Table of Contents
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 June 30, 2020
☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______to________
Commission file number 0-22208
QCR HOLDINGS, INC.
(Exact name of Registrant as specified in its charter)
Delaware
42-1397595
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
3551 7th Street, Moline, Illinois 61265
(Address of principal executive offices, including zip code)
(309) 736-3580
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common Stock, $1.00 Par Value
QCRH
The Nasdaq Global Market
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐
Accelerated filer ☒
Non-accelerated filer ☐
Smaller reporting company ☐
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ☐ No ☒
Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date: As of August 1, 2020, the Registrant had outstanding 15,791,536 shares of common stock, $1.00 par value per share.
1
QCR HOLDINGS, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
PageNumber(s)
Part I
FINANCIAL INFORMATION
Item 1
Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets As of June 30, 2020 and December 31, 2019
4
Consolidated Statements of Income For the Three Months Ended June 30, 2020 and 2019
5
Consolidated Statements of Income
For the Six Months Ended June 30, 2020 and 2019
6
Consolidated Statements of Comprehensive Income For the Three and Six Months Ended June 30, 2020 and 2019
7
Consolidated Statements of Changes in Stockholders' Equity For the Three and Six Months Ended June 30, 2020 and 2019
8
Consolidated Statements of Cash Flows For the Six Months Ended June 30, 2020 and 2019
9
Notes to Consolidated Financial Statements
11
Note 1. Summary of Significant Accounting Policies
Note 2. Investment Securities
13
Note 3. Loans/Leases Receivable
17
Note 4. Derivatives and Hedging Activities
28
Note 5. Earnings Per Share
29
Note 6. Fair Value
30
Note 7. Business Segment Information
32
Note 8. Regulatory Capital Requirements
33
Note 9. Pending Sale
35
Item 2
Management's Discussion and Analysis of Financial Condition and Results of Operations
Introduction
36
General
Impact of COVID-19
Executive Overview
40
Strategic Financial Metrics
42
Strategic Developments
43
GAAP to Non-GAAP Reconciliations
Net Interest Income - (Tax Equivalent Basis)
47
Critical Accounting Policies
51
Goodwill
Allowance for Loan and Lease Losses
52
2
Results of Operations
Interest Income
Interest Expense
Provision for Loan/Lease Losses
53
Noninterest Income
54
Noninterest Expense
57
Income Taxes
59
Financial Condition
60
Investment Securities
Loans/Leases
61
Allowance for Estimated Losses on Loans/Leases
63
Nonperforming Assets
64
Deposits
65
Borrowings
66
Stockholders' Equity
67
Liquidity and Capital Resources
68
Special Note Concerning Forward-Looking Statements
69
Item 3
Quantitative and Qualitative Disclosures About Market Risk
71
Item 4
Controls and Procedures
73
Part II
OTHER INFORMATION
74
Legal Proceedings
Item 1A
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
78
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5
Other Information
Item 6
Exhibits
79
Signatures
80
Throughout this Quarterly Report on Form 10-Q, we use certain acronyms and abbreviations, as defined in Note 1 to the Consolidated Financial Statements.
3
CONSOLIDATED BALANCE SHEETS (UNAUDITED)
As of June 30, 2020 and December 31, 2019
June 30,
December 31,
2020
2019
(dollars in thousands)
Assets
Cash and due from banks
$
88,577
76,254
Federal funds sold
2,125
9,800
Interest-bearing deposits at financial institutions
140,775
147,891
Securities held to maturity, at amortized cost
425,976
400,646
Securities available for sale, at fair value
322,907
210,695
Total securities
748,883
611,341
Loans receivable held for sale
8,327
3,673
Loans/leases receivable held for investment
4,131,932
3,686,532
Gross loans/leases receivable
4,140,259
3,690,205
Less allowance for estimated losses on loans/leases
(60,827)
(36,001)
Net loans/leases receivable
4,079,432
3,654,204
Bank-owned life insurance
59,645
58,834
Premises and equipment, net
72,915
73,859
Restricted investment securities
23,209
23,252
Other real estate owned, net
157
4,129
74,248
74,748
Intangibles
13,872
14,970
Derivatives
225,164
87,827
Assets held for sale
10,765
11,966
Other assets
64,994
59,975
Total assets
5,604,761
4,909,050
Liabilities and Stockholders' Equity
Liabilities:
Deposits:
Noninterest-bearing
1,177,482
777,224
Interest-bearing
3,172,293
3,133,827
Total deposits
4,349,775
3,911,051
Short-term borrowings
124,818
13,423
Federal Home Loan Bank advances
145,000
159,300
Subordinated notes
68,516
68,394
Junior subordinated debentures
37,916
37,838
233,589
88,437
Liabilities held for sale
1,588
5,003
Other liabilities
87,539
90,253
Total liabilities
5,048,741
4,373,699
Stockholders' Equity:
Preferred stock, $1 par value; shares authorized 250,000 June 2020 and December 2019 - no shares issued or outstanding
—
Common stock, $1 par value; shares authorized 20,000,000 June 2020 - 15,790,611 shares issued and outstanding December 2019 - 15,828,098 shares issued and outstanding
15,791
15,828
Additional paid-in capital
274,315
274,785
Retained earnings
267,081
245,836
Accumulated other comprehensive income (loss):
Securities available for sale
8,738
2,817
(9,905)
(3,915)
Total stockholders' equity
556,020
535,351
Total liabilities and stockholders' equity
See Notes to Consolidated Financial Statements (Unaudited)
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
Three Months Ended June 30, 2020 and 2019
(dollars in thousands, except share data)
Interest and dividend income:
Loans/leases, including fees
42,614
47,515
Securities:
Taxable
2,048
1,678
Nontaxable
3,565
3,474
134
1,168
288
290
56
Total interest and dividend income
48,650
54,181
Interest expense:
5,766
13,825
22
81
347
601
Other borrowings
92
994
993
573
576
Total interest expense
7,702
16,168
Net interest income
40,948
38,013
Provision for loan/lease losses
19,915
1,941
Net interest income after provision for loan/lease losses
21,033
36,072
Noninterest income:
Trust department fees
2,227
2,361
Investment advisory and management fees
1,399
1,888
Deposit service fees
1,286
1,658
Gains on sales of residential real estate loans, net
1,196
489
Gains on sales of government guaranteed portions of loans, net
39
Swap fee income
19,927
7,891
Securities gains (losses), net
(52)
Earnings on bank-owned life insurance
612
412
Debit card fees
775
914
Correspondent banking fees
198
172
Other
941
1,293
Total noninterest income
28,626
17,065
Noninterest expense:
Salaries and employee benefits
21,304
22,749
Occupancy and equipment expense
3,748
3,533
Professional and data processing fees
3,646
3,031
Post-acquisition compensation, transition and integration costs
70
708
Disposition costs
(83)
FDIC insurance, other insurance and regulatory fees
908
926
Loan/lease expense
339
312
Net cost of (income from) and gains/losses on operations of other real estate
(332)
1,182
Advertising and marketing
552
1,037
Bank service charges
501
508
Losses on liability extinguishment
429
Correspondent banking expense
212
206
Intangibles amortization
548
615
1,280
1,753
Total noninterest expense
33,122
36,560
Net income before income taxes
16,537
16,577
Federal and state income tax expense
2,798
3,073
Net income
13,739
13,504
Basic earnings per common share
0.87
0.86
Diluted earnings per common share
0.85
Weighted average common shares outstanding
15,747,056
15,714,588
Weighted average common and common equivalent shares outstanding
15,895,336
15,938,377
Cash dividends declared per common share
0.06
Six Months Ended June 30, 2020 and 2019
85,774
93,082
3,775
3,344
7,024
7,018
495
2,091
546
598
18
150
97,632
106,283
14,972
26,304
86
152
796
1,662
539
1,988
1,557
1,144
1,148
18,986
31,362
78,646
74,921
28,282
4,075
50,364
70,846
4,539
4,854
3,126
3,624
2,763
3,212
1,848
858
26,731
11,089
952
1,533
1,706
413
388
1,863
2,357
43,822
29,058
Noninterest expenses:
39,823
43,628
7,780
7,227
7,015
5,781
221
842
434
1,591
1,890
567
526
(319)
1,480
1,234
1,822
1,005
991
428
410
1,097
1,147
Goodwill impairment
500
2,585
3,251
Total noninterest expenses
64,537
68,995
29,649
30,909
4,682
4,487
24,967
26,422
1.58
1.68
1.56
1.66
15,771,926
15,703,967
15,956,958
15,930,659
0.12
See Notes to Consolidated Financial Statements (Unaudited
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
Three and Six Months Ended June 30, 2020 and 2019
Three Months Ended June 30,
Other comprehensive income (loss):
Unrealized gains on securities available for sale:
Unrealized holding gains arising during the period before tax
5,336
4,669
Less reclassification adjustment for gains (losses) included in net income before tax
5,271
4,721
Unrealized losses on derivatives:
Unrealized holding losses arising during the period before tax
(654)
(1,780)
Less reclassification adjustment for caplet amortization before tax
(124)
(134)
(530)
(1,646)
Other comprehensive income, before tax
4,741
3,075
Tax expense
1,119
833
Other comprehensive income, net of tax
3,622
2,242
Comprehensive income
17,361
15,746
Six Months Ended June 30,
7,817
8,813
7,752
8,865
(7,815)
(2,942)
Less reclassification adjustment for ineffectiveness and caplet amortization before tax
(234)
(291)
(7,581)
(2,651)
Other comprehensive income (loss), before tax
171
6,214
240
1,628
Other comprehensive income (loss), net of tax
(69)
4,586
24,898
31,008
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)
Accumulated
Additional
Common
Paid-In
Retained
Comprehensive
Stock
Capital
Earnings
(Loss)
Total
Balance December 31, 2019
(1,098)
11,228
Other comprehensive loss, net of tax
(3,691)
Common cash dividends declared, $0.06 per share
(942)
Repurchase and cancellation of 100,932 shares of common stock
as a result of a share repurchase program
(101)
(1,844)
(1,835)
(3,780)
Issuance of 5,553 shares of common stock as a result of
stock purchased under the Employee Stock Purchase Plan
208
214
Issuance of 31,729 shares of common stock as a result of
stock options exercised
274
306
Stock-based compensation expense
641
Restricted stock awards and restricted stock units- 10,300 shares
of common stock , net of restricted stock units
withheld for payment for taxes
10
(8)
Exchange of 1,012 shares of common stock in connection
with payroll taxes for restricted stock and in connection
with stock options exercised
(1)
(189)
(190)
Balance, March 31, 2020
15,774
273,867
254,287
(4,789)
539,139
(945)
Issuance of 16,413 shares of common stock as a result of
16
462
478
Issuance of 975 shares of common stock as a result of
423
Exchange of 513 shares of common stock in connection
with payroll taxes for restricted stock vested and in
connection with stock options exercised
(446)
Balance, June 30, 2020
(1,167)
Balance December 31, 2018
15,718
270,761
192,203
(5,544)
473,138
12,918
2,344
Issuance of 4,446 shares of common stock as a result of
124
128
Issuance of 25,238 shares of common stock as a result of
25
263
722
Restricted stock awards and restricted stock units - 12,719
shares of common stock, net of restricted stock units
withheld for payment of taxes
(50)
(37)
Exchange of 5,169 shares of common stock in connection
(5)
(147)
(152)
Balance, March 31, 2019
15,755
271,673
204,179
(3,200)
488,407
Issuance of 11,346 shares of common stock as a result of
323
334
Issuance of 2,414 shares of common stock as a result of
41
44
719
Restricted stock awards and restricted stock units- 4,769
Exchange of 1,032 shares of common stock in connection
(7)
Balance, June 30, 2019
15,773
272,744
216,741
(958)
504,300
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation
2,690
2,518
1,064
1,441
Deferred compensation expense accrued
1,705
1,323
Losses (gains) on other real estate owned, net
(369)
1,214
Amortization of premiums on securities, net
557
854
Caplet amortization
234
Securities (gains) losses, net
(65)
Loans originated for sale
(98,837)
(45,926)
Proceeds on sales of loans
96,031
43,969
Gains on sales of residential real estate loans
(1,848)
(858)
Gains on sales of government guaranteed portions of loans
(70)
Loss on liability extinguishment, net
Gains on sales of premises and equipment
(67)
Amortization of intangibles
Accretion of acquisition fair value adjustments, net
(1,361)
(2,145)
Increase in cash value of bank-owned life insurance
(941)
(952)
Decrease (increase) in other assets
(2,255)
942
Decrease in other liabilities
(12,729)
(4,615)
Net cash provided by operating activities
39,290
29,324
CASH FLOWS FROM INVESTING ACTIVITIES
Net decrease in federal funds sold
7,675
16,183
Net decrease (increase) in interest-bearing deposits at financial institutions
7,116
(62,084)
Proceeds from sales of other real estate owned
4,341
Activity in securities portfolio:
Purchases
(166,743)
(10,709)
Calls, maturities and redemptions
11,946
5,958
Paydowns
22,541
27,088
Sales
4,592
4,661
Activity in restricted investment securities:
(4,274)
(3,868)
Redemptions
4,317
7,362
Net increase in loans/leases originated and held for investment
(447,385)
(176,394)
Purchase of premises and equipment
(1,828)
(6,032)
Proceeds from sales of premises and equipment
88
146
Net cash (used in) investing activities
(557,614)
(197,150)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposit accounts
408,849
345,614
Net increase (decrease) in short-term borrowings
111,395
(9,583)
Activity in Federal Home Loan Bank advances:
Term advances
85,000
5,000
Calls and maturities
(40,000)
(35,000)
Net change in short-term and overnight advances
(59,300)
(130,865)
Activity in other borrowings:
Calls, maturities and scheduled principal payments
(11,937)
Prepayments
(46,313)
Paydown of revolving line of credit
(9,000)
Prepayments on brokered and public time deposits
29,359
Proceeds from subordinated notes
63,393
Payment of cash dividends on common stock
(1,884)
(1,881)
Proceeds from issuance of common stock, net
1,008
794
Repurchase and cancellation of shares
Net cash provided by financing activities
530,647
170,222
Net increase in cash and due from banks
12,323
2,396
Cash and due from banks, beginning
85,523
Cash and due from banks, ending
87,919
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) - continued
Supplemental disclosure of cash flow information, cash payments (receipts) for:
Interest
19,377
29,346
Income/franchise taxes
(1,099)
(1,032)
Supplemental schedule of noncash investing activities:
Change in accumulated other comprehensive income, unrealized gains on securities available for sale and derivative instruments, net
Exchange of shares of common stock in connection with payroll taxes for restricted stock and in connection with stock options exercised
(636)
(160)
Transfers of loans to other real estate owned
1,012
Due to broker for purchases of securities
4,338
Due from broker for sales of securities
1,735
Increase (decrease) in the fair value of back-to-back interest rate swap assets and liabilities
140,048
Dividends payable
945
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
June 30, 2020
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of presentation: The interim unaudited Consolidated Financial Statements contained herein should be read in conjunction with the audited Consolidated Financial Statements and accompanying notes to the consolidated financial statements for the fiscal year ended December 31, 2019, included in the Company's Annual Report on Form 10-K filed with the SEC on March 13, 2020. Accordingly, footnote disclosures, which would substantially duplicate the disclosures contained in the audited Consolidated Financial Statements, have been omitted.
The financial information of the Company included herein has been prepared in accordance with GAAP for interim financial reporting and has been prepared pursuant to the rules and regulations for reporting on Form 10-Q and Rule 10-01 of Regulation S-X. Such information reflects all adjustments (consisting of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the periods presented. Any differences appearing between the numbers presented in financial statements and management's discussion and analysis are due to rounding. The results of the interim period ended June 30, 2020 are not necessarily indicative of the results expected for the year ending December 31, 2020, or for any other period.
The acronyms and abbreviations identified below are used throughout this Quarterly Report on Form 10-Q. It may be helpful to refer back to this page as you read this report.
Allowance: Allowance for estimated losses on loans/leases
Guaranty: Guaranty Bancshares, Ltd.
AOCI: Accumulated other comprehensive income (loss)
Guaranty Bank: Guaranty Bank and Trust Company
AFS: Available for sale
HTM: Held to maturity
ASC: Accounting Standards Codification
LRP: Loan Relief Program
ASU: Accounting Standards Update
m2: m2 Lease Funds, LLC
Bates Companies: Bates Financial Advisors, Inc., Bates
MSELF: Main Street Expanded Loan Facility
Financial Services, Inc., Bates Securities, Inc. and
MSNLF: Main Street New Loan Facility
Bates Financial Group, Inc.
NIM: Net interest margin
BOLI: Bank-owned life insurance
NPA: Nonperforming asset
Caps: Interest rate cap derivatives
NPL: Nonperforming loan
CARES Act: Coronavirus Aid, Relief and Economy
OREO: Other real estate owned
Security Act
OTTI: Other-than-temporary impairment
CDI: Core deposit intangible
PCI: Purchased credit impaired
CECL: Current Expected Credit Losses
PPP: Paycheck Protection Program
Community National: Community National Bancorporation
Provision: Provision for loan/lease losses
COVID-19: Coronavirus Disease 2019
QCBT: Quad City Bank & Trust Company
CRBT: Cedar Rapids Bank & Trust Company
RB&T: Rockford Bank & Trust Company
CRE: Commercial real estate
ROAA: Return on Average Assets
CSB: Community State Bank
SBA: U.S. Small Business Administration
C&I: Commercial and industrial
SEC: Securities and Exchange Commission
EPS: Earnings per share
SFC Bank: Springfield First Community Bank
Exchange Act: Securities Exchange Act of 1934, as
Springfield Bancshares: Springfield Bancshares, Inc.
amended
TA: Tangible assets
FASB: Financial Accounting Standards Board
TCE: Tangible common equity
FDIC: Federal Deposit Insurance Corporation
TDRs: Troubled debt restructurings
FHLB: Federal Home Loan Bank
TEY: Tax equivalent yield
FRB: Federal Reserve Bank of Chicago
The Company: QCR Holdings, Inc.
GAAP: Generally Accepted Accounting Principles
USDA: U.S. Department of Agriculture
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) – continued
The Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries which include the accounts of four commercial banks: QCBT, CRBT, CSB and SFC Bank. All are state-chartered commercial banks and all are members of the Federal Reserve system. The Company engages in direct financing lease contracts through m2, a wholly-owned subsidiary of QCBT. The Company also engages in wealth management services through its banking subsidiaries and its subsidiaries, the Bates Companies. All material intercompany transactions and balances have been eliminated in consolidation.
On November 30, 2019, the Company sold substantially all of the assets and transferred substantially all of the deposits and certain other liabilities of the Company’s wholly-owned subsidiary, RB&T. The financial results of RB&T prior to its sale are included in this report. See Note 2 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 for additional information about the sale.
Recent accounting developments: In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses. Under the standard, assets measured at amortized cost (including loans, leases and AFS securities) will be presented at the net amount expected to be collected. Rather than the “incurred” model that is currently being utilized, the standard will require the use of a forward-looking approach to recognizing all expected credit losses at the beginning of an asset’s life. For public companies, ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including items periods within those fiscal years. On March 27, 2020, the CARES Act, a stimulus package designed in response to the economic disruption created by COVID-19, was signed into law. The CARES Act includes provisions that, if elected, temporarily delay the required implementation date of ASU 2016-13. Section 4014 of the CARES Act stipulates that no insured depository institution, bank holding company, or affiliate will be required to comply with ASU 2016-13, beginning on the date of the enactment, March 27, 2020 until the earlier of the two following dates: (1) the date on which the national emergency related to the COVID-19 outbreak is terminated or (2) December 31, 2020. The Company has elected to defer its implementation of ASU 2016-13 as allowed by the CARES Act. The Company has developed a CECL allowance model which calculates allowances over the life of the loan and is largely driven by portfolio characteristics, risk-grading, economic outlook, and other key methodology assumptions. Those assumptions are based upon the existing probability of default and loss given default framework. The Company will utilize economic and other forecasts over a four quarter reasonable and supportable forecast period and then fully revert back to average historical losses. The Company’s credit administration team will periodically refine the model as needed and is running parallel calculations. The Company anticipates increases in the allowance for credit losses on longer dated portfolios and decreases in the shorter dated portfolios. The Company estimates an increase in the allowance for estimated losses on loans/leases in the range of $4 million to $6 million upon adoption of CECL at both January 1, 2020 and June 30, 2020. The Company continues to work on the process of finalizing the review of the most recent model run and on finalizing the assumptions, including qualitative adjustments and economic forecasts, which has resulted in adjustments to previous estimates.
Risks and Uncertainties: On January 30, 2020, the World Health Organization declared the COVID-19 outbreak a “Public Health Emergency of International Concern” and on March 11, 2020, declared it to be a pandemic. Actions taken around the world to help mitigate the spread of COVID-19 include restrictions on travel, and quarantines in certain areas, and forced closures for certain types of public places and businesses. COVID-19 and actions taken to mitigate the spread of it have had and are expected to continue to have an adverse impact on the economies and financial markets of many countries, including the geographical area in which the Company operates. On March 27, 2020, the CARES Act was enacted to, among other things, provide emergency assistance for individuals, families and businesses affected by the COVID-19 pandemic. The Company currently expects that the COVID-19 pandemic and the specific developments referred to above will have a significant impact on its business. In particular, the Company anticipates that a significant portion of the subsidiary banks’ borrowers in the hotel, restaurant, entertainment and retail industries will continue to endure significant economic distress, and could adversely affect their ability and willingness to repay existing indebtedness, and could adversely impact the value of collateral pledged to the banks. These developments, together with economic conditions generally, are also expected to impact the Company’s commercial real estate portfolio, particularly with respect to real estate with exposure to these industries, the Company’s equipment leasing business and loan portfolio, the Company’s consumer loan business and loan portfolio, and the value of certain collateral securing the Company’s loans. As a result,
12
the Company anticipates that its financial condition, capital levels, asset quality and results of operations will be adversely affected, as described in further detail on this report.
Due to the economic impact that COVID-19 has had on the Company, management concluded that factors such as the decline in macroeconomic conditions led to the occurrence of a triggering event during the first quarter of 2020, therefore an interim impairment test over goodwill was performed as of March 31, 2020. When such an assessment is performed, should the Company conclude that all or a portion of goodwill is impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. Such a charge would have no impact on tangible capital or regulatory capital. Based upon the results of the interim goodwill assessment during the first quarter of 2020, the Company concluded that an impairment did not exist on the bank reporting units as of the time of the assessment. There was no occurrence of a triggering event during the second quarter of 2020 therefore no impairment test over goodwill was needed.
NOTE 2– INVESTMENT SECURITIES
The amortized cost and fair value of investment securities as of June 30, 2020 and December 31, 2019 are summarized as follows:
Gross
Amortized
Unrealized
Fair
Cost
Gains
(Losses)
Value
June 30, 2020:
Securities HTM:
Municipal securities
424,926
21,323
(2,231)
444,018
Other securities
1,050
445,068
Securities AFS:
U.S. govt. sponsored agency securities
16,663
809
17,472
Residential mortgage-backed and related securities
138,044
7,659
(31)
145,672
98,388
2,962
(84)
101,266
Asset-backed securities
39,712
414
(329)
39,797
18,550
173
(23)
18,700
311,357
12,017
(467)
December 31, 2019:
399,596
26,042
(143)
425,495
426,545
19,872
283
(77)
20,078
118,724
2,045
(182)
120,587
46,659
1,602
(4)
48,257
16,958
(71)
16,887
4,749
138
4,886
206,962
4,068
(335)
The Company's HTM municipal securities consist largely of private issues of municipal debt. The large majority of the municipalities are located within the Midwest. The municipal debt investments are underwritten using specific guidelines with ongoing monitoring.
The Company's residential mortgage-backed and related securities portfolio consists entirely of government sponsored or government guaranteed securities. The Company has not invested in private mortgage-backed securities or pooled trust preferred securities.
Gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of June 30, 2020 and December 31, 2019, are summarized as follows:
Less than 12 Months
12 Months or More
Losses
47,822
48,872
19,127
12,105
16,611
1,977
49,820
509
10,047
(142)
10,556
550
1,059
11,106
1,431
(21)
2,117
(56)
3,548
2,263
(17)
17,862
(165)
20,125
724
16,886
249
20,829
(110)
20,703
(225)
41,532
At June 30, 2020, the investment portfolio included 609 securities. Of this number, 54 securities were in an unrealized loss position. The aggregate losses of these securities totaled approximately 0.4% of the total amortized cost of the portfolio. Of these 54 securities, no securities had an unrealized loss for twelve months or more. Asset-backed securities are comprised of collateralized loan obligations, which are debt securities backed by pools of senior secured commercial loans to a diverse group of companies across a broad spectrum of industries. At June 30, 2020, the Company only owned collateralized loan obligations that were AAA rated. All of the debt securities in unrealized loss positions are considered acceptable credit risks. Based upon an evaluation of the available evidence, including the recent changes in market rates, credit rating information and information obtained from regulatory filings, management believes the declines in fair value for these debt securities are temporary. In addition, the Company lacks the intent to sell these securities and it is not more-likely-than-not that the Company will be required to sell these debt securities before their anticipated recovery.
The Company did not recognize OTTI on any investment securities for the three or six months ended June 30, 2020 and 2019.
14
All sales of securities for the three and six months ended June 30, 2020 and June 30, 2019 were securities identified as AFS.
Three and Six Months Ended
June 30, 2019
Proceeds from sales of securities
6,327
Gross gains from sales of securities
Gross losses from sales of securities
The amortized cost and fair value of securities as of June 30, 2020 by contractual maturity are shown below. Expected maturities of residential mortgage-backed and related securities and asset-backed securities may differ from contractual maturities because the residential mortgages underlying the securities may be prepaid without any penalties. Therefore, these securities are not included in the maturity categories in the following table.
Amortized Cost
Fair Value
Due in one year or less
3,448
3,469
Due after one year through five years
35,903
36,526
Due after five years
386,625
405,073
1,921
1,903
14,976
15,411
116,704
120,124
133,601
137,438
Portions of the U.S. government sponsored agency securities, municipal securities and other securities contain call options, at the discretion of the issuer, to terminate the security at par and at predetermined dates prior to the stated maturity. These callable securities are summarized as follows:
202,436
205,736
84,011
86,534
4,500
4,650
88,511
91,184
As of June 30, 2020, the Company's municipal securities portfolios were comprised of general obligation bonds issued by 97 issuers with fair values totaling $83.3 million and revenue bonds issued by 170 issuers, primarily consisting of states, counties, towns, villages and school districts with fair values totaling $462.0 million. The Company held investments in general obligation bonds in 23 states, including seven states in which the aggregate fair value exceeded $5.0 million. The Company held investments in revenue bonds in 22 states, including 12 states in which the aggregate fair value exceeded $5.0 million.
15
As of December 31, 2019, the Company's municipal securities portfolios were comprised of general obligation bonds issued by 93 issuers with fair values totaling $77.2 million and revenue bonds issued by 154 issuers, primarily consisting of states, counties, towns, villages and school districts with fair values totaling $396.6 million. The Company held investments in general obligation bonds in 22 states, including six states in which the aggregate fair value exceeded $5.0 million. The Company held investments in revenue bonds in 17 states, including nine states in which the aggregate fair value exceeded $5.0 million.
Both general obligation and revenue bonds are diversified across many issuers. As of June 30, 2020 the Company did not hold any revenue bonds of one single issuer of which the aggregate book or market value exceeded 5% of the Company’s stockholders’ equity. As of December 31, 2019, the Company held revenue bonds of one single issuer, located in Ohio, of which the aggregate book or market value exceeded 5% of the Company’s stockholders’ equity. The issuer’s financial condition is strong and the source of repayment is diversified. The Company monitors the investment and concentration closely. Of the general obligation and revenue bonds in the Company's portfolio, the majority are unrated bonds that represent small, private issuances. All unrated bonds were underwritten according to loan underwriting standards and have an average loan risk rating of 2, indicating very high quality. Additionally, many of these bonds are funding essential municipal services such as water, sewer, education, and medical facilities.
The Company's municipal securities are owned by each of the four charters, whose investment policies set forth limits for various subcategories within the municipal securities portfolio. Each charter is monitored individually, and as of June 30, 2020, all were within policy limitations approved by the board of directors. Policy limits are calculated as a percentage of each charter's total risk-based capital.
As of June 30, 2020, the Company's standard monitoring of its municipal securities portfolio had not uncovered any facts or circumstances resulting in significantly different credit ratings than those assigned by a nationally recognized statistical rating organization, or in the case of unrated bonds, the rating assigned using the credit underwriting standards.
NOTE 3 – LOANS/LEASES RECEIVABLE
The composition of the loan/lease portfolio as of June 30, 2020 and December 31, 2019 is presented as follows:
C&I loans*
1,850,110
1,507,825
CRE loans
Owner-occupied CRE
467,537
443,989
Commercial construction, land development, and other land
441,364
378,797
Other non owner-occupied CRE
960,261
913,610
1,869,162
1,736,396
Direct financing leases **
79,105
87,869
Residential real estate loans ***
241,069
239,904
Installment and other consumer loans
99,150
109,352
4,138,596
3,681,346
Plus deferred loan/lease origination costs, net of fees
1,663
8,859
Less allowance
** Direct financing leases:
Net minimum lease payments to be received
87,389
97,025
Estimated unguaranteed residual values of leased assets
616
547
Unearned lease/residual income
(8,900)
(9,703)
Plus deferred lease origination costs, net of fees
1,448
1,892
80,553
89,761
(1,639)
(1,464)
78,914
88,297
* Includes equipment financing agreements outstanding at m2, totaling $153.7 million and $142.0 million as of June 30, 2020 and December 31, 2019, respectively.
** Management performs an evaluation of the estimated unguaranteed residual values of leased assets on an annual basis, at a minimum. The evaluation consists of discussions with reputable and current vendors, which is combined with management's expertise and understanding of the current states of particular industries to determine informal valuations of the equipment. As necessary and where available, management will utilize valuations by independent appraisers. The large majority of leases with residual values contain a lease options rider, which requires the lessee to pay the residual value directly, finance the payment of the residual value, or extend the lease term to pay the residual value. In these cases, the residual value is protected and the risk of loss is minimal.
*** Includes residential real estate loans held for sale totaling $8.3 million and $3.7 million as of June 30, 2020 and December 31, 2019, respectively.
Changes in accretable yield for acquired loans were as follows:
Three months ended June 30, 2020
Six months ended June 30, 2020
PCI
Performing
Loans
Balance at the beginning of the period
(59)
(5,725)
(5,784)
(57)
(6,378)
(6,435)
Reclassification of nonaccretable discount to accretable
(30)
Accretion recognized
790
791
1,443
1,472
Balance at the end of the period
(58)
(4,935)
(4,993)
Three months ended June 30, 2019
Six months ended June 30, 2019
(9,301)
(9,620)
(667)
(10,127)
(10,794)
(159)
327
812
1,139
675
1,638
2,313
(151)
(8,489)
(8,640)
The aging of the loan/lease portfolio by classes of loans/leases as of June 30, 2020 and December 31, 2019 is presented as follows:
As of June 30, 2020
Accruing Past
30-59 Days
60-89 Days
Due 90 Days or
Nonaccrual
Classes of Loans/Leases
Current
Past Due
More
C&I
1,846,417
1,650
311
62
1,670
CRE
Owner-Occupied CRE
467,032
185
320
Commercial Construction, Land Development, and Other Land
441,336
Other Non Owner-Occupied CRE
950,993
1,776
7,492
Direct Financing Leases
77,637
277
151
1,040
Residential Real Estate
239,729
404
936
Installment and Other Consumer
98,435
27
37
640
4,121,579
3,742
1,078
99
12,099
As a percentage of total loan/lease portfolio
99.59
%
0.09
0.03
0.29
100.00
As of December 31, 2019
1,499,891
6,126
572
1,236
443,707
177
34
375,940
2,857
909,684
3,853
85,636
463
253
1,517
235,845
2,939
706
108,750
556
3,659,453
12,638
1,320
7,902
99.41
0.34
0.04
0.00
0.21
NPLs by classes of loans/leases as of June 30, 2020 and December 31, 2019 are presented as follows:
Percentage of
Loans/Leases **
Accruing TDRs
Total NPLs
652
2,384
18.17
2.44
-
57.12
268
1,308
9.97
7.14
677
5.16
920
13,118
** Nonaccrual loans/leases included $352 thousand of TDRs, including $129 thousand in commercial and industrial loans, $138 thousand in direct financing leases, $31 thousand in residential real estate loans, and $54 thousand in installment loans.
646
1,882
21.12
0.38
43.22
333
1,850
20.75
7.92
589
6.61
979
8,914
** Nonaccrual loans/leases included $747 thousand of TDRs, including $98 thousand in C&I loans, $269 thousand in CRE loans, $294 thousand in direct financing leases, $31 thousand in residential real estate loans, and $55 thousand in installment loans.
19
Changes in the allowance by portfolio segment for the three and six months ended June 30, 2020 and 2019, respectively, are presented as follows:
Three Months Ended June 30, 2020
Direct Financing
Residential Real
Installment and
Leases
Estate
Other Consumer
Balance, beginning
18,151
19,269
1,303
1,197
42,233
Provisions charged to expense
7,859
10,365
887
697
107
Loans/leases charged off
(340)
(511)
(595)
(1,450)
Recoveries on loans/leases previously charged off
129
Balance, ending
25,748
29,123
1,639
3,010
1,307
60,827
Three Months Ended June 30, 2019
17,260
18,303
1,606
2,538
1,457
41,164
Provisions (credits) charged to expense
1,116
331
(6)
(193)
(1,369)
(497)
(73)
(20)
(2,152)
31
21
18,248
17,363
1,459
2,582
1,452
41,104
Six Months Ended June 30, 2020
16,072
15,379
1,464
1,948
1,138
36,001
11,556
14,181
1,281
1,033
231
(1,979)
(1,195)
(100)
(3,785)
89
38
329
Six Months Ended June 30, 2019
16,420
17,719
1,792
2,557
1,359
39,847
2,123
948
776
160
(527)
(1,149)
(94)
(3,212)
232
394
20
The allowance by impairment evaluation and by portfolio segment as of June 30, 2020 and December 31, 2019 is presented as follows:
Allowance for impaired loans/leases
341
1,692
23
2,154
Allowance for nonimpaired loans/leases
25,407
27,431
1,619
2,987
1,229
58,673
Impaired loans/leases
2,547
7,815
1,419
884
13,305
Nonimpaired loans/leases
1,847,563
1,861,347
77,686
240,185
98,510
4,125,291
Allowance as a percentage of impaired loans/leases
13.39
21.65
1.41
2.60
12.19
16.19
Allowance as a percentage of nonimpaired loans/leases
1.38
1.47
2.08
1.24
1.25
1.42
Total allowance as a percentage of total loans/leases
1.39
2.07
1.32
170
125
270
660
15,902
15,254
1,194
1,933
1,058
35,341
1,846
3,585
2,025
649
8,661
1,505,979
1,732,811
85,844
239,255
108,796
3,672,685
9.21
3.49
13.33
2.31
14.41
7.62
1.06
0.88
0.81
0.97
0.96
1.07
0.89
1.67
1.04
0.98
Information for impaired loans/leases is presented in the tables below. The recorded investment represents customer balances net of any partial charge-offs recognized on the loan/lease. The unpaid principal balance represents the recorded balance outstanding on the loan/lease prior to any partial charge-offs.
Loans/leases, by classes of financing receivable, considered to be impaired as of and for the six months ended June 30, 2020 are presented as follows:
Average
Recognized for
Recorded
Unpaid Principal
Related
Cash Payments
Investment
Balance
Allowance
Recognized
Received
Impaired Loans/Leases with No Specific Allowance Recorded:
1,978
2,051
1,512
577
965
742
1,364
1,379
624
474
562
525
5,813
6,171
4,760
50
Impaired Loans/Leases with Specific Allowance Recorded:
569
479
6,530
5,329
55
260
6,140
Total Impaired Loans/Leases:
2,620
1,991
7,495
6,071
1,438
912
680
592
13,663
10,900
Loans/leases, by classes of financing receivable, considered to be impaired as of and for the three months ended June 30, 2020 and 2019 are presented as follows:
1,742
1,683
174
194
603
978
3,985
1,411
1,795
524
801
816
5,379
26
9,877
568
2,046
127
143
6,560
1,980
227
220
822
7,475
5,495
2,310
3,729
321
746
7,538
5,965
1,468
2,022
744
1,623
620
966
12,854
15,372
84
Loans/leases, by classes of financing receivable, considered to be impaired as of December 31, 2019 are presented as
follows:
Unpaid
Principal
1,607
1,647
684
686
1,642
469
614
476
4,912
5,115
239
2,867
383
180
3,749
1,886
3,551
3,553
8,864
Impaired loans/leases for which no allowance has been provided have adequate collateral, based on management’s current estimates.
For C&I and CRE loans, the Company’s credit quality indicator consists of internally assigned risk ratings. Each commercial loan is assigned a risk rating upon origination. The risk rating is reviewed every 15 months, at a minimum, and on an as-needed basis depending on the specific circumstances of the loan.
For certain C&I loans (equipment financing agreements), direct financing leases, residential real estate loans, and installment and other consumer loans, the Company’s credit quality indicator is performance determined by delinquency status. Delinquency status is updated daily by the Company’s loan system.
24
For each class of financing receivable, the following presents the recorded investment by credit quality indicator as of June 30, 2020 and December 31, 2019:
Non-Owner Occupied
Commercial
Construction,
Land
Owner-Occupied
Development,
As a % of
Internally Assigned Risk Rating
and Other Land
Other CRE
Pass (Ratings 1 through 5)
1,643,654
463,570
430,206
883,724
3,421,154
95.95
Special Mention (Rating 6)
29,046
857
11,158
63,547
104,608
2.93
Substandard (Rating 7)
23,755
3,110
12,990
39,855
1.12
Doubtful (Rating 8)
1,696,455
3,565,617
Delinquency Status *
151,242
77,797
240,133
98,472
567,644
99.07
Nonperforming
2,413
678
5,335
0.93
153,655
572,979
1,334,446
439,418
378,572
896,206
3,048,642
98.28
12,962
3,044
3,905
19,952
0.65
18,439
1,527
184
13,499
33,649
1.09
0.01
1,365,847
3,102,243
140,992
86,019
239,198
108,763
574,972
99.29
986
4,131
0.71
141,978
579,103
* Performing = loans/leases accruing and less than 90 days past due. Nonperforming = loans/leases on nonaccrual, accruing loans/leases that are greater than or equal to 90 days past due, and accruing TDRs.
As of June 30, 2020 and December 31, 2019, TDRs totaled $1.3 million and $1.7 million, respectively.
For each class of financing receivable, the following presents the number and recorded investment of TDRs, by type of concession, that were restructured during the three and six months ended June 30, 2020 and 2019. The difference between the pre-modification recorded investment and the post-modification recorded investment would be any partial charge-offs at the time of the restructuring.
For the three months ended June 30, 2020
For the three months ended June 30, 2019
Pre-
Post-
Modification
Number of
Specific
Loans / Leases
CONCESSION - Significant Payment Delay
CONCESSION - Forgiveness of Principal
587
537
TOTAL
639
For the six months ended June 30, 2020
For the six months ended June 30, 2019
C & I
111
145
103
256
761
711
Of the loans restructured during the six months ended June 30, 2020, none were on nonaccrual. Of the loans restructured during the six months ended June 30, 2019, two with post-modification recorded balances of $65 thousand were on nonaccrual.
For the three months ended June 30, 2020, two of the Company's TDRs redefaulted within 12 months subsequent to restructure, where default is defined as delinquency of 90 days or more and/or placement on nonaccrual status. These TDRs were related to one equipment financing agreement customer whose loans were restructured in fourth quarter of 2019 with pre-modification balances totaling $93 thousand. For the six months ended June 30, 2020, three of the Company's TDRs redefaulted within 12 months subsequent to restructure, where default is defined as delinquency of 90 days or more and/or placement on nonaccrual status. These TDRs included the two that defaulted in the current quarter as well as a lease that was restructured in the fourth quarter of 2019 with pre-modification balances totaling $55 thousand.
For the three and six months ended June 30, 2019, three of the Company's TDRs redefaulted within 12 months subsequent to restructure, where default is defined as delinquency of 90 days or more and/or placement on nonaccrual status. Two of these TDRs were related to one customer whose leases were restructured in the first quarter of 2019 with pre-modification balances totaling $66 thousand. The other TDR related to a customer whose loan was restructured in the third quarter of 2018 with an original pre-modification balance of $2.9 million and a current pre-modification balance of $1.5 million and a partial charge off of $879 thousand in the second quarter of 2019.
Not included in the table above, the Company had seven TDRs that were restructured and charged off for the six months ended June 30, 2020, totaling $354 thousand. The Company had three TDRs that were restructured and charged off for the six months ended June 30, 2019, totaling $161 thousand.
On March 22, 2020, federal banking regulators issued an interagency statement that included guidance on their approach for the accounting of loan modifications in light of the economic impact of the COVID-19 pandemic. The guidance interprets current accounting standards and indicates that a lender can conclude that a borrower is not experiencing financial difficulty if short-term modifications are made in response to COVID-19, such as payment deferrals, fee waivers, extensions of repayment terms or other delays in payment that are insignificant related to the loans in which the borrower is less than 30 days past due on its contractual payments at the time a modification program is implemented. The agencies confirmed in working with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not TDRs.
In addition, the CARES Act provides financial institutions the option to temporarily suspend certain requirements under GAAP related to TDRs for a limited period of time to account for the effects of COVID-19. To be eligible, the modification must be related to COVID-19, existing loan could not be more than 30 days past due as of December 31, 2019 and modification executed between March 1, 2020 and earlier of 60 days after the termination of the National Emergency or December 31, 2020. If a modification does not meet the criteria of the CARES act, a deferral can still be excluded from TDR treatment as long as the modifications meet the FASB criteria discussed in the preceding paragraph.
The Company implemented its LRP offering to extend qualifying customers’ payments for 90 days. As of June 30, 2020, the program has provided 1,466 Bank modifications of loans to commercial and consumer clients totaling $491 million and 935 m2 modifications of loans and leases totaling $53 million, representing 11.86% and 1.2% of the total loan and lease portfolio, respectively.
NOTE 4 – DERIVATIVES AND HEDGING ACTIVITIES
The Company uses interest rate swap and cap instruments to manage interest rate risk related to the variability of interest payments due to changes in interest rates.
The Company entered into interest rate caps in December 2019 to hedge against the risk of rising interest rates on liabilities. The liabilities consist of $375.0 million of deposits and the benchmark rates hedged vary at 1-month LIBOR, 3-month LIBOR and Prime. The interest rate caps are designated as cash flow hedges in accordance with ASC 815. An initial premium of $4.3 million was paid upfront for the caps executed in 2019. The details of the interest rate caps are as follows:
Balance Sheet
Fair Value as of
Hedged Item
Effective Date
Maturity Date
Location
Notional Amount
Strike Rate
December 31, 2019
1/1/2020
1/1/2023
Other Assets
25,000
1.75
112
50,000
1.57
218
1.90
96
1.80
109
1/1/2024
401
2/1/2020
2/1/2024
202
201
1/1/2025
48
337
97
617
3/1/2020
3/1/2025
332
309
375,000
437
3,148
The Company has entered into interest rate swaps to hedge against the risk of rising rates on its rolling fixed rate short-term FHLB advances or brokered CDs and its variable rate trust preferred securities. All of the interest rate swaps are designated as cash flow hedges in accordance with ASC 815. The details of the interest rate swaps are as follows:
Receive Rate
Pay Rate
CRBT - FHLB Advances or Brokered CDs
3/16/2020
3/16/2023
Derivatives - Liabilities
30,000
0.31
(730)
SFCB - FHLB Advances or Brokered CDs
10,000
0.32
0.95
(200)
QCR Holdings Statutory Trust II
9/30/2018
9/30/2028
3.16
5.85
(2,051)
(971)
QCR Holdings Statutory Trust III
8,000
(1,641)
(777)
QCR Holdings Statutory Trust V
7/7/2018
7/7/2028
2.77
4.54
(1,993)
(944)
Community National Statutory Trust II
9/20/2018
9/20/2028
3,000
2.48
5.17
(613)
Community National Statutory Trust III
9/15//2018
9/15/2028
3,500
2.06
4.75
(715)
(339)
Guaranty Bankshares Statutory Trust I
9/15/2018
(919)
(436)
79,000
1.92
5.24
(8,862)
(3,758)
Changes in fair values of derivative financial instruments accounted for as cash flow hedges, to the extent that they are included in the assessment of effectiveness, are recorded as a component of AOCI.
The Company has also entered into interest rate swap contracts that are not designated as hedging instruments. These derivative contracts relate to transactions in which the Company enters into an interest rate swap with a customer while at the same time entering into an equal and offsetting interest rate swap with a third party financial institution. Additionally, the Company receives an upfront fee from the counterparty, dependent upon the pricing that is recognized upon receipt from the counterparty. Because the Company acts as an intermediary for the customer, changes in the fair value of the
underlying derivative contracts, for the most part, offset each other and do not significantly impact the Company’s results of operations.
Interest rate swaps that are not designated as hedging instruments are summarized as follows:
Estimated Fair Value
Non-Hedging Interest Rate Derivatives Assets:
Interest rate swap contracts
1,100,913
224,727
787,221
84,679
Non-Hedging Interest Rate Derivatives Liabilities:
Swap fee income totaled $19.9 million and $7.9 million for the three months ended June 30, 2020 and 2019, respectively. Swap fee income totaled $26.7 million and $11.1 million for the six months ended June 30, 2020 and 2019, respectively.
The Company’s hedged interest rate swaps and non-hedged interest rate swaps are collateralized with cash and investment securities with carrying values as follows:
Cash
80,250
10,990
U.S govt. sponsored agency securities
3,657
3,541
41,863
68,089
107,190
27,027
232,960
109,647
The Company may be exposed to credit risk in the event of non-performance by the counterparties to its interest rate derivative agreements. The Company assesses the credit risk of its financial institution counterparties by monitoring publicly available credit rating and financial information. Additionally, the Company enters into interest rate derivatives only with primary and highly rated counterparties, and uses ISDA master agreements, central clearing mechanisms and counterparty limits. The ISDA master agreements contain bilateral collateral agreements with the amount of collateral to be posted generally governed by the settlement value of outstanding swaps. The Company manages the risk of default by its borrower counterparties through its normal loan underwriting and credit monitoring policies and procedures. The Company does not currently anticipate any losses from failure of interest rate derivative counterparties to honor their obligations.
NOTE 5 - EARNINGS PER SHARE
The following information was used in the computation of EPS on a basic and diluted basis:
Three months ended
Six months ended
Basic EPS
Diluted EPS
Weighted average common shares issuable upon exercise of stock options
and under the employee stock purchase plan
148,280
223,789
185,032
226,692
NOTE 6 – FAIR VALUE
Accounting guidance on fair value measurement uses a hierarchy intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy includes three levels and is based upon the valuation techniques used to measure assets and liabilities. The three levels are as follows:
Assets and liabilities measured at fair value on a recurring basis comprise the following at June 30, 2020 and December 31, 2019:
Fair Value Measurements at Reporting Date Using
Quoted Prices
Significant
in Active
Markets for
Observable
Unobservable
Identical Assets
Inputs
(Level 1)
(Level 2)
(Level 3)
Total assets measured at fair value
548,071
Total liabilities measured at fair value
298,522
The securities AFS portfolio consists of securities whereby the Company obtains fair values from an independent pricing service. The fair values are determined by pricing models that consider observable market data, such as interest rate volatilities, LIBOR yield curve, credit spreads and prices from market makers and live trading systems (Level 2 inputs).
Interest rate caps are used for the purpose of hedging interest rate risk. The interest rate caps are further described in Note 4 to the Consolidated Financial Statements. The fair values are determined by pricing models that consider observable market data for derivative instruments with similar structures (Level 2 inputs).
Interest rate swaps are used for the purpose of hedging interest rate risk on FHLB advances, brokered deposits and junior subordinated debt. The interest rate swaps are further described in Note 4 to the Consolidated Financial Statements. The fair values are determined by comparing the contract rate on the swap with the then-current market rate for the remaining term of the transaction (Level 2 inputs).
Interest rate swaps are also executed for select commercial customers. The interest rate swaps are further described in Note 4 to the Consolidated Financial Statements. The fair values are determined by comparing the contract rate on the swap with the then-current market rate for the remaining term of the transaction (Level 2 inputs).
Certain financial assets are measured at fair value on a non-recurring basis; that is, the assets are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).
Assets measured at fair value on a non-recurring basis comprise the following at June 30, 2020 and December 31, 2019:
Level 1
Level 2
Level 3
5,821
OREO
5,991
3,394
4,459
7,853
Impaired loans/leases are evaluated and valued at the time the loan/lease is identified as impaired, at the lower of cost or fair value, and are classified as Level 3 in the fair value hierarchy. Fair value is measured based on the value of the collateral securing these loans/leases. Collateral may be real estate and/or business assets, including equipment, inventory and/or accounts receivable, and is determined based on appraisals by qualified licensed appraisers hired by the Company. Appraised and reported values are discounted based on management's historical knowledge, changes in market conditions from the time of valuation, and/or management's expertise and knowledge of the client and client's business.
OREO in the table above consists of property acquired through foreclosures and settlements of loans. Property acquired is carried at the estimated fair value of the property, less disposal costs, and is classified as Level 3 in the fair value hierarchy. The estimated fair value of the property is determined based on appraisals by qualified licensed appraisers hired by the Company. Appraised and reported values are discounted based on management's historical knowledge, changes in market conditions from the time of valuation, and/or management's expertise and knowledge of the property.
The following table presents additional quantitative information about assets measured at fair value on a non-recurring basis for which the Company has utilized Level 3 inputs to determine fair value:
Quantitative Information about Level Fair Value Measurements
Valuation Technique
Unobservable Input
Range
Appraisal of collateral
Appraisal adjustments
(10.00)
to
(30.00)
(35.00)
For the impaired loans/leases and OREO, the Company records carrying value at fair value less disposal or selling costs. The amounts reported in the tables above are fair values before the adjustment for disposal or selling costs.
There have been no changes in valuation techniques used for any assets or liabilities measured at fair value during the three and six months ended June 30, 2020 and 2019.
The following table presents the carrying values and estimated fair values of financial assets and liabilities carried on the Company's consolidated balance sheets, including those financial assets and liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis:
Hierarchy
Carrying
Estimated
Level
Investment securities:
HTM
AFS
*
Loans/leases receivable, net
5,390
3,143
4,074,042
4,049,076
3,651,061
3,606,520
Nonmaturity deposits
3,674,337
3,184,726
Time deposits
675,438
682,827
726,325
742,444
FHLB advances
146,788
159,193
68,705
68,563
30,458
30,477
*See previous table in Note 2.
NOTE 7 – BUSINESS SEGMENT INFORMATION
Selected financial and descriptive information is required to be disclosed for reportable operating segments, applying a “management perspective” as the basis for identifying reportable segments. The management perspective is determined by the view that management takes of the segments within the Company when making operating decisions, allocating resources, and measuring performance. The segments of the Company have been defined by the structure of the Company's internal organization, focusing on the financial information that the Company's operating decision-makers routinely use to make decisions about operating matters.
The Company's primary segment, Commercial Banking, is geographically divided by markets into the secondary segments comprised of the four held for investment subsidiary banks wholly owned by the Company: QCBT, CRBT, CSB, and SFC Bank. Each of these secondary segments offers similar products and services, but is managed separately due to different pricing, product demand, and consumer markets. Each offers commercial, consumer, and mortgage loans and deposit services.
The Company's Wealth Management segment represents the trust, asset management, investment management and advisory services offered at the Company's subsidiary banks and the Bates Companies in aggregate. This segment generates income primarily from fees charged based on assets under administration for corporate and personal trusts, custodial services, and investments managed. No assets of the subsidiary banks have been allocated to the Wealth Management segment.
The Company's All Other segment includes the corporate operations of the parent and operations of all other consolidated subsidiaries and/or defined operating segments that fall below the segment reporting thresholds. The financial results for RB&T prior to the sale of the majority of its assets and liabilities at November 30, 2019 are also included in the Company’s All Other Segment as are the assets held for sale at June 30, 2020.
Selected financial information on the Company's business segments is presented as follows as of and for the three and six months ended June 30, 2020 and 2019.
Commercial Banking
Wealth
Intercompany
Consolidated
QCBT
CRBT
CSB
SFC Bank
Management
All other
Eliminations
Total revenue
19,727
34,612
9,752
9,533
3,627
17,813
(17,788)
77,276
15,653
12,820
6,201
(1,509)
245
7,539
7,160
2,811
2,405
Net income (loss) from continuing operations
3,307
10,580
591
1,899
13,797
(17,421)
3,223
14,980
9,888
45,975
182
2,437
3,643
6,344
1,984,245
2,021,043
903,648
745,470
715,740
(765,385)
20,374
23,575
9,730
7,757
4,249
23,431
(17,870)
71,246
12,632
10,785
7,294
5,425
1,877
973
300
485
4,505
6,928
2,207
2,079
583
14,369
(17,167)
3,682
77,748
2,935
4,328
7,268
1,558
16,089
1,637,115
1,527,521
806,704
671,644
1,164,901
(613,033)
5,194,852
39,227
56,607
19,802
18,224
7,665
33,431
(33,502)
141,454
30,080
24,206
15,038
11,843
(2,998)
477
10,722
9,410
4,775
3,375
Net income (loss)
8,210
16,957
1,629
4,105
1,806
24,934
(32,674)
38,918
42,819
19,000
15,045
8,478
43,609
(32,528)
135,341
24,771
21,193
14,260
10,651
4,046
1,993
725
301
985
8,690
12,028
4,363
3,732
1,741
27,485
(31,617)
NOTE 8 – REGULATORY CAPITAL REQUIREMENTS
The Company (on a consolidated basis) and the subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company and subsidiary banks' financial statements.
Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the subsidiary banks must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification
are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the subsidiary banks to maintain minimum amounts and ratios (set forth in the following table) of total common equity Tier 1 and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets, each as defined by regulation. Management believes, as of June 30, 2020 and December 31, 2019, that the Company and the subsidiary banks met all capital adequacy requirements to which they are subject.
Under the regulatory framework for prompt corrective action, to be categorized as “well capitalized,” an institution must maintain minimum total risk-based, Tier 1 risk-based, Tier 1 leverage and common equity Tier 1 ratios as set forth in the following tables. The Company and the subsidiary banks' actual capital amounts and ratios as of June 30, 2020 and December 31, 2019 are presented in the following table (dollars in thousands). As of June 30, 2020 and December 31, 2019, each of the subsidiary banks met the requirements to be “well capitalized”.
For Capital
To Be Well
Adequacy Purposes
Capitalized Under
With Capital
Prompt Corrective
Actual
Conservation Buffer
Action Provisions
Amount
Ratio
As of June 30, 2020:
Company:
Total risk-based capital
630,347
13.71
367,866
>
8.00
482,824
10.50
459,832
10.00
Tier 1 risk-based capital
509,216
11.07
275,899
6.00
390,858
8.50
Tier 1 leverage
8.91
228,572
4.00
285,716
5.00
Common equity Tier 1
471,300
10.25
206,925
4.50
321,883
7.00
298,891
6.50
Quad City Bank & Trust:
200,053
12.40
129,068
169,401
161,335
179,859
11.15
96,801
137,134
7.57
95,014
118,767
72,601
112,934
104,867
Cedar Rapids Bank & Trust:
200,479
12.15
132,034
173,295
165,043
179,841
10.90
99,026
140,287
9.66
74,475
93,094
74,269
115,530
107,278
Community State Bank:
96,839
12.76
60,732
79,710
75,915
87,338
11.50
45,549
64,527
9.86
35,430
44,287
34,162
53,140
49,344
Springfield First Community Bank:
79,054
13.43
47,106
61,827
58,883
68,519
11.64
35,330
50,050
9.29
29,494
36,867
26,497
41,218
38,274
As of December 31, 2019:
581,234
348,937
457,980
10.500
436,171
481,702
11.04
261,703
370,746
8.500
9.53
202,207
4.000
252,758
443,864
10.18
196,277
305,320
7.000
283,511
183,855
11.83
124,362
163,225
155,452
170,137
10.94
93,271
132,134
9.94
68,479
85,598
69,953
108,817
101,044
175,498
11.90
117,953
154,813
147,441
162,127
11.00
88,465
125,325
10.41
62,286
77,857
66,349
103,209
95,837
92,095
12.32
59,813
78,504
74,766
85,437
11.43
44,860
63,551
10.39
32,902
41,128
33,645
52,336
48,598
71,074
12.72
44,704
58,674
55,880
63,956
11.45
33,528
47,498
9.70
26,379
32,974
25,146
39,116
36,322
NOTE 9 – PENDING SALE
On April 2, 2020, the Company entered into a stock purchase agreement to sell all the issued and outstanding capital stock of the Bates Companies. The aggregate consideration to be paid to the Company shall be an amount equal to $500,000 plus cancellation of all future amounts otherwise to become payable to the purchaser by the Company under an earn-out agreement entered into between the same parties in 2018 with a non-discounted value of approximately $1.6 million at June 30, 2020.
This transaction received regulatory approval and the closing date is scheduled for August 10, 2020.
Goodwill impairment related to the execution of the agreement to sell the Bates Companies was $500,000 in the first quarter of 2020.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
This section reviews the financial condition and results of operations of the Company and its subsidiaries as of and for the three and six months ending June 30, 2020. Some tables may include additional periods to comply with disclosure requirements or to illustrate trends. When reading this discussion, also refer to the Consolidated Financial Statements and related notes in this report. The page locations and specific sections and notes that are referred to in this discussion are presented in the table of contents.
Additionally, a comprehensive list of the acronyms and abbreviations used throughout this discussion is included in Note 1 to the Consolidated Financial Statements.
GENERAL
QCR Holdings, Inc. is a financial holding company and the parent company of QCBT, CRBT, CSB and SFC Bank. QCBT, CRBT and CSB are Iowa-chartered commercial banks and SFC Bank is a Missouri-chartered commercial bank. All four charters are members of the Federal Reserve system with depository accounts insured to the maximum amount permitted by the FDIC.
IMPACT OF COVID-19
The progression of the COVID-19 pandemic in the United States has had an adverse impact on the Company’s financial condition and results of operations as of and for the three and six months ended June 30, 2020, and could have a complex and significant adverse impact on the economy, the banking industry and the Company in future fiscal periods, all subject to a high degree of uncertainty.
Effects on the Company’s Market Areas
The Company offers commercial and consumer banking products and services primarily in Illinois, Missouri and Iowa. Each of these three states has recently taken different steps to reopen since COVID-19 thrust the country into lockdown starting in March 2020. In Illinois, Governor J.B Pritzker has moved the state into Phase 4 of Restore Illinois which allows
FINANCIAL CONDITION AND RESULTS OF OPERATIONS – continued
businesses to open with Illinois Department of Public Health approved safety guidance and requires certain businesses to open at reduced capacity. This went into effect on June 26, 2020. In Missouri, Governor Mike Parson announced the full opening of the state, effective June 16, 2020. In Iowa, Governor Kim Reynolds lifted all capacity limits on businesses effective June 10, 2020. Despite these measures, the reopening of each jurisdiction is subject to change, delay and setbacks based on ongoing regional monitoring of the pandemic. However, currently all of the subsidiary banks’ branches are open during normal business hours with the exception of four branch locations that are currently limiting lobby access to appointment only.
Each state has experienced rapidly increasing unemployment levels as a result of the curtailment of business activities, rising from an average of 4.6% in Illinois in March 2020 to an average of 15.2% in May 2020, according to the Illinois Department of Employment Security. The unemployment rate in Illinois improved slightly in June 2020 to an average of 14.6%. Unemployment rose from an average of 4.5% in Missouri in March 2020 to 10.1% in May 2020, according to the Missouri Department of Labor and Industrial Relations. The unemployment rate in Missouri improved in June 2020 to an average of 7.9%. In Iowa, unemployment rose from an average of 3.7% in March 2020 to 10.0% in May 2020, according to the Iowa Workforce Development. The unemployment rate in Iowa improved in June 2020 to an average of 7.9%.
Policy and Regulatory Developments
Federal, state and local governments and regulatory authorities have enacted and issued a range of policy responses to the COVID-19 pandemic, including the following:
Effects on the Company’s Business
The Company currently expects that the COVID-19 pandemic and the specific developments referred to above could have a significant impact on its business. In particular, the Company anticipates that a significant portion of the subsidiary banks’ borrowers in the hotel, restaurant, entertainment and retail industries will continue to endure significant economic distress, and could adversely affect their ability to repay existing indebtedness, and could adversely impact the value of collateral pledged to the banks. These developments, together with economic conditions generally, may impact the Company’s commercial real estate portfolio, particularly with respect to real estate with exposure to these industries, the Company’s equipment leasing business and loan portfolio, the Company’s consumer loan business and loan portfolio, and the value of certain collateral securing the Company’s loans. In addition, the Company’s loan and lease growth could slow exclusive of the PPP loans, while deposit growth could accelerate as businesses and consumers navigate the impact. As a result, the Company anticipates that its financial condition, capital levels, asset quality and results of operations could be adversely affected, as described in further detail below.
The Company’s Response
The Company has taken numerous steps in response to the COVID-19 pandemic, including the following:
EXECUTIVE OVERVIEW
The Company reported net income of $13.7 million and diluted EPS of $0.86 for the quarter ended June 30, 2020. By comparison, for the quarter ended March 31, 2020, the Company reported net income of $11.2 million and diluted EPS of $0.70. For the quarter ended June 30, 2019, the Company reported net income of $13.5 million, and diluted EPS of $0.85. For the six months ended June 30, 2020, the Company reported net income of $25.0 million, and diluted EPS of $1.56. By comparison, for the six months ended June 30, 2019, the Company reported net income of $26.4 million, and diluted EPS of $1.66.
The second quarter of 2020 was also highlighted by the following results and events:
Following is a table that represents various income measurements for the Company.
For the three months ended
For the six months ended
March 31, 2020
0.70
16,011,456
Following is a table that represents the major income and expense categories for the Company:
37,698
Provision expense
8,367
Noninterest income
15,196
Noninterest expense
31,415
1,884
Following are some noteworthy changes in the Company's financial results:
STRATEGIC FINANCIAL METRICS
The Company has established certain strategic financial metrics by which it manages its business and measures its performance. The goals are periodically updated to reflect changes in business developments. While the Company is determined to work prudently to achieve these metrics, there is no assurance that they will be met. Moreover, the Company's ability to achieve these metrics will be affected by the factors discussed under “Forward Looking Statements” as well as the factors detailed in the “Risk Factors” section included under Item 1A. of Part I of the Company's Annual Report on Form 10-K for the year ended December 31, 2019. The Company's long-term strategic financial metrics are as follows:
The following table shows the evaluation of the Company’s strategic financial metrics:
Year to Date
Strategic Financial Metric
Key Metric
Target
June 30, 2020*
Loans and leases growth organically
Loans and leases growth
> 9% annually
5.0
Fee income growth
> 6% annually
31.7
Improve operational efficiencies and hold noninterest expense growth
Noninterest expense growth
< 5% annually
(11.6)
* Ratios and amounts provided for these measurements represent year-to-date actual amounts for the respective period that are then annualized for comparison. The calculations provided exclude non-core noninterest income and noninterest expense.
** Loans and leases growth excludes PPP loans.
It should be noted that these initiatives are long-term targets. Due to the impact of the COVID-19 pandemic, the Company may not be able to achieve these goals for the full year 2020.
STRATEGIC DEVELOPMENTS
The Company has taken the following actions during the second quarter of 2020 to support its corporate strategy:
GAAP TO NON-GAAP RECONCILIATIONS
The following table presents certain non-GAAP financial measures related to the “TCE/TA ratio”, “adjusted net income”, “adjusted EPS”, “adjusted ROAA”, “pre-provision/pre-tax adjusted income”, “NIM (TEY)”, “adjusted NIM”, “pre-provision/pre-tax adjusted ROAA”, “efficiency ratio”, “ALLL to total loans and leases excluding PPP loans” and “loan growth annualized excluding PPP loans”. In compliance with applicable rules of the SEC, all non-GAAP measures are reconciled to the most directly comparable GAAP measure, as follows:
The TCE/TA non-GAAP ratio has been a focus for investors and management believes that this ratio may assist investors in analyzing the Company's capital position without regard to the effects of intangible assets. The TCE/TA ratio excluding PPP loans non-GAAP ratio is provided as the Company’s management believes this financial measure is important to investors as total assets for the quarter ended June 30, 2020 was materially higher due to the addition of PPP loans. By excluding the PPP loans, management believes the investor is provided a better comparison to prior periods for analysis.
The following tables also include several “adjusted” non-GAAP measurements of financial performance. The Company's management believes that these measures are important to investors as they exclude non-recurring income and expense items; therefore, they provide a better comparison for analysis and may provide a better indicator of future performance.
The pre-provision/pre-tax adjusted income and pre-provision/pre-tax adjusted ROAA are measurements of the Company’s financial performance excluding provision and income taxes as well as non-recurring income and expense items. The Company’s management believes this financial measure is important to investors as provision for the quarter ended June 30, 2020 was materially higher due to the impact of COVID-19 as well as its impact on income taxes. By excluding the provision and income taxes as well as non-recurring income and expense items, the investor is provided a better comparison to prior periods for analysis.
NIM (TEY) is a financial measure that the Company's management utilizes to take into account the tax benefit associated with certain tax-exempt loans and securities. It is standard industry practice to measure net interest margin using tax-equivalent measures. In addition, the Company calculates NIM without the impact of acquisition accounting net accretion (adjusted NIM), as accretion amounts can fluctuate widely, making comparisons difficult.
The efficiency ratio is a ratio that management utilizes to compare the Company to its peers. It is a standard ratio used to calculate overhead as a percentage of revenue in the banking industry and is widely utilized by investors.
ALLL to total loans and leases, excluding PPP loans and loan growth annualized, excluding PPP loans are ratios that management utilizes to compare the Company to its peers. The Company’s management believes these financial measures are important to investors as total loans and leases for the quarter ended June 30, 2020 was materially higher due to the addition of PPP loans which are guaranteed by the government and therefore do not necessitate an increase in ALLL. By excluding the PPP loans, the investor is provided a better comparison to prior periods for analysis.
As of
GAAP TO NON-GAAP
March 31,
RECONCILIATIONS
(dollars in thousands, except per share data)
TCE/TA RATIO
Stockholders' equity (GAAP)
Less: Intangible assets
88,120
88,669
93,837
TCE (non-GAAP)
467,900
450,470
410,463
Total assets (GAAP)
5,232,075
TA (non-GAAP)
5,516,641
5,143,406
5,101,015
TCE/TA ratio (non-GAAP)
8.48
8.76
8.05
TCE/TA RATIO EXCLUDING PPP LOANS
Less: PPP loan interest income (post-tax)
2,085
465,815
Less: PPP loans
358,052
5,158,589
TCE/TA ratio excluding PPP loans (non-GAAP)
9.03
45
For the Quarter Ended
For the Six Months Ended
ADJUSTED NET INCOME
Net income (GAAP)
Less non-core items (post-tax) (*):
Income:
(41)
Total non-core income (non-GAAP)
Expense:
Losses on debt extinguishment
116
455
(66)
408
343
119
559
175
665
Total non-core expense (non-GAAP)
1,143
2,281
Adjusted net income (non-GAAP)
14,016
12,371
14,104
26,388
27,128
PRE-PROVISION/PRE-TAX ADJUSTED INCOME
Less: Non-core income not tax-effected
Plus: Non-core expense not tax-effected
416
1,315
1,731
Pre-provision/pre-tax adjusted income (non-GAAP)
36,803
22,794
19,278
59,597
35,878
PRE-PROVISION/PRE-TAX ADJUSTED RETURN ON AVERAGE ASSETS (NON-GAAP)
Average assets
5,800,164
4,948,311
5,077,900
5,374,224
5,023,201
Pre-provision/pre-tax adjusted return on average assets (non-GAAP)
2.54
1.84
1.52
2.22
1.43
ADJUSTED EPS
Adjusted net income (non-GAAP) (from above)
15,796,796
Adjusted EPS (non-GAAP):
Basic
0.78
0.90
1.73
Diluted
0.77
1.65
1.70
ADJUSTED ROAA
Average Assets
Adjusted ROAA (annualized) (non-GAAP)
1.00
1.11
1.08
ADJUSTED NIM (TEY)*
Net interest income (GAAP)
Plus: Tax equivalent adjustment
1,728
1,790
1,808
3,517
3,509
Net interest income - tax equivalent (non-GAAP)
42,676
39,488
39,821
82,163
78,430
Less: Acquisition accounting net accretion
736
625
1,076
1,361
2,145
Adjusted net interest income
41,940
38,863
38,745
80,802
76,285
Average earning assets
5,252,663
4,461,018
4,698,021
4,856,842
4,655,288
NIM (GAAP)
3.14
3.40
3.25
3.26
NIM (TEY) (non-GAAP)
3.27
3.56
Adjusted NIM (TEY) (non-GAAP)
3.21
3.50
3.31
3.35
3.30
EFFICIENCY RATIO
Noninterest expense (GAAP)
Noninterest income (GAAP)
Total income
69,574
52,894
55,078
122,468
103,979
Efficiency ratio (noninterest expense/total income) (non-GAAP)
47.61
59.39
66.38
52.70
66.35
ALLLTO TOTAL LOANS AND LEASES, EXCLUDING PPP LOANS
ALLL
Total loans and leases
3,704,668
3,910,519
Total loans and leases, excluding PPP loans
3,782,207
ALLL to total loans and leases, excluding PPP loans
1.61
1.14
1.05
LOAN GROWTH ANNUALIZED, EXCLUDING PPP LOANS
Loan growth annualized, excluding PPP loans
8.37
13.57
4.99
9.52
* Nonrecurring items (after-tax) are calculated using an estimated effective tax rate of 21% with the exception of goodwill impairment which is not deductible for tax and gain on sale of subsidiary which has an estimated effective tax rate of 30.5%.
46
NET INTEREST INCOME - (TAX EQUIVALENT BASIS)
Net interest income, on a tax equivalent basis, increased 7% to $42.7 million for the quarter ended June 30, 2020 compared to the same quarter of the prior year, and increased 5% to $82.2 million for the six months ended June 30, 2020 compared to the same period of the prior year. Excluding the tax equivalent adjustments, net interest income increased 8% for the quarter ended June 30, 2020 compared to the same quarter of the prior year, and increased 5% for the six months ended June 30, 2020 compared to the same period of the prior year. Net interest income improved due to the following factors:
A comparison of yields, spread and margin on a tax equivalent and GAAP basis is as follows:
Tax Equivalent Basis
GAAP
Average Yield on Interest-Earning Assets
3.86
4.58
4.78
3.70
4.39
4.63
Average Cost of Interest-Bearing Liabilities
0.80
1.33
1.76
0.79
Net Interest Spread
3.06
3.24
3.02
2.91
3.07
2.87
NIM
NIM Excluding Acquisition Accounting Net Accretion
3.10
3.37
3.15
4.19
4.76
4.02
4.60
1.74
2.86
Acquisition accounting net accretion can fluctuate mostly depending on the payoff activity of the acquired loans. In evaluating net interest income and NIM, it’s important to understand the impact of acquisition accounting net accretion when comparing periods. The above table reports NIM with and without the acquisition accounting net accretion to allow for more appropriate comparisons. A comparison of acquisition accounting net accretion included in NIM is as follows:
Acquisition Accounting Net Accretion in NIM
NIM on a tax equivalent basis was down 29 basis points on a linked quarter basis. Excluding acquisition accounting net accretion, NIM was down 29 basis points on a linked quarter basis. The decrease in net interest margin during the quarter was due to a 72 basis point decline in the yield on earning assets, partially offset by a 53 basis point decline in total cost of interest-bearing funds (due to both mix and rate). Due to significant core deposit growth outpacing loans throughout
the quarter, the Company carried excess liquidity of approximately $400 million which contributed to 30 bps of the decline in NIM. Excluding the impact of this excess liquidity, Adjusted NIM would have been stable with the first quarter.
The Company’s management closely monitors and manages NIM. From a profitability standpoint, an important challenge for the Company's subsidiary banks and leasing company is focusing on quality growth in conjunction with the improvement of their NIMs. Management continually addresses this issue with pricing and other balance sheet
strategies which include better loan pricing, reducing reliance on very rate-sensitive funding, closely managing deposit rate changes and finding additional ways to manage NIM through derivatives.
In response to the COVID-19 pandemic, the Federal Reserve decreased interest rates by a total of 150 basis points in March 2020. These decreases impact the comparability of net interest income between 2019 and 2020.
The Company's average balances, interest income/expense, and rates earned/paid on major balance sheet categories, as well as the components of change in net interest income, are presented in the following tables:
For the Three Months Ended June 30,
Earned
Yield or
or Paid
ASSETS
Interest earning assets:
865
0.46
9,690
2.32
533,483
0.10
182,651
2.56
Investment securities (1)
697,559
6,536
3.77
644,999
6,062
21,234
5.46
21,007
5.54
Gross loans/leases receivable (1) (2) (3)
3,999,522
43,417
4.37
3,839,674
48,413
5.06
Total interest earning assets
50,376
55,989
Noninterest-earning assets:
82,171
82,394
Premises and equipment
73,376
78,008
(42,878)
(41,224)
434,865
260,701
5,800,197
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities:
Interest-bearing deposits
2,840,860
2,429
2,461,768
8,271
1.35
809,233
3,337
1,013,391
5,554
2.20
25,064
0.35
16,145
2.01
95,616
1.46
76,154
3.17
10,550
68,480
5.84
68,239
37,891
6.07
37,731
6.12
Total interest-bearing liabilities
3,877,144
3,683,978
Noninterest-bearing demand deposits
1,082,532
796,232
Other noninterest-bearing liabilities
284,461
99,427
5,244,137
4,579,637
Stockholders' equity
556,060
498,263
42,674
Net interest spread
Net interest margin
Net interest margin (TEY)(Non-GAAP)
Adjusted net interest margin (TEY)(Non-GAAP)
Ratio of average interest-earning assets to average interest-bearing liabilities
135.48
127.53
Analysis of Changes of Interest Income/Interest Expense
For the Three Months Ended June 30, 2020
Inc./(Dec.)
Components
from
of Change (1)
Prior Period (1)
Rate
Volume
2020 vs. 2019
INTEREST INCOME
(55)
(26)
(29)
(1,033)
(6,343)
5,310
Investment securities (2)
(14)
488
(2)
(16)
Gross loans/leases receivable (2) (3)
(4,996)
(16,223)
11,227
Total change in interest income
(5,612)
(22,622)
17,010
INTEREST EXPENSE
(5,842)
(13,308)
7,466
(2,217)
(1,218)
(999)
(250)
191
(254)
(1,008)
754
(92)
(46)
Total change in interest expense
(8,467)
(15,846)
7,379
Total change in net interest income
2,855
(6,776)
9,631
49
For the Six Months Ended June 30,
3,095
1.17
12,713
2.38
331,048
0.30
169,057
2.49
658,433
12,616
3.85
652,727
12,158
3.76
21,300
21,146
5.70
3,842,966
87,474
3,799,645
94,795
5.03
101,149
109,792
90,799
80,513
73,641
77,266
(39,439)
(40,843)
392,401
250,978
5,374,242
Interest-bearing demand deposits
2,610,248
7,756
0.60
2,374,939
15,445
1.31
797,184
7,216
1.82
1,012,925
10,859
2.16
22,190
15,261
103,512
1.55
111,755
3.00
27,126
4.01
68,449
53,438
5.88
37,872
37,709
6.14
3,639,455
3,633,151
936,223
803,266
247,697
96,441
4,823,374
4,532,858
550,869
490,343
Ratio of average interest earning assets to average interest-bearing liabilities
133.45
128.13
(132)
(53)
(79)
Interest-bearing deposits at other financial institutions
(1,596)
(4,631)
3,035
458
342
(7,321)
(10,368)
3,047
(8,643)
(14,775)
6,132
(7,689)
(11,727)
4,038
(3,643)
(1,552)
(2,091)
(198)
132
(866)
(752)
(114)
(539)
(270)
(269)
431
(12,376)
(14,499)
3,733
(276)
4,009
CRITICAL ACCOUNTING POLICIES
The Company's financial statements are prepared in accordance with GAAP. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred.
Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified the following as critical accounting policies:
GOODWILL
The Company records all assets and liabilities purchased in an acquisition, including intangibles, at fair value. Goodwill is not amortized but is subject, at a minimum, to annual tests for impairment. In certain situations, interim impairment tests may be required if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. A more detailed discussion of this critical accounting policy can be found in the Company's Annual Report on Form 10-K for the year ended December 31, 2019.
Due to the economic impact of COVID-19 during the first quarter of 2020, management concluded that factors such as the decline in macroeconomic conditions led to the occurrence of a triggering event and therefore an interim impairment test over goodwill was performed as of March 31, 2020. There was no occurrence of a triggering event in the second quarter of 2020, therefore no impairment test of goodwill was performed as of June 30, 2020. When such an assessment is
performed, should the Company conclude that all or a portion of goodwill is impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. Such a charge would have no impact on tangible capital or regulatory capital. Based upon the results of the interim goodwill assessment during the first quarter of 2020, the Company concluded that an impairment did not exist on the bank reporting units as of the time of the assessment.
During the first quarter of 2020, the Company incurred goodwill impairment expense of $500 thousand related to the Bates Companies. This was the result of the announcement of a sale of the Bates Companies as discussed in Note 9 of the Consolidated Financial Statements.
ALLOWANCE FOR LOAN AND LEASE LOSSES
The Company's allowance methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance that management believes is appropriate at each reporting date. A more detailed discussion of this critical accounting policy can be found in the Company's Annual Report on Form 10-K for the year ended December 31, 2019.
The Company believes the COVID-19 pandemic may have an adverse effect on the credit quality of its loan portfolio during the remainder of 2020. Disruption to the Company’s customers could result in increased loan delinquencies and defaults resulting in an increase in quantitative allocations. Management believes impaired loans may increase in the future as a result of the COVID-19 pandemic, having a direct impact on the specific component of the allowance for loan and lease losses.
RESULTS OF OPERATIONS
Interest income decreased 10%, comparing the second quarter of 2020 to the same period of 2019, and decreased 8% comparing the first half of 2020 to the same period of 2019. This decrease was primarily the result of a reduction in average yields on loans and leases.
Overall, the Company's average earning assets increased 12%, comparing the second quarter of 2020 to the second quarter of 2019. During the same time period, excess liquidity increased by 15%. Average gross loans and leases increased 4%, while average investment securities increased 8% during the same time period. Average earning assets increased 4%, comparing the first half of 2020 to the same period of 2019. Excess liquidity increased by $235 million comparing the first half of 2020 to the same period of 2019. Average gross loans and leases and average investment securities both increased slightly during the same time period. The increases in excess liquidity were the result of outsized growth in core deposits led by the Company’s correspondent banking client base.
The Company intends to continue to grow quality loans and leases as well as its private placement tax-exempt securities portfolio to maximize yield while minimizing credit and interest rate risk.
Interest expense for the second quarter of 2020 decreased 52% from the second quarter of 2019 and decreased 39%, comparing the first half of 2020 to the same period of 2019. The cost of funds on the Company’s average interest-bearing liabilities has decreased with the current rate environment. During the last month of the first quarter, market interest rates fell as the Federal Reserve cut the Federal Funds rate by 150 bps to a range of 0%-0.25%. As a direct result, the Company’s interest expense declined sharply on a linked-quarter basis.
The Company's management intends to continue to shift the mix of funding from wholesale funds to well-priced core deposits, including noninterest-bearing deposits. Continuing this trend is expected to strengthen the Company's franchise value, reduce funding costs and increase fee income opportunities through deposit service charges.
PROVISION FOR LOAN/LEASE LOSSES
The Company’s provision for loan and lease losses totaled $19.9 million for the second quarter of 2020, which is significantly higher than $1.9 million for the second quarter of 2019. Provision for the first six months of 2020 totaled $28.3 million, which was up from $4.1 million in the first six months of 2019. The increase in the provision for loan and lease losses was primarily due to increased qualitative allocations in response to deteriorating economic conditions related to the effects of COVID-19.
The Company anticipates the provision to be elevated in future periods due to the broad reach of COVID-19 across many impacted individuals and industries. The dramatic slowdown in economic activity will likely negatively impact the credit quality of the Company’s loan portfolio with increased levels of loan defaults. The CARES Act provides significant resources for individuals and industries that could lessen the impact of COVID-19, in addition to the Company’s own loan relief programs.
The Company has elected to defer its implementation of CECL as allowed by the CARES Act. See Note 1 of the Consolidated Financial Statements for further discussion.
The provision is established based on a number of factors, including the Company's historical loss experience, delinquencies and charge-off trends, the local, state and national economies and risk associated with the loans/leases and securities in the portfolio as described in more detail in the “Critical Accounting Policies” section.
In accordance with GAAP for business combination accounting, acquired loans are recorded at fair value; therefore, no allowance is associated with such loans at acquisition. As acquired loans renew, the discount associated with those loans is eliminated and the Company must establish an allowance through provision. This provision, when coupled with net charge-offs of $3.46 million for the first six months of 2020, increased the Company's allowance to $60.8 million at June 30, 2020. As of June 30, 2020, the Company's allowance to total loans/leases was 1.47%, which was up from 1.14% at March 31, 2020 and 1.05% at June 30, 2019. Management continues to evaluate the allowance needed on acquired loans factoring in the net remaining discount ($5.5 million and $9.3 million at June 30, 2020 and June 30, 2019, respectively).
The following table represents the current balance of loans to customers with concentrations in industries that management has deemed to have a higher risk of being impacted by COVID-19:
As of June 30,
% of Total Gross
Loans and Leases
Retail and Lessors of Property Secured by Retail Property
236,147
Hotels
86,543
2.09
Restaurants (full service and limited service only)
41,077
0.99
Arts & Entertainment
30,513
0.74
Aviation
Energy
394,280
Additional discussion of the Company's allowance can be found in the “Financial Condition” section of this Report.
NONINTEREST INCOME
The following tables set forth the various categories of noninterest income for the three and six months ended June 30, 2020 and 2019.
Three Months Ended
$ Change
% Change
(5.7)
(489)
(25.9)
(372)
(22.4)
707
144.6
(39)
(100.0)
12,036
152.5
117
200
48.5
(139)
(15.2)
15.1
(352)
(27.2)
11,561
67.7
Six Months Ended
(315)
(6.5)
(498)
(13.7)
(449)
(14.0)
990
115.4
15,642
141.1
(11)
(1.2)
(173)
(10.1)
6.4
(494)
(21.0)
14,764
50.8
In recent years, the Company has been successful in expanding its wealth management client base. Trust department fees continue to be a significant contributor to noninterest income. Assets under management increased by $291.3 million in the second quarter of 2020, however assets under management decreased $183.4 million in the first six months of 2020 due to deteriorating economic conditions caused by the COVID-19 pandemic. With the decrease in assets under management, trust department fees decreased 7%, comparing the first six months of 2020 to the same period of the prior year. Income is generated primarily from fees charged based on assets under administration for corporate and personal trusts and for custodial services. The majority of the trust department fees are determined based on the value of the investments within the fully-managed trusts. The Company expects trust department fees to be negatively impacted during periods of significantly lower market valuations.
Investment advisory and management fees decreased 26%, comparing the second quarter of 2020 to the same period of the prior year and they decreased 14% when comparing the first half of 2020 to the first half of 2019. Brokerage assets decreased $124.1 million in the first six months of 2020 due to deteriorating economic conditions caused by the COVID-
19 pandemic. Similar to trust department fees, investment advisory and management fees are largely determined based on the value of the investments managed. As a result, fee income from this line of business fluctuates with market valuations. The levels of trust and brokerage assets under management were negatively impacted by the decline in the market as a result of COVID-19.
Deposit service fees decreased 22% comparing the second quarter of 2020 to the same period of the prior year, and decreased 14% when comparing the first half of 2020 to the same period of the prior year. This decrease was primarily due to the sale of RB&T, as well as lower transactional volume due to current economic conditions. The Company continues to emphasize shifting the mix of deposits from brokered and retail time deposits to non-maturity demand deposits across all its markets. With this continuing shift in mix, the Company has increased the number of demand deposit accounts, which tend to be lower in interest cost and higher in service fees. The Company plans to continue this shift in mix and to further focus on growing deposit service fees.
Gains on sales of residential real estate loans, net, increased 145% when comparing the second quarter of 2020 to the same period of the prior year, and increased 115% when comparing the first half of 2020 to the same period of the prior year. The increase was primarily due to the refinancing of residential real estate loans with lower interest rates in the first half of 2020.
The Company did not have any gains on the sale of government-guaranteed portions of loans for the three or six months ended June 30, 2020. Large fluctuations can occur from quarter-to-quarter and year-to-year. The Company continues to leverage its expertise by taking advantage of programs offered by the SBA and the USDA. In some cases, it is more beneficial for the Company to sell the government-guaranteed portion on the secondary market for a premium rather than retain the loans in the Company's portfolio. Sales activity for government-guaranteed portions of loans tends to fluctuate depending on the demand for loans that fit the criteria for the government guarantee. Further, the size of the transactions can vary and, as the gain is determined as a percentage of the guaranteed amount, the resulting gain on sale can vary. Recently, competitors have been offering SBA loan candidates traditional financing without a guarantee and the Company is not willing to relax its structure for those lending opportunities.
As a result of the low interest rate environment and its continued focus across all subsidiary banks, the Company was able to execute numerous interest rate swaps on select commercial loans, including tax credit project loans. The interest rate swaps allow commercial borrowers to pay a fixed interest rate while the Company receives a variable interest rate as well as an upfront fee dependent upon the pricing. Management will continue to review opportunities to execute these swaps at all of its subsidiary banks, as the circumstances are appropriate for the borrowers and the Company. An optimal interest rate swap candidate must be of a certain size and sophistication which can lead to volatility in activity from quarter to quarter. Swap fee income totaled $19.9 million for the second quarter of 2020, compared to $7.9 million for the second quarter of 2019. Swap fee income totaled $26.7 million for the first half of 2020, compared to $11.1 million in the first half of 2020. The increase in swap fee income for the first six months of 2020, as compared to all prior periods, was due to both the volume and the size of the transactions executed. Future levels of swap fee income are somewhat dependent upon prevailing interest rates.
Securities gains totaled $65 thousand for the three and six months ended June 30, 2020. By comparison, securities losses totaled $52 thousand for the three and six months ended June 30, 2019.
Earnings on BOLI increased 49% comparing the second quarter of 2020 to the second quarter of 2019, and decreased 1% comparing the first half of 2020 to the first half of 2019. There were no purchases of BOLI within the last 12 months. Notably, a portion of the Company's BOLI is variable rate whereby returns are determined by the performance of the equity markets and can lead to volatility in earnings. Management intends to continue to review its BOLI investments to be consistent with policy and regulatory limits in conjunction with the rest of its earning assets in an effort to maximize returns while minimizing risk.
Debit card fees are the interchange fees paid on certain debit card customer transactions. Debit card fees decreased 15% comparing the second quarter of 2020 to the second quarter of the prior year, and decreased 10% comparing the first half
of 2020 to the first half of 2019. These fees can vary based on customer debit card usage, so fluctuations from period to period may occur. As an opportunity to maximize fees, the Company offers a retail deposit product with a higher interest rate that incentivizes debit card activity.
Correspondent banking fees increased 15% comparing the second quarter of 2020 to the second quarter of the prior year, and increased 6% comparing the first half of 2020 to the first half of 2019. The fees are generally included in the earnings credit rates which incent the correspondent bank to maintain higher levels of noninterest bearing deposits to offset the correspondent banking fees. Management will continue to evaluate earnings credit rates and the resulting impact on deposit balances and fees while balancing the ability to grow market share. Correspondent banking continues to be a core strategy for the Company, as this line of business provides a high level of deposits that can be used to fund loan growth as well as a steady source of fee income. The Company now serves approximately 191 banks in Iowa, Illinois, Missouri and Wisconsin.
Other noninterest income decreased 27% comparing the second quarter of 2020 to the second quarter of the prior year, and decreased 21% comparing the first half of 2020 to the first half of 2019. This decrease was primarily due to the sale of RB&T.
NONINTEREST EXPENSE
The following tables set forth the various categories of noninterest expense for the three and six months ended June 30, 2020 and 2019.
(1,445)
(6.4)
215
6.1
20.3
(638)
(90.1)
100.0
(18)
(1.9)
8.7
(1,514)
(128.1)
(485)
(46.8)
(1.4)
Loss on liability extinguishment
2.9
(10.9)
(473)
(27.0)
(3,438)
(9.4)
(3,805)
(8.7)
553
7.7
21.3
(621)
(73.8)
(299)
(15.8)
7.8
(1,799)
(121.6)
(588)
(32.3)
1.4
Losses on liability extinguishment, net
4.4
(4.4)
Goodwill Impairment
(666)
(20.5)
(4,458)
Management places a strong emphasis on overall cost containment and is committed to improving the Company's general efficiency.
Salaries and employee benefits, which is the largest component of noninterest expense, decreased from the second quarter of 2019 to the second quarter of 2020 by 6%. This line item also decreased 9% when comparing the first half of 2020 to the first half of 2019. This decrease was primarily related to the sale of RB&T, deferred costs due to PPP loans and reduced bonus and incentive compensation due to the impact of COVID-19.
Occupancy and equipment expense increased 6% comparing the second quarter of 2020 to the same period of the prior year, and increased 8% comparing the first half of 2020 to the same period of the prior year. The increased expense was due to higher information technology service contract costs and increases in repairs and maintenance costs to existing buildings.
Professional and data processing fees increased 20% comparing the second quarter of 2020 to the same period in 2019, and increased 21% comparing the first half of 2020 to the same period of the prior year. This increased expense was mostly due to higher data processing costs.
Post-acquisition costs totaled $70 thousand for the second quarter of 2020 as compared to $708 thousand for the same period of the prior year. Post-acquisition costs totaled $221 thousand for the first half of 2020 as compared to $842 thousand for the same period of the prior year. These costs were comprised primarily of personnel costs, IT integration and data conversion costs related to previous mergers/acquisitions.
Disposition costs totaled $434 thousand for the first half of 2020. The costs were primarily legal, accounting, personnel costs and IT deconversion costs related to the sale of RB&T in the fourth quarter of 2019. There were no disposition costs for the first quarter or first half of 2019.
FDIC insurance, other insurance and regulatory fee expense decreased 2%, comparing the second quarter of 2020 to the second quarter of 2019, and decreased 16% comparing the first half of 2020 to the same period of the prior year. The decrease in expense was due to the award of assessment credits by the FDIC in September 2019 that carried forward into 2020.
Loan/lease expense increased 9% when comparing the second quarter of 2020 to the same quarter of 2019, and increased 8% comparing the first half of 2020 to the same period of the prior year. Generally, loan/lease expense has a direct relationship with the level of NPLs; however, it may deviate depending upon the individual NPLs.
Net cost of (income from) and gains/losses on operations of other real estate includes gains/losses on the sale of OREO, write-downs of OREO and all income/expenses associated with OREO. Net income from and gains/losses on operations of other real estate totaled $332 thousand for the second quarter of 2020, compared to net cost of and gains/losses on operations of other real estate of $1.2 million for the second quarter of 2019. Net income from and gains/losses on operations of other real estate totaled $319 thousand for the first half of 2020 compared to net cost of and gains/losses on operations of other real estate of $1.5 million for the same period of the prior year. In the first half of 2020, the Company has sold OREO property of $4 million with corresponding gains of $369 thousand.
Advertising and marketing expense decreased 47% comparing the second quarter of 2020 to the second quarter of 2019, and decreased 32% comparing the second half of 2020 to the same period of the prior year. The decrease in expense was primarily due to the sale of RB&T.
Bank service charges, a large portion of which includes indirect costs incurred to provide services to QCBT's correspondent banking customer portfolio, decreased 1% when comparing the second quarter of 2020 to the same quarter of 2019, and increased 1% comparing the first half of 2020 to the same period of the prior year. As transaction volumes continue to increase and the number of correspondent banking clients increases, the associated expenses will also increase.
Losses on liability extinguishment were $429 thousand for the second quarter of 2020 and $576 thousand for the first half of 2020. These losses relate to the prepayment of certain high-cost brokered and public certificates of deposit. There were no losses on debt extinguishment for the three and six months ended June 30, 2019.
Correspondent banking expense increased 3% when comparing the second quarter of 2020 to the second quarter of 2019 and increased 4% when comparing the first half of 2020 to the same period of the prior year. These are direct costs incurred to provide services to QCBT's correspondent banking customer portfolio, including safekeeping and cash management services.
58
Intangibles amortization expense decreased 11% when comparing the second quarter of 2020 to the same quarter of 2019 and decreased 4% when comparing the first half of 2020 to the same period of the prior year. The second quarter of 2019 included $82 thousand of intangible amortization expense related to the finalization of purchase accounting related to the acquisition of Bates Companies.
Goodwill impairment expense totaled $500 thousand in the first half of 2020 related to the sale of the Bates Companies. There was no goodwill impairment expense in the first half of 2019.
Other noninterest expense decreased 27% when comparing the second quarter of 2020 to the second quarter of 2019, and decreased 21% when comparing the first half of 2020 to the same period of the prior year. This was primarily due to the sale of RB&T. Included in other noninterest expense are items such as subscriptions, sales and use tax and expenses related to wealth management.
INCOME TAXES
In the second quarter of 2020, the Company incurred income tax expense of $2.8 million. During the first half of the year, the Company incurred income tax expense of $4.7 million. Following is a reconciliation of the expected income tax expense to the income tax expense included in the consolidated statements of income for the three and six months ended June 30, 2020 and 2019.
% of
Pretax
Income
Computed "expected" tax expense
3,472
21.0
3,481
6,226
6,491
Tax exempt income, net
(1,247)
(7.5)
(1,068)
(2,472)
(8.3)
(2,175)
(7.1)
(115)
(0.7)
(87)
(0.5)
(170)
(0.6)
State income taxes, net of federal benefit, current year
4.7
772
1,453
4.9
1,421
4.6
Tax credits
(116)
(38)
(0.2)
(232)
(0.8)
(0.3)
True-up adjustment to year-end provision
(2.3)
Excess tax benefit on stock options exercised and restricted stock awards vested
(54)
(262)
(0.9)
(154)
0.1
0.3
139
0.5
(104)
16.9
18.5
15.8
14.5
The effective tax rate for the quarter ended June 30, 2020 was 16.9%, which was a decrease from the effective tax rate of 18.5% for the quarter ended June 30, 2019. The effective tax rate for the six months ended June 30, 2020 was 15.8%, which was an increase over the effective tax rate of 14.5% for the six months ended June 30, 2019. During the first quarter of 2019 and in conjunction with the Company’s year-end tax preparation process, the Company identified a one-time true-up adjustment of $715 thousand. Excluding this, the Company’s effective tax rate was approximately 16.8% for the six months ended June 30, 2019.
FINANCIAL CONDITION
Following is a table that represents the major categories of the Company’s balance sheet. On November 30, 2019, the Company sold substantially all of the assets and transferred substantially all of the deposits and certain other liabilities of the Company’s wholly-owned subsidiary, RB&T. As a result, those assets and liabilities of RB&T are not included in the Company’s results of its financial condition as of June 30, 2020, March 31, 2020 and December 31, 2019, the removal of which impacts balance sheet comparisons to June 30, 2019.
Cash, federal funds sold, and interest-bearing deposits
231,477
376,535
233,945
293,416
Securities
684,571
643,803
Net loans/leases
3,662,435
75
3,869,415
195,973
65,922
309,040
301,803
309,767
322,296
10,758
100
4,170,478
4,322,510
Total borrowings
376,250
244,399
278,955
230,953
203,744
69,556
71,185
67,533
3,130
0
During the second quarter of 2020, the Company's total assets increased $372.7 million, or 7% from March 31, 2020, to a total of $5.6 billion. The Company’s loans increased $417.0 million in the second quarter of 2020. Included in this amount was $358.1 million of PPP loans made to both new and existing customers. Total deposits increased $179.3 million in the second quarter of 2020 primarily due to an increase in noninterest-bearing demand deposits. Borrowings increased $131.9 million in the second quarter of 2020 which consisted primarily of an increase in overnight FRB borrowings of $70.0 million and an increase in short-term FHLB advances of $50.0 million. During the quarter, the Company had significant core deposit growth mostly from its correspondent banking clients. The outsized deposit growth exceeded the strong loan growth and led to the Company carrying excess liquidity during the quarter. At the end of the quarter, a large portion of the outsized correspondent banking deposits shifted off balance sheet temporarily which prompted some overnight borrowing. Subsequently, the majority of the balances have returned to the balance sheet.
INVESTMENT SECURITIES
The composition of the Company's securities portfolio is managed to meet liquidity needs while prioritizing the impact on interest rate risk, maximizing return and minimizing credit risk. Over the years, the Company has further diversified the portfolio by decreasing U.S government sponsored agency securities and increasing residential mortgage-backed and related securities and tax-exempt municipal securities. Of the latter, the large majority are privately placed tax-exempt debt issuances by municipalities located in the Midwest (with some in or near the Company's existing markets) and require a thorough underwriting process before investment.
Following is a breakdown of the Company's securities portfolio by type, the percentage of unrealized gains (losses) to carrying value on the total portfolio, and the portfolio duration:
19,457
35,762
526,192
493,664
72
447,853
440,852
122,853
159,228
28,499
19,750
20,098
5,936
7,961
Securities as a % of Total Assets
13.36
13.11
12.45
12.39
Net Unrealized Gains as a % of Amortized Cost
4.16
3.73
4.88
3.23
Duration (in years)
6.3
6.7
Yield on investment securities (tax equivalent)
3.95
3.80
Management monitors the level of unrealized gains/losses including performing quarterly reviews of individual securities for evidence of OTTI. Management identified no OTTI in any of the periods presented.
The Company has not invested in non-agency commercial or residential mortgage-backed securities or pooled trust preferred securities. The asset-backed securities, which are comprised of collateral loan obligations, are backed by pools of senior secured commercial loans and were AAA rated as of June 30, 2020.
See Note 2 to the Consolidated Financial Statements for additional information regarding the Company's investment securities.
LOANS/LEASES
Total loans/leases, excluding PPP loans (non-GAAP), grew 8.4% on an annualized basis during the second quarter of 2020 and 5.0% year-to-date. The Company experienced several large payoffs during the first quarter, which impacted loan growth, as well as slower growth in the first half of the year due to the pandemic. The mix of the loan/lease types within the Company's loan/lease portfolio is presented in the following table.
1,484,979
1,548,657
1,783,086
1,837,473
Direct financing leases
83,324
101,180
Residential real estate loans
237,742
293,479
106,728
120,947
Total loans/leases
3,695,859
3,901,736
8,809
8,783
(42,233)
(41,104)
*Excludes PPP loans totaling $358.1 million as of June 30, 2020.
As CRE loans have historically been the Company's largest portfolio segment, management places a strong emphasis on monitoring the composition of the Company's CRE loan portfolio. For example, management tracks the level of owner-occupied CRE loans relative to non-owner-occupied loans. Owner-occupied loans are generally considered to have less risk. As of June 30, 2020 and March 31, 2020, approximately 25% and 26% of the CRE loan portfolio was owner-occupied, respectively.
Following is a listing of significant industries within the Company's CRE loan portfolio:
As of March 31,
As of December 31,
Lessors of Nonresidential Buildings
593,063
546,384
553,142
612,526
Lessors of Residential Buildings
545,026
500,871
465,172
394,235
70,675
56,573
63,720
82,180
New Housing For-Sale Builders
56,229
56,916
55,525
43,520
Land Subdivision
55,555
53,899
46,318
45,847
Nonresidential Property Managers
44,887
48,069
48,059
58,207
Lessors of Other Real Estate Property
40,248
42,260
39,297
36,706
Other Activities Related to Real Estate
38,044
39,352
42,060
32,652
New Single-Family Housing Construction
36,837
31,856
28,708
27,962
Other *
388,598
406,906
394,395
503,638
Total CRE Loans
* “Other” consists of all other industries. None of these had concentrations greater than $23.8 million, or approximately 1.3% of total CRE loans in the most recent period presented.
The Company's residential real estate loan portfolio includes the following:
The remaining residential real estate loans originated by the Company were sold on the secondary market to avoid the interest rate risk associated with longer term fixed rate loans. Loans originated for this purpose were classified as held for sale and are included in the residential real estate loans above. The Company has not originated any subprime, Alt-A, no documentation, or stated income residential real estate loans throughout its history.
Following is a listing of significant equipment types within the m2 loan and lease portfolio:
Trucks, Vans and Vocational Vehicles
59,782
57,225
55,749
46,650
Manufacturing - General
16,939
16,277
15,847
17,879
Food Processing Equipment
16,244
16,703
16,742
15,863
Construction - General
15,156
16,236
16,026
Marine - Travelifts
11,642
10,908
11,659
Computer Hardware
11,385
12,142
11,509
6,282
Trailers
9,541
9,469
9,907
9,303
92,071
90,821
92,301
107,014
Total m2 loans and leases
232,760
228,583
229,847
230,676
* “Other” consists of all other equipment types. None of these had concentrations greater than 3% of total m2 loan and lease portfolio in the most recent period presented.
See Note 3 to the Consolidated Financial Statements for additional information regarding the Company's loan and lease portfolio.
ALLOWANCE FOR ESTIMATED LOSSES ON LOANS/LEASES
Changes in the allowance for the three and six months ended June 30, 2020 and 2019 are presented as follows:
The adequacy of the allowance was determined by management based on factors that included the overall composition of the loan/lease portfolio, types of loans/leases, historical loss experience, loan/lease delinquencies, potential substandard and doubtful credits, economic conditions, collateral positions, government guarantees and other factors that, in management's judgment, deserved evaluation. To ensure that an adequate allowance was maintained, provisions were made based on a number of factors, including the increase in loans/leases and a detailed analysis of the loan/lease portfolio. The loan/lease portfolio is reviewed and analyzed quarterly with specific detailed reviews completed on all credits risk-rated less than “fair quality”, as described in Note 1 to the Consolidated Financial Statements contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2019, and carrying aggregate exposure in excess of $250 thousand. The adequacy of the allowance is monitored by the credit administration staff and reported to management and the board of directors.
The Company's levels of criticized and classified loans are reported in the following table.
Internally Assigned Risk Rating *
34,738
19,913
36,612
40,935
144,463
71,350
53,601
60,848
Criticized Loans **
Classified Loans ***
Criticized Loans as a % of Total Loans/Leases
1.93
1.45
Classified Loans as a % of Total Loans/Leases
0.91
* Amounts above include the government guaranteed portion, if any. For the calculation of allowance, the Company assigns internal risk ratings of Pass (Rating 2) for the government guaranteed portion.
** Criticized loans are defined as commercial and industrial and commercial real estate loans with internally assigned risk ratings of 6, 7, or 8, regardless of performance.
*** Classified loans are defined as commercial and industrial and commercial real estate loans with internally assigned risk ratings of 7 or 8, regardless of performance.
Criticized loans increased 102% and classified loans increased 9% from March 31, 2020 to June 30, 2020. Criticized loans increased 170% during the first six months of 2020 primarily due to loans related to borrowers in industries impacted by COVID-19 including hotels. Classified loan increased 18% during the first six months of 2020. The increase in classified
loans was due to a few isolated relationships. The Company continues its strong focus on improving credit quality in an effort to limit NPLs.
Allowance / Gross Loans/Leases
Allowance / NPLs
463.69
310.72
403.87
283.10
Although management believes that the allowance at June 30, 2020 was at a level adequate to absorb losses on existing loans/leases, there can be no assurance that such losses will not exceed the estimated amounts or that the Company will not be required to make additional provisions in the future. Unpredictable future events could adversely affect cash flows for both commercial and individual borrowers, which could cause the Company to experience increases in problem assets, delinquencies and losses on loans/leases, and require further increases in the provision. Based on current economic indicators, the Company increased the economic allocations within the allowance for loan losses calculation. The Company anticipates that the allowance for loan losses as a percent of total loans may increase in future periods based on the belief that the credit quality of the loan portfolio could decline and loan defaults may increase as a result of the COVID-19 pandemic. Asset quality is a priority for the Company and its subsidiaries. The ability to grow profitably is in part dependent upon the ability to maintain that quality. The Company continually focuses efforts at its subsidiary banks and leasing company with the intention to improve the overall quality of the Company's loan/lease portfolio.
See Note 3 to the Consolidated Financial Statements for additional information regarding the Company's allowance.
NONPERFORMING ASSETS
The table below presents the amount of NPAs and related ratios.
Nonaccrual loans/leases (1) (2)
11,628
13,148
Accruing loans/leases past due 90 days or more
TDRs - accruing
545
1,313
13,592
14,519
3,298
8,637
Other repossessed assets
Total NPAs
13,300
16,935
13,084
23,156
NPLs to total loans/leases
0.37
0.24
NPAs to total loans/leases plus repossessed property
0.59
NPAs to total assets
0.27
0.45
NPAs at June 30, 2020 were $13.3 million, down $3.6 million from March 31, 2020 and down $9.9 million from June 30, 2019. The decrease in NPAs in the second quarter of 2020 was primarily due to the sale of one OREO property. The improvement from prior year was primarily attributed to the sale of RB&T.
The ratio of NPAs to total assets was 0.24% at June 30, 2020, down from 0.32% at March 31, 2020 and down from 0.45% at June 30, 2019.
The large majority of the NPAs consist of nonaccrual loans/leases, accruing TDRs, and OREO. For nonaccrual loans/leases and accruing TDRs, management has thoroughly reviewed these loans/leases and has provided specific allowances as appropriate.
OREO is carried at the lower of carrying amount or fair value less costs to sell.
The Company's lending/leasing practices remain unchanged and asset quality remains a priority for management.
Due to the economic impacts of COVID-19, the Company established its LRP for its clients. The LRP allows borrowers to request the deferral of principal and interest payments for an agreed upon term. Those deferred payments will be added to the end of the original term of the loan through a three month extension of the maturity date. The CARES Act includes provisions that allow financial institutions to elect to not apply GAAP requirements to loan modifications related to COVID-19 that would otherwise be categorized as a TDR, including arrangements that defer or delay payments of principal or interest for up to 90 days. The relief from TDR guidance applies to modifications of loans that were not more than 30 days past due as of December 31, 2019, and that occur beginning on March 1, 2020 until the earlier of sixty days after the date on which the national emergency related to COVID-19 is terminated or December 31, 2020. The Company expects that the majority of LRP participants will not be categorized as a TDR by meeting the CARES Act provisions. As of June 30, 2020, the program has provided 1,466 Bank modifications of loans to commercial and consumer clients totaling $491 million and 935 m2 modifications of loans and leases totaling $53 million, representing 11.86% and 1.2% of the total loan and lease portfolio, respectively.
DEPOSITS
Deposits increased $179.3 million during the second quarter of 2020, primarily due to an increase in noninterest bearing correspondent deposits, net of prepayment of large brokered certificates of deposits. The table below presents the composition of the Company's deposit portfolio.
Noninterest bearing demand deposits
829,782
795,951
Interest bearing demand deposits
2,488,755
2,440,907
2,407,502
2,505,956
560,982
617,979
571,343
733,135
Brokered deposits
122,556
281,810
154,982
287,468
Quarter-end balances can greatly fluctuate due to large customer and correspondent bank activity. During the quarter, the Company had significant core deposit growth mostly from its correspondent banking clients. The outsized deposit growth exceeded the strong loan growth and led to the Company carrying excess liquidity during the quarter. At the end of the quarter, a large portion of the outsized correspondent banking deposits shifted off balance sheet temporarily which prompted some overnight borrowing. Subsequently, the majority of the balances have returned to the balance sheet. As a result of strong core deposit growth, the Company reduced its reliance on higher cost CDs and brokered deposits.
Management will continue to focus on growing its core deposit portfolio, including its correspondent banking business at QCBT, as well as shifting the mix from brokered and other higher cost deposits to lower cost core deposits. With the significant success achieved by QCBT in growing its correspondent banking business, QCBT has developed procedures to proactively monitor this industry concentration of deposits and loans. Other deposit-related industry concentrations and large accounts are monitored by the internal asset liability management committees.
BORROWINGS
The subsidiary banks purchase federal funds for short-term funding needs from the FRB or from their correspondent banks. The table below presents the composition of the Company's short-term borrowings.
Overnight repurchase agreements
2,368
2,377
2,193
2,181
Federal funds purchased
22,450
10,690
11,230
Overnight federal reserve borrowings
100,000
43,067
19,191
The Company's federal funds purchased and Federal Reserve borrowings fluctuate based on the short-term funding needs of the Company's subsidiary banks. At the end of the quarter, a large portion of the outsized correspondent banking deposits shifted off balance sheet temporarily which prompted some overnight borrowing. Subsequently, the majority of the balances have returned to the balance sheet.
As a result of their memberships in the FHLB of Des Moines, the subsidiary banks have the ability to borrow funds for short or long-term purposes under a variety of programs. The subsidiary banks can utilize FHLB advances for loan matching as a hedge against the possibility of changing interest rates and when these advances provide a less costly or more readily available source of funds than customer deposits.
The table below presents the Company's term and overnight FHLB advances.
Term FHLB advances
90,000
55,000
46,433
Overnight FHLB advances
40,000
109,300
59,300
95,000
105,733
FHLB advances increased $50.0 million in the current quarter compared to the prior quarter due to the temporary liquidity need from the aforementioned temporary shift of excess liquidity straddling quarter-end. All of the net growth in advances were either overnight or shorter term with maximum maturities of 3 months.
The Company renewed its revolving credit note in the second quarter of 2020. At renewal, the line amount was increased from $20.0 million to $25.0 million. The interest on the revolving line of credit is now calculated at a rate per annum equal to the greater of (a) Prime less 0.50% and (b) 3.00% per annum. Prior to the renewal, the interest on the revolving line of credit was calculated at the effective LIBOR rate plus 2.25% per annum. The collateral on the revolving line of credit is 100% of the outstanding stock of the Company’s bank subsidiaries. There was no outstanding balance on the revolving line of credit at June 30, 2020.
The Company had subordinated notes totaling $68.5 million as of June 30, 2020, relatively unchanged from $68.4 million as of December 31, 2019.
It is management's intention to reduce its reliance on wholesale funding, including FHLB advances and brokered deposits. Replacement of this funding with core deposits helps to reduce interest expense as wholesale funding tends to be higher cost. However, the Company may choose to utilize advances and/or brokered deposits to supplement funding needs, as this is a way for the Company to effectively and efficiently manage interest rate risk.
The table below presents the maturity schedule including weighted average interest cost for the Company's combined wholesale funding portfolio (defined as FHLB advances and brokered deposits).
Weighted
Maturity:
Amount Due
Interest Rate
Year ending December 31:
214,156
0.63
200,110
2021
43,887
2022
28,400
50,285
1.79
2023
20,000
Total Wholesale Funding
267,556
314,282
1.20
During the first six months of 2020, wholesale funding decreased $46.7 million as the Company grew core deposits to build on balance sheet liquidity and the Company used a portion of that excess liquidity to prepay brokered certificates of deposits.
STOCKHOLDERS' EQUITY
The table below presents the composition of the Company's stockholders' equity.
Common stock
Additional paid in capital
AOCI (loss)
TCE / TA ratio (non-GAAP)
9.25
* TCE is defined as total common stockholders' equity excluding goodwill and other intangibles. This ratio is a non-GAAP financial measure. See GAAP to Non-GAAP Reconciliations.
AOCI improved $3.6 million during the quarter for mark-to-market adjustments on interest rate caps and an interest rate swap on trust preferred securities and an increase in net unrealized gains on AFS securities portfolio. Furthermore as it relates to the Company’s TCE/TA, the Company experienced net dilution as TCE/TA fell from 8.76% to 8.48% which was primarily driven by an inflated balance sheet at quarter-end. Specifically, the balance sheet was inflated by PPP loans totaling $358.1 million. Excluding the impact of PPP loans, the adjusted TCE/TA at June 30, 2020 was 9.03% (non-GAAP).
LIQUIDITY AND CAPITAL RESOURCES
Liquidity measures the ability of the Company to meet maturing obligations and its existing commitments, to withstand fluctuations in deposit levels, to fund its operations, and to provide for customers' credit needs. The Company monitors liquidity risk through contingency planning stress testing on a regular basis. The Company seeks to avoid over-concentration of funding sources and to establish and maintain contingent funding facilities that can be drawn upon if normal funding sources become unavailable. One source of liquidity is cash and short-term assets, such as interest-bearing deposits in other banks and federal funds sold, which averaged $534.3 million during the second quarter of 2020 and $334.1 million during the first six months of 2020. The Company's on balance sheet liquidity position can fluctuate based on short-term activity in deposits and loans.
The Federal Reserve Bank has provided a lending facility that will allow the Company, if desired, to obtain funding specifically for loans that the Company makes under the PPP, which will allow the Company to retain existing sources of liquidity for traditional operations. The Company has been able to access available funding sources to address liquidity needs during the COVID-19 pandemic.
The subsidiary banks have a variety of sources of short-term liquidity available to them, including federal funds purchased from correspondent banks, FHLB advances, wholesale structured repurchase agreements, brokered deposits, lines of credit, borrowing at the Federal Reserve Discount Window, sales of securities AFS, and loan/lease participations or sales. The Company also generates liquidity from the regular principal payments and prepayments made on its loan/lease portfolio, and on the regular monthly payments on its securities portfolio.
At June 30, 2020, the subsidiary banks had 29 lines of credit totaling $627.9 million, of which $294.4 million was secured and $333.5 million was unsecured. At June 30, 2020, the Company had $527.9 million of the $627.9 million available.
At December 31, 2019, the subsidiary banks had 27 lines of credit totaling $380.6 million, of which $45.3 million was secured and $335.3 million was unsecured. At December 31, 2019, the full $380.6 million was available.
The Company has emphasized growing the number and amount of lines of credit in an effort to strengthen this contingent source of liquidity. Additionally, the Company maintains a $25.0 million secured revolving credit note with a variable interest rate and a maturity of June 30, 2021. At June 30, 2020, the full $25.0 million was available.
As of June 30, 2020, the Company had $754.4 million in average correspondent banking deposits spread over 191 relationships. While the Company believes that these funds are relatively stable, there is the potential for large fluctuations that can impact liquidity. Seasonality and the liquidity needs of these correspondent banks can impact balances. Management closely monitors these fluctuations and runs stress scenarios to measure the impact on liquidity and interest rate risk with various levels of correspondent deposit run-off.
Investing activities used cash of $560.2 million during the first six months of 2020, compared to $197.1 million for the same period of 2019. The net decrease in federal funds sold was $7.7 million for the first six months of 2020, compared to a net decrease of $16.2 million for the same period of 2019. The net decrease in interest-bearing deposits at financial institutions was $7.1 million for the first six months of 2020, compared to a net increase of $62.1 million for the same period of 2019. Proceeds from calls, maturities, and paydowns of securities were $34.5 million for the first six months of 2020, compared to $33.0 million for the same period of 2019. Purchases of securities used cash of $171.1 million for the first six months of 2020, compared to $10.7 million for the same period of 2019. Proceeds from sales of securities were $6.3 million for the first six months of 2020, compared to $4.7 million in proceed from sales of securities for the first six months of 2019. The net increase in loans/leases used cash of $447.4 million for the first six months of 2020 compared to $176.4 million for the same period of 2019.
Financing activities provided cash of $530.6 million for the first six months of 2020, compared to $170.2 million for same period of 2019. Net increases in deposits totaled $409.0 million for the first six months of 2020, compared to $345.6 million for the same period of 2019. During the first six months of 2020, the Company's short-term borrowings increased
$111.4 million, compared to a decrease in short-term borrowings of $9.6 million for the same period of 2019. Long-term FHLB advances increased $85.0 million during the first six months of 2020, compared to $5.0 million for the same period of 2020. In the first six months of 2020, the Company decreased short-term and overnight FHLB advances by $59.3 million. Maturities and principal payments on FHLB term advances totaled $40.0 million in the first six months of 2020. In the first six months of 2019, the Company decreased short-term and overnight FHLB advances by $130.9 million. Maturities and principal payments on FHLB term advances totaled $35.0 million and on other borrowings totaled $11.9 million in the first six months of 2019. Prepayments on other borrowings totaled $46.3 million in the first six months of 2019. Prepayments on brokered and public time deposits totaled $29.2 million during the first six months of 2020. During the first six months of 2019, proceeds from subordinated notes were $63.4 million.
Total cash provided by operating activities was $41.9 million for the first six months of 2020, compared to $29.3 million for the same period of 2019.
Throughout its history, the Company has secured additional capital through various sources, including the issuance of common and preferred stock, as well as trust preferred securities and, most recently, subordinated notes.
The Company (on a consolidated basis) and the subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company and subsidiary banks' financial statements. Refer to Note 8 of the Consolidated Financial Statements for additional information regarding regulatory capital.
SPECIAL NOTE CONCERNING FORWARD-LOOKING STATEMENTS
This document (including information incorporated by reference) contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “bode,” “predict,” “suggest,” “project,” “appear,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should,” “likely,” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.
The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could have a material adverse effect on the operations and future prospects of the Company and its subsidiaries include, but are not limited to, the following:
These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. For a discussion of the factors that could have a material adverse effect on the operations and future prospects of the Company and its subsidiaries, see the “Risk Factors” section included under Item 1A of Part I of the Company's Annual Report on Form 10-K for the year ended December 31, 2019.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company, like other financial institutions, is subject to direct and indirect market risk. Direct market risk exists from changes in interest rates. The Company's net income is dependent on its net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities mature or reprice on a different basis than interest-earning assets. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income.
In an attempt to manage the Company's exposure to changes in interest rates, management monitors the Company's interest rate risk. Each subsidiary bank has an asset/liability management committee of the board of directors that meets quarterly to review the bank's interest rate risk position and profitability, and to make or recommend adjustments for consideration by the full board of each bank.
Internal asset/liability management teams consisting of members of the subsidiary banks' management meet weekly to manage the mix of assets and liabilities to maximize earnings and liquidity and minimize interest rate and other risks. Management also reviews the subsidiary banks' securities portfolios, formulates investment strategies, and oversees the timing and implementation of transactions to assure attainment of the board's objectives in an effective manner. Notwithstanding the Company's interest rate risk management activities, the potential for changing interest rates is an uncertainty that can have an adverse effect on net income.
In adjusting the Company's asset/liability position, the board of directors and management attempt to manage the Company's interest rate risk while maintaining or enhancing net interest margins. At times, depending on the level of general interest rates, the relationship between long-term and short-term interest rates, market conditions and competitive factors, the board of directors and management may decide to increase the Company's interest rate risk position somewhat in order to increase its net interest margin. The Company's results of operations and net portfolio values remain vulnerable to increases in interest rates and to fluctuations in the difference between long-term and short-term interest rates.
One method used to quantify interest rate risk is a short-term earnings at risk summary, which is a detailed and dynamic simulation model used to quantify the estimated exposure of net interest income to sustained interest rate changes. This simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all interest sensitive assets and liabilities reflected on the Company's consolidated balance sheet. This sensitivity analysis demonstrates net interest income exposure annually over a five-year horizon, assuming no balance sheet growth, no balance sheet mix change, and various interest rate scenarios including no change in rates; 100, 200, 300, and 400 basis point upward shifts; and a 100 and 200 basis point downward shifts in interest rates, where interest-bearing assets and liabilities reprice at their earliest possible repricing date.
The model assumes parallel and pro rata shifts in interest rates over a twelve-month period for the 200 basis point upward shift and 100 and 200 basis point downward shifts. For the 400 basis point upward shift, the model assumes a parallel and pro rata shift in interest rates over a twenty-four month period.
Further, in recent years, the Company added additional interest rate scenarios where interest rates experience a parallel and instantaneous shift (“shock”) upward of 100, 200, 300, and 400 basis points and a parallel and instantaneous shock downward of 100 and 200 basis points. The Company will run additional interest rate scenarios on an as-needed basis.
The asset/liability management committees of the subsidiary bank boards of directors have established policy limits of a 10% decline in net interest income for the 200 basis point upward parallel shift and the 100 basis point downward parallel shift. For the 300 basis point upward shock, the established policy limit is a 25% decline in net interest income. The increased policy limit is appropriate as the shock scenario is extreme and unlikely and warrants a higher limit than the more realistic and traditional parallel/pro-rata shift scenarios.
Application of the simulation model analysis for select interest rate scenarios at the most recent quarter-end available is presented in the following table:
NET INTEREST INCOME EXPOSURE in YEAR 1
INTEREST RATE SCENARIO
POLICY LIMIT
2018
100 basis point downward shift
(10.0)
0.6
0.7
200 basis point upward shift
0.9
1.2
(2.7)
300 basis point upward shock
(25.0)
7.2
(9.0)
The simulation is within the board-established policy limits for all three scenarios. Additionally, for all of the various interest rate scenarios modeled and measured by management (as described above), the results at June 30, 2020 were within established risk tolerances as established by policy or by best practice (if the interest rate scenario didn't have a specific policy limit).
Interest rate risk is considered to be one of the most significant market risks affecting the Company. For that reason, the Company engages the assistance of a national consulting firm and its risk management system to monitor and control the Company's interest rate risk exposure. Other types of market risk, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company's business activities.
CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) promulgated under the Exchange Act of 1934) as of June 30, 2020. Based on that evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective, as of the end of the period covered by this report, to ensure that information required to be disclosed in the reports filed and submitted under the Exchange Act was recorded, processed, summarized and reported as and when required.
Changes in Internal Control over Financial Reporting. There have been no significant changes to the Company's internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
PART II - OTHER INFORMATION
Item 1 Legal Proceedings
There are no material pending legal proceedings to which the Company or any of its subsidiaries is a party other than ordinary routine litigation incidental to their respective businesses.
Item 1A Risk Factors
In addition to the risk factors set forth under Part I, Item 1A “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, the following risk factors apply to the Company:
The outbreak of COVID-19 has led to an economic recession and other severe disruptions in the U.S. economy and has adversely disrupted banking and other financial activity and industries in the areas in which the Company operates. As a result, we are starting to see the impact of COVID-19 on our business, and we believe that it could be significant, adverse and potentially material.
Currently, COVID-19 is spreading through the United States and the world. The spread of highly infectious or contagious diseases could cause, and the spread of COVID-19 has caused, severe disruptions in the U.S. economy at large, and for small businesses in particular, which could disrupt the Company’s operations. The resulting concerns on the part of the U.S. and global populations have resulted in a recessionary environment, reduced economic activity and caused significant volatility in the global stock markets. The Company has experienced disruptions across the Company’s business due to these effects, leading to decreased earnings and slowdowns in loan collections.
The outbreak of COVID-19 has resulted in a decline in our clients’ businesses, a decrease in consumer confidence, an increase in unemployment and a disruption in the services provided by our vendors. Continued disruption to our clients’ businesses could result in increased risk of delinquencies, defaults, foreclosures and losses on our loans, declines in assets under management and wealth management revenues, negatively impact regional economic conditions, result in declines in local loan demand, liquidity of loan guarantors, loan collateral (particularly in real estate), loan originations and deposit availability and negatively impact the implementation of our growth strategy. Although the U.S. government has introduced a number of programs designed to soften the impact of COVID-19 on small businesses, once these programs expire, our borrowers may not be able to satisfy their financial obligations to us.
COVID-19 has impacted and will likely continue to impact businesses’ and consumers’ financial ability to borrow money, which would negatively impact loan volumes. In addition, certain of the Company’s borrowers are in or have exposure to the hotel, restaurant, entertainment and retail industries and are located in areas that are or were quarantined or under stay-at-home orders, and COVID-19 may also have an adverse effect on the Company’s direct lease financing, commercial real estate and consumer loan portfolios. Any new or prolonged quarantine or stay-at-home orders would have a negative adverse impact on these borrowers and their revenue streams, which consequently impacts their ability to meet their financial obligations and could result in loan defaults.
As a result of the COVID-19 pandemic we may experience adverse financial consequences due to a number of other factors, including, but not limited to:
Overall, we believe that the economic impact from COVID-19 may be severe and could have a material and adverse impact on our business and result in significant losses in our loan portfolio, all of which would adversely and materially impact our earnings and capital. Even after the COVID-19 pandemic has subsided, we may continue to experience materially adverse impacts to our business as a result of the global economic impact of the COVID-19 pandemic, including the availability of credit, adverse impacts on liquidity and any recession that has occurred or may occur in the future. There are no comparable recent events that provide guidance as to the effect of the spread of COVID-19 as a global pandemic may have, and as a result, the ultimate impact of the pandemic is highly uncertain and subject to change.
The U.S. government and banking regulators, including the Federal Reserve, have taken a number of unprecedented actions in response to the COVID-19 pandemic, which could ultimately have a material adverse effect on our business and results of operations.
On March 27, 2020, President Trump signed into law the CARES Act, which established a $2.0 trillion economic stimulus package, including cash payments to individuals, supplemental unemployment insurance benefits and a $349 billion loan program administered through the SBA, referred to as the PPP. In addition to implementing the programs contemplated by the CARES Act, the federal bank regulatory agencies have issued a steady stream of guidance in response to the COVID-19 pandemic and have taken a number of unprecedented steps to help banks navigate the pandemic and mitigate its impact. These include, without limitation:
The COVID-19 pandemic has significantly affected the financial markets, and the Federal Reserve has taken a number of actions in response. In March 2020, the Federal Reserve dramatically reduced the target federal funds rate and announced a $700 billion quantitative easing program in response to the expected economic downturn caused by the COVID-19 pandemic. In addition, the Federal Reserve reduced the interest that it pays on excess reserves. We expect that these reductions in interest rates, especially if prolonged, could adversely affect our net interest income and margins and our profitability. The Federal Reserve also launched the Main Street Lending Program, which will offer deferred interest on four-year loans to small and mid-sized businesses. The full impact of the COVID-19 pandemic on our business activities as a result of new government and regulatory laws, policies, programs and guidelines, as well as market reactions to such activities, remains uncertain but may ultimately have a material adverse effect on our business and results of operations.
COVID-19 has disrupted banking and other financial activities in the areas in which we operate and could potentially create widespread business continuity issues for us.
The COVID-19 pandemic has negatively impacted the ability of our employees and clients to engage in banking and other financial transactions in the geographic area in which we operate and could create widespread business continuity issues for us. We also could be adversely affected if key personnel or a significant number of employees were to become unavailable due to the effects and restrictions of an outbreak or escalation of the COVID-19 pandemic in our market area, including because of illness, quarantines, government actions or other restrictions in connection with the COVID-19 pandemic. Although we have business continuity plans and other safeguards in place, there is no assurance that such plans and safeguards will be effective. Further, we rely upon our third-party vendors to conduct business and to process, record, and monitor transactions. If any of these vendors are unable to continue to provide us with these services, it could negatively impact our ability to serve our clients.
As a participating lender in the PPP, the Company and the subsidiary banks are subject to additional risks of litigation from our customers or other parties regarding our processing of loans for the PPP and risks that the SBA may not fund some or all PPP loan guaranties.
The CARES Act included a $349 billion loan program administered through the SBA referred to as the PPP. Under the PPP, small businesses and other entities and individuals can apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. The subsidiary banks are participating as lenders in the PPP. The PPP opened on April 3, 2020; however, because of the short timeframe between the passing of the CARES Act and the opening of the PPP, there is some ambiguity in the laws, rules and guidance regarding the operation of the PPP, which exposes the Company to risks relating to noncompliance with the PPP. On or about April 16, 2020, the SBA notified lenders that the $349 billion earmarked for the PPP was exhausted. Congress has authorized an additional $310 billion funding for PPP loans; however, it is unknown if and when this the additional authorized amount will be exhausted and whether Congress will again authorize additional PPP loan funding.
Since the opening of the PPP, several other larger banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP and claims related to agent fees. The Company and the subsidiary banks may be exposed to the risk of similar litigation, from both customers and non-customers that approached the banks regarding PPP loans, regarding their process and procedures used in processing applications for the PPP. If any such litigation is filed against the Company or the subsidiary banks and is not resolved in a manner favorable to the Company or the banks, it may result in significant financial liability or adversely affect the Company’s reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP related litigation could have a material adverse impact on our business, financial condition and results of operations.
The subsidiary banks also have credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the banks, such as an
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issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by the Company, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from the Company.
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Item 2 Unregistered Sales of Equity Securities and Use of Proceeds
On February 13, 2020, the Board of Directors of the Company approved a share repurchase program under which the Company is authorized to repurchase, from time to time as the Company deems appropriate, up to 800,000 shares of its outstanding common stock, or approximately 5% of the outstanding shares as of December 31, 2019. The Company suspended the repurchase of shares on March 16, 2020 due to the uncertainties related to the COVID-19 pandemic and it is uncertain when the Company will resume the repurchase of shares as part of this program in the future. All shares repurchased under the share repurchase program were retired.
Total number of shares
Maximum number
purchased as part of
of shares that may yet
Total number of
Average price
publicly announced
be purchased under
Period
shares purchased
paid per share
plans or programs
the plans or programs
April 1-30, 2020
100,932
699,068
May 1-31, 2020
June 1-30, 2020
Item 3 Defaults Upon Senior Securities
None
Item 4 Mine Safety Disclosures
Not applicable
Item 5 Other Information
Item 6 Exhibits
31.1
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
31.2
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
32.1
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101
Inline XBRL Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets as of June 30, 2020 and December 31, 2019; (ii) Consolidated Statements of Income for the three and six months ended June 30, 2020 and June 30, 2019; (iii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2020 and June 30, 2019; (iv) Consolidated Statements of Changes in Stockholders' Equity for the three and months ended June 30, 2020 and June 30, 2019; (v) Consolidated Statements of Cash Flows for the six months ended June 30, 2020 and June 30, 2019; and (vi) Notes to the Consolidated Financial Statements.
104
Inline XBRL cover page interactive data file pursuant to Rule 406 of Regulation S-T for the interactive data files referenced in Exhibit 101.
SIGNATURES
Pursuant to the requirements of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
Date
August 7, 2020
/s/ Larry J. Helling
Larry J. Helling
Chief Executive Officer
/s/ Todd A. Gipple
Todd A. Gipple, President
Chief Operating Officer
Chief Financial Officer
/s/ Nick W. Anderson
Nick W. Anderson
Chief Accounting Officer
(Principal Accounting Officer)