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 September 30, 2020
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: 0-23636
HAWTHORN BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
Missouri
43-1626350
(State or other jurisdiction of
(I.R.S. Employer Identification No.)
incorporation or organization)
132 East High Street, Box 688, Jefferson City, Missouri 65102
(Address of principal executive offices) (Zip Code)
(573) 761-6100
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report.)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common Stock, $1.00 par value
HWBK
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
As of November 5, 2020, the registrant had 6,480,108 shares of common stock, par value $1.00 per share, outstanding.
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
September 30,
December 31,
(In thousands, except per share data)
2020
2019
(Unaudited)
ASSETS
Cash and due from banks
$
17,340
22,576
Federal funds sold and other interest-bearing deposits
112,050
55,545
Cash and cash equivalents
129,390
78,121
Certificates of deposit in other banks
9,874
10,862
Available-for-sale debt securities, at fair value
186,723
175,093
Other investments
6,452
5,808
Total investment securities
193,175
180,901
Loans held for investment
1,279,165
1,168,797
Allowances for loan losses
(17,764)
(12,477)
Net loans
1,261,401
1,156,320
Loans held for sale, at lower of cost or fair value
7,886
428
Premises and equipment - net
34,769
35,388
Mortgage servicing rights, at fair value
2,327
2,482
Other real estate owned - net
12,601
12,781
Accrued interest receivable
8,241
6,481
Cash surrender value - life insurance
2,438
2,398
Other assets
7,668
6,800
Total assets
1,669,770
1,492,962
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest bearing demand
372,355
261,166
Savings, interest checking and money market
665,351
614,331
Time deposits $250,000 and over
100,018
104,262
Other time deposits
189,028
206,762
Total deposits
1,326,752
1,186,521
Federal funds purchased and securities sold under agreements to repurchase
35,405
27,272
Federal Home Loan Bank advances and other borrowings
112,743
96,919
Subordinated notes
49,486
Operating lease liabilities
2,036
2,224
Accrued interest payable
886
1,136
Other liabilities
18,095
14,366
Total liabilities
1,545,403
1,377,924
Stockholders’ equity:
Common stock, $1 par value, authorized 15,000,000 shares; issued 6,769,322 and 6,519,874 shares, respectively
6,769
6,520
Surplus
59,307
55,727
Retained earnings
64,594
61,590
Accumulated other comprehensive loss, net of tax
(353)
(3,755)
Treasury stock; 289,214, and 243,638 shares, at cost, respectively
(5,950)
(5,044)
Total stockholders’ equity
124,367
115,038
Total liabilities and stockholders’ equity
See accompanying notes to the consolidated financial statements (unaudited).
2
Consolidated Statements of Income (unaudited)
Three Months Ended
Nine Months Ended
(In thousands, except per share amounts)
INTEREST INCOME
Interest and fees on loans
14,777
14,806
43,735
43,662
Interest and fees on loans held for sale
41
—
96
Interest on investment securities:
Taxable
781
831
2,367
2,857
Nontaxable
173
119
489
408
Federal funds sold, other interest-bearing deposits, and certificates of deposit in other banks
111
103
553
897
Dividends on other investments
75
66
247
199
Total interest income
15,958
15,925
47,487
48,023
INTEREST EXPENSE
Interest on deposits:
310
1,047
1,546
4,217
Time deposit accounts $250,000 and over
327
475
1,089
1,761
Time deposits
623
801
2,067
2,268
Total interest expense on deposits
1,260
2,323
4,702
8,246
Interest on federal funds purchased and securities sold under agreements to repurchase
25
34
121
110
Interest on Federal Home Loan Bank advances
505
619
1,749
1,699
Interest on subordinated notes
326
588
1,208
1,821
Total interest expense on borrowings
856
1,241
3,078
3,630
Total interest expense
2,116
3,564
7,780
11,876
Net interest income
13,842
12,361
39,707
36,147
Provision for loan losses
1,200
450
5,400
850
Net interest income after provision for loan losses
12,642
11,911
34,307
35,297
NON-INTEREST INCOME
Service charges and other fees
816
953
2,181
2,701
Bank card income and fees
846
794
2,351
2,282
Trust department income
263
371
920
960
Real estate servicing fees, net
54
36
(48)
38
Gain on sale of mortgage loans, net
3,026
215
4,369
499
Other
70
55
183
157
Total non-interest income
5,075
2,424
9,956
6,637
Investment securities gains (losses), net
12
(40)
18
Gain on branch sale, net
109
2,183
NON-INTEREST EXPENSE
Salaries and employee benefits
6,771
5,366
19,404
16,220
Occupancy expense, net
909
2,303
2,348
Furniture and equipment expense
725
671
2,172
2,166
Processing, network, and bank card expense
877
893
2,806
2,867
Legal, examination, and professional fees
381
316
1,155
948
Advertising and promotion
343
786
884
Postage, printing, and supplies
227
181
661
650
FDIC insurance assessment
336
133
564
462
1,202
778
3,260
2,604
Total non-interest expense
11,616
9,590
33,111
29,149
Income before income taxes
6,113
4,814
11,170
14,928
Income tax expense
1,153
954
2,060
2,882
Net income
4,960
3,860
9,110
12,046
Basic earnings per share
0.77
0.59
1.40
1.85
Diluted earnings per share
3
Consolidated Statements of Comprehensive Income (unaudited)
(In thousands)
Other comprehensive income, net of tax
Investment securities available-for-sale:
Unrealized gains on investment securities available-for-sale, net of tax
218
280
3,290
3,357
Adjustment for (gains) losses on sale of investment securities, net of tax
(10)
32
(15)
Defined benefit pension plans:
Amortization of prior service cost included in net periodic pension cost, net of tax
43
15
127
46
Total other comprehensive income
251
3,402
3,435
Total comprehensive income
5,211
4,187
12,512
15,481
4
Consolidated Statements of Stockholders’ Equity (unaudited)
For the Three Months Ended September 30, 2020 and 2019
Accumulated
Total
Stock -
Common
Retained
Comprehensive
Treasury
holders'
Stock
Earnings
Loss
Equity
Balance, June 30, 2020
59,556
60,412
(604)
(5,853)
120,031
Other comprehensive income
Purchase of treasury stock
(97)
Stock dividend
249
(249)
Cash dividends declared, common stock ($0.12 per share)
(778)
Balance, September 30, 2020
Balance, June 30, 2019
6,279
55,968
55,168
(2,991)
109,380
241
(241)
(753)
Balance, September 30, 2019
58,275
(2,664)
112,814
For the Nine Months Ended September 30, 2020 and 2019
Balance, December 31, 2019
(906)
3,580
(3,829)
Cash dividends declared, common stock ($0.36 per share)
(2,277)
Balance, December 31, 2018
50,173
54,105
(6,099)
99,414
5,554
(5,795)
Cash dividends declared, common stock ($0.34 per share)
(2,081)
5
Consolidated Statements of Cash Flows (unaudited)
Nine Months Ended September 30,
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation expense
1,687
1,505
Net amortization of investment securities, premiums, and discounts
1,023
Change in fair value of mortgage servicing rights
686
543
Investment securities (gains) losses, net
(18)
40
(Gains) losses on sales and dispositions of premises and equipment
(87)
53
Gain on sales and dispositions of other real estate
(219)
(102)
(2,183)
Provision for other real estate owned
(3)
49
Increase in accrued interest receivable
(1,760)
(53)
Increase in cash surrender value - life insurance
(65)
Decrease in other assets
878
(188)
(140)
Decrease in accrued interest payable
(250)
Increase (decrease) in other liabilities
1,986
(1,466)
Origination of mortgage loans held for sale
(136,249)
(29,443)
Proceeds from the sale of mortgage loans held for sale
133,160
28,275
(4,369)
(499)
Other, net
(531)
(187)
Net cash provided by operating activities
9,879
11,109
Cash flows from investing activities:
Purchase of certificates of deposit in other banks
(735)
(988)
Proceeds from maturities of certificates of deposit in other banks
1,723
1,634
Net increase in loans
(110,554)
(3,959)
Purchase of available-for-sale debt securities
(72,050)
(20,423)
Proceeds from maturities of available-for-sale debt securities
40,096
29,460
Proceeds from calls of available-for-sale debt securities
18,685
9,620
Proceeds from sales of available-for-sale debt securities
4,715
21,503
Purchases of FHLB stock
(1,891)
(6,522)
Proceeds from sales of FHLB stock
1,246
5,988
Purchases of premises and equipment
(1,246)
(1,903)
Proceeds from sales of premises and equipment
162
6
Proceeds from Bank owned life insurance policy
222
Payment for branch sale, net
(6,700)
Proceeds from sales of other real estate and repossessed assets
209
1,277
Net cash (used in) provided by investing activities
(119,640)
29,215
Cash flows from financing activities:
Net increase in demand deposits
111,188
27,285
Net increase (decrease) in interest-bearing transaction accounts
51,020
(60,433)
Net decrease in time deposits
(21,977)
(17,284)
Net increase in federal funds purchased and securities sold under agreements to repurchase
8,133
2,544
Repayment of FHLB advances and other borrowings
(53,176)
(166,647)
FHLB advances
69,000
178,474
Cash dividends paid - common stock
(2,252)
(1,931)
Net cash provided by (used in) financing activities
161,030
(37,992)
Net increase in cash and cash equivalents
51,269
2,332
Cash and cash equivalents, beginning of year
42,083
Cash and cash equivalents, end of year
44,415
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest
8,029
11,891
Income taxes
797
2,280
Noncash investing and financing activities:
Other real estate and repossessed assets acquired in settlement of loans
73
411
Net deposits and fixed assets transferred to other assets related to the Branson branch sale
(8,885)
Right of use assets obtained in exchange for new operating lease liabilities
Stock dividends
3,829
5,795
AND SUBSIDIARIES
Notes to the Consolidated Financial Statements
(1) Summary of Significant Accounting Policies
Hawthorn Bancshares, Inc. (the Company) through its subsidiary, Hawthorn Bank (the Bank), provides a broad range of banking services to individual and corporate customers located within the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, St. Louis, and the greater Kansas City metropolitan area. The Company is subject to competition from other financial and nonfinancial institutions providing financial products. Additionally, the Company and its subsidiaries are subject to the regulations of certain regulatory agencies and undergo periodic examinations by those regulatory agencies.
The accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and disclosures required by U.S. GAAP for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.
The preparation of the consolidated financial statements includes all adjustments that, in the opinion of management, are necessary in order to make those statements not misleading. Management is required to make estimates and assumptions, including the determination of the allowance for loan losses, real estate acquired in connection with foreclosure or in satisfaction of loans, and fair values of investment securities available-for-sale that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions are subject to many risks and uncertainties, including changes in interest rates and other general economic, business and political conditions, including the effects of the Coronavirus Disease 2019 (“COVID-19”) pandemic, including its potential effects on the economic environment, our customers and our operations, as well as any changes to federal, state and local government laws, regulations and orders in connection with the pandemic. Actual results could differ from those estimates. The Company’s management has evaluated and did not identify any subsequent events or transactions requiring recognition or disclosure in the consolidated financial statements.
Stock Dividend On July 1, 2020, the Company paid a special stock dividend of four percent to shareholders of record at the close of business on June 15, 2020. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.
CARES Act On March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act ("CARES Act") was signed into law, which, in part, established a loan program administered through the U.S. Small Business Administration ("SBA"), referred to as the Paycheck Protection Program ("PPP"). Under the PPP, small businesses, sole proprietorships, independent contractors, non-profit organizations and self-employed individuals could apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. The Company is participating as a lender in the PPP program. All loans have a 1% interest rate and the Company earns a fee that is based upon a tiered schedule corresponding with the amount of the loan to the borrower, which is deferred and recognized over the life of the loan. Based upon the borrower meeting certain criteria as defined by the CARES Act, the loan may be forgiven by the SBA. The Company reports these loans at their principal amount outstanding, net of unearned income, unamortized deferred loan fee income and loan origination costs. Interest is accrued as earned and loan origination fees and direct costs are deferred and accreted or amortized into interest income, as an adjustment to the yield, over the life of the loan using the level yield method. When a PPP loan is paid off or forgiven by the SBA, the remaining unaccreted or unamortized net origination fees or costs are immediately recognized into income.
7
The following represents significant new accounting principles adopted in 2020:
Intangibles In August 2018, the FASB issued ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Topic 350-40) Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. This ASU aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). ASU 2018-15 is effective for annual reporting periods beginning after December 15, 2019. The ASU did not have a material impact on the Company's Consolidated Financial Statements.
Fair Value Measurement In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820) - Changes to the Disclosure Requirements for Fair Value Measurement. ASU 2018-13 removes the requirement to disclose the amount of and reasons for transfers between Level 1 and Level 2 fair value measurement methodologies, the policy for timing of transfers between levels and the valuation processes for Level 3 fair value measurements. It also adds a requirement to disclose changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period and the range and weighted average of significant unobservable inputs used to develop Level 3 measurements. For certain unobservable inputs, entities may disclose other quantitative information in lieu of the weighted average if the other quantitative information would be a more reasonable and rational method to reflect the distribution of unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The ASU did not have a material impact on the Company's Consolidated Financial Statements.
(2) Loans and Allowance for Loan Losses
Loans
A summary of loans, by major class within the Company’s loan portfolio, at September 30, 2020 and December 31, 2019 is as follows:
(in thousands)
Commercial, financial, and agricultural (a)
293,801
199,022
Real estate construction - residential
27,722
23,035
Real estate construction - commercial
86,896
84,998
Real estate mortgage - residential
258,030
252,643
Real estate mortgage - commercial
584,559
576,635
Installment and other consumer
28,157
32,464
Total loans held for investment
The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the Missouri communities surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, St. Louis, and the greater Kansas City metropolitan area. As such, the Bank is susceptible to changes in the economic environment in these communities. The Bank does not have a concentration of credit in any one economic sector. Installment and other consumer loans consist primarily of the financing of automotive vehicles. At September 30, 2020, loans of $578.5 million were pledged to the Federal Home Loan Bank as collateral for borrowings and letters of credit.
8
Allowance for Loan Losses
The following table illustrates the changes in the allowance for loan losses by portfolio segment:
Three Months Ended September 30, 2020
Commercial,
Real Estate
Installment
Financial, &
Construction -
Mortgage -
and Other
Un-
Agricultural
Residential
Commercial
Consumer
allocated
Balance at beginning of period
3,614
171
722
2,711
9,048
306
50
16,622
Additions:
178
100
577
58
20
Deductions:
Loans charged off
13
42
101
Less recoveries on loans
(11)
(13)
(4)
(43)
Net loan charge-offs (recoveries)
35
27
Balance at end of period
3,757
233
822
3,292
9,253
337
17,764
Nine Months Ended September 30, 2020
2,918
64
369
2,118
6,547
80
12,477
867
125
453
1,186
2,740
39
130
52
37
352
(44)
(50)
(239)
28
83
113
Three Months Ended September 30, 2019
2,783
69
704
1,772
6,109
307
139
11,883
155
97
252
62
(104)
61
86
60
213
(12)
(8)
(7)
(19)
(58)
78
(1)
2,889
84
1,946
6,095
328
12,178
Nine Months Ended September 30, 2019
3,237
140
757
2,071
4,914
334
11,652
(232)
(81)
44
30
1,193
(164)
255
266
21
151
693
(139)
(25)
(111)
(9)
(85)
(369)
116
324
Loans, or portions of loans, are charged off to the extent deemed uncollectible or a loss is confirmed. Loan charge-offs reduce the allowance for loan losses, and recoveries of loans previously charged off are added back to the allowance. If
9
management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration.
In the first quarter of 2019, management adjusted the look-back period to begin with loss history in the first quarter 2012 as the starting point through the current quarter and it will continue to include this starting point going forward. At that time, Management determined that with the extended economic recovery then existing, the look-back period should be expanded to include the current economic cycle. The look-back period will be adjusted once a sustained loss producing downturn is recognized by allowing the look-back period to shift forward by eliminating the earliest loss period and replenishing it with losses from the most recent period. The look-back period is consistently evaluated for relevance given the current facts and circumstances.
As a result of rapidly increasing unemployment rates resulting from the COVID-19 virus, management determined that the first quarter 2020 allowance for loan loss economic qualitative adjustment should be temporarily adapted to utilize currently published statistics rather than the lagging statistics that had been utilized historically. While these lagging indicators have been very reliable for some time, they did not accurately capture the risk that has been brought about by rapid changes in the economy due to the pandemic. Based upon the change in the national unemployment rate available as of June 30, 2020, the economic qualitative adjustment was increased according to the Company’s methodology to account for uncertainty in economic conditions compared to the lookback period. As of September 30, 2020, and based on the continuing high rates of national unemployment as compared to historic levels, management believes this temporary alteration will be a better indicator until the economy stabilizes and the true impact can be measured.
Additionally, the funding of $88.4 million in PPP loans during the second and third quarter required management to assess the methodology that would be adopted in regard to the allowance for loan loss applicable to these loans. As the SBA PPP loans are expected to be mostly paid off in the next six to twelve months and carry a 100% credit guarantee from the SBA, management determined that no allowance for loan loss was deemed necessary for these loans.
10
The following table illustrates the allowance for loan losses and recorded investment by portfolio segment:
Financial, and
September 30, 2020
Allowance for loan losses:
Individually evaluated for impairment
142
85
276
63
581
Collectively evaluated for impairment
3,615
737
3,016
9,190
322
17,183
Loans outstanding:
1,376
552
3,777
2,277
8,095
292,425
86,344
254,253
582,282
28,044
1,271,070
December 31, 2019
311
264
23
17
615
2,607
1,854
6,524
364
11,862
1,514
137
3,856
1,711
177
7,395
197,508
84,861
248,787
574,924
32,287
1,161,402
Impaired Loans
Loans evaluated under ASC 310-10-35 include loans which are individually evaluated for impairment. All other loans are collectively evaluated for impairment under ASC 450-20. Impaired loans individually evaluated for impairment totaled $8.1 million and $7.4 million at September 30, 2020 and December 31, 2019, respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructurings (TDRs).
The net carrying value of impaired loans is based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. At September 30, 2020, $2.9 million of impaired loans were evaluated based on the fair value less estimated selling costs of the loans' collateral compared to $3.0 million at December 31, 2019. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2020, $581,000 of the Company’s allowance for loan losses was allocated to impaired loans totaling $8.1 million compared to $615,000 of the Company’s allowance for loan losses allocated to impaired loans totaling approximately $7.4 million at December 31, 2019. Management determined that $2.7 million, or 33%, of total impaired loans required no reserve allocation at September 30, 2020 compared to $2.6 million, or 35%, at December 31, 2019, primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.
11
The categories of impaired loans at September 30, 2020 and December 31, 2019 are as follows:
Non-accrual loans
5,632
4,754
Non-performing TDRs - 90 days past due
106
Performing TDRs
2,463
2,535
Total impaired loans
The following tables provide additional information about impaired loans at September 30, 2020 and December 31, 2019, respectively, segregated between loans for which an allowance has been provided and loans for which no allowance has been provided.
Unpaid
Recorded
Principal
Specific
Investment
Balance
Reserves
With no related allowance recorded:
Commercial, financial and agricultural
170
Real estate - residential
1,354
1,442
Real estate - commercial
1,148
1,213
2,672
2,877
With an allowance recorded:
1,206
1,545
Real estate - construction commercial
598
2,423
2,875
1,129
1,261
5,423
6,400
9,277
342
487
697
784
1,388
1,433
2,576
1,172
1,470
3,159
3,482
323
425
165
189
4,819
5,566
8,455
The following table presents by class, information related to the average recorded investment and interest income recognized on impaired loans during the periods indicated.
Three Months Ended September 30,
Average
Recognized
For the
Period Ended
172
128
851
1,289
1,036
146
234
149
1,414
1,301
1,542
651
861
380
907
393
2,447
145
2,682
3,980
158
2,232
1,359
1,086
1,226
1,095
609
2,412
2,818
2,772
3,881
68
1,133
1,112
911
14
788
188
1
221
5,626
24
5,204
5,316
5,985
8,073
169
9,296
242
8,217
The recorded investment varies from the unpaid principal balance primarily due to partial charge-offs taken resulting from current appraisals received. The amount recognized as interest income on impaired loans continuing to accrue interest, primarily related to troubled debt restructurings, was $169,000 and $242,000 for the three and nine months ended
September 30, 2020, respectively, compared to $40,000 and $125,000 for the three and nine months ended September 30, 2019, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported.
Delinquent and Non-Accrual Loans
The delinquency status of loans is determined based on the contractual terms of the notes. Borrowers are generally classified as delinquent once payments become 30 days or more past due. The Company’s policy is to discontinue the accrual of interest income on any loan when, in the opinion of management, the ultimate collectability of interest or principal is no longer probable. In general, loans are placed on non-accrual when they become 90 days or more past due. However, management considers many factors before placing a loan on non-accrual, including the delinquency status of the loan, the overall financial condition of the borrower, the progress of management’s collection efforts and the value of the underlying collateral. Subsequent interest payments received on non-accrual loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis. Non-accrual loans are returned to accrual status when, in the opinion of management, the financial condition of the borrower indicates that the timely collectability of interest and principal is probable and the borrower demonstrates the ability to pay under the terms of the note through a sustained period of repayment performance, which is generally six months.
The following table provides aging information for the Company’s past due and non-accrual loans at September 30, 2020 and December 31, 2019.
Current or
90 Days
Less Than
Past Due
30 Days
30 - 89 Days
And Still
Accruing
Non-Accrual
Commercial, Financial, and Agricultural
292,823
Real Estate Construction - Residential
27,527
195
Real Estate Construction - Commercial
86,279
65
Real Estate Mortgage - Residential
254,632
987
175
2,236
Real Estate Mortgage - Commercial
581,990
636
1,933
Installment and Other Consumer
28,045
71
33
1,271,296
2,054
197,828
212
982
22,468
567
249,516
688
304
2,135
575,140
136
32,179
132
141
1,161,992
1,735
The Company's past due and non-accrual loans at September 30, 2020 do not include $91.1 million of loans accepting forbearance. Their delinquency status will not change through the forbearance period as they are fulfilling the agreement they have made with the bank.
Credit Quality
The Company categorizes loans into risk categories based upon an internal rating system reflecting management’s risk assessment. Loans are placed on watch status when one or more weaknesses are identified that may result in the borrower being unable to meet repayment terms or the Company’s credit position could deteriorate at some future date. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified may have a well-defined weakness or weaknesses that jeopardize the repayment of the debt. Such loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not corrected. A loan is classified as a troubled debt restructuring (TDR) when a borrower is experiencing financial difficulties that lead to the restructuring of a loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. Loans classified as TDRs that are accruing interest are classified as performing TDRs. Loans classified as TDRs, that are not accruing interest are classified as nonperforming TDRs and are included with all other nonaccrual loans for presentation purposes. It is the Company’s policy to discontinue the accrual of interest income on loans when management believes that the collection of interest or principal is doubtful.
The following table presents the risk categories by class at September 30, 2020 and December 31, 2019.
and other
At September 30, 2020
Watch
16,308
551
17,213
14,415
73,873
122,360
Substandard
608
1,073
584
2,265
498
1,541
344
18,292
17,765
19,265
76,734
132,720
At December 31, 2019
16,288
763
8,484
15,280
37,271
78,086
3,249
273
2,291
677
6,490
532
1,615
21,051
8,894
21,427
39,659
91,971
Troubled Debt Restructurings
At September 30, 2020, loans classified as TDRs totaled $3.6 million, of which $1.1 million were classified as non-performing TDRs and $2.5 million were classified as performing TDRs. At December 31, 2019, loans classified as TDRs totaled $4.1 million, of which $1.6 million were classified as non-performing TDRs and $2.5 million were classified as performing TDRs. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $211,000 and $442,000 related to TDRs were allocated to the allowance for loan losses at September 30, 2020 and December 31, 2019, respectively.
The CARES Act provides all banks with the option to elect either or both of the following from March 1, 2020 until the earlier of December 31, 2020 or the date that is 60 days after the termination of the national emergency:
(i) to suspend the requirements under GAAP for loan modifications related to the COVID–19 pandemic that would otherwise be categorized as a TDR; and/or
(ii) to suspend any determination of a loan modified as a result of the effects of the COVID–19 pandemic as being a TDR, including impairment for accounting purposes.
If a bank elects a suspension noted above, the suspension (i) will be effective for the term of the loan modification, but solely with respect to any modification, including a forbearance arrangement, an interest rate modification, a repayment plan, and any other similar arrangement that defers or delays the payment of principal or interest, that occurs during the applicable period for a loan that was not more than 30 days past due as of December 31, 2019; and (ii) will not apply to any adverse impact on the credit of a borrower that is not related to the COVID–19 pandemic.
As provided for by the CARES Act, the Company offered payment modifications to borrowers. Disaster relief payment modifications granted to-date include approximately 578 loans totaling $303.2 million, or 23.7% of the total loan portfolio. At September 30, 2020, 42 loans totaling $91.1 million, or 7.1% of total loans, remained in some form of a modification. These loan modifications include $44.6 million, or 48.9%, on interest only, and $46.5 million, or 51.1%, on full deferral. (See table below titled – Loan Modifications under the CARES Act by NAICS Code.)
As of September 30, 2020
Loan Modifications under the CARES Act by NAICS Code
%
Full
Industry Category
Only
Deferral
Totals
Real Estate and Rental and Leasing
13,003
14.3
3,343
3.7
16,346
Accommodations and Food Services
19,859
21.8
37,918
41.7
57,777
Construction
0.6
-
Cinemas
4,691
5.2
Retail Trade
0.1
Arts, Entertainment, Recreation
10,166
11.2
Non-NAICS (Consumer)
77
427
0.5
504
943
1.0
Total modifications
44,553
48.9
46,498
51.1
91,051
Remaining loan modifications under the CARES Act as a percent of the total loan portfolio
7.1
Total loan modifications under the CARES Act to date
303,214
Total loan modifications under the CARES Act to date as a percent of the total loan portfolio
23.7
16
The following table summarizes loans that were modified as TDRs during the periods indicated.
Recorded Investment (1)
Number of
Pre-
Post-
Contracts
Modification
117
124
The Company’s portfolio of loans classified as TDRs include concessions for the borrower given their financial condition such as interest rates below the current market rate, deferring principal payments, and extending maturity dates. There were no loans meeting the TDR criteria that were modified during the three months ended September 30, 2020 and 2019. The Company considers a TDR to be in default when it is 90 days or more past due under the modified terms, a charge-off occurs, or in the process of foreclosure. There were no loans and one loan modified as a TDR that defaulted during any of the three and nine months ended September 30, 2020, compared no loans and one loan during the three and nine months September 30, 2019, respectively, and within twelve months of their modification date. See Lending and Credit Management section for further information.
Loans Held For Sale
The Company designates certain long-term fixed rate personal real estate loans as held for sale, and the Company carries them at the lower of cost or fair value. The loans are primarily sold to Freddie Mac, Fannie Mae, PennyMac, and other various secondary market investors. At September 30, 2020, the carrying amount of these loans was $7.9 million compared to $428,000 and $2.3 million at December 31, 2019 and September 30, 2019, respectively.
(3) Other Real Estate Acquired in Settlement of Loans
11,553
230
2,799
15,554
15,737
Less valuation allowance for other real estate owned
(2,953)
(2,956)
Total other real estate owned
Changes in the net carrying amount of other real estate owned were as follows for the periods indicated:
15,488
16,066
16,693
Additions
Proceeds from sales
(352)
(209)
(1,277)
Charge-offs against the valuation allowance for other real estate owned, net
(64)
Donation
(266)
Net gain on sales
219
102
15,865
(2,987)
12,878
At September 30, 2020, $217,000 of consumer mortgage loans secured by residential real estate properties were in the process of foreclosure compared to $252,000 of consumer mortgage loans at December 31, 2019.
Activity in the valuation allowance for other real estate owned was as follows for the periods indicated:
Balance, beginning of period
2,968
2,956
3,002
31
Charge-offs
Balance, end of period
2,953
2,987
(4) Investment Securities
Available for sale securities
The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2020 and December 31, 2019 were as follows:
Amortized
Gross Unrealized
Fair
Cost
Gains
Losses
Value
U.S. Treasury
2,774
2,804
U.S. government and federal agency obligations
6,122
201
6,323
U.S. government-sponsored enterprises
26,994
491
27,485
Obligations of states and political subdivisions
44,408
1,340
45,748
Mortgage-backed securities
90,822
2,156
(68)
92,910
Other debt securities (a)
10,000
10,231
Bank issued trust preferred securities (a)
1,486
(264)
1,222
Total available-for-sale securities
182,606
4,452
(335)
995
8,124
(77)
8,047
22,300
22,283
33,704
144
(59)
33,789
105,522
522
(428)
105,616
3,000
3,053
(176)
1,310
175,123
768
(798)
(a) Certain hybrid instruments possessing characteristics typically associated with debt obligations.
The Company’s investment securities are classified as available for sale. Agency bonds and notes, Small Business Administration guaranteed loan certificates (SBA), residential and commercial agency mortgage-backed securities, and agency collateralized mortgage obligations (CMO) include securities issued by the Government National Mortgage Association (GNMA), a U.S. government agency, and the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC), and the Federal Home Loan Bank (FHLB), which are U.S. government-sponsored enterprises.
Debt securities with carrying values aggregating approximately $164.4 million and $139.8 million at September 30, 2020 and December 31, 2019, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.
19
The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2020, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without prepayment penalties.
Due in one year or less
5,327
5,360
Due after one year through five years
21,969
22,261
Due after five years through ten years
40,550
41,708
Due after ten years
23,938
24,484
91,784
93,813
Other securities
Other investment securities include equity securities with readily determinable fair values and other investment securities that do not have readily determinable fair values. Investments in Federal Home Loan Bank (FHLB) stock, and Midwest Independent Bank (MIB) bankers bank stock, that do not have readily determinable fair values, are required for membership in those organizations.
Other securities:
FHLB stock
6,289
5,644
MIB stock
Equity securities with readily determinable fair values
Total other investment securities
Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2020 and December 31, 2019 were as follows:
Less than 12 months
12 months or more
Unrealized
1,530
8,957
Other debt securities
2,997
Bank issued trust preferred securities
13,484
(71)
14,706
6,238
(69)
1,809
5,949
(47)
7,488
13,437
10,729
1,931
(6)
12,660
5,444
(37)
40,120
(391)
45,564
28,360
(206)
52,658
(592)
81,018
The total available for sale portfolio consisted of approximately 305 securities at September 30, 2020. The portfolio included 15 securities having an aggregate fair value of $14.7 million that were in a loss position at September 30, 2020. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $1.2 million at fair value at September 30, 2020. The $335,000 aggregate unrealized loss included in accumulated other comprehensive loss at September 30, 2020 was caused by interest rate fluctuations.
The total available for sale portfolio consisted of approximately 322 securities at December 31, 2019. The portfolio included 128 securities having an aggregate fair value of $81.0 million that were in a loss position at December 31, 2019. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer had a fair value of $52.7 million at December 31, 2019. The $798,000 aggregate unrealized loss included in accumulated other comprehensive loss at December 31, 2019 was caused by interest rate fluctuations.
Because the decline in fair value is attributable to changes in interest rates and not credit quality, these investments were not considered other-than-temporarily impaired at September 30, 2020 and December 31, 2019, respectively. In the absence of changes in credit quality of these investments, the fair value is expected to recover on all debt securities as they approach their maturity date or re-pricing date, or if market yields for such investments decline. In addition, the Company does not have the intent to sell these investments over the period of recovery, and it is not more likely than not that the Company will be required to sell such investment securities.
The table presents the components of investment securities gains and losses, which have been recognized in earnings:
Available for sale securities:
Gains realized on sales
Losses realized on sales
(46)
Other-than-temporary impairment recognized
Other investment securities:
Fair value adjustments, net
The Company received $3.2 million and $4.7 million proceeds from the sale of available for sale debt securities and recognized net securities gains, which include the unrealized net losses related to equity securities, of $12,000 and $18,000 for the three and nine months September 30, 2020, respectively. This is compared to $21.5 million proceeds from the sale of available for sale of debt securities and recognized net securities losses of $40,000 for both the three and nine months ended September 30, 2019.
(5) Intangible Assets
Mortgage Servicing Rights
At September 30, 2020, the Company was servicing approximately $289.3 million of loans sold to the secondary market compared to $271.4 million at December 31, 2019, and $270.8 million at September 30, 2019. Mortgage loan servicing fees, reported in real estate servicing fees, net, earned on loans sold were $215,000 and $638,000 for the three and nine months ended September 30, 2020, compared to $205,000 and $581,000 for the three and nine months ended September 30, 2019.
The table below presents changes in mortgage servicing rights (MSRs) for the periods indicated.
2,145
2,657
2,931
Originated mortgage servicing rights
88
531
187
Changes in fair value:
Due to changes in model inputs and assumptions (1)
(21)
(340)
(318)
Other changes in fair value (2)
(93)
(346)
(225)
Total changes in fair value
(161)
(170)
(686)
(543)
2,575
The change in fair value resulting from changes in valuation inputs or assumptions, reported in real estate servicing fees, net, used in the valuation model reflects the change in discount rates and prepayment speed assumptions primarily due to changes in interest rates.
(2)
Other changes in fair value, reported in real estate servicing fees, net, reflect changes due to customer payments and passage of time.
22
The following key data and assumptions were used in estimating the fair value of the Company’s MSRs as of September 30, 2020 and 2019, respectively:
Weighted average constant prepayment rate
16.89
13.27
Weighted average note rate
3.67
3.95
Weighted average discount rate
7.75
8.75
Weighted average expected life (in years)
4.7
4.8
(6) Federal funds purchased and securities sold under agreements to repurchase
Federal funds purchased
Repurchase agreements
The Company offers a sweep account program whereby amounts in excess of an established limit are “swept” from the customer’s demand deposit account on a daily basis into retail repurchase agreements pursuant to individual repurchase agreements between the Company and its customers. Repurchase agreements are agreements to sell securities subject to an obligation to repurchase the same or similar securities. They are accounted for as collateralized financing transactions, not as sales and purchases of the securities portfolio. The securities collateral pledged for the repurchase agreements with customers is maintained by a designated third party custodian. The collateral amounts pledged to repurchase agreements by remaining maturity in the table below are limited to the outstanding balances of the related asset or liability; thus amounts of excess collateral are not shown.
Repurchase Agreements
Remaining Contractual Maturity of the Agreements
Overnight
Less
Greater
and
than
continuous
90 days
17,967
17,438
754
12,853
13,665
(7) Leases
The Company's leases primarily consist of office space and bank branches with remaining lease terms of generally 1 to 10 years. As of September 30, 2020, operating right of use (ROU) assets and liabilities were $2.0 million and $2.0 million,
respectively. As of September 30, 2020, the weighted-average remaining lease term on these operating leases is approximately 7.9 years and the weighted-average discount rate used to measure the lease liabilities is approximately 4.0%.
Operating leases in which the Company is the lessee are recorded as operating lease ROU assets and operating lease liabilities. Currently, the Company does not have any finance leases. The ROU assets are included in premises and equipment, net on the consolidated balance sheets.
Operating lease ROU assets represent the Company's right to use an underlying asset during the lease term and operating lease liabilities represent the Company's obligation to make lease payments arising from the lease. ROU assets and operating lease liabilities are recognized at lease commencement based on the present value of the remaining lease payments using a discount rate that represents the Company's incremental borrowing rate at the lease commencement date.
Operating lease cost, which is comprised of amortization of the ROU asset and the implicit interest accreted on the operating lease liability, is recognized on a straight-line basis over the lease term, and is recorded in net occupancy expense in the consolidated statements of income. The operating lease cost was $86,000 and $252,000 for the three and nine months ended September 30, 2020, respectively, compared to $86,000 and $202,000 for the three and nine months ended September 30, 2019 respectively.
At adoption of ASU 2016-02 on January 1, 2019, lease and non-lease components of new lease agreements are accounted for separately. Lease components include fixed payments including rent, real estate taxes and insurance costs and non-lease components include common-area maintenance costs. Leases with an initial term of 12 months or less are not recorded on the balance sheet; the Company recognizes lease expense for these leases on a straight-line basis over the lease term. Operating lease expense for these leases was $15,000 and $75,000 for the three and nine months ended September 30, 2020, respectively, compared to $20,000 and $71,000 for the three and nine months ended September 30, 2019, respectively.
The table below summarizes the maturity of remaining operating lease liabilities:
Operating
Lease payments due in:
Lease
2020 (excluding 9 months ending September 30, 2020)
2021
317
2022
2023
312
2024
258
Thereafter
1,087
Total lease payments
2,368
Less imputed interest
(332)
Total lease liabilities, as reported
(8) Income Taxes
Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 18.9% and 18.4% for the three and nine months ended September 30, 2020, respectively, compared to 19.8% and 19.3% for the three and nine months ended September 30, 2019, respectively. The decrease in the effective tax rate for the three months ended September 30, 2020 compared to the three months ended September 30, 2019 was primarily attributable to the impact of tax-free revenues. The decrease in the effective tax rate for the nine months ended September 30, 2020 was primarily attributable to tax-free revenues having a greater impact on pre-tax income due to the reduced level of earnings.
The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income of the appropriate character during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning initiatives in making this assessment. In management's opinion, the Company will more likely than not realize the benefits of its deferred tax assets and, therefore, has not established a valuation allowance against its deferred tax assets as of September 30, 2020. Management arrived at this conclusion based upon the level of historical taxable income and projections for future taxable income of the appropriate character over the periods in which the deferred tax assets are deductible.
The Company follows ASC Topic 740, Income Taxes, which addresses the accounting for uncertain tax positions. For each of the three and nine months ended September 30, 2020 and 2019, respectively, the Company did not have any uncertain tax provisions, and did not record any related tax liabilities.
(9) Stockholders’ Equity
Accumulated Other Comprehensive Loss
The following details the change in the components of the Company’s accumulated other comprehensive loss for the nine months ended September 30, 2020 and 2019:
Unrecognized Net
Pension and
Gains (Losses)
Postretirement
(Loss)
on Securities (1)
Costs (2)
Income
(23)
(3,732)
Other comprehensive income, before reclassifications
4,165
160
4,325
Amounts reclassified from accumulated other comprehensive (loss) income
Current period other comprehensive income, before tax
4,146
4,306
(871)
(33)
(904)
Current period other comprehensive income, net of tax
3,275
3,252
(3,605)
(3,455)
(2,644)
4,250
4,308
4,290
4,348
(901)
(913)
3,389
(66)
(2,598)
(10) Employee Benefit Plans
Employee Benefits
Employee benefits charged to operating expenses are summarized in the table below for the periods indicated.
Payroll taxes
305
256
1,030
871
Medical plans
446
432
1,370
1,360
401(k) match and profit sharing
490
349
1,134
928
Periodic pension cost
404
358
1,211
Total employee benefits
1,659
1,410
4,787
4,272
The Company’s profit-sharing plan includes a matching 401(k) portion, in which the Company matches the first 3% of eligible employee contributions. The Company makes annual contributions in an amount up to 6% of income before income taxes and before contributions to the profit-sharing and pension plans for all participants, limited to the maximum amount deductible for federal income tax purposes, for each of the periods shown.
Other Plans
On November 7, 2018, the Board of Directors of the Company adopted a supplemental executive retirement plan (SERP) which became effective on January 1, 2018. The SERP provides select employees who satisfy certain eligibility requirements with certain benefits upon retirement, termination of employment or death.
26
As of September 30, 2020, the accrued liability was $880,000 and the expense for both the three and nine months ended September 30, 2020 and 2019 was $80,000 and $240,000, respectively, and is recognized over the required service period.
Pension
The Company provides a noncontributory defined benefit pension plan for all full-time eligible employees. Beginning January 1, 2018 and for all retrospective periods presented, the Company adopted the guidance under ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. Under the new guidance, only the service cost component of the net periodic benefit cost is reported in the same income statement line item as salaries and benefits, and the remaining components are reported as other non-interest expense. An employer is required to recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Under the Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. The Company made a pension contribution of $500,000 on March 25, 2020. Effective July 1, 2017, the Company amended the pension plan to effectuate a “soft freeze” such that no individual hired (or rehired in the case of a former employee) by the Company after September 30, 2017, whether or not such individual is or was a vested member in the plan, will be eligible to be an active member and be entitled to accrue any benefits under the plan.
Components of Net Pension Cost and Other Amounts Recognized in Accumulated Other Comprehensive Income
The following items are components of net pension cost for the periods indicated:
Pension Benefits
Service cost - benefits earned during the year
1,614
1,431
Interest costs on projected benefit obligations (a)
1,127
1,168
Expected return on plan assets (a)
(1,598)
(1,467)
Expected administrative expenses (a)
122
Amortization of prior service cost (a)
79
Amortization of unrecognized net loss (a)
164
Net periodic pension cost
1,467
1,333
Net periodic pension cost for the three months ended September 30, (actual)
Net periodic pension cost for the nine months ended September 30, (actual)
Net periodic pension benefit costs include interest costs based on an assumed discount rate, the expected return on plan assets based on actuarially derived market-related values, and the amortization of net actuarial losses. Net periodic postretirement benefit costs include service costs, interest costs based on an assumed discount rate, and the amortization of prior service credits and net actuarial gains. Differences between expected and actual results in each year are included in the net actuarial gain or loss amount, which is recognized in other comprehensive income. The net actuarial gain or loss in excess of a 10% corridor is amortized in net periodic benefit cost over the average remaining service period of active
participants in the Plans. The prior service credit is amortized over the average remaining service period to full eligibility for participating employees expected to receive benefits.
(11) Earnings per Share
Stock Dividend
On July 1, 2020, the Company paid a special stock dividend of 4% to common shareholders of record at the close of business on June 15, 2020. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.
Basic earnings per share is computed by dividing income available to shareholders by the weighted average number of shares outstanding during the year. Diluted earnings per share gives effect to all dilutive potential shares that were outstanding during the year.
Presented below is a summary of the components used to calculate basic and diluted earnings per common share, which have been restated for all stock dividends:
(dollars in thousands, except per share data)
Basic earnings per share:
Net income available to shareholders
Average shares outstanding
6,483,429
6,525,684
6,493,054
Diluted earnings per share:
Effect of dilutive stock options
Average shares outstanding including dilutive stock options
Under the treasury stock method, outstanding stock options are dilutive when the average market price of the Company’s common stock, when combined with the effect of any unamortized compensation expense, exceeds the option price during the period, except when the Company has a loss from continuing operations available to shareholders. In addition, proceeds from the assumed exercise of dilutive options along with the related tax benefit are assumed to be used to repurchase common shares at the average market price of such stock during the period. There were no shares for the three and nine months ended September 30, 2020 that were omitted from the computation of diluted earnings per share as a result of being considered anti-dilutive.
Repurchase Program
In the third quarter of 2020, the Company's Board of Directors authorized the purchase of up to $2.5 million market value of the Company's common stock. Management was given discretion to determine the number and pricing of the shares to be purchased, as well as, the timing of any such purchases. As of September 30, 2020, $2.4 million remained for share repurchase pursuant to that authorization.
(12) Fair Value Measurements
Fair value represents the amount expected to be received to sell an asset or paid to transfer a liability in its principal or most advantageous market in an orderly transaction between market participants at the measurement date.
Depending on the nature of the asset or liability, the Company uses various valuation methodologies and assumptions to estimate fair value. The measurement of fair value under US GAAP uses a hierarchy intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows.
The fair value hierarchy is as follows:
Level 1 – Inputs are unadjusted quoted prices for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and is used to measure fair value whenever available. A contractually binding sales price also provides reliable evidence of fair value.
Level 2 – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, such as interest rates and yield curves that are observable at commonly quoted intervals.
Level 3 – Inputs are unobservable inputs for the asset or liability and significant to the fair value. These may be internally developed using the Company’s best information and assumptions that a market participant would consider.
In accordance with fair value accounting guidance, the Company measures, records, and reports various types of assets and liabilities at fair value on either a recurring or non-recurring basis in the Consolidated Financial Statements. Nonfinancial assets measured at fair value on a nonrecurring basis would include foreclosed real estate, long-lived assets, and core deposit intangible assets, which are reviewed when circumstances or other events indicate that impairment may have occurred.
Valuation Methods for Assets and Liabilities Measured at Fair Value on a Recurring Basis
Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a recurring basis:
Available-for-Sale Securities
The fair value measurements of the Company’s investment securities are determined by a third party pricing service which considers observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. The fair value measurements are subject to independent verification to another pricing source by management each quarter for reasonableness.
Equity securities with readily determinable fair values are recorded at fair value, with changes in fair value reflected in earnings. The Company uses level 1 inputs to value equity securities that are traded in active markets. Equity securities that do not have readily determinable fair values are carried at cost and are periodically assessed for impairment. Equity securities that are not actively traded are classified in level 2.
29
The fair value of mortgage servicing rights is based on the discounted value of estimated future cash flows utilizing contractual cash flows, servicing rate, constant prepayment rate, servicing cost, and discount rate factors. Accordingly, the fair value is estimated based on a valuation model that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees. The valuation models estimate the present value of estimated future net servicing income. The Company classifies its servicing rights as Level 3.
Fair Value Measurements
Quoted Prices
in Active
Markets for
Significant
Identical
Observable
Unobservable
Assets
Inputs
Fair Value
(Level 1)
(Level 2)
(Level 3)
Assets:
Bank-issued trust preferred securities
Equity securities
Mortgage servicing rights
189,062
2,816
183,919
177,588
1,008
174,098
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:
Fair Value Measurements Using
Total (losses) or gains (realized/unrealized):
Included in earnings
Included in other comprehensive income
Purchases
Sales
Issues
Settlements
Valuation methods for Assets and Liabilities measured at fair value on a nonrecurring basis
Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a nonrecurring basis:
Collateral dependent impaired loans
While the overall loan portfolio is not carried at fair value, the Company periodically records nonrecurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans. Nonrecurring adjustments also include certain impairment amounts for collateral dependent loans when establishing the allowance for loan losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan. In determining the value of real estate collateral, the Company relies on external and internal appraisals of property values depending on the size and complexity of the real estate collateral. The Company maintains staff that is trained to perform in-house evaluations and also review third party appraisal reports for reasonableness. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgments based on the experience and expertise of internal specialists. Values of all loan collateral are regularly reviewed by senior loan committee. Because many of these inputs are not observable, the measurements are classified as Level 3. As of September 30, 2020, the Company identified $2.9 million in collateral dependent impaired loans that had specific allowances for losses aggregating $178,000. Related to these loans, there were $36,000 and $129,000 in charge-offs recorded during the three and nine months ended September 30, 2020, respectively. As of September 30, 2019, the Company identified $2.9 million in collateral dependent impaired loans that had specific allowances for losses aggregating $398,000. Related to these loans, there were $77,000 and $204,000 in charge-offs recorded during the three and nine months ended September 30, 2019, respectively.
Other Real Estate and Foreclosed Assets
Other real estate owned (OREO) and foreclosed assets consisted of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Subsequent to foreclosure, these assets initially
are carried at fair value of the collateral less estimated selling costs. Fair value, when recorded, is generally based upon appraisals by approved, independent state certified appraisers. Like impaired loans, appraisals on OREO may be discounted based on the Company’s historical knowledge, changes in market conditions from the time of appraisal or other information available. During the holding period, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. Because many of these inputs are not observable, the measurements are classified as Level 3.
Three Months
Nine Months
Ended
Total Gains
(Losses)*
Collateral dependent impaired loans:
Commercial, financial, & agricultural
308
(20)
360
454
(52)
1,635
2,757
(36)
(129)
Other real estate and repossessed assets
September 30, 2019
529
(132)
933
(45)
860
(5)
2,480
(204)
(166)
*
Total losses reported for other real estate and foreclosed assets includes charge-offs, valuation write downs, and net losses taken during the periods reported.
(13) Fair Value of Financial Instruments
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate such value:
Fair values are estimated for portfolios with similar financial characteristics. Loans are segregated by type, such as commercial, real estate, and consumer. Each loan category is further segmented into fixed and variable interest rate categories. The fair value of loans, or exit price, is estimated by using the future value of discounted cash flows using comparable market rates for similar types of loan products and adjusted for market factors. The discount rates used are estimated using comparable market rates for similar types of loan products adjusted to be commensurate with the credit risk, overhead costs, and optionality of such instruments.
Loans Held for Sale
Loans originated and intended to be sold in the secondary market, generally 1-4 family residential mortgage loans, are carried, in aggregate, at the lower of cost or estimated fair value. The estimated fair value measurements of loans held for sale are management's best estimate of market value, which is primarily based on quoted market prices for similar loans in the secondary market.
Investment Securities
A detailed description of the fair value measurement of the debt instruments in the available-for-sale sections of the investment security portfolio is provided in the Fair Value Measurement section above. A schedule of investment securities by category and maturity is provided in the notes on Investment Securities.
Other investment securities
Other investment securities include equity securities with readily determinable fair values and other investment securities that do not have readily determinable fair values. Investments in Federal Home Loan Bank (FHLB) stock, and Midwest Independent Bank (MIB) bankers bank stock, that do not have readily determinable fair values, are required for membership in those organizations. Equity securities that are not actively traded are classified in level 2.
Equity securities with readily determinable fair values are recorded at fair value, with changes in fair value reflected in earnings. Equity securities that do not have readily determinable fair values are carried at cost and are periodically assessed for impairment. The Company uses level 1 inputs to value equity securities that are traded in active markets.
Federal Funds Sold, Cash, and Due from Banks
The carrying amounts of short-term federal funds sold, interest earning deposits with banks, and cash and due from banks approximate fair value. Federal funds sold classified as short-term generally mature in 90 days or less.
Certificates of Deposit in other banks
Certificates of deposit are other investments made by the Company with other financial institutions that are carried at cost which is equal to fair value.
Cash Surrender Value - Life Insurance
The fair value of Bank owned life insurance (BOLI) approximates the carrying amount. Upon liquidation of these investments, the Company would receive the cash surrender value which equals the carrying amount.
Accrued Interest Receivable and Payable
For accrued interest receivable and payable, the carrying amount is a reasonable estimate of fair value because of the short maturity for these financial instruments.
The fair value of deposits with no stated maturity, such as noninterest-bearing demand, NOW accounts, savings, and money market, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
Federal funds purchased and Securities Sold under Agreements to Repurchase
For Federal funds purchased and securities sold under agreements to repurchase, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.
Subordinated Notes and Other Borrowings
The fair value of subordinated notes and other borrowings is based on the discounted value of contractual cash-flows. The discount rate is estimated using the rates currently offered for other borrowed money of similar remaining maturities.
Operating Lease Liabilities
The fair value of operating lease liabilities are recognized at lease commencement based on the present value of the remaining lease payments using a discount rate that represents the Company's incremental borrowing rate at the lease commencement date.
A summary of the carrying amounts and fair values of the Company’s financial instruments at September 30, 2020 and December 31, 2019 is as follows:
Net
Carrying
amount
value
Federal funds sold and overnight interest-bearing deposits
6,440
Loans, net
1,388,523
Loans held for sale
8,203
1,612,405
1,739,844
150,321
192,797
1,396,726
Liabilities:
Deposits:
289,046
291,547
116,630
40,682
1,527,308
1,524,892
1,073,997
159,348
Available-for-sale securities
1,148,339
435
1,435,511
1,427,537
96,472
182,291
1,148,774
311,024
311,489
97,833
43,640
1,363,558
1,359,091
903,905
143,697
Off-Balance Sheet Financial Instruments
The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the likelihood of the counterparties drawing on such financial instruments, and the present creditworthiness of such counterparties. The Company believes such commitments have been made on terms that are competitive in the markets in which it operates.
Limitations
The fair value estimates provided are made at a point in time based on market information and information about the financial instruments. Because no market exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and
involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the fair value estimates.
(14) Commitments and Contingencies
The Company issues financial instruments with off-balance-sheet risk in the normal course of business of meeting the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments may involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.
The Company’s extent of involvement and maximum potential exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At September 30, 2020, no amounts have been accrued for any estimated losses for these financial instruments.
The contractual amount of off-balance-sheet financial instruments were as follows as of the dates indicated:
Commitments to extend credit
295,265
240,758
Commitments to originate residential first and second mortgage loans
56,357
Standby letters of credit
74,635
97,348
426,257
342,086
Commitments
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain of the commitments and letters of credit are expected to expire without being drawn upon, the total commitment amounts 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 extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, furniture and equipment, and real estate.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support contractual obligations of the Company’s customers. The approximate remaining term of standby letters of credit range from one month to five years at September 30, 2020.
Pending Litigation
The Company and its subsidiaries are defendants in various legal actions incidental to the Company’s past and current business activities. Based on the Company’s analysis, and considering the inherent uncertainties associated with litigation, management does not believe that it is reasonably possible that these legal actions will materially adversely affect the Company’s consolidated financial condition or results of operations in the near term. The Company records a loss accrual
for all legal matters for which it deems a loss is probable and can be reasonably estimated. Some legal matters, which are at early stages in the legal process, have not yet progressed to the point where a loss is deemed probable or an amount can be estimated.
(15) Revenue Recognition
On January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) and all subsequent ASUs that modified Topic 606.
Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and securities. In addition, certain noninterest income streams such as fees associated with mortgage servicing rights, financial guarantees, derivatives, and certain credit card fees are not in the scope of the new guidance. Topic 606 is applicable to noninterest revenue streams such as trust department revenue, service charges and fees, debit card income, ATM surcharge income, and sales of other real estate owned. However, the recognition of these revenue streams did not change current business practices or result in any changes to the Company’s consolidated financial statements.
Descriptions of our revenue-generating activities within the scope of this guidance, which are presented in our income statement as components of noninterest income are as follows:
Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company, Hawthorn Bancshares, Inc., and its subsidiaries, including, without limitation:
Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:
We have described under the caption Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, and in other reports filed with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that have not been identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.
Overview
Crucial to the Company’s community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, the Company, with $1.7 billion in assets at September 30, 2020, provides a broad range of commercial and personal banking services. The Bank’s specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business Administration (SBA) loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, St. Louis, and the greater Kansas City metropolitan area.
The Company’s primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company’s business is commercial, commercial real estate development, and residential mortgage
lending. The Company’s income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancing activity.
The success of the Company’s growth strategy depends primarily on the ability of its banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company’s financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company’s growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.
The Company’s subsidiary bank is a full-service bank conducting a general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, the Bank provides trust services.
The deposit accounts of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC) to the extent provided by law. The operations of the Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of the Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. The Company is subject to supervision and examination by the Board of Governors of the Federal Reserve System.
Significant Developments and Transactions
Each item listed below materially affects the comparability of our results of operations for the three and nine months ended September 30, 2020 and 2019, and our financial condition as of September 30, 2020 and December 31, 2019, and may affect the comparability of financial information we report in future fiscal periods.
Impact of COVID-19. The progression of the COVID-19 pandemic in the United States has had an adverse impact on our financial condition and results of operations as of and for the three months ended September 30, 2020, and is expected to have a complex and significant adverse impact on the economy, the banking industry and our Company in future fiscal periods, all subject to a high degree of uncertainty.
Effects on Our Market Areas. Our commercial and consumer banking products and services are delivered primarily in Missouri, where individual and governmental responses to the COVID-19 pandemic have led to a broad curtailment of economic activity beginning March 2020. In Missouri, the Director of the Missouri Department of Health and Senior Services issued an order that individuals stay at home and that businesses abide by certain limitations on gathering sizes. This order was effective from April 6, 2020 and extended through May 3, 2020. Effective May 4, 2020, the governor of Missouri announced a partial relaxation of these limitations by lifting the stay at home order for individuals and allowing businesses to reopen subject to social distancing guidelines. The Bank and its branches remained open during these orders because banking is deemed an essential business, although it suspended lobby access at its branches from March 18, 2020 until May 4, 2020. Effective June16, 2020 the governor of Missouri rescinded all COVID-19 related statewide public health orders. He announced it would be the responsibility of local officials to put further measures and regulations in place.
Policy and Regulatory Developments. Federal, state and local governments and regulatory authorities have enacted and issued a range of policy responses to the COVID-19 pandemic, including the following:
Effects on Our Business. The COVID-19 pandemic and the specific developments referred to above will continue to have a significant impact on our business. In particular, we anticipate that a significant portion of the Bank’s borrowers in the hotel, restaurant, gaming, long-term healthcare and retail industries will continue to endure significant economic distress, which has caused, and will continue to cause, them to draw on their existing lines of credit and adversely affect their ability to repay existing indebtedness, and is expected to adversely impact the value of collateral. These developments, together with economic conditions generally, are also expected to impact our commercial real estate portfolio, particularly with respect to real estate with exposure to these industries, our consumer loan business and loan portfolio, and the value of certain collateral securing our loans. As a result, we anticipate that our financial condition, capital levels and results of operations will be adversely affected, as described in further detail below.
Our Response. We have taken numerous steps in response to the COVID-19 pandemic, including the following:
CRITICAL ACCOUNTING POLICIES
The following accounting policies are considered most critical to the understanding of the Company’s financial condition and results of operations. These critical accounting policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to the critical accounting policies on the business operations are discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations, where such policies affect the reported and expected financial results.
Management has identified the accounting policy related to the allowance for loan losses as critical to the understanding of the Company’s results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on the Company’s business operations is provided in note 1 to the Company’s unaudited consolidated financial statements and is also discussed in the Lending and Credit Management section below. Many of the loans are deemed collateral dependent for purposes of the measurement of the impairment loss, thus the fair value of the underlying collateral and sensitivity of such fair values due to changing market conditions, supply and demand, condition of the collateral and other factors can be volatile over periods of time. Such volatility can have an impact on the financial performance of the Company.
SELECTED CONSOLIDATED FINANCIAL DATA
The following table presents selected consolidated financial information for the Company as of and for each of the three and nine months ended September 30, 2020 and 2019, respectively. The selected consolidated financial data should be read in conjunction with the unaudited consolidated financial statements of the Company, including the related notes, presented elsewhere herein.
Selected Financial Data
Per Share Data
Cash dividends paid on common stock
750
604
2,252
Book value per share
19.15
17.29
Market price per share
18.94
22.91
Selected Ratios
(Based on average balance sheets)
Return on total assets
1.18
1.07
0.76
1.09
Return on stockholders' equity
15.99
13.72
10.15
15.03
Stockholders' equity to total assets
7.40
7.79
7.47
7.22
Efficiency ratio (1)
61.41
64.86
66.67
68.13
Net interest spread
3.30
3.32
3.27
3.15
Net interest margin
3.50
3.64
3.47
(Based on end-of-period data)
Stockholders' equity to assets
7.45
7.78
Total risk-based capital ratio
15.05
14.47
Tier 1 risk-based capital ratio
13.28
12.60
Common equity Tier 1 capital
9.97
9.50
Tier 1 leverage ratio (2)
9.99
10.69
Efficiency ratio is calculated as non-interest expense as a percentage of revenue. Total revenue includes net interest income and non-interest income.
Tier 1 leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets.
Use of Non-GAAP Measures
Several financial measures in this report are non-GAAP, meaning they are not presented in accordance with generally accepted accounting principles (GAAP) in the U.S. The non-GAAP items presented in this report are non-GAAP net income, non-GAAP basic earnings per share, non-GAAP diluted earnings per share, non-GAAP return on average assets and non-GAAP return on average common equity. These measures include the adjustments to exclude the additional loan loss provision recorded in the three and nine months ended September 30, 2020 caused by the impact on current economic conditions due to the COVID-19 pandemic and the impact of the gain on the sale of our Branson branch that closed during the quarter ended March 31, 2019. The Company believes that the exclusion of these items provides a useful basis for evaluating the Company's underlying performance, but should not be considered in isolation and is not in accordance with, or a substitute for, evaluating performance utilizing GAAP financial information. The Company uses non-GAAP measures to analyze its financial performance and to make financial comparisons to prior periods presented on a similar basis. The Company believes that providing such adjusted results allows investors to better understand the Company's comparative operating performance for the periods presented. Non-GAAP measures are not formally defined by GAAP or codified in the federal banking regulations, and other entities may use calculation methods that differ from those used by the Company. The Company has reconciled each of these measures to a comparable GAAP measure below:
Income Statement Data
Net income - GAAP
Effect of ALL provision COVID-19 (a)
632
3,476
Effect of net gain on branch sale (b)
(86)
(1,725)
Net income - non-GAAP
5,592
3,774
12,586
10,321
Basic earnings per share - GAAP
0.10
0.54
(0.01)
(0.26)
Basic earnings per share - non-GAAP
0.87
0.58
1.94
1.59
Diluted earnings per share - GAAP
Diluted earnings per share - non-GAAP
Key Ratios
Return on average total assets - GAAP
0.15
0.29
(0.02)
(0.16)
Return on average total assets - non-GAAP
1.33
1.05
0.93
Return on average stockholders' equity - GAAP
2.04
3.87
(0.31)
(2.15)
Return on average stockholders' equity - non-GAAP
18.03
13.41
14.02
12.88
RESULTS OF OPERATIONS ANALYSIS
The Company has prepared all of the consolidated financial information in this report in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). In preparing the consolidated financial statements in accordance with U.S. GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported
amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.
$ Change
% Change
1,481
12.0
3,560
9.8
166.7
4,550
535.3
Non-interest income
2,651
109.4
3,319
50.0
Investment securities gains, net
(130.0)
(145.0)
(109)
(100.0)
Non-interest expense
2,026
21.1
3,962
13.6
1,299
27.0
(3,758)
(25.2)
20.9
(822)
(28.5)
1,100
28.5
(2,936)
(24.4)
NM = not meaningful
Consolidated net income of $5.0 million, or $0.77 per diluted share, for the three months ended September 30, 2020 increased $1.1 million compared to $3.9 million, or $0.59 per diluted share, for the three months ended September 30, 2019. For the three months ended September 30, 2020, the return on average assets was 1.18%, the return on average stockholders’ equity was 15.99%, and the efficiency ratio was 61.4%.
Consolidated net income of $9.1 million, or $1.40 per diluted share, for the nine months ended September 30, 2020 decreased $2.9 million compared to $12.0 million, or $1.85 per diluted share, for the nine months ended September 30, 2019. For the nine months ended September 30, 2020, the return on average assets was 0.76%, the return on average stockholders’ equity was 10.15%, and the efficiency ratio was 66.7%.
Net interest income was $13.8 million and $39.7 million for the three and nine months ended September 30, 2020, respectively, compared to $12.4 million and $36.1 million for the three and nine months ended September 30, 2019, respectively. The net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.50% for the three months ended September 30, 2020 compared to 3.64% for the three months ended September 30, 2019, and increased to 3.50% for the nine months ended September 30, 2020 compared to 3.47% for the nine months ended September 30, 2019. These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below.
A $1.2 million and $5.4 million provision for loan losses was required for the three and nine months ended September 30, 2020, respectively, compared to a $450,000 and $850,000 provision for the three and nine months ended September 30, 2019, respectively. The increase in the provision was primarily due to an additional $800,000 and $4.4 million recorded during the three and nine months ended September 30, 2020, respectively, due to the current and continued economic conditions resulting from the COVID-19 pandemic and the resulting financial stress being felt by the Company's borrowers.
The Company’s net loan charge-offs were $58,000 and $113,000 for the three and nine months ended September 30, 2020, respectively, compared to net loan charge-offs of $155,000 and $324,000 for the three and nine months ended September 30, 2019, respectively.
Non-performing loans totaled $5.8 million, or 0.45% of total loans, at September 30, 2020 compared to $5.1 million, or 0.43% of total loans, at December 31, 2019, and $4.8 million, or 0.41% of total loans, at September 30, 2019. These changes are discussed in greater detail under the Lending and Credit Management section below.
Non-interest income increased $2.7 million, or 109.4%, for the three months ended September 30, 2020 compared to the three months ended September 30, 2019, and increased $3.3 million, or 50.0% for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019. These changes are discussed in greater detail under the Non-interest Income and Expense section below.
45
Investment securities gains, net The Company recognized net securities gains, which include the unrealized net gains related to equity securities, of $12,000 and $18,000 for the three and nine months September 30, 2020, respectively, compared to net securities losses of $40,000 for both the three and nine months ended September 30, 2019, respectively. These changes are discussed in greater detail under Investment securities gains, net section below.
Gain on branch sale, net On February 8, 2019, Hawthorn Bank, a wholly-owned subsidiary of Hawthorn Bancshares, Inc., completed the sale of its branch located in Branson, Missouri to Branson Bank, Branson, Missouri. The Company sold the land and building for $3.5 million with a net book value of $1.7 million and transferred approximately $10.6 million in deposits, subject to future adjustments required in the definitive agreement for a deposit premium of 4.1%, or $0.3 million, excluding future contingent adjustments. The sale resulted in a pre-tax gain of approximately $2.2 million, or $1.7 million after tax, for the nine months ended September 30, 2019. Included in the current quarter's net income is the final pretax gain on the sale of our Branson branch of $0.1 million, or $86,000 after tax, was recognized resulting from contingent deposit accounts.
Non-interest expense increased $2.0 million, or 21.1%, for the three months ended September 30, 2020 compared to the three months ended September 30, 2019, and increased $4.0 million, or 13.6% for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019. These changes are discussed in greater detail under the Non-interest Income and Expense section below.
Average Balance Sheets
Net interest income is the largest source of revenue resulting from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table presents average balance sheets, net interest
income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the periods ended September 30, 2020 and 2019, respectively.
Rate
Income/
Earned/
Expense(1)
Paid(1)
Loans: (2) (3)
291,657
3,364
4.59
198,444
2,777
5.55
26,263
345
5.23
24,895
5.88
86,056
989
4.57
122,179
5.24
253,451
2,967
4.66
246,833
3,229
5.19
588,464
6,959
4.70
527,324
6,538
4.92
28,691
297
4.12
31,689
354
4.43
Total loans
1,274,582
14,921
1,151,364
14,881
5.13
11,573
1.41
1,337
Investment securities:
2,808
1.13
2.07
39,927
179
1.78
33,249
150
1.79
45,609
2.66
30,129
2.88
96,017
1.70
119,911
595
1.97
11,133
152
5.43
4,415
5.66
195,494
1,055
2.15
189,044
1,034
2.17
6,623
4.51
5,968
4.39
Federal funds sold and interest bearing deposits in other financial institutions
112,710
0.39
16,375
2.50
Total interest earning assets
1,600,982
16,203
4.03
1,364,088
16,084
4.68
All other assets
84,068
80,345
Allowance for loan losses
(16,727)
(11,933)
1,668,323
1,432,500
NOW accounts
198,913
0.25
165,275
272
0.65
Savings
123,405
0.04
98,008
0.11
Interest checking
53,734
0.56
11,807
2.08
Money market
281,454
0.14
271,068
687
1.01
297,359
950
1.27
324,081
1,276
1.56
Total interest bearing deposits
954,865
0.53
870,239
1.06
36,412
0.27
21,947
0.61
116,977
1.72
100,990
2.43
2.62
4.71
Total borrowings
202,875
1.68
172,423
2.86
Total interest bearing liabilities
1,157,740
0.73
1,042,662
1.36
Demand deposits
368,709
263,336
18,486
14,879
1,544,935
1,320,877
Stockholders' equity
123,388
111,623
Total liabilities and stockholders' equity
Net interest income (FTE)
14,087
12,520
Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the three months ended September 30, 2020 and 2019. Such adjustments totaled $245,000 and $159,000 for the three months ended September 30, 2020 and 2019, respectively.
Non-accruing loans are included in the average amounts outstanding.
Fees and costs on loans are included in interest income. ($445,000 of PPP fees were included in commercial loan income for the three months ended September 30, 2020)
47
Loans: (2) (4)
257,328
9,055
202,708
8,408
25,245
999
5.29
26,623
1,195
6.00
85,486
3,059
4.78
115,923
4,536
251,029
9,031
4.81
246,053
9,456
5.14
582,568
20,955
4.80
528,152
19,263
4.88
30,063
4.22
31,965
1,035
4.33
1,231,719
44,049
1,151,424
43,893
5.10
8,338
1.54
873
Investment securities: (3)
1,453
1.47
2,160
41,353
2.00
43,982
621
1.89
42,088
895
2.84
35,876
743
2.77
100,186
1,348
1.80
120,698
1,961
7,229
294
4,389
190
5.79
192,309
3,172
2.20
207,105
3,550
2.29
6,765
5,709
98,238
0.75
47,724
2.51
1,537,369
48,117
4.18
1,412,835
48,539
83,104
82,791
(15,061)
(11,874)
1,605,412
1,483,752
190,734
533
0.37
208,639
1,708
112,917
0.05
95,792
0.09
49,026
0.88
11,572
1.96
278,244
647
0.31
280,643
2,274
1.08
308,442
3,156
1.37
341,466
4,029
1.58
939,363
0.67
938,112
34,028
0.48
21,716
0.68
120,650
94,969
2.39
3.26
204,164
2.01
166,171
2.92
1,143,527
0.91
1,104,283
1.44
324,479
257,157
17,498
15,143
1,485,504
1,376,583
119,908
107,169
40,337
36,663
Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the nine months ended September 30, 2020 and 2019. Such adjustments totaled $630,000 and $516,000 for the nine months ended September 30, 2020 and 2019, respectively.
Fees and costs on loans are included in interest income. ($800,000 of PPP fees were included in commercial loan income for the nine months ended September 30, 2020)
Rate and Volume Analysis
The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates for the three and nine months ended September 30, 2020 compared to the three and nine months ended September 30, 2019. The change in
48
interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.
2020 vs. 2019
Change due to
Change
Volume
Interest income on a fully taxable equivalent basis: (1)
587
1,139
(552)
2,050
(1,403)
(24)
(196)
(60)
(136)
(625)
(435)
(190)
(1,477)
(1,116)
(361)
(262)
(347)
(425)
(613)
421
734
(313)
1,692
1,966
(274)
(57)
(32)
(61)
(38)
105
(184)
(110)
(74)
(305)
(308)
89
92
104
159
(151)
(344)
549
(893)
1,799
(1,680)
(422)
3,450
(3,872)
Interest expense:
(148)
(195)
(1,175)
(1,039)
(22)
(73)
153
291
(138)
(587)
(612)
(1,627)
(1,608)
(326)
(99)
(227)
(873)
(504)
(39)
(114)
(202)
(358)
(1,448)
168
(1,616)
(4,096)
236
(4,332)
Net interest income on a fully taxable equivalent basis
1,567
1,631
3,674
3,214
460
Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 21%, net of nondeductible interest expense, for the three and nine months ended September 30, 2020 and 2019. Such adjustments totaled $245,000 and $630,000 for the three and nine months ended September 30, 2020, respectively, compared to $159,000 and $516,000 for the three and nine months ended September 30, 2019, respectively.
Fees and costs on loans are included in interest income. ($445,000 and $800,000 of PPP fees were included in commercial loan income for the three and nine months ended September 30, 2020)
Financial results for the quarter ended September 30, 2020 compared to the quarter ended September 30, 2019, reflected an increase in net interest income, on a tax equivalent basis, of $1.6 million, or 12.5%, and financial results for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019 reflected an increase of $3.7 million, or 10.0%. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.50% for the quarter ended September 30, 2020, compared to 3.64% for the quarter ended September 30, 2019, respectively, and increased to 3.50% for the nine months ended September 30, 2020 compared to 3.47% for the nine months ended September 30, 2019, respectively.
Net interest income increased primarily due to a decrease in rates paid on average interest bearing liabilities in the three and nine month comparative periods. Although average earning assets increased for both the three and nine month comparative periods, net interest margin decreased quarter over quarter primarily due to a decrease in rates earned, while net interest margin increased for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019 primarily due to the decrease in rates paid on interest bearing liabilities partially offset by the decrease in rates earned on average interest earning assets.
Average interest-earning assets increased $236.9 million, or 17.4%, to $1.60 billion for the three months ended September 30, 2020 compared to $1.36 billion for the three months ended September 30, 2019, and average interest bearing liabilities increased $115.1 million, or 11.0%, to $1.16 billion for the three months ended September 30, 2020 compared to $1.04 billion for the three months ended September 30, 2019.
Average interest-earning assets increased $124.5 million, or 8.8%, to $1.54 billion for the nine months ended September 30, 2020 compared to $1.41 billion for the nine months ended September 30, 2019, and average interest bearing liabilities increased $39.2 million, or 3.6%, to $1.14 billion for the nine months ended September 30, 2020 compared to $1.10 billion for the nine months ended September 30, 2019.
Total interest income (expressed on a fully taxable equivalent basis) was $16.2 million and $48.1 million for the three and nine months ended September 30, 2020, respectively, compared to $16.1 million and $48.5 million for the three and nine months ended September 30, 2019, respectively. The Company’s rates earned on interest earning assets were 4.03% and 4.18% for the three and nine months ended September 30, 2020, respectively, compared to 4.68% and 4.59% for the three and nine months ended September 30, 2019, respectively.
Interest income on loans was $14.9 million and $44.0 million for the three and nine months ended September 30, 2020, respectively, compared to $14.9 million and $43.9 million for the three and nine months ended September 30, 2019, respectively.
Average loans outstanding increased $123.2 million, or 10.7%, to $1.27 billion for the three months ended September 30, 2020 compared to $1.15 billion for the three months ended September 30, 2019. The average yield on loans decreased to 4.66% for the three months ended September 30, 2020 compared to 5.13% for the three months ended September 30, 2019.
Average loans outstanding increased $80.3 million, or 7.0%, to $1.23 billion for the nine months ended September 30, 2020 compared to $1.15 billion for the nine months ended September 30, 2019. The average yield on loans decreased to 4.78% for the nine months ended September 30, 2020 compared to 5.10% for the nine months ended September 30, 2019. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.
Interest income on available-for-sale securities was $1.1 million and $3.2 million for the three and nine months ended September 30, 2020, respectively, compared to $1.0 million and $3.6 million for the three and nine months ended September 30, 2019, respectively.
Average securities increased $6.5 million, or 3.4%, to $195.5 million for the three months ended September 30, 2020 compared to $189.0 million for the three months ended September 30, 2019. The average yield on securities decreased to 2.15% for the three months ended September 30, 2020 compared to 2.17% for the three months ended September 30, 2019.
Average securities decreased $14.8 million, or 7.1%, to $192.3 million for the nine months ended September 30, 2020 compared to $207.1 million for the nine months ended September 30, 2019. The average yield on securities decreased to 2.20% for the nine months ended September 30, 2020 compared to 2.29% for the nine months ended September 30, 2019. See the Liquidity Management section for further discussion.
Total interest expense decreased to $2.1 million and $7.8 million for the three and nine months ended September 30, 2020, respectively, compared to $3.6 million and $11.9 million for the three and nine months ended September 30, 2019, respectively. The Company’s rates paid on interest bearing liabilities were 0.73% and 0.91% for the three and nine months
ended September 30, 2020, respectively, compared to 1.36% and 1.44% for the three and nine months ended September 30, 2019, respectively. See the Liquidity Management section for further discussion.
Interest expense on deposits decreased to $1.3 million and $4.7 million for the three and nine months ended September 30, 2020, respectively, compared to $2.3 million and $8.2 million for the three and nine months ended September 30, 2019, respectively.
Average interest bearing deposits increased $84.6 million, or 9.7%, to $954.9 million for the three months ended September 30, 2020 compared to $870.2 million for the three months ended September 30, 2019. The average cost of deposits decreased to 0.53% for the three months ended September 30, 2020 compared to 1.06% for the three months ended September 30, 2019. During the three months ended September 30, 2019, public funds decreased significantly resulting from the loss of a public fund account at renewal.
Average interest bearing deposits increased $1.3 million, or 0.13%, to $939.4 million for the nine months ended September 30, 2020 compared to $938.1 million for the nine months ended September 30, 2019. The average cost of deposits decreased to 0.67% for the nine months ended September 30, 2020 compared to 1.18% for the nine months ended September 30, 2019. Although offering rates remain low in response to lower market interest rates growth in deposits was positively impacted in part by customers who deposited PPP loan proceeds.
Interest expense on borrowings was $0.9 million and $3.1 million for the three and nine months ended September 30, 2020, respectively, compared to $1.2 million and $3.6 million for the three and nine months ended September 30, 2019, respectively.
Average borrowings increased to $202.9 million for the three months ended September 30, 2020 compared to $172.4 million for the three months ended September 30, 2019. The average cost of borrowings decreased to 1.68% for the three months ended September 30, 2020 compared to 2.86% for the three months ended September 30, 2019. The decrease in cost of funds primarily resulted from lower market interest rates.
Average borrowings increased to $204.2 million for the nine months ended September 30, 2020 compared to $166.2 million for the nine months ended September 30, 2019. The average cost of borrowings decreased to 2.01% for the nine months ended September 30, 2020 compared to 2.92% for the nine months ended September 30, 2019. The decrease in cost of funds primarily resulted from lower market interest rates.
The increase in average borrowings was primarily due to an increase in FHLB advances to fund liquidity needs as refinancing activity increased when rates dropped during the first quarter of 2020. This in turn was offset beginning in April of 2020 when the Company had an increase in liquidity due to participation in the CARES Act economic stimulus programs. The Company experienced significant deposit growth primarily due to stimulus checks, proceeds from PPP loan funding, deferral of income tax payments, and customers holding on to savings due to uncertain times. See the Liquidity Management section for further discussion.
51
Non-interest income and expense
Non-interest income for the periods indicated was as follows:
(137)
(14.4)
(520)
(19.3)
6.5
3.0
(108)
(29.1)
(4.2)
(226.3)
Gain on sales of mortgage loans, net
2,811
1,307.4
3,870
775.6
27.3
16.6
Non-interest income as a % of total revenue *
26.8
16.4
20.0
15.5
Total revenue is calculated as net interest income plus non-interest income.
Total non-interest income increased $2.7 million, or 109.4%, to $5.1 million for the quarter ended September 30, 2020 compared to $2.4 million for the quarter ended September 30, 2019, and increased $3.3 million, or 50.0%, to $10.0 million for the nine months ended September 30, 2020 compared to $6.6 million for the nine months ended September 30, 2019.
Service charges and fees decreased $137,000, or 14.4%, to $816,000 for the quarter ended September 30, 2020 compared to $953,000 for the quarter ended September 30, 2019, and decreased $520,000, or 19.3%, to $2.2 million for the nine months ended September 30, 2020 compared to $2.7 million for nine months ended September 30, 2019. The decrease in fees was primarily due to a decrease in nonsufficient fund service charges (NSF) resulting from both a decrease in volume, in addition to temporary fee waivers for customers related to the COVID-19 pandemic.
Real estate servicing fees, net of the change in valuation of mortgage servicing rights (MSRs) increased $18,000 to $54,000 for the quarter ended September 30, 2020 compared to $36,000 for the quarter ended September 30, 2019, and decreased $86,000 to $(48,000) for the nine months ended September 30, 2020 compared to $38,000 for the nine months ended September 30, 2019.
Mortgage loan servicing fees earned on loans sold were $215,000 and $638,000 for the three and nine months ended September 30, 2020, respectively, compared to $205,000 and $581,000 for the three and nine months ended September 30, 2019, respectively. The current quarter's MSR valuation decreased $21,000 from the prior linked quarter, and decreased $340,000 for the nine months ended September 30, 2020 primarily due to increased prepayment assumptions. The dramatic drop in market interest rates from December 31, 2019 to September 30, 2020, created an economic incentive for borrowers to refinance their existing home mortgage loans.
The Company was servicing $289.3 million of mortgage loans at September 30, 2020 compared to $271.4 million and $270.8 million at December 31, 2019 and September 30, 2019, respectively.
Gain on sales of mortgage loans increased $2.8 million to $3.0 million for the quarter ended September 30, 2020 compared to $215,000 for the quarter ended September 30, 2019, and increased $3.9 million to $4.4 million for the nine months ended September 30, 2020 compared to $499,000 for the nine months ended September 30, 2019. During the fourth quarter of 2019, the Company focused on creation and development of a new mortgage loan department and began offering new mortgage loan products in addition to Freddie and Fannie loans that are sold to the secondary market. The Company sold $73.5 million and $133.2 million of loans for the three and nine months ended September 30, 2020, respectively, compared to $13.3 million and $28.3 million for the three and nine months ended September 30, 2019, respectively.
Other Income increased $15,000, or 27.3%, to $70,000 for the quarter ended September 30, 2020 compared to $55,000 for the quarter ended September 30, 2019, and increased $26,000, or 16.6%, to $183,000 for the nine months ended compared to $157,000 for the nine months ended September 30, 2019. The increase in the periods presented was primarily due to increased brokerage income partially offset by a decrease in insurance commissions, rental income from other real estate owned, and income earned on bank owned life insurance policies due to one of the Company's polices being redeemed in the third quarter of 2019.
Investment securities gains (losses), net for the periods indicated were as follows:
Non-interest expense for the periods indicated was as follows:
Salaries
5,112
3,956
1,156
29.2
14,617
11,948
2,669
22.3
Employee benefits
17.7
515
12.1
(128)
(14.1)
(1.9)
8.0
0.3
Processing, network and bank card expense
(16)
(1.8)
(2.1)
20.6
207
(27)
(7.9)
(98)
(11.1)
25.4
1.7
Loan expense
203
152.6
22.1
424
54.5
656
25.2
Efficiency ratio*
61.4
64.9
66.7
68.1
Number of full-time equivalent employees
301
277
Efficiency ratio is calculated as non-interest expense as a percent of revenue. Total revenue includes net interest income and non-interest income.
Total non-interest expense increased $2.0 million, or 21.1%, to $11.6 million for the quarter ended September 30, 2020 compared to $9.6 million for the quarter ended September 30, 2019, and increased $4.0 million, or 13.6%, to $33.1 million for the nine months ended September 30, 2020 compared to $29.1 million for the nine months ended September 30, 2019.
Salaries increased $1.2 million, or 29.2%, to $5.1 million for the quarter ended September 30, 2020 compared to $4.0 million for the quarter ended September 30, 2019, and increased $2.7 million, or 22.3%, to $14.6 million for the nine months ended September 30, 2020 compared to $11.9 million for the nine months ended September 30, 2019. The increases were primarily due to adding 25 full-time equivalent (FTE) employees to expand the Company's new mortgage loan department that was formed in late 2019. In addition, annual merit increases average approximately 4.0% each year and are awarded in the first quarter of each year.
Employee benefits increased $249,000, or 17.7%, to $1.7 million for the quarter ended September 30, 2020 compared to $1.4 million for the quarter ended September 30, 2019 and increased $515,000, or 12.1%, to $4.8 million for the nine months ended September 30, 2020 compared to $4.3 million for the nine months ended September 30, 2019. The increases were primarily due to higher pension cost due to lower annual discount rate assumptions compared to the prior year's annual assumptions, an increase in payroll taxes due to the increase in FTE mentioned above, and an increase in 401(k) plan contributions.
Occupancy expense decreased $128,000, or 14.1%, to $781,000 for the quarter ended September 30, 2020 compared to $909,000 for the quarter ended September 30, 2019 and was consistent at $2.3 million for both the nine months ended September 30, 2020 and 2019, respectively. The net decrease for the quarter ended September 30, 2020 over the quarter ended September 30, 2019 primarily consisted of decreases in building repairs and maintenance, and utilities, partially offset by increases in building depreciation and building lease expense. During 2019 there were increases in building and parking lot repairs and maintenance. The increase in building lease expense was primarily related to the Company's new Columbia branch location that began in March of 2019.
The net decrease for the nine months ended September 30, 2020 over the nine months ended September 30, 2019 primarily consisted of a $67,000 net gain primarily related to the sale of land adjacent to one of the Company's branches compared to a net loss of $43,000 in the prior year recognized on the sale of equipment. This decrease was partially offset by increases in core maintenance agreements and depreciation.
Legal, examination, and professional fees increased $65,000, or 20.6%, to $381,000 for the quarter ended September 30, 2020 compared to $316,000 for the quarter ended September 30, 2019, and increased $207,000, or 21.8%, to $1.2 million for the nine months ended September 30, 2020 compared to $948,000 for the nine months ended September 30, 2019. These increases are primarily related to an increase in legal fees related to one pending lawsuit that is in its early stages, and consulting expenses.
Loan expense increased $203,000, or 152.6%, to $336,000 for the quarter ended September 30, 2020 compared to $133,000 for the quarter ended September 30, 2019, and increased $102,000, or 22.1, to $564,000 compared to $462,000 for the nine months ended September 30, 2019. The increases were primarily related to increases in real estate loan expenses related to the growth in loan volume, partially offset by real estate foreclosure (gain) expense. In the second quarter of 2020, the Company sold an out-of-service branch building being held as other real estate owned (OREO) to a non-profit organization. This transaction consisted of a $266,000 donation expense and the company realized a net gain of $210,000
Other non-interest expense increased $424,000, or 54.5%, to $1.2 million for the quarter ended September 30, 2020 compared to $778,000 for the quarter ended September 30, 2019, and increased $656,000, or 25.2, to $3.3 million compared to $2.6 million for the nine months ended September 30, 2019. The increases were primarily related to increases in donations, FDIC assessment expense, and credit card fraud charge-offs. In the second quarter of 2020, the Company sold an out-of-service branch building being held as other real estate owned (OREO) to a non-profit organization. This transaction consisted of a $266,000 donation expense and the company realized a net gain of $210,000. During the third quarter of 2020 the Company recognized approximately $150,000 of disputed credit card fraud losses from prior years.
Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 18.9% for the three months ended September 30, 2020 compared to 19.8% for the three months ended September 30, 2019,
and 18.4% for the nine months ended September 30, 2020 compared to 19.3% for the nine months ended September 30, 2019. The decrease in the effective tax rate for the three months ended September 30, 2020 compared to the three months ended September 30, 2019 was primarily attributable to the impact of tax-free revenues. The decrease in the effective tax rate for the nine months ended September 30, 2020 was primarily attributable to tax-free revenues having a greater impact on pre-tax income due to the reduced level of earnings.
Lending and Credit Management
Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 75.5% of total assets as of September 30, 2020 compared to 77.5% as of December 31, 2019.
Lending activities are conducted pursuant to an established loan policy approved by the Bank’s Board of Directors. The Bank’s credit review process is overseen by regional loan committees with established loan approval limits. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.
A summary of loans, by major class within the Company’s loan portfolio as of the dates indicated is as follows:
Percent of categories to total loans:
Commercial, financial, and agricultural
23.0
17.0
2.2
2.0
6.8
7.3
20.2
21.6
45.7
49.3
2.8
100.0
The Company extends credit to its local community markets through traditional real estate mortgage products. The Company does not participate in extending credit to sub-prime residential real estate markets. The Company does not lend funds for transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in nonaccrual, past due, or restructured loans if such assets were loans.
The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. During the nine months ended September 30, 2020, the Company sold approximately $133.2 million of loans to investors compared to $28.3 million for the nine months ended September 30, 2019. At September 30, 2020, the Company was servicing approximately $289.3 million of loans sold to the secondary market compared to $271.4 million at December 31, 2019, and $270.8 million at September 30, 2019.
Risk Elements of the Loan Portfolio
Management, the senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Loans in excess of $2.0 million in aggregate and all adversely classified credits identified by management are reviewed by the senior loan committee. In addition, all other loans are reviewed on a risk weighted selection process. The senior loan committee reviews and reports to the board of directors, on a monthly basis: past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided in the FASB's ASC Topic 310-10-35 in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered necessary by management to provide for probable losses inherent in the loan portfolio.
Non-performing Assets
The following table summarizes non-performing assets at the dates indicated:
Nonaccrual loans:
1,027
2,158
1,111
123
4,564
Loans contractually past - due 90 days or more and still accruing:
193
197
Total non-performing loans (a)
5,815
5,070
4,761
Other real estate owned and repossessed assets
Total non-performing assets
18,416
17,851
17,639
1,149,268
Allowance for loan losses to loans
1.39
Non-performing loans to loans (a)
0.45
0.43
0.41
Non-performing assets to loans (b)
1.53
Non-performing assets to assets (b)
1.10
1.20
1.22
Allowance for loan losses to non-performing loans
305.49
246.09
255.79
56
Total non-performing assets were $18.4 million, or 1.44% of total loans, at September 30, 2020 compared to $17.9 million, or 1.53% of total loans, at December 31, 2019, and $17.6 million, or 1.53% of total loans, at September 30, 2019, respectively.
Total non-accrual loans at September 30, 2020 increased $878,000 million, 18.5%, to $5.6 million compared to $4.8 million at December 31, 2019. The increase in non-accrual loans primarily consisted of increases in real estate mortgage commercial loans and real estate construction commercial loans. The increase in real estate mortgage commercial loans primarily related to two loan relationships and the increase in real estate construction commercial loans primarily related to one loan relationships.
Loans past due 90 days and still accruing interest at September 30, 2020, were $183,000 compared to $316,000 at December 31, 2019. Other real estate and repossessed assets were $12.6 million and $12.8 million at September 30, 2020 and December 31, 2019, respectively. During the nine months ended September 30, 2020, $73,000 of non-accrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $411,000 during the nine months ended September 30, 2019.
As of September 30, 2020, approximately $4.7 million compared to $9.0 million and $5.9 million at December 31, 2019 and September 30, 2019, respectively, of loans classified as substandard, which include performing TDRs, and are not included in the non-performing asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. Management believes the allowance for loan losses was sufficient to cover the risks and probable losses related to such loans at September 30, 2020 and December 31, 2019, respectively.
The following table summarizes the Company’s TDRs at the dates indicated:
contracts
Total performing TDRs
Non-performing TDRs
496
99
814
782
72
Total non-performing TDRs
1,118
1,616
223
Total TDRs
3,581
211
4,151
442
At September 30, 2020, loans classified as TDRs totaled $3.6 million, with $211,000 of specific reserves compared to $4.1 million of loans classified as TDRs, with $442,000 of specific reserves at December 31, 2019. Non-performing loans, included $1.1 million of loans classified as TDRs at September 30, 2020 compared to $1.6 million at December 31, 2019. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs if the loan is collateral dependent. The net decrease in total TDRs from December 31, 2019 to September 30, 2020 was primarily due to $687,000 of payments received on TDRs, partially offset by two new TDR totaling $125,000.
57
Allowance for Loan Losses and Provision
The following table is a summary of the allocation of the allowance for loan losses:
Allocation of allowance for loan losses at end of period:
Unallocated
The allowance for loan losses (ALL) was $17.8 million, or 1.39% of loans outstanding, at September 30, 2020 compared to $12.5 million, or 1.07%, at December 31, 2019, and $12.2 million, or 1.06% at September 30, 2019. The ratio of the allowance for loan losses to nonperforming loans was 305.49% at September 30, 2020, compared to 246.09% at December 31, 2019, and 255.79% at September 30, 2019.
The following table is a summary of the general and specific allocations of the allowance for loan losses:
Allocation of allowance for loan losses:
Individually evaluated for impairment - specific reserves
Collectively evaluated for impairment - general reserves
The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2020, $581,000 of the Company’s ALL was allocated to impaired loans totaling approximately $8.1 million compared to $615,000 of the Company’s ALL allocated to impaired loans totaling approximately $7.4 million at December 31, 2019. Management determined that $2.7 million, or 33%, of total impaired loans required no reserve allocation at September 30, 2020 compared to $2.6 million, or 35%, at December 31, 2019, primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.
The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying loss rates to pools of loans by asset type. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type. In the first quarter of 2019, management adjusted the look-back period to begin with loss history in the first quarter 2012 as the starting point through the current quarter and it will continue to include this starting point going forward. At that time, Management determined that with the extended economic recovery then existing, the look-back period should be expanded to include the current economic cycle. The look-back period will then be adjusted once a sustained loss producing downturn is recognized by allowing the look-back period to shift forward by eliminating the earliest loss period and replenishing it with losses from the most recent period. The look-back period is consistently evaluated for relevance given the current facts and circumstances.
These historical loss rates for each risk group are used as the starting point to determine loss rates for measurement purposes. The historical loan loss rates are multiplied by loss emergence periods (LEP) which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss.
The Company’s methodology includes qualitative risk factors that allow management to adjust its estimates of losses based on the most recent information available and to address other limitations in the quantitative component that is based on historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions and developments, the nature, volume and terms of loans in the portfolio, including changes in volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans, loan concentrations, assessment of trends in collateral values, assessment of changes in the quality of the Company’s internal loan review department, and changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices.
The specific and general reserve allocations represent management’s best estimate of probable losses inherent in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.
As a result of rapidly increasing unemployment rates resulting from the COVID-19 virus, management determined that the first quarter 2020 allowance for loan loss economic qualitative adjustment should be temporarily adapted to utilize currently published statistics rather than the lagging statistics that had been utilized historically. While these lagging indicators have been very reliable for some time, they did not accurately capture the risk that has been brought about by rapid changes in the economy due to the pandemic. Based upon the change in the national unemployment rate available as of March 31, 2020, the economic qualitative adjustment was increased according to the Company’s methodology to account for uncertainty in economic conditions compared to the lookback period. As of September 30, 2020, and based on the continuing high rates of national unemployment as compared to historic levels, management believes this temporary alteration will be a better indicator until the economy stabilizes and the true impact can be measured. In addition, as of September 30, 2020, management increased the lending staff and management qualitative adjustment to reflect changes which have occurred, both organizational and operational.
The more significant changes from December 31, 2019 to September 30, 2020 in the allocations of the allowance for loan losses to the loan portfolios listed above was primarily attributed to the additional economic qualitative factor adjustment resulting from the COVID-19 pandemic.
Additionally, the funding of $88.4 million in PPP loans during the second and third quarter required management to assess the methodology that would be adopted in regard to the allowance for loan loss applicable to these loans. As the SBA PPP loans are expected to begin paying off in the next six to twelve months and carry a 100% credit guarantee from the SBA, management determined that no allowance for loan loss was deemed necessary for these loans.
Provision
A $1.2 million and $5.4 million provision for loan losses was required for the three and nine months ended September 30, 2020, respectively, compared to a $450,000 and $850,000 provision for the three and nine months ended September 30, 2019, respectively. An additional $800,000 and $4.4 million provision was recorded during the three and nine months ended September 30, 2020, respectively, due to current economic conditions resulting from the COVID-19 pandemic.
59
The following table summarizes loan loss experience for the periods indicated:
Analysis of allowance for loan losses:
Balance beginning of period
Charge-offs:
Total charge-offs
Recoveries:
Total recoveries
239
Net charge-offs
Balance end of period
Net Loan Charge-offs
The Company’s net charge-offs were $58,000 for the three months ended September 30, 2020 compared to net charge-offs of $155,000 for the three months ended September 30, 2019, and net charge-offs were $113,000, for the nine months ended September 30, 2020 compared to $324,000 for the nine months ended September 30, 2019.
The decrease in net charge-offs for the three months ended September 30, 2020 compared to the three months ended September 30, 2019 was primarily related to a decrease in commercial, financial, and agricultural, real estate mortgage – residential charge-offs, and installment loans to individuals. The net decrease in the Company's net charge-offs for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019 was primarily due to a decrease in commercial, financial, and agricultural, and real estate mortgage – residential loan charge-offs. The Company recovered commercial deposit fraud charge-offs through the Company's insurance captive during the second quarter of 2020, two real estate construction – residential recoveries, and one real estate mortgage – residential recovery obtained in a settlement. This is compared to one large commercial loan relationship recovery and one real estate mortgage – residential recovery received during the first quarter of 2019.
The Company designates certain long-term fixed rate personal real estate loans as held for sale, and the Company carries them at the lower of cost or fair value. The loans are primarily sold to Freddie Mac, Fannie Mae, and PennyMac and other various secondary market investors. At September 30, 2020, the carrying amount of these loans was $7.9 million compared to $428,000 at December 31, 2019. A contributing factor for the increase in balance of loans held for sale at September 30, 2020 was due to the significant increase in real estate mortgage originations, as compared to the capability of the relatively recently formed mortgage lending department to sell the mortgages to investors (as more fully described in the following paragraph.)
In the fourth quarter of 2019 the Company expanded its current home loan program to better serve our customers. This expansion began with hiring new mortgage lending personnel and expanding the bank’s available loan products and upgrading the Company's operating systems. New home loan programs for its customers include VA loans, designed for military families and veterans; USDA loans for those buying homes in rural communities; and FHA loans, which offer low down payments and flexible underwriting guidelines. In addition, we have added several secondary market investors, allowing us to sell loans on the secondary market versus servicing them at the Company. This provides us with the ability to offer clients more aggressive pricing and at the same time improve the Company's financial return.
Liquidity and Capital Resources
Liquidity Management
The role of liquidity management is to ensure funds are available to meet depositors’ withdrawal and borrowers’ credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by the Company, management prefers to focus on transaction accounts and full service relationships with customers as the primary sources of funding.
The Company’s Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for the Company’s liquidity position and profile. A combination of daily, weekly, and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital, and exposure to contingent draws on the Company’s liquidity.
The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company’s most liquid assets are comprised of available-for-sale investment securities, not including other debt securities, federal funds sold, and excess reserves held at the Federal Reserve.
Federal funds sold and other overnight interest-bearing deposits
Available-for-sale investment securities
308,647
241,500
Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was $186.7 million at September 30, 2020 and included an unrealized net gain of $4.1 million. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $10.4 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company’s deposit base.
The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. At September 30, 2020 and December 31, 2019, the Company’s unpledged securities in the available for sale portfolio totaled approximately $22.3 million and $35.3 million, respectively.
Total investment securities pledged for these purposes were as follows:
Investment securities pledged for the purpose of securing:
Federal Reserve Bank borrowings
9,327
9,385
52,704
38,238
Other deposits
102,351
92,189
Total pledged, at fair value
164,382
139,812
Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than $250,000, less all brokered deposits under $250,000. At September 30, 2020, such deposits totaled $1.2 billion and represented 89.2% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships.
Core deposits at September 30, 2020 and December 31, 2019 were as follows:
Core deposit base:
237,669
227,662
Savings and money market
387,508
346,593
185,559
197,089
1,183,091
1,032,510
Time deposits and certificates of deposit of $250,000 and greater at September 30, 2020 and December 31, 2019 were $100.0 million and $104.3 million, respectively. The Company had brokered deposits totaling $40.2 million and $45.2 million at September 30, 2020 and December 31, 2019, respectively.
Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company’s outside borrowings are comprised of securities sold under agreements to repurchase, Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of September 30, 2020, under agreements with these unaffiliated banks, the Bank may borrow up to $50.0 million in federal funds on an unsecured basis and $16.0 million on a secured basis. There were no federal funds purchased outstanding at September 30, 2020. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At September 30, 2020, there were $35.4 million in repurchase agreements. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window, although no such borrowings were outstanding at September 30, 2020.
The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB) and has access to credit products of the FHLB. As of September 30, 2020, the Bank had $112.7 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.
Borrowings outstanding at September 30, 2020 and December 31, 2019 were as follows:
Borrowings:
Federal Home Loan Bank advances
112,719
96,895
Other borrowings
197,634
173,677
The Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, the FHLB establishes a collateral value from which the Company may draw advances against this collateral. This collateral is also used to enable the FHLB to issue letters of credit in favor of public fund depositors of the Company. The Federal Reserve Bank also establishes a collateral value of assets pledged to support borrowings from the discount window. The following table reflects collateral value of assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to the Company as follows:
Federal
Funds
Purchased
FHLB
Reserve Bank
Lines
Advance equivalent
295,616
9,100
56,869
361,585
284,813
56,839
350,842
Letters of credit
(71,500)
(115,000)
Advances outstanding
(112,719)
(96,895)
Total available
111,397
177,366
72,918
138,947
At September 30, 2020, loans of $578.5 million were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At September 30, 2020, investments totaling $18.3 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.
Based upon the above, management believes the Company has more than adequate liquidity, both on balance sheet and through the additional funding capacity with the FHLB, the Federal Reserve Bank and Federal funds purchased lines to meet future anticipated needs; this includes the impact of the COVID-19 pandemic that is difficult to currently measure. Management believes the most significant impact to the Company’s liquidity position in the short-term may be related to the PPP as loans are expected to be forgiven and depositors may choose to redirect their funds. The longer-term impact on the Company's liquidity from the pandemic will be closely monitored and addressed as needs arise.
The Company also has available additional liquidity having pledged the PPP loans to the FHLB as collateral for available advances.
Sources and Uses of Funds
Cash and cash equivalents were $129.4 million at September 30, 2020 compared to $78.1 million at December 31, 2019. The $51.3 million increase resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the nine months ended September 30, 2020. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $9.9 million for the nine months ended September 30, 2020.
Investing activities consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio used total cash of $119.6 million. The cash outflow primarily consisted of $110.6 million increase
in loans and $72.1 million purchase of investment securities, partially offset by $63.5 million from maturities, calls, and sales of investment securities. The increase in loans was primarily a result of $85.6 million (net of PPP deferred fees) increase in commercial loans due to customers who participated in the PPP.
Financing activities provided cash of $161.0 million, resulting primarily from a $111.2 million increase in demand deposits, a $51.0 million increase in interest-bearing transaction accounts, and a $15.8 million increase in net FHLB advances. The growth in deposits was positively impacted by customers who deposited PPP loan proceeds into demand accounts. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2020.
In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company’s liquidity. The Company had $426.3 million in unused loan commitments and standby letters of credit as of September 30, 2020. Although the Company’s current liquidity resources are adequate to fund this commitment level the nature of these commitments is such that the likelihood of such a funding demand is very low.
The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company’s ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its shareholders. The Company paid cash dividends to its shareholders totaling approximately $2.3 million and $1.9 million for the nine months ended September 30, 2020 and 2019, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $2.5 million and $5.5 million in dividends to the Company during the nine months ended September 30, 2020 and 2019, respectively. At September 30, 2020 and December 31, 2019, the Company had cash and cash equivalents totaling $1.5 million and $2.6 million, respectively.
Capital Management
The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of the Company and the Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.
In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for the Company began on January 1, 2015. The Federal Reserve System’s (FRB) capital adequacy guidelines require that bank holding companies maintain a Common Equity Tier 1 risk-based capital ratio equal to at least 4.5% of its risk-weighted assets, a Tier 1 risk-based capital ratio equal to at least 6% of its risk-weighted assets and a total risk-based capital ratio equal to at least 8% of its risk-weighted assets. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 4%.
In addition, the final rules establish a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer requirement began being phased in over four years beginning in 2016. On January 1, 2016, the first phase of the requirement went into effect at 0.625% of risk-weighted assets, and increased each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of risk weighted assets on January 1, 2019. At December 31, 2019, the capital conservation buffer of 2.5%, effectively raised the minimum required risk-based capital ratios to 7% Common Equity Tier 1 Capital, 8.5% Tier 1 Capital and 10.5% Total Capital on a fully phased-in basis.
Under the Basel III requirements, at September 30, 2020 and December 31, 2019, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of periods indicated:
Minimum Capital
Required to be
Required - Basel III
Considered Well-
Actual
Fully Phased-In
Capitalized
Amount
Ratio
Total Capital (to risk-weighted assets):
Company
188,390
131,393
10.50
N.A
Bank
186,837
14.97
131,006
124,768
10.00
Tier 1 Capital (to risk-weighted assets):
166,176
106,365
8.50
171,213
106,052
99,814
8.00
Common Equity Tier 1 Capital (to risk-weighted assets):
124,720
87,595
7.00
87,337
81,099
6.50
Tier 1 leverage ratio (to adjusted average assets):
66,525
4.00
10.34
66,231
82,788
5.00
179,430
14.89
126,511
175,459
14.60
126,165
120,158
157,139
13.04
102,414
162,822
13.55
102,134
96,126
Common Equity Tier 1 Capital (to risk-weighted assets)
118,793
9.86
84,341
84,110
78,102
Tier 1 leverage ratio:
10.73
58,562
11.18
58,280
72,850
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Asset/Liability and Interest Rate Risk
Management and the Board of Directors are responsible for managing interest rate risk and employing risk management policies that monitor and limit this exposure. Interest rate risk is measured using net interest income simulations and market value of portfolio equity analyses. These analyses use various assumptions, including the nature and timing of interest rate changes, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment/replacement of asset and liability cash flows.
The principal objective of the Company’s asset and liability management function is to evaluate the interest rate risk within the balance sheet and pursue a controlled assumption of interest rate risk while maximizing earnings and preserving adequate levels of liquidity and capital. The asset and liability management function is under the guidance of the Asset Liability Committee from direction of the Board of Directors. The Asset Liability Committee meets monthly to review, among other things, the sensitivity of the Company’s assets and liabilities to interest rate changes, local and national market
conditions and rates. The Asset Liability Committee also reviews the liquidity, capital, deposit mix, loan mix and investment positions of the Company.
Instantaneous parallel rate shift scenarios are modeled and utilized to evaluate risk and establish exposure limits for acceptable changes in net interest margin. These scenarios, known as rate shocks, simulate an instantaneous change in interest rates and use various assumptions, including, but not limited to, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment and replacement of asset and liability cash flows.
Management analyzes the economic value of equity as a secondary measure of interest rate risk. This is a complementary measure to net interest income where the calculated value is the result of the market value of assets less the market value of liabilities. The economic value of equity is a longer term view of interest rate risk because it measures the present value of the future cash flows. The impact of changes in interest rates on this calculation is analyzed for the risk to our future earnings and is used in conjunction with the analyses on net interest income.
The table below illustrates the impact of an immediate and sustained 200 and 100 basis point increase and a 200 and 100 basis point decrease in interest rates on net interest income based on the interest rate risk model at September 30, 2020 and December 31, 2019.
% Change in projected net interest income
Hypothetical shift in interest rates
(bps)
200
1.16
0.78
1.61
(100)
0.71
(200)
0.55
(0.51)
The change in our interest rate risk exposure from December 31, 2019 to September 30, 2020 was primarily due to the significant decrease in market rates over this time period that has caused offering rates for interest-bearing liabilities to decrease more than offering rates for earning assets. In addition, the increase in fed funds sold and PPP loan program have caused an overall shortening of the balance sheet, creating a larger asset sensitive position in a rising rate environment. These factors have caused the Company’s balance sheet to become more asset sensitive in the next 12 months, where interest rate increases translate into higher net interest income. Management believes the change in projected net interest income from interest rate shifts of up 200 bps and down 200 bps is an acceptable level of interest rate risk.
Many assumptions are used to calculate the impact of interest rate fluctuations. Actual results may be significantly different than our projections due to several factors, including the timing and frequency of rate changes, market conditions and the shape of the yield curve. The computations of interest rate risk shown above do not include actions that management may undertake to manage the risks in response to anticipated changes in interest rates and actual results may also differ due to any actions taken in response to the changing rates.
Effects of Inflation
The effects of inflation on financial institutions are different from the effects on other commercial enterprises since financial institutions make few significant capital or inventory expenditures, which are directly affected by changing prices. Because bank assets and liabilities are virtually all monetary in nature, inflation does not affect a financial institution as much as do changes in interest rates. The general level of inflation does underlie the general level of most interest rates, but interest rates do not increase at the rate of inflation as do prices of goods and services. Rather, interest rates react more to changes in the expected rate of inflation and to changes in monetary and fiscal policy.
Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate capital to asset ratio. In the opinion of management, inflation did not have a significant effect on the Company’s operations for the three months ended September 30, 2020.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934, as amended) are designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and to ensure that information required to be disclosed is accumulated and communicated to management, including our principal executive and financial officers, to allow timely decisions regarding disclosure. The Chief Executive Officer (CEO) and the Chief Financial Officer (CFO), with assistance from other members of management, have reviewed the effectiveness of our disclosure controls and procedures as of November 5, 2020 and, based on their evaluation, have concluded the disclosure controls and procedures were not effective as of that date due to a material weakness in internal control over financial reporting that was disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019.
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) of the Exchange Act) that occurred during the three months ending September 30, 2020 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Remediation
As previously described in Part II, Item 9A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, we began implementing a remediation plan to address the material weakness mentioned above. The material weakness will not be considered remediated, until the applicable controls operate for a sufficient period of time and management has concluded, through testing, that these controls are operating effectively. We expect that the remediation of this material weakness will be completed prior to the end of fiscal 2020.
Impact of New Accounting Standards
Pension In August 2018, the FASB issued ASU 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans -General (Subtopic 715-20) Disclosure Framework – Changes to the Disclosure Requirements for Defined Benefit Plans. These amendments modify the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. ASU 2018-14 is effective for annual reporting periods beginning after December 15, 2020 and is not expected to have a significant impact on the Company’s consolidated financial statements.
Financial Instruments In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (CECL). The revised accounting guidance will remove all recognition thresholds and will require a company to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the company expects to collect over the instrument's contractual life. It also amends the credit loss measurement guidance for available-for-sale debt securities and beneficial interests in securitized financial assets. This new accounting guidance will be effective for interim and annual reporting periods beginning after December 15, 2022. While the Company generally expects to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, the Company has not determined the magnitude of any such one-time adjustment or the overall impact of the new guidance on the Company's consolidated financial statements. The Company has formed a committee and is continuing to evaluate the impact of the ASU's adoption on the Company's consolidated financial statements by assessing different credit risk models. As a result of the FASB issuing a delay in the implementation of this ASU, the Company will extend its evaluation process over the new implementation deadline of January 1, 2023.
Rate Reform In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848) - Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The amendments in this update provide 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. It provides optional expedients and exceptions for applying generally accepted accounting
67
principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. The amendments in this update are effective for all entities as of March 12, 2020 through December 31, 2022. The Company is currently evaluating the impact of the reference rate reform on the Company’s consolidated financial statements.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The information required by this Item is set forth in Commitments and Contingencies, Pending Litigation, in our Company’s Notes to Consolidated Financial Statements (unaudited).
Item 1A. Risk Factors
In addition to the risk factors set forth under Part I, Item 1A “Risk Factors” in the Company’s Form 10-K for the fiscal year ended December 31, 2019, the following risk factor applies to the Company.
The outbreak of Coronavirus Disease 2019 (“COVID-19”) has adversely impacted, or an outbreak of other highly infectious or contagious diseases could adversely impact certain industries in which the Company’s customers operate and impair their ability to fulfill their obligations to the Company. Further, the spread of the outbreak could lead to an economic recession or other severe disruptions in the U.S. economy and may disrupt banking and other financial activity in the areas in which the Company operates and could potentially create widespread business continuity issues for the Company.
The spread of highly infectious or contagious diseases could cause, and the spread of COVID-19 has caused, severe disruptions in the U.S. economy at large, and for small businesses in particular, which could disrupt the Company’s operations. We are starting to see the impact from COVID-19 on our business, and we believe that it will be significant, adverse and potentially material. Currently, COVID-19 is spreading through the United States and the world. The resulting concerns on the part of the U.S. and global population have created the threat of a recession, reduced economic activity and a significant correction in the global stock markets. We expect that we will experience significant disruption across our business due to these effects, leading to decreased earnings, significant slowdowns in our loan collections and loan defaults.
COVID-19 may impact businesses’ and consumers’ desire and willingness to borrow money, which would negatively impact loan volumes. In addition, certain of our borrowers are in or have exposure to the hospitality, restaurant, gaming, and long-term health care industries and/or are located in areas that are quarantined or under stay-at-home orders, and COVID-19 may also have an adverse effect on our commercial real estate, and consumer loan portfolios. A prolonged quarantine or stay-at-home order would have an adverse impact on these borrowers and their revenue streams, which consequently impacts their ability to meet their financial obligations and could result in loan defaults.
The outbreak of COVID-19 or an outbreak of other highly infectious or contagious diseases may result in a decrease in our customers’ businesses, a decrease in consumer confidence and business generally, an increase in unemployment or a disruption in the services provided by the Company’s vendors. Disruptions to our customers could result in increased risk of delinquencies, defaults, foreclosures and losses on our loans, declines in assets under management and wealth management revenues, negatively impact regional economic conditions, result in declines in local loan demand, liquidity of loan guarantors, loan collateral (particularly in real estate), loan originations and deposit availability and negatively impact the implementation of our growth strategy.
The Company relies upon its third-party vendors to conduct business and to process, record, and monitor transactions. If any of these vendors are unable to continue to provide the Company with these services, it could negatively impact the Company’s ability to serve its customers. Furthermore, the outbreak could negatively impact the ability of the Company’s employees and customers to engage in banking and other financial transactions in the geographic areas in which the Company operates and could create widespread business continuity issues for the Company. The Company also could be
adversely affected if key personnel or a significant number of employees were to become unavailable due to the effects and restrictions of a COVID-19 outbreak in our market areas. Although the Company has business continuity plans and other safeguards in place, there is no assurance that such plans and safeguards will be effective.
Management believes that the economic impact from COVID-19 will be severe and could have a material and adverse impact on our business and that it could result in significant losses in our loan portfolio, all of which would adversely and materially impact our earnings and capital.
Item 2.Unregistered Sales of Equity Securities and Use of Proceeds
The following table summarizes the purchases made by or on behalf of the Company or certain affiliated purchasers of shares of the Company's common stock during the three months ended September 30, 2020:
(d) Maximum Number (or
(c) Total Number of
Approximate Dollar
Shares (or Units)
Value) of Shares (or
(a) Total Number of
(b) Average Price
Purchased as Part of
Units) that May Yet Be
Paid per Share (or
Publicly Announced Plans
Purchased Under the
Period
Unit)
or Programs
Plans or Programs *
2,500,000
July 1-31, 2020
August 1-31, 2020
1,223
18.23
2,477,706
September 1-30, 2020
4,317
17.38
2,402,688
5,540
17.57
* In the third quarter of 2020, the Company’s Board of Directors authorized the purchase of up to $2.5 million market value of the Company’s common stock. Management was given discretion to determine the number and pricing of the shares to be purchased, as well as, the timing of any such purchases. As of September 30, 2020, $2.4 million remained for share repurchase pursuant to that authorization.
Item 3.
Defaults Upon Senior Securities
None
Item 4.
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
Exhibit No.
Description
3.1
Restated Articles of Incorporation of the Company (filed as Exhibit 3.1 to the Company’s current report on Form 8-K on August 9, 2007 and incorporated herein by reference).
3.2
Amended and Restated Bylaws of the Company (filed as Exhibit 3.1 to the Company’s current report on Form 8-K on June 8, 2009 and incorporated herein by reference).
4.1
Specimen certificate representing shares of the Company’s $1.00 par value Common Stock (filed as Exhibit 4.1 to the Company’s current report on Form 8-K/A on June 23, 2017 and incorporated herein by reference).
31.1
Certificate of the Chief Executive Officer of the Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certificate of the Chief Financial Officer of the Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certificate of the Chief Executive Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certificate of the Chief Financial Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS
Inline XBRL Instance Document (the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document).
101.SCH
Inline XBRL Taxonomy Extension Schema Document.
101.CAL
Inline XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF
Inline XBRL Taxonomy Extension Definition Linkbase Document.
101.LAB
Inline XBRL Taxonomy Extension Label Linkbase Document.
101.PRE
Inline XBRL Taxonomy Extension Presentation Linkbase Document.
Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101).
INDEX TO EXHIBITS
September 30, 2020 Form 10-Q
ExhibitNo.
Restated Articles of Incorporation of our Company (filed as Exhibit 3.1 to the Company’s current report on Form 8-K on August 9, 2007 and incorporated herein by reference).
Certificate of the Chief Executive Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *
Certificate of the Chief Financial Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *
This information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933, as amended, and Section 18 of the Securities Exchange Act of 1934, as amended.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date
/s/ David T. Turner
November 5, 2020
David T. Turner, Chairman of the Board and
Chief Executive Officer (Principal Executive Officer)
/s/ Stephen E. Guthrie
Stephen E. Guthrie, Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)