U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended March 31, 2019
OR
For the transition period from _______ to ________
Commission file number: 000-22507
THE FIRST BANCshARES, INC.
(Exact name of Registrant as specified in its charter)
(601) 268-8998
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
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.
Yesþ 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
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.
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¨ Noþ
Securities registered pursuant to Section 12(b) of the Act:
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Common stock, $1.00 par value, 17,299,975 shares issued and 17,171,894 outstanding as of May 3, 2019.
The First Bancshares, Inc.
Form 10-Q
Quarter Ended March 31, 2019
Index
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
THE FIRST BANCSHARES, INC.
CONSOLIDATED BALANCE SHEETS
($ in thousands)
See Notes to Consolidated Financial Statements
CONSOLIDATED STATEMENTS OF INCOME
($ in thousands, except earnings and dividends per share)
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
($ in thousands, unaudited)
CONSOLIDATED STATEMENTS OF CASH FLOWS
Right-of-use assets obtained in exchange for operating lease liabilities
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
March 31, 2019
NOTE 1 — BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial statements and the instructions to Form 10-Q of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2019, are not necessarily indicative of the results that may be expected for the year ending December 31, 2019. For further information, please refer to the consolidated financial statements and footnotes thereto included in the Company's Form 10-K for the fiscal year ended December 31, 2018.
NOTE 2 — SUMMARY OF ORGANIZATION
The First Bancshares, Inc., Hattiesburg, Mississippi (the "Company"), was incorporated June 23, 1995, under the laws of the State of Mississippi for the purpose of operating as a bank holding company. The Company’s primary asset is its interest in its wholly-owned subsidiary, The First, A National Banking Association (the “Bank” or “The First”).
At March 31, 2019, the Company had approximately $3.533 billion in assets, $2.330 billion in net loans, $2.914 billion in deposits, and $454.3 million in stockholders' equity. For the three months ended March 31, 2019, the Company reported net income of $7.6 million. After tax merger related costs of $2.5 million were expensed during the three months ended March 31, 2019.
On February 26, 2019, the Company paid a cash dividend in the amount of $0.07 per share to shareholders of record as of the close of business on Monday, February 11, 2019.
NOTE 3 — RECENT ACCOUNTING PRONOUNCEMENTS
In August 2018, the FASB issued ASU No. 2018-13, Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement. ASU 2018-11 eliminates, adds and modifies certain disclosure requirements for fair value measurements. Among the changes, entities will no longer be required to disclose the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, but will be required to disclose the range and weighted average used to develop significant unobservable inputs for Level 3 fair value measurements. ASU 2018-13 is effective for interim and annual reporting periods beginning after December 15, 2019; early adoption is permitted. Entities are also allowed to elect for early adoption the eliminated or modified disclosure requirements and delay adoption of the new disclosure requirements until their effective date. The revised disclosure requirements will not have a material impact on the Company’s Consolidated Financial Statements.
In June 2018, the FASB issued ASU No. 2018-07, Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. ASU 2018-07 has been issued as part of a simplification initiative which will expand the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from non-employees and expands the scope through the amendments to address and improve aspects of the accounting for non-employee share-based payment transactions. The amendments will be effective for interim and annual reporting periods beginning after December 15, 2018. The Company is currently evaluating the provisions of ASU 2018-07 to determine the potential impact the new standard will have on its Consolidated Financial Statements.
In August 2018, the FASB issued ASU No. 2018-15, “Intangibles – Goodwill and Other – Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract.” These amendments align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). The accounting for the service element of a hosting arrangement that is a service contract is not affected by these amendments. The guidance is effective for public business entities for annual periods, including interim periods within those annual periods, beginning after December 15, 2019. Early adoption is permitted. The Company is currently assessing ASU 2018-15 and the impact the new standard will have on its Consolidated Financial Statements.
In January 2017, the FASB issued ASU No. 2017-04, “Simplifying the Test for Goodwill Impairment.” ASU 2017-04 removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation. Under the amended guidance, a goodwill impairment charge will now be recognized for the amount by which the carrying value of a reporting unit exceeds its fair value, not to exceed the carrying amount of goodwill. This guidance is effective for interim and annual periods beginning after December 15, 2019, with early adoption permitted for any impairment tests performed after January 1, 2017. The Company is currently assessing the impact of ASU 2017-04 on its Consolidated Financial Statements.
In June 2016, the Financial Accounting Standards Board (FASB) issued ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments”. ASU 2016-13 requires a new impairment model known as the current expected credit loss (“CECL”) which significantly changes the way impairment of financial instruments is recognized by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of financial instruments. The main provisions of ASU 2016-13 include (1) replacing the “incurred loss” approach under current GAAP with an “expected loss” model for instruments measured at amortized cost, (2) requiring entities to record an allowance for credit losses related to available-for-sale debt securities rather than a direct write-down of the carrying amount of the investments, as is required by the other-than-temporary-impairment model under current GAAP, and (3) a simplified accounting model for purchased credit-impaired debt securities and loans. ASU 2016-13 is effective for interim and annual reporting periods beginning after December 15, 2019, although early adoption is permitted. The Company is currently working with a third party to assess the impact of the adoption of ASU 2016-13 on its Consolidated Financial Statements. While we are currently unable to reasonably estimate the impact of the adoption of ASU 2016-13, we expect that the impact of adoption could be influenced by the composition, characteristics and quality of our loan portfolio as well as the prevailing economic conditions and forecasts as of the adoption date. As part of our implementation process, the working group that is responsible for quarterly allowance for loan and lease losses(“ALLL”) model review and approval, also serves as the Bank’s CECL Implementation Team. These individuals come from various functional areas including Accounting, Credit Administration, Risk Management and Portfolio Management; as well as the CEO. The Bank has engaged the same third party vendor that currently provides ALLL modeling software and support to assist with the development of a CECL model that will be ready for use as of the adoption date. During the development phase of building a model specific to the needs of the Bank, concurrent CECL modeling will be performed to generate a loss projection using the new model for each quarter of 2019. This model estimate will be reviewed and discussed by the Implementation Team after each quarterly run as it does with the current ALLL Model. The Implementation Team will provide direction to management and the third party vendor throughout the implementation process.
In February 2016, the FASB issued ASU No. 2016-02 “Leases (Topic 842).” ASU 2016-02 establishes a right of use model that requires a lessee to record a right of use asset and a lease liability for all leases with terms longer than 12 months. Leases will be classified as either finance or operating with classification affecting the pattern of expense recognition in the income statement. For lessors, the guidance modifies the classification criteria and the accounting for sales-type and direct financing leases. A lease will be treated as a sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as a financing. If neither risks and rewards nor control is conveyed, an operating lease results. The amendments are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years for public business entities. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements, with certain practical expedients available. Early adoption is permitted. In July 2018, the FASB issued ASU No. 2018-11, Leases – Targeted Improvements. ASU 2018-11 provides entities with relief from the costs of implementing certain aspects of ASU 2016-02. Under the amendments in ASU 2018-11 entities may elect not to recast the comparative periods presented when transitioning to the new leasing standard and lessors may elect not to separate lease and non-lease components when certain conditions are met. The amendments have the same effective date as ASU 2016-02, January 1, 2019. We have elected to apply ASU 2016-02 as of the beginning of the period of adoption (January 1, 2019) and will not restate comparative periods. Our operating leases relate primarily to bank branches. As a result of the adoption of ASC 842 on January 1, 2019, we recorded operating lease right-of-use (“ROU”) assets of $1.8 million and lease liabilities of $1.8 million. ROU assets are adjusted for lease incentives. The adoption of ASC 842 had an immaterial impact on our Consolidated Statements of Income and Consolidated Statements of Cash Flows compared to the prior lease accounting model. The ROU asset and operating lease liability are recorded in premises and equipment and other liabilities, respectively, in the Consolidated Balance Sheets. See Note 12 – Leases for additional information.
NOTE 4 – BUSINESS COMBINATIONS
Acquisitions
FPB Financial Corp.
On March 2, 2019, the Company completed its acquisition of FPB Financial Corp., (“FPB”), and immediately thereafter merged its wholly-owned subsidiary, Florida Parishes Bank, with and into The First. The company paid a total consideration of approximately $78.2 million in stock to the FPB shareholders as consideration in the merger, which included 2,377,501 shares of Company common stock, and approximately $5 thousand in cash.
In connection with the acquisition, preliminarily, the Company recorded approximately $30.3 million of goodwill and $4.8 million of core deposit intangible. Goodwill is not deductible for income taxes. The core deposit intangible will be amortized to expense over 10 years.
The Company acquired the $247.8 million loan portfolio at an estimated fair value discount of $3.1 million. The discount represents expected credit losses, adjusted for market interest rates and liquidity adjustments.
Expenses associated with the acquisition were $1.7 million for the three month period ended March 31, 2019. These costs included system conversion and integrating operations charges as well as legal and consulting expenses, which have been expensed as incurred.
The preliminary amounts of the acquired identifiable assets and liabilities as of the acquisition date were as follows ($ in thousands):
The outstanding principal balance and the carrying amount of these loans included in the consolidated balance sheets as of the date of acquisition and at March 31, 2019, are as follows ($ in thousands):
Purchased credit impaired loans are detailed in Note 10 – Loans.
FMB Financial Corp.
On November 1, 2018, the Company completed its acquisition of FMB Banking Corporation (“FMB”), and immediately thereafter merged its wholly-owned subsidiary, Farmers & Merchants Bank, with and into The First. The Company paid a total consideration of approximately $79.5 million to the former FMB shareholders including 1,763,042 shares of the Company’s common stock and approximately $16.0 million in cash.
In connection with the acquisition, the Company recorded approximately $36.2 million of goodwill and $10.2 million of core deposit intangible. Goodwill is not deductible for income taxes. The core deposit intangible will be amortized to expense over 10 years.
The Company acquired FMB’s $325.5 million loan portfolio at an estimated fair value discount of $7.6 million. The discount represents expected credit losses, adjusted for market interest rates and liquidity adjustments.
Expenses associated with the acquisition were $998 thousand for the three month period ended March 31, 2019. These costs included system conversion and integrating operations charges, as well as legal and consulting expenses, which have been expensed as incurred.
The following table summarized the provisional fair values of the assets acquired and liabilities assumed on November 1, 2018 ($ in thousands):
The outstanding principal balance and the carrying amount of these loans included in the consolidated balance sheet March 31, 2019, are as follows ($ in thousands):
Sunshine Financial, Inc.
On April 1, 2018, the Company completed its acquisition of Sunshine Financial, Inc., (“Sunshine”), and immediately thereafter merged its wholly-owned subsidiary, Sunshine Community Bank, with and into The First. The Company paid a total consideration of $30.5 million to the Sunshine shareholders as consideration in the merger which included 726,461 shares of Company common stock and $7 million in cash.
In connection with the acquisition, the Company recorded $9.5 million of goodwill and $4.1 million of core deposit intangible. Goodwill is not deductible for income taxes. The core deposit intangible will be amortized to expense over 10 years.
The Company acquired the $173.1 million loan portfolio at an estimated fair value discount of $4.5 million. The discount represents expected credit losses, adjusted for market interest rates and liquidity adjustments.
Expenses associated with the acquisition were $227 thousand for the three month period ended March 31, 2019. These costs included system conversion and integrating operations charges as well as legal and consulting expenses, which have been expensed as incurred.
The outstanding principal balance and the carrying amount of these loans included in the consolidated balance sheet as of the date of acquisition and at March 31, 2019, are as follows ($ in thousands):
Southwest Banc Shares, Inc.
On March 1, 2018, the Company completed its acquisition of Southwest Banc Shares, Inc., (“Southwest”), and immediately thereafter merged its wholly-owned subsidiary, First Community Bank, with and into The First. The Company paid a total consideration of $60.0 million to the Southwest shareholders as consideration in the merger which included 1,134,010 shares of Company common stock and $24 million in cash.
In connection with the acquisition, the Company recorded $23.9 million of goodwill and $5.8 million of core deposit intangible. Goodwill is not deductible for income taxes. The core deposit intangible will be amortized to expense over 10 years.
The Company acquired the $274.7 million loan portfolio at an estimated fair value discount of $3.5 million. The discount represents expected credit losses, adjusted for market interest rates, and liquidity adjustments.
Expenses associated with the acquisition were $257 thousand for the three months period ended March 31, 2019. These costs included systems conversions and integrating operations charges, as well as legal and consulting expenses, which have been expensed as incurred.
The following unaudited pro-forma financial information for the three months ended March 31, 2019 and March 31, 2018 gives effect to the acquisitions as if the acquisitions had occurred on January 1, 2019 and 2018. The pro-forma financial information is not necessarily indicative of the results of operations had the acquisitions been effective as of this date.
Supplemental pro-forma earnings were adjusted to exclude acquisition costs incurred.
Non-credit impaired loans acquired in the acquisitions were accounted for in accordance with ASC 310-20, Receivables-Nonrefundable Fees and Other Costs.Purchased credit impaired loans acquired in the Southwest, Sunshine, FMB and FPB acquisitions were accounted for in accordance with ASC 310-30 Accounting for Purchased Loans with Deteriorated Credit Quality.
NOTE 5 – EARNINGS APPLICABLE TO COMMON STOCKHOLDERS
Basic per share data is calculated based on the weighted-average number of common shares outstanding during the reporting period. Diluted per share data includes any dilution from potential common stock outstanding, such as restricted stock grants. There were no antidilutive common stock equivalents excluded in the calculations.
The following tables disclose the reconciliation of the numerators and denominators of the basic and diluted computations applicable to common stockholders ($ in thousands, expect per share amount):
The Company granted 66,132 shares of restricted stock in the first quarter of 2019 and 51,851 shares of restricted stock in the first quarter of 2018.
NOTE 6 – COMPREHENSIVE INCOME
As presented in the Consolidated Statements of Comprehensive Income, comprehensive income includes net income and other comprehensive income. The Company’s sources of other comprehensive income are unrealized gains and losses on available-for-sale debt securities. Gains or losses on debt securities that had previously been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose were realized and reflected in net income of the current period, and as a result are considered to be reclassification adjustments that are excluded from other comprehensive income in the current period.
NOTE 7 – FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. At March 31, 2019, and December 31, 2018, these financial instruments consisted of the following:
Fixed
Rate
Variable
Commitments to make loans are generally made for periods of 90 days or less. The fixed rate loan commitments have interest rates ranging from 3.25% to 18.00% and maturities ranging from 1 year to 30 years.
NOTE 8 – FAIR VALUE DISCLOSURES AND REPORTING, THE FAIR VALUE OPTION AND FAIR VALUE MEASUREMENTS
FASB’s standards on financial instruments, and on fair value measurements and disclosures, require all entities to disclose in their financial statement footnotes the estimated fair values of financial instruments for which it is practicable to estimate fair values. In addition to disclosure requirements, FASB’s standard on investments requires that our debt securities which are classified as available-for-sale and our equity securities that have readily determinable fair values be measured and reported at fair value in our Consolidated Financial Statements. Certain impaired loans are also reported at fair value, as explained in greater detail below, and foreclosed assets are carried at the lower of cost or fair value. FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, but we have not elected the fair value option for any of those financial instruments.
Fair value measurement and disclosure standards also establish a framework for measuring fair values. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants on the measurement date. Further, the standards establish a fair value hierarchy that encourages an entity to maximize the use of observable inputs and limit the use of unobservable inputs when measuring fair values. The standards describe three levels of inputs that may be used to measure fair values:
Fair value estimates are made at a specific point in time based on relevant market data and information about the financial instruments. The estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to realized gains and losses could have a significant effect on fair value estimates but have not been considered in those estimates. Because no active market exists for a significant portion of our financial instruments, fair value disclosures are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors. The estimates are subjective and involve uncertainties and matters of significant judgment, and therefore cannot be determined with precision. Changes in assumptions could significantly alter the fair values presented. The following methods and assumptions were used by the Company to estimate its financial instrument fair values disclosed at March 31, 2019 and December 31, 2018:
Estimated fair values for the Company’s financial instruments are as follows, as of the dates noted:
Estimated Fair
Value
Quoted
Prices (Level 1)
Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, securities are classified within Level 2 of the valuation hierarchy, and fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow. Level 2 securities include U. S. agency securities, mortgage-backed securities, obligations of states and political subdivisions and certain corporate, asset-backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.
Assets measured at fair value on a recurring basis are summarized below:
The following is a reconciliation of activity for assets measured at fair value based on significant unobservable (non-market) information. There were no transfers into or out of the Level 3 fair value hierarchy for the periods presented below.
The following table presents quantitative information about recurring Level 3 fair value measurements ($ in thousands):
Significant
Unobservable Inputs
Following is a description of the valuation methodologies used for assets measured at fair value on a non-recurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.
Impaired Loans
Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms are measured for impairment. If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral. These 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 independent appraisers to adjust for differences between the comparable sales and income data available for similar loans and collateral underlying such loans. Such adjustments, if any, result in a Level 3 classification of the inputs for determining fair value. The Company generally adjusts the appraisal down by approximately 10 percent to account for selling costs. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment.
Purchased Credit Impaired Loans (“PCI”)
Purchased credit impaired loan valuations utilize third party appraisals and are classified as Level 3 due to the significant judgement involved. Appraisals may include the utilization of unobservable inputs, subjective factors and utilize quantitative data to estimate fair market value. The Company generally adjusts the appraisal down by approximately 10 percent to account for selling costs.
Other Real Estate Owned
Other real estate owned consists of properties obtained through foreclosure. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Fair value of other real estate owned is based on current independent appraisals of the collateral less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals, which are updated no less frequently than annually. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach with data from comparable properties. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments, if any, result in a Level 3 classification of the inputs for determining fair value. In the determination of fair value subsequent to foreclosure, Management also considers other factors or recent developments, such as changes in market conditions from the time of valuation and anticipated sales values considering plans for disposition, which could result in an adjustment to lower the collateral value estimates indicated in the appraisals. The Company generally adjusts the appraisal down by approximately 10 percent to account for selling costs. Periodic revaluations are classified as Level 3 in the fair value hierarchy since assumptions are used that may not be observable in the market. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined the fair value declines subsequent to foreclosure, a valuation allowance is recorded through other non-interest income. Operating costs associated with the assets after acquisition are also recorded as non-interest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and recorded in other non-interest income. Other real estate measured at fair value on a non-recurring basis at March 31, 2019, amounted to $11.6 million. Other real estate owned is classified within Level 3 of the fair value hierarchy.
The following table presents the fair value measurement of assets measured at fair value on a nonrecurring basis and the level within the fair value hierarchy in which the fair value measurements declined at March 31, 2019 and December 31, 2018.
December 31, 2018
NOTE 9 - SECURITIES
The following disclosure of the estimated fair value of financial instruments is made in accordance with authoritative guidance. The estimated fair value amounts have been determined using available market information and valuation methodologies that management believes are appropriate. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
A summary of the amortized cost and estimated fair value of available-for-sale securities and held-to-maturity securities at March 31, 2019 and December 31, 2018, follows:
The scheduled maturities of securities at March 31, 2019 and December 31, 2018 were as follows:
Actual maturities can differ from contractual maturities because the obligations may be called or prepaid with or without penalties.
The details concerning securities classified as available-for-sale with unrealized losses as of March 31, 2019 and December 31, 2018 were as follows:
At March 31, 2019 and December 31, 2018, the Company’s securities portfolio consisted of 910 and 427 securities, respectively, that were in an unrealized loss position. The Company reviews its investment portfolio quarterly for indications of other-than-temporary impairment (“OTTI”), with attention given to securities in a continuous loss position of at least ten percent for over twelve months. Management believes that none of the losses on available-for-sale securities noted above constitute an OTTI. The noted losses are considered temporary due to market fluctuations in available interest rates. Management considers the issuers of the securities to be financially sound, the corporate bonds are investment grade, and the collectability of all contractual principal and interest payments is reasonably expected. On January 1, 2018, the Company adopted the new accounting standard for Financial Instruments, which requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with the changes in fair value recognized in net income. The adoption of this guidance resulted in a $348 thousand decrease to retained earnings. No OTTI losses were recognized during the three months ended March 31, 2019 or the year ended December 31, 2018.
NOTE 10 – LOANS
Generally, the Company will place a delinquent loan in nonaccrual status when the loan becomes 90 days or more past due. At the time a loan is placed in nonaccrual status, all interest which has been accrued on the loan but remains unpaid is reversed and deducted from earnings as a reduction of reported interest income. No additional interest is accrued on the loan balance until the collection of both principal and interest becomes reasonably certain.
The following tables summarize by class our loans classified as past due in excess of 30 days or more in addition to those loans classified as non-accrual or PCI:
We acquired loans with deteriorated credit quality in 2014, 2017, 2018 and 2019. These loans were recorded at estimated fair value at the acquisition date with no carryover of the related allowance for loan losses. The acquired loans were segregated as of the acquisition date between those considered to be performing (purchased non-impaired loans) and those with evidence of credit deterioration (purchased credit impaired loans). Acquired loans are considered to be impaired if it is probable, based on current available information, that the Company will be unable to collect all cash flows as expected. If the collection of expected cash flows cannot reasonably be estimated, no interest income will be recognized on these loans.
The following table presents information regarding the contractually required payments receivable, cash flows expected to be collected and the estimated fair value of PCI loans acquired in the FPB acquisition.
Total outstanding purchased credit impaired loans were $21.7 million and the related purchase accounting discount was $4.0 million as of March 31, 2019, and $17.7 million and $3.8 million as of December 31, 2018, respectively. The outstanding balance of these loans is the undiscounted sum of all amounts, including amounts deemed principal, interest, fees, penalties, and other under the loans, owed at the reporting date, whether or not currently due and whether or not any such amounts have been charged off. There was no related allowance allocated to the acquired impaired loans.
Changes in the accretable yield for purchased credit impaired loans were as follows at March 31, 2019 and 2018:
The following tables provide additional detail of impaired loans broken out according to class as of March 31, 2019 and December 31, 2018. The recorded investment included in the following tables represents customer balances net of any partial charge-offs recognized on the loans, net of any deferred fees and costs. As nearly all of our impaired loans at March 31, 2019 are on nonaccrual status, recorded investment excludes any insignificant amount of accrued interest receivable on loans 90-days or more past due and still accruing. The unpaid balance represents the recorded balance prior to any partial charge-offs.
(1) – The total unpaid balance of impaired loans with no related allowance as of March 31, 2019 includes $21,702 in PCI loans.
As of March 31, 2019, the Company had $2.1 million of foreclosed residential real estate property obtained by physical possession and $368 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process according to local jurisdictions.
(1) – The total unpaid balance of impaired loans with no related allowance as of December 31, 2018 includes $17,652 in PCI loans.
Interest income recognized and cash-basis interest income recognized on impaired loans was approximately $122 thousand and $97 thousand, respectively, for the three months ended March 31, 2019 and 2018. The gross interest income that would have been recorded in the period that ended if the non-accrual loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination, if held for part of the three months ended March 31, 2019 and March 31, 2018 and $409 thousand and $86 thousand, respectively. The Company had no loan commitments to borrowers in non-accrual status at March 31, 2019 and December 31, 2018.
Troubled Debt Restructuring
If the Company grants a concession to a borrower in financial difficulty, the loan is classified as a troubled debt restructuring (“TDR”).
There were 3 and 0 TDRs modified during the three months ended March 31, 2019 and 2018, respectively. The balance of TDRs was $17.0 million at March 31, 2019 and $14.3 million at December 31, 2018. The increase of $2.7 million is attributable to acquired loans. There was $215 thousand allocated in specific reserves established with respect to these loans as of March 31, 2019. As of March 31, 2019, the Company had no additional amount committed on any loan classified as TDR.
The following tables set forth the amounts and past due status for the Company’s TDRs at March 31, 2019 and December 31, 2018:
A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms. There was 1 loan which totaled $10 thousand and 12 loans which totaled $4.3 million that were modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the quarters ending March 31, 2019 and March 31, 2018, respectively.
Internal Risk Ratings
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, among other factors. The Company uses the following definitions for risk ratings, which are consistent with the definitions used in supervisory guidance:
Special Mention: Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date.
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 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.
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.
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.
As of March 31, 2019 and December 31, 2018, and based on the most recent analysis performed, the risk categories of loans by class of loans (excluding mortgage loans held for sale) were as follows:
Allowance for Loan Losses
Activity in the allowance for loan losses for the period was as follows:
The following tables provide the ending balances in the Company's loans (excluding mortgage loans held for sale) and allowance for loan losses, broken down by portfolio segment as of March 31, 2019 and December 31, 2018. The tables also provide additional detail as to the amount of our loans and allowance that correspond to individual versus collective impairment evaluation. The impairment evaluation corresponds to the Company's systematic methodology for estimating its Allowance for Loan Losses. See Item 2. – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Allowance for Loan and Lease Losses” for a description of our methodology.
NOTE 11 – REVENUE FROM CONTRACTS WITH CUSTOMERS
On January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers. ASU 2014-09 implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract; (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract and (v) recognize revenue when (or as) the entity satisfies a performance obligation.
The Company concluded that there was no change to the timing and pattern of revenue recognition for its current revenue streams or the presentation of revenue as gross versus net. No adjustment to retained earnings was required on the adoption date. Because there was no change to the timing and pattern of revenue recognition, there were no material changes to the Company’s processes and internal controls.
All of the Company’s revenue from contracts with customers within the scope of ASC 606 is recognized within noninterest income. The guidance does not apply to revenue associated with financial instruments, including loans and investment securities that are accounted for under other GAAP, which comprise a significant portion of our revenue stream. A description of the Company’s revenue streams accounted for under ASC 606 is as follows:
Service Charges on Deposit Accounts: The Company earns fees from deposit customers for transaction-based, account maintenance, and overdraft services. Transaction-based fees, which include services such as ATM use fees, stop payment charges, statement rendering, and ACH fees, are recognized at the time the transaction is executed at the point in the time the Company fulfills the customer’s request. Account maintenance fees, which relate primarily to monthly maintenance, are earned over the course of a month, representing the period over which the Company satisfies the performance obligation. Overdraft fees are recognized at the point in time that the overdraft occurs. Service charges on deposits are withdrawn from the customer’s account balance.
Interchange Income: The Company earns interchange fees from debit and credit card holder transactions conducted through various payment networks. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized daily, concurrently with the transaction processing services provided by the cardholder.
Gains/Losses on Sales of OREO: The Company records a gain or loss from the sale of OREO when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. When the Company finances the sale of OREO to the buyer, the Company assesses whether the buyer is committed to perform their obligations under the contract and whether the collectability of the transaction prices is probable. Once these criteria are met, the OREO asset is derecognized and the gain or loss on sale is recorded upon the transfer of control of the property to the buyer. In determining the gain or loss on the sale, the Company adjusts the transaction price and related gain (loss) on sale if a significant financing component is present.
All of the Company’s revenue from contracts with customers in the scope of ASC 606 is recognized within non-interest income. The following table presents the Company’s sources of non-interest income revenue by operating segments for the three months ended March 31, 2019 and 2018. Items outside the scope of ASC 606 are noted as such.
NOTE 12 – LEASES
Operating leases in which we are the lessee are recorded as operating lease ROU assets and operating lease liabilities, which are included in premises and equipment and other liabilities, respectively, on our consolidated balance sheets. We do not currently have any significant finance leases in which we are the lessee.
Operating lease ROU assets represent our right to use an underlying asset during the lease term and operating lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and operating lease liabilities are recognized at lease commencement based on the present value of the remaining lease payments using a discount rate that represents our incremental borrowing rate at the lease commencement date. Operating lease expense, which is comprised of amortization of the ROU asset and the implicit interest accreted on the operating lease liability, is recognized on a straight-line basis over the lease term, and is recorded in net occupancy and equipment expense in the consolidated statements of income and other comprehensive income.
Our leases relate primarily to bank branches with remaining lease terms of generally 1 to 8 years. Certain lease arrangements contain extension options which are not generally considered reasonably certain of exercise and they are not included in the lease term. As of March 31, 2019, operating lease ROU assets and liabilities were $3.6 million and $3.6 million, respectively.
The table below summarizes our net lease costs:
The table below summarizes other information related to our operating leases:
The table below summarizes the maturity of remaining lease liabilities:
As a result of the adoption of ASC 842, The Company did not restate the prior period unaudited consolidated financial statements and all prior period amounts and disclosures are presented under ASC 840. At December 31, 2018, minimum future lease payments were as follows ($ in thousands):
NOTE 13 – RECLASSIFICATION
Certain amounts in the 2018 financial statements have been reclassified for comparative purposes to conform to the current period financial statement presentation.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “expects,” “will,” “intends,” “anticipates,” “plans,” “believes,” “seeks,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements. Such statements are based on currently available information and are subject to various risks and uncertainties that could cause actual results to differ materially from the Company’s present expectations. Factors that might cause such differences include, but are not limited to: competitive pressures among financial institutions increasing significantly; economic conditions, either nationally or locally, in areas in which the Company conducts operations being less favorable than expected; interest rate risk; legislation or regulatory changes which adversely affect the ability of the consolidated Company to conduct business combinations or new operations; financial success or changing strategies of the Bank’s customers or vendors; actions of government regulators; and the risk that anticipated benefits from the recent acquisitions are not realized in the time frame anticipated or at all as a result of changes in general economic and market conditions or other unexpected factors or events.
Potential risks and uncertainties that could cause our actual results to differ materially from those anticipated in any forward-looking statements include, but are not limited to, the following:
We have based our forward-looking statements on our current expectations about future events. Although we believe that the expectations reflected in and the assumptions underlying our forward-looking statements are reasonable, we cannot guarantee that these expectations will be achieved or the assumptions will be accurate. The Company disclaims any obligation to update such factors or to publicly announce the results of any revisions to any of the forward-looking statements included herein to reflect future events or developments. Additional information concerning these risks and uncertainties is contained in Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2018, and in our future filings with the Securities and Exchange Commission, available at the SEC’s website, http://www.sec.gov.
CRITICAL ACCOUNTING POLICIES
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and incorporate various assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.
Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas: the establishment of the allowance for loan and lease losses (referred to as the “allowance for loan losses” or the “ALLL”), as explained in detail in Note 10 - Loans to the Consolidated Financial Statements and in the “Allowance for Loan and Lease Losses” sections of this Item 2. – Management’s Discussion and Analysis of Financial Condition and Results of Operations; the valuation of impaired loans and foreclosed assets, as discussed in Note 10 - Loans to the Consolidated Financial Statements; income taxes and deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this Item No. 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations; and goodwill and other intangible assets, which are evaluated annually for impairment, as discussed in the “Other Assets” section of this Item 2. – Management’s Discussion and Analysis of Financial Condition and Results of Operations. Critical accounting policies are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations with regard to those areas.
OVERVIEW OF THE RESULTS OF OPERATIONS AND FINANCIAL CONDITION
RESULTS OF OPERATIONS SUMMARY
First quarter 2019 compared to first quarter 2018
The Company reported net income available to common shareholders of $7.6 million for the three months ended March 31, 2019, compared with net income available to common shareholders of $4.0 million for the same period last year. For the first quarter of 2019, fully diluted earnings per share were $0.48, compared to $0.34 for the first quarter of 2018.
Operating net earnings for the first quarter of 2019 totaled $9.9 million compared to $5.4 million for the first quarter of 2018, an increase of $4.6 million or 85.2%. Operating net earnings excludes merger-related costs of $2.5 million, net of tax and income in the form of an award from the Community Development Financial Institutions Fund of the U.S. Department of Treasury of $233 thousand, net of tax, for the first quarter of 2019, and excludes merger-related costs of $1.4 million, net of tax for the first quarter of 2018. Operating earnings per share were $0.63 on a fully diluted basis for the first quarter 2019, compared to $0.46 for the same period in 2018. See reconciliation of non-GAAP financial measures provided below.
Net interest income increased to $27.1 million, or 65.6% for the three months ended March 31, 2019, compared to $16.4 million for the same period in 2018. The increase was due to interest income earned on a higher volume of loans as well as increased interest rates. Quarterly average earning assets at March 31, 2019, increased $1.0 billion, or 55.4% and quarterly average interest-bearing liabilities increased $778 thousand or 55.1% when compared to March 31, 2018.
Non-interest income for the three months ended March 31, 2019, was $5.6 million compared to $3.5 million for the same period in 2018, reflecting an increase of $2.1 million or 60.6%. This increase was composed of increases in service charges and interchange fee income of $1.4 million primarily based on the increased deposit base due to the acquisitions. The Company also received a Bank Enterprise Award of $233 thousand from the U.S. Department of the Treasury during the first quarter of 2019 as a result of our designation as a Community Development Financial Institution.
The provision for loan losses was $1.1 million for the three months ended March 31, 2019, compared with $277 thousand for the same period in 2018. The allowance for loan losses of $11.2 million at March 31, 2019 or 0.48% of total loans is based on our methodology and is considered by management to be adequate to cover losses inherent in the loan portfolio. See “Allowance for Loan and Lease Losses” in this Item 2. – Management’s Discussion and Analysis of Financial Condition and Results of Operations for more information on this evaluation.
Non-interest expense was $21.9 million for the three months ended March 31, 2019, an increase of $7.3 million or 50.0%, when compared with the same period in 2018. Excluding the increase in acquisition charges of $1.4 million for first quarter of 2019, non-interest expense increased $5.9 million in the first quarter of 2019, of which $3.8 million was attributable to the operations of Southwest, Sunshine, FMB and FPB, as compared to first quarter of 2018.
FINANCIAL CONDITION
The First represents the primary asset of the Company. The First reported total assets of $3.533 billion at March 31, 2019 compared to $3.004 billion at December 31, 2018, an increase of $529.0 million. Loans increased $274.9 million to $2.335 billion, or 13.3%, during the first three months of 2019. Deposits at March 31, 2019, totaled $2.914 billion compared to $2.457 billion at December 31, 2019. The First acquired loans of $241.6 million, net of fair value marks and deposits of $314.4 million, net of fair value marks as a result of the acquisition of FPB during the first quarter of 2019. See Note 4 – Business Combinations to the Consolidated Financial Statements.
For the three month period ended March 31, 2019, The First reported net income of $7.6 million compared to $4.0 million for the three months ended March 31, 2018. Merger charges, net of tax, equaled $2.5 million for the first three months of 2019 as compared to $1.4 million for the first three months of 2018.
EARNINGS PERFORMANCE
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 deposits and other borrowed money. The second is non-interest income, which primarily consists of customer service charges and fees as well as mortgage income but also comes from non-customer sources such as bank-owned life insurance. The majority of the Company’s non-interest expense is comprised of operating costs that facilitate offering a full range of banking services to our customers.
Net interest income AND NET INTEREST MARGIN
Net interest income increased by $10.8 million, or 65.6%, for the first quarter of 2019 relative to the first quarter of 2018. The increase was due to interest income earned in a higher volume of loans as well as increased interest rates. The level of net interest income we recognize in any given period depends on a combination of factors including the average volume and yield for interest-earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. Net interest income is also impacted by the reversal of interest for loans placed on non-accrual status during the reporting period, and the recovery of interest on loans that had been on non-accrual and were paid off, sold or returned to accrual status.
The following tables depict, for the periods indicated, certain information related to the average balance sheet and average yields on assets and average costs of liabilities. Such yields are derived by dividing income or expense by the average balance of the corresponding assets or liabilities. Average balances have been derived from daily averages.
Average Balances, Tax Equivalent Interest and Yields/Rates
*See reconciliation of Non-GAAP financial measures.
NON-INTEREST INCOME AND NON-INTEREST EXPENSE
The following table provides details on the Company’s non-interest income and non-interest expense for the three month period ended March 31, 2019 and 2018:
PROVISION FOR INCOME TAXES
The Company sets aside a provision for income taxes on a monthly basis. The amount of the provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits if applicable. Permanent differences include but are not limited to tax-exempt interest income, bank-owned life insurance cash surrender value income, and certain book expenses that are not allowed as tax deductions.
The Company’s provision for income taxes was $2.0 million or 21.03% of earnings before income taxes for the first quarter of 2019, compared to $1.0 million or 20.3% of earnings before income taxes for the same period in 2018.
BALANCE SHEET ANALYSIS
EARNING ASSETS
The Company’s interest-earning assets are comprised of investments and loans, and the composition, growth characteristics, and credit quality of both are significant determinants of the Company’s financial condition. Investments are analyzed in the section immediately below, while the loan and lease portfolio and other factors affecting earning assets are discussed in the sections following investments.
INVESTMENTS
The Company’s investments can at any given time consist of debt securities and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest-earning balances in our Federal Reserve Bank (“FRB”) account, and overnight fed funds sold. Surplus FRB balances and fed funds sold to correspondent banks represent the temporary investment of excess liquidity. The Company’s investments serve several purposes: 1) they provide liquidity to even out cash flows from the loan and deposit activities of customers; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with maturity and interest rate characteristics that can be changed more readily than the loan portfolio, to better match changes in the deposit base and other funding sources of the Company; 4) they are another interest-earning option for surplus funds when loan demand is light; and 5) they can provide partially tax exempt income. Total securities, excluding other securities, totaled $605.2 million, or 17.1% of total assets at March 31, 2019 compared to $498.7 million, or 16.6% of total assets at December 31, 2018.
We had no federal funds sold at March 31, 2019 and December 31, 2018; and interest-bearing balances at other banks increased to $157.0 million at March 31, 2019 from $87.8 million at December 31, 2018. The Company’s investment portfolio increased $105.6 million, or 20.5%, to a total fair market value of $620.5 million at March 31, 2019 compared to December 31, 2018, $93.6 million of which was due to the acquisition of FPB during the first three months of 2019, as well as a increase in the fair market value of $8.0 million. The Company carries investments principally at their fair market values. The Company holds a small amount of “held-to-maturity” investments with a fair market value of $7.6 million at March 31, 2019 as compared to $7.0 million at December 31, 2018. All other investment securities are classified as “available-for-sale” to allow maximum flexibility with regard to interest rate risk and liquidity management.
Refer to the table shown in Note 9 – Securities to the Consolidated Financial Statements for information on the Company’s amortized cost and fair market value of its investment portfolio by investment type.
LOAN AND LEASE PORTFOLIO
The Company’s gross loans and leases, excluding the associated allowance for loan losses and including loans held for sale, totaled $2.342 billion at March 31, 2019, an increase of $276.3 million, or 13.4%, from December 31, 2018. The acquisition of Florida Parishes Bank accounted for approximately $241.6 million, net of fair value marks, of the increase.
A distribution of the Company’s loans showing the balance and percentage of loans by type is presented for the noted periods in the table below.
The following table shows the composition of the loan portfolio by category ($ in thousands):
Composition of Loan Portfolio
In the context of this discussion, a "real estate residential loan" is defined as any loan, other than a loan for construction purposes, secured by real estate, regardless of the purpose of the loan. The Company follows the common practice of financial institutions in the Company’s market area of obtaining a security interest in real estate whenever possible, in addition to any other available collateral. This collateral is taken to reinforce the likelihood of the ultimate repayment of the loan and tends to increase the magnitude of the real estate loan portfolio component. Generally, the Company limits its loan-to-value ratio to 80%. Management attempts to maintain a conservative philosophy regarding its underwriting guidelines and believes that the risk elements of its loan portfolio have been reduced through strategies that diversify the lending mix.
Loans held for sale consist of mortgage loans originated by the Bank and sold into the secondary market. Associated servicing rights are not retained. Commitments from investors to purchase the loans are obtained upon origination.
LOAN CONCENTRATIONS
Diversification within the loan portfolio is an important means of reducing inherent lending risk. At March 31, 2019, The First had no concentrations of ten percent or more of total loans in any single industry or any geographical area outside its immediate market areas, which include Mississippi, Louisiana, Alabama, Florida and Georgia.
NON-PERFORMING ASSETS
At March 31, 2019, The First had loans past due as follows ($ in thousands):
Non-performing assets are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets including mobile homes and OREO. Loans are placed on non-accrual status when they become ninety days past due (principal and/or interest), unless the loans are adequately secured and in the process of collection. Non-accrual and PCI loans totaled $26.5 million at March 31, 2019, an increase of $1.4 million from December 31, 2018. This increase is primarily due to acquired PCI loans.
Other real estate owned is carried at fair value, determined by an appraisal, less estimated costs to sell. Other real estate owned totaled $11.6 million at March 31, 2019 as compared to $10.9 million at December 31, 2018.
A loan is classified as a restructured loan when the following two conditions are present: first, the borrower is experiencing financial difficulty and second, the creditor grants a concession it would not otherwise consider but for the borrower’s financial difficulty. At March 31, 2019, the Bank had $17.0 million in loans that were classified as troubled debt restructurings (“TDRs”), of which $8.0 million were performing as agreed with modified terms. At December 31, 2018, the Bank had $14.3 million in loans that were classified as troubled debt restructurings of which $5.3 million were performing as agreed with modified terms. TDRs may be classified as either non-performing or performing loans depending on their accrual status. As of March 31, 2019, $8.6 million in loans categorized as TDRs were classified as non-performing as compared to $8.3 million at December 31, 2018.
The following table, which includes purchased credit impaired loans, presents comparative data for the Company’s non-performing assets and performing TDRs as of the dates noted:
Non-performing assets totaled $38.1 million at March 31, 2019, compared to $35.9 million at December 31, 2018, an increase of $2.2 million. The ALLL/total loans ratio was 0.48% at March 31, 2019, and 0.49% at December 31, 2018. Total valuation accounting adjustments total $16.1 million on acquired loans. The ratio of annualized net charge-offs (recoveries) to total loans was (0.008%) for the quarter ended March 31, 2019 compared to 0.02% at December 31, 2018.
The following table represents the Company’s impaired loans at March 31, 2019, and December 31, 2018.
ALLOWANCE FOR LOAN AND LEASE LOSSES
The Company has developed policies and procedures for evaluating the overall quality of its credit portfolio and the timely identification of potential problem loans. Management’s judgment as to the adequacy of the allowance for loan losses is based upon a number of assumptions about future events which it believes to be reasonable, but which may not prove to be accurate. Thus, there can be no assurance that charge-offs in future periods will not exceed the allowance for loan losses or that additional increases in the loan loss allowance will not be required.
The Company’s allowance consists of two parts. The first part is determined in accordance with authoritative guidance issued by the FASB regarding the allowance. The Company’s determination of this part of the allowance is based upon quantitative and qualitative factors. The Company uses a loan loss history based upon the prior ten years to determine the appropriate allowance. Historical loss factors are determined by criticized and uncriticized loans by loan type. These historical loss factors are applied to the loans by loan type to determine an indicated allowance. The loss factors of peer groups are considered in the determination of the allowance and are used to assist in the establishment of a long-term loss history for areas in which this data is unavailable and incorporated into the qualitative factors to be considered. The historical loss factors may also be modified based upon other qualitative factors including but not limited to local and national economic conditions, trends of delinquent loans, changes in lending policies and underwriting standards, concentrations, and management’s knowledge of the loan portfolio. These factors require judgment on the part of management and are based upon state and national economic reports received from various institutions and agencies including the Federal Reserve Bank, United States Bureau of Economic Analysis, Bureau of Labor Statistics, meetings with the Company’s loan officers and loan committees, and data and guidance received or obtained from the Company’s regulatory authorities.
The second part of the allowance is determined in accordance with guidance issued by the FASB regarding impaired loans. Impaired loans are determined based upon a review by internal loan review and senior loan officers. Impaired loans are loans for which the Bank does not expect to receive contractual interest and/or principal by the due date. A specific allowance is assigned to each loan determined to be impaired based upon the value of the loan’s underlying collateral. Appraisals are used by management to determine the value of the collateral.
The sum of the two parts constitutes management’s best estimate of an appropriate allowance for loan losses. When the estimated allowance is determined, it is presented to the Company’s audit committee for review and approval on a quarterly basis.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
Impairment is measured on a loan by loan basis, and a specific allowance is assigned to each loan determined to be impaired. Impaired loans not deemed collateral dependent are analyzed according to the ultimate repayment source, whether that is cash flow from the borrower, guarantor or some other source of repayment. Impaired loans are deemed collateral dependent if, in the Company’s opinion, the ultimate source of repayment will be generated from the liquidation of collateral.
The Company discontinues accrual of interest on loans when management believes, after considering economic and business conditions and collection efforts, that a borrower’s financial condition is such that the collection of interest is doubtful. Generally, the Company will place a delinquent loan in non-accrual status when the loan becomes 90 days or more past due. At the time a loan is placed in non-accrual status, all interest which has been accrued on the loan but remains unpaid is reversed and deducted from earnings as a reduction of reported interest income. No additional interest is accrued on the loan balance until the collection of both principal and interest becomes reasonably certain.
At March 31, 2019, the consolidated allowance for loan losses was approximately $11.2 million, or 0.48% of outstanding loans excluding loans held for sale. At December 31, 2018, the allowance for loan losses amounted to approximately $10.1 million, which was 0.49% of outstanding loans. The provision for loan losses is a charge to earnings to maintain the allowance for loan losses at a level consistent with management’s assessment of the collectability of the loan portfolio in light of current economic conditions and market trends. It is maintained at a level that management believes is adequate to absorb probable incurred losses inherent in the loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge off. The Company’s provision for loan losses was $1.1 million at March 31, 2019, $2.1 million at December 31, 2018 and $277 thousand at March 31, 2018. The overall allowance for loan losses results from consistent application of our loan loss reserve methodology as described above. At March 31, 2019, management believes the allowance is appropriate and has been derived from consistent application of our methodology. Should any of the factors considered by management in evaluating the appropriateness of the allowance for loan losses change, management’s estimate of inherent losses in the portfolio could also change, which would affect the level of future provisions for loan losses.
The table that follows summarizes the activity in the allowance for loan and lease losses for the noted periods:
Three
Months Ended
For the
Year Ended
The following tables represent how the allowance for loan losses is allocated to a particular loan type, as well as the percentage of the category to total loans at March 31, 2019 and December 31, 2018.
Allocation of the Allowance for Loan Losses
OTHER ASSETS
The Company’s balance of non-interest earning cash and due from banks was $91.5 million at March 31, 2019 and $71.4 million at December 31, 2018. The balance of cash and due from banks depends on the timing of collection of outstanding cash items (checks), the level of cash maintained on hand at our branches, and our reserve requirement among other things, and is subject to significant fluctuation in the normal course of business. While cash flows are normally predictable within limits, those limits are fairly broad and the Company manages its short-term cash position through the utilization of overnight loans to and borrowings from correspondent banks, including the Federal Reserve Bank and the Federal Home Loan Bank. Should a large “short” overnight position persists for any length of time, the Company typically raises money through focused retail deposit gathering efforts or by adding brokered time deposits. If a “long” position is prevalent, the Company will let brokered deposits or other wholesale borrowings roll off as they mature, or might invest excess liquidity in higher-yielding, longer-term bonds.
Total equity securities decreased $929 thousand due to an decrease in FHLB stock. The Company’s net premises and equipment at March 31, 2019 was $94.6 million and $74.8 million at December 31, 2018; an increase of $19.8 million, or 26.5% for the first three months of 2019. Included in the acquisition of FPB was $7.3 million in bank-owned life insurance, creating a balance of $58.4 million at March 31, 2019. Bank-owned life insurance is also discussed above under the heading “Non-Interest Income and Non-Interest Expense.” Goodwill increased to $119.9 million at March 31, 2019, an increase of $30.2 million from the first quarter of 2018 as a result of the acquisition FPB. Other intangible assets, consisting primarily of the Company’s core deposit intangible, increased by $4.1 million in the first quarter of 2019, as compared to the prior year quarter due to the acquisition. The Company’s goodwill and other intangible assets are evaluated annually for potential impairment, and pursuant to that analysis management has determined that no impairment exists as of March 31, 2019.
Other real estate owned increased by $719 thousand, or 6.6%, to $11.6 million at March 31, 2019 as compared to December 31, 2018. A majority of the increase is attributable to acquired loans.
OFF-BALANCE SHEET ARRANGEMENTS
The Company maintains commitments to extend credit in the normal course of business, as long as there are no violations of conditions established in the outstanding contractual arrangements. Unused commitments to extend credit totaled $453.0 million at March 31, 2019 and $316.6 million at December 31, 2018, although it is not likely that all of those commitments will ultimately be drawn down. Unused commitments represented approximately 19.3% of gross loans at March 31, 2019 and 15.3% at December 31, 2018, with the increase due in part to higher commitments in commercial and industrial loans. The Company also had undrawn commercial and similar letters of credit to customers totaling $10.9 million at March 31, 2019 and $10.7 million at December 31, 2018. 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 guarantee that the lines of credit will ever be used. However, the “Liquidity” section in this Form 10-Q outlines resources available to draw upon should we be required to fund a significant portion of unused commitments. For more information regarding the Company’s off-balance sheet arrangements, see Note 7 to the consolidated financial statements.
In addition to unused commitments to provide credit, the Company is utilizing a $5.0 million letter of credit issued by the Federal Home Loan Bank (“FHLB”) on the Company’s behalf as security as of March 31, 2019. That letter of credit is backed by loans which are pledged to the FHLB by the Company.
liquidity and CAPITAL RESOURCES
LIQUIDITY
Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by management on a monthly basis, with various scenarios applied to assess our ability to meet liquidity needs under adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored and we are focused on maintaining adequate liquidity resources to draw upon should unexpected needs arise.
The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet short-term needs, the Company can borrow overnight funds from other financial institutions, draw advances via FHLB lines of credit, or solicit brokered deposits if deposits are not immediately obtainable from local sources. The net availability on lines of credit from the FHLB totaled $777.2 million at March 31, 2019. Furthermore, funds can be obtained by drawing down the Company’s correspondent bank deposit accounts, or by liquidating unpledged investments or other readily saleable assets. In addition, the Company can raise immediate cash for temporary needs by selling under agreement to repurchase those investments in its portfolio which are not pledged as collateral. As of March 31, 2019, the market value of unpledged debt securities plus pledged securities in excess of current pledging requirements comprised $117.3 million of the Company’s investment balances, compared to $110.8 million at December 31, 2018. The increase in unpledged securities from March 2019 compared to December 2018 is primarily due to an increase in portfolio assets. Other forms of balance sheet liquidity include but are not necessarily limited to any outstanding federal funds sold and vault cash. Management is of the opinion that available investments and other potentially liquid assets, along with the standby funding sources it has arranged, are more than sufficient to meet the Company’s current and anticipated short-term liquidity needs.
The Company’s liquidity ratio as of March 31, 2019 was 14.2%, as compared to internal liquidity policy guidelines of 10% minimum. Other liquidity ratios reviewed include the following along with policy guidelines:
Continued growth in core deposits and relatively high levels of potentially liquid investments have had a positive impact on our liquidity position in recent periods, but no assurance can be provided that our liquidity will continue at current robust levels.
The Company’s primary uses of funds are ordinary operating expenses and stockholder dividends, and its primary source of funds is dividends from the Bank since the Company does not conduct regular banking operations. Management anticipates that the Bank will have sufficient earnings to provide dividends to the Company to meet its funding requirements for the foreseeable future. Both the Company and the Bank are subject to legal and regulatory limitations on dividend payments, as outlined in Item 1. Business – Supervision and Regulation in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.
DEPOSITS
Deposits are another key balance sheet component impacting the Company’s net interest margin and other profitability metrics. Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity deposits such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts. Information concerning average balances and rates paid by deposit type for the three-month periods ended March 31, 2019 and 2018 is included in the Average Balances and Rates tables appearing above, under the heading “Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits showing the balance and percentage of total deposits by type is presented for the noted periods in the following table.
As of March 31, 2019, cash and cash equivalents were $248.6 million. In addition, loans and investment securities repricing or maturing within one year or less were approximately $508.7 million at March 31, 2019. Approximately $453.0 million in loan commitments could fund within the next three months and other commitments, primarily commercial and similar letters of credit, totaled $10.9 million at March 31, 2019.
OTHER INTEREST-BEARING LIABILITIES
The Company’s non-deposit borrowings may, at any given time, include federal funds purchased from correspondent banks, borrowings from the Federal Home Loan Bank (“FHLB”), advances from the Federal Reserve Bank, securities sold under agreements to repurchase, and/or junior subordinated debentures. The Company uses short-term FHLB advances and fed funds purchased on uncommitted lines to support liquidity needs created by seasonal deposit flows, to temporarily satisfy funding needs from increased loan demand, and for other short-term purposes. The FHLB line is committed, but the amount of available credit depends on the level of pledged collateral.
Total non-deposit interest-bearing liabilities decreased by $23.7 million, or 14.3%, in the first three months of 2019, due in part to a decrease in note payables to the FHLB of $23.8 million. The Company had junior subordinated debentures totaling $80.6 million at March 31, 2019 and $80.5 million December 31, 2018, in the form of long-term borrowings from trust subsidiaries formed specifically to issue trust preferred securities.
OTHER LIABILITIES
Other liabilities are principally comprised of accrued interest payable and other accrued but unpaid expenses. Other liabilities increased by $4.2 million, or 27.0%, during the first three months of 2019, due to the increase in other accrued but unpaid expenses.
CAPITAL
At March 31, 2019 the Company had total stockholders’ equity of $454.3 million, comprised of $17.3 million in common stock, less than $464 thousand in treasury stock, $354.8 million in surplus, $78.6 million in undivided profits and $4.1 million in accumulated comprehensive income (loss) on available-for-sale securities. Total stockholders’ equity at the end of 2018 was $363.3 million. The increase of $91.1 million, or 25.1%, in stockholders’ equity during the first three months of 2019 is comprised of capital added via net earnings of $7.6 million, $5.9 million increase in accumulated comprehensive income for available-for-sale securities, and $78.2 million of common stock issued for the purchase of FPB, offset by $1.0 million in cash dividends paid.
On March 28, 2019, the Company announced that its Board of Directors authorized a share repurchase program to purchase up to an aggregate of $20 million of the Company’s common stock (the “March 2019 program”). This share repurchase program has an expiration date of December 31, 2019. Under the program, the Company may repurchase shares of its common stock periodically in a manner determined by the Company’s management. The actual means and timing of purchase, target number of shares and maximum price or range of prices under the program will be determined by management at its discretion and will depend on a number of factors, including the market price of the Company’s common stock, general market and economic conditions, and applicable legal and regulatory requirements. No shares were purchased under the March 2019 program during the three months ended March 31, 2019.
The Company uses a variety of measures to evaluate its capital adequacy, including risk-based capital and leverage ratios that are calculated separately for the Company and the Bank. Management reviews these capital measurements on a quarterly basis and takes appropriate action to help ensure that they meet or surpass established internal and external guidelines. As permitted by the regulators for financial institutions that are not deemed to be “advanced approaches” institutions, the Company has elected to opt out of the Basel III requirement to include accumulated other comprehensive income in risk-based capital. The following table sets forth the Company’s and the Bank’s regulatory capital ratios as of the dates indicated.
* The numerator does not include Preferred Stock and Trust Preferred.
** The numerator includes Trust Preferred.
Our capital ratios remain very strong relative to the median for peer financial institutions, and at March 31, 2019 were well above the threshold for the Company and the Bank to be classified as “well capitalized,” the highest rating of the categories defined under the Bank Holding Company Act and the Federal Deposit Insurance Corporation Improvement Act of 1991. Basel III rules require a “capital conservation buffer” for both the Company and the Bank. The capital conservation buffer is subject to a three year phase-in period that began January 1, 2016 and was fully phased-in on January 1, 2019 at 2.5%. The required phase-in capital conservation buffer during 2018 was 1.875%. Under this guidance banking institutions with a CETI, Tier 1 Capital Ratio and Total Risk Based Capital above the minimum regulatory adequate capital ratios but below the capital conservation buffer will face constraints on their ability to pay dividends, repurchase equity and pay discretionary bonuses to executive officers, based on the amount of the shortfall. As of March 31, 2019, management believes that each of the Bank and the Company met all capital adequacy requirements to which they are subject. We do not foresee any circumstances that would cause the Company or the Bank to be less than well capitalized, although no assurance can be given that this will not occur.
Total consolidated equity capital at March 31, 2019, was $454.3 million, or approximately 12.9% of total assets. The Company currently has adequate capital positions to meet the minimum capital requirements for all regulatory agencies.
On June 30, 2006, The Company issued $4,124,000 of floating rate junior subordinated deferrable interest debentures to The First Bancshares Statutory Trust 2 (“Trust 2”) in which the Company owns all of the common equity. The debentures are the sole asset of the Trust. Trust 2 issued $4,000,000 of Trust Preferred Securities (TPSs) to investors. The Company’s obligations under the debentures and related documents, taken together, constitute a full and unconditional guarantee by the Company of Trust 2’s obligations under the preferred securities. The preferred securities are redeemable by the Company at its option. The preferred securities must be redeemed upon maturity of the debentures in 2036. Interest on the preferred securities is the three month London Interbank Offer Rate (LIBOR) plus 1.65% and is payable quarterly. The terms of the subordinated debentures are identical to those of the preferred securities.
On July 27, 2007, The Company issued $6,186,000 of floating rate junior subordinated deferrable interest debentures to The First Bancshares Statutory Trust 3 (“Trust 3”) in which the Company owns all of the common equity. The debentures are the sole asset of Trust 3. The Trust issued $6,000,000 of Trust Preferred Securities (TPSs) to investors. The Company’s obligations under the debentures and related documents, taken together, constitute a full and unconditional guarantee by the Company of the Trust 3’s obligations under the preferred securities. The preferred securities are redeemable by the Company at its option. The preferred securities must be redeemed upon maturity of the debentures in 2037. Interest on the preferred securities is the three month LIBOR plus 1.40% and is payable quarterly. The terms of the subordinated debentures are identical to those of the preferred securities.
In 2018, the Company acquired FMB’s Capital Trust 1 (“Trust 1”), which consisted of $6.1 million of floating rate junior subordinated deferrable interest debentures in which the Company owns all of the common equity. The debentures are the sole asset of Trust 1. Trust 1 issued $6,000,000 of Trust Preferred Securities to investors. The Company’s obligations under the debentures and related documents, taken together, constitute a full and unconditional guarantee by the Company of the Trust 1’s obligations under the preferred securities. The preferred securities are redeemable by the Company at its option. The preferred securities must be redeemed upon maturity of the debentures in 2033. Interest on the preferred securities is the three month LIBOR plus 2.85% and is payable quarterly. The terms of the subordinated debentures are identical to those of the preferred securities.
In accordance with the provisions of ASC Topic 810, Consolidation, the trusts are not included in the consolidated financial statements.
Subordinated Notes
On April 30, 2018, The Company entered into two Subordinated Note Purchase Agreements pursuant to which the Company sold and issued $24 million in aggregate principal amount of 5.875% fixed-to-floating rate subordinated notes due 2028 and $42 million in aggregate principal amount of 6.40% fixed-to-floating rate subordinated notes due 2033 (collectively, the “Notes”).
The Notes are not convertible into or exchangeable for any other securities or assets of the Company or any of its subsidiaries. The Notes are not subject to redemption at the option of the holder. Principal and interest on the Notes are subject to acceleration only in limited circumstances. The Notes are unsecured, subordinated obligations of the Company and rank junior in right to payment to the Company’s current and future senior indebtedness, and each Note is pari passu in right to payment with respect to the other Notes.
The Company intends to use the net proceeds from the sale of the Notes for general corporate purposes, which may include increasing bank level capital ratios to support future growth, repaying an existing line of credit and establishing holding company reserves.
Reconciliation of Non-GAAP Financial Measures
Our accounting and reporting policies conform to generally accepted accounting principles (“GAAP”) in the United States and prevailing practices in the banking industry. However, certain non-GAAP measures are used by management to supplement the evaluation of our performance. This Quarterly Report on Form 10-Q includes operating net earnings, operating earnings per share, fully tax equivalent (“FTE”) net interest income, net interest margin and tangible book value. The Company believes that the non-GAAP financial measures included in this Quarterly Report on Form 10-Q allow management and investors to understand and compare results in a more consistent manner for the periods presented herein. The tax equivalent adjustment to net interest income recognizes the income tax savings when comparing taxable and tax-exempt assets and assumes a 25.3% tax rate. Management believes that it is a standard practice in the banking industry to present net interest income and net interest margin on a fully tax equivalent basis, and believes it enhances the comparability of income and expenses arising from taxable and nontaxable sources. Non-GAAP financial measures should be considered supplemental and not a substitute for the Company’s results reported in accordance with GAAP for the periods presented, and other bank holding companies may define or calculate these measures differently. These non-GAAP financial measures should not be considered in isolation and do not purport to be an alternative to net income, earnings per share, net interest income, net interest margin, book value per common share or other GAAP financial measures as a measure of operating performance. A reconciliation of these non-GAAP financial measures to the most comparable GAAP measure is provided below.
Operating Net Earnings
Operating Earnings Per Share
Net Interest Income Fully Tax Equivalent
ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company does not engage in the trading of financial instruments, nor does it have exposure to currency exchange rates. Our market risk exposure is primarily that of interest rate risk, and we have established policies and procedures to monitor and limit our earnings and balance sheet exposure to changes in interest rates. The principal objective of interest rate risk management is to manage the financial components of the Company’s balance sheet in a manner that will optimize the risk/reward equation for earnings and capital under a variety of interest rate scenarios.
To identify areas of potential exposure to interest rate changes, we utilize commercially available modeling software to perform earnings simulations and calculate the Company’s market value of portfolio equity under varying interest rate scenarios every month. The model imports relevant information for the Company’s financial instruments and incorporates Management’s assumptions on pricing, duration, and optionality for anticipated new volumes. Various rate scenarios consisting of key rate and yield curve projections are then applied in order to calculate the expected effect of a given interest rate change on interest income, interest expense, and the value of the Company’s financial instruments. The rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels).
The following table shows the estimated changes in net interest income at risk and market value of equity along with policy limits:
We use seven standard interest rate scenarios in conducting our 12-month net interest income simulations: “static,” upward shocks of 100, 200, 300 and 400 basis points, and downward shocks of 100, and 200 basis points. Pursuant to policy guidelines, we typically attempt to limit the projected decline in net interest income relative to the stable rate scenario to no more than 5% for a 100 basis point (bp) interest rate shock, 10% for a 200 bp shock, 15% for a 300 bp shock, and 20% for a 400 bp shock. As of March 31, 2019, the Company had the following estimated net interest income sensitivity profile, without factoring in any potential negative impact on spreads resulting from competitive pressures or credit quality deterioration:
If there were an immediate and sustained downward adjustment of 200 basis points in interest rates, all else being equal, net interest income over the next twelve months would likely be approximately $13.4 million lower than in a stable interest rate scenario, for a negative variance of 11.3%. The unfavorable variance increases if rates were to drop below 200 basis points, due to the fact that certain deposit rates are already relatively low (on NOW accounts and savings accounts, for example), and will hit a natural floor of close to zero while non-floored variable-rate loan yields continue to drop. This effect would be exacerbated by accelerated prepayments on fixed-rate loans and mortgage-backed securities when rates decline, although rate floors on some of our variable-rate loans partially offset other negative pressures. While management believes that further interest rate reductions are highly unlikely, the potential percentage drop in net interest income exceeds our internal policy guidelines in declining interest rate scenarios and we will continue to monitor our interest rate risk profile and take corrective action as deemed appropriate.
Net interest income would likely improve by $8.0 million, or 6.7%, if interest rates were to increase by 200 basis points relative to a stable interest rate scenario, with the favorable variance expanding the higher interest rates rise. The initial increase in rising rate scenarios will be limited to some extent by the fact that some of our variable-rate loans are currently at rate floors, resulting in a re-pricing lag while base rates are increasing to floored levels, but the Company would expect to benefit from a material upward shift in the yield curve.
The Company’s one year cumulative GAP ratio is approximately 206.2%, which means that there are more assets repricing than liabilities within the first year. The Company is “asset-sensitive.” These results are based on cash flows from assumptions of assets and liabilities that reprice (maturities, likely calls, prepayments, etc.) Typically, the net interest income of asset-sensitive financial institutions should improve with rising rates and decrease with declining rates.
In addition to the net interest income simulations shown above, we run stress scenarios modeling the possibility of no balance sheet growth, the potential runoff of “surge” core deposits which flowed into the Company in the most recent economic cycle, and potential unfavorable movement in deposit rates relative to yields on earning assets. Even though net interest income will naturally be lower with no balance sheet growth, the rate-driven variances projected for net interest income in a static growth environment are similar to the changes noted above for our standard projections. When a greater level of non-maturity deposit runoff is assumed or unfavorable deposit rate changes are factored into the model, projected net interest income in declining rate and flat rate scenarios does not change materially relative to standard growth projections. However, the benefit we would otherwise experience in rising rate scenarios is minimized and net interest income remains relatively flat.
The economic value (or “fair value”) of financial instruments on the Company’s balance sheet will also vary under the interest rate scenarios previously discussed. The difference between the projected fair value of the Company’s financial assets and the fair value of its financial liabilities is referred to as the economic value of equity (“EVE”), and changes in EVE under different interest rate scenarios are effectively a gauge of the Company’s longer-term exposure to interest rate risk. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at projected replacement interest rates for each account type, while the fair value of non-financial accounts is assumed to equal their book value for all rate scenarios. An economic value simulation is a static measure utilizing balance sheet accounts at a given point in time, and the measurement can change substantially over time as the characteristics of the Company’s balance sheet evolve and interest rate and yield curve assumptions are updated.
The change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including stated interest rates or spreads relative to current or projected market-level interest rates or spreads, the likelihood of principal prepayments, whether contractual interest rates are fixed or floating, and the average remaining time to maturity. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical patterns and Management’s best estimates. The table below shows estimated changes in the Company’s EVE as of March 31, 2019, under different interest rate scenarios relative to a base case of current interest rates:
The table shows that our EVE will generally deteriorate in declining rate scenarios, but should benefit from a parallel shift upward in the yield curve. As noted previously, however, Management believes that the potential for a significant rate decline is low. We also run stress scenarios for EVE to simulate the possibility of higher loan prepayment rates, unfavorable changes in deposit rates, and higher deposit decay rates. Model results are highly sensitive to changes in assumed decay rates for non-maturity deposits, in particular.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
As of March 31, 2019, (the “Evaluation Date”), we carried out an evaluation, under the supervision of and with the participation of our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Disclosure controls and procedures are controls and procedures designed to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based on the evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that as of the Evaluation Date, our disclosure controls and procedures were not effective due to the material weaknesses disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018 filed with the SEC on March 18, 2019 (the “2018 Form 10-K”).
Changes in Internal Controls
There have been no changes in our internal controls over financial reporting that occurred during the quarter ended March 31, 2019, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. As disclosed in our 2018 Form 10-K, management implemented the additional controls and procedures described therein starting in the fourth quarter of 2018 in order to remediate the material weaknesses identified, and will continue to take steps as necessary that management and the Audit Committee believe will remediate the control deficiencies. However, the identified control deficiencies that led to the material weaknesses in internal control over financial reporting will not be considered fully addressed until the new and additional controls, processes and procedures described in the 2018 Form 10-K have been in operation for a sufficient period of time to allow the Company’s management to conclude, through testing, that the controls are operating effectively and the material weaknesses have been fully remediated. Management expects the remediation of the material weaknesses will be completed during 2019.
PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is involved in various legal proceedings in the normal course of business. Management does not believe, based on currently available information, that the outcome of any such proceedings will have a material adverse effect on our financial condition or results of operations.
ITEM 1A. RISK FACTORS
There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Not applicable
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
ITEM 4. MINE SAFETY DISCLOSURES
Item 5. Other Information
ITEM 6. EXHIBITS
(a) Exhibits
10.1
Form of 2019 Stock Incentive Agreement for Restricted Stock Award pursuant to The First Bancshares, Inc. 2007 Stock Incentive Plan.*
* Filed herewith.
** Furnished herewith.
SIGNATURES
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.