UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
Commission file number 001-33013
FLUSHING FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
(State or other jurisdiction of incorporation or organization)
11-3209278
(I.R.S. Employer Identification No.)
220 RXR Plaza, Uniondale, New York 11556
(Address of principal executive offices)
(718) 961-5400
(Registrant's telephone number, including area code)
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. X 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).X Yes No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer X
Non-accelerated filer __
Emerging growth company __
Accelerated filer __
Smaller reporting 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 Act). ___Yes X No
The number of shares of the registrant’s Common Stock outstanding as of October 31, 2018 was 28,001,422.
TABLE OF CONTENTS
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PART I – FINANCIAL INFORMATION
FLUSHING FINANCIAL CORPORATION and SUBSIDIARIES
Consolidated Statements of Financial Condition
(Unaudited)
Item 1. Financial Statements
The accompanying notes are an integral part of these consolidated financial statements.
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Consolidated Statements of Income
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Consolidated Statements of Comprehensive Income
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Consolidated Statements of Cash Flows
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Consolidated Statements of Changes in Stockholders’ Equity
For the nine months ended September 30, 2018 and 2017
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Notes to Consolidated Financial Statements
The primary business of Flushing Financial Corporation (the “Holding Company”), a Delaware corporation, is the operation of its wholly owned subsidiary, Flushing Bank (the “Bank”).
The unaudited consolidated financial statements presented in this Quarterly Report on Form 10-Q (“Quarterly Report”) include the collective results of the Holding Company and its direct and indirect wholly-owned subsidiaries, including the Bank, Flushing Preferred Funding Corporation, Flushing Service Corporation, and FSB Properties Inc., which are collectively herein referred to as “we,” “us,” “our” and the “Company.”
The Holding Company also owns Flushing Financial Capital Trust II, Flushing Financial Capital Trust III, and Flushing Financial Capital Trust IV (the “Trusts”), which are special purpose business trusts. The Trusts are not included in the Company’s consolidated financial statements, as the Company would not absorb the losses of the Trusts if any losses were to occur.
The accompanying unaudited consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and general practices within the banking industry. The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such presented periods of the Company. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Quarterly Report. All inter-company balances and transactions have been eliminated in consolidation. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for the full year.
The accompanying unaudited consolidated financial statements have been prepared in conformity with the instructions to Quarterly Report on Form 10-Q and Article 10, Rule 10-01 of Regulation S-X for interim financial statements. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The unaudited consolidated interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
When necessary, certain reclassifications were made to prior-year amounts to conform to the current-year presentation.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements, and reported amounts of revenue and expenses during the reporting period. Estimates that are particularly susceptible to change in the near term are used in connection with the determination of the allowance for loan losses (“ALLL”), the evaluation of goodwill for impairment, the review of the need for a valuation allowance of the Company’s deferred tax assets, the fair value of financial instruments and the evaluation of other-than-temporary impairment (“OTTI”) on securities. Actual results could differ from these estimates.
Earnings per common share have been computed based on the following:
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The Company did not hold any trading securities at September 30, 2018 and December 31, 2017. Securities available for sale are recorded at fair value. Securities held-to-maturity are recorded at amortized cost.
The following table summarizes the Company’s portfolio of securities held-to-maturity at September 30, 2018:
The following table summarizes the Company’s portfolio of securities held-to-maturity at December 31, 2017:
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The following table summarizes the Company’s portfolio of securities available for sale at September 30, 2018:
The following table summarizes the Company’s portfolio of securities available for sale at December 31, 2017:
Mortgage-backed securities shown in the table above include one private issue collateralized mortgage obligation (“CMO”) that is collateralized by commercial real estate mortgages with an amortized cost and market value of $21,000 at December 31, 2017. We did not hold any private issue CMO’s that are collateralized by commercial real estate mortgages at September 30, 2018.
The corporate securities held by the Company at September 30, 2018 and December 31, 2017 are issued by U.S. banking institutions.
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The following tables detail the amortized cost and fair value of the Company’s securities classified as held-to-maturity and available for sale at September 30, 2018, by contractual maturity. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
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The following tables show the Company’s securities with gross unrealized losses and their fair value, aggregated by category and length of time that individual securities have been in a continuous unrealized loss position, at the dates indicated:
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OTTI losses on impaired securities must be fully recognized in earnings if an investor has the intent to sell the debt security or if it is more likely than not that the investor will be required to sell the debt security before recovery of its amortized cost. However, even if an investor does not expect to sell a debt security in an unrealized loss position, the investor must evaluate the expected cash flows to be received and determine if a credit loss has occurred. In the event that a credit loss has occurred, only the amount of impairment associated with the credit loss is recognized in earnings in the Consolidated Statements of Income. Amounts relating to factors other than credit losses are recorded in accumulated other comprehensive loss (“AOCL”) within Stockholders’ Equity. Unrealized losses on available for sale securities, that are deemed to be temporary, are recorded in AOCL, net of tax.
The Company reviewed each investment that had an unrealized loss at September 30, 2018 and December 31, 2017. The unrealized losses in held-to-maturity municipal securities at September 30, 2018 and December 31, 2017 were caused by illiquidity in the market and movements in interest rates. The unrealized losses in held-to-maturity FNMA securities at September 30, 2018 and December 31, 2017 were caused by movements in interest rates. The unrealized losses in securities available for sale at September 30, 2018 and December 31, 2017 were caused by movements in interest rates.
It is not anticipated that these securities would be settled at a price that is less than the amortized cost of the Company’s investment. Each of these securities is performing according to its terms and, in the opinion of management, will continue to perform according to its terms. The Company does not have the intent to sell these securities and it is more likely than not the Company will not be required to sell the securities before recovery of the securities’ amortized cost basis. This conclusion is based upon considering the Company’s cash and working capital requirements and contractual and regulatory obligations, none of which the Company believes would cause the sale of the securities. Therefore, the Company did not consider these investments to be other-than-temporarily impaired at September 30, 2018 and December 31, 2017.
Realized gains and losses on the sales of securities are determined using the specific identification method. The Company did not sell any securities during the three and nine months ended September 30, 2018. The Company sold available for sale securities totaling $112.4 million during the three and nine months ended September 30, 2017.
The following table represents the gross gains and gross losses realized from the sale of securities available for sale for the periods indicated:
Loans are reported at their outstanding principal balance net of any unearned income, charge-offs, deferred loan fees and costs on originated loans and unamortized premiums or discounts on purchased loans. Loan fees and certain loan origination costs are deferred. Net loan origination costs and premiums or discounts on loans purchased are amortized into interest income over the contractual life of the loans using the level-yield method. Prepayment penalties received on loans which pay in full prior to their scheduled maturity are included in interest income in the period they are collected.
Interest on loans is recognized on the accrual basis. The accrual of income on loans is generally discontinued when certain factors, such as contractual delinquency of 90 days or more, indicate reasonable doubt as to the timely collectability of such income. Uncollected interest previously recognized on non-accrual loans is reversed from interest income at the time the loan is placed on non-accrual status. A non-accrual loan can be returned to accrual status when contractual delinquency returns to less than 90 days delinquent. Payments received on non-accrual loans that do not bring the loan to less than 90 days delinquent are recorded on a cash basis. Payments can also be applied first as a reduction of principal until all principal is recovered and then subsequently to interest, if in management’s opinion, it is evident that recovery of all principal due is likely to occur.
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The Company recognizes a loan as non-performing when the borrower has demonstrated the inability to bring the loan current, or due to other circumstances which, in management’s opinion, indicate the borrower will be unable to bring the loan current within a reasonable time. All loans classified as non-performing, which includes all loans past due 90 days or more, are classified as non-accrual unless there is, in our opinion, compelling evidence the borrower will bring the loan current in the immediate future. Prior to a loan becoming 90 days delinquent, an updated appraisal is ordered and/or an internal evaluation is prepared.
A loan is considered impaired when, based upon current information, the Company believes it is probable that it will be unable to collect all amounts due, both principal and interest, in accordance with the original terms of the loan. Impaired loans are measured based on the present value of the expected future cash flows discounted at the loan’s effective interest rate or at the loan’s observable market price or, as a practical expedient, the fair value of the collateral if the loan is collateral dependent. All non-accrual loans are considered impaired.
The Company maintains an allowance for loan losses at an amount, which, in management’s judgment, is adequate to absorb probable estimated losses inherent in the loan portfolio. Management’s judgment in determining the adequacy of the allowance is based on evaluations of the collectability of loans. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revisions as more information becomes available. An unallocated component may at times be maintained to cover uncertainties that could affect management's estimate of probable losses. When necessary an unallocated component of the allowance will reflect the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. The allowance is established through charges to earnings in the form of a provision for loan losses based on management’s evaluation of the risk inherent in the various components of the loan portfolio and other factors, including historical loan loss experience (which is updated quarterly), current economic conditions, delinquency and non-accrual trends, classified loan levels, risk in the portfolio and volumes and trends in loan types, recent trends in charge-offs, changes in underwriting standards, experience, ability and depth of the Company’s lenders, collection policies and experience, internal loan review function and other external factors. Increases and decreases in the allowance other than charge-offs and recoveries are included in the provision for loan losses. When a loan or a portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance, and subsequent recoveries, if any, are credited to the allowance.
The determination of the amount of the allowance for loan losses includes estimates that are susceptible to significant changes due to changes in appraisal values of collateral, national and local economic conditions and other factors. We review our loan portfolio by separate categories with similar risk and collateral characteristics. Impaired loans are segregated and reviewed separately.
The Company reviews each impaired loan on an individual basis to determine if either a charge-off or a valuation allowance needs to be allocated to the loan. The Company does not charge-off or allocate a valuation allowance to loans for which management has concluded the current value of the underlying collateral will allow for recovery of the loan balance through the sale of the loan or by foreclosure and sale of the property.
The Company considers fair value of collateral dependent loans to be 85% of the appraised or internally estimated value of the property. The 85% is based on the actual net proceeds the Bank has received from the sale of other real estate owned (“OREO”) as a percentage of OREO’s appraised value. For collateral dependent taxi medallion loans, the Company considers fair value to be the value of the underlying medallion based upon the most recently reported arm’s length sales transaction. When there is no recent sale activity, the fair value is calculated using capitalization rates. For both collateral dependent mortgage loans and taxi medallion loans, the amount by which the loan’s book value exceeds fair value is charged-off.
Prior to the quarter ended September 30, 2018, we have segregated our loans into two portfolios based on year of origination. One portfolio was reviewed for loans originated after December 31, 2009 and a second portfolio for loans originated prior to January 1, 2010. Our decision to segregate the portfolio based upon origination dates was based on changes made in our underwriting standards during 2009. For the September 30, 2018 ALLL calculation, the decision was made to no longer segregate the loans by origination year and collapse the two portfolios. Management concluded this revision was appropriate due to the loan balance of loans originated before January 1, 2010 represents approximately 11% of the total loan portfolio and these loans are seasoned, therefore most losses in the pre January 1, 2010 originations have already been identified and incurred. Additionally, in connection with this change in methodology we also combined the economic factors used to calculate the qualitative component of the ALLL. The combined impact of these changes in methodology reduced the ALLL by approximately $0.2 million from what would have been recorded if we did not change our methodology. The Loss Emergence Period (“LEP”) used was 1.33 years for the Residential portfolio and 1.58 years for the Commercial portfolio. The Company’s Board of Directors reviews and approves management’s evaluation of the adequacy of the allowance for loan losses on a quarterly basis.
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The Company evaluates the underlying collateral through a third party appraisal, or when a third party appraisal is not available, the Company will use an internal evaluation. The internal evaluations are prepared using an income approach or a sales approach. The income approach is used for income producing properties and uses current revenues less operating expenses to determine the net cash flow of the property. Once the net cash flow is determined, the value of the property is calculated using an appropriate capitalization rate for the property. The sales approach uses comparable sales prices in the market. When an internal evaluation is used, we place greater reliance on the income approach to value the collateral.
The Company may restructure a loan to enable a borrower experiencing financial difficulties to continue making payments when it is deemed to be in the Company’s best long-term interest. This restructure may include reducing the interest rate or amount of the monthly payment for a specified period of time, after which the interest rate and repayment terms revert to the original terms of the loan. We classify these loans as Troubled Debt Restructured (“TDR”).
These restructurings have not included a reduction of principal balance. The Company believes that restructuring these loans in this manner will allow certain borrowers to become and remain current on their loans. All loans classified as TDR are considered impaired, however TDR loans which have been current for six consecutive months at the time they are restructured as TDR remain on accrual status and are not included as part of non-performing loans. Loans which were delinquent at the time they are restructured as a TDR are placed on non-accrual status and reported as non-accrual performing TDR loans until they have made timely payments for six consecutive months.
The allocation of a portion of the allowance for loan losses for a performing TDR loan is based upon the present value of the future expected cash flows discounted at the loan’s original effective rate, or for a non-performing TDR loan which is collateral dependent, the fair value of the collateral. At September 30, 2018, there were no commitments to lend additional funds to borrowers whose loans were modified to a TDR. The modification of loans to a TDR did not have a significant effect on our operating results, nor did it require a significant allocation of the allowance for loan losses.
The following tables shows loans modified and classified as TDR during the periods indicated:
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The recorded investment of the loans modified and classified as TDR presented in the table above, were unchanged as there was no principal forgiven in this modification.
The following table shows our recorded investment for loans classified as TDR that are performing according to their restructured terms at the periods indicated:
During the nine months ended September 30, 2018, we sold one commercial real estate TDR loan totaling $1.8 million, for a loss of $0.3 million and foreclosed on one taxi medallion TDR loan of $35,000, which is included in “Other Assets”. There were no TDR loans that defaulted during the period, which were within 12 months of their modification date.
The following table shows our recorded investment for loans classified as TDR that are not performing according to their restructured terms at the periods indicated:
There were no TDR loans transferred to non-performing status during the three and nine months ended September 30, 2018 and 2017.
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The following table shows our non-performing loans at the periods indicated:
The following is a summary of interest foregone on non-accrual loans and loans classified as TDR for the periods indicated:
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The following tables show an age analysis of our recorded investment in loans, including loans past maturity, at the periods indicated:
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The following tables show the activity in the allowance for loan losses for the three month periods indicated:
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The following tables show the activity in the allowance for loan losses for the nine month periods indicated:
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The following tables show the manner in which loans were evaluated for impairment at the periods indicated:
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The following table shows our recorded investment, unpaid principal balance and allocated allowance for loan losses for impaired loans at the periods indicated:
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The following table shows our average recorded investment and interest income recognized for impaired loans for the three months ended:
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The following table shows our average recorded investment and interest income recognized for impaired loans for the nine months ended:
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In accordance with our policy and the current regulatory guidelines, we designate loans as “Special Mention,” which are considered “Criticized Loans,” and “Substandard,” “Doubtful,” or “Loss,” which are considered “Classified Loans”. If a loan does not fall within one of the previous mentioned categories then the loan would be considered “Pass.” Loans that are non-accrual are designated as Substandard, Doubtful or Loss. These loan designations are updated quarterly. We designate a loan as Substandard when a well-defined weakness is identified that may jeopardize the orderly liquidation of the debt. We designate a loan Doubtful when it displays the inherent weakness of a Substandard loan with the added provision that collection of the debt in full, on the basis of existing facts, is highly improbable. We designate a loan as Loss if it is deemed the debtor is incapable of repayment. The Company does not hold any loans designated as Loss, as loans that are designated as Loss are charged to the Allowance for Loan Losses. We designate a loan as Special Mention if the asset does not warrant classification within one of the other classifications, but does contain a potential weakness that deserves closer attention.
The following table sets forth the recorded investment in loans designated as Criticized or Classified at the periods indicated:
Commitments to extend credit (principally real estate mortgage loans) and lines of credit (principally home equity lines of credit and business lines of credit) amounted to $45.0 million and $304.1 million, respectively, at September 30, 2018.
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Loans held for sale are carried at the lower of cost or estimated fair value. At September 30, 2018 and December 31, 2017, the Bank did not have any loans held for sale.
The Company has implemented a strategy of selling certain delinquent and non-performing loans. Once the Company has decided to sell a loan, the sale usually closes in a short period of time, generally within the same quarter. Loans designated held for sale are reclassified from loans held for investment to loans held for sale. Terms of sale include cash due upon the closing of the sale, no contingencies or recourse to the Company and servicing is released to the buyer. Additionally, at times the Company may sell participating interests in performing loans.
The following tables show loans sold during the period indicated:
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During the nine months ended September 30, 2018 we foreclosed on one residential real estate property for $0.6 million. During the three months ended September 30, 2018 and the three and nine months ended September 30, 2017, we did not foreclose on any consumer mortgages through in-substance repossession. We did not hold any foreclosed residential real estate properties at September 30, 2018 and December 31, 2017. Included within net loans as of September 30, 2018 and December 31, 2017 was a recorded investment of $8.1 million and $10.5 million, respectively, of consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process according to local requirements of the applicable jurisdiction.
For the three months ended September 30, 2018 and 2017, the Company’s net income, as reported, includes $1.1 million and $1.1 million, respectively, of stock-based compensation costs and $0.2 million and $0.4 million of income tax benefits, respectively, related to the stock-based compensation plans in each of the periods. For the nine months ended September 30, 2018 and 2017, the Company’s net income, as reported, includes $5.7 million and $5.2 million, respectively, of stock-based compensation costs and $1.2 million and $1.7 million of income tax benefits, respectively, related to the stock-based compensation plans in each of the periods. The Company did not grant any restricted stock units during the three months ended September 30, 2018 and 2017. During the nine months ended September 30, 2018 and 2017, the Company granted 280,590 and 276,900 restricted stock units, respectively. The Company has not granted stock options since 2009. At September 30, 2018, the Company had 600 stock options, all 100% vested, outstanding, at an average exercise price of $8.44 per share.
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The Company uses the fair value of the common stock on the date of award to measure compensation cost for restricted stock unit awards. Compensation cost is recognized over the vesting period of the award using the straight-line method.
The following table summarizes the Company’s restricted stock unit (“RSU”) awards at or for the nine months ended September 30, 2018:
As of September 30, 2018, there was $9.4 million of total unrecognized compensation cost related to RSU awards granted. That cost is expected to be recognized over a weighted-average period of 3.0 years. The total fair value of awards vested for the three months ended September 30, 2018 and 2017 was $0.2 million and $14,000, respectively. The total fair value of awards vested for each of the nine month periods ended September 30, 2018 and 2017 was $7.0 million. The vested but unissued RSU awards consist of awards made to employees and directors who are eligible for retirement. According to the terms of these awards, which provide for vesting upon retirement, these employees and directors have no risk of forfeiture. These shares will be issued at the original contractual vesting and settlement dates.
Phantom Stock Plan: The Company maintains a non-qualified phantom stock plan as a supplement to its profit sharing plan for officers who have achieved the designated level and completed one year of service. The Company adjusts its liability under this plan to the fair value of the shares at the end of each period.
The following table summarizes the Phantom Stock Plan at or for the nine months ended September 30, 2018:
The Company recorded stock-based compensation benefit for the Phantom Stock Plan of $0.1 million and $0.2 million for the three months ended September 30, 2018 and 2017, respectively. The total fair value of the distributions from the Phantom Stock Plan was less than $1,000 and $0.2 million for the three months ended September 30, 2018 and 2017, respectively.
For the nine months ended September 30, 2018 and 2017, the company recorded stock-based compensation benefit for the Phantom Stock Plan of $0.2 million and $0.1 million, respectively. The total fair value of the distributions from the Phantom Stock Plan was $2,000 and $0.2 million for the nine months ended September 30, 2018 and 2017, respectively.
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The following table sets forth information regarding the components of net expense for the pension and other postretirement benefit plans.
The Company previously disclosed in its Consolidated Financial Statements for the year ended December 31, 2017 that it expects to contribute $0.2 million to each of the Outside Director Pension Plan (the “Outside Director Pension Plan”) and the other postretirement benefit plans (the “Other Postretirement Benefit Plans”), during the year ending December 31, 2018. The Company does not expect to make a contribution to the Employee Pension Plan (the “Employee Pension Plan”). As of September 30, 2018, the Company has contributed $72,000 to the Outside Director Pension Plan and $64,000 in contributions were made to the Other Postretirement Benefit Plans. As of September 30, 2018, the Company has not revised its expected contributions for the year ending December 31, 2018.
The Company carries certain financial assets and financial liabilities at fair value in accordance with GAAP which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, establishes a framework for measuring fair value and expands disclosures about fair value measurements. GAAP permits entities to choose to measure many financial instruments and certain other items at fair value. At September 30, 2018, the Company carried financial assets and financial liabilities under the fair value option with fair values of $13.9 million and $40.2 million, respectively. At December 31, 2017, the Company carried financial assets and financial liabilities under the fair value option with fair values of $14.3 million and $37.0 million, respectively. The Company did not elect to carry any additional financial assets or financial liabilities under the fair value option during the three and nine months ended September 30, 2018.
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The following table presents the financial assets and financial liabilities reported at fair value under the fair value option, and the changes in fair value included in the Consolidated Statement of Income – Net gain (loss) from fair value adjustments, at or for the periods ended as indicated:
Included in the fair value of the financial assets and financial liabilities selected for the fair value option is the accrued interest receivable or payable for the related instrument. The Company reports as interest income or interest expense in the Consolidated Statement of Income, the interest receivable or payable on the financial instruments selected for the fair value option at their respective contractual rates.
The borrowed funds had a contractual principal amount of $61.9 million at both September 30, 2018 and December 31, 2017. The fair value of borrowed funds includes accrued interest payable of $0.2 million at September 30, 2018 and December 31, 2017.
The Company generally holds its earning assets, other than securities available for sale, to maturity and settles its liabilities at maturity. However, fair value estimates are made at a specific point in time and are based on relevant market information. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular instrument. Accordingly, as assumptions change, such as interest rates and prepayments, fair value estimates change and these amounts may not necessarily be realized in an immediate sale.
Disclosure of fair value does not require fair value information for items that do not meet the definition of a financial instrument or certain other financial instruments specifically excluded from its requirements. These items include core deposit intangibles and other customer relationships, premises and equipment, leases, income taxes and equity.
Further, fair value disclosure does not attempt to value future income or business. These items may be material and accordingly, the fair value information presented does not purport to represent, nor should it be construed to represent, the underlying “market” or franchise value of the Company.
Financial assets and financial liabilities reported at fair value are required to be measured based on either: (1) quoted prices in active markets for identical financial instruments (Level 1); (2) significant other observable inputs (Level 2); or (3) significant unobservable inputs (Level 3).
A description of the methods and significant assumptions utilized in estimating the fair value of the Company’s assets and liabilities that are carried at fair value on a recurring basis are as follows:
Level 1 – where quoted market prices are available in an active market. At September 30, 2018 and December 31, 2017, Level 1 included one mutual fund.
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Level 2 – when quoted market prices are not available, fair value is estimated using quoted market prices for similar financial instruments and adjusted for differences between the quoted instrument and the instrument being valued. Fair value can also be estimated by using pricing models, or discounted cash flows. Pricing models primarily use market-based or independently sourced market parameters as inputs, including, but not limited to, yield curves, interest rates, equity or debt prices and credit spreads. In addition to observable market information, models also incorporate maturity and cash flow assumptions. At September 30, 2018 and December 31, 2017, Level 2 included mortgage related securities, corporate debt, municipals and interest rate swaps.
Level 3 – when there is limited activity or less transparency around inputs to the valuation, financial instruments are classified as Level 3. At September 30, 2018 and December 31, 2017, Level 3 included trust preferred securities owned and junior subordinated debentures issued by the Company.
The methods described above may produce fair values that may not be indicative of net realizable value or reflective of future fair values. While the Company believes, its valuation methods are appropriate and consistent with those of other market participants, the use of different methodologies, assumptions and models to determine fair value of certain financial instruments could produce different estimates of fair value at the reporting date.
The following table sets forth the assets and liabilities that are carried at fair value on a recurring basis and their respective category in the fair value hierarchy, at September 30, 2018 and December 31, 2017:
The following tables sets forth the Company's assets and liabilities that are carried at fair value on a recurring basis, classified within Level 3 of the valuation hierarchy for the periods indicated:
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During the three and nine months ended September 30, 2018 and 2017, there were no transfers between Levels 1, 2 and 3.
The following tables present the quantitative information about recurring Level 3 fair value of financial instruments and the fair value measurements at the periods indicated:
The significant unobservable inputs used in the fair value measurement of the Company’s trust preferred securities and junior subordinated debentures valued under Level 3 at September 30, 2018 and December 31, 2017, are the effective yields used in the cash flow models. Significant increases or decreases in the effective yield in isolation would result in a significantly lower or higher fair value measurement.
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The following table sets forth the Company’s assets and liabilities that are carried at fair value on a non-recurring basis and their respective category in the fair value hierarchy at September 30, 2018 and December 31, 2017:
The following tables present the qualitative information about non-recurring Level 3 fair value of financial instruments and the fair value measurements at the periods indicated:
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The Company did not have any liabilities that were carried at fair value on a non-recurring basis at September 30, 2018 and December 31, 2017.
The methods and assumptions used to estimate fair value at September 30, 2018 and December 31, 2017 are as follows:
Securities:
The fair values of securities are contained in Note 4 of Notes to Consolidated Financial Statements. Fair value is based upon quoted market prices, where available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities and adjusted for differences between the quoted instrument and the instrument being valued. When there is limited activity or less transparency around inputs to the valuation, securities are valued using discounted cash flows.
Impaired Loans:
For non-accruing loans, fair value is generally estimated by discounting management’s estimate of future cash flows with a discount rate commensurate with the risk associated with such assets or, for collateral dependent loans, 85% of the appraised or internally estimated value of the property, except for taxi medallion loans. The fair value of the underlying collateral of taxi medallion loans is the most recent reported arm’s length transaction. When there is no recent sale activity, the fair value is calculated using capitalization rates.
Other Real Estate Owned and Other Repossessed Assets:
OREO and other repossessed assets are carried at fair value less selling costs. The fair value for OREO is based on appraised value through a current appraisal, or sometimes through an internal review, additionally adjusted by the estimated costs to sell the property. The fair value for other repossessed assets are based upon the most recently reported arm’s length sales transaction. When there is no recent sale activity, the fair value is calculated using capitalization rates.
Junior Subordinated Debentures:
The fair value of the junior subordinated debentures was developed using a credit spread based on the subordinated debt issued by the Company adjusting for differences in the junior subordinated debt’s credit rating, liquidity and time to maturity. The unrealized net gain/loss attributable to changes in our own credit risk was determined by adjusting the fair value as determined in the proceeding sentence by the average rate of default on debt instruments with a similar debt rating as our junior subordinated debentures, with the difference from the original calculation and this calculation resulting in the instrument-specific unrealized gain/loss.
Interest Rate Swaps:
The fair value of interest rate swaps is based upon broker quotes.
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The following tables set forth the carrying amounts and estimated fair values of selected financial instruments based on the assumptions described above used by the Company in estimating fair value at the periods indicated:
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At September 30, 2018 and December 31, 2017, the Company’s derivative financial instruments consist of interest rate swaps. The Company’s interest rate swaps are used for three purposes: 1) to mitigate the Company’s exposure to rising interest rates on a portion ($18.0 million) of its floating rate junior subordinated debentures that have a contractual value of $61.9 million, at September 30, 2018 and December 31, 2017; 2) to mitigate the Company’s exposure to rising interest rates on certain fixed rate loans totaling $288.1 million and $280.2 million at September 30, 2018 and December 31, 2017, respectively; and 3) to mitigate exposure to rising interest rates on certain short-term advances totaling $441.5 million at September 30, 2018 and December 31, 2017.
At September 30, 2018 and December 31, 2017, we held derivatives designated as cash flow hedges, fair value hedges and certain derivatives not designated as hedges.
The Company’s derivative instruments are carried at fair value in the Company’s financial statements as part of Other Assets for derivatives with positive fair values and Other Liabilities for derivatives with negative fair values. The accounting for changes in the fair value of a derivative instrument is dependent upon whether or not it qualifies and has been designated as a hedge for accounting purposes, and further, by the type of hedging relationship.
At September 30, 2018 and December 31, 2017, derivatives with a combined notional amount of $36.3 million were not designated as hedges. At September 30, 2018 and December 31, 2017, derivatives with a combined notional amount of $269.7 million and $261.9 million were designated as fair value hedges. At September 30, 2018 and December 31, 2017, derivatives with a combined notional amount of $441.5 million were designated as cash flow hedges.
For cash flow hedges, the effective portion of changes in the fair value of the derivative is reported in AOCL, net of tax, with the ineffective portion of changes in the fair value of the derivative is recognized directly in earnings. Amounts in accumulated other comprehensive income are reclassified into earnings in the same period during which the hedged forecasted transaction effects earnings. During the three and nine months ended September 30, 2018, $0.1 million and $0.2 million, respectively, was reclassified from accumulated other comprehensive loss to interest expense.
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Changes in the fair value of interest rate swaps not designated as hedges are reflected in “Net gain/loss from fair value adjustments” in the Consolidated Statements of Income.
The following table sets forth information regarding the Company’s derivative financial instruments at the periods indicated:
The following table sets forth the effect of derivative instruments on the Consolidated Statements of Income for the periods indicated:
During the three and nine months ended September 30, 2018 and 2017, the Company did not record any hedge ineffectiveness.
The Company’s interest rate swaps are subject to master netting arrangements between the Company and its two designated counterparties. The Company has not made a policy election to offset its derivative positions.
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The following tables present the effect of the master netting arrangements on the presentation of the derivative assets and liabilities in the Consolidated Statements of Condition as of the dates indicated:
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Flushing Financial Corporation files consolidated Federal and combined New York State and New York City income tax returns with its subsidiaries, with the exception of the Company’s trusts, which file separate Federal income tax returns as trusts, and Flushing Preferred Funding Corporation, which files a separate Federal income tax return as a real estate investment trust. Additionally, the Bank files New Jersey State tax returns. As of September 30, 2018, the Company is undergoing examination for its Federal income tax return for 2015, its New York State income tax returns for 2014, 2015 and 2016 and its New York City income tax return for 2014.
Income tax provisions are summarized as follows:
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The following tables sets forth the changes in accumulated other comprehensive income (loss) by component for the periods indicated:
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The following tables set forth significant amounts reclassified from accumulated other comprehensive income (loss) by component for the periods indicated:
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Under current capital regulations, the Bank is required to comply with four separate capital adequacy standards. As of September 30, 2018, the Bank continues to be categorized as “well-capitalized” under the prompt corrective action regulations and continues to exceed all regulatory capital requirements. In 2016, a Capital Conservation Buffer (“CCB”) requirement became effective for banks. The CCB is designed to establish a capital range above minimum capital requirements and impose constraints on dividends, share buybacks and discretionary bonus payments when capital levels fall below prescribed levels. The minimum CCB in 2018 is 1.875% and increases 0.625% annually through 2019 to 2.5%. The CCB for the Bank at September 30, 2018 was 5.88%.
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Set forth below is a summary of the Bank’s compliance with banking regulatory capital standards.
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The Holding Company is subject to the same regulatory capital requirements as the Bank. As of September 30, 2018, the Holding Company continues to be categorized as “well-capitalized” under the prompt corrective action regulations and continues to exceed all regulatory capital requirements. The CCB for the Holding Company at September 30, 2018 was 5.82%.
Set forth below is a summary of the Holding Company’s compliance with banking regulatory capital standards.
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Accounting Standards Adopted in 2018:
In February 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2018-02, “Income Statement – Reporting Comprehensive Income (Topic 220).” As a result of the Tax Cuts and Jobs Act (the “TCJA”), concerns arose regarding the guidance which requires deferred tax assets and liabilities to be adjusted for the effect of a change in tax laws or rates with the effect included in income from continuing operations in the reporting period that includes the enactment date. The amendments in this ASU require a reclassification for stranded tax effects from accumulated other comprehensive income to retained earnings, furthermore eliminating the stranded tax effects resulting from the TCJA. The amount of the reclassification is the difference between the previous corporate income tax rate of 35% and the newly enacted corporate income tax rate of 21%. The amendments of this ASU are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years, with early adoption permitted in any interim period or fiscal year before the effective date. We have elected to early adopt this guidance as of January 1, 2018. Our Consolidated Statements of Financial Condition reflect adoption of this ASU and reclassification of $2.1 million in stranded tax effects from accumulated other comprehensive income to retained earnings. See Note 12 “Income Taxes” for additional information.
In August 2016, the FASB issued ASU No. 2016-15 “Classification of Certain Cash Receipts and Cash Payments”, to clarify how certain cash receipts and cash payments are presented and classified in the statements of cash flows. The amendments are intended to reduce diversity in practice by clarifying whether the following items should be categorized as operating, investing or financing in the statement of cash flows: (i) debt prepayments and extinguishment costs, (ii) settlement of zero-coupon debt, (iii) settlement of contingent consideration, (iv) insurance proceeds, (v) settlement of corporate-owned life insurance (COLI) and bank-owned life insurance (BOLI) policies, (vi) distributions from equity method investees, (vii) beneficial interests in securitization transactions, and (viii) receipts and payments with aspects of more than one class of cash flows. The ASU will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. Early adoption is permitted. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. An entity that elects early adoption must adopt all of the amendments in the same period. This ASU was adopted on January 1, 2018 and did not have a significant impact on the presentation of our cash flows.
In January 2016, FASB issued ASU No. 2016-01 “Financial Instruments” which requires an entity to: (i) measure equity investments at fair value through net income, with certain exceptions; (ii) present in other comprehensive income the changes in instrument-specific credit risk for financial liabilities measured using the fair value option; (iii) present financial assets and financial liabilities by measurement category and form of financial asset; (iv) calculate the fair value of financial instruments for disclosure purposes based on an exit price and; (v) assess a valuation allowance on deferred tax assets related to unrealized losses of available for sale debt securities in combination with other deferred tax assets. The ASU provides an election to subsequently measure certain nonmarketable equity investments at cost less any impairment and adjusted for certain observable price changes. The ASU also requires a qualitative impairment assessment of such equity investments and amends certain fair value disclosure requirements. This ASU became effective for us on January 1, 2018. The adoption of the guidance resulted in a cumulative-effect adjustment totaling $0.8 million and did not have a significant impact on our results of operations, financial condition and cash flows.
In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers (Topic 606)”. This ASU establishes a comprehensive revenue recognition standard for virtually all industries under GAAP, including those that previously followed industry-specific guidance such as real estate, construction and software industries. The revenue standard’s core principle is built on the contract between a vendor and a customer for the provision of goods and services. It attempts to depict the exchange of rights and obligations between the parties in the pattern of revenue recognition based on the consideration to which the vendor is entitled. The guidance in this ASU for public companies is effective for the annual periods beginning after December 15, 2016, including interim periods therein. In August 2015, the FASB approved a one-year delay of the effective date of this standard to reporting periods beginning after December 15, 2017. This ASU allows for either full retrospective adoption or modified retrospective adoption. This ASU became effective for us on January 1, 2018. We adopted this standard through the modified retrospective transition method. The modified retrospective method requires application of ASU 2014-09 to uncompleted contracts at the date of adoption; however, periods prior to the date of adoption have not been retrospectively revised as the impact of the new standard on uncompleted contracts as the date of adoption was not material as such a cumulative effective adjustment to opening retained earnings was not deemed necessary.
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Topic 606 does not apply to the majority of our revenue streams which are primarily comprised of interest and dividend income and associated fees within those revenue streams. The revenue streams derived by the Company that are within the scope of Topic 606 are primarily certain banking service fees, including wire transfer fees, ATM fees, account maintenance fees, overdraft fees and other deposit fees. We generally satisfy our performance obligations on contracts with customers as services are rendered, and the transaction prices are typically fixed and charged either on a periodic basis or based on activity. Being that performance obligations are satisfied as services are rendered and the transaction prices are fixed, there is little judgment involved in applying Topic 606 that significantly affects the determination of the amount and timing of revenue from contracts with customers. Additionally, the Company will receive revenue from the sale of investment products through a third party as part of a revenue sharing agreement. This revenue is included in “Other Income” in the Consolidated Statements of Income. These fees are remitted to the Company monthly as our performance obligation is satisfied. We have evaluated the nature of our contracts with customers and determined that further disaggregation of revenue from contracts with customers into more granular categories beyond what is present in the Consolidated Statements of Income was not necessary.
Accounting Standards Pending Adoption:
In August 2018, the FASB issued ASU No. 2018-14, “Compensation – Retirement Benefits – Defined Benefit Plans – General (Subtopic 715-20)”providing targeted improvements to the disclosures required for Defined Benefit Plans. The amendments in in this Update are effective for fiscal years ended after December 15, 2020. Early adoption is permitted. The amendments are to be applied on a retrospective basis to all periods presented. We are currently evaluating the impact of adopting this new guidance on our disclosures.
In August 2018, the FASB issued ASU No. 2018-13, “Fair Value Measurement (Topic 820)”. The amendments in this Update modify the disclosure requirements on fair value measurements in Topic 820. The amendments in in this Update are effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2019. Early adoption is permitted. The amendments are to be applied on a retrospective basis to all periods presented. We are currently evaluating the impact of adopting this new guidance on our disclosures.
In August 2017, the FASB issued ASU No. 2017-12, “Derivatives and Hedging (Topic 815)” providing targeted improvements to the accounting for hedging activities, which is effective January 1, 2019, with early adoption permitted in any interim period or fiscal year before the effective date. The guidance introduces a number of amendments, several of which are optional, that are designed to simplify the application of hedge accounting, improve financial statement transparency and more closely align hedge accounting with an entity’s risk management strategies. This ASU eliminates the requirement to separately measure and report hedge ineffectiveness and changes the presentation so that all items that affect earnings are in the same income statement line as the hedged item. We are currently evaluating the impact of adopting this new guidance on our consolidated results of operations, financial condition and cash flows.
In March 2017, the FASB issued ASU No. 2017-08, “Premium Amortization on Purchased Callable Debt Securities” which shortens the amortization period for premiums on purchased callable debt securities to the earliest call date, rather than amortizing over the full contractual term. The ASU does not change the accounting for securities held at a discount. The amendments in this ASU require companies to reset the effective yield using the payment terms of the debt security if the call option is not exercised on the earliest call date. If the security has additional future call dates, any excess of the amortized cost basis over the amount repayable by the issuer at the next call date should be amortized to the next call date. The amendments in this update are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The guidance is not expected to have an impact on the Company's financial positions, results of operations or disclosures.
In January 2017, the FASB issued ASU No. 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” The ASU simplifies the subsequent measurement of goodwill and eliminates Step 2 from the goodwill impairment test. Under this ASU, the Company should perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value. The impairment charge is limited to the amount of goodwill allocated to that reporting unit. The amendments in this update are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for goodwill impairment tests performed on testing dates after January 1, 2017. The guidance is not expected to have a significant impact on the Company's financial positions, results of operations or disclosures.
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In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Losses” which sets forth a “current expected credit loss” (“CECL”) model which requires the Company to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable supportable forecasts. This replaces the existing incurred loss model and will apply to the measurement of credit losses on financial assets measured at amortized cost and to some off-balance sheet credit exposures. This ASU will be effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company has been collecting and evaluating data and system requirements to implement this standard. Management has developed inter-departmental steering and working committees to evaluate and implement CECL. We have chosen a vendor solution to model CECL results and are in the beginning stages of implementing this solution. The adoption of this update could have a material impact on the Company’s consolidated results of operations and financial condition. The extent of the impact is still unknown and will depend on many factors, such as the composition of the Company’s loan portfolio and expected loss history at adoption.
In February 2016, the FASB issued ASU No. 2016-02, “Leases”. From the lessee's perspective, the new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement for a lessee. From the lessor's perspective, the new standard requires a lessor to classify leases as either sales-type, finance or operating. A lease will be treated as a sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as a financing. If the lessor doesn’t convey risks and rewards or control, an operating lease results. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. A modified retrospective transition approach is required to be applied for leases in existence as of the date of initial application. Reporting entities may elect to apply the transition approach either as of the beginning of the earliest period presented in the financial statements, or as of the beginning of the period of adoption. The Company has not adopted the new accounting policy as of the filing date. The Company has yet to make an election on the method of adoption or which practical expedients, if any, will be elected. Our operating leases relate primarily to office space and bank branches. Under current accounting standards, substantially all of the Company’s leases are considered operating leases and, as such, are not recognized on the Company’s Consolidated Balance Sheet. Based on our current lease portfolio, upon adoption of the new accounting standard, we anticipate recognizing a lease liability and related right-of-use asset on our balance sheet. Management is continuing to evaluate the Company’s outstanding inventory of leases and determining the effect of recognizing operating leases on the Consolidated Statements of Financial Condition which is expected to be material. However, the final impact of the standard will depend on the company’s leases composition as of the adoption date.
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Management’s Discussion and Analysis of
Financial Condition and Results of Operations
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Quarterly Report should be read in conjunction with the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2017. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein.
As used in this Quarterly Report, the words “we,” “us,” “our” and the “Company” are used to refer to Flushing Financial Corporation and its direct and indirect wholly owned subsidiaries, Flushing Bank (the “Bank”), Flushing Preferred Funding Corporation, Flushing Service Corporation, and FSB Properties Inc.
Statements contained in this Quarterly Report relating to plans, strategies, objectives, economic performance and trends, projections of results of specific activities or investments and other statements that are not descriptions of historical facts may be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking information is inherently subject to risks and uncertainties and actual results could differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed elsewhere in this Quarterly Report and in other documents filed by us with the Securities and Exchange Commission from time to time, including, without limitation, our Annual Report on Form 10-K for the year ended December 31, 2017. Forward-looking statements may be identified by terms such as “may,” “will,” “should,” “could,” “expects,” “plans,” “intends,” “anticipates,” “believes,” “estimates,” “predicts,” “forecasts,” “goals,” “potential” or “continue” or similar terms or the negative of these terms. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We have no obligation to update these forward-looking statements.
Executive Summary
We are a Delaware corporation organized in May 1994. The Bank was organized in 1929 as a New York State-chartered mutual savings bank. Today the Bank operates as a full-service New York State commercial bank. The Bank’s primary regulator is the New York State Department of Financial Services, and its primary federal regulator is the Federal Deposit Insurance Corporation (“FDIC”). Deposits are insured to the maximum allowable amount by the FDIC. Additionally, the Bank is a member of the Federal Home Loan Bank system. The primary business of Flushing Financial Corporation has been the operation of the Bank. The Bank owns three subsidiaries: Flushing Preferred Funding Corporation, Flushing Service Corporation, and FSB Properties Inc. The Bank also operates an internet branch, which operates under the brands of iGObanking.com® and BankPurely® (the “Internet Branch”). The activities of Flushing Financial Corporation are primarily funded by dividends, if any, received from the Bank, issuances of subordinated debt, junior subordinated debt, and issuances of equity securities. Flushing Financial Corporation’s common stock is traded on the NASDAQ Global Select Market under the symbol “FFIC.”
Our principal business is attracting retail deposits from the general public and investing those deposits together with funds generated from ongoing operations and borrowings, primarily in (1) originations and purchases of multi-family residential loans, commercial business loans, commercial real estate mortgage loans and, to a lesser extent, one-to-four family loans (focusing on mixed-use properties, which are properties that contain both residential dwelling units and commercial units); (2) Small Business Administration (“SBA”) loans and other small business loans; (3) construction loans; (4) mortgage loan surrogates such as mortgage-backed securities; and (5) U.S. government securities, corporate fixed-income securities and other marketable securities. We also originate certain other consumer loans including overdraft lines of credit. Our results of operations depend primarily on net interest income, which is the difference between the income earned on our interest-earning assets and the cost of our interest-bearing liabilities. Net interest income is the result of our interest rate margin, which is the difference between the average yield earned on interest-earning assets and the average cost of interest-bearing liabilities, adjusted for the difference in the average balance of interest-earning assets as compared to the average balance of interest-bearing liabilities. We also generate non-interest income primarily from loan fees, service charges on deposit accounts, mortgage servicing fees, and other fees, income earned on Bank Owned Life Insurance (“BOLI”), dividends on Federal Home Loan Bank of New York stock and net gains and losses on sales of securities and loans. Our operating expenses consist principally of employee compensation and benefits, occupancy and equipment costs, other general and administrative expenses and income tax expense. Our results of operations also can be significantly affected by changes in the fair value of financial assets and financial liabilities for which changes in value are recorded through earnings, our periodic provision for loan losses and specific provision for losses on real estate owned.
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Our strategy is to continue our focus on being an institution serving consumers, businesses, and governmental units in our local markets. In furtherance of this objective, we intend to:
There can be no assurance that we will be able to effectively implement this strategy. Our strategy is subject to change by the Board of Directors.
Our investment policy, which is approved by the Board of Directors, is designed primarily to manage the interest rate sensitivity of our overall assets and liabilities, to generate a favorable return without incurring undue interest rate risk and credit risk, to complement our lending activities and to provide and maintain liquidity. In establishing our investment strategies, we consider our business and growth strategies, the economic environment, our interest rate risk exposure, our interest rate sensitivity “gap” position, the types of securities to be held and other factors. We classify our investment securities as available for sale or held-to-maturity.
We carry a portion of our financial assets and financial liabilities at fair value and record changes in their fair value through earnings in non-interest income on our Consolidated Statements of Income and Comprehensive Income. A description of the financial assets and financial liabilities that are carried at fair value through earnings can be found in Note 10 of the Notes to the Consolidated Financial Statements.
Our strategic focus of increasing net interest income through emphasizing rate over volume and reducing our liability sensitive position has resulted in net loans growth of 0.9% (non-annualized) for the third quarter. Similar to the prior quarter, we allowed $62 million of participations with another financial institution to repay, as the rates offered during the refinancing process did not meet our rate criteria. Year-to-date, we have allowed approximately $139 million of participations to repay rather than refinance at a rate below our criteria. During the quarter, approximately 70% of our new loans and 40% of our new investment securities were adjustable rate products. Additionally, approximately $450 million of forward swaps entered in late 2017 have provided a benefit of one basis point to the quarter’s net interest margin. These swaps coupled with the extension of the maturity of liabilities has mitigated our liability sensitive position.
The yield on interest-earning assets increased 17 basis points to 4.27% during the three months ended September 30, 2018, from 4.10% for the three months ended June 30, 2018, while the cost of interest-bearing liabilities increased 26 basis points to 1.76% from 1.50% during the same period. This resulted in the net interest margin declining five basis points to 2.71% for the three months ended September 30, 2018 from 2.76% for the linked quarter. The increase in the cost of interest-bearing liabilities was driven primarily by the Bank raising the rates we pay on our deposit products to stay competitive within our market and an increase in borrowing costs from recent increases in the Fed Funds rate.
As we continued to improve loan yields we have retained our focus on credit quality. Non-performing assets decreased by 30% and total delinquencies have decreased 17% since December 31, 2017. The allowance for loan losses to gross loans was 0.38% while the allowance for loan losses to non-performing loans increased to 161% from 137% in the linked quarter. The loan-to-value on our non-performing real estate loans at September 30, 2018 remains conservative at 35.1%. During the three months ended September 30, 2018 we recorded net recoveries of $89,000.
The Bank and Company are subject to the same regulatory capital requirements. See Note 14 of the Notes to the Consolidated Financial Statements “Regulatory Capital.”
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COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED
SEPTMEBER 30, 2018 AND 2017
General. Net income for the three months ended September 30, 2018 was $17.3 million, an increase of $7.2 million, or 70.3%, compared to $10.2 million for the three months ended September 30, 2017. Diluted earnings per common share were $0.61 for the three months ended September 30, 2018, an increase of $0.26, or 74.3%, from $0.35 for the three months ended September 30, 2017.
Return on average equity increased to 12.9% for the three months ended September 30, 2018 from 7.6% for the three months ended September 30, 2017. Return on average assets increased to 1.1% for the three months ended September 30, 2018 from 0.7% for the three months ended September 30, 2017.
Interest Income. Total interest and dividend income increased $6.2 million, or 10.4%, to $65.5 million for the three months ended September 30, 2018 from $59.3 million for the three months ended September 30, 2017. The increase in interest income was primarily attributable to an increase of 27 basis points in the yield of interest-earning assets to 4.27% for the three months ended September 30, 2018 from 4.00% in the comparable prior year period, combined with an increase of $194.3 million in the average balance of interest-earning assets to $6,130.4 million for the three months ended September 30, 2018 from $5,936.1 million for the comparable prior year period. The increase in the yield on interest-earning assets was primarily due to an increase of 28 basis points in the yield of total loans, net to 4.52% for the three months ended September 30, 2018 from 4.24% for the comparable prior year period. Additionally, interest income increased due to an increase of $246.5 million in the average balance of total loans, net, which have a higher yield than the yield of total interest-earning assets. Excluding prepayment penalty income and recovered interest from loans, the yield on total loans, net, would have increased 20 basis points to 4.29% for the three months ended September 30, 2018 from 4.09% for the three months ended September 30, 2017.
Interest Expense. Interest expense increased $7.7 million, or 47.2%, to $24.0 million for the three months ended September 30, 2018 from $16.3 million for the three months ended September 30, 2017. The increase in interest expense was primarily due to an increase of 53 basis points in the average cost of interest-bearing liabilities to 1.76% for the three months ended September 30, 2018 from 1.23% for the three months ended September 30, 2017, combined with an increase of $180.0 million in the average balance of interest-bearing liabilities to $5,455.9 million for the three months ended September 30, 2018, from $5,275.9 million for the comparable prior year period. The 53 basis point increase in the cost of interest-bearing liabilities was primarily due to the Bank raising the rates we pay on our deposit products to stay competitive within our market and an increase in borrowing costs from increases in the Fed Funds rate.
Net Interest Income. For the three months ended September 30, 2018, net interest income was $41.5 million, a decrease of $1.5 million, or 3.5%, from $43.0 million for the three months ended September 30, 2017. The decrease in net interest income was primarily due to the 53 basis point increase in the cost of interest-bearing liabilities to 1.76% for the three months ended September 30, 2018 from 1.23% for the comparable prior year period, partially offset by an increase of 27 basis points in the yield of interest-earning assets to 4.27% for the three months ended September 30, 2018 as compared to 4.00% for the three months ended September 30, 2017. The effects of the above on both the net interest spread and net interest margin were decreases of 26 basis points to 2.51% and 19 basis points to 2.71%, respectively, for the quarter ended September 30, 2018, compared to the quarter ended September 30, 2017. Included in net interest income was prepayment penalty income from loans for the three months ended September 30, 2018 and 2017 totaling $1.9 million and $1.6 million, respectively, and recovered interest from non-accrual loans totaling $1.1 million and $0.3 million, respectively. Without the prepayment penalty income and recovered interest, the net interest margin for the three months ended September 30, 2018 would have been 2.51%, a decrease of 26 basis points, as compared to 2.77% for the three months ended September 30, 2017.
Provision for Loan Losses. There was no provision for loan losses recorded for the three months ended September 30, 2018 compared to $3.3 million for three months ended in September 30, 2017. No provision was recorded due to the Company’s analysis of the adequacy of the allowance for loan losses indicating that the reserve was at an appropriate level. During the three months ended September 30, 2018, the Bank recorded net recoveries totaling $89,000 , while non-accrual loans decreased $1.5 million to $12.5 million at September 30, 2018 from $14.1 million at June 30, 2018. The current average loan-to-value ratio for our non-performing loans collateralized by real estate was 35.1% at September 30, 2018. The Bank continues to maintain conservative underwriting standards. We anticipate that we will continue to see low loss content in our loan portfolio. See Note 5 of the Notes to the Consolidated Financial Statements “Loans” and “ALLOWANCE FOR LOAN LOSSES.”
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Non-Interest Income. Non-interest income for the three months ended September 30, 2018 was $5.0 million, an increase of $3.3 million, or 198.3%, from $1.7 million for the three months ended September 30, 2017. The increase in non-interest income was primarily due to an increase of $2.0 million in gains from life insurance proceeds to $2.2 million for the three months ended September 30, 2018 compared to $0.2 million for the three months ended September 30, 2017 and a decline of $1.1 million in net losses from fair value adjustments to $0.2 million for the three months ended September 30, 2018 from $1.3 million for the comparable prior year period.
Non-Interest Expense. Non-interest expense was $27.2 million for the three months ended September 30, 2018, an increase of $1.3 million, or 4.9%, from $26.0 million for the three months ended September 30, 2017. The increase in non-interest expense was primarily due to increases in salaries and benefits, legal, consulting and depreciation expense due to the growth of the Bank.
Income before Income Taxes. Income before the provision for income taxes increased $3.8 million, or 24.4%, to $19.2 million for the three months ended September 30, 2018 from $15.5 million for the three months ended September 30, 2017, for the reasons discussed above.
Provision for Income Taxes. The provision for income taxes was $1.9 million for the three months ended September 30, 2018, a decrease of $3.4 million, or 63.9%, from $5.3 million for the three months ended September 30, 2017. The effective tax rate decreased to 9.9% for the three months ended September 30, 2018 from 34.2% in the comparable prior year period. The decrease in the effective tax rate was primarily due to the release of a previously accrued tax liability totaling $1.8 million and the impact of the top federal tax rate declining to 21% in 2018 from 35% in 2017, as a result of the Tax Cuts and Jobs Act (the “TCJA”).
COMPARISON OF OPERATING RESULTS FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 2018 AND 2017
General. Net income for the nine months ended September 30, 2018 was $42.7 million, an increase of $7.5 million, or 21.3%, compared to $35.2 million for the nine months ended September 30, 2017. Diluted earnings per common share were $1.48 for the nine months ended September 30, 2018, an increase of $0.27, or 22.3%, from $1.21 for the nine months ended September 30, 2017.
Return on average equity was 10.7% and 8.9% for the nine months ended September 30, 2018 and 2017. Return on average assets was 0.9% and 0.8% for the nine months ended September 30, 2018 and 2017.
Interest Income. Total interest and dividend income increased $14.7 million, or 8.4%, to $189.6 million for the nine months ended September 30, 2018 from $174.9 million for the nine months ended September 30, 2017. The increase in interest income was primarily attributable to an increase of $227.0 million in the average balance of interest-earning assets to $6,136.9 million for the nine months ended September 30, 2018 from $5,909.9 million for the comparable prior year period, combined with an increase of 17 basis points in the yield of interest-earning assets to 4.12% for the nine months ended September 30, 2018 from 3.95% for the comparable prior year period. The increase in the yield on interest-earning assets was primarily due to a 16 basis point increase in the yield of total loans, net to 4.35% for the nine months ended September 30, 2018 from 4.19% for the nine months ended September 30, 2017. The yield on interest-earning assets was also positively impacted by an increase of $320.6 million in the average balance of total loans, net, which have a higher yield than the yield of total interest-earning assets, combined with a decrease of $105.5 million in the average balance of total securities, which have a lower yield than the yield of total interest-earning assets. In addition, the yield of interest-earning assets improved due to increases of four basis points in the yield of total securities to 2.84% for the nine months ended September 30, 2018 from 2.80% for the comparable prior year period and 68 basis points in the yield of interest-earning deposits and federal funds sold to 1.49% for the nine months ended September 30, 2018 from 0.81% for the comparable prior year period. The 16 basis point increase in the yield on the total loans, net was primarily due to new loans being originated at a higher rate than the average yield of the existing loan portfolio and adjustable rate loans repricing higher. Excluding prepayment penalty income and recovered interest from loans, the yield on total loans, net, would have increased 13 basis points to 4.20% for the nine months ended September 30, 2018 from 4.07% for the nine months ended September 30, 2017.
Interest Expense. Interest expense increased $18.0 million, or 40.0%, to $62.8 million for the nine months ended September 30, 2018 from $44.8 million for the nine months ended September 30, 2017. The increase in interest expense was primarily due to an increase of 40 basis points in the average cost of interest-bearing liabilities to 1.53% for the nine months ended September 30, 2018 from 1.13% for the nine months ended September 30, 2017, combined with an increase of $198.5 million in the average balance of interest-bearing liabilities to $5,471.4 million for the nine months ended September 30, 2018 from $5,272.8 million for the comparable prior year period. The 40 basis point increase in the cost of interest-bearing liabilities was primarily due to the Bank raising the rates we pay on our deposit products to stay competitive within our market and an increase in borrowing costs from recent increases in the Fed Funds rate.
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Net Interest Income. For the nine months ended September 30, 2018, net interest income was $126.8 million, a decrease of $3.3 million, or 2.5%, from $130.0 million for the nine months ended September 30, 2017. The decrease in net interest income was primarily due to the 40 basis point increase in the cost of interest-bearing liabilities to 1.53% for the nine months ended September 30, 2018 from 1.13% for the comparable prior year period, partially offset by an increase of 17 basis points in the yield of interest-earning assets to 4.12% for the nine months ended September 30, 2018 as compared to 3.95% for the nine months ended September 30, 2017. The effects of the above on both the net interest spread and net interest margin were decreases of 23 basis points to 2.59% and 18 basis points to 2.75%, respectively, for the nine months ended September 30, 2018, compared to the nine months ended September 30, 2017. Included in net interest income was prepayment penalty income from loans and securities for the nine months ended September 30, 2018 and 2017 totaling $4.3 million and $3.6 million, respectively, recovered interest from non-accrual loans totaling $1.5 million and $1.1 million, respectively, and accelerated accretion of discount upon the call of CLO securities totaling $0.1 million and $0.4 million, respectively. Without the prepayment penalty income, recovered interest and accelerated discount upon call, the net interest margin for the nine months ended September 30, 2018 would have been 2.62%, a decrease of 20 basis points, as compared to 2.82% for the nine months ended September 30, 2017.
Provision for Loan Losses. During the nine month ended September 30, 2018, a provision for loan losses was recorded for $0.2 million, compared to $3.3 million recorded during the comparable prior year period. The $0.2 million provision was recorded during the nine months ended September 30, 2018 due to the quarterly analysis of the adequacy of the allowance for loan losses indicating that the provision was necessary to maintain the reserve at an appropriate level. During the nine months ended September 30, 2018, the Bank recorded net charge-offs totaling $0.2 million, while non-accrual loans decreased $3.2 million to $12.5 million at September 30, 2018 from $15.7 million at December 31, 2017. The current average loan-to-value ratio for our non-performing loans collateralized by real estate was 35.1% at September 30, 2018. The Bank continues to maintain conservative underwriting standards. We anticipate that we will continue to see low loss content in our loan portfolio. See Note 5 of the Notes to the Consolidated Financial Statements “Loans” and “ALLOWANCE FOR LOAN LOSSES.”
Non-Interest Income. Non-interest income for the nine months ended September 30, 2018 was $11.3 million, an increase of $4.0 million, or 55.2%, from $7.3 million for the nine months ended September 30, 2017. The increase in non-interest income was primarily due to a decline of $2.3 million in net losses from fair value adjustments to $0.5 million for the nine months ended September 30, 2018 from $2.8 million for the comparable prior year period, coupled with an increase of $1.6 million in gains from life insurance proceeds to $3.0 million for the nine months ended September 30, 2018 from $1.4 million for the comparable prior year period.
Non-Interest Expense. Non-interest expense was $85.9 million for the nine months ended September 30, 2018, an increase of $4.3 million, or 5.3%, from $81.6 million for the nine months ended September 30, 2017. The increase in non-interest expense was primarily due to increases in salaries and benefits, legal, consulting, depreciation, data processing and FDIC insurance premiums all due to the growth of the Bank.
Income before Income Taxes. Income before the provision for income taxes decreased $0.5 million, or 0.9%, to $52.0 million for the nine months ended September 30, 2018 from $52.5 million for the nine months ended September 30, 2017 for the reasons discussed above.
Provision for Income Taxes. The provision for income taxes for the nine months ended September 30, 2018 was $9.3 million, a decrease of $8.0 million, or 46.0%, from $17.3 million for the comparable prior year period. The decrease was primarily due to a decrease in the effective tax rate to 18.0% for the nine months ended September 30, 2018 from 33.0% in the comparable prior year period and the $0.5 million decrease in income before income taxes. The decrease in the effective tax rate reflects the impact of the TCJA on the tax provision and the release of a previously accrued tax liability totaling $1.8 million for the nine months ended September 30, 2018.
FINANCIAL CONDITION
Assets. Total assets at September 30, 2018 were $6,539.5 million, an increase of $240.3 million, or 3.8%, from $6,299.3 million at December 31, 2017. Total loans, net increased $203.1 million, or 3.9%, during the nine months ended September 30, 2018 to $5,359.8 million from $5,156.6 million at December 31, 2017. Loan originations and purchases were $906.1 million for the nine months ended September 30, 2018, an increase of $195.4 million, or 27.5%, from $710.7 million for the nine months ended September 30, 2017. During the nine months ended September 30, 2018, we continued to focus on the origination of multi-family residential, commercial real estate and commercial business loans with a full banking relationship. The loan pipeline totaled $355.2 million at September 30, 2018 compared to $359.8 million at December 31, 2017.
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The following table shows loan originations and purchases for the periods indicated:
The Bank maintains its conservative underwriting standards that include, among other things, a loan-to-value ratio of 75% or less and a debt coverage ratio of at least 125%. Multi-family residential (excluding underlying co-operative mortgages), commercial real estate and one-to-four family mixed-use property mortgage loans originated and purchased during the three months ended September 30, 2018 had an average loan-to-value ratio of 42.2% and an average debt coverage ratio of 173%.
The Bank’s non-performing assets totaled $12.7 million at September 30, 2018, a decrease of $5.5 million, or 30.1%, from $18.1 million at December 31, 2017. Total non-performing assets as a percentage of total assets were 0.19% at September 30, 2018 compared to 0.29% at December 31, 2017. The ratio of allowance for loan losses to total non-performing loans was 160.62% at September 30, 2018 and 112.23% at December 31, 2017.
During the nine months ended September 30, 2018, mortgage-backed securities including held-to-maturity increased $18.5 million, or 3.6%, to $536.1 million from $517.6 million at December 31, 2017. The increase in mortgage-backed securities during the nine months ended September 30, 2018 was primarily due to purchases of $92.6 million at an average yield of 3.54%, partially offset by principal repayments of $57.8 million and a decline in the fair value of $15.2 million.
During the nine months ended September 30, 2018, other securities, including held-to-maturity, increased $4.5 million, or 1.8%, to $256.1 million from $251.6 million at December 31, 2017. The increase in other securities during the nine months ended September 30, 2018 was primarily due to the purchase of one collateralized loan obligation (“CLO”) security and one corporate security totaling $20.0 million, partially offset by the call of one CLO at par for $10.0 million and the decline in fair value of $4.3 million. At September 30, 2018, other securities primarily consist of securities issued by mutual or bond funds that invest in government and government agency securities, municipal bonds, corporate bonds and CLO’s.
Liabilities. Total liabilities were $5,997.8 million at September 30, 2018, an increase of $231.1 million, or 4.0%, from $5,766.7 million at December 31, 2017. During the nine months ended September 30, 2018, due to depositors increased $317.0 million, or 7.3%, to $4,657.6 million, due to increases of $105.9 million in non-maturity deposits and $211.0 million in certificates of deposit. The increase in non-maturity deposits was due to increases of $243.7 million and $13.3 million in money market and demand accounts, respectively, partially offset by a decrease of $77.8 million and $73.3 million in NOW and savings accounts. Borrowed funds decreased $112.6 million during the nine months ended September 30, 2018. The decrease in borrowed funds was primarily due to a decrease in FHLB short-term borrowings as funding needs were provided by increased deposits.
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Equity. Total stockholders’ equity increased $9.1 million, or 1.7%, to $541.8 million at September 30, 2018 from $532.6 million at December 31, 2017. Stockholders’ equity increased primarily due to net income of $42.7 million and the net impact of vesting and exercising of shares of employee and director stock plans totaling $6.5 million. These increases were partially offset by the purchase of 744,953 treasury shares, at an average cost of $26.18 per share, totaling $19.5 million, the declaration and payment of dividends on the Company’s common stock of $0.60 per common share totaling $17.2 million and an increase of $4.6 million in accumulated other comprehensive loss. Book value per common share was $19.33 at September 30, 2018 compared to $18.63 at December 31, 2017.
Cash flow. During the nine months ended September 30, 2018, funds provided by the Company's operating activities amounted to $59.4 million. These funds, combined with $178.0 million provided from financing activities and $51.5 million available from the beginning of the period, were utilized to fund net investing activities of $243.8 million. The Company's primary business objective is the origination and purchase of multi-family residential loans, commercial business loans and commercial real estate mortgage loans and to a lesser extent one-to-four family (including mixed-use properties) and SBA loans. During the nine months ended September 30, 2018, the net total of loan originations and purchases less loan repayments and sales was $217.2 million. During the nine months ended September 30, 2018, the Company also funded $102.8 million in purchases of securities available for sale and $0.7 million of securities held-to-maturity. During the nine months ended September 30, 2018, funds were provided by net increases in total deposits of $332.7 million and short-term borrowed funds of $115.3 million, as well as proceeds from new long-term borrowing of $25.0 million. In addition to funding loan growth, these funds were used to repay $256.1 million in long-term borrowings. The Company also used funds of $21.6 million and $17.2 million for purchases of treasury stock and dividend payments, respectively, during the nine months ended September 30, 2018.
INTEREST RATE RISK
The Consolidated Statements of Financial Position have been prepared in accordance with generally accepted accounting principles in the United States of America, which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in fair value of certain investments due to changes in interest rates. Generally, the fair value of financial investments such as loans and securities fluctuates inversely with changes in interest rates. As a result, increases in interest rates could result in decreases in the fair value of the Company’s interest-earning assets which could adversely affect the Company’s results of operations if such assets were sold, or, in the case of securities classified as available for sale, decreases in the Company’s stockholders’ equity, if such securities were retained.
The Company manages the mix of interest-earning assets and interest-bearing liabilities on a continuous basis to maximize return and adjust its exposure to interest rate risk. On a quarterly basis, management prepares the “Earnings and Economic Exposure to Changes in Interest Rate” report for review by the Asset Liability Committee of the Board of Directors, as summarized below. This report quantifies the potential changes in net interest income and net portfolio value should interest rates go up or down (shocked) 200 basis points, assuming the yield curves of the rate shocks will be parallel to each other. The Company’s regulators currently place focus on the net portfolio value, focusing on a rate shock up or down of 200 basis points. Net portfolio value is defined as the market value of assets net of the market value of liabilities. The market value of assets and liabilities is determined using a discounted cash flow calculation. The net portfolio value ratio is the ratio of the net portfolio value to the market value of assets. All changes in income and value are measured as percentage changes from the projected net interest income and net portfolio value at the base interest rate scenario. The base interest rate scenario assumes interest rates at September 30, 2018. Various estimates regarding prepayment assumptions are made at each level of rate shock. However, prepayment penalty income is excluded from this analysis. Actual results could differ significantly from these estimates. At September 30, 2018, the Company was within the guidelines set forth by the Board of Directors for each interest rate level.
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The following table presents the Company’s interest rate shock as of September 30, 2018:
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AVERAGE BALANCES
Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the relative amount of interest-earning assets and interest-bearing liabilities and the interest rate earned or paid on them. The following tables sets forth certain information relating to the Company’s Consolidated Statements of Financial Condition and Consolidated Statements of Income for the three and nine months ended September 30, 2018 and 2017, and reflects the average yield on assets and average cost of liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown. Average balances are derived from average daily balances. The yields include amortization of fees which are considered adjustments to yields.
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LOANS
The following table sets forth the Company’s loan originations (including the net effect of refinancing) and the changes in the Company’s portfolio of loans, including purchases, sales and principal reductions for the periods indicated.
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TROUBLED DEBT RESTRUCUTURED (“TDR”) AND NON-PERFORMING ASSETS
The following table shows loans classified as TDR that are performing according to their restructured terms at the periods indicated:
During the three months ended September 30, 2018, one commercial business loan for $1.6 million became a TDR.
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The following table shows non-performing assets at the periods indicated:
Included in loans over 90 days past due and still accruing was one loan for $0.1 million, one loan for $0.7 million and three loans totaling $2.4 million at September 30, 2018, June 30, 2018 and December 31, 2017, respectively, which are past their respective maturity dates and are still remitting payments. The Bank actively works with borrowers to extend the loans maturity or have the loan repaid when loans go past their contractual maturity date.
Included in non-performing loans was one multi-family loan totaling $0.4 million at September 30, 2018, June 30, 2018 and December 31, 2017 which was restructured as TDR and not performing in accordance with its restructured terms.
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CRITICIZED AND CLASSIFIED ASSETS
Our policy is to review our assets, focusing primarily on the loan portfolio, OREO and the investment portfolios, to ensure that credit quality is maintained at the highest levels. See Note 5 of the Notes to the Consolidated Financial Statements “Loans” for a description of how loans are determined to be criticized or classified and a table displaying criticized and classified loans at September 30, 2018 and December 31, 2017. The Company had classified other assets acquired through foreclosure totaling $35,000 at September 30, 2018 and none at December 31, 2017. The Company did not hold any criticized or classified investment securities at September 30, 2018 and December 31, 2017. Our total Criticized and Classified assets were $56.7 million at September 30, 2018, a decrease of $6.0 million from $62.7 million at December 31, 2017.
On a quarterly basis, all collateral dependent loans that are classified as Substandard or Doubtful are internally reviewed for impairment, based on updated cash flows for income producing properties, or updated independent appraisals. The loan balances of collateral dependent loans reviewed for impairment are then compared to the loans updated fair value. We consider fair value of collateral dependent loans to be 85% of the appraised or internally estimated value of the property, except for taxi medallion loans. The fair value of the underlying collateral of taxi medallion loans is the value of the underlying medallion based upon the most recently reported arm’s length transaction. When there is no recent sale activity, the fair value is calculated using the income approach. All taxi medallion loans are classified and impaired. For collateral dependent mortgage loans and taxi medallion loans, the portion of the loan balance which exceeds fair value is generally charged-off. At September 30, 2018, the current average loan-to-value ratio on our collateral dependent loans reviewed for impairment was 50.3%.
ALLOWANCE FOR LOAN LOSSES
The Allowance for loan losses (“ALLL”) represents the expense charged to earnings based upon management’s quarterly analysis of credit risk. The amount of the ALLL is based upon multiple factors that reflect management’s assessment of the credit quality of the loan portfolio. The factors are both quantitative and qualitative in nature including, but not limited to, historical losses, economic conditions, trends in delinquencies, value and adequacy of underlying collateral, volume and portfolio mix, and internal loan processes.
Management has developed a comprehensive analytical process to monitor the adequacy of the ALLL. The process and guidelines were developed using, among other factors, the guidance from federal banking regulatory agencies and GAAP. The results of this process, along with the conclusions of our independent loan review officer, support management’s assessment as to the adequacy of the ALLL at each balance sheet date. See Note 5 of the Notes to the Consolidated Financial Statements “Loans” for a detailed explanation of management’s methodology and policy.
As a component of the credit risk assessment, the Bank has established an Asset Classification Committee which carefully evaluates loans which are past due 90 days and/or are classified. The Asset Classification Committee thoroughly assesses the condition and circumstances surrounding each loan meeting the criteria. The Bank also has a Delinquency Committee that evaluates loans meeting specific criteria. The Bank’s loan policy requires loans to be placed into non-accrual status once the loan becomes 90 days delinquent unless there is, in our opinion, compelling evidence the borrower will bring the loan current in the immediate future.
As described in Note 5 of the Notes to the Consolidated Financial Statements “Loans”, during the three months ended September 30, 2018, the Company revised its ALLL methodology to no longer segregated its loans into two portfolios based on year of origination and converged our qualitative factors. This change in methodology increased slightly the portion of the ALLL related to the loss history, while the qualitative factors decreased slightly, partially offset by growth in the loan portfolio. Charge-offs recorded in the past twelve quarters were minimal, with the exception of taxi medallion charge-offs recorded in the fourth quarter of 2017, as credit conditions have remained stable. An unallocated component is maintained as part of our ALLL to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the ALLL reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. The impact from the above resulted in the ALLL totaling $20.3 million, a decrease of $42,000 million, or 0.2%, from December 31, 2017. Based upon management consistently applying the ALLL methodology and review of the loan portfolio, management concluded a charge to earnings to increase the ALLL was not warranted. The ALLL at September 30, 2018 and December 31, 2017, represented 0.38% and 0.39% of gross loans outstanding, respectively. The ALLL represented 160.6% of non-performing loans at September 30, 2018 compared to 112.2% at December 31, 2017.
Management recommends to the Board of Directors the amount of the ALLL quarterly. The Board of Directors approves the ALLL.
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The following table sets forth the activity in the Company's allowance for loan losses for the periods indicated:
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For a discussion of the qualitative and quantitative disclosures about market risk, see the information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate Risk."
ITEM 4. CONTROLS AND PROCEDURES
The Company carried out, under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this Quarterly Report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2018, the design and operation of these disclosure controls and procedures were effective. During the period covered by this Quarterly Report, there have been no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is a defendant in various lawsuits. Management of the Company, after consultation with outside legal counsel, believes that the resolution of these various matters will not result in any material adverse effect on the Company's consolidated financial condition, results of operations and cash flows.
ITEM 1A. RISK FACTORS
There have been no material changes from the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table sets forth information regarding the shares of common stock repurchased by the Company during the three months ended September 30, 2018:
During the quarter ended September 30, 2018, the Company repurchased 299,509 shares of the Company’s common stock at an average cost of $25.58 per share. On September 30, 2018, 509,327 shares may still be repurchased under the currently authorized stock repurchase program. Stock will be purchased under the current stock repurchase programs from time to time, in the open market or through private transactions, subject to market conditions. There is no expiration or maximum dollar amount under these authorizations.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
ITEM 5. OTHER INFORMATION
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PART II – OTHER INFORMATIOMTION
ITEM 6. EXHIBITS
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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.
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EXHIBIT INDEX
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