Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
☒QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2022 OR
☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 001-35589
FS BANCORP, INC.
(Exact name of registrant as specified in its charter)
Washington
45-4585178
(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No.)
6920 220th Street SW, Mountlake Terrace, Washington 98043
(Address of principal executive offices; Zip Code)
(425) 771-5299
(Registrant’s telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed since last report)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common Stock, par value $.01 per share
FSBW
The NASDAQ Stock Market LLC
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐
Accelerated filer ☒
Non-accelerated filer ☐
Smaller reporting company ☐
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No☒
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: As of May 6, 2022, there were 7,906,583 outstanding shares of the registrant’s common stock.
FS Bancorp, Inc.
Form 10-Q
Page Number
PART I
FINANCIAL INFORMATION
Item 1.
Financial Statements
Consolidated Balance Sheets at March 31, 2022 and December 31, 2021 (Unaudited)
3
Consolidated Statements of Income for the Three Months Ended March 31, 2022 and 2021 (Unaudited)
4
Consolidated Statements of Comprehensive (Loss) Income for the Three Months Ended March 31, 2022 and 2021 (Unaudited)
5
Consolidated Statements of Changes in Stockholders’ Equity for the Three Months Ended March 31, 2022 and 2021 (Unaudited)
6
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2022 and 2021 (Unaudited)
7 - 8
Notes to Consolidated Financial Statements
9 - 44
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
45 - 57
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
57
Item 4.
Controls and Procedures
PART II
OTHER INFORMATION
58
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
59
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
60
SIGNATURES
61
As used in this report, the terms “we,” “our,” “us,” “Company” and “FS Bancorp” refer to FS Bancorp, Inc. and its consolidated subsidiary, 1st Security Bank of Washington, unless the context indicates otherwise. When we refer to “Bank” in this report, we are referring to 1st Security Bank of Washington, the wholly owned subsidiary of FS Bancorp.
2
Item 1. Financial Statements
FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share amounts) (Unaudited)
March 31,
December 31,
ASSETS
2022
2021
Cash and due from banks
$
12,014
12,043
Interest-bearing deposits at other financial institutions
17,592
14,448
Total cash and cash equivalents
29,606
26,491
Certificates of deposit at other financial institutions
8,177
10,542
Securities available-for-sale, at fair value
263,306
271,359
Securities held-to-maturity, net of allowance for credit losses of $72 and none, respectively (fair value of $7,663 and $8,128, respectively)
7,428
7,500
Loans held for sale, at fair value
42,068
125,810
Loans receivable, net (includes $14,918 and $16,083, at fair value, respectively)
1,797,663
1,728,540
Accrued interest receivable
8,436
7,594
Premises and equipment, net
26,116
26,591
Operating lease right-of-use (“ROU”) assets
5,172
4,557
Federal Home Loan Bank (“FHLB”) stock, at cost
4,666
4,778
Deferred tax asset, net
2,611
—
Bank owned life insurance (“BOLI”), net
36,890
37,092
Servicing rights, held at the lower of cost or fair value
18,041
16,970
Goodwill
2,312
Core deposit intangible, net
3,887
4,060
Other assets
17,554
12,195
TOTAL ASSETS
2,273,933
2,286,391
LIABILITIES
Deposits:
Noninterest-bearing accounts
475,142
459,522
Interest-bearing accounts
1,444,646
1,456,222
Total deposits
1,919,788
1,915,744
Borrowings
35,528
42,528
Subordinated notes:
Principal amount
50,000
Unamortized debt issuance costs
(589)
(606)
Total subordinated notes less unamortized debt issuance costs
49,411
49,394
Operating lease liabilities
5,406
4,792
Deferred tax liability, net
1,183
Other liabilities
27,850
25,243
Total liabilities
2,037,983
2,038,884
COMMITMENTS AND CONTINGENCIES (NOTE 9)
STOCKHOLDERS’ EQUITY
Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued or outstanding
Common stock, $.01 par value; 45,000,000 shares authorized; 8,067,211 and 8,169,887 shares issued and outstanding at March 31, 2022 and December 31, 2021, respectively
81
82
Additional paid-in capital
65,035
67,958
Retained earnings
184,748
179,215
Accumulated other comprehensive (loss) income, net of tax
(13,914)
252
Total stockholders’ equity
235,950
247,507
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
_______________________________
Share and per share data has been adjusted for all periods to reflect a two-for-one stock split effective July 14, 2021.
See accompanying notes to these consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share amounts) (Unaudited)
Three Months Ended
INTEREST INCOME
Loans receivable, including fees
23,047
21,534
Interest and dividends on investment securities, cash and cash equivalents, and certificates of deposit at other financial institutions
1,579
1,250
Total interest and dividend income
24,626
22,784
INTEREST EXPENSE
Deposits
1,285
1,982
133
446
Subordinated notes
486
256
Total interest expense
1,904
2,684
NET INTEREST INCOME
22,722
20,100
PROVISION FOR CREDIT LOSSES
1,043
1,500
NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
21,679
18,600
NONINTEREST INCOME
Service charges and fee income
1,013
765
Gain on sale of loans
3,857
11,685
Earnings on cash surrender value of BOLI
217
214
Other noninterest income
789
370
Total noninterest income
5,876
13,034
NONINTEREST EXPENSE
Salaries and benefits
11,972
11,609
Operations
2,479
2,467
Occupancy
1,223
1,139
Data processing
1,360
1,307
Loss on sale of OREO
9
Loan costs
523
524
Professional and board fees
993
822
Federal Deposit Insurance Corporation (“FDIC”) insurance
157
248
Marketing and advertising
188
97
Amortization of core deposit intangible
173
177
Recovery of servicing rights
(1)
(2,050)
Total noninterest expense
19,067
16,349
INCOME BEFORE PROVISION FOR INCOME TAXES
8,488
15,285
PROVISION FOR INCOME TAXES
1,618
3,402
NET INCOME
6,870
11,883
Basic earnings per share
0.83
1.39
Diluted earnings per share
0.81
1.35
____________________________
Per share data has been adjusted for all periods to reflect a two-for-one stock split effective July 14, 2021.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
(In thousands) (Unaudited)
Net income
Other comprehensive loss:
Securities available-for-sale:
Unrealized loss during period
(20,973)
(2,186)
Income tax benefit related to unrealized holding loss
4,510
472
Cash flow hedges:
Unrealized derivative gain during period
2,827
1,036
Income tax provision related to unrealized derivative gain
(608)
(223)
Reclassification adjustment for realized loss, net included in net income
101
114
Income tax benefit related to reclassification, net
(23)
(25)
Other comprehensive loss, net of tax
(14,166)
(812)
COMPREHENSIVE (LOSS) INCOME
(7,296)
11,071
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Three Months Ended March 31, 2021 and 2022
Accumulated
Other
Additional
Comprehensive
Unearned
Total
Common Stock
Paid-in
Retained
Income,
ESOP
Stockholders’
Shares
Amount
Capital
Earnings
Net of Tax
Equity
BALANCE, January 1, 2021
8,475,912
84
81,276
146,405
2,533
(291)
230,007
Dividends paid ($0.13 per share)
(1,095)
Share-based compensation
295
Common stock repurchased - repurchase plan
(14,832)
(273)
Stock options exercised, net
5,000
(96)
ESOP shares allocated
336
66
402
BALANCE, March 31, 2021
8,466,080
81,538
157,193
1,721
(225)
240,311
BALANCE, January 1, 2022
8,169,887
New credit standard (Topic 326) - impact in year of adoption
297
Dividends paid ($0.20 per share)
(1,634)
451
(115,356)
(3,444)
(3,445)
12,680
70
BALANCE, March 31, 2022
8,067,211
_________________________________
CONSOLIDATED STATEMENTS OF CASH FLOWS
.
Three Months Ended March 31,
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net income to net cash from operating activities
Provision for credit losses
Depreciation, amortization and accretion
4,289
5,165
Compensation expense related to stock options and restricted stock awards
ESOP compensation expense for allocated shares
Change in cash surrender value of BOLI
(217)
(214)
Gain on sale of loans held for sale
(3,857)
(11,685)
Origination of loans held for sale
(211,575)
(409,209)
Proceeds from sale of loans held for sale
302,553
423,983
Changes in operating assets and liabilities
(842)
(399)
(476)
(2,547)
(296)
1,066
Net cash from operating activities
97,942
18,199
CASH FLOWS USED BY INVESTING ACTIVITIES
Activity in securities available-for-sale:
Maturities, prepayments, and calls
3,333
6,919
Purchases
(16,762)
(32,729)
Maturities of certificates of deposit at other financial institutions
2,365
Portfolio loan originations and principal collections, net
(73,340)
(50,704)
Purchase of portfolio loans
(2,806)
Proceeds from sale of portfolio loans
Purchase of premises and equipment
(160)
(128)
Proceeds from bank owned life insurance death benefits
419
Change in FHLB stock, net
112
964
Net cash used by investing activities
(86,839)
(75,597)
CASH FLOWS (USED BY) FROM FINANCING ACTIVITIES
Net increase in deposits
4,021
106,680
Proceeds from borrowings
38,000
Repayments of borrowings
(45,000)
(93,281)
Dividends paid on common stock
Net proceeds from issuance of subordinated notes
49,333
Repayment of subordinated notes
(10,000)
Disbursements from stock options exercised, net
Common stock repurchased
Net cash (used by) from financing activities
(7,988)
51,268
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
3,115
(6,130)
CASH AND CASH EQUIVALENTS, beginning of period
91,576
CASH AND CASH EQUIVALENTS, end of period
85,446
SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest on deposits and borrowings
1,921
2,546
Income taxes
7
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
SUPPLEMENTARY DISCLOSURES OF NONCASH OPERATING, INVESTING AND FINANCING ACTIVITIES
Change in unrealized loss on available-for-sale investment securities
Change in unrealized gain on cash flow hedges
2,928
1,150
Retention in gross mortgage servicing rights from loan sales
2,550
3,144
Right-of-use assets in exchange for lease liabilities
938
422
See accompanying notes to these consolidated financial statements
8
NOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations - FS Bancorp, Inc. (the “Company”) was incorporated in September 2011 as the holding company for 1st Security Bank of Washington (the “Bank” or “1st Security Bank”) in connection with the Bank’s conversion from the mutual to stock form of ownership which was completed on July 9, 2012. The Bank is a community-based savings bank with 21 full-service bank branches, a headquarters that also originates loans and accepts deposits, and loan production offices in suburban communities in the greater Puget Sound area, the Tri-Cities, and our newest loan production office in Vancouver, Washington. The Bank provides loan and deposit services to customers who are predominantly small- and middle-market businesses and individuals. The Company and its subsidiary are subject to regulation by certain federal and state agencies and undergo periodic examination by these regulatory agencies.
Financial Statement Presentation - The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission (“SEC”). It is recommended that these unaudited interim consolidated financial statements be read in conjunction with the Company’s Annual Report on Form 10-K with all of the audited financial statements and footnotes required by U.S. GAAP for complete financial statements for the year ended December 31, 2021, as filed with the SEC on March 16, 2022. In the opinion of management, all normal adjustments and recurring accruals considered necessary for a fair presentation of the financial position and results of operations for the periods presented have been included.
The results for the three months ended March 31, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022, or any other future period. The preparation of financial statements, in conformity with U.S. GAAP, requires management to make estimates and assumptions that affect amounts reported in the financial statements. Actual results could differ from these estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for credit losses, fair value of financial instruments, the valuation of servicing rights, deferred income taxes, and if needed, a deferred tax asset valuation allowance.
Amounts presented in the consolidated financial statements and footnote tables are rounded and presented to the nearest thousands of dollars except per share amounts. If the amounts are above $1.0 million, they are rounded one decimal point, and if they are above $1.0 billion, they are rounded two decimal points.
Principles of Consolidation - The consolidated financial statements include the accounts of FS Bancorp, Inc. and its wholly owned subsidiary, 1st Security Bank of Washington. All material intercompany accounts have been eliminated in consolidation.
Segment Reporting - The Company operates in two business segments through the Bank: commercial and consumer banking and home lending. The Company’s business segments are determined based on the products and services provided, as well as the nature of the related business activities, and they reflect the manner in which financial information is regularly reviewed for the purpose of allocating resources and evaluating performance of the Company’s businesses. The results for these business segments are based on management’s accounting process, which assigns income statement items and assets to each responsible operating segment. This process is dynamic and is based on management’s view of the Company’s operations. See “Note 15 - Business Segments.”
Subsequent Events - The Company has evaluated events and transactions subsequent to March 31, 2022 for potential recognition or disclosure.
RECENT ACCOUNTING PRONOUNCEMENTS
In March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-04, “Reference Rate Reform” (“Topic 848”). This ASU provides optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. The amendments in this ASU apply to contract modifications that replace a reference rate affected by reference rate reform (including rates referenced in fallback provisions) and contemporaneous modifications of other contract terms related to the replacement of the reference rate (including contract modifications to add or change fallback provisions). The following optional expedients for applying the requirements of certain Topics or Industry Subtopics in the Codification are permitted
for contracts that are modified because of reference rate reform and that meet certain scope guidance: 1) Modifications of contracts within the scope of Topics 310, Receivables, and 470, Debt, should be accounted for by prospectively adjusting the effective interest rate; 2) Modifications of contracts within the scope of Topics 840, Leases, and 842, Leases, should be accounted for as a continuation of the existing contracts with no reassessments of the lease classification and the discount rate (for example, the incremental borrowing rate) or remeasurements of lease payments that otherwise would be required under those Topics for modifications not accounted for as separate contracts; and 3) Modifications of contracts do not require an entity to reassess its original conclusion about whether that contract contains an embedded derivative that is clearly and closely related to the economic characteristics and risks of the host contract under Subtopic 815-15, Derivatives and Hedging - Embedded Derivatives. In January 2021, ASU 2021-01 updated amendments in the new ASU to clarify that certain optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting apply to derivative instruments that use an interest rate for margining, discounting, or contract price alignment that is modified as a result of reference rate reform. Amendments in this ASU and the expedients and exceptions in Topic 848 capture the incremental consequences of the scope clarification and tailor the existing guidance to derivative instruments affected by the discounting transition. An entity may elect to apply the amendments in this ASU on a full retrospective basis as of any date from the effective dates. The amendments in this ASU have differing effective dates, beginning with an interim period including and subsequent to March 12, 2020 through December 31, 2022. The Company does not expect the adoption of ASU 2020-04 to have a material impact on its consolidated financial statements.
In March 2022, the FASB issued ASU No. 2022-02, Financial Instruments - Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures. The amendments eliminate the accounting guidance for troubled debt restructurings (“TDRs”) for creditors, require new disclosures for creditors for certain loan refinancings and restructurings when a borrower is experiencing financial difficulty, and require public business entities to include current-period gross write-offs in the vintage disclosure tables. The amendments in this ASU are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Since the Company previously adopted the amendments in ASU 2016-13, which is commonly referred to as the current expected credit loss methodology, on January 1, 2022, the amendments can be adopted early. The Company is currently evaluating the impact of the adoption of ASU 2022-02.
Application of New Accounting Guidance Adopted in 2022
On January 1, 2022, the Company adopted ASU 2016-13 Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which replaces the incurred loss methodology that delays recognition until it is probable a loss has been incurred with an expected loss methodology that is referred to as the current expected credit loss (“CECL”) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables and held-to-maturity debt securities. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in leases recognized by a lessor in accordance with Topic 842 on leases. Additionally, Accounting Standards Codification (“ASC”) 326 made changes to the accounting for available-for-sale debt securities. One such change is to require credit losses to be presented as an allowance rather than as a write-down on available-for-sale debt securities management does not intend to sell or believes that is more likely than not they will be required to sell.
The Company adopted ASC 326 using the modified retrospective method for all financial assets measured at amortized cost and off-balance-sheet credit exposures. Results for reporting periods beginning after January 1, 2022 are presented under ASC 326. The adoption resulted in a decrease of $2.9 million to our allowance for credit losses on loans (“ACLL”), an increase of $2.4 million to our allowance for unfunded commitments and letters of credit, an increase of $72,000 to our allowance for held-to-maturity securities, and a net-of-tax cumulative-effect adjustment of $297,000 to increase the beginning balance of retained earnings.
10
The Company finalized the adoption as of January 1, 2022 as detailed in the following table:
January 1, 2022 As Reported
January 1, 2022 Pre-Topic 326
Impact of Topic 326
Assets
Under Topic 326
Adoption
Allowance for credit losses on debt securities held-to-maturity
72
Loans
Commercial
1,728
5,667
(3,939)
Construction and development
2,328
4,448
(2,120)
Home equity
455
279
176
One-to-four-family
3,656
1,424
2,232
Multi-family
1,397
2,980
(1,583)
Indirect home improvement
9,394
3,540
5,854
Marine
900
702
198
Other consumer
64
38
26
Commercial and industrial
2,727
5,953
(3,226)
Warehouse lending
127
583
(456)
Unallocated
21
(21)
Allowance for credit losses on loans
22,776
25,635
(2,859)
Liabilities
Allowance for credit losses on unfunded loan commitments
2,908
499
2,409
(378)
________________________
The adoption of CECL resulted in an increase of retained earnings of $297,000, net of tax.
Allowance for Credit Losses on Held-to-Maturity Securities
Management measures expected credit losses on held-to-maturity securities by individual security. Accrued interest receivable on held-to-maturity debt securities totaled $103,000 at March 31, 2022, is recorded in Other Assets on the Consolidated Balance Sheets and excluded from the estimate of credit losses. The estimate of expected credit losses considers credit ratings and historical credit loss information that is adjusted for current conditions and reasonable and supportable forecasts.
The held-to-maturity portfolio consists entirely of corporate securities. Securities are generally rated BBB- or higher. Securities are analyzed individually to establish a CECL reserve.
Allowance for Credit Losses on Available-for-Sale Securities
For available-for-sale securities in an unrealized loss position, management first assesses whether it intends to sell, or is more likely than not to be required to sell, the security before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value through income. For debt securities available-for-sale that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than
11
the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income (“OCI”).
Changes in the allowance for credit losses are recorded as a provision for (or reversal of) credit loss expense. Losses are charged against the allowance when management believes the uncollectibility of an available-for-sale security is confirmed or when either of the criteria regarding intent or requirement to sell is met. Accrued interest receivable on available-for-sale debt securities totaled $1.8 million at March 31, 2022, is recorded in Other Assets on the Consolidated Balance Sheets and is not included in the estimate of credit losses.
Allowance for Credit Losses on Loans
The allowance for credit losses on loans is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged off against the allowance when management believes the uncollectibility of a loan balance is confirmed and recoveries are credited to the allowance when received. The Company may also account for expected recoveries should information of an anticipated recovery become available. In the case of actual or expected recoveries, amounts may not exceed the aggregate of amounts previously charged off.
Management utilizes relevant available information, from internal and external sources, relating to past events, current conditions, historical loss experience, and reasonable and supportable forecasts. The lookback period in the analysis includes historical data from 2009 to present. Adjustments to historical loss information are made when management determines historical data is not likely reflective of the current portfolio such as limited data sets or lack of default or loss history. Management may selectively apply external market data to subjectively adjust the Company’s own loss history including index or peer data. Accrued interest receivable totaled $6.5 million at March 31, 2022, was reported in Other Assets on the Consolidated Balance Sheets, and was excluded from the estimate of credit losses for loans.
Collective Assessment
The allowance for credit losses on loans is measured on a collective cohort basis when similar risk characteristics exist. Generally, collectively assessed loans are grouped by call report code and then risk grade grouping. Risk grade is grouped within each call report code by pass, watch, special mention, substandard, and doubtful. Other loan types are separated into their own cohorts due to specific risk characteristics for that pool of loans.
The Company has elected a non-discounted cash flow methodology with probability of default (“PD”) and loss given default (“LGD”) for all call report code cohorts (“cohorts”), with the exception of the indirect and marine portfolios which are evaluated under a vintage methodology. Guaranteed portions of loans are measured with zero risk due to cash collateral and full guaranty.
The PD calculation looks at the historical loan portfolio at particular points in time (each month during the lookback period) to determine the probability that loans in a certain cohort will default over the next 12-month period. A default is defined as a loan that has moved to past due 90 days and greater, nonaccrual status, or experienced a charge-off during the period. In cohorts where the Company’s historical data are insufficient due to a minimal amount of default activity or zero defaults, management uses index PDs comprised of rates derived from the PD experience of other community banks in place of the Company’s historical PDs. Additionally, management reviews all other cohorts to determine if index PDs should be used outside of these criteria.
The LGD calculation looks at actual losses (net charge-offs) experienced over the entire lookback period for each cohort of loans. The aggregate loss amount is divided by the exposure at default to determine an LGD rate. All defaults (non-accrual, charge-off, or greater than 90 days past due) occurring during the lookback period are included in the denominator, whether a loss occurred or not and exposure at default is determined by the loan balance immediately preceding the default event (i.e. nonaccrual or charge-off). Due to very limited charge-off history, management uses index LGDs comprised of rates derived from the LGD experience of other community banks in place of the Company’s historical LGDs.
The Company utilizes reasonable and supportable forecasts of future economic conditions when estimating the allowance for credit losses on loans. The calculation includes a 12-month PD forecast based on the Company’s regression model
12
comparing peer nonperforming loan ratios to the national unemployment rate and other forecast data. After the forecast period, PD rates revert on a straight-line basis back to long-term historical average rates over a 12-month period.
The Company recognizes that all significant factors that affect the collectability of the loan portfolio must be considered to determine the estimated credit losses as of the evaluation date. Furthermore, the methodology, in and of itself and even when selectively adjusted by comparison to market and peer data, does not provide a sufficient basis to determine the estimated credit losses. The Company adjusts the modeled historical losses by a Qualitative and Environmental adjustment to incorporate all significant risks to form a sufficient basis to estimate the credit losses.
Individual Assessment
Loans classified as Nonaccrual, Troubled Debt Restructuring (“TDR”), or Reasonably Expected TDR will be reviewed quarterly for potential individual assessment. Any loan classified as a Nonaccrual or TDR that is not determined to need individual assessment will be evaluated collectively within its respective cohort. All Reasonably Expected TDR loans will be evaluated individually to account for expected modifications in loan terms.
Where the primary and/or expected source of repayment of a specific loan is believed to be the future liquidation of available collateral, impairment will generally be measured based upon expected future collateral proceeds, net of disposition expenses including sales commissions as well as other costs potentially necessary to sell the asset(s) (i.e. past due taxes, liens, etc.). Estimates of future collateral proceeds will be based upon available appraisals, reference to recent valuations of comparable properties, use of consultants or other professionals with relevant market and/or property-specific knowledge, and any other sources of information believed appropriate by management under the specific circumstances. When appraisals are ordered to support the impairment analysis of an impaired loan, the appraisal is reviewed by the Company’s internal appraisal reviewer.
Where the primary and/or expected source of repayment of a specific loan is believed to be the receipt of principal and interest payments from the borrower and/or the refinancing of the loan by another creditor, impairment will generally be measured based upon the present value of expected proceeds discounted at the contractual interest rate. Expected refinancing proceeds may be estimated from review of term sheets actually received by the borrower from other creditors and/or from the Company’s knowledge of terms generally available from other banks.
Determining the Contractual Term
Expected credit losses are estimated over the contractual term of the loans, adjusted for expected prepayments when appropriate. The contractual term excludes expected extensions, renewals and modifications unless either of the following applies: management has a reasonable expectation at the reporting date that a TDR will be executed with an individual borrower or the extension or renewal options are included in the original or modified contract at the reporting date and are not unconditionally cancellable by the Company. Prepayment assumptions will be determined by analysis of historical behavior by loan cohort.
Troubled Debt Restructurings
A loan for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, is considered to be a TDR. Any loan that is being considered for modification and expected to result in a TDR is identified as a Reasonably Expected TDR. Reasonably Expected TDRs are assessed in the CECL calculation utilizing their expected modified terms. The allowance for credit losses on a TDR is measured using the same method as all other loans held for investment, except that the original interest rate is used to discount the expected cash flows when a rate modification has occurred.
Allowance for Credit Losses on Unfunded Commitments
The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company. The allowance for credit losses on unfunded commitments is adjusted through a provision for credit loss expense. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life. The estimate utilizes the same factors and assumptions as the allowance for credit losses on loans and is applied at the same collective cohort level.
13
NOTE 2 - INVESTMENTS
The following tables present the amortized costs, unrealized gains, unrealized losses, estimated fair values of securities available-for-sale and held-to-maturity, and allowance for credit losses at March 31, 2022 and December 31, 2021:
March 31, 2022
Estimated
Allowance
Amortized
Unrealized
Fair
for Credit
SECURITIES AVAILABLE-FOR-SALE
Cost
Gains
Losses
Values
U.S. agency securities
21,154
94
(2,256)
18,992
Corporate securities
9,496
(774)
8,734
Municipal bonds
144,572
255
(13,091)
131,736
Mortgage-backed securities
92,346
25
(5,724)
86,647
U.S. Small Business Administration securities
17,403
(267)
17,197
Total securities available-for-sale
284,971
447
(22,112)
SECURITIES HELD-TO-MATURITY
191
(28)
7,663
Total securities held-to-maturity
Total securities
292,471
638
(22,140)
270,969
December 31, 2021
21,155
(318)
20,970
9,495
31
(524)
9,002
136,377
1,577
(2,521)
135,433
88,641
1,457
(696)
89,402
16,383
235
(66)
16,552
272,051
3,433
(4,125)
628
8,128
279,551
4,061
279,487
The following table presents the activity in the allowance for credit losses on securities held-to-maturity by major security type for the three months ended March 31, 2022:
Corporate
For the Three Months Ended March 31, 2022
Securities
Beginning allowance balance
Impact of adopting ASU 2016-13
Securities charged-off
Recoveries
Total ending allowance balance
Management measures expected credit losses on held-to-maturity debt securities on an individual basis. The estimate of expected credit losses considers historical credit loss information that is adjusted for current conditions and reasonable and supportable forecasts. Accrued interest receivable on held-to-maturity debt securities totaled $103,000 and $113,000 as of
14
March 31, 2022 and December 31, 2021, respectively and was $1.8 million and $1.1 million on available-for-sale debt securities as of March 31, 2022 and December 31, 2021, respectively. Accrued interest receivable on securities is reported in accrued interest receivable on the Consolidated Balance Sheets and is excluded from the calculation of the allowance for credit losses.
The Bank monitors the credit quality of debt securities held-to-maturity quarterly through the use of credit rating, material event notices, and changes in market value. The following table summarizes the amortized cost of debt securities held-to-maturity at March 31, 2022, aggregated by credit quality indicator:
BBB/BBB-
As of March 31, 2022, there were no debt securities held-to-maturity that were classified as either nonaccrual or 90 days or more past due and still accruing.
At March 31, 2022, the Bank pledged seven securities held at the FHLB of Des Moines with a carrying value of $7.5 million to secure Washington State public deposits of $14.7 million with a $5.8 million collateral requirement by the Washington Public Deposit Protection Commission. At March 31, 2022, the Bank had pledged two securities with a total carrying value of $2.8 million to secure interest rate swaps designated as cash flow hedges. See “Note 5- Derivatives”, for detail on the Bank’s interest rate swaps.
Investment securities that were in an unrealized loss position at March 31, 2022 and December 31, 2021 are presented in the following tables, based on the length of time individual securities have been in an unrealized loss position.
Less than 12 Months
12 Months or Longer
Value
12,749
(1,485)
3,196
(771)
15,945
4,226
84,565
(8,963)
31,746
(4,128)
116,311
75,898
(5,600)
4,291
(124)
80,189
8,458
181,670
(16,315)
43,459
(5,797)
225,129
972
182,642
(16,343)
226,101
15
13,125
(105)
3,752
(213)
16,877
5,476
72,098
(1,961)
14,116
(560)
86,214
33,291
(620)
3,825
(76)
37,116
2,988
121,502
(2,752)
27,169
(1,373)
148,671
There was one held-to-maturity debt security with unrealized losses less than one year and none with unrealized losses of more than one year at March 31, 2022. There were no held-to-maturity debt securities in an unrealized loss position as of December 31, 2021.
There were 145 available-for-sale securities with unrealized losses of less than one year, and 29 available-for-sale securities with an unrealized loss of more than one year at March 31, 2022. There were 75 available-for-sale securities with unrealized losses of less than one year, and 17 available-for-sale securities with an unrealized loss of more than one year at December 31, 2021. The unrealized losses associated with these securities are believed to be caused by changing market conditions that are considered to be temporary and the Company does not intend to sell the securities, and it is not likely to be required to sell these securities prior to maturity. Management monitors the published credit ratings of the issuers of the debt securities for material ratings or outlook changes. Subsequently, all of the Company’s obligations of states and political subdivisions is local municipal debt from within the Company’s geographic footprint and is monitored through quarterly or annual financial review. All of the available-for-sale mortgage-backed securities and U.S. Small Business Administration securities in an unrealized loss position are issued or guaranteed by government-sponsored enterprises, and the available-for-sale corporate securities are all investment grade and monitored for rating or outlook changes. Based on the Company’s evaluation of these securities, no credit impairment was recorded for the three months ended March 31, 2022, or for the year ended December 31, 2021.
The contractual maturities of securities available-for-sale and held-to-maturity at March 31, 2022 and December 31, 2021 are listed below. Expected maturities of mortgage-backed securities may differ from contractual maturities because borrowers may have the right to call or prepay the obligations; therefore, these securities are classified separately with no specific maturity date.
Due after one year through five years
954
959
1,004
Due after five years through ten years
6,923
6,351
6,920
6,850
Due after ten years
13,277
11,682
13,276
13,116
Subtotal
3,496
3,508
3,495
3,526
4,000
3,578
3,627
2,000
1,648
1,849
3,717
3,746
3,724
3,850
8,037
7,932
6,857
7,035
132,818
120,058
125,796
124,548
Federal National Mortgage Association (“FNMA”)
77,518
72,265
75,171
75,737
16
Federal Home Loan Mortgage Corporation (“FHLMC”)
9,514
9,237
9,606
9,768
Government National Mortgage Association (“GNMA”)
5,314
5,145
3,864
3,897
3,453
3,374
2,485
2,507
4,951
4,955
4,420
4,515
8,999
8,868
9,478
9,530
There were no sales proceeds, gains or losses from the sale of securities available-for-sale for both the three months ended March 31, 2022 and 2021.
NOTE 3 - LOANS RECEIVABLE AND ALLOWANCE FOR CREDIT LOSSES - LOANS
The composition of the loan portfolio was as follows at the dates indicated:
REAL ESTATE LOANS
269,517
264,429
258,680
240,553
44,394
41,017
One-to-four-family (excludes loans held for sale)
361,079
366,146
196,924
178,158
Total real estate loans
1,130,594
1,090,303
CONSUMER LOANS
359,443
336,285
82,560
82,778
2,994
Total consumer loans
444,997
422,043
COMMERCIAL BUSINESS LOANS
Commercial and industrial (includes Paycheck Protection Program ("PPP") loans)
207,480
208,552
37,957
33,277
Total commercial business loans
245,437
241,829
Total loans receivable, gross
1,821,028
1,754,175
Allowance for credit losses on loans (1)
(23,365)
(25,635)
Total loans receivable, net
_________________________
Loan amounts are net of unearned loan fees in excess of unamortized costs and premiums of $5.2 million as of March 31, 2022 and $4.9 million as of December 31, 2021. Net loans include net discounts on acquired loans of $614,000 and $751,000 as of March 31, 2022 and December 31, 2021, respectively. Net loans does not include accrued interest receivable. Accrued interest receivable on loans was $6.5 million as of March 31, 2022 and $6.3 million as of December 31, 2021 and was reported in accrued interest receivable on the Consolidated Balance Sheets.
17
Most of the Company’s commercial and multi-family real estate, construction, residential, and/or commercial business lending activities are with customers located in Western Washington near our newest loan production office in Vancouver, Washington, or near our loan production office located in the Tri-Cities, Washington. The Company originates real estate, consumer, and commercial business loans and has concentrations in these areas, however, indirect home improvement loans, including solar-related home improvement loans, are originated through a network of home improvement contractors and dealers located throughout Washington, Oregon, California, Idaho, Colorado, Arizona, Minnesota, and Nevada. Loans are generally secured by collateral and rights to collateral vary and are legally documented to the extent practicable. Local economic conditions may affect borrowers’ ability to meet the stated repayment terms.
At March 31, 2022, the Bank held approximately $750.6 million in loans that are pledged as collateral for FHLB advances, compared to approximately $761.6 million at December 31, 2021. The Bank held approximately $451.8 million in loans that are pledged as collateral for the Federal Reserve Bank of San Francisco (“FRB”) line of credit at March 31, 2022, compared to approximately $428.7 million at December 31, 2021.
The Company has defined its loan portfolio into three segments that reflect the structure of the lending function, the Company’s strategic plan and the manner in which management monitors performance and credit quality. The three loan portfolio segments are: (a) Real Estate Loans, (b) Consumer Loans, and (c) Commercial Business Loans. Each of these segments is disaggregated into classes based on the risk characteristics of the borrower and/or the collateral type securing the loan. The following is a summary of each of the Company’s loan portfolio segments and classes:
Real Estate Loans
Commercial Lending. Loans originated by the Company primarily secured by income producing properties, including retail centers, warehouses, and office buildings located in our market areas.
Construction and Development Lending. Loans originated by the Company for the construction of, and secured by, commercial real estate, one-to-four-family, and multi-family residences and tracts of land for development that are not pre-sold. A portion of the one-to-four-family construction portfolio is custom construction loans to the intended occupant of the residence.
Home Equity Lending. Loans originated by the Company secured by second mortgages on one-to-four-family residences, including home equity lines of credit in our market areas.
One-to-Four-Family Real Estate Lending. One-to-four-family residential loans include owner occupied properties (including second homes), and non-owner-occupied properties with four or less units. These loans originated by the Company or periodically purchased from banks are secured by first mortgages on one-to-four-family residences in our market areas that the Company intends to hold (excludes loans held for sale).
Multi-Family Lending. Apartment term lending (five or more units) to current banking customers and community reinvestment loans for low to moderate income individuals in the Company’s footprint.
Consumer Loans
Indirect Home Improvement. Fixture secured loans for home improvement are originated by the Company through its network of home improvement contractors and dealers and are secured by the personal property installed in, on, or at the borrower’s real property, and may be perfected with a UCC-2 financing statement filed in the county of the borrower’s residence. These indirect home improvement loans include replacement windows, siding, roofing, pools, and other home fixture installations, including solar related home improvement projects.
Marine. Loans originated by the Company, secured by boats, to borrowers primarily located in the states the Company originates consumer loans.
Other Consumer. Loans originated by the Company to consumers in our retail branch footprint, including automobiles, recreational vehicles, direct home improvement loans, loans on deposits, and other consumer loans, primarily consisting of personal lines of credit and credit cards.
18
Commercial Business Loans
Commercial and Industrial Lending (“C&I”). Loans originated by the Company to local small- and mid-sized businesses in our Puget Sound market area are secured primarily by accounts receivable, inventory, or personal property, plant and equipment. Some of the C&I loans purchased by the Company are outside of the greater Puget Sound market area. C&I loans are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. PPP loans originated by the Company are also included in this loan class.
Warehouse Lending. Loans originated to non-depository financial institutions and secured by notes originated by the non-depository financial institution. The Company has two distinct warehouse lending divisions: commercial warehouse re-lending secured by notes on construction loans and mortgage warehouse re-lending secured by notes on one-to-four-family loans. The Company’s commercial construction warehouse lines are secured by notes on construction loans and typically guaranteed by principals with experience in construction lending. Mortgage warehouse lending loans are funded through third-party residential mortgage bankers. Under this program the Company provides short-term funding to the mortgage banking companies for the purpose of originating residential mortgage loans for sale into the secondary market.
The following tables detail activity in the allowance for credit losses on loans by loan categories at or for the three months ended March 31, 2022 and in the allowance for loan losses under the incurred loss methodology for the three months ended March 31, 2021:
At or For the Three Months Ended March 31, 2022
Real
Estate
Consumer
Business
Beginning balance, prior to adoption of ASC 326
14,798
4,280
6,536
Impact of adopting ASC 326
(5,234)
6,078
(3,682)
Provision for credit losses on loans
996
(303)
159
852
Loans charged-off
(523)
260
10,560
9,792
3,013
23,365
At or For the Three Months Ended March 31, 2021
Allowance for loan losses
Beginning balance
13,846
6,696
4,939
691
26,172
Provision for loan losses
(231)
378
768
585
(503)
(38)
(541)
244
13,615
6,815
5,669
1,276
27,375
Period end amount allocated to:
Loans individually evaluated for impairment
241
1,169
1,425
Loans collectively evaluated for impairment
13,600
6,574
4,500
25,950
Ending balance
LOANS RECEIVABLE
2,896
689
5,691
9,276
926,973
380,817
303,369
1,611,159
929,869
381,506
309,060
1,620,435
Nonaccrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are automatically placed on nonaccrual once the loan is 90 days past due or sooner if, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, or as required by regulatory authorities.
19
At March 31, 2022 and December 31, 2021, the Company had no TDRs. There were no TDRs which incurred a payment default within twelve months of the restructure date during the three months ended March 31, 2022 and 2021.
The following tables provide information pertaining to the aging analysis of contractually past due loans and nonaccrual loans at March 31, 2022 and December 31, 2021:
30-59
60-89
Days
90 Days
Past
or More
Non-
Due
Past Due
Current
Receivable
Accrual
40
155
195
44,199
257
815
199
538
1,552
359,527
751
239
693
1,747
1,128,847
1,008
830
228
213
1,271
358,172
28
82,532
2,982
868
230
1,311
443,686
581
1,087
206,393
5,208
244,350
Total loans
1,683
469
1,993
4,145
1,816,883
6,797
179
40,838
301
593
264
480
1,337
364,809
659
1,516
1,088,787
781
1,047
280
1,622
334,663
554
119
82,659
2,949
1,177
282
313
1,772
420,271
629
791
207,761
4,419
241,038
2,561
546
4,079
1,750,096
5,829
There were no loans 90 days or more past due and still accruing interest at both March 31, 2022 and December 31, 2021.
20
Impaired Loans and the Allowance for Loan Losses - Prior to the implementation of Financial Instruments - Credit Losses (Topic 326) on January 1, 2022, a loan was considered impaired when, based on current information and circumstances, the Company determines it was probable that it would be unable to collect all amounts due according to the contractual terms of the loan agreement, including scheduled interest payments. Factors involved in determining impairment included, but were not limited to, the financial condition of the borrower, the value of the underlying collateral and the status of the economy. Impaired loans were comprised of loans on nonaccrual, TDRs that were performing under their restructured terms, and loans that were 90 days or more past due, but were still on accrual.
The following table provides additional information on impaired loans with and without allowance reserves at December 31, 2021. Recorded investment includes the unpaid principal balance or the carrying amount of loans less charge-offs and net deferred loan fees (in thousands):
Unpaid
WITH NO RELATED ALLOWANCE RECORDED
Principal
Recorded
Related
Real estate loans:
Balance
Investment
259
227
497
756
707
WITH RELATED ALLOWANCE RECORDED
92
74
23
Consumer loans:
Indirect
551
193
56
Commercial business loans:
4,417
921
5,134
5,122
1,163
5,890
The following tables present the average recorded investment in loans individually evaluated for impairment and the interest income recognized and received for the three months ended March 31, 2021:
March 31, 2021
Average Recorded
Interest Income
Recognized
1,850
652
543
3,045
WITH AN ALLOWANCE RECORDED
786
36
1
5,678
6,563
9,608
Credit Quality Indicators
As part of the Company’s on-going monitoring of credit quality of the loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grading of loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) non-performing loans, and (v) the general economic conditions in the Company’s markets.
The Company utilizes a risk grading matrix to assign a risk grade to its real estate and commercial business loans. Loans are graded on a scale of 1 to 10, with loans in risk grades 1 to 6 considered “Pass” and loans in risk grades 7 to 10 are reported as classified loans in the Company’s allowance for loan loss analysis.
A description of the 10 risk grades is as follows:
Consumer, Home Equity, and One-to-Four-Family Real Estate Loans
Homogeneous loans are risk rated based upon the Federal Financial Institutions Examination Council’s Uniform Retail
22
Credit Classification and Account Management Policy. Loans classified under this policy at the Company are consumer loans which include indirect home improvement, solar, marine, other consumer, and one-to-four-family first and second liens. Under the Uniform Retail Credit Classification Policy, loans that are current or less than 90 days past due are graded “Pass” and risk rated “4” or “5” internally. Loans that are past due more than 90 days are classified “Substandard” and risk graded “8” internally until the loan has demonstrated consistent performance, typically six months of contractual payments. Closed-end loans that are 120 days past due and open-end loans that are 180 days past due are charged off based on the value of the collateral less cost to sell. Management may more conservatively risk rate credits even if paying in accordance with the loan’s repayment terms.
Commercial real estate, construction and development, multi-family and commercial business loans are evaluated individually for their risk classification and may be classified as “Substandard” even if current on their loan payment obligations.
The following tables summarize risk rated loan balances by category as of March 31, 2022. Revolving loans that are converted to term loans are treated as new originations and are presented by year of origination. Term loans that are renewed or extended for periods longer than 90 days are presented as a new origination in the year of the most recent renewal or extension.
Term Loans by Year of Origination
2020
2019
2018
Prior
Revolving Loans
Total Loans
Pass
10,492
78,064
51,243
42,521
15,070
65,267
262,657
Watch
222
411
594
Special Mention
306
5,194
5,500
Substandard
Total commercial
51,465
43,238
15,664
70,594
32,629
145,121
61,757
18,441
732
Total construction and development
2,584
2,099
7,193
1,371
2,104
28,783
44,134
143
Total home equity
1,485
2,247
150,822
90,638
34,097
19,738
45,470
358,357
1,971
145
606
Total one-to-four-family
21,854
46,076
19,270
63,574
34,147
48,555
4,648
26,730
Total multi-family
82,567
439,680
245,200
144,334
43,651
146,379
53,224
152,815
60,831
39,858
23,132
29,045
358,917
142
95
90
125
526
Total indirect home improvement
152,957
60,926
39,948
23,206
29,170
5,610
17,335
25,380
9,931
12,889
11,358
82,503
Total marine
11,415
315
163
30
55
192
1,903
Total other consumer
59,170
170,607
86,469
49,909
36,150
40,777
1,915
7,058
42,776
22,103
3,036
4,421
11,399
101,676
192,469
940
1,217
345
1,357
2,297
1,101
4,238
249
4,987
922
11,497
Total commercial and industrial
7,403
43,877
23,460
7,312
4,698
16,706
104,024
Total warehouse lending
141,981
TOTAL LOANS RECEIVABLE, GROSS
148,795
652,921
353,455
196,469
81,324
192,297
170,331
1,795,592
449
372
2,577
1,999
5,275
1,243
4,331
582
5,918
13,091
149,140
654,164
355,129
201,555
84,499
203,862
172,679
24
Special
Mention
Doubtful
Loss
(1 - 5)
(6)
(7)
(8)
(9)
(10)
253,092
4,652
5,769
916
40,716
363,682
2,464
1,076,201
3,681
335,731
82,721
2,962
421,414
188,767
4,182
1,829
13,774
222,044
1,719,659
8,834
7,598
18,084
The following table presents the amortized cost basis of loans on nonaccrual status and loans 90 days or more past due and still accruing as of March 31, 2022:
Nonaccrual with No
Nonaccrual with
90 Days or More
Allowance for Credit
Past Due and
Nonaccrual
Still Accruing
4,121
2,095
4,702
The Company recognized interest income on nonaccrual loans of $98,000 and $19,000 during the three months ended March 31, 2022 and 2021, respectively.
The following table presents the amortized cost basis of collateral dependent loans by class of loans as of March 31, 2022:
Real Estate
Equipment
NOTE 4 - SERVICING RIGHTS
Loans serviced for others are not included on the Consolidated Balance Sheets. The unpaid principal balances of permanent loans serviced for others were $2.75 billion and $2.61 billion at March 31, 2022 and December 31, 2021, respectively.
The following table summarizes servicing rights activity at or for the dates indicated:
At or For the Three Months Ended
Beginning balance, at the lower of cost or fair value
12,595
Additions
Servicing rights amortized
(1,480)
(2,054)
2,050
Ending balance, at the lower of cost or fair value
15,735
The fair value of the servicing rights’ assets was $32.1 million and $26.1 million at March 31, 2022 and December 31, 2021, respectively. Fair value adjustments to servicing rights are mainly due to market-based assumptions associated with discounted cash flows, loan prepayment speeds, and changes in interest rates. A significant change in prepayments of the loans in the servicing portfolio could result in significant changes in the valuation adjustments, thus creating potential volatility in the carrying amount of servicing rights.
The following provides valuation assumptions used in determining the fair value of mortgage servicing rights (“MSR”) at the dates indicated:
At March 31,
At December 31,
Key assumptions:
Weighted average discount rate
9.1
%
Conditional prepayment rate (“CPR”)
9.5
13.8
Weighted average life in years
7.4
5.9
Key economic assumptions of the current fair value for single family MSR are presented in the table below. Also presented is the sensitivity to market rate changes for the par rate coupon for a conventional one-to-four-family FNMA, FHLMC, GNMA, or FHLB serviced home loan. The table below references a 50 basis point and 100 basis point adverse rate change and the impact on prepayment speeds and discount rates at March 31, 2022 and December 31, 2021:
Aggregate portfolio principal balance
2,753,477
2,609,776
Weighted average rate of note
3.2
At March 31, 2022
Base
0.5% Adverse Rate Change
1.0% Adverse Rate Change
Conditional prepayment rate
10.5
12.7
Fair value MSR
32,140
30,931
28,475
Percentage of MSR
1.2
1.1
1.0
Discount rate
9.6
10.1
31,464
30,813
At December 31, 2021
20.0
31.5
26,070
21,188
15,348
0.8
0.6
25,586
25,119
These sensitivities are hypothetical and should be used with caution as the tables above demonstrate the Company’s methodology for estimating the fair value of MSR which is highly sensitive to changes in key assumptions. For example, actual prepayment experience may differ and any difference may have a material effect on MSR fair value. Changes in fair value resulting from changes in assumptions generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear. Also, in these tables, the effects of a variation in a particular assumption on the fair value of the MSR is calculated without changing any other assumption; in reality, changes in one factor may be associated with changes in another (for example, decreases in market interest rates may provide an incentive to refinance, however, this may also indicate a slowing economy and an increase in the unemployment rate, which reduces the number of borrowers who qualify for refinancing), which may magnify or counteract the sensitivities. Thus, any measurement of MSR fair value is limited by the conditions existing and assumptions made at a particular point in time. Those assumptions may not be appropriate if they are applied to a different time.
The Company recorded $1.7 million and $1.4 million of gross contractually specified servicing fees, late fees, and other ancillary fees resulting from servicing of loans for the three months ended March 31, 2022 and 2021, respectively. The income, net of MSR amortization, is reported in noninterest income on the Consolidated Statements of Income.
NOTE 5 - DERIVATIVES
The Bank regularly enters into commitments to originate and sell loans held for sale. The Bank has established a hedging strategy to protect itself against the risk of loss associated with interest rate movements on loan commitments. The Bank enters into contracts to sell forward To-Be-Announced (“TBA”) mortgage-backed securities. These commitments and contracts are considered derivatives but have not been designated as hedging instruments for reporting purposes under U.S. GAAP. Rather, they are accounted for as free-standing derivatives, or economic hedges, with changes in the fair value of the derivatives reported in noninterest income or noninterest expense. The Bank recognizes all derivative instruments as either other assets or other liabilities on the Consolidated Balance Sheets and measures those instruments at fair value.
Derivative instruments not related to mortgage banking activities primarily relate to interest rate swap agreements. The Bank's objectives in using certain interest rate derivatives are to add stability to interest expense and to manage its exposure
27
to interest rate movements. To accomplish this objective, the Bank uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Bank making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.
The Bank has entered into interest rate swaps to reduce the exposure to variability in interest-related cash outflows attributable to changes in forecasted LIBOR-based borrowings and brokered deposits. These derivative instruments are designated as cash flow hedges. The hedged item is the LIBOR portion of the series of future adjustable-rate borrowings and deposits over the term of the interest rate swap. Accordingly, changes to the amount of interest payment cash flows for the hedged transactions attributable to a change in credit risk are excluded from management’s assessment of hedge effectiveness. The Bank tests for hedging effectiveness on a quarterly basis. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The Bank has not recorded any hedge ineffectiveness since inception. The Bank has master netting agreements with derivative dealers with which it does business, but reflects gross assets and liabilities as other assets and other liabilities, respectively, on the Consolidated Balance Sheets.
The Bank reclassified net realized losses of $101,000 and $114,000 from accumulated other comprehensive income (loss) to interest expense related to these cash flow hedges for the three months ended March 31, 2022 and March 31, 2021, respectively. The Bank expects that approximately $943,000 will be reclassified from accumulated other comprehensive income as a decrease to interest expense over the next twelve months related to these cash flow hedges.
The following tables summarize the Bank’s derivative instruments at the dates indicated:
Fair Value
Notional
Asset
Liability
Interest rate swaps
90,000
3,941
Non-hedging derivatives:
Fallout adjusted interest rate lock commitments with customers
82,592
250
Mandatory and best effort forward commitments with investors
33,255
885
Forward TBA mortgage-backed securities
81,000
1,706
1,168
71,890
757
74,375
808
111,000
53
At March 31, 2022 and December 31, 2021, the Bank had $81.0 million and $111.0 million of TBA trades, respectively, with counterparties that held margin collateral of $305,000 for both periods. At March 31, 2022, the Bank had pledged two securities with a carrying value of $2.8 million to secure interest rate swaps designated as cash flow hedges.
Changes in the fair value of the non-hedging derivatives recognized in noninterest income on the Consolidated Statements of Income and included in gain on sale of loans resulted in net losses of $238,000 and $931,000 for the three months ended March 31, 2022 and 2021, respectively.
NOTE 6 - LEASES
The Company has operating leases for retail bank branches, home lending branches, and certain equipment. The Company’s leases have remaining lease terms of eight months to eight years and three months, some of which include options to extend the leases for up to five years.
The components of lease cost (included in occupancy expense on the Consolidated Statements of Income) are as follows for the three months ended March 31, 2022 and 2021:
Lease cost:
Operating lease cost
343
348
Short-term lease cost
Total lease cost
344
349
The following table provides supplemental information related to operating leases at or for the three months ended March 31, 2022 and 2021:
At or For the
Cash paid for amounts included in the
measurement of lease liabilities:
Operating cash flows from operating leases
346
Weighted average remaining lease term- operating leases
4.8
years
5.1
Weighted average discount rate- operating leases
2.06
2.33
The Company’s leases typically do not contain a discount rate implicit in the lease contract. As an alternative, the discount rate used in determining the lease liability for each individual lease was the FHLB of Des Moines’ fixed-advance rate.
Maturities of operating lease liabilities at March 31, 2022 for future periods are as follows:
1,065
2023
1,226
2024
1,173
2025
861
2026
737
Thereafter
688
Total lease payments
5,750
Less imputed interest
(344)
29
NOTE 7 - OTHER REAL ESTATE OWNED (“OREO”)
The following table presents the activity related to OREO at or for the three months ended March 31, 2022 and 2021:
Gross proceeds from sale of OREO
(81)
There were no OREO properties at March 31, 2022 and 2021 and there were no OREO holding costs for the three months ended March 31, 2022 and 2021.
There was $755,000 in portfolio mortgage loans collateralized by residential real estate property in the process of foreclosure at March 31, 2022.
NOTE 8 - DEPOSITS
Deposits are summarized as follows at March 31, 2022 and December 31, 2021:
Noninterest-bearing checking
449,075
443,133
Interest-bearing checking (1)
329,938
349,251
Savings
198,184
193,922
Money market (2)
545,442
552,357
Certificates of deposit less than $100,000 (3)
210,984
186,974
Certificates of deposit of $100,000 through $250,000
107,429
116,206
Certificates of deposit of $250,000 and over
52,669
57,512
Escrow accounts related to mortgages serviced
26,067
16,389
Scheduled maturities of time deposits at March 31, 2022 for future periods ending are as follows:
Maturing in 2022
199,402
Maturing in 2023
65,635
Maturing in 2024
34,382
Maturing in 2025
56,961
Maturing in 2026
14,103
599
371,082
Interest expense by deposit category for the three months ended March 31, 2022 and 2021 is as follows:
Interest-bearing checking
161
50
Savings and money market
383
468
Certificates of deposit
741
1,464
NOTE 9 - COMMITMENTS AND CONTINGENCIES
Commitments - The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized on the Consolidated Balance Sheets.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
The following table provides a summary of the Company’s commitments at March 31, 2022 and December 31, 2021:
COMMITMENTS TO EXTEND CREDIT
559
787
217,274
182,297
One-to-four-family (includes locks for saleable loans)
111,160
78,264
71,964
67,596
3,465
3,434
404,422
332,378
38,692
35,873
119,528
126,220
53,516
64,160
173,044
190,380
Total commitments to extend credit
616,158
558,631
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the amount of the total commitments do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon an extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, and income-producing commercial properties.
Unfunded commitments under commercial lines of credit, revolving credit lines, and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are uncollateralized and usually do not contain a specified maturity date and ultimately may not be drawn upon to the total extent to which the Company is committed. The Company’s allowance for credit losses - unfunded loan commitments at March 31, 2022 and reserves for estimated losses from unfunded commitments at December 31, 2021 was $3.1 million and $499,000, respectively. The increase in the allowance for credit losses – unfunded loan commitments reflects the adoption of CECL, as well as the increased provision for credit losses – unfunded loan commitments recorded during the current quarter. One-
to-four-family commitments included in the table above are accounted for as fair value derivatives and do not carry an associated holdback. The Company’s derivative positions are presented with discussion in “Note 5 - Derivatives.”
The Company also sells one-to-four-family loans to the FHLB of Des Moines that require a limited level of recourse if the loans default and exceed a certain loss exposure. Specific to that recourse, the FHLB of Des Moines established a first loss account (“FLA”) related to the loans and required a credit enhancement (“CE”) obligation by the Bank to be utilized after the FLA is used. Based on loans sold through March 31, 2022, the total loans sold to the FHLB were $11.7 million with the FLA totaling $938,000 and the CE obligation at $811,000 or 6.9% of the loans outstanding. Management has established a holdback of 10% of the outstanding CE, or $81,000, which is a part of the off-balance sheet holdback for loans sold. At both March 31, 2022 and December 31, 2021, there were no loans sold to the FHLB of Des Moines that were greater than 30 days past their contractual payment due date.
Contingent liabilities for loans held for sale - In the ordinary course of business, loans are sold with limited recourse against the Company and may have to subsequently be repurchased due to defects that occurred during the origination of the loan. The defects are categorized as documentation errors, underwriting errors, early payoff, early payment defaults, breach of representation or warranty, servicing errors, and/or fraud. When a loan sold to an investor without recourse fails to perform according to its contractual terms, the investor will typically review the loan file to determine whether defects in the origination process occurred. If a defect is identified, the Company may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, the Company has no commitment to repurchase the loan. The Company has recorded a holdback reserve of $2.6 million and $2.7 million to cover loss exposure related to these guarantees for one-to-four-family loans sold into the secondary market at March 31, 2022 and December 31, 2021, respectively, which is included in other liabilities on the Consolidated Balance Sheets.
The Company has entered into a severance agreement with its Chief Executive Officer (“CEO”). The severance agreement, subject to certain requirements, generally includes a lump sum payment to the CEO equal to 24 months of base compensation in the event his employment is involuntarily terminated, other than for cause or the executive terminates his employment with good reason, as defined in the severance agreement.
The Company has entered into change of control agreements with its Chief Financial Officer, Chief Operating Officer, Chief Lending Officer, Chief Credit Officer, Chief Risk Officer, Chief Human Resources Officer, Senior Vice President Compliance Officer, Executive Vice President of Retail Banking and Marketing, and the Executive Vice President of Home Lending. The change of control agreements, subject to certain requirements, generally remain in effect until canceled by either party upon at least 24 months prior written notice. Under the change of control agreements, the executive generally will be entitled to a change of control payment from the Company if the executive is involuntarily terminated within six months preceding or 12 months after a change in control (as defined in the change of control agreements). In such an event, the executives would each be entitled to receive a cash payment in an amount equal to 12 months of their then current salary, subject to certain requirements in the change of control agreements.
As a result of the nature of our activities, the Company is subject to various pending and threatened legal actions, which arise in the ordinary course of business. From time to time, subordination liens may create litigation which requires us to defend our lien rights. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on our financial position. The Company had no material pending legal actions at March 31, 2022.
NOTE 10 - FAIR VALUE MEASUREMENTS
The Company determines fair value based on the requirements established in Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements, which provides a framework for measuring fair value in accordance with U.S. GAAP and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820 defines fair value as the exit price, or the price that would be received for an asset or paid to transfer a liability, in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date under current market conditions. ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities, requires us to use the exit price notion when measuring the fair value of instruments for disclosure purposes.
32
The following definitions describe the levels of inputs that may be used to measure fair value:
Level 1 - Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2 - Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
Level 3 - Inputs to the valuation methodology are unobservable and significant to the fair value measurement.
The following methods were used to estimate the fair value of certain assets and liabilities on a recurring and nonrecurring basis:
Securities - The fair value of securities available-for-sale and held-to-maturity are recorded on a recurring basis. The fair value of investments and mortgage-backed securities are provided by a third-party pricing service. These valuations are based on market data using pricing models that vary by asset class and incorporate available current trade, bid, and other market information, and for structured securities, cash flow, and loan performance data. The pricing processes utilize benchmark curves, benchmarking of similar securities, sector groupings, and matrix pricing. Option adjusted spread models are also used to assess the impact of changes in interest rates and to develop prepayment scenarios (Level 2). Certain other corporate securities and municipal bonds are generally measured at fair value based on discounted cash flow models (Level 3). Transfers between the fair value hierarchy are determined through the third-party service provider which, from time to time will transfer between levels based on market conditions per the related security. All models and processes used take into account market convention.
Mortgage Loans Held for Sale - The fair value of loans held for sale reflects the value of commitments with investors and/or the relative price as delivered into a TBA mortgage-backed security (Level 2).
Loans receivable - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type, including commercial, real estate and consumer loans. Each loan category is further segregated by fixed and adjustable rate loans. The fair value of loans is calculated by discounting expected cash flows at rates at which similar loans are currently being made. These amounts are discounted further by embedded probable losses expected to be realized in the portfolio. For loans originated as held for sale and transferred into loans held for investment, the fair value is determined based on quoted secondary market prices for similar loans. As of March 31, 2022 and December 31, 2021, there were $14.9 million and $16.1 million, respectively, in residential mortgage loans recorded at fair value as they were previously transferred from held for sale to loans held for investment (Level 2).
Derivative Instruments - Fair values for derivative assets and liabilities are measured on a recurring basis. The primary use of derivative instruments is related to the mortgage banking activities of the Company. The fair value of the interest rate lock commitments and forward sales commitments are estimated using quoted or published market prices for similar instruments, adjusted for factors such as pull-though rate assumptions based on historical information, where appropriate. TBA mortgage-backed securities are fair valued on similar contracts in active markets (Level 2), while locks and forwards with customers and investors are fair valued using similar contracts in the market and changes in the market interest rates (Level 2 and 3). Derivative instruments not related to mortgage banking activities include interest rate swap agreements. The fair values of interest rate swap agreements are based on valuation models using observable market data as of the measurement date (Level 2). The Company’s derivatives are traded in an over-the-counter market where quoted market prices are not always available. Therefore, the fair values of derivatives are determined using quantitative models that utilize multiple market inputs. The inputs will vary based on the type of derivative, but could include interest rates, prices and indices to generate continuous yield or pricing curves, prepayment rates, and volatility factors to value the position. The majority of market inputs are actively quoted and can be validated through external sources, including market transactions and third-party pricing services. The fair values of all interest rate swaps are determined from third-party pricing services without adjustment.
Loans individually evaluated - Expected credit losses for loans evaluated individually are measured based on the present value of expected future cash flows discounted at the loan’s original effective interest rate or when the Bank determines
33
that foreclosure is probable, the expected credit loss is measured based on the fair value of the collateral as of the reporting date, less estimated selling costs, as applicable. As a practical expedient, the Bank measures the expected credit loss for a loan using the fair value of the collateral, if repayment is expected to be provided substantially through the operation or sale of the collateral when the borrower is experiencing financial difficulty based on the Bank’s assessment as of the reporting date. In both cases, if the fair value of the collateral is less than the amortized cost basis of the loan, the Bank will recognize an allowance as the difference between the fair value of the collateral, less costs to sell (if applicable), at the reporting date and the amortized cost basis of the loan. If the fair value of the collateral exceeds the amortized cost basis of the loan, any expected recovery added to the amortized cost basis will be limited to the amount previously charged-off by the subsequent changes in the expected credit losses for loans evaluated individually are included within the provision for credit losses in the same manner in which the expected credit loss initially was recognized or as a reduction in the provision that would otherwise be reported (Level 3).
Servicing Rights - The fair value of mortgage servicing rights is estimated using net present value of expected cash flows using a third-party model that incorporates assumptions used in the industry to value such rights, adjusted for factors such as weighted average prepayments speeds based on historical information where appropriate (Level 3).
The following tables present securities available-for-sale, mortgage loans held for sale, and derivative assets and liabilities measured at fair value on a recurring basis at the dates indicated:
Financial Assets
Level 1
Level 2
Level 3
7,734
1,000
131,615
121
Mortgage loans held for sale, at fair value
Loans receivable, at fair value
14,918
Derivatives:
Interest rate lock commitments with customers
Total assets measured at fair value
324,818
2,256
327,074
Financial Liabilities
Total liabilities measured at fair value
34
7,995
1,007
135,302
131
16,083
413,335
2,703
416,038
(155)
The following tables present loans individually evaluated and servicing rights measured at fair value on a nonrecurring basis for which a nonrecurring change in fair value has been recorded during the reporting periods indicated. The amounts disclosed below represent the fair values at the time the nonrecurring fair value measurements were evaluated.
Loans individually evaluated
Servicing rights
Quantitative Information about Level 3 Fair Value Measurements - Shown in the table below is the fair value of financial instruments measured under a Level 3 unobservable input on a recurring and nonrecurring basis at March 31, 2022 and December 31, 2021:
Significant
Weighted Average
Valuation
Unobservable
Instruments
Techniques
Inputs
Range
RECURRING
Quoted market prices
Pull-through expectations
80% - 99%
93.5
93.3
Individual forward sale commitments with investors
Discounted cash flows
2.2% - 2.7%
2.7
2.2
6.0% - 6.2%
6.2
6.0
35
NONRECURRING
Fair value of underlying collateral
Discount applied to the obtained appraisal
10.0%
10.0
Industry sources
Pre-payment speeds
0% - 50%
An increase in the pull-through rate utilized in the fair value measurement of the interest rate lock commitments with customers and forward sale commitments with investors will result in positive fair value adjustments (and an increase in the fair value measurement). Conversely, a decrease in the pull-through rate will result in a negative fair value adjustment (and a decrease in the fair value measurement).
The following tables provides a reconciliation of assets and liabilities measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the three months ended March 31, 2022 and 2021:
Net change in
Beginning
and
Sales and
Ending
fair value for
Issuances
Settlements
gains/(losses) (1)
gains/(losses) (2)
(2,602)
507
2,143
(2,066)
77
1,138
(17)
1,121
4,024
7,691
(9,730)
1,985
(2,039)
(67)
654
506
573
1,111
(3)
1,129
______________________________
(1) Relating to items held at end of period included in income.
(2) Relating to items held at end of period included in other comprehensive income (loss).
Gains (losses) on interest rate lock commitments carried at fair value are recorded in other noninterest income. Gains (losses) on forward sale commitments with investors carried at fair value are recorded in noninterest income. Unrealized gains (losses) on securities available-for-sale, at fair value are recorded in accumulated other comprehensive income.
The following table provides estimated fair values of the Company’s financial instruments at March 31, 2022 and December 31, 2021, whether or not recognized at fair value on the Consolidated Balance Sheets:
Carrying
Level 1 inputs:
Cash and cash equivalents
Level 2 inputs:
262,185
270,221
Securities held-to-maturity
FHLB stock, at cost
Level 3 inputs:
Loans receivable, gross
1,806,110
1,801,329
1,738,092
1,725,651
Servicing rights, held at lower of cost or fair value
Fair value interest rate locks with customers
1,908,324
1,912,498
35,714
43,365
Subordinated notes, excluding unamortized debt issuance costs
49,000
51,688
Accrued interest payable
766
NOTE 11 - EMPLOYEE BENEFITS
Employee Stock Ownership Plan (“ESOP”)
On January 1, 2012, the Company established an ESOP for eligible employees of the Company and the Bank. Employees of the Company and the Bank are eligible to participate in the ESOP if they have been credited with at least 1,000 hours of service during the employees’ first 12-month period and based on the employee’s anniversary date will be vested in the ESOP. The employee will be 100% vested in the ESOP after two years of working at least 1,000 hours in each of those two years.
The ESOP borrowed $2.6 million from FS Bancorp, Inc. and used those funds to acquire 518,420 shares of FS Bancorp, Inc. common stock in the open market at an average price of $5.09 per share during the second half of 2012. It is anticipated that the Bank will make contributions to the ESOP in amounts necessary to amortize the ESOP loan payable to FS Bancorp, Inc. over a period of 10 years, bearing interest at 2.30%. Intercompany expenses associated with the ESOP are eliminated in consolidation. Shares purchased by the ESOP with the loan proceeds are held in a suspense account and allocated to ESOP participants on a pro rata basis as principal and interest payments are made by the ESOP to FS Bancorp, Inc. The loan is secured by shares purchased with the loan proceeds and will be repaid by the ESOP with funds from the Bank’s discretionary contributions to the ESOP and earnings on the ESOP assets. Payments of principal and interest are due annually on December 31, the Company’s fiscal year end. On December 31, 2021, the ESOP paid the tenth
37
annual and final installment of principal in the amount of $288,000, plus accrued interest of $7,000 pursuant to the ESOP loan agreement.
All ESOP shares have been allocated as of December 31, 2021. Compensation expense related to the ESOP for the three months ended March 31, 2022 and 2021 was $0 and $402,000, respectively.
NOTE 12 - EARNINGS PER SHARE
The Company computes earnings per share using the two-class method, which is an earnings allocation method for computing earnings per share that treats a participating security as having rights to earnings that would otherwise have been available to common shareholders. Basic earnings per share are computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Unvested share-based awards containing non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and are included in the computation of earnings per share pursuant to the two-class method. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. For earnings per share calculations, the ESOP shares committed to be released are included as outstanding shares for both basic and diluted earnings per share.
The following table presents a reconciliation of the components used to compute basic and diluted earnings per share at or for the three months ended March 31, 2022 and 2021:
At or For the Three Months Ended March 31,
Numerator (in thousands):
Dividends and undistributed earnings allocated to participating securities
(127)
(170)
Net income available to common shareholders
6,743
11,713
Denominator (shown as actual):
Basic weighted average common shares outstanding
8,145,138
8,430,752
Dilutive shares
149,828
247,416
Diluted weighted average common shares outstanding
8,294,966
8,678,168
Potentially dilutive weighted average share options that were not included in the computation of diluted earnings per share because to do so would be anti-dilutive
45,564
10,588
_______________________
Share data has been adjusted for all periods to reflect the two-for-one stock split effective July 14, 2021.
NOTE 13 - STOCK-BASED COMPENSATION
Stock Options and Restricted Stock
On May 17, 2018, the shareholders of FS Bancorp, Inc. approved the 2018 Equity Incentive Plan (the “2018 Plan”) that authorized 1.3 million shares of the Company’s common stock to be awarded. The 2018 Plan provides for the grant of incentive stock options, non-qualified stock options, and up to 326,000 restricted stock awards (“RSAs”) to directors, emeritus directors, officers, employees or advisory directors of the Company. At March 31, 2022, there were 441,296 stock option awards and 144,460 RSAs available to be granted under the 2018 Plan. Share and per share data has been adjusted for all periods to reflect the two-for-one stock split effective July 14, 2021.
Total share-based compensation expense was $451,000 and $295,000 for the three months ended March 31, 2022 and 2021, respectively.
Stock Options
The 2018 Plan consists of stock option awards that may be granted as incentive stock options or non-qualified stock options. Stock option awards generally vest at one year or three years for independent directors or over a five-year period for employees and officers with 20% vesting on the anniversary date of each grant date as long as the award recipient remains in service to the Company. The options are exercisable after vesting for up to the remaining term of the original grant. The maximum term of the options granted is 10 years. Any unexercised stock options will expire 10 years after the grant date or sooner in the event of the award recipient’s termination of service with the Company or the Bank. The fair value of each stock option award is estimated on the grant date using a Black-Scholes Option pricing model that uses the following assumptions. The dividend yield is based on the current quarterly dividend in effect at the time of the grant. Historical employment data is used to estimate the forfeiture rate. The Company elected to use Staff Accounting Bulletin 107, simplified expected term calculation for the “Share-Based Payments” method permitted by the SEC to calculate the expected term. This method uses the vesting term of an option along with the contractual term, setting the expected life at 5.5 years for one-year vesting, 6.0 years for three-year vesting, and 6.5 years for five-year vesting.
The following table presents a summary of the Company’s stock option awards during the three months ended March 31, 2022 (shown as actual):
Weighted-Average
Weighted-
Remaining
Average
Contractual Term In
Aggregate
Exercise Price
Years
Intrinsic Value
Outstanding at January 1, 2022
613,626
25.24
7.17
5,362,902
Granted
Less exercised
14.73
227,948
Forfeited or expired
Outstanding at March 31, 2022
600,946
25.47
6.97
3,855,397
Expected to vest, assuming a 0.31% annual forfeiture rate (1)
599,182
25.46
6.96
3,848,062
Exercisable at March 31, 2022
249,142
21.29
5.36
2,418,267
Share and per share data has been adjusted to reflect the two-for-one stock split effective July 14, 2021.
__________________________
At March 31, 2022, there was $1.9 million of total unrecognized compensation cost related to nonvested stock options granted under the 2018 plan. The cost is expected to be recognized over the remaining weighted-average vesting period of 3.3 years.
Restricted Stock Awards
The RSAs’ fair value is equal to the value of the market price of FS Bancorp’s common stock on the grant date and compensation expense is recognized over the vesting period of the awards based on the fair value of the restricted stock. Shares for the 2018 Plan generally vest at one year or three years for independent directors or over a five-year period for employees and officers beginning on the grant date. Any unvested RSAs will expire after vesting or sooner in the event of the award recipient’s termination of service with the Company or the Bank.
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The following table presents a summary of the Company’s nonvested awards during the three months ended March 31, 2022 (shown as actual):
Grant-Date Fair Value
Nonvested Shares
Per Share
Nonvested at January 1, 2022
121,672
28.02
Less vested
Nonvested at March 31, 2022
At March 31, 2022, there was $2.7 million of total unrecognized compensation cost related to nonvested shares granted under the 2018 Plan as RSAs. The cost is expected to be recognized over the remaining weighted-average vesting period of 3.3 years.
NOTE 14 - REGULATORY CAPITAL
The Bank is subject to various regulatory capital requirements administered by the Federal Reserve and the FDIC. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines of the regulatory framework for prompt corrective action, the Bank must meet specific capital adequacy guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital classification is also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
The federal banking agencies jointly issued a final rule that provides for an optional, simplified measure of capital adequacy, the community bank leverage ratio framework, for qualifying community banking organizations, consistent with Section 201 of the Economic Growth, Regulatory Relief, and Consumer Protection Act. This final rule is applicable to all non-advanced approaches FDIC-supervised institutions with less than $10 billion in total consolidated assets. The community bank leverage ratio (“CBLR”) final rule was effective on January 1, 2020, and will allow qualifying community banking organizations to calculate a leverage ratio to measure capital adequacy. Banks opting into the CBLR framework are not required to calculate or report risk-based capital. A qualifying community banking organization is defined as having less than $10 billion in total consolidated assets, a leverage ratio greater than 9%, off-balance sheet exposures of 25% or less of total consolidated assets, and trading assets and liabilities of 5% or less of total consolidated assets. The final rule adopts Tier 1 capital and the existing leverage ratio into the community bank leverage ratio framework. A bank electing the framework is not subject to other capital and leverage requirements. Under the CBLR framework, a bank will generally be considered well-capitalized and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%. A bank electing the framework that ceases to meet any qualifying criteria in a future period and that has a leverage ratio greater than 8% will be allowed a grace period of two reporting periods to satisfy the CBLR qualifying criteria or comply with the generally applicable capital requirements. A bank may opt out of the framework at any time, without restriction, by reverting to the generally applicable risk-based capital rule.
The Bank qualified for and elected the CBLR framework as of March 31, 2022. The CBLR calculated for the Bank at March 31, 2022 and December 31, 2021 was 12.2%. At March 31, 2022, the Bank had Tier 1 capital of $276.3 million and a minimum Tier 1 capital requirement of $203.8 million to be considered well capitalized under the CBLR framework. At December 31, 2021, the Bank had Tier 1 capital of $270.8 million and a minimum Tier 1 capital requirement of $189.3 million to be considered well capitalized under the CBLR framework. At both March 31, 2022 and December 31, 2021, the Bank was categorized as well capitalized under applicable regulatory requirements. There are no conditions or events since that notification that management believes have changed the Bank’s category. Management believes, at March 31, 2022, that the Bank met all capital adequacy requirements.
FS Bancorp, Inc. is a bank holding company registered with the Federal Reserve. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. Bank holding companies with less than $3.0 billion in assets are generally not subject to compliance with the Federal Reserve’s capital regulations, which are generally the same as the capital regulations applicable to the Bank. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to the holding company’s subsidiary bank and expects the holding company’s subsidiary bank to be well capitalized under the prompt corrective action regulations. If FS Bancorp, Inc. was subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets at March 31, 2022, FS Bancorp, Inc. would have exceeded all regulatory capital requirements. For informational purposes, the Tier 1 leverage-based capital ratio calculated for FS Bancorp, Inc. at March 31, 2022 and December 31, 2021 was 10.8%.
NOTE 15 - BUSINESS SEGMENTS
The Company’s business segments are determined based on the products and services provided, as well as the nature of the related business activities, and they reflect the manner in which financial information is currently evaluated by management. This process is dynamic and is based on management’s current view of the Company’s operations and is not necessarily comparable with similar information for other financial institutions. The Company defines its business segments by product type and customer segment which it has organized into two lines of business: commercial and consumer banking and home lending.
The Company uses various management accounting methodologies to assign certain income statement items to the responsible operating segment, including:
●a funds transfer pricing (“FTP”) system, which allocates interest income credits and funding charges between the segments, assigning to each segment a funding credit for its liabilities, such as deposits, and a charge to fund its assets;
●a cost per loan serviced allocation based on the number of loans being serviced on the balance sheet and the number of loans serviced for third parties;
●an allocation based upon the approximate square footage utilized by the home lending segment in Company owned locations;
●an allocation of charges for services rendered to the segments by centralized functions, such as corporate overhead, which are generally based on the number of full-time employees (“FTEs”) in each segment; and
●an allocation of the Company’s consolidated income taxes which are based on the effective tax rate applied to the segment’s pretax income or loss.
The FTP methodology is based on management’s estimated cost of originating funds including the cost of overhead for deposit generation.
A description of the Company’s business segments and the products and services that they provide is as follows:
Commercial and Consumer Banking Segment
The commercial and consumer banking segment provides diversified financial products and services to our commercial and consumer customers through Bank branches, automated teller machines (“ATM”), online banking platforms, mobile banking apps, and telephone banking. These products and services include deposit products; residential, consumer, business and commercial real estate lending portfolios and cash management services. The Company originates consumer loans, commercial and multi-family real estate loans, construction loans for residential and multi-family construction, and commercial business loans. At March 31, 2022, the Company’s retail deposit branch network consisted of 21 branches in the Pacific Northwest. This segment is also responsible for the management of the investment portfolio and other assets of the Bank.
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Home Lending Segment
The home lending segment originates one-to-four-family residential mortgage loans primarily for sale in the secondary markets as well as loans held for investment. The majority of mortgage loans are sold to or securitized by FNMA, FHLMC, GNMA, or the FHLB of Des Moines, while the Company generally retains the right to service these loans. Loans originated under the guidelines of the Federal Housing Administration or FHA, US Department of Veterans Affairs or VA, and United States Department of Agriculture or USDA are generally sold servicing released to a correspondent bank or mortgage company. The Company has the option to sell loans on a servicing-released or servicing-retained basis to securitizers and correspondent lenders. A small percentage of its loans are brokered to other lenders. On occasion, the Company may sell a portion of its MSR portfolio and may sell small pools of loans initially originated to be held in the loan portfolio. The Company manages the loan funding and the interest rate risk associated with the secondary market loan sales and the retained one-to-four-family mortgage servicing rights within this business segment. One-to-four-family loans originated for investment and held in this segment are allocated to the home lending segment with a corresponding provision expense and FTP for cost of funds.
Segment Financial Results
The tables below summarize the financial results for each segment based on the factors mentioned above within each segment for the three months ended March 31, 2022 and 2021:
Condensed income statement:
Home Lending
Commercial and Consumer Banking
Net interest income (1)
2,444
20,278
Benefit (provision) for credit losses (2)
154
(1,197)
(1,043)
Noninterest income
3,371
2,505
Noninterest expense
(4,891)
(14,176)
(19,067)
Income before provision for income taxes
1,078
7,410
Provision for income taxes
(240)
(1,378)
(1,618)
838
6,032
Total average assets for period ended
385,451
1,884,820
2,270,271
FTEs
153
536
18,478
Benefit (provision) for loan losses (2)
(1,558)
(1,500)
10,832
2,202
(3,131)
(13,218)
(16,349)
9,381
5,904
(2,088)
(1,314)
(3,402)
7,293
4,590
405,001
1,725,597
2,130,598
355
509
(1) Net interest income is the difference between interest earned on assets and the cost of liabilities to fund those assets. Interest earned includes actual interest earned on segment assets and, if the segment has excess liabilities, interest credits for providing funding to the other segment. The cost of liabilities includes interest expense on segment liabilities and, if
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the segment does not have enough liabilities to fund its assets, a funding charge based on the cost of assigned liabilities to fund segment assets.
(2) Provision for credit losses and provision for loan losses include shifts in allocation between segments due to various changes, to include adjustments to qualitative factors, changes in loan balances, and charge-off and recovery activity.
NOTE 16 - GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and certain other intangibles generally arise from business combinations accounted for under the acquisition method of accounting. Goodwill totaled $2.3 million at March 31, 2022 and December 31, 2021, and represents the excess of the total acquisition price paid over the fair value of the assets acquired, net of the fair values of liabilities assumed as a result of the purchase of four retail bank branches (“Branch Purchase”) from Bank of America on January 22, 2016. Goodwill is not amortized but is evaluated for impairment on an annual basis at December 31 of each year or whenever events or changes in circumstances indicate the carrying value may not be recoverable. The Company performed an impairment analysis at December 31, 2021, and determined that no impairment of goodwill existed. However, if adverse economic conditions or the decrease in the Company’s stock price and market capitalization as a result of the COVID-19 pandemic were to be deemed sustained rather than temporary, it may significantly affect the fair value of our goodwill. Accordingly, no assurances can be given that the Company will not record an impairment loss on goodwill in the future.
Core deposit intangible (“CDI”) is evaluated for impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable, with any changes in estimated useful life accounted for prospectively over the revised remaining life. As of March 31, 2022, management believes that there have been no events or changes in the circumstances that would indicate a potential impairment of CDI.
The following table summarizes the changes in the Company’s other intangible assets comprised solely of CDI for the year ended December 31, 2021, and the three months ended March 31, 2022.
Other Intangible Assets
Gross CDI
Amortization
Net CDI
Balance, December 31, 2020
7,490
(2,739)
4,751
(691)
Balance, December 31, 2021
(3,430)
(173)
Balance, March 31, 2022
(3,603)
The CDI represents the fair value of the intangible core deposit base acquired in business combinations. The CDI will be amortized on a straight-line basis over 10 years for the CDI related to the Anchor Acquisition and on an accelerated basis over approximately nine years for the CDI related to the Branch Purchase. Total amortization expense was $173,000 for the three months ended March 31, 2022, and $177,000 for the same period in 2021.
Amortization expense for CDI is expected to be as follows at March 31, 2022:
Remainder of 2022
518
621
525
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NOTE 17 - REVENUE FROM CONTRACTS WITH CUSTOMERS
Revenue Recognition
In accordance with Topic 606, revenues are recognized when control of promised goods or services is transferred to customers in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. To determine revenue recognition for arrangements that an entity determines are within the scope of Topic 606, the Company performs the following five 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 Company satisfies a performance obligation. The Company only applies the five-step model to contracts when it is probable that the entity will collect the consideration it is entitled to in exchange for the goods or services it transfers to the customer. At contract inception, once the contract is determined to be within the scope of Topic 606, the Company assesses the goods or services that are promised within each contract and identifies those that contain performance obligations and assesses whether each promised good or service is distinct. The Company then recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied.
All the Company’s revenue from contracts with customers in-scope of ASC 606 is recognized in noninterest income and included in our commercial and consumer banking segment. The following table presents noninterest income, segregated by revenue streams in-scope and out-of-scope of Topic 606, for the three months ended March 31, 2022 and 2021.
(Dollars in thousands):
In-scope of Topic 606:
Debit card interchange fees
515
Deposit service and account maintenance fees
216
Noninterest income (in-scope of Topic 606)
759
Noninterest income (out-of-scope of Topic 606)
5,117
12,346
Deposit Fees
The Bank earns fees from its deposit customers for account maintenance, transaction-based services, and overdraft charges. Account maintenance fees consist primarily of account fees and analyzed account fees charged on deposit accounts on a monthly basis. The performance obligation is satisfied and the fees are recognized on a monthly basis as the service period is completed. Transaction-based fees on deposit accounts are charged to deposit customers for specific services provided to the customer, such as wire fees, as well as charges against the account, such as fees for non-sufficient funds and overdrafts. The performance obligation is completed as the transaction occurs and the fees are recognized at the time each specific service is provided to the customer.
Debit Interchange Income
Debit and ATM interchange income represent fees earned when a debit card issued by the Bank is used. The Bank earns interchange fees from debit cardholder transactions through the Visa payment network. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized daily, concurrently with the transaction processing services provided to the cardholder. The performance obligation is satisfied and the fees are earned when the cost of the transaction is charged to the cardholders’ debit card.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This report contains forward-looking statements, which can be identified by the use of words such as “believes,” “expects,” “anticipates,” “estimates,” or similar expressions. Forward-looking statements include, but are not limited to:
These forward-looking statements are subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:
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Any of the forward-looking statements made in this Form 10-Q and in other public statements may turn out to be wrong because of inaccurate assumptions we might make, because of the factors illustrated above or because of other factors that we cannot foresee. Forward-looking statements are based upon management’s beliefs and assumptions at the time they are made. The Company undertakes no obligation to update or revise any forward-looking statement included in this report or to update the reasons why actual results could differ from those contained in such statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, the forward-looking statements discussed in this report might not occur and you should not put undue reliance on any forward-looking statements.
Overview
FS Bancorp, Inc. and its subsidiary bank, 1st Security Bank of Washington have been serving the Puget Sound area since 1907. Originally chartered as a credit union, known as Washington’s Credit Union, the credit union served various select employment groups. On April 1, 2004, the credit union converted to a Washington state-chartered mutual savings bank. On July 9, 2012, the Bank converted from mutual to stock ownership and became the wholly owned subsidiary of FS Bancorp, Inc.
The Company is relationship-driven, delivering banking and financial services to local families, local and regional businesses and industry niches within distinct Western Washington communities, predominately the Puget Sound area, one loan production office located in the Tri-Cities, and our newest loan production office in Vancouver, Washington.
The Company also maintains its long-standing indirect consumer lending platform which operates primarily throughout the West Coast. The Company emphasizes long-term relationships with families and businesses within the communities served, working with them to meet their financial needs. The Company is also actively involved in community activities and events within these market areas, which further strengthens our relationships within those markets.
The Company focuses on diversifying revenues, expanding lending channels, and growing the banking franchise. Management remains focused on building diversified revenue streams based upon credit, interest rate, and concentration risks. Our business plan remains as follows:
The Company is a diversified lender with a focus on the origination of one-to-four-family loans, commercial real estate mortgage loans, second mortgage or home equity loan products, consumer loans including indirect home improvement (“fixture secured”) loans which also include solar-related home improvement loans, marine lending, and commercial business loans. As part of our expanding lending products, the Company experienced growth in residential mortgage and commercial construction warehouse lending consistent with our business plan to further diversify revenues. Historically, consumer loans, in particular, fixture secured loans had represented the largest portion of the Company’s loan portfolio and had traditionally been the mainstay of the Company’s lending strategy. At March 31, 2022 consumer loans represented 24.4% of the Company’s total gross loan portfolio, compared to 24.1% at March 31, 2021. In recent years, the Company has placed more of an emphasis on real estate lending products, such as one-to-four-family loans, commercial real estate loans, including speculative residential construction loans, as well as commercial business loans, while growing the current size of the consumer loan portfolio.
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Fixture secured loans to finance window, gutter, siding replacement, solar panels, pools, and other improvement renovations are a large and regionally expanding segment of the consumer loan portfolio. These fixture secured consumer loans are dependent on the Bank’s contractor/dealer network of 99 active dealers located throughout Washington, Oregon, California, Idaho, Colorado, Nevada, Arizona, and Minnesota with four contractor/dealers responsible for 48.1% of the funded loans dollar volume for the three months ended March 31, 2022. The Company funded $68.9 million, or approximately 3,000 loans during the quarter ended March 31, 2022.
The following table details fixture secured loan originations by state for the periods indicated:
For the Three Months Ended
For the Year Ended
State
Percent
22,991
33.4
103,970
42.0
Oregon
14,929
21.7
54,301
22.0
California
12,421
18.0
49,053
19.8
Idaho
5,437
7.9
19,790
8.0
Colorado
3,004
4.4
7,957
Arizona
998
1.4
4,294
1.7
Nevada
1,490
3,664
1.5
Minnesota
7,582
11.0
4,418
1.8
68,852
100.0
247,447
The Company originates one-to-four-family residential mortgage loans through referrals from real estate agents, financial planners, builders, and from existing customers. Retail banking customers are also an important source of the Company’s loan originations. The Company originated $245.1 million of one-to-four-family loans which includes loans held for sale, loans held for investment, and fixed seconds in addition to loans brokered to other institutions of $2.0 million through the home lending segment during the three months ended March 31, 2022, of which $301.1 million were sold to investors. Of the loans sold to investors, $236.4 million were sold to the FNMA, FHLMC, FHLB, and/or GNMA with servicing rights retained for the purpose of further developing these customer relationships. At March 31, 2022, one-to-four-family residential mortgage loans held for investment, which excludes loans held for sale of $42.1 million, totaled $364.0 million, or 20.0%, of the total gross loan portfolio.
For the three months ended March 31, 2022, there were more one-to-four-family loans originated to finance home purchases, reflecting increased sales of one-to-four-family homes, and decreased refinance activity, compared to the same period in the prior year as refinances surged due to the lowering of market interest rates in response to COVID-19. Residential construction and development lending, while not as common as other options like one-to-four-family loans, will continue to be an important element in our total loan portfolio, and we will continue to take a disciplined approach by concentrating our efforts on loans to builders and developers in our market areas known to us. These short-term loans typically mature in six to twelve months. In addition, the funding is usually not fully disbursed at origination, thereby reducing our net loans receivable in the short term.
The Company is significantly affected by prevailing economic conditions, as well as government policies and regulations concerning, among other things, monetary and fiscal affairs. Deposit flows are influenced by a number of factors, including interest rates paid on time deposits, other investments, account maturities, and the overall level of personal income and savings. Lending activities are influenced by the demand for funds, the number and quality of lenders, and regional economic cycles. Sources of funds for lending activities include primarily deposits, including brokered deposits, borrowings, payments on loans, and income provided from operations.
The Company’s earnings are primarily dependent upon net interest income, the difference between interest income and interest expense. Interest income is a function of the balances of loans and investments outstanding during a given period and the yield earned on these loans and investments. Interest expense is a function of the amount of deposits and borrowings outstanding during the same period and interest rates paid on these deposits and borrowings.
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Another significant influence on the Company’s earnings is fee income from mortgage banking activities. The Company’s earnings are also affected by the provision for loan losses, service charges and fees, gains from sales of assets, operating expenses and income taxes. The Company recorded a provision for credit losses on loans of $1.0 million for the three months ended March 31, 2022, compared to a provision for loan losses of $1.5 million for the same period one year ago, reflecting improved economic factors on credit-deterioration utilized to calculate the ACLL at March 31, 2022, primarily related to the COVID-19 pandemic and the adoption of CECL. The provision for credit losses on loans also reflects the increase in total loans receivable, partially offset by improvements in classified loans that were downgraded based on the COVID-19 pandemic and have shown loan-level improvements at March 31, 2022.
Summary of Critical Accounting Policies and Estimates
Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex, or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy, and changes in the financial condition of borrowers. Management believes that its critical accounting policies include the following:
Allowance for Credit Losses on Loans (“ACLL”). The ACLL is the amount estimated by management as necessary to cover expected losses inherent in the loan portfolio at the balance sheet date. The ACLL is established through the provision for loan losses, which is charged to income. A high degree of judgment is necessary when determining the amount of the ACLL. Among the material estimates required to establish the ACLL are: loss exposure at default; the amount and timing of future cash flows on impacted loans; value of collateral; and determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the ACLL at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions, reasonable and supportable forecasts, and other factors related to the collectability of the loan portfolio. Although the Company believes that use of the best information available currently establishes the ACLL, future adjustments to the ACLL may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. As the Company adds new products to the loan portfolio and expands the Company’s market area, management intends to enhance and adapt the methodology to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have a significant effect on the calculation of the ACLL in any given period. Management believes that its systematic methodology continues to be appropriate. In June 2016, the FASB issued ASU No. 2016-13, Measurement of Credit Losses on Financial Instruments, referred to as the Current Expected Credit Loss or CECL model, which was early adopted by the Company and effective January 1, 2022. For additional information on CECL see “Note 1 - Basis of Presentation and Summary of Significant Accounting Policies - Application of New Accounting Guidance Adopted in 2022” of the Notes to the Consolidated Financial Statements included in Part I. Item 1 of this report.
Servicing Rights. Servicing assets are recognized as separate assets when rights are acquired through the purchase or through the sale of financial assets. Generally, purchased servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage loans, the value of servicing is capitalized during the month of sale. Fair value is based on market prices for comparable mortgage contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds, and default rates and losses.
Servicing assets are evaluated quarterly for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant characteristics, such as interest rate, loan type, and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranches. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as a recovery and an increase to income. Capitalized servicing rights are stated separately on the Consolidated Balance Sheets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets.
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Derivatives and Hedging Activity. ASC 815, “Derivatives and Hedging,” requires that derivatives of the Company be recorded in the consolidated financial statements at fair value. Management considers its accounting policy for derivatives to be a critical accounting policy because these instruments have certain interest rate risk characteristics that change in value based upon changes in the capital markets. Fair values for derivative assets and liabilities are measured on a recurring basis. The Company’s primary use of derivative instruments are related to the mortgage banking activities in the form of commitments to extend credit, commitments to sell loans, TBA mortgage-backed securities trades and option contracts to mitigate the risk of the commitments to extend credit. Estimates of the percentage of commitments to extend credit on loans to be held for sale that may not fund are based upon historical data and current market trends. The fair value adjustments of the derivatives are recorded in the Consolidated Statements of Income with offsets to other assets or other liabilities on the Consolidated Balance Sheets.
Derivative instruments not related to mortgage banking activities primarily relate to interest rate swap agreements accounted for as cash flow hedges. To qualify for hedge accounting, derivatives must be highly effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the derivative contract. If derivative instruments are designated as cash flow hedges, fair value adjustments related to the effective portion are recorded in other comprehensive income and are reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of cash flow hedges are reflected in earnings as they occur. Actual cash receipts and/or payments and related accruals on derivatives related to hedges are recorded as adjustments to the interest income or interest expense associated with the hedged item. During the life of the hedge, the Company formally assesses whether derivatives designated as hedging instruments continue to be highly effective in offsetting changes in the fair value or cash flows of hedged items. If it is determined that a hedge has ceased to be highly effective, the Company will discontinue hedge accounting prospectively. At such time, previous adjustments to the carrying value of the hedged item are reversed into current earnings and the derivative instrument is reclassified to a trading position recorded at fair value. For derivatives not designated as hedges, changes in fair value are recognized in earnings, in noninterest income.
Fair Value. ASC 820, “Fair Value Measurements and Disclosures,” establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions (that is, an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability). For additional details, see “Note 10 - Fair Value Measurements” of the Notes to Consolidated Financial Statements included in Part I. Item 1 of this report.
Income Taxes. Income taxes are reflected in the Company’s consolidated financial statements to show the tax effects of the operations and transactions reported in the consolidated financial statements and consist of taxes currently payable plus deferred taxes. ASC 740, “Accounting for Income Taxes,” requires the asset and liability approach for financial accounting and reporting for deferred income taxes. Deferred tax assets and liabilities result from temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. They are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled and are determined using the assets and liability method of accounting. The deferred income provision represents the difference between net deferred tax asset/liability at the beginning and end of the reported period. In formulating the deferred tax asset, the Company is required to estimate income and taxes in the jurisdiction in which the Company operates. This process involves estimating the actual current tax exposure for the reported period together with assessing temporary differences resulting from differing treatment of items, such as depreciation and the provision for loan losses, for tax and financial reporting purposes.
Deferred tax assets and liabilities occur when taxable income is larger or smaller than reported income on the income statements due to accounting valuation methods that differ from tax, as well as tax rate estimates and payments made quarterly and adjusted to actual at the end of the year. Deferred tax assets and liabilities are temporary differences
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deductible or payable in future periods. The Company had net deferred tax assets of $2.6 million and net deferred tax liabilities of $1.2 million, at March 31, 2022 and December 31, 2021, respectively.
Comparison of Financial Condition at March 31, 2022 and December 31, 2021
Assets. Total assets decreased $12.5 million to $2.27 billion at March 31, 2022, compared to $2.29 billion at December 31, 2021, primarily due to decreases in loans held for sale of $83.7 million, securities available-for-sale of $8.1 million, and certificates of deposit at other financial institutions of $2.4 million, partially offset by increases in loans receivable, net of $69.1 million, other assets of $5.4 million, total cash and cash equivalents of $3.1 million, deferred tax asset, net of $2.6 million, and servicing rights of $1.1 million.
Loans receivable, net increased $69.1 million to $1.80 billion at March 31, 2022, from $1.73 billion at December 31, 2021. Total real estate loans increased $40.3 million, including increases in multi-family loans of $18.8 million, construction and development loans of $18.1 million, commercial real estate loans of $5.1 million, and home equity loans of $3.4 million, partially offset by a decrease in one-to-four-family loans of $5.1 million. Undisbursed construction and development loan commitments increased $35.0 million to $217.3 million at March 31, 2022, as compared to $182.3 million at December 31, 2021. Consumer loans increased $23.0 million, primarily due to an increase of $23.2 million in indirect home improvement loans, partially offset by a decrease of $218,000 in marine loans. Commercial business loans increased $3.6 million, as a result of an increase in warehouse lending of $4.7 million.
Loans held for sale, consisting of one-to-four-family loans, decreased by $83.7 million, or 66.6%, to $42.1 million at March 31, 2022, from $125.8 million at December 31, 2021. The Company continues to invest its home lending operations and strategically add production staff in the markets we serve.
One-to-four-family loan originations for the three months ended March 31, 2022, included $211.5 million of loans originated for sale, $31.6 million of portfolio loans including first and second liens, and $2.0 million of loans brokered to other institutions. The decrease in purchase and refinance activity compared to the prior quarter reflects a limited available inventory of homes for sale and increased market interest rates adversely impacting refinance activity.
Originations of one-to-four-family loans to purchase and to refinance a home for the periods indicated were as follows:
Year
over Year
$ Change
% Change
Purchase
152,950
62.4
185,461
42.7
(32,511)
(17.5)
Refinance
92,164
37.6
248,992
57.3
(156,828)
(63.0)
245,114
434,453
(189,339)
(43.6)
During the three months ended March 31, 2022, the Company sold $301.1 million of one-to-four-family loans compared to sales of $414.0 million for the same period one year ago. Gross margins on home loan sales decreased to 2.94% for the three months ended March 31, 2022, compared to 4.60% for the three months ended March 31, 2021. Gross margins are defined as the margin on loans sold (cash sales) without the impact of deferred costs.
The ACLL was $23.4 million, or 1.28% of gross loans receivable, excluding loans held for sale at March 31, 2022, compared to $25.6 million, or 1.46% of gross loans receivable, excluding loans held for sale at December 31, 2021. The decrease was primarily due to the one-time cumulative-effect adjustment of $2.9 million as of the CECL adoption date. The allowance for credit losses - unfunded loan commitments increased $2.6 million to $3.1 million at March 31, 2022, from $499,000 at December 31, 2021, primarily due to the one-time cumulative-effect adjustment of $2.4 million as of the CECL adoption date and increases in unfunded commitments during the quarter ended March 31, 2022.
Loans classified as substandard decreased $5.0 million to $13.1 million at March 31, 2022, compared to $18.1 million at December 31, 2021. The decrease was primarily due to decreases of $2.3 million in commercial and industrial loans and $1.7 million in one-to-four-family loans, and $916,000 in commercial real estate loans. Nonperforming loans, consisting solely of nonaccruing loans 90-days or more past due, increased $968,000 to $6.8 million at March 31, 2022, from $5.8
million at December 31, 2021. The ratio of nonperforming loans to total gross loans was 0.37% at March 31, 2022, compared to 0.33% at December 31, 2021. There were no OREO properties at March 31, 2022, or December 31, 2021.
Liabilities. Total liabilities remained relatively unchanged at $2.04 billion at March 31, 2022 and December 31, 2021, decreasing $901,000 primarily due to decreases of $7.0 million in borrowings and $1.2 million in deferred tax liability, partially offset by increases of $4.0 million in deposits and $2.6 million in other liabilities.
Total deposits increased $4.0 million to $1.92 billion at March 31, 2022, from December 31, 2021. The increase in deposits was primarily driven by growth in certificates of deposit (“CDs”). Time deposits increased $10.4 million to $371.1 million at March 31, 2022, from $360.7 million at December 31, 2021. Nonretail CDs which include brokered CDs, online CDs, and public funds increased $30.0 million to $144.2 million at March 31, 2022, compared to $114.2 million at December 31, 2021, primarily due to a $30.0 million increase in brokered CDs. Transactional accounts (noninterest-bearing checking, interest-bearing checking, and escrow accounts) decreased $3.7 million to $805.1 million at March 31, 2022, from $808.8 million at December 31, 2021, primarily due to a decrease of $19.3 million in interest-bearing checking which included a $30.0 million decrease in brokered deposits, partially offset by increases of $9.7 million in escrow accounts related to mortgages serviced and $5.9 million in noninterest-bearing checking. Money market and savings accounts decreased $2.7 million to $743.6 million at March 31, 2022, from $746.3 million at December 31, 2021.
Deposits are summarized as follows at the dates indicated:
2022 (1)(2)
2021 (1)(2)
Interest-bearing checking (3)
Money market (4)
Certificates of deposit less than $100,000 (5)
Certificates of deposit of $250,000 and over (6)
Borrowings comprised of FHLB advances decreased $7.0 million to $35.5 million at March 31, 2022, from $42.5 million at December 31, 2021, primarily related to repayments.
Management entered into two liability interest rate swap arrangements designated as cash flow hedges in the first quarter of 2020 and one liability interest rate swap arrangement in the third quarter of 2020 to lock the expense costs associated with $90.0 million in brokered deposits and borrowings. The average cost of these $90.0 million in notional pay fixed interest rate swap agreements was 73 basis points for which the Bank will pay a fixed rate of 73 basis points to the interest rate swap counterparty, compared to the quarterly reset of three-month LIBOR that will adjust quarterly. Management will continue to implement processes to match balance sheet funding duration and minimize interest rate risk and costs.
Stockholders’ Equity. Total stockholders’ equity decreased $11.6 million to $236.0 million at March 31, 2022, from $247.5 million at December 31, 2021. The decrease in stockholders’ equity during the three months ended March 31, 2022, was primarily due to net unrealized losses in securities available-for-sale of $16.5 million, net of tax, reflecting increases in market interest rates during the quarter, share repurchases totaling $3.5 million, and dividends paid of $1.6 million,
51
partially offset by net income of $6.9 million, and unrealized gains on cash flow hedges of $2.3 million, net of tax. In addition, the adoption of CECL on January 1, 2022, resulted in a $297,000 increase to retained earnings reflecting the combined impact of the $2.9 million decrease to our ACLL and a $2.4 million increase to the allowance for credit losses on unfunded commitments as of the adoption date. The Company repurchased 115,356 shares of its common stock during the three months ended March 31, 2022, at an average price of $31.45 per share. Book value per common share was $29.70 at March 31, 2022, compared to $30.75 at December 31, 2021.
We calculated book value based on common shares outstanding of 8,067,211 at March 31, 2022, less 121,672 unvested restricted stock shares for the reported common shares outstanding of 7,945,539. Common shares outstanding was calculated using 8,169,887 shares at December 31, 2021, less 121,672 unvested restricted stock shares for the reported common shares outstanding of 8,048,215.
Comparison of Results of Operations for the Three Months Ended March 31, 2022 and 2021
General. Net income was $6.9 million for the three months ended March 31, 2022, and $11.9 million for the three months ended March 31, 2021. The decrease in net income for the three months ended March 31, 2022 was primarily due to a $7.2 million, or 54.9% decrease in noninterest income and a $2.7 million increase in noninterest expenses, partially offset by a $2.6 million increase in net interest income, and a $1.8 million decrease in the provision for income tax.
52
Average Balances, Interest and Average Yields/Cost
The following table sets forth for the periods indicated, information regarding average balances of assets and liabilities, as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spread, net interest margin (otherwise known as net yield on interest-earning assets), and the ratio of average interest-earning assets to average interest-bearing liabilities. Also presented is the weighted average yield on interest-earning assets, rates paid on interest-bearing liabilities and the resultant spread at for the periods presented. Income and all average balances are monthly average balances. Nonaccruing loans have been included in the table as loans carrying a zero yield. The yields on tax-exempt municipal bonds have not been computed on a tax equivalent basis.
Average Balances
Average Balance Outstanding
Interest Earned/ Paid
Yield/ Rate
Loans receivable, net and loans held for sale (1)
1,834,443
5.10%
1,717,050
5.09%
Taxable mortgage-backed securities
91,678
1.97%
64,549
353
2.22%
Taxable AFS investment securities
60,422
321
2.15%
46,127
2.12%
Tax-exempt AFS investment securities
126,508
587
1.88%
73,043
363
2.02%
Taxable HTM investment securities
5.14%
FHLB stock
4,302
4.24%
7,247
4.70%
48,672
85
0.71%
127,382
0.36%
Total interest-earning assets
2,173,525
4.59%
2,042,898
4.52%
Noninterest-earning assets
96,746
87,700
Total assets
LIABILITIES AND STOCKHOLDERS' EQUITY
738,597
0.21%
604,917
0.31%
351,061
0.19%
230,106
0.09%
354,722
0.85%
491,306
1.21%
31,006
1.74%
130,174
1.39%
49,400
3.99%
28,248
3.68%
Total interest-bearing liabilities
1,524,786
0.51%
1,484,751
0.73%
462,808
387,918
Other noninterest-bearing liabilities
31,355
28,519
Stockholders’ equity
251,322
229,410
Total liabilities and stockholders’ equity
Net interest income
Net interest rate spread
4.08%
3.79%
Net earning assets
648,739
558,147
Net interest margin
Average interest-earning assets to average interest-bearing liabilities
142.55%
137.59%
(1) Includes recognized “net” deferred PPP fees.
Net Interest Income. Net interest income increased $2.6 million to $22.7 million for the three months ended March 31, 2022, from $20.1 million for the three months ended March 31, 2021. This comparable quarter over quarter increase was primarily the result of an improved mix of loans versus other interest-earning assets and increased balances in higher
yielding loans funded by lower cost deposits. Interest income increased $1.8 million, primarily due to an increase of $1.5 million in interest income on loans receivable, including fees, impacted primarily by loan growth and net deferred fees recognized upon Small Business Administration (“SBA”) forgiveness of PPP loans. Interest expense decreased $780,000, primarily as a result of repricing deposit rates and a reduction in higher cost borrowings. For the three months ended March 31, 2022, the total recognition of net deferred fees on forgiven and amortizing PPP loans was $264,000, as compared to $653,000 for the three months ended March 31, 2021.
The net interest margin (“NIM”) increased 25 basis points to 4.24% for the three months ended March 31, 2022, from 3.99% for the same period in the prior year. The comparable quarter over quarter increase in NIM was impacted by an improved mix of interest-bearing assets, including a higher balance of higher yielding portfolio loans and investment securities instead of interest-bearing cash, earning a nominal yield combined with declining deposit and borrowing costs.
Interest Income. Interest income for the three months ended March 31, 2022, increased $1.8 million, to $24.6 million, from $22.8 million for the three months ended March 31, 2021. The increase during the period was primarily attributable to the $130.6 million increase in the average balance of total interest-earning assets.
The following table compares average earning asset balances, associated yields, and resulting changes in interest income for the three months ended March 31, 2022 and 2021:
Increase/
(Decrease)
Yield/
in Interest
(Dollars in thousands)
Outstanding
Rate
Income
Loans receivable, net and loans held for sale
5.10
5.09
1,513
1.97
2.22
93
2.15
2.12
80
1.88
2.02
224
5.14
4.24
4.70
(39)
0.71
0.36
(29)
4.59
4.52
1,842
Interest Expense. Interest expense decreased $780,000, to $1.9 million for the three months ended March 31, 2022, from $2.7 million for the same prior year quarter, primarily due to a decrease of interest expense on deposits of $697,000. The average cost of funds for total interest-bearing liabilities decreased 22 basis points to 0.51% for the three months ended March 31, 2022, from 0.73% for the three months ended March 31, 2021. The decrease was predominantly due to the decrease in cost for market rate deposits and decreased borrowing costs reflecting a decrease in average borrowings from the same quarter in the prior year. The average cost of total interest-bearing deposits decreased 25 basis points to 0.36%, for the three months ended March 31, 2022, compared to 0.61%, for the three months ended March 31, 2021, predominantly due to the decrease in cost for market rate deposits as well as a strategic shift away from higher cost CDs. The average cost of funds, including noninterest-bearing checking, decreased 19 basis points to 0.39% for the three months ended March 31, 2022, from 0.58% for the three months ended March 31, 2021.
54
The following table details average balances for cost of funds on interest-bearing liabilities and the change in interest expense for the three months ended March 31, 2022 and 2021:
(Decrease)/
Increase
Expense
0.21
0.31
(85)
0.19
0.09
111
0.85
1.21
(723)
1.74
(313)
Subordinated note
3.99
3.68
0.51
0.73
(780)
Provision for Credit Losses. For the three months ended March 31, 2022, the provision for credit losses on loans was $852,000, compared to a provision for loan losses of $1.5 million for the three months ended March 31, 2021 as calculated under the prior incurred loss methodology. The provision for credit losses on loans reflects the increase in total loans receivable partially offset by a decrease in classified loans that were downgraded based on the COVID-19 pandemic and improved economic factors on credit-deterioration used to calculate the ACLL primarily related to the COVID-19 pandemic as compared to the same time last year. For the three months ended March 31, 2022, the provision for credit losses on unfunded commitments was $191,000, compared to a recovery of reserves for unfunded commitments of $9,000 for the three months ended March 31, 2021. The increase was attributable to a change in methodology as a result of the adoption of CECL, as well as increases in total unfunded commitments during the quarter. During the three months ended March 31, 2022, net loan charge-offs totaled $263,000, compared to $297,000 during the three months ended March 31, 2021. The decrease in net charge-offs was primarily due to decreased commercial business loan charge-offs. A further decline in national and local economic conditions, as a result of the COVID-19 pandemic or other factors, could result in a material increase in the ACL and may adversely affect the Company’s financial condition and results of operations.
Noninterest Income. Noninterest income decreased $7.2 million, to $5.9 million for the three months ended March 31, 2022, from $13.0 million for the three months ended March 31, 2021. The decrease during the period primarily reflects a $7.8 million, or 67.0% decrease in gain on sale of loans due primarily to a reduction in origination and sales volume of loans held for sale and a reduction in gross margins of sold loans, partially offset by a $419,000 increase in other noninterest income, primarily due to proceeds from a bank owned life insurance policy of $482,000, a $248,000 increase in service charges and fee income as a result of less MSR amortization reflecting increased market interest rates and increased servicing fees from nonportfolio loans. Refinance originations were $92.2 million for the three months ended March 31, 2022 compared to $249.0 million for the same period last year. Gross margins on home loan sales decreased to 2.94% for the three months ended March 31, 2022, from 4.60% for the three months ended March 31, 2021.
Noninterest Expense. Noninterest expense increased $2.7 million to $19.1 million for the three months ended March 31, 2022, from $16.3 million for the three months ended March 31, 2021. The increase in noninterest expense primarily reflects a $2.0 million decrease in the recovery of servicing rights, to $1,000 the first quarter of 2022 from $2.1 million in the first quarter of 2021. Additional increases in noninterest expense include $363,000 in salaries and benefits, and $171,000 in professional and board fees.
The efficiency ratio, which is noninterest expense as a percentage of net interest income and noninterest income, rose to 66.67% for the three months ended March 31, 2022, compared to 49.34% for the three months ended March 31, 2021, primarily representing the decrease in noninterest income, as well as the increase in noninterest expense noted above.
Provision for Income Tax. For the three months ended March 31, 2022, the Company recorded a provision for income tax expense of $1.6 million as compared to $3.4 million for the three months ended March 31, 2021. The decrease in the tax provision is primarily due to a $6.8 million decrease in pre-tax income during the three months ended March 31, 2022, as compared to the same quarter last year. The effective corporate income tax rates for the three months ended March 31, 2022 and 2021 were 19.1% and 22.3%, respectively. The decrease in the effective corporate income tax rate was primarily
due to increases in tax exempt municipal securities income, and a reduction in nondeductible expenses from the prior quarter due to the end of the ESOP plan and reductions in nondeductible compensation cost attributable to Internal Revenue Code Section 162(m) limitations.
Liquidity
Management maintains a liquidity position that it believes will adequately provide funding for loan demand and deposit runoff that may occur in the normal course of business. The Company relies on a number of different sources in order to meet potential liquidity demands. The primary sources are increases in deposit accounts, FHLB advances, purchases of federal funds, sale of securities available-for-sale, cash flows from loan payments, sales of one-to-four-family loans held for sale, and maturing securities. While the maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.
The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund its operations. The Bank generally maintains sufficient cash and short-term investments to meet short-term liquidity needs. At March 31, 2022, the Bank’s total borrowing capacity was $520.2 million with the FHLB of Des Moines, with unused borrowing capacity of $478.8 million. The FHLB borrowing limit is based on certain categories of loans, primarily real estate loans that qualify as collateral for FHLB advances. At March 31, 2022, the Bank held approximately $750.6 million in loans that qualify as collateral for FHLB advances.
In addition to the availability of liquidity from the FHLB of Des Moines, the Bank maintained a short-term borrowing line with the FRB, with a current limit of $189.6 million, and a combined credit limit of $101.0 million in written federal funds lines of credit through correspondent banking relationships at March 31, 2022. The FRB borrowing limit is based on certain categories of loans, primarily consumer loans that qualify as collateral for FRB line of credit. At March 31, 2022, the Bank held approximately $451.8 million in loans that qualify as collateral for the FRB line of credit. Subject to market conditions, we expect to utilize these borrowing facilities from time to time in the future to fund loan originations and deposit withdrawals, to satisfy other financial commitments, repay maturing debt and to take advantage of investment opportunities to the extent feasible.
The Bank’s Asset and Liability Management Policy permits management to utilize brokered deposits up to 20% of deposits or $387.4 million at March 31, 2022. Total brokered deposits at March 31, 2022 were $187.8 million. Management utilizes brokered deposits to mitigate interest rate risk and liquidity risk exposure when appropriate.
Liquidity management is both a daily and long-term function of the Company’s management. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer-term basis, a strategy is maintained of investing in various lending products and investment securities, including U.S. Government obligations and U.S. agency securities. The Company uses sources of funds primarily to meet ongoing commitments, pay maturing deposits, fund withdrawals, and to fund loan commitments. At March 31, 2022, the approved outstanding loan commitments, including unused lines of credit amounted to $616.2 million. Securities purchased during the three months ended March 31, 2022 and 2021 totaled $16.8 million and $32.7 million, respectively, and securities repayments, maturities and sales in those quarters were $3.3 million and $6.9 million, respectively.
The Bank’s liquidity is also affected by the volume of loans sold and loan principal payments. During the three months ended March 31, 2022 and 2021, the Bank sold $301.1 million and $414.1 million in loans and loan participation interests, respectively.
The Bank’s liquidity has been positively impacted by increases in deposit levels. Total deposits increased $4.0 million during the three months ended March 31, 2022 primarily driven by growth in CDs. CDs scheduled to mature in three months or less at March 31, 2022, totaled $92.0 million. It is management’s policy to offer deposit rates that are competitive with other local financial institutions. Based on this management strategy, the Company believes that a majority of maturing relationship deposits will remain with the Bank.
As a separate legal entity from the Bank, FS Bancorp, Inc. must provide for its own liquidity. Sources of capital and liquidity for FS Bancorp, Inc. include distributions from the Bank and the issuance of debt or equity securities. Dividends and other capital distributions from the Bank are subject to regulatory notice. The Company currently expects to continue
the current practice of paying quarterly cash dividends on common stock subject to the Board of Directors' discretion to modify or terminate this practice at any time and for any reason without prior notice. Our current quarterly common stock dividend rate is $0.20 per share, as approved by our Board of Directors, which we believe is a dividend rate per share which enables us to balance our multiple objectives of managing and investing in the Bank, and returning a substantial portion of our cash to our shareholders. Assuming continued payment during 2022 at this rate of $0.20 per share, our average total dividend paid each quarter would be approximately $1.1 million based on the number of our current outstanding shares (which assumes no increases or decreases in the number of shares, except in connection with the anticipated vesting of currently outstanding equity awards). At March 31, 2022, FS Bancorp, Inc. had $17.0 million in unrestricted cash to meet liquidity needs.
Capital Resources
The Bank is subject to minimum capital requirements imposed by the FDIC. Based on its capital levels at June 30, 2021, the Bank exceeded these requirements as of that date. Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a well capitalized status under the capital categories of the FDIC. Based on capital levels at March 31, 2022, the Bank was considered to be well capitalized. Effective January 1, 2022, a bank that elects to use the Community Bank Leverage Ratio (“CBLR”) will generally be considered well-capitalized and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%. At March 31, 2022, the Bank qualified and elected to use the CBLR to measure capital adequacy. The Tier 1 leverage-based capital ratio calculated for the Bank at March 31, 2022 was 12.2%.
As a bank holding company registered with the Federal Reserve, the Company is subject to the capital adequacy requirements of the Federal Reserve. Bank holding companies with less than $3.0 billion in assets are generally not subject to compliance with the Federal Reserve’s capital regulations, which are generally the same as the capital regulations applicable to the Bank. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to the holding company’s subsidiary bank and the Federal Reserve expects the holding company’s subsidiary bank to be well capitalized under the prompt corrective action regulations. If FS Bancorp, Inc. were subject to regulatory capital guidelines for bank holding companies with $3.0 billion or more in assets at March 31, 2022, FS Bancorp, Inc. would have exceeded all regulatory capital requirements. For informational purposes, the Tier 1 leverage-based capital ratio calculated for FS Bancorp, Inc. at March 31, 2022 was 10.8%. For additional information regarding regulatory capital compliance, see the discussion included in “Note 14 - Regulatory Capital” to the Notes to Consolidated Financial Statements included in Part I. Item 1 of this report.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
There have been no material changes in the market risk disclosures contained in FS Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2021.
Item 4. Controls and Procedures
(a)Evaluation of Disclosure Controls and Procedures
An evaluation of the disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) was carried out as of March 31, 2022 under the supervision and with the participation of the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) and several other members of the Company’s senior management. In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
The Company’s CEO and CFO concluded that based on their evaluation at March 31, 2022, the Company’s disclosure controls and procedures were effective in ensuring that information we are required to disclose in the reports we file or
submit under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to FS Bancorp management, including its CEO and CFO, as appropriate to allow timely decisions regarding required disclosure, specified in the SEC’s rules and forms.
(b)Changes in Internal Controls
There were no significant changes in the Company’s internal control over financial reporting that occurred during the three months ended March 31, 2022, that have materially affected or are reasonably likely to materially affect our internal control over financial reporting. The Company does not expect that its disclosure controls and procedures and internal control over financial reporting will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls may be circumvented by the individual acts of some persons, by collusion of two or more people, or by override of the control. The design of any control procedure is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In the normal course of business, the Company occasionally becomes involved in various legal proceedings. In the opinion of management, any liability from such proceedings would not have a material adverse effect on the business or financial condition of the Company.
Item 1A. Risk Factors
There have been no material changes in the Risk Factors previously disclosed in FS Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2021.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Maximum
Total Number
Dollar Value of
of Shares
Shares that
Repurchased as
May Yet Be
Price
Part of Publicly
Repurchased
Paid per
Announced
Under the
Period
Purchased
Share
Plan
January 1, 2022 - January 31, 2022
1,019
32.91
7,338,206
February 1, 2022 - February 28, 2022 (1)
15,477
32.84
6,830,005
March 1, 2021 - March 31, 2022
98,860
31.22
3,743,607
Total for the quarter
115,356
31.45
On April 6, 2022, the Company announced that its Board of Directors approved an additional share repurchase program of up to $10.0 million of the Company’s common shares authorized and outstanding in addition to the $3.8 million remaining common shares authorized and available for repurchase under the previous share repurchase plan. These repurchase programs permit shares to be repurchased in open market or private transactions, through block trades, from time to time. Repurchases may be made under the previous share repurchase plan through June 30, 2022 and under the newly announced share repurchase plan through June 30, 2023, depending on market conditions and other factors, and pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 of the Securities and Exchange Commission.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Mine Safety Disclosures
Item 5. Other Information
Item 6. Exhibits
3.1
Articles of Incorporation of FS Bancorp, Inc. (1)
Bylaws of FS Bancorp, Inc. (2)
4.1
Form of Common Stock Certificate of FS Bancorp, Inc. (1)
4.2
Indenture dated February 10, 2021, by and between FS Bancorp, Inc. and U.S. Bank National Association, as trustee (3)
4.3
Forms of 3.75 Fixed-to-Floating Rate Subordinated Notes due 2031 (included as Exhibit A-1 and Exhibit A-2 to the Indenture filed as Exhibit 4.2 hereto (3)
Severance Agreement between 1st Security Bank of Washington and Joseph C. Adams (1)
10.2
Form of Change of Control Agreement between 1st Security Bank of Washington and Matthew D. Mullet (1)
10.3
FS Bancorp, Inc. 2013 Equity Incentive Plan (the “2013 Plan”) (4)
10.4
Form of Incentive Stock Option Agreement under the 2013 Plan (4)
Form of Non-Qualified Stock Option Agreement under the 2013 Plan (4)
10.6
Form of Restricted Stock Agreement under the 2013 Plan (4)
10.9
Form of change of control agreement with Donn C. Costa, Dennis O’Leary, Rob Fuller, Erin Burr, Victoria Jarman, Kelli Nielsen, Lisa Cleary, and May-Ling Sowell (5)
10.10
FS Bancorp, Inc. 2018 Equity Incentive Plan (6)
10.11
Form of Incentive Stock Option Award Agreement under the 2018 Equity Incentive Plan (6)
10.12
Form of Non-Qualified Stock Option Award Agreement under the 2018 Equity Incentive Plan (6)
10.13
Form of Restricted Stock Award Agreement under the 2018 Equity Incentive Plan (6)
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2022 formatted in Inline Extensible Business Reporting Language (IXBRL): (1) Consolidated Balance Sheets; (2) Consolidated Statements of Income; (3) Consolidated Statements of Comprehensive Income; (4) Consolidated Statements of Changes in Stockholders’ Equity; (5) Consolidated Statements of Cash Flows; and (6) Notes to Consolidated Financial Statements.
104
Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101)
Filed as an exhibit to the Registrant’s Registration Statement on Form S-1 (333-177125) filed on October 3, 2011, and incorporated by reference.
(2)
Filed as an exhibit to the Registrant’s Current Report on Form 8-K filed on July 10, 2013 (File No. 001-355589).
Filed as an exhibit to the Registrant’s Current Report on Form 8-K filed on February 11, 2021 (File No. 001-35589).
(4)
Filed as an exhibit to the Registrant’s Registration Statement on Form S-8 (333-192990) filed on December 20, 2013 and incorporated by reference.
(5)
Filed as an exhibit to the Registrant’s Current Report on Form 8-K filed on February 1, 2016 (File No. 001-35589).
Filed as an exhibit to the Registrant’s Registration Statement on Form S-8 (333-22513) filed on May 23, 2018.
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.
Date: May 10, 2022
By:
/s/Joseph C. Adams
Joseph C. Adams,
Chief Executive Officer
(Principal Executive Officer)
/s/Matthew D. Mullet
Matthew D. Mullet
Secretary, Treasurer and
Chief Financial Officer
(Principal Financial and Accounting Officer)