of Federal funds purchase arrangements with correspondent banks, including the FHLB and FRB. HBC can borrow from the FHLB on a short-term (typically overnight) or long-term (over one year) basis. HBC had no overnight borrowings from the FHLB at June 30, 2022, June 30, 2021, and December 31, 2021. HBC had $260.9 million of loans pledged to the FHLB as collateral on an available line of credit of $175.7 million at June 30, 2022. HBC also had $1.2 million of securities pledged to the FHLB as collateral on an available line of credit of $1.2 million at June 30, 2022, none of which was outstanding.
HBC can also borrow from the FRB’s discount window. HBC had $996.8 million of loans pledged to the FRB as collateral on an available line of credit of $725.0 million at June 30, 2022, none of which was outstanding.
At June 30, 2022, HBC had Federal funds purchased arrangements available of $90.0 million. There were no Federal funds purchased outstanding at June 30, 2022, June 30, 2021, and December 31, 2021.
The Company has a $20.0 million line of credit with a correspondent bank, of which none was outstanding at June 30, 2022.
HBC may also utilize securities sold under repurchase agreements to manage its liquidity position. There were no securities sold under agreements to repurchase at June 30, 2022, June 30, 2021, and December 31, 2021.
Capital Resources
The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a regular basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the Federal Reserve and the FDIC, establish a risk adjusted ratio relating capital to different categories of assets and off balance sheet exposures.
On May 11, 2022, the Company completed a private placement offering of $40.0 million aggregate principal amount of its 5.00% fixed-to-floating rate subordinated notes due May 15, 2032 (“Sub Debt due 2032”). The Company used the net proceeds of the Sub Debt due 2032 for general corporate purposes, including the repayment on June 1, 2022 of the Company’s $40.0 million aggregate principal amount of 5.25% fixed-to-floating rate subordinated notes due June 1, 2027 (“Sub Debt due 2027”). The Sub Debt due 2032, net of unamortized issuance costs of $726,000, totaled $39.3 million at June 30, 2022, and qualifies as Tier 2 capital for the Company under the guidelines established by the Federal Reserve Bank
On May 26, 2017, the Company completed an underwritten public offering of $40.0 million aggregate principal amount of its Sub Debt due 2027. The Sub Debt due 2027 had a fixed interest rate of 5.25% per year through June 1, 2022. On June 1, 2022, the Company completed the redemption of all of its outstanding $40.0 million of Sub Debt due 2027, prior to resetting to a floating rate. The Sub Debt due 2027 was redeemed pursuant to the terms of the Subordinated Indenture, as supplemented by the First Supplemental Indenture, each dated as of May 26, 2017, between the Company and Wilmington Trust, National Association, as Trustee, at the redemption price of 100% of its principal amount, plus accrued and unpaid interest of $1.1 million.
The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the consolidated Company under the Basel III requirements for the periods indicated:
Capital components:
Common Equity Tier 1 capital
418,134
Additional Tier 1 capital
Tier 2 Capital
77,104
73,341
72,721
491,475
Risk-weighted assets
3,579,740
3,142,524
3,521,058
Average assets for capital purposes
5,152,549
4,853,907
5,504,834
Capital ratios:
15.6
13.3
Common equity Tier 1 Capital
Tier 1 Leverage(1)
8.6
The following table summarizes risk based capital, risk-weighted assets, and risk-based capital ratios of HBC under the Basel III requirements for the periods indicated:
436,192
37,830
33,509
32,796
469,701
3,577,894
3,140,695
3,518,391
5,150,742
4,852,000
5,502,185
15.0
13.9
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The following table presents the applicable well-capitalized regulatory guidelines and the standards for minimum capital adequacy requirements under Basel III and the regulatory guidelines for a “well–capitalized” financial institution under Prompt Corrective Action (“PCA”):
Financial
Minimum
Institution PCA
The Basel III capital rules introduced a new “capital conservation buffer,” for banking organizations to maintain a common equity Tier 1 ratio more than 2.5% above these minimum risk-weighted asset ratios. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of common equity Tier 1 to risk-weighted assets above the minimum but below the capital conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.
At June 30, 2022, the Company’s consolidated capital ratio exceeded regulatory guidelines and HBC’s capital ratios exceed the highest regulatory capital requirement of “well-capitalized” under Basel III prompt corrective action provisions. Quantitative measures established by regulation to help ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios of total risk-based capital, Tier 1 capital, and common equity Tier 1 (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of June 30, 2022, June 30, 2021, and December 31, 2021, the Company and HBC met all capital adequacy guidelines to which they were subject.
At June 30, 2022, the Company had total shareholders’ equity of $607.2 million, compared to $583.4 million at June 30, 2021, and $598.0 million at December 31, 2021. At June 30, 2022, total shareholders’ equity included $499.8 million in common stock, $123.3 million in retained earnings, and ($15.9) million of accumulated other comprehensive loss. The book value per share was $10.01 at June 30, 2022, compared to $9.69 at June 30, 2021, and $9.91 at December 31, 2021. The tangible book value per share was $7.04 at June 30, 2022, compared to $6.65 at June 30, 2021, and $6.91 at December 31, 2021.
The following table reflects the components of accumulated other comprehensive loss, net of taxes, for the periods indicated:
Accumulated Other Comprehensive Loss
Unrealized gain on securities available-for-sale
(3,036)
1,991
2,674
Remaining unamortized unrealized gain on securities
available-for-sale transferred to held-to-maturity
Split dollar insurance contracts liability
(5,501)
(5,480)
(6,142)
Supplemental executive retirement plan liability
(7,508)
(7,669)
(8,506)
Unrealized gain on interest-only strip from SBA loans
162
Total accumulated other comprehensive loss
Market Risk
Market risk is the risk of loss of future earnings, fair values, or future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk sensitive instruments. Market risk is attributed to all market risk sensitive financial instruments, including securities,
72
loans, deposits and borrowings, as well as the Company’s role as a financial intermediary in customer-related transactions. The objective of market risk management is to avoid excessive exposure of the Company’s earnings and equity to loss and to reduce the volatility inherent in certain financial instruments. The Company’s exposure to market risk is reviewed on a regular basis by the Management’s Asset/Liability Committee and the Director’s Finance and Investment Committee.
Interest Rate Management
The Company’s market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.
The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. Interest rate risk is the potential of 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. Management realizes certain risks are inherent, and that the goal is to identify and manage the risks. Management uses two methodologies to manage interest rate risk: (i) a standard GAP analysis; and (ii) an interest rate shock simulation model.
The planning of asset and liability maturities is an integral part of the management of an institution’s net interest margin. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, the net interest margin may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or securities or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest-bearing liabilities.
Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity GAP report may not provide a complete assessment of the exposure to changes in interest rates.
The Company uses modeling software for asset/liability management in order to simulate the effects of potential interest rate changes on the Company’s net interest margin, and to calculate the estimated fair values of the Company’s financial instruments under different interest rate scenarios. The program imports current balances, interest rates, maturity dates and repricing information for individual financial instruments, and incorporates assumptions on the characteristics of embedded options along with pricing and duration for new volumes to project the effects of a given interest rate change on the Company’s interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company’s investment, loan, deposit and borrowed funds’ portfolios. These rate projections can be shocked (an immediate and parallel change in all base rates, up or down) and ramped (an incremental increase or decrease in rates over a specified time period), based on current trends and econometric models or stable economic conditions (unchanged from current actual levels).
The following table sets forth the estimated changes in the Company’s annual net interest income that would result from the designated instantaneous parallel shift in interest rates noted, as of June 30, 2022:
Increase/(Decrease) in
Estimated Net
Interest Income (1)
Change in Interest Rates (basis points)
+400
40,591
22.7
+300
30,388
17.0
+200
20,241
11.3
+100
10,153
5.7
−100
(19,568)
(11.0)
−200
(36,408)
(20.4)
As with any method of gauging interest rate risk, there are certain shortcomings inherent to the methodology noted above. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short-term and long-term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react in the same way to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the methodology noted above does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients’ ability to service their debt. All of these factors are considered in monitoring the Company’s exposure to interest rate risk.
ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information concerning quantitative and qualitative disclosure or market risk called for by Item 305 of Regulation S-K is included as part of Item 2 above.
ITEM 4—CONTROLS AND PROCEDURES
Disclosure Control and Procedures
The Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of June 30, 2022. As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), disclosure controls and procedures are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded the Company’s disclosure controls were effective at June 30, 2022, the period covered by this report on Form 10-Q.
During the three and six months ended June 30, 2022, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
Part II—OTHER INFORMATION
ITEM 1—LEGAL PROCEEDINGS
We evaluate all claims and lawsuits with respect to their potential merits, our potential defenses and counterclaims, settlement or litigation potential and the expected effect on us. The outcome of any claims or litigation, regardless of the merits, is inherently uncertain. Any claims and other lawsuits, and the disposition of such claims and lawsuits, whether through settlement or litigation, could be time-consuming and expensive to resolve, divert our attention from executing our business plan, result in efforts to enjoin our activities, and lead to attempts by third parties to seek similar claims.
For more information regarding legal proceedings, see Note 13 “Commitments and Loss Contingencies” to the consolidated financial statements.
ITEM 1A—RISK FACTORS
A discussion of risk factors affecting us as is set forth in Part I, Item 1A. Risk Factors, on pages 24 – 50 of our 2021 Annual Report on Form 10-K. The discussion of risk factors provides a description of some of the important risk factors that could affect our actual results and could cause our results to vary materially from those expressed in public statements or documents. However, other factors besides those included in the discussion of risk factors, or discussed elsewhere in any of our reports filed with or furnished to the SEC could affect our business or results. The readers should not consider any description of such factors to be a complete set of all potential risks that we may face.
ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None
ITEM 3—DEFAULTS UPON SENIOR SECURITIES
ITEM 4—MINE SAFETY DISCLOSURES
ITEM 5—OTHER INFORMATION
ITEM 6—EXHIBITS
Exhibit
Description
3.1
Heritage Commerce Corp Restated Articles of Incorporation, (incorporated by reference to Exhibit 3.1 to the Registrant’s Annual Report on Form 10-K filed on March 16, 2009)
3.2
Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the California Secretary of State on June 1, 2010 (incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement on Form S-1 filed July 23, 2010).
3.3
Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the Secretary of State on August 29, 2019 (incorporated by reference to Exhibit 3.3 to the Registrant’s Quarterly Report on Form 10-Q filed on November 11, 2019)
3.4
Heritage Commerce Corp Bylaws, as amended (incorporated by reference to the Registrant’s Current Report on Form 8-K filed on June 28, 2013)
31.1
Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Registrant’s Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of Registrant’s Chief Executive Officer Pursuant To 18 U.S.C. Section 1350
32.2
Certification of Registrant’s Chief Financial Officer Pursuant To 18 U.S.C. Section 1350
101.INS
XBRL Instance Document Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document
101.SCH
XBRL Taxonomy Extension Schema
101.CAL
XBRL Taxonomy Extension Calculation Linkbase
101.DEF
XBRL Taxonomy Extension Definition Linkbase
101.LAB
XBRL Taxonomy Extension Label Linkbase
101.PRE
XBRL Taxonomy Extension Presentation Linkbase
104.
The cover page from Heritage Commerce Corp's Quarterly Report on Form 10-Q for the quarter ended June 30, 2022, formatted in Inline XBRL
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Heritage Commerce Corp (Registrant)
Date: August 5, 2022
/s/ wALTER T. KACZMAREK
Walter T. Kaczmarek
Chief Executive Officer
/s/ Lawrence D. mcgovern
Lawrence D. McGovern
Chief Financial Officer