UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2019
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to ____________
Commission File Number: 0-19065
SANDY SPRING BANCORP, INC.
(Exact name of registrant as specified in its charter)
Maryland
52-1532952
(State of incorporation)
(I.R.S. Employer Identification Number)
17801 Georgia Avenue, Olney, Maryland
20832
(Address of principal executive office)
(Zip Code)
301-774-6400
(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, par value $1.00 per share
SASR
The NASDAQ Stock Market, LLC
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to 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 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 ☑
The number of outstanding shares of common stock outstanding as of August 7, 2019
Common stock, $1.00 par value – 35,618,558 shares
TABLE OF CONTENTS
Page
PART I - FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
Condensed Consolidated Statements of Condition - Unaudited at
June 30, 2019 and December 31, 2018
4
Condensed Consolidated Statements of Income - Unaudited for the Three and Six
Months Ended June 30, 2019 and 2018
5
Condensed Consolidated Statements of Comprehensive Income – Unaudited for
the Three and Six Months Ended June 30, 2019 and 2018
6
Condensed Consolidated Statements of Cash Flows – Unaudited for the Six
7
Condensed Consolidated Statements of Changes in Stockholders’ Equity – Unaudited for the
Three and Six Months Ended June 30, 2019 and 2018
8
Notes to Condensed Consolidated Financial Statements
10
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
36
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
62
Item 4. CONTROLS AND PROCEDURES
PART II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
Item 1A. RISK FACTORS
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Item 3. DEFAULTS UPON SENIOR SECURITIES
Item 4. MINE SAFETY DISCLOSURES
Item 5. OTHER INFORMATION
Item 6. EXHIBITS
63
SIGNATURES
64
2
Forward-Looking Statements
This Quarterly Report on Form 10-Q, as well as other periodic reports filed with the Securities and Exchange Commission, and written or oral communications made from time to time by or on behalf of Sandy Spring Bancorp and its subsidiaries (the “Company”), may contain statements relating to future events or future results of the Company that are considered “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements may be identified by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “estimate,” “intend” and “potential,” or words of similar meaning, or future or conditional verbs such as “should,” “could,” or “may.” Forward-looking statements include statements of our goals, intentions and expectations; statements regarding our business plans, prospects, growth and operating strategies; statements regarding the quality of our loan and investment portfolios; and estimates of our risks and future costs and benefits.
Forward-looking statements reflect our expectation or prediction of future conditions, events or results based on information currently available. These forward-looking statements are subject to significant risks and uncertainties that may cause actual results to differ materially from those in such statements. These risks and uncertainties include, but are not limited to, the risks identified in Item 1A of the Company’s 2018 Annual Report on Form 10-K, Item 1A of Part II of this report and the following:
general business and economic conditions nationally or in the markets that the Company serves could adversely affect, among other things, real estate prices, unemployment levels, and consumer and business confidence, which could lead to decreases in the demand for loans, deposits and other financial services that we provide and increases in loan delinquencies and defaults;
changes or volatility in the capital markets and interest rates may adversely impact the value of securities, loans, deposits and other financial instruments and the interest rate sensitivity of our balance sheet as well as our liquidity;
our liquidity requirements could be adversely affected by changes in our assets and liabilities;
our investment securities portfolio is subject to credit risk, market risk, and liquidity risk as well as changes in the estimates we use to value certain of the securities in our portfolio;
the effect of legislative or regulatory developments including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial services industry;
acquisition integration risks, including potential deposit attrition, higher than expected costs, customer loss, business disruption and the inability to realize benefits and costs savings from, and limit any unexpected liabilities associated with, any business combinations;
competitive factors among financial services companies, including product and pricing pressures and our ability to attract, develop and retain qualified banking professionals;
the effect of changes in accounting policies and practices, as may be adopted by the Financial Accounting Standards Board, the Securities and Exchange Commission, the Public Company Accounting Oversight Board and other regulatory agencies; and
the effect of fiscal and governmental policies of the United States federal government.
Forward-looking statements speak only as of the date of this report. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date of this report or to reflect the occurrence of unanticipated events except as required by federal securities laws.
3
Part I
Sandy Spring Bancorp, Inc. and Subsidiaries
CONDENSED CONSOLIDATED STATEMENTS OF CONDITION – UNAUDITED
June 30,
December 31,
(Dollars in thousands)
2019
2018
Assets
Cash and due from banks
$
75,781
67,014
Federal funds sold
583
609
Interest-bearing deposits with banks
155,312
33,858
Cash and cash equivalents
231,676
101,481
Residential mortgage loans held for sale (at fair value)
50,511
22,773
Investments available-for-sale (at fair value)
901,025
937,335
Other equity securities
54,690
73,389
Total loans
6,551,243
6,571,634
Less: allowance for loan losses
(54,024)
(53,486)
Net loans
6,497,219
6,518,148
Premises and equipment, net
60,372
61,942
Other real estate owned
1,486
1,584
Accrued interest receivable
26,148
24,609
Goodwill
347,149
Other intangible assets, net
8,813
9,788
Other assets
219,430
145,074
Total assets
8,398,519
8,243,272
Liabilities
Noninterest-bearing deposits
2,023,614
1,750,319
Interest-bearing deposits
4,366,135
4,164,561
Total deposits
6,389,749
5,914,880
Securities sold under retail repurchase agreements and federal funds purchased
150,604
327,429
Advances from FHLB
582,768
848,611
Subordinated debentures
37,353
37,425
Accrued interest payable and other liabilities
118,600
47,024
Total liabilities
7,279,074
7,175,369
Stockholders' Equity
Common stock -- par value $ 1.00 ; shares authorized 100,000,000; shares issued and outstanding 35,614,953
and 35,530,734 at June 30, 2019 and December 31, 2018, respectively
35,615
35,531
Additional paid in capital
608,006
606,573
Retained earnings
479,389
441,553
Accumulated other comprehensive loss
(3,565)
(15,754)
Total stockholders' equity
1,119,445
1,067,903
Total liabilities and stockholders' equity
The accompanying notes are an integral part of these statements
SANDY SPRING BANCORP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME – UNAUDITED
Three Months Ended
Six Months Ended
(Dollars in thousands, except per share data)
Interest income:
Interest and fees on loans
79,464
70,672
159,861
138,264
Interest on loans held for sale
381
279
573
647
Interest on deposits with banks
428
514
622
871
Interest and dividends on investment securities:
Taxable
5,396
5,083
11,081
10,185
Exempt from federal income taxes
1,544
2,042
3,254
4,114
Interest on federal funds sold
1
20
Total interest income
87,214
78,597
175,397
154,101
Interest expense:
Interest on deposits
16,146
8,851
30,626
15,810
Interest on retail repurchase agreements and federal funds purchased
290
108
688
216
Interest on advances from FHLB
4,103
5,338
10,167
10,416
Interest on subordinated debt
490
482
981
950
Total interest expense
21,029
14,779
42,462
27,392
Net interest income
66,185
63,818
132,935
126,709
Provision for loan losses
1,633
1,733
1,505
3,730
Net interest income after provision for loan losses
64,552
62,085
131,430
122,979
Non-interest income:
Investment securities gains
-
Service charges on deposit accounts
2,442
2,290
4,749
4,549
Mortgage banking activities
3,270
2,064
6,133
4,271
Wealth management income
5,539
5,387
10,775
10,448
Insurance agency commissions
1,265
1,180
3,165
3,004
Income from bank owned life insurance
654
670
1,843
3,001
Bank card fees
1,467
1,393
2,719
2,763
Other income
1,914
1,884
4,136
3,887
Total non-interest income
16,556
14,868
33,525
31,986
Non-interest expense:
Salaries and employee benefits
25,489
24,664
51,465
48,576
Occupancy expense of premises
4,760
4,642
9,991
9,584
Equipment expense
2,712
2,243
5,288
4,468
Marketing
887
945
1,830
2,093
Outside data services
1,962
1,707
3,740
3,104
FDIC insurance
1,084
1,390
2,220
2,583
Amortization of intangible assets
483
541
974
1,082
Merger expenses
2,228
11,186
Professional fees and services
1,634
1,699
2,879
2,739
Other expenses
4,876
5,023
9,692
9,308
Total non-interest expense
43,887
45,082
88,079
94,723
Income before income taxes
37,221
31,871
76,876
60,242
Income tax expense
8,945
7,472
18,283
14,178
Net income
28,276
24,399
58,593
46,064
Per share information:
Basic net income per share
0.79
0.68
1.64
1.29
Diluted net income per share
1.63
Dividends declared per common share
0.30
0.28
0.58
0.54
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME – UNAUDITED
Three Months Ended June 30,
Six Months Ended June 30,
(In thousands)
Other comprehensive income:
Investments available-for-sale:
Net change in unrealized gains/(losses) on investments available-for-sale
7,167
(4,230)
15,981
(16,919)
Related income tax expense/(benefit)
(1,873)
1,107
(4,179)
4,428
Net investment gains reclassified into earnings
(5)
(63)
Related income tax expense
16
Net effect on other comprehensive income/(loss) for the period
5,290
(3,123)
11,798
(12,538)
Defined benefit pension plan:
Recognition of unrealized loss
265
250
530
500
Related income tax benefit
(70)
(65)
(139)
(184)
Net effect on other comprehensive income for the period
195
185
391
316
Total other comprehensive income/(loss)
5,485
(2,938)
12,189
(12,222)
Comprehensive income
33,761
21,461
70,782
33,842
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS – UNAUDITED
Operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
6,724
6,099
Stock based compensation expense
1,473
1,250
Tax benefits associated with share based compensation
57
252
Deferred income tax expense
1,795
2,358
Origination of loans held for sale
(299,401)
(186,777)
Proceeds from sales of loans held for sale
278,290
186,211
Gains on sales of loans held for sale
(6,627)
(3,674)
Losses on sales of other real estate owned
173
106
Net increase in accrued interest receivable
(1,540)
(1,211)
Net increase in other assets
(4,880)
(443)
Net decrease in accrued expenses and other liabilities
(6,126)
(2,239)
Other – net
1,162
Net cash provided by operating activities
31,193
54,375
Investing activities:
(Purchases of)/proceeds from other equity securities
18,699
(12,027)
Purchases of investments available-for-sale
(15,919)
(497)
Proceeds from sales of investment available-for-sale
994
Proceeds from maturities, calls and principal payments of investments available-for-sale
66,887
52,798
Net (increase)/ decrease in loans
19,979
(315,872)
Proceeds from the sales of other real estate owned
324
676
Proceeds from sales of loans previously held for investment
59,945
Acquisition of business activity, net of cash acquired
32,552
Expenditures for premises and equipment
(2,456)
(6,788)
Net cash provided by/ (used in) investing activities
87,514
(188,219)
Financing activities:
Net increase in deposits
474,869
263,322
Net increase/ (decrease) in retail repurchase agreements and federal funds purchased
(176,825)
13,402
Proceeds from advances from FHLB
2,123,000
3,920,000
Repayment of advances from FHLB
(2,388,843)
(3,861,413)
Proceeds from issuance of common stock
746
829
Stock tendered for payment of withholding taxes
(702)
(760)
Dividends paid
(20,757)
(19,268)
Net cash provided by financing activities
11,488
316,112
Net increase in cash and cash equivalents
130,195
182,268
Cash and cash equivalents at beginning of period
112,500
Cash and cash equivalents at end of period
294,768
Supplemental disclosures:
Interest payments
43,348
26,587
Income tax payments
18,629
11,598
Transfer from loans to residential mortgage loans held for sale
60,043
Transfer from loans to other real estate owned
414
289
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY – UNAUDITED
Accumulated
Additional
Other
Total
Common
Paid-In
Retained
Comprehensive
Stockholders’
Stock
Capital
Earnings
Income (Loss)
Equity
Balances at April 1, 2019
35,557
607,479
461,862
(9,050)
1,095,848
Other comprehensive income, net of tax
Common stock dividends - $0.30 per share
(10,749)
Stock compensation expense
783
Common stock issued pursuant to:
Directors stock purchase plan - 867 shares
29
30
Stock option plan - 4,142 shares
91
95
Employee stock purchase plan - 10,004 shares
268
278
Restricted stock - 42,830 shares
43
(644)
(601)
Balances at June 30, 2019
Balance at April 1, 2018
35,463
604,399
392,364
(17,618)
1,014,608
Common stock dividends - $0.28 per share
(10,001)
668
Stock option plan - 5,574 shares
132
138
Employee stock purchase plan - 6,909 shares
228
235
Restricted stock - 36,191 shares
(796)
Balances at June 30, 2018
35,512
604,631
406,762
(20,556)
1,026,349
Balances at January 1, 2019
Common stock dividends - $0.58 per share
Stock option plan - 10,897 shares
11
213
224
Employee stock purchase plan - 17,666 shares
17
475
492
Restricted stock - 54,789 shares
55
(757)
Balance at January 1, 2018
23,996
168,188
378,489
(6,857)
563,816
Common stock dividends - $0.54 per share
Acquisition of WashingtonFirst - 11,446,197 shares
11,446
435,194
446,640
Stock option plan - 17,927 shares
18
352
370
Employee stock purchase plan - 13,821 shares
14
445
459
Restricted stock - 37,705 shares
38
(798)
Reclassification of tax effects from other comprehensive income
1,477
(1,477)
9
Notes to the CONDENSED Consolidated Financial Statements - UNAUDITED
Note 1 – Significant Accounting Policies
Nature of Operations
Sandy Spring Bancorp (the “Company”), a Maryland corporation, is the bank holding company for Sandy Spring Bank (the “Bank”). Independent and community-oriented, Sandy Spring Bank offers a broad range of commercial banking, retail banking, mortgage and trust services throughout central Maryland, Northern Virginia, and the greater Washington, D.C. market. Sandy Spring Bank also offers a comprehensive menu of insurance and wealth management services through its subsidiaries, Sandy Spring Insurance Corporation and West Financial Services, Inc.
Basis of Presentation
The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”) and prevailing practices within the financial services industry for interim financial information and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required for complete financial statements and prevailing practices within the banking industry. The following summary of significant accounting policies of the Company is presented to assist the reader in understanding the financial and other data presented in this report. Operating results for the three and six months ended June 30, 2019 are not necessarily indicative of the results that may be expected for any future periods or for the year ending December 31, 2019. In the opinion of management, all adjustments (comprising only normal recurring accruals) necessary for a fair presentation of the results of the interim periods have been included. Certain reclassifications have been made to prior period amounts, as necessary, to conform to the current period presentation. The Company has evaluated subsequent events through the date of the issuance of its financial statements.
These statements should be read in conjunction with the financial statements and accompanying notes included in the Company’s 2018 Annual Report on Form 10-K as filed with the Securities and Exchange Commission (“SEC”) on February 22, 2019. There have been no significant changes to the Company’s accounting policies as disclosed in the 2018 Annual Report on Form 10-K.
Principles of Consolidation
The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Sandy Spring Bank and its subsidiaries, Sandy Spring Insurance Corporation and West Financial Services, Inc. Consolidation has resulted in the elimination of all intercompany accounts and transactions.
Use of Estimates
The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements, in addition to affecting the reported amounts of revenues earned and expenses incurred during the reporting period. Actual results could differ from those estimates. Estimates that could change significantly relate to the provision for loan losses and the related allowance, determination of impaired loans and the related measurement of impairment, potential impairment of goodwill or other intangible assets, valuation of investment securities and the determination of whether impaired securities are other-than-temporarily impaired, valuation of other real estate owned, valuation of share-based compensation, the assessment that a liability should be recognized with respect to any matters under litigation, the calculation of current and deferred income taxes and the actuarial projections related to pension expense and the related liability.
Cash Flows
For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, federal funds sold and interest-bearing deposits with banks (items with stated original maturity of three months or less).
Revenue from Contracts with Customers
The Company’s revenue includes net interest income on financial instruments and non-interest income. Specific categories of revenue are presented in the Condensed Consolidated Statements of Income. Most of the Company’s revenue is not within the scope of Accounting Standard Update (ASU) No. 2014-09 – Revenue from Contracts with Customers. For revenue within the scope of ASU 2014-09, the Company provides services to customers and has related performance obligations. The revenue from such services is recognized upon satisfaction of all contractual performance obligations. The following discusses key revenue streams within the scope of revenue recognition guidance.
Wealth Management Income
West Financial Services, Inc., a subsidiary of the Bank, provides comprehensive investment management and financial planning services. Wealth management income is comprised of income for providing trust, estate and investment management services. Trust services include acting as a trustee for corporate or personal trusts. Investment management services include investment management, record-keeping and reporting of security portfolios. Fees for these services are recognized based on a contractually-agreed fixed percentage applied to net assets under management at the end of each reporting period. The Company does not charge/recognize any performance based fees.
Insurance Agency Commissions
Sandy Spring Insurance, a subsidiary of the Bank, performs the function of an insurance intermediary by introducing the policyholder and insurer and is compensated by a commission fee for placement of an insurance policy. Sandy Spring Insurance does not provide any captive management services or any claim handling services. Commission fees are set as a percentage of the premium for the insurance policy for which Sandy Spring Insurance is a producer. The Company recognizes revenue when the insurance policy has been contractually agreed to by the insurer and policyholder (at transaction date).
Service Charges on Deposit Accounts
Service charges on deposit accounts are earned on depository accounts for consumer and commercial account holders and include fees for account and overdraft services. Account services include fees for event-driven services and periodic account maintenance activities. The obligation for event-driven services is satisfied at the time of the event when service is delivered and revenue recognized as earned. Obligation for maintenance activities is satisfied over the course of each month and revenue recognized at month end. Obligation for overdraft services is satisfied at the time of the overdraft and revenue recognized as earned.
Loans Acquired with Deteriorated Credit Quality
Acquired loans with evidence of credit deterioration since their origination as of the date of the acquisition are recorded at their initial fair value. Credit deterioration is determined based on the probability of collection of all contractually required principal and interest payments. The historical allowance for loan losses related to the acquired loans is not carried over to the Company’s financial statements. The determination of credit quality deterioration as of the purchase date may include parameters such as past due and non-accrual status, commercial risk ratings, cash flow projections, type of loan and collateral, collateral value and recent loan-to-value ratios or appraised values. For loans acquired with evidence of credit deterioration, the Company determines at the acquisition date the excess of the loan’s contractually required payments over all cash flows expected to be collected as an amount that should not be accreted into interest income (nonaccretable difference). The remaining amount, representing the difference in the expected cash flows of acquired loans and the initial investment in the acquired loans, is accreted into interest income over the remaining life of the loan or pool of loans (accretable yield). Subsequent to the purchase date, increases in expected cash flows over those expected at the purchase date are recognized prospectively as interest income over the remaining life of the loan as an adjustment to the accretable yield. The present value of any decreases in expected cash flows after the purchase date is recognized as impairment through addition to the valuation allowance.
Leases
The Company determines if an arrangement is a lease at inception. All of the Company’s leases are currently classified as operating leases and are included in other assets and other liabilities on the Company’s Condensed Consolidated Statements of Condition.
Right-of-use (“ROU”) assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease arrangements. Operating lease ROU assets and liabilities are recognized at the lease commencement date based on the present value of the expected future lease payments over the remaining lease term. In determining the present value of future lease payments, the Company uses its incremental borrowing rate based on the information available at the lease commencement date. The operating ROU assets are adjusted for any lease payments made at or before lease commencement date, initial direct costs and any lease incentives received. The Company’s lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise such options. Lease expense is recognized on a straight line basis over the expected lease term. Lease agreements that include lease and non-lease components, such as common area maintenance charges, are accounted for separately.
Adopted Accounting Pronouncements
The FASB issued Update No. 2016-02, Leases, in February 2016. From the lessee’s perspective, the new standard requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. The Company adopted the standard on January 1, 2019 (“adoption date”) using modified retrospective approach. The Company elected the transition option to apply the provisions of the new standard only as of the beginning of the adoption period and did not restate comparative historical periods presented. The Company also elected a package of practical expedients permitted under the transition guidance within the new standard, which among other things, allowed the Company to carry forward the historical lease classification of those leases in existence as of the adoption date.
The standard had a material impact on the Company’s Condensed Consolidated Statements of Condition, but did not have a material impact on Condensed Consolidated Statements of Income. The most significant impact at the adoption date was the recognition of ROU assets and lease liabilities for operating leases which totaled $77.7 million and $85.1 million, respectively. Refer to Note 12 – Leases for other required disclosures.
Pending Accounting Pronouncements
The FASB issued Update No. 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities, in March 2017. This guidance is intended to eliminate the current diversity in practice with respect to the amortization period for certain purchased callable debt securities held at a premium. Under current GAAP, entities generally amortize the premium as an adjustment of yield over the contractual life. As a result, upon the exercise of a call on a callable debt security held at a premium, the unamortized premium is recorded as a loss in earnings. The amendments in this update shorten the amortization period for such callable debt securities held at a premium requiring the premium to be amortized to the earliest call date. This guidance is effective for a public business entity that is a U.S. Securities and Exchange Commission (SEC) filer for its fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The adoption of this standard is not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
The FASB issued Update No. 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, in January 2017. The objective of this guidance is to simplify an entity’s required test for impairment of goodwill by eliminating Step 2 from the goodwill impairment test. In Step 2 an entity measured a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. In computing the implied fair value of goodwill, an entity had to determine the fair value at the impairment date of its assets and liabilities, including any unrecognized assets and liabilities, following a procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Under this Update, an entity should perform its annual or quarterly goodwill impairment test by comparing the fair value of the reporting unit with its carrying amount and record an impairment charge for the excess of the carrying amount over the reporting unit’s fair value. The loss recognized should not exceed the total amount of goodwill allocated to the reporting unit and the entity must consider the income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. This guidance is effective for a public business entity that is an SEC filer for its annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. The adoption of this standard is not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
The FASB issued Update No. 2016-13, Current Expected Credit Losses (CECL), in June 2016. This guidance changes the impairment model for most financial assets measured at amortized cost and certain other instruments. Entities will be required to use an expected loss model, replacing the incurred loss model that is currently in use. Under the new guidance, an entity will measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts. This will result in earlier recognition of loss allowances in most instances. Credit losses related to available-for-sale debt securities (regardless of whether the impairment is considered to be other-than-temporary) will be measured in a manner similar to the present, except that such losses will be recorded as allowances rather than as reductions in the amortized cost of the related securities. With respect to trade and other receivables, loans, held-to-maturity debt securities, net investments in leases and off-balance-sheet credit exposures, the guidance requires that an entity estimate its lifetime expected credit loss and record an allowance resulting in the net amount expected to be collected to be reflected as the financial asset. Entities will also be required to provide significantly more disclosures, including information used to track credit quality by year of origination for most financing receivables. This guidance is effective for public business entities for the first interim or annual period beginning after December 15, 2019. The standard’s provisions will be applied as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. Early adoption by public business entities is permitted for the first interim or annual period beginning after December 15, 2018. The Company assessed the guidance and has identified the available historical loan level information and completed a data gap analysis. The Company is in process of designing calculation methodologies under the new guidance and quantifying the approximate impact on the Company’s financialposition and results of operations.
12
Note 2 – Investments
Investments available-for-sale
The amortized cost and estimated fair values of investments available-for-sale at the dates indicated are presented in the following table:
June 30, 2019
December 31, 2018
Gross
Estimated
Amortized
Unrealized
Fair
Cost
Gains
Losses
Value
U.S. treasuries and government agencies
314,564
1,072
(867)
314,769
300,338
(4,030)
296,678
State and municipal
245,086
4,499
(9)
249,576
280,725
2,080
(781)
282,024
Mortgage-backed and asset-backed
324,394
2,930
(978)
326,346
355,267
653
(7,405)
348,515
Corporate debt
9,100
356
9,456
140
9,240
Trust preferred
310
Total debt securities
893,454
8,857
(1,854)
900,457
945,740
3,243
(12,216)
936,767
Marketable equity securities
568
Total investments available-for-sale
894,022
946,308
Any unrealized losses in the U.S. treasuries and government agencies, state and municipal, mortgage-backed and asset-backed investment securities at June 30, 2019 are not the result of credit related events but due to changes in interest rates. These declines in fair market value are considered temporary in nature and are expected to recover over time as these securities approach maturity.
The mortgage-backed securities portfolio at June 30, 2019 is composed entirely of either the most senior tranches of GNMA, FNMA or FHLMC collateralized mortgage obligations ($114.2 million), GNMA, FNMA or FHLMC mortgage-backed securities ($164.3 million) and SBA asset-backed securities ($47.8 million). The Company does not intend to sell these securities and has sufficient liquidity to hold these securities for an adequate period of time to allow for any anticipated recovery in fair value.
Gross unrealized losses and fair value by length of time that the individual available-for-sale securities have been in an unrealized loss position at the dates indicated are presented in the following table:
13
Continuous Unrealized
Losses Existing for:
Number
of
Less than
More than
Securities
Fair Value
12 months
134,475
667
200
867
6,065
28
120,081
978
260,621
1,187
1,854
33
194,135
452
3,578
4,030
80
78,232
569
212
781
110
308,254
1,592
5,813
7,405
223
580,621
2,613
9,603
12,216
The amortized cost and estimated fair values of debt securities available-for-sale by contractual maturity at the dates indicated are provided in the following table. The Company has allocated mortgage-backed securities into the four maturity groupings reflected in the following table using the expected average life of the individual securities based on statistics provided by independent third party industry sources. Expected maturities will differ from contractual maturities as borrowers may have the right to prepay obligations with or without prepayment penalties.
Due in one year or less
64,147
64,455
63,482
63,747
Due after one year through five years
278,728
281,339
277,297
276,830
Due after five years through ten years
172,732
175,655
212,825
210,386
Due after ten years
377,847
379,008
392,136
385,804
Total debt securities available for sale
At June 30, 2019 and December 31, 2018, investments available-for-sale with a book value of $467.6 million and $477.3 million, respectively, were pledged as collateral for certain government deposits and for other purposes as required or permitted by law. The outstanding balance of no single issuer, except for U.S. Agencies securities, exceeded ten percent of stockholders' equity at June 30, 2019 and December 31, 2018.
Equity securities
Other equity securities at the dates indicated are presented in the following table:
Federal Reserve Bank stock
22,515
22,456
Federal Home Loan Bank of Atlanta stock
32,175
50,933
Total equity securities
Note 3 – LOANS
Outstanding loan balances at June 30, 2019 and December 31, 2018 are net of unearned income including net deferred loan fees of $0.6 million and $0.9 million, respectively. The loan portfolio segment balances at the dates indicated are presented in the following table:
Residential real estate:
Residential mortgage
1,241,081
1,228,247
Residential construction
171,106
186,785
Commercial real estate:
Commercial owner occupied real estate
1,224,986
1,202,903
Commercial investor real estate
1,994,027
1,958,395
Commercial AD&C
658,709
681,201
Commercial business
772,158
796,264
Consumer
489,176
517,839
The fair value of the financial assets acquired in the Company’s acquisition of WashingtonFirst Bancshares, Inc. (“WashingtonFirst”) on January 1, 2018 included loans receivable with a gross amortized cost basis of $1.7 billion. The table below illustrates the fair value adjustments made to the amortized cost basis in order to present a fair value of the loans acquired. Interest and credit fair value adjustments related to loans acquired without evidence of credit quality deterioration are accreted or amortized into interest income over the remaining expected lives of the loans. The specific credit adjustment on acquired credit impaired loans includes accretable and non-accretable components. Of the $14.5 million specific credit mark on acquired credit impaired loans, approximately $4.0 million was estimated to be an accretable adjustment recognized over the remaining expected lives of the loans and $10.5 million was estimated to be non-accretable adjustment.
In conjunction with the WashingtonFirst acquisition, the acquired loan portfolio was accounted for at fair value as follows:
January 1, 2018
Gross amortized cost basis at January 1, 2018
1,697,760
Interest rate fair value adjustment
15,370
Credit fair value adjustment on pools of homogeneous loans
(22,421)
Credit fair value adjustment on purchased credit impaired loans
(14,518)
Fair value of acquired loan portfolio at January 1, 2018
1,676,191
The following table presents the acquired credit impaired loans receivable as of January 1, 2018 (the “Acquisition Date”):
Contractual principal and interest at acquisition
49,412
Contractual cash flows not expected to be collected (Nonaccretable yield)
(17,915)
Expected cash flows at acquisition
31,497
Interest component of expected cash flows (Accretable yield)
(3,988)
Fair value of purchased credit impaired loans
27,509
The outstanding balance of purchased credit impaired loans receivable totaled $41.9 million, $26.0 million and $13.2 million at January 1, 2018, December 31, 2018 and June 30, 2019, respectively. The fair value of purchased credit impaired loans was $9.7 million and $15.3 million at June 30, 2019 and December 31, 2018, respectively. The decrease in the outstanding amounts of purchased credit impaired loans receivable from the acquisition date through the current period was driven by the efforts of credit management function to resolve the most material credit deteriorated borrowers. During 2018, liquidation of the collateral resulted in full pay-off of the outstanding principal balances of $12.4 million and the related release of accretable and non-accretable adjustments into interest income in the total amounts of $0.9 million and $1.3 million, respectively. During the current year to date, the Company settled additional purchased credit impaired loans with total outstanding balances of $5.8 million resulting in the related release of accretable and non-accretable adjustments into interest income in the total amounts of $0.2 million and $1.6 million, respectively. During the current quarter, the Company completed the charge-off of a purchased credit impaired loan with a total outstanding balance of $4.1 million. This charge-off did not result in any associated impact to the valuation allowance due to adequacy of non-accretable discount.
Activity for the accretable yield since the Acquisition Date was as follows:
15
For the Period Ended,
Accretable yield at the beginning of the period
1,279
Addition of accretable yield due to acquisition
3,988
Accretion into interest income
(664)
(1,860)
Disposals (including maturities, foreclosures, and charge-offs)
(199)
(849)
Accretable yield at the end of the period.
416
Note 4 – CREDIT QUALITY ASSESSMENT
Allowance for Loan Losses
Summary information on the allowance for loan loss activity for the period indicated is provided in the following table:
Balance at beginning of year
53,486
45,257
Loan charge-offs
(1,197)
(818)
Loan recoveries
230
Net charge-offs
(967)
(494)
Balance at period end
54,024
48,493
The following tables provide information on the activity in the allowance for loan losses by the respective loan portfolio segment for the period indicated:
For the Six Months Ended June 30, 2019
Commercial Real Estate
Residential Real Estate
Commercial
Owner
Residential
Business
AD&C
Investor R/E
Occupied R/E
Mortgage
Construction
11,377
5,944
17,603
6,307
2,113
8,881
1,261
Provision (credit)
(61)
474
1,070
(212)
153
297
(216)
Charge-offs
(776)
(308)
(113)
Recoveries
34
144
Net recoveries (charge-offs)
(742)
(164)
(79)
Balance at end of period
10,574
6,422
18,683
6,095
2,102
9,099
1,049
Allowance for loans losses to total loans ratio
1.37%
0.97%
0.94%
0.50%
0.43%
0.73%
0.61%
0.82%
Balance of loans specifically evaluated for impairment
7,347
1,990
7,184
3,766
na.
1,370
21,657
Allowance for loans specifically evaluated for impairment
2,945
393
1,413
26
4,777
Specific allowance to specific loans ratio
40.08%
19.67%
0.69%
22.06%
Balance of loans collectively evaluated
762,100
656,719
1,977,069
1,221,220
488,068
1,239,702
6,515,984
Allowance for loans collectively evaluated
7,629
6,029
17,270
6,069
49,247
Collective allowance to collective loans ratio
1.00%
0.92%
0.87%
0.76%
Balance of loans acquired with deteriorated credit quality
2,711
9,774
1,108
13,602
Allowance for loans acquired with deteriorated credit quality
Allowance to loans acquired with deteriorated credit quality ratio
For the Year Ended December 31, 2018
8,711
3,501
14,970
7,178
2,383
7,268
1,246
2,857
2,381
2,677
(871)
203
1,776
9,023
(449)
(131)
(611)
(225)
(1,416)
258
87
(191)
(44)
(473)
(163)
(794)
Allowance for loan losses to total loans ratio
1.43%
0.90%
0.52%
0.41%
0.72%
0.68%
0.81%
7,586
3,306
5,355
4,234
1,729
22,210
3,594
1,207
123
4,924
47.38%
22.54%
2.91%
22.17%
780,523
677,895
1,938,712
1,196,487
516,567
1,226,508
6,523,477
7,783
16,396
6,184
48,562
0.88%
0.85%
0.74%
8,155
14,328
2,182
1,272
25,947
Allowance to loan acquired with deteriorated credit quality ratio
The following table provides summary information regarding impaired loans at the dates indicated and for the periods then ended:
Impaired loans with a specific allowance
14,498
12,876
Impaired loans without a specific allowance
7,159
9,334
Total impaired loans
Allowance for loan losses related to impaired loans
Allowance for loan losses related to loans collectively evaluated
Total allowance for loan losses
Average impaired loans for the period
23,335
20,211
Contractual interest income due on impaired loans during the period
1,313
2,513
Interest income on impaired loans recognized on a cash basis
267
506
Interest income on impaired loans recognized on an accrual basis
78
The following tables present the recorded investment with respect to impaired loans, the associated allowance by the applicable portfolio segment and the principal balance of the impaired loans prior to amounts charged-off at the dates indicated:
Total Recorded
All
Investment in
Impaired
Loans
Non-accruing
4,034
5,468
767
11,530
Restructured accruing
102
Restructured non-accruing
1,957
782
127
2,866
Balance
6,093
6,250
894
Allowance
169
729
159
1,053
2,110
162
775
1,094
2,031
923
1,819
276
3,018
1,254
934
2,872
4,203
5,627
1,820
13,640
264
2,133
2,880
1,946
5,884
Unpaid principal balance in total impaired loans
9,840
11,744
5,598
2,725
31,897
7,740
2,867
6,461
4,664
1,603
240
358
145
154
94
25
19
4,126
5,117
10,010
328
1,766
772
2,538
6,220
1,539
220
3,170
238
1,216
4,844
172
1,442
1,614
136
1,479
287
2,876
1,366
2,695
4,346
1,983
14,854
1,942
2,740
2,251
5,414
11,056
4,419
9,909
6,656
3,081
35,121
7,685
770
5,696
3,823
2,237
858
495
610
407
143
215
175
96
75
Credit Quality
The following tables provide information on the credit quality of the loan portfolio by segment at the dates indicated:
Non-performing loans and assets:
Non-accrual loans (1)
7,083
6,409
4,439
10,625
34,312
Loans 90 days past due
1,248
Restructured loans
Total non-performing loans
8,432
11,719
37,693
39
665
409
309
Total non-performing assets
7,386
2,655
8,841
4,503
12,028
39,179
(1) Includes $4.3 million of loans acquired from WashingtonFirst and considered performing at the Acquisition Date.
7,086
4,107
9,336
33,583
49
219
221
489
7,635
4,326
10,999
36,014
315
821
7,674
3,621
5,764
11,820
37,598
(1) Includes $4.8 million of loans acquired from WashingtonFirst and considered performing at the Acquisition Date.
Past due loans
31-60 days
2,855
3,790
2,244
385
1,513
11,009
2,386
24,182
61-90 days
2,958
711
1,200
2,567
477
8,082
> 90 days
Total past due
3,661
1,096
2,713
13,576
2,863
33,512
Loans acquired with deteriorated credit quality
Current loans
756,551
652,929
1,974,183
1,220,124
480,916
1,216,871
168,243
6,469,817
2,737
3,041
433
3,871
8,181
3,226
21,963
789
2,517
4,783
2,786
3,830
5,567
10,919
27,235
778,237
677,421
1,934,882
1,196,054
506,893
1,207,982
183,400
6,484,869
The following tables provide information by credit risk rating indicators for each segment of the commercial loan portfolio at the dates indicated:
Pass
752,645
1,972,903
1,214,105
4,596,372
Special Mention (1)
5,111
3,910
3,117
12,138
Substandard (2)
14,402
17,214
7,764
41,370
Doubtful
4,649,880
(1) Includes $2.0 million of loans acquired from WashingtonFirst and considered performing at the Acquisition Date.
(2) Includes $12.1 million of purchased credit impaired loans acquired from WashingtonFirst and $8.1 million of loans acquired from WashingtonFirst and considered performing at the Acquisition Date.
773,958
677,574
1,934,886
1,189,903
4,576,321
321
3,826
2,738
8,827
20,364
19,683
10,262
53,615
4,638,763
(1) Includes $4.2 million of loans acquired from WashingtonFirst and considered performing at the Acquisition Date.
(2) Includes $24.3 million of purchased credit impaired loans acquired from WashingtonFirst and $7.2 million of loans acquired from WashingtonFirst and considered performing at the Acquisition Date.
Homogeneous loan pools do not have individual loans subjected to internal risk ratings therefore, the credit indicator applied to these pools is based on their delinquency status. The following tables provide information by credit risk rating indicators for those remaining segments of the loan portfolio at the dates indicated:
21
Performing
484,737
1,229,362
1,885,205
Non-performing:
90 days past due
Non-accruing (1)
15,064
1,901,363
(1) Includes $1.2 million of consumer loans acquired from WashingtonFirst and considered performing at the Acquisition Date.
513,513
1,217,248
186,626
1,917,387
440
1,932,871
(1) Includes $1.3 million of consumer loans acquired from WashingtonFirst and considered performing at the Acquisition Date.
During the six months ended June 30, 2019, the Company restructured $1.8 million in loans that were designated as troubled debt restructurings. No modifications resulted in the reduction of the principal in the associated loan balances. Restructured loans are subject to periodic credit reviews to determine the necessity and adequacy of a specific loan loss allowance based on the collectability of the recorded investment in the restructured loan. Loans restructured during the six months ended June 30, 2019 had specific reserves of $0.4 million. For the year ended December 31, 2018, the Company restructured $1.6 million in loans. Modifications consisted principally of interest rate concessions and no modifications resulted in the reduction of the recorded investment in the associated loan balances. Loans restructured during 2018 had specific reserves of $0.6 million at December 31, 2018. The commitments to lend additional funds on loans that have been restructured at June 30, 2019 and December 31, 2018 were not significant.
The following table provides the amounts of the restructured loans at the date of restructuring for specific segments of the loan portfolio during the period indicated:
Troubled debt restructurings
254
1,036
1,557
1,811
Specific allowance
204
202
406
Restructured and subsequently defaulted
22
1,464
158
1,622
563
Other Real Estate OwnedOther real estate owned totaled $1.5 million and $1.6 million at June 30, 2019 and December 31, 2018, respectively. There were no consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process as of June 30, 2019.
Note 5 – Goodwill and Other Intangible Assets
The gross carrying amounts and accumulated amortization of intangible assets and goodwill are presented at the dates indicated in the following table:
Weighted
Net
Average
Carrying
Remaining
Amount
Amortization
Life
Amortizing intangible assets:
Core deposit intangibles
10,678
(2,815)
7,863
8.5
years
(1,941)
8,737
9.0
Other identifiable intangibles
1,478
(528)
10.2
(427)
1,051
10.6
Total amortizing intangible assets
12,156
(3,343)
(2,368)
The amount of goodwill by reportable segment is presented in the following table:
Community
Investment
Banking
Insurance
Management
Balance December 31, 2018
331,173
6,788
9,188
No Activity
Balance June 30, 2019
The following table presents the estimated future amortization expense for amortizing intangible assets within the years ending December 31:
969
2020
1,720
2021
1,507
2022
1,295
Thereafter
3,322
Note 6 – Deposits
The following table presents the composition of deposits at the dates indicated:
23
Interest-bearing deposits:
Demand
721,389
703,145
Money market savings
1,705,164
1,605,024
Regular savings
331,164
330,231
Time deposits of less than $100,000
456,520
427,421
Time deposits of $100,000 or more
1,151,898
1,098,740
Total interest-bearing deposits
Note 7 – SUBORDINATED DEBENTURES
In conjunction with the acquisition of WashingtonFirst, the Company assumed $25.0 million in non-callable subordinated debt and $10.3 million in callable junior subordinated debt securities. The associated purchase premiums at acquisition were $2.2 million and $0.1 million, respectively. The premiums are amortized over the contractual life of each obligation.
The subordinated debt has a maturity of ten years, is due in full on October 15, 2025, is non-callable and currently bears a fixed interest rate of 6.00% per annum, payable quarterly, subject to a reset after 5 years (on October 5, 2020) at 3 month LIBOR plus 467 basis points. The entire amount of subordinated debt is considered Tier 2 capital under current regulatory guidelines.
In 2003, Alliance Bankshares Corporation, which was acquired by WashingtonFirst in 2012, issued $10.3 million of junior subordinated debt securities to Alliance Virginia Capital Trust I, of which Alliance Bankshares Corporation owned all of the common securities. The trust used the proceeds from the issuance of its underlying common securities and preferred securities, which were sold to third parties, to purchase the debt securities. These debt securities are the trust’s only assets and the interest payments from the debentures finance the distributions paid on the preferred securities. The obligations under the debt securities were assumed by the Company at the date of acquisition of WashingtonFirst. The debt securities are due on June 30, 2033 and are callable at any time, without penalty. The interest rate associated with the debt securities is three month LIBOR plus 3.15% subject to quarterly interest rate adjustments. The interest rate as of June 30, 2019 was 5.47%. Under the indenture governing the debt securities, the Company has the right to defer payments of interest for up to twenty consecutive quarterly periods. During any such extension period, distributions on the trust’s preferred securities will also be deferred, and the Company’s ability to pay dividends on its common stock will be restricted. The trust’s preferred securities are mandatorily redeemable upon maturity of the debt securities, or upon earlier redemption as provided in the indenture. If the debt securities are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest. The Company unconditionally guarantees payment of accrued and unpaid distributions required to be paid on the trust securities subject to certain exceptions, the redemption price with respect to any trust securities called for redemption and amounts due if the trust is liquidated or terminated. As of June 30, 2019, the Company was current on all interest payments. Under current regulatory guidelines the trust preferred securities are considered to be Tier 1 capital.
The following table provides information on subordinated debentures as the date indicated:
25,000
Add: Purchase accounting premium
1,954
2,023
Trust preferred securities
10,310
89
92
Total subordinated debentures
Note 8 – Share Based Compensation
At June 30, 2019, the Company had two share based compensation plans in existence, the 2005 Omnibus Stock Plan (“Omnibus Stock Plan”) and the 2015 Omnibus Incentive Plan (“Omnibus Incentive Plan”). The Omnibus Stock Plan expired during the second quarter of 2015 but has outstanding options that may still be exercised. The Omnibus Incentive Plan is described in the following paragraph.
24
The Company’s Omnibus Incentive Plan was approved on May 6, 2015 and provides for the granting of incentive stock options, non-qualifying stock options, stock appreciation rights, restricted stock grants, restricted stock units and performance awards to selected directors and employees on a periodic basis at the discretion of the board. The Omnibus Incentive Plan authorizes the issuance of up to 1,500,000 shares of common stock, of which 1,153,936 are available for issuance at June 30, 2019, has a term of ten years, and is administered by a committee of at least three directors appointed by the board of directors. Options granted under the plan have an exercise price which may not be less than 100% of the fair market value of the common stock on the date of the grant and must be exercised within seven to ten years from the date of grant. The exercise price of stock options must be paid for in full in cash or shares of common stock, or a combination of both. The board committee has the discretion when making a grant of stock options to impose restrictions on the shares to be purchased upon the exercise of such options. The Company generally issues authorized but previously unissued shares to satisfy option exercises.
The fair values of all of the options granted for the periods indicated have been estimated using a binomial option-pricing moddel. The weighted-average assumptions for the periods shown are presented in the following table:
Dividend yield
%
2.64
Weighted average expected volatility
39.13
Weighted average risk-free interest rate
2.61
Weighted average expected lives (in years)
5.61
Weighted average grant-date fair value
$11.73
The dividend yield is based on estimated future dividend yields. The risk-free rate for periods within the contractual term of the share option is based on the U.S. Treasury yield curve in effect at the time of the grant. Expected volatilities are generally based on historical volatilities. The expected term of share options granted is generally derived from historical experience.
Compensation expense is recognized on a straight-line basis over the vesting period of the respective stock option or restricted stock grant. The Company recognized compensation expense of $0.7 million and $0.6 million for the three months ended June 30, 2019 and 2018, respectively, related to the awards of stock options and restricted stock grants. Compensation expense of $1.4 million and $1.1 million was recognized for the six months ended June 30, 2019 and 2018, respectively. The intrinsic value of stock options exercised in the six months ended June 30, 2019 and 2018 was $0.1 million and $0.3 million, respectively. The total of unrecognized compensation cost related to stock options was approximately $0.1 million as of June 30, 2019. That cost is expected to be recognized over a weighted average period of approximately 1.5years. The total of unrecognized compensation cost related to restricted stock was approximately $6.8 million as of June 30, 2019. That cost is expected to be recognized over a weighted average period of approximately 3.1years. The fair value of the options vested during the six months ended June 30, 2019 and 2018, was not significant.
The Company granted 96,191 shares of restricted stock in the first quarter of 2019, of which 21,390 shares are subject to a three year vesting schedule with one third of the shares vesting on April 1st of each year and 74,801 shares subject to a five year vesting schedule with one fifth of the shares vesting on April 1st of each year. The
Company did not grant any additional shares of restricted stock during the second quarter of 2019. The Company did not grant any stock options during 2019.
A summary of share option activity for the period indicated is reflected in the following table:
Aggregate
Contractual
Intrinsic
Exercise
Shares
Share Price
Life (Years)
(in thousands)
Balance at January 1, 2019
81,508
29.74
369
Granted
Exercised
(10,897)
20.56
Forfeited
(1,007)
37.11
Expired
(142)
42.48
Balance at June 30, 2019
69,462
31.05
3.6
403
Exercisable at June 30, 2019
55,362
28.94
3.1
Weighted average fair value of options
granted during the year
A summary of the activity for the Company’s restricted stock for the period indicated is presented in the following table:
Grant-Date
(In dollars, except share data):
Restricted stock at January 1, 2019
203,603
35.14
96,191
33.27
Vested
(69,842)
31.55
(6,673)
33.16
Restricted stock at June 30, 2019
223,279
35.52
Note 9 – Pension, Profit Sharing, and Other Employee Benefit Plans
Defined Benefit Pension Plan
The Company has a qualified, noncontributory, defined benefit pension plan (the “Plan”). Benefits after January 1, 2005, are based on the benefit earned as of December 31, 2004, plus benefits earned in future years of service based on the employee’s compensation during each such year. All benefit accruals for employees were frozen as of December 31, 2007 based on past service and thus salary increases and additional years of service after such date no longer affect the defined benefit provided by the Plan although additional vesting may continue to occur.
The Company's funding policy is to contribute amounts to the Plan sufficient to meet the minimum funding requirements of the Employee Retirement Income Security Act of 1974 (“ERISA”), as amended. In addition, the Company contributes additional amounts as it deems appropriate based on benefits attributed to service prior to the date of the Plan freeze. The Plan invests primarily in a diversified portfolio of managed fixed income and equity funds.
The components of net periodic benefit cost for the periods indicated are presented in the following table:
Interest cost on projected benefit obligation
402
804
Expected return on plan assets
(412)
(465)
(824)
(930)
Recognized net actuarial loss
Net periodic benefit cost
255
170
510
340
Contributions
The decision as to whether or not to make a plan contribution and the amount of any such contribution is dependent on a number of factors. Such factors include the investment performance of the plan assets in the current economy and, since the Plan is currently frozen, the remaining investment horizon of the Plan. After consideration of these factors, the Company made a contribution of $0.2 million in 2019. Management continues to monitor the funding level of the Plan and may make additional contributions as necessary during 2019.
Note 10 – Net Income per Common Share
The calculation of net income per common share for the periods indicated is presented in the following table:
(Dollars and amounts in thousands, except per share data)
Basic:
Basic weighted average EPS shares
35,862
35,721
35,816
35,686
Diluted:
Dilutive common stock equivalents
50
Dilutive EPS shares
35,890
35,744
35,866
35,710
Anti-dilutive shares
NOTE 11 – ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
Comprehensive income is defined as net income plus transactions and other occurrences that are the result of non-owner changes in equity. For condensed financial statements presented for the Company, non-owner changes in equity are comprised of unrealized gains or losses on available-for-sale debt securities and any minimum pension liability adjustments. The following table presents the activity in net accumulated other comprehensive income (loss) and the components of the activity for the periods indicated:
Unrealized Gains
(Losses) on
Investments
Defined Benefit
Available-for-Sale
Pension Plan
(6,630)
(9,124)
Other comprehensive income before reclassification, net of tax
11,802
Reclassifications from accumulated other comprehensive income, net of tax
(4)
387
Current period change in other comprehensive income, net of tax
5,168
(8,733)
687
(7,544)
(12,491)
(47)
269
Reclassification of tax effects from accumulated other comprehensive income
148
(1,625)
Balance at June 30, 2018
(11,703)
(8,853)
27
The following table provides the information on the reclassification adjustments out of accumulated other comprehensive income for the periods indicated:
Unrealized gains on investments available-for-sale
Affected line item in the Statements of Income:
Income before taxes
Tax expense
(1)
(16)
47
Amortization of defined benefit pension plan items
Recognized actuarial loss(1)
(530)
(500)
Tax benefit
139
184
Net loss
(391)
(316)
(1) This amount is included in the computation of net periodic benefit cost, see Note 9.
In the first quarter of 2018, the Company elected to make a one-time reclassification from accumulated other comprehensive income to retained earnings for the effects of re-measuring the deferred tax assets and liabilities originally recorded in other comprehensive income as a result of the change in the federal tax rate by the Tax Cuts and Jobs Act.
NOTE 12 – LEASES
The Company leases real estate properties for its network of bank branches, financial centers and corporate offices. All of the Company’s leases are currently classified as operating. Most lease agreements include one or more options to renew, with renewal terms that can extend the original lease term from one to twenty years or more. The Company does not sublease any of its leased real estate properties.
As June 30, 2019, ROU assets and lease liabilities totaled $73.1 million and $80.6 million, respectively. For the three and six months ended June 30, 2019, the Company recognized total operating lease expense in the amount of $2.8 million and $5.7 million, respectively. Cash paid for amounts included in the measurement of lease liabilities for the three and six months ended June 30, 2019 was $2.2 million and $4.3 million, respectively and is included in Net cash provided by operating activities in our Condensed Consolidated Statements of Cash Flows. There were no new ROU assets obtained in exchange for lease obligations during the six months ended June 30, 2019.
As of June 30, 2019, the maturities of the Company’s operating lease liabilities were as follows:
Maturity:
One year
11,023
Two years
10,563
Three years
10,002
Four years
10,090
Five years
9,494
46,671
Total undiscounted lease payments
97,843
Less: Present value discount
(17,228)
Lease Liability
80,615
As of June 30, 2019, the weighted average remaining lease term was 10.7 years and the weighted average operating discount rate to determine the operating lease liability was 3.31%.
The Company had one operating lease for a branch location that had not commenced at June 30, 2019. The Company does not have any lease arrangements with any of its related parties as of June 30, 2019.
Note 13 – Financial Instruments with Off-balance Sheet Risk and Derivatives
The Company has entered into interest rate swaps (“swaps”) to facilitate customer transactions and meet their financing needs. These swaps qualify as derivatives, but are not designated as hedging instruments. Interest rate swap contracts involve the risk of dealing with counterparties and their ability to meet contractual terms. When the fair value of a derivative instrument contract is positive, this generally indicates that the counterparty or customer owes the Company, and results in credit risk to the Company. When the fair value of a derivative instrument contract is negative, the Company owes the customer or counterparty and therefore, has no credit risk. The notional value of commercial loan swaps outstanding was $106.7 million with a fair value of $1.4 million as of June 30, 2019 compared to $16.6 million with a fair value of $0.4 million as of December 31, 2018. The swap positions are offset to minimize the potential impact on the Company’s financial statements. Fair values of the swaps are carried as both gross assets and gross liabilities in the Condensed Consolidated Statements of Condition. The associated net gains and losses on the swaps are recorded in other non-interest income.
Note 14 – Litigation
The Company and its subsidiaries are subject in the ordinary course of business to various pending or threatened legal proceedings in which claims for monetary damages are asserted. After consultation with legal counsel, management does not anticipate that the ultimate liability, if any, arising out of these legal matters will have a material adverse effect on the Company's financial condition, operating results or liquidity.
Note 15 – Fair Value
Generally accepted accounting principles provide entities the option to measure eligible financial assets, financial liabilities and commitments at fair value (i.e. the fair value option), on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other accounting standards. The election to use the fair value option is available when an entity first recognizes a financial asset or financial liability or upon entering into a commitment. Subsequent changes in fair value must be recorded in earnings. The Company applies the fair value option on residential mortgage loans held for sale. The fair value option on residential mortgage loans held for sale allows the recognition of gains on sale of mortgage loans to more accurately reflect the timing and economics of the transaction.
The standard for fair value measurement establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below.
Basis of Fair Value Measurement:
Level 1- Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2- Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability;
Level 3- Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity).
A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
Changes to interest rates may result in changes in the cash flows due to prepayments or extinguishments. Accordingly, this could result in higher or lower measurements of the fair values.
Assets and Liabilities
Mortgage loans held for sale
Mortgage loans held for sale are valued based on quotations from the secondary market for similar instruments and are classified as Level 2 of the fair value hierarchy.
U.S. government agencies, mortgage-backed, and asset-backed securities
Valuations are based on active market data and use of evaluated broker pricing models that vary based by asset class and includes available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, descriptive terms and conditions databases coupled with extensive quality control programs. Multiple quality control evaluation processes review available market, credit and deal level information to support the evaluation of the security. If there is a lack of objectively verifiable information available to support the valuation, the evaluation of the security is discontinued. Additionally, proprietary models and pricing systems, mathematical tools, actual transacted prices, integration of market developments and experienced evaluators are used to determine the value of a security based on a hierarchy of market information regarding a security or securities with similar characteristics. The Company does not adjust the quoted price for such securities. Such instruments are generally classified within Level 2 of the fair value hierarchy.
State and municipal securities
Proprietary valuation matrices are used for valuing all tax-exempt municipals that can incorporate changes in the municipal market as they occur. Market evaluation models include the ability to value bank qualified municipals and general market municipals that can be broken down further according to insurer, credit support, state of issuance and rating to incorporate additional spreads and municipal curves. Taxable municipals are valued using a third party model that incorporates a methodology that captures the trading nuances associated with these bonds. Such instruments are generally classified within Level 2 of the fair value hierarchy.
Interest rate swap agreements
Interest rate swap agreements are measured by alternative pricing sources with reasonable levels of price transparency in markets that are not active. Based on the complex nature of interest rate swap agreements, the markets these instruments trade in are not as efficient and are less liquid than that of the more mature Level 1 markets. These markets do however have comparable, observable inputs in which an alternative pricing source values these assets in order to arrive at a fair market value. These characteristics classify interest rate swap agreements as Level 2.
Assets Measured at Fair Value on a Recurring Basis
The following tables set forth the Company’s financial assets and liabilities at the dates indicated that were accounted for or disclosed at fair value. Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement:
Quoted Prices in
Significant
Active Markets for
Significant Other
Unobservable
Identical Assets
Observable Inputs
Inputs
(Level 1)
(Level 2)
(Level 3)
Residential mortgage loans held for sale
U.S. government agencies
1,358
(1,358)
446
(446)
The following table provides unrealized losses included in assets measured in the Condensed Consolidated Statements of Condition at fair value on a recurring basis for the period indicated:
9,550
Additions of Level 3 assets
Sales of Level 3 assets
Total unrealized gain included in other comprehensive income
9,766
Assets Measured at Fair Value on a Nonrecurring Basis
The following table sets forth the Company’s financial assets subject to fair value adjustments (impairment) on a nonrecurring basis at the date indicated that are valued at the lower of cost or market. Assets are classified in their entirety based on the lowest level of input that is significant to the fair value measurement:
Active Markets
for Identical
Observable
Assets (Level 1)
Inputs (Level 2)
Inputs (Level 3)
Total Losses
Impaired loans
6,653
(6,561)
(277)
8,139
(6,838)
6,780
(10,932)
(262)
8,364
(11,194)
31
At June 30, 2019, impaired loans totaling $21.7 million were written down to fair value of $16.9 million as a result of specific loan loss allowances of $4.8 million associated with the impaired loans which was included in the allowance for loan losses. Impaired loans totaling $22.2 million were written down to fair value of $17.3 million at December 31, 2018 as a result of specific loan loss allowances of $4.9 million associated with the impaired loans.
Loan impairment is measured using the present value of expected cash flows, the loan’s observable market price or the fair value of the collateral (less selling costs) if the loans are collateral dependent. Collateral may be real estate and/or business assets including equipment, inventory and/or accounts receivable. The value of business equipment, inventory and accounts receivable collateral is based on net book value on the business’ financial statements and, if necessary, discounted based on management’s review and analysis. Appraised and reported values may be discounted based on management’s historical experience, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the factors identified above. Valuation techniques are consistent with those techniques applied in prior periods.
Other real estate owned (“OREO”) is adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair value. The estimated fair value for other real estate owned included in Level 3 is determined by independent market based appraisals and other available market information, less cost to sell, that may be reduced further based on market expectations or an executed sales agreement. If the fair value of the collateral deteriorates subsequent to initial recognition, the Company records the OREO as a non-recurring Level 3 adjustment. Valuation techniques are consistent with those techniques applied in prior periods.
Fair Value of Financial Instruments
The Company discloses fair value information of financial instruments that are not measured at fair value in the financial statements based on the exit price notion. Fair value is the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced sale or liquidation, and is best evidenced by a quoted market price, if one exists.
Quoted market prices, where available, are shown as estimates of fair market values. Because no quoted market prices are available for a significant portion of the Company's financial instruments, the fair value of such instruments has been derived based on the amount and timing of future cash flows and estimated discount rates based on observable inputs (“Level 2”) or unobservable inputs (“Level 3”).
Present value techniques used in estimating the fair value of many of the Company's financial instruments are significantly affected by the assumptions used. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate cash settlement of the instrument. Additionally, the accompanying estimates of fair values are only representative of the fair values of the individual financial assets and liabilities, and should not be considered an indication of the fair value of the Company. Management utilizes internal models used in asset liability management to determine the fair values disclosed below.
The carrying amounts and fair values of the Company’s financial instruments at the dates indicated are presented in the following table:
32
Fair Value Measurements
Unobservable Inputs
Financial Assets
Loans, net of allowance
6,383,069
Other assets (1)
111,850
Financial Liabilities
Time deposits
1,608,418
1,615,849
Securities sold under retail repurchase agreements and
federal funds purchased
590,246
35,435
(1) Includes bank owned life insurance products.
6,376,307
110,823
1,526,161
1,536,238
850,186
33,588
Note 16 - Segment Reporting
Currently, the Company conducts business in three operating segments—Community Banking, Insurance and Investment Management. Each of the operating segments is a strategic business unit that offers different products and services. The Insurance and Investment Management segments were businesses that were acquired in separate transactions where management of the acquired business was retained. The accounting policies of the segments are the same as those of the Company. However, the segment data reflect inter-segment transactions and balances.
The Community Banking segment is conducted through Sandy Spring Bank and involves delivering a broad range of financial products and services, including various loan and deposit products to both individuals and businesses. Parent company income is included in the Community Banking segment, as the majority of effort of these functions is related to this segment. Major revenue sources include net interest income, gains on sales of mortgage loans, trust income fees and service charges on deposit accounts. Expenses include personnel, occupancy, marketing, equipment and other expenses. Non-cash charges associated with amortization of intangibles were $0.4 million and $0.5 million for the three months ended June 30, 2019 and 2018, respectively. These charges totaled $0.9 million and $1.0 million for the six months ended June 30, 2019 and 2018, respectively.
The Insurance segment is conducted through Sandy Spring Insurance Corporation, a subsidiary of the Bank, and offers annuities as an alternative to traditional deposit accounts. Sandy Spring Insurance Corporation operates Sandy Spring Insurance, a general insurance agency located in Annapolis, Maryland, and Neff and Associates, located in Ocean City, Maryland. Major sources of revenue are insurance commissions from commercial lines, personal lines, and medical liability lines. Expenses include personnel and support charges. Non-cash charges associated with amortization of intangibles were not significant for the three and six months ended June 30, 2019 and 2018, respectively.
The Investment Management segment is conducted through West Financial Services, Inc., a subsidiary of the Bank. This asset management and financial planning firm, located in McLean, Virginia, provides comprehensive investment management and financial planning to individuals, families, small businesses and associations including cash flow analysis, investment review, tax planning, retirement planning, insurance analysis and estate planning. West Financial currently has approximately $1.7 billion in assets under management. Major revenue sources include non-interest income earned on the above services. Expenses include personnel and support charges. Non-cash charges associated with amortization of intangibles were not significant for the three and six months ended June 30, 2019 and 2018, respectively.
Information for the operating segments and reconciliation of the information to the condensed consolidated financial statements for the periods indicated is presented in the following tables:
Three Months Ended June 30, 2019
Inter-Segment
Mgmt.
Elimination
Interest income
Interest expense
21,033
Provision (credit) for loan losses
Noninterest income
12,856
1,269
2,597
(166)
Noninterest expense
40,859
1,304
1,890
36,545
(34)
710
8,769
(8)
27,776
(26)
526
8,398,263
11,552
20,253
(31,549)
Three Months Ended June 30, 2018
78,596
(2)
14,781
Non-interest income
11,252
1,179
2,590
(153)
Non-interest expense
42,302
1,302
1,631
31,032
(122)
961
7,249
(32)
23,783
(90)
706
8,154,957
9,041
15,407
(26,805)
8,152,600
Six Months Ended June 30, 2019
(7)
42,469
25,563
3,173
5,122
(333)
82,070
2,724
3,618
74,916
451
1,509
17,762
394
57,154
1,115
Six Months Ended June 30, 2018
154,100
(3)
27,395
24,423
4,869
(307)
89,333
2,681
3,016
58,065
1,856
485
44,463
1,371
35
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The Company
Sandy Spring Bancorp, Inc. (the “Company") is the bank holding company for Sandy Spring Bank (the "Bank"). The Company is an $8.4 billion community banking organization that focuses its lending and other services on businesses and consumers in the local market area. The Company, which began operating in 1988, is registered as a bank holding company pursuant to the Bank Holding Company Act of 1956, as amended. As such, the Company is subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve").
The Bank traces its origin to 1868, making it among the oldest institutions in the region. Independent and community-oriented, Sandy Spring Bank offers a broad range of commercial banking, retail banking, mortgage and trust services throughout central Maryland, Northern Virginia, and the greater Washington, D.C. market. Through its subsidiaries, Sandy Spring Insurance Corporation and West Financial Services, Inc., Sandy Spring Bank also offers a variety of comprehensive insurance and wealth management services. The Bank is a state chartered bank subject to supervision and regulation by the Federal Reserve and the State of Maryland. The Bank's deposit accounts are insured by the Deposit Insurance Fund administered by the Federal Deposit Insurance Corporation (the "FDIC") to the maximum permitted by law. The Bank is a member of the Federal Reserve System and is an Equal Housing Lender. The Company, the Bank, and its other subsidiaries are Affirmative Action/Equal Opportunity Employers.
The Bank’s subsidiaries, Sandy Spring Insurance Corporation and West Financial Services, Inc., offer a variety of comprehensive insurance and investment management services. During 2018, the Company completed the acquisition of WashingtonFirst Bankshares, Inc., the parent company for WashingtonFirst Bank (collectively referred to as “WashingtonFirst”). At the date of acquisition, WashingtonFirst had 19 community banking offices and more than $2.1 billion in assets. The all-stock transaction resulted in the issuance of 11.4 million common shares and was valued at approximately $447 million.
Overview
Net income for the Company for the second quarter of 2019 totaled $28.3 million ($0.79 per diluted share) as compared to net income of $24.4 million ($0.68 per diluted share) for the second quarter of 2018 and net income of $30.3 million ($0.85 per diluted share) for the first quarter of 2019. The prior year’s earnings for the second quarter contained $2.2 million in merger expenses, while the prior quarter contained a $1.8 million interest recovery from acquired impaired loans, a credit versus a provision for loan losses and $0.6 million in life insurance mortality proceeds. There were no similar items in the current quarter’s earnings.
These results reflect the following events:
Total loans increased 5% compared to the second quarter of 2018. Loans outstanding remained stable compared to the prior quarter, as overall loan production and commitment origination in previously unfunded construction lending was offset by portfolio run-off which was impacted by changes in the interest rate environment and competitive forces in the marketplace. The Bank also successfully executed on a strategy to sell the majority of its mortgage loan production for gains versus retaining them in the loan portfolio.
Total deposits grew 9% from the second quarter of 2018 and 8% from the end of 2018. This deposit growth has reduced the loan to deposit ratio from 111% at year-end 2018 to 103% at the end of the current quarter. The year-to-date deposit growth included a 16% increase in noninterest-bearing deposits and a 20% reduction in wholesale deposits.
Current quarter has a $1.6 million charge for the provision for loan losses compared to the prior quarter’s $0.1 million credit to the provision.
The net interest margin was 3.54% for the second quarter of 2019 compared to 3.56% for the second quarter of 2018 and 3.52% for the first quarter of 2019, after adjusting for recovered interest income of $1.8 million on acquired credit impaired loans. The current quarter’s margin benefited from an increase in average noninterest-bearing deposits from the first quarter of 2019 and the current quareter’s shifting of short-term FHLB borrowings into medium-term lower rate borrowings.
Second quarter results reflected an annualized return on average assets of 1.37% and annualized return on average equity of 10.32% as compared to 1.23% and 9.66% respectively for the second quarter of 2018. Exclusive of merger costs on an after-tax basis, the return on average assets and return on average equity for the second quarter of 2018 would have been 1.32% and 10.32%, respectively.
Non-interest income increased 11% from the prior year quarter driven by income from mortgage banking activities that grew 58% during the same period. Growth was experienced in almost every other major category of non-interest income.
The non-GAAP efficiency ratio was 51.71% for the current quarter as compared to 52.98% for the second quarter of 2018 and 51.44% for the first quarter of 2019. The stability of the current quarter’s non-GAAP ratio, as compared to the previous quarter’s, reflects the slight decline in non-interest expense during the second quarter of 2019 compared to the first quarter of the current year.
Dividends paid increased by 7% or $0.02 per share during the current quarter to $0.30 per share. Additionally, as a result of net earnings during the past twelve months, tangible book value per share and tangible common equity have grown 11% from the second quarter of 2018.
The local economy continues to experience low unemployment rate, wage growth and increased housing starts; however, these trends have been tempered by other concerns of deficit growth, domestic political turmoil and geo-political uncertainty. These factors, in concert, impact the pace of economic expansion and create volatility in global economic markets. Additionally, the recent trends in interest rates have caused a degree of concern among individual consumers and small and mid-sized businesses. Management remains confident that the Company remains well positioned for continued growth opportunities as they present themselves, despite the current mixed economic environment.
Total assets at June 30, 2019 increased 3% compared to June 30, 2018. This growth has been driven by organic loan growth as loan balances at June 30, 2019 have increased 5% compared to June 30, 2018. Deposits increased 9% compared to balances at June 30, 2018. The Company’s liquidity position remains strong as a result of its operational cash flows in addition to the available borrowing lines with the Federal Home Loan Bank of Atlanta, the Federal Reserve and other sources, and the size and composition of the available-for-sale investment portfolio. Stockholders’ equity has grown $93.1 million compared to June 30, 2018 due to the retention of earnings from the past twelve months.
Non-performing loans (which excludes purchased credit impaired loans) represented 0.58% of total loans at June 30, 2019 compared to 0.46% at June 30, 2018. The Company’s non-performing loans were $37.7 million at June 30, 2019 compared to $28.8 million at June 30, 2018. The ratio of annualized net charge-offs to average loans for the current quarter was 0.04% compared to 0.01% for the prior year quarter.
Net interest income for the second quarter of 2019 increased 4% compared to the second quarter of 2018. As a result of the Company’s organic loan growth during the period interest income increased by $8.6 million, which more than offset the $6.3 million growth in interest expense which was driven by the increased rates paid on deposits. The net interest margin was 3.54% for the second quarter of 2019 compared to 3.56% for the second quarter of 2018. The provision for loan losses was $1.6 million for the second quarter of 2019 compared to $1.7 million for the second quarter of 2018. Non-interest income increased 11% for the second quarter of 2019 as compared to the second quarter of 2018. This increase in non-interest income was driven by the impact of increased mortgage banking income and, to a lesser extent, income from other major categories of non-interest income. Non-interest expenses decreased 3% to $43.9 million for the second quarter of 2019 compared to $45.1 million in the second quarter of 2018, which included $2.2 million in merger expenses. Excluding these expenses, non-interest expenses increased 2% compared to the second quarter of 2018 due to increased compensation and benefit costs driven by a combination of increases in compensation levels resulting from annual merit increases and an increase in the Company’s contribution to the employee retirement savings plans. The non-GAAP efficiency ratio was 51.71% for the second quarter of 2019, compared to 52.98% for the second quarter of 2018. The decrease in the current quarter compared to the prior period was the result of the growth in the net revenue streams.
37
Results of Operations
For the Six Months Ended June 30, 2019 Compared to the Six Months Ended June 30, 2018
Net income for the Company for the first six months of 2019 totaled $58.6 million ($1.63 per diluted share) compared to net income of $46.1 million ($1.29 per diluted share) for the first six months of 2018.
Net Interest Income
Net interest income for the first six months of 2019 was $132.9 million compared to $126.7 million for the first six months of 2018. On a tax-equivalent basis, net interest income for the first six months of 2019 was $135.4 million compared to $129.0 million for the first six months of 2018, a 5% increase. Net interest income increased as a result of the Company’s organic loan growth during the previous twelve months which more than offset the impact of deposit growth and the corresponding interest expense, as average interest rates rose during that period.
The following tables provide an analysis of net interest income performance that reflects a net interest margin that has increased to 3.58% for the first six months of 2019 compared to 3.57% for the first six months of 2018. Net interest income for the first six months of 2019 included $1.8 million of recovered interest income from previously acquired credit impaired loans. Excluding these recoveries, the net interest margin would have been 3.53%. In addition, after excluding the impact of amortization of the fair value adjustments to both interest-earning assets and interest-bearing liabilities directly attributable to the acquisition, the net interest margin for the first six months of 2019 would have been 3.47%, compared to 3.45% for the first six months of 2018.
The impact of the amortization of the fair value adjustments on net interest income for the first six months of 2019 is presented in the following table:
Net Interest Income Excluding Purchase Accounting Adjustments:
Accretion of fair value adjustment on pools of homogeneous loans
(567)
Accretion of loan fair value adjustment on purchased credit impaired loans
Settlements of purchased credit impaired loans
(1,799)
Accretion of fair value adjustment on certificates of deposits
(311)
Accretion of fair value adjustment on subordinated debentures
(72)
Net Interest Income Excluding Purchase Accounting Adjustments
129,522
CONSOLIDATED AVERAGE BALANCES, YIELDS AND RATES
Annualized
(Dollars in thousands and tax-equivalent)
Balances
Interest
Yield/Rate
Residential mortgage loans
1,237,241
23,759
3.84
1,075,540
19,795
3.68
Residential construction loans
181,864
3,836
4.25
208,332
4,043
3.91
Total mortgage loans
1,419,105
27,595
3.89
1,283,872
23,838
3.72
Commercial AD&C loans
681,271
20,148
5.96
579,458
16,407
5.71
Commercial investor real estate loans
1,962,799
50,086
5.15
1,956,374
46,089
4.75
Commercial owner occupied real estate loans
1,211,737
29,226
4.86
1,062,912
24,567
4.66
Commercial business loans
768,390
21,129
5.55
661,851
16,856
5.14
Total commercial loans
4,624,197
120,589
5.26
4,260,595
103,919
4.92
Consumer loans
510,411
12,665
5.00
535,064
11,299
4.32
Total loans (2)
6,553,713
160,849
4.94
6,079,531
139,056
4.61
Loans held for sale
27,537
4.17
30,557
4.24
Taxable securities
756,613
11,665
3.09
747,862
10,549
2.82
Tax-exempt securities (3)
231,161
4,132
3.57
297,359
5,220
3.51
Total investment securities (4)
987,774
15,797
3.20
1,045,221
15,769
3.02
53,543
2.34
104,115
1.69
624
1.97
2,925
1.36
Total interest-earning assets
7,623,191
177,847
4.70
7,262,349
156,363
4.33
(53,081)
(46,689)
64,264
71,664
61,294
61,027
580,933
535,844
8,276,601
7,884,195
Liabilities and Stockholders' Equity
Interest-bearing demand deposits
725,816
760
0.21
744,048
426
0.12
Regular savings deposits
332,138
211
0.13
412,053
395
0.19
Money market savings deposits
1,674,608
12,896
1.55
1,467,823
7,698
1.06
1,625,469
16,759
2.08
1,225,755
7,291
1.20
4,358,031
1.42
3,849,679
0.83
Other borrowings
164,043
0.85
144,100
773,856
2.65
1,055,982
1.99
37,394
5.25
37,536
5.07
Total interest-bearing liabilities
5,333,324
1.61
5,087,297
1.09
Noninterest-bearing demand deposits
1,740,076
1,724,353
Other liabilities
116,945
60,943
Stockholders' equity
1,086,256
1,011,602
Net interest income and spread
135,385
128,971
3.24
Less: tax-equivalent adjustment
2,450
2,262
Interest income/earning assets
Interest expense/earning assets
1.12
0.76
Net interest margin
3.58
(1) Tax-equivalent income has been adjusted using the combined marginal federal and state rate of 26.13% for both 2019 and 2018. The annualized
taxable-equivalent adjustments utilized in the above table to compute yields aggregated to $2.5 million and $2.3 million in 2019 and 2018, respectively.
(2) Non-accrual loans are included in the average balances.
(3) Includes only investments that are exempt from federal taxes.
(4) Investments available-for-sale are presented at amortized cost.
Effect of Volume and Rate Changes on Net Interest Income
The following table analyzes the reasons for the changes from year-to-year in the principal elements that comprise net interest income:
2019 vs. 2018
2018 vs. 2017
Increase
Or
Due to Change In Average:*
(Dollars in thousands and tax equivalent)
(Decrease)
Volume
Rate
Interest income from earning assets:
3,964
3,075
889
4,916
4,024
892
(207)
(540)
333
1,028
875
3,741
2,995
8,986
7,545
1,441
3,997
150
3,847
24,390
22,952
1,438
4,659
3,566
1,093
5,558
6,688
(1,130)
4,273
1,416
6,787
4,985
1,802
(536)
1,902
3,198
1,760
(74)
493
494
1,116
(66)
1,182
3,136
3,026
Tax exempt securities
(1,088)
(1,131)
(1,060)
(1,082)
(249)
(514)
690
449
241
(14)
(20)
21,484
9,771
11,713
58,132
52,501
5,631
Interest expense on funding of earning assets:
334
(10)
344
189
(114)
42
247
5,198
1,214
3,984
5,844
1,252
4,592
9,468
2,915
6,553
3,977
3,575
472
439
61
(3,195)
2,946
4,139
3,462
677
938
922
15,070
883
14,187
15,437
9,328
6,109
6,414
8,888
(2,474)
42,695
43,173
(478)
* Variances that are the combined effect of volume and rate, but cannot be separately identified, are allocated to the volume and rate variances based on their respective relative amounts.
40
Interest Income
The Company's total tax-equivalent interest income increased 14% for the first six months of 2019 compared to the prior year period. During this period, the yield on interest-earning assets increased 37 basis points to 4.70%. The previous tables reflect that the increase in interest income has been driven predominantly by the 5% growth in interest-earning assets as well as the rise in the associated interest rates during the past twelve months.
The average balance of the loan portfolio increased 8% for the first six months of 2019 compared to the first six months of 2018. This growth occurred in the majority of segments of the loan portfolio with the most significant growth in the commercial real estate portfolios. The yield on average loans increased 33 basis points compared to the prior year period. Excluding the previously mentioned interest recoveries of $1.8 million, the yield on average loans increased 28 basis points. The average yield on total investment securities increased 18 basis points as the average balance of the portfolio decreased 5% for the first six months of 2019 compared to the first six months of 2018. Composition of the average investment portfolio shifted to a higher percentage of taxable securities (77%) in the current period as compared to 72% for the prior year period. During the same period, the average yield for taxable securities rose 27 basis points versus the average yield on tax-exempt securities, which rose 6 basis points.
Interest Expense
Interest expense increased 55% in the first six months of 2019 compared to the first six months of 2018. The majority of the increase from period to period was due to increased rates on the majority of deposit categories to provide funding for loan growth. The cost of interest-bearing deposits increased due predominantly to the 14% growth in money market and 33% growth in time deposit average balances coupled with a 49 basis point increase in money market deposit rates and an 88 basis point increase in time deposit rates. Additionally, while the amount of average borrowings decreased 21% from period to period, the average rate paid increased 66 basis points. This resulted in the associated interest expense remaining stable. The overall impact to the total rate paid on interest-bearing liabilities was an increase of 52 basis points in the first six months of 2019 compared to the first six months of 2018.
Non-interest Income
Non-interest income amounts and trends are presented in the following table for the periods indicated:
2019/2018
$ Change
% Change
Securities gains
(58)
(92.1)
4.4
1,862
43.6
327
161
5.4
(1,158)
(38.6)
(1.6)
249
6.4
4.8
41
Total non-interest income was $33.5 million for the first six months of 2019 compared to $32.0 million for the first six months of 2018. Excluding life insurance mortality proceeds of $0.6 million and $1.6 million from the first six months of each year, non-interest income increased 8%. The increase was driven primarily by income from mortgage banking activities, and to a lesser degree, wealth management income, insurance agency commissions and service charges. Further detail by type of non-interest income follows:
Service charges on deposit accounts increased 4% in the first six months of 2019, compared to the first six months of 2018.
Income from mortgage banking activities increased 44% in the first six months of 2019, compared to the first six months of 2018. Origination volume associated with the mortgage lending operations contributed to the significant growth in mortgage banking income for the first six months of 2019. Sales of originated mortgage loans rose 27% during the current period compared to the same period for 2018.
Wealth management income (which is comprised of income from trust and estate services and investment management fees earned by the Company’s investment management subsidiary) increased 3% for the first six months of 2019 compared to the same period of the prior year. Trust services fees increased 5% for the first six months of 2019 compared to the prior year period due to an increase in personal trust services. Investment management fees increased 2% for the first six months of 2019 compared to the same period of 2018, due to an increase in assets under management. Overall total assets under management increased to $3.2 billion at June 30, 2019 compared to $2.9 billion at June 30, 2018 primarily as a result of positive trends occurring in the financial markets and an increase in sales efforts.
Insurance agency commissions increased 5% for the first six months of 2019 as compared to the first six months of 2018 driven by an increase in commissions on physician’s liability policies.
Bank-owned life insurance income decreased for the first six months of 2019 as compared to the first six months of 2018 due to the decline in insurance mortality proceeds from year-to-year of $0.6 million and $1.6 million, respectively.
Bank card fee income remained level during the first six months of 2019, compared to the first six months of 2018.
Non-interest Expense
Non-interest expense amounts and trends are presented in the following table for the periods indicated:
2,889
5.9
4.2
Equipment expenses
820
18.4
(263)
(12.6)
636
20.5
(363)
(14.1)
(108)
(10.0)
(11,186)
N/M
5.1
384
4.1
(6,644)
(7.0)
Non-interest expenses decreased 7% to $88.1 million in the first six months of 2019 compared to $94.7 million in the first six months of 2018. The first six months of 2018 included $11.2 million in merger expenses. Excluding merger expenses, non-interest expenses increased 5% over the prior year period. The majority of the increase was in compensation, software costs and other expenses from outside data services. Further detail by category of non-interest expense follows:
Salaries and employee benefits, the largest component of non-interest expenses, increased 6% in the first six months of 2019 as a result of a combination of higher compensation expense from annual merit increases over the preceding twelve months and management’s decision, beginning in the current year, to increase the Company’s contribution to the employee retirement savings plan as a result of the reduction of the corporate tax rate that occurred at the end of 2017. The average number of full-time equivalent employees declined to 911 in the first six months of 2019 compared to 922 in the first six months of 2018.
Combined occupancy and equipment expenses increased 9% compared to the prior year as a result of increases to software cost and, to a lesser extent, increases in rental expense and equipment depreciation.
Marketing expense decreased 13% as a result of decreased advertising campaigns associated with the prior year’s WashingtonFirst acquisition.
FDIC insurance experienced a 14% decrease due to an improved assessment-based institutional rating.
Outside data services grew by $0.6 million or 20% primarily due to increased transaction volume.
Professional fees and services grew 5% from the prior year due to increased costs associated with consulting services.
Operating Expense Performance
Management views the GAAP efficiency ratio as an important financial measure of expense performance and cost management. The ratio expresses the level of non-interest expenses as a percentage of total revenue (net interest income plus total non-interest income). Lower ratios indicate improved productivity.
Non-GAAP Financial Measures
The Company also uses a traditional efficiency ratio that is a non-GAAP financial measure of operating expense control and efficiency of operations. Management believes that its traditional efficiency ratio better focuses attention on the operating performance of the Company over time than does a GAAP efficiency ratio, and is highly useful in comparing period-to-period operating performance of the Company’s core business operations. It is used by management as part of its assessment of its performance in managing non-interest expenses. However, this measure is supplemental, and is not a substitute for an analysis of performance based on GAAP measures. The reader is cautioned that the non-GAAP efficiency ratio used by the Company may not be comparable to GAAP or non-GAAP efficiency ratios reported by other financial institutions.
In general, the efficiency ratio is non-interest expenses as a percentage of net interest income plus non-interest income. Non-interest expenses used in the calculation of the non-GAAP efficiency ratio exclude merger expenses, the amortization of intangibles, and other non-recurring expenses. Income for the non-GAAP efficiency ratio includes the favorable effect of tax-exempt income, and excludes securities gains and losses, which vary widely from period to period without appreciably affecting operating expenses, and other non-recurring gains. The measure is different from the GAAP efficiency ratio, which also is presented in this report. The GAAP measure is calculated using non-interest expense and income amounts as shown on the face of the Condensed Consolidated Statements of Income. The GAAP and non-GAAP efficiency ratios are reconciled and provided in the following table. The non-GAAP efficiency ratio remained relatively stable at 51.57% in the first six months of 2019 compared to 51.25% for the first six months of 2018.
In addition, the Company uses pre-tax, pre-provision income adjusted for merger expenses as a measure of the level of recurring income before taxes. Management believes this provides financial statement users with a useful metric of the run-rate of revenues and expenses that is readily comparable to other financial institutions. This measure is calculated by adding the provision for loan losses, merger expenses and the provision for income taxes back to net income. This metric increased in the first six months of 2019 compared to the first six months of 2018 due primarily to the increase in net interest income.
Pre-tax pre-provision pre-merger income:
Plus non-GAAP adjustments:
Income taxes
Pre-tax pre-provision pre-merger income
78,381
75,158
Efficiency ratio - GAAP basis:
Net interest income plus non-interest income
166,460
158,695
Efficiency ratio - GAAP basis
52.91%
59.69%
Efficiency ratio - Non-GAAP basis:
Less non-GAAP adjustments:
Non-interest expenses - as adjusted
87,105
82,455
Plus non-GAAP adjustment:
Tax-equivalent income
Less non-GAAP adjustment:
Net interest income plus non-interest income - as adjusted
168,905
160,894
Efficiency ratio - Non-GAAP basis
51.57%
51.25%
Income Taxes
The Company’s income tax expense increased to $18.3 million in the first six months of 2019, compared to income tax expense of $14.2 million in the first six months of 2018 as a result of the increase in pre-tax income. The resulting effective tax rates were 23.8% for the first six months of 2019 and 23.5% for the first six months of 2018. The increase in the effective tax rate was the result of a decline in tax-advantaged income for the first six months of 2019 compared to the same period for 2018.
44
For the Three Months Ended June 30, 2019 Compared to the Three Months Ended June 30, 2018
Net income for the Company for the second quarter of 2019 totaled $28.3 million ($0.79 per diluted share) compared to net income of $24.4 million ($0.68 per diluted share) for the second quarter of 2018.
For the second quarter of 2019, net interest income increased 4% to $66.2 million compared to $63.8 million for the second quarter of 2018. On a tax-equivalent basis, net interest income for the second quarter of 2019 was $67.4 million compared to $65.0 million for the second quarter of 2018, an increase of 4%. The growth in net interest income was the result of the Company’s 7% growth in average loans during the previous twelve months which more than offset the impact of deposit growth as interest rates rose during that period.
Net interest margin was 3.54% for the second quarter of 2019, compared to 3.56% for the second quarter of 2018. Amortization of the fair value adjustments to both interest-earning assets and interest-bearing liabilities directly attributable to the acquisition had a 5 basis point positive effect on net interest margin for the current period. Excluding the amortization of fair value adjustments, the net interest margin for the current quarter would have been 3.49%, compared to 3.44% for the prior year’s second quarter.
The impact of the amortization of the fair value adjustments on net interest income for the current quarter is presented in the following table:
For the Three Months Ended June 30, 2019
(370)
(372)
(133)
(36)
65,274
45
1,244,086
11,971
3.85
1,034,062
9,414
3.64
174,095
1,873
223,171
2,199
3.95
1,418,181
13,844
1,257,233
11,613
3.70
686,282
10,268
6.00
576,076
8,271
5.76
1,960,919
24,357
4.98
1,924,759
22,661
4.72
1,215,632
14,840
4.90
1,184,409
13,989
4.74
756,594
10,321
5.47
666,280
8,807
5.30
4,619,427
59,786
5.19
4,351,524
53,728
4.95
505,235
6,335
5.03
531,965
5,753
4.40
6,542,843
79,965
6,140,722
71,094
4.64
37,121
4.11
25,403
4.39
744,701
5,689
3.06
734,482
5,282
2.88
220,162
1,959
3.56
293,824
2,598
3.54
964,863
7,648
3.17
1,028,306
7,880
73,793
2.32
114,869
1.79
620
0.60
1,972
1.44
7,619,240
88,423
4.65
7,311,272
79,774
4.37
(53,068)
(47,694)
66,031
66,420
60,871
61,900
601,809
534,837
8,294,883
7,926,735
747,343
460
0.25
729,948
222
332,796
118
0.14
356,077
0.11
1,690,413
6,589
1.56
1,554,304
4,571
1.18
1,680,055
8,979
2.14
1,220,447
1.30
4,450,607
1.46
3,860,776
0.92
157,499
0.74
148,542
0.29
623,727
1,011,180
2.12
37,376
37,518
5,269,209
1.60
5,058,016
1.17
1,796,802
1,796,644
129,794
58,994
1,099,078
1,013,081
67,394
3.05
64,995
1,209
1,177
1.11
0.81
taxable-equivalent adjustments utilized in the above table to compute yields aggregated to $1.2 million in both 2019 and 2018.
46
The Company's total tax-equivalent interest income increased 11% for the second quarter of 2019 compared to the prior year quarter. The previous table reflects the growth in the various categories of interest-earning assets as loan growth during the previous twelve months more than offset modest declines in other interest-earning assets.
The average balance of the loan portfolio increased 7% for the second quarter of 2019 compared to the prior year period. A significant amount of this growth was concentrated in the commercial real estate loan portfolio. The yield on average loans increased by 26 basis points compared to the prior year quarter. The average yield on total investment securities increased 11 basis points while the average balance of the investment portfolio decreased by 6% for the second quarter of 2019 compared to the second quarter of 2018. The increase in the yield on investments was driven by the yield increase in taxable investments as a result of an increase in yields on U.S. treasuries and government agencies. The increase in the yield on loans and the investment portfolio resulted in the 28 basis point rise in the yield on interest-earning assets from period to period.
Interest expense increased 42% in the second quarter of 2019 compared to the second quarter of 2018. The majority of the increase from period to period was mainly attributable to the rates that were increased to promote deposit growth. The main drivers in the 82% rise in the cost of interest-bearing deposits were the 9% growth in money market and the 38% growth in time deposit average balances coupled with the significant increases in money market and time deposits rates. The increase in the average interest-bearing deposits directly resulted in the 38% decrease in average FHLB borrowings from period to period as the average rate paid on those borrowings increased 52 basis points. The overall impact was an increase of 43 basis points in the average rate paid on interest-bearing liabilities in the second quarter of 2019 compared to the second quarter of 2018.
152
6.6
1,206
58.4
2.8
85
7.2
(2.4)
74
5.3
1.6
1,688
11.4
Total non-interest income was $16.6 million for the second quarter of 2019 compared to $14.9 million for the second quarter of 2018, an increase of 11%. This increase was driven predominantly by income from mortgage banking activities, and to a lesser extent, modest increases in the majority of sources of non-interest income. Further detail by type of non-interest income follows:
Service charges on deposit accounts increased 7% in the second quarter of 2019, compared to the second quarter of 2018.
Income from mortgage banking activities increased by $1.2 million or 58% in the second quarter of 2019 as compared to the second quarter of 2018. The increased income from mortgage banking activities was attributable to the increased origination volume during the period. The Company sold the majority of its mortgage loan production for gains during the quarter versus retaining them in the loan portfolio.
Wealth management income increased 3% in the second quarter of 2019 as compared to the second quarter of 2018. This increase was driven by a 5% a rise in income from trust and estate services. Overall total assets under management increased to $3.2 billion at June 30, 2019 compared to $2.9 billion at June 30, 2018 due to positive market movements and additions from new and existing clients.
Insurance agency commissions increased 7% in the second quarter of 2019, compared to the second quarter of 2018 driven by increases in commercial insurance and physician’s liability policies.
Bank card income grew 5% in the second quarter of 2019, compared to the second quarter of 2018 as transaction volume increased from the prior year.
825
3.3
2.5
469
20.9
(6.1)
14.9
(306)
(22.0)
(10.7)
(2,228)
(3.8)
(147)
(2.9)
(1,195)
(2.7)
Non-interest expenses totaled $43.9 million in the second quarter of 2019 compared to $45.1 million in the second quarter of 2018, a decrease of 3%. The prior year included $2.2 million in merger costs. Exclusive of these expenses, non-interest expense increased 2%. Further detail by category of non-interest expense follows:
Salaries and employee benefits, the largest component of non-interest expenses, increased 3% in the second quarter of 2019 as a result of a combination of higher compensation expense from annual merit increases over the preceding twelve months and management’s decision, beginning in the current year, to increase the Company’s contribution to the employee retirement savings plan as a result of the reduction of the corporate tax rate that occurred at the end of 2017. The average number of full-time equivalent employees declined to 912 in the second quarter of 2019 compared to 922 in the second quarter of 2018.
Occupancy and equipment expenses for the quarter increased 9% compared to the prior year quarter as a result of increased software cost and, to a lesser extent, increases in rental expense and equipment depreciation.
Marketing expense decreased 6% as a result of decreased advertising campaigns associated with the WashingtonFirst acquisition in the prior year.
FDIC insurance expense decreased 22% due to an improved assessment-based institutional rating.
Outside data service expense has grown 15% driven by transaction-based services offered by the Bank.
Other non-interest expenses decreased 3% in the second quarter of 2019 compared to the second quarter of 2018 primarily due to a decrease in franchise taxes.
The Company had income tax expense of $8.9 million in the second quarter of 2019, compared to income tax expense of $7.5 million in the second quarter of 2018. The higher tax expense for the second quarter of 2019 was the result of an increase in income before taxes compared to the same period of the prior year. The resultant effective tax rate increased to 24.0% for the second quarter of 2019 compared to 23.4% for the second quarter of 2018 as a result of the lower proportion of tax-advantaged income to income before taxes in the current period versus the prior year period.
Management views the GAAP efficiency ratio as an important financial measure of expense performance and cost management. The ratio expresses the level of non-interest expenses as a percentage of total revenue (net interest income plus total non-interest income). Lower ratios may indicate improved productivity as the growth rate in revenue streams exceeds the growth in operating expenses.
48
In general, the efficiency ratio is non-interest expenses as a percentage of net interest income plus non-interest income. Non-interest expenses used in the calculation of the non-GAAP efficiency ratio exclude merger expenses, the amortization of intangibles, and other non-recurring expenses. Income for the non-GAAP efficiency ratio includes the favorable effect of tax-exempt income, and excludes securities gains and losses, which vary widely from period to period without appreciably affecting operating expenses, and other non-recurring gains. The measure is different from the GAAP efficiency ratio, which also is presented in this report. The GAAP measure is calculated using non-interest expense and income amounts as shown on the face of the Condensed Consolidated Statements of Income. The GAAP efficiency ratio in the second quarter of 2019 improved compared to the second quarter of 2018, as non-interest expense decreased due to the lack of merger expenses and net interest income increased. The GAAP and non-GAAP efficiency ratios are reconciled and provided in the following table. The non-GAAP efficiency ratio improved to 51.71% in the second quarter of 2019 compared to 52.98% in the second quarter of 2018 as the rate of increase in the non-GAAP income exceeded the rate of increase in the non-GAAP expenses.
In addition to efficiency ratios, the Company uses pre-tax, pre-provision income, excluding merger expenses, as a measure of the level of recurring income before taxes. Management believes this provides financial statement users with a useful metric of the run-rate of revenues and expenses which is readily comparable to other financial institutions. This measure is calculated by adding the provision for loan losses, merger expenses and the provision for income taxes back to net income. This metric increased in the second quarter of 2019 compared to the second quarter of 2018 primarily due to an increase in net interest and non-interest income which offset the decline in merger expenses from the prior year quarter.
38,854
35,832
82,741
78,686
53.04%
57.29%
43,404
42,313
83,945
79,863
51.71%
52.98%
FINANCIAL CONDITION
The Company’s total assets grew to $8.4 billion at June 30, 2019, as compared to $8.2 billion at December 31, 2018 as a result of an increase in interest-bearing deposits with banks, in addition to an increase in other assets from the newly adopted lease accounting requirements. Total loans remained level at June 30, 2019 compared December 31, 2018 at $6.6 billion despite $389 million in new funded loan production during this period. In addition, commercial loans originated year-to-date had total unfunded commitments of $209 million as of June 30, 2019. The growth of the loan portfolio during the previous six months was limited due to the attrition attributable to the competitive forces in the regional economy and recent shifts that have occurred in interest rates and the sales of the majority of mortgage loan production. Total deposits grew 8% from the end of 2018 resulting in a reduction of the loan to deposit ratio from 111% at year-end 2018 to 103% at the end of the current quarter. The year-to-date deposit growth included a 16% increase in noninterest-bearing deposits and a 20% reduction in wholesale deposits.
Analysis of Loans
A comparison of the loan portfolio at the dates indicated is presented in the following table:
Period-to-Period Change
18.9
18.7
12,834
1.0
2.6
(15,679)
(8.4)
18.3
22,083
1.8
30.4
29.8
35,632
10.1
10.4
(22,492)
(3.3)
11.8
12.1
(24,106)
(3.0)
7.5
7.9
(28,663)
(5.5)
100.0
(20,391)
(0.3)
Analysis of Investment Securities
The composition of investment securities at the periods indicated is presented in the following table:
33.0
29.4
18,091
6.1
26.1
27.9
(32,448)
(11.5)
34.1
34.4
(22,169)
(6.4)
0.9
2.3
0.1
Total available-for-sale securities
94.3
92.7
(36,310)
(3.9)
Other equity securities:
5.7
7.3
(18,699)
(25.5)
Total other equity securities
Total securities
955,715
1,010,724
(55,009)
(5.4)
51
The investment portfolio consists primarily of U.S. Treasuries, U.S. Agency securities, U.S. Agency mortgage-backed securities, U.S. Agency collateralized mortgage obligations, asset-backed securities and state and municipal securities. The portfolio is monitored on a continuing basis with consideration given to interest rate trends and the structure of the yield curve and with a frequent assessment of economic projections and analysis. At June 30, 2019, 97% of the investment portfolio was invested in Aa/AA or Aaa/AAA-rated securities. The composition and size of the portfolio at June 30, 2019 has remained stable compared to the prior year-end. The duration of the portfolio is monitored to ensure the adequacy and ability to meet liquidity demands. At June 30, 2019 the duration of the portfolio was 3.3 years compared to 3.9 years at December 31, 2018. The decrease in the duration is attributable to the declining interest rate environment during the first half of 2019. These attributes have resulted in a portfolio with low credit risk that would provide the liquidity necessary to meet the loan and operational demands.
Other Earning Assets
Residential mortgage loans held for sale increased to $50 million at June 30, 2019, compared to $23 million at December 31, 2018 as a result of the increased volume in loan originations during the period. The aggregate of interest-bearing deposits with banks and federal funds increased by $131 million at June 30, 2019 compared to December 31, 2018 due to the timing of cash flows.
Deposits
The composition of deposits at the periods indicated is presented in the following table:
31.7
29.6
273,295
15.6
11.3
11.9
18,244
26.7
27.1
100,140
6.2
5.2
5.6
933
0.3
7.1
29,099
6.8
18.0
18.6
53,158
68.3
70.4
201,574
8.0
Deposits and Borrowings
Total deposits increased by 8% from $5.9 billion at December 31, 2018 to $6.4 billion at June 30, 2019. The majority of this increase occurred in noninterest-bearing deposits with other notable increases in money market and time deposit categories. Interest-bearing deposits represented 68% of deposits with the remaining 32% in noninterest-bearing balances at June 30, 2019 compared to 30% and 70%, respectively, at December 31, 2018. As a result of the increase in deposits, total borrowings were reduced by $0.4 billion or 36% at June 30, 2019 compared to December 31, 2018, primarily in advances from the FHLB and overnight funding. During the quarter, the Company shifted short-term FHLB borrowings into medium-term lower rate borrowings. This shift accompanied by the increase in noninterest-bearing deposits benefited the Company’s net interest margin during the current quarter.
Capital Management
Management monitors historical and projected earnings, dividends and asset growth, as well as risks associated with the various types of on and off-balance sheet assets and liabilities, in order to determine appropriate capital levels. Total stockholders' equity was $1.1 billion at June 30, 2019 and December 31, 2018. The ratio of average equity to average assets was 13.12% for the six months ended June 30, 2019, as compared to 12.83% for the first six months of 2018.
Bank holding companies and banks are required to maintain capital ratios in accordance with guidelines adopted by the federal bank regulators. These guidelines are commonly known as Risk-Based Capital guidelines. The actual regulatory ratios and required ratios for capital adequacy are summarized for the Company in the following table.
Risk-Based Capital Ratios
52
Minimum
Ratios at
Regulatory
Requirements
Total capital to risk-weighted assets
12.79%
12.26%
8.00%
Tier 1 capital to risk-weighted assets
11.59%
11.06%
6.00%
Common equity tier 1 capital
11.43%
10.90%
4.50%
Tier 1 leverage
9.80%
9.50%
4.00%
As of June 30, 2019, the most recent notification from the Bank’s primary regulator categorized the Bank as a "well-capitalized" institution under the prompt corrective action rules of the Federal Deposit Insurance Act. Designation as a well-capitalized institution under these regulations is not a recommendation or endorsement of the Company or the Bank by federal bank regulators.
The minimum capital level requirements applicable to the Company and the Bank are: (1) a common equity Tier 1 capital ratio of 4.5%; (2) a Tier 1 capital ratio of 6%; (3) a total capital ratio of 8%; and (4) a Tier 1 leverage ratio of 4%. The rules also establish a “capital conservation buffer” of 2.5% above the regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital. An institution would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses to executive officers if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.
Tangible Common Equity
Tangible equity, tangible assets and tangible book value per share are non-GAAP financial measures calculated using GAAP amounts. Tangible common equity and tangible assets exclude the balances of goodwill and other intangible assets from stockholder’s equity and total assets, respectively. Management believes that this non-GAAP financial measure provides information to investors that may be useful in understanding our financial condition. Because not all companies use the same calculation of tangible equity and tangible assets, this presentation may not be comparable to other similarly titled measures calculated by other companies.
Tangible common equity totaled $767 million at June 30, 2019, compared to $727 million at December 31, 2018. At June 30, 2019, the ratio of tangible common equity to tangible assets has increased to 9.54% compared to 9.21% at December 31, 2018. Tangible common equity growth was the result of increased net earnings during the current quarter.
A reconciliation of the non-GAAP ratio of tangible equity to tangible assets and tangible book value per share are provided in the following table:
Tangible Common Equity Ratio – Non-GAAP
Tangible common equity ratio:
3,565
15,754
(347,149)
(8,813)
(9,788)
Tangible common equity
767,048
726,720
Tangible assets
8,042,557
7,886,335
Tangible common equity ratio
9.54%
9.21%
Tangible book value per share
$ 21.54
$ 20.45
53
Credit Risk
The fundamental lending business of the Company is based on understanding, measuring and controlling the credit risk inherent in the loan portfolio. The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk entails both general risks, which are inherent in the process of lending, and risk specific to individual borrowers. The Company’s credit risk is mitigated through portfolio diversification, which limits exposure to any single customer, industry or collateral type. Typically, each consumer and residential lending product has a generally predictable level of credit losses based on historical loss experience. Residential mortgage and home equity loans and lines generally have the lowest credit loss experience. Loans secured by personal property, such as auto loans, generally experience medium credit losses. Unsecured loan products, such as personal revolving credit, have the highest credit loss experience and for that reason, the Company has chosen not to engage in a significant amount of this type of lending. Credit risk in commercial lending can vary significantly, as losses as a percentage of outstanding loans can shift widely during economic cycles and are particularly sensitive to changing economic conditions. Generally, improving economic conditions result in improved operating results on the part of commercial customers, enhancing their ability to meet their particular debt service requirements. Improvements, if any, in operating cash flows can be offset by the impact of rising interest rates that may occur during improved economic times. Inconsistent economic conditions may have an adverse effect on the operating results of commercial customers, reducing their ability to meet debt service obligations.
Loans acquired with evidence of credit deterioration since their origination as of the date of the acquisition are recorded at their initial fair value. Credit deterioration is determined based on the probability of collection of all contractually required principal and interest payments. These loans are not considered non-performing for reporting purposes but are managed and monitored in the same manner and using the same techniques and strategies as organically generated loans. In accordance with GAAP, the historical allowance for loan losses related to the acquired loans is not carried over to the Company’s financial statements. The following credit related sections should be read in conjunction with the section “Loans Acquired with Deteriorated Credit Quality” in “Note 1 – Significant Accounting Policies” of the Notes to the Condensed Consolidated Financial Statements.
Total non-performing loans increased to $37.7 million or 0.58% of total loans at June 30, 2019 compared to $36.0 million or 0.55% of total loans at December 31, 2018. While the diversification of the lending portfolio among different commercial, residential and consumer product lines along with different market conditions of the D.C. suburbs, Northern Virginia and Baltimore metropolitan area has mitigated some of the risks in the portfolio, local economic conditions and levels of non-performing loans may continue to be influenced by the conditions being experienced in various business sectors of the economy on both a regional and national level.
To control and manage credit risk, management has a credit process in place to reasonably ensure that credit standards are maintained along with an in-house loan administration accompanied by oversight and review procedures. The primary purpose of loan underwriting is the evaluation of specific lending risks and involves the analysis of the borrower’s ability to service the debt as well as the assessment of the value of the underlying collateral. Oversight and review procedures include the monitoring of portfolio credit quality, early identification of potential problem credits and the proactive management of problem credits. As part of the oversight and review process, the Company maintains an allowance for loan losses (the “allowance”).
The allowance represents an estimation of the losses that are inherent in the loan portfolio. The adequacy of the allowance is determined through the ongoing evaluation of the credit portfolio, and involves consideration of a number of factors, as outlined below, to establish an adequate allowance for loan losses. Determination of the allowance is inherently subjective and requires significant estimates, including estimated losses on pools of homogeneous loans based on historical loss experience and consideration of current economic trends, which may be susceptible to significant change. Loans deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for loan losses, which is recorded as a current period operating expense.
The methodology for assessing the appropriateness of the allowance includes: (1) a general allowance that reflects historical losses supplemented by qualitative factors, as adjusted, by credit category, and (2) a specific allowance for impaired credits on an individual or portfolio basis. The amount of the allowance is reviewed quarterly by the Risk Committee of the board of directors.
54
The Company recognizes a collateral dependent lending relationship as non-performing when either the loan becomes 90 days delinquent or as a result of factors (such as bankruptcy, interruption of cash flows, etc.) considered at the monthly credit committee meeting. When a commercial loan is placed on non-accrual status, it is considered to be impaired and all accrued but unpaid interest is reversed. Classification as an impaired loan is based on a determination that the Company may not collect all principal and interest payments according to contractual terms. Impaired loans exclude large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment such as residential real estate and consumer loans. Typically, all payments received on non-accrual loans are first applied to the remaining principal balance of the loans. Any additional recoveries are credited to the allowance. Integral to the assessment of the allowance process is an evaluation that is performed to determine whether a specific allowance on an impaired loan is warranted and, when losses are confirmed, a charge-off is taken to reduce the loan to its net realizable value. Any further collateral deterioration results in either further specific allowances being established or additional charge-offs. When additional deterioration becomes apparent, an action plan is developed for the particular loan and an appraisal will be obtained depending on the time elapsed since the prior appraisal, the loan balance and/or the result of the internal evaluation. A current appraisal on large loans is usually obtained if the appraisal on file is more than 12 months old and there has been a material change in market conditions, zoning, physical use or the adequacy of the collateral based on an internal evaluation. The Company’s policy is to strictly adhere to regulatory appraisal standards. If an appraisal is ordered, no more than a 30 day turnaround is requested from the appraiser, who is selected by Credit Administration from an approved appraiser list. After receipt of the updated appraisal, the assigned credit officer will recommend to the Chief Credit Officer whether a specific allowance or a charge-off should be taken. The Chief Credit Officer has the authority to approve a specific allowance or charge-off between monthly credit committee meetings to ensure that there are no significant time lapses during this process.
The Company’s methodology for evaluating whether a loan is impaired begins with risk-rating credits on an individual basis and includes consideration of the borrower’s overall financial condition, payment record and available cash resources that may include the sufficiency of collateral value and, in a select few cases, verifiable support from financial guarantors. In measuring impairment, the Company looks primarily to the discounted cash flows of the project itself or to the value of the collateral as the primary sources of repayment of the loan. The Company may consider the existence of guarantees and the financial strength and wherewithal of the guarantors involved in any loan relationship. Guarantees may be considered as a source of repayment based on the guarantor’s financial condition and respective payment capacity. Accordingly, absent a verifiable payment capacity, a guarantee alone would not be sufficient to avoid classifying the loan as impaired.
Management has established a credit process that dictates that structured procedures be performed to monitor these loans between the receipt of an original appraisal and the updated appraisal. These procedures include the following:
An internal evaluation is updated periodically to include borrower financial statements and/or cash flow projections.
The borrower may be contacted for a meeting to discuss an updated or revised action plan which may include a request for additional collateral.
Re-verification of the documentation supporting the Company’s position with respect to the collateral securing the loan.
At the monthly credit committee meeting the loan may be downgraded and a specific allowance may be decided upon in advance of the receipt of the appraisal.
Upon receipt of the updated appraisal (or based on an updated internal financial evaluation) the loan balance is compared to the appraisal and a specific allowance is decided upon for the particular loan, typically for the amount of the difference between the appraisal and the loan balance.
The Company will specifically reserve for or charge-off the excess of the loan amount over the amount of the appraisal net of closing costs.
If an updated appraisal is received subsequent to the preliminary determination of a specific allowance or partial charge-off, and it is less than the initial appraisal used in the initial assessment, an additional specific allowance or charge-off is taken on the related credit. Partially charged-off loans are not written back up based on updated appraisals and always remain on non-accrual with any and all subsequent payments first applied to the remaining balance of the loan as principal reductions. No interest income is recognized on loans that have been partially charged-off.
Loans considered to be troubled debt restructurings (“TDRs”) are loans that have their terms restructured (e.g., interest rates, loan maturity date, payment and amortization period, etc.) in circumstances that provide payment relief to a borrower experiencing financial difficulty. All restructured loans are considered impaired loans and may either be in accruing status or non-accruing status. Non-accruing restructured loans may return to accruing status provided doubt has been removed concerning the collectability of principal and interest as evidenced by a sufficient period of payment performance in accordance with the restructured terms. Loans may be removed from the restructured category if the borrower is no longer experiencing financial difficulty, a re-underwriting event took place and the revised loan terms of the subsequent restructuring agreement are considered to be consistent with terms that can be obtained in the credit market for loans with comparable risk.
The Company may extend the maturity of a performing or current loan that may have some inherent weakness associated with the loan. However, the Company generally follows a policy of not extending maturities on non-performing loans under existing terms. Maturity date extensions only occur under revised terms that clearly place the Company in a position to increase the likelihood of or assure full collection of the loan under the contractual terms and /or terms at the time of the extension that may eliminate or mitigate the inherent weakness in the loan. These terms may incorporate, but are not limited to additional assignment of collateral, significant balance curtailments/liquidations and assignments of additional project cash flows. Guarantees may be a consideration in the extension of loan maturities. As a general matter, the Company does not view extension of a loan to be a satisfactory approach to resolving non-performing credits. On an exception basis, certain performing loans that have displayed some inherent weakness in the underlying collateral values, an inability to comply with certain loan covenants which are not affecting the performance of the credit or other identified weakness may be extended.
Collateral values or estimates of discounted cash flows (inclusive of any potential cash flow from guarantees) are evaluated to estimate the probability and severity of potential losses. The actual occurrence and severity of losses involving impaired credits can differ substantially from estimates.
The determination of the allowance requires significant judgment, and estimates of probable losses in the loan portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future additions to the allowance may be necessary based on changes in the credits comprising the portfolio and changes in the financial condition of borrowers, such as may result from changes in economic conditions. In addition, federal and state regulatory agencies, as an integral part of their examination process, and independent consultants engaged by the Bank, periodically review the loan portfolio and the allowance. Such reviews may result in adjustments to the allowance based upon their analysis of the information available at the time of each examination.
The Company makes provisions for loan losses in amounts necessary to maintain the allowance at an appropriate level, as established by use of the allowance methodology previously discussed. The provision for loan losses was $1.6 million for the second quarter of 2019 compared to $1.7 million for the second quarter of 2018. The current quarter’s provision reflects the impact of organic loan production and the need to establish a loan loss provision for re-underwritten previously acquired loans that had reached their maturity under their original lending arrangements.
The Company typically sells a substantial portion of its fixed-rate residential mortgage originations in the secondary mortgage market. Concurrent with such sales, the Company is required to make customary representations and warranties to the purchasers about the mortgage loans and the manner in which they were originated. The related sale agreements grant the purchasers recourse back to the Company, which could require the Company to repurchase loans or to share in any losses incurred by the purchasers. This recourse exposure typically extends for a period of six to twelve months after the sale of the loan although the time frame for repurchase requests can extend for an indefinite period. Such transactions could be due to a number of causes including borrower fraud or early payment default. The Company has seen a very limited number of repurchase and indemnity demands from purchasers for such events and routinely monitors its exposure in this regard. The Company maintains a liability of $0.7 million for probable losses due to repurchases.
The Company periodically engages in whole loan sale transactions of its residential mortgage loans as a part its interest rate risk management strategy. There were no whole loan sales of mortgage loans from the portfolio during the current quarter.
Mortgage loan servicing rights are accounted for at amortized cost and are monitored for impairment on an ongoing basis. The amortized cost of the Company's mortgage loan servicing rights was $1.0 million and $1.1 million at June 30, 2019 and December 31, 2018, respectively. The Company did not incur any impairment losses during the current period.
56
During the second quarter of 2019, there were no changes in the Company’s methodology for assessing the appropriateness of the allowance for loan losses from the prior year. Variations can occur over time in the estimation of the allowance as a result of the credit performance of borrowers.
The allowance for loan losses as a percent of total loans was 0.82% and 0.81% at June 30, 2019 and December 31, 2018, respectively. At June 30, 2019, total non-performing loans, excluding credit deteriorated loans from acquisitions, were $37.7 million, or 0.58% of total loans, compared to $36.0 million, or 0.55% of total loans, at December 31, 2018. The growth in non-performing loans occurred as a result of modest increases in all segments of the loan portfolio, predominantly loans secured by real estate. Non-performing loans include accruing loans 90 days or more past due and restrucutred loans, but exclude acquired non-performing loans. The allowance for loan losses represented 143% of non-performing loans at June 30, 2019 as compared to 149% at December 31, 2018. While non-performing loans increased from December 31, 2018 to the current quarter, the related reserves for those loans remained stable due to adequate collateral values.
Continued analysis of the actual loss history on the problem credits in 2018 and 2019 provided an indication that the coverage of the inherent losses on the problem credits was adequate. The Company continues to monitor the impact of the economic conditions on our commercial customers together with the reduced inflow of non-accruals and criticized loans. The improvement in these credit metrics supports management’s outlook for continued improved credit quality performance.
The balance of impaired loans was $21.7 million, with specific allowances of $4.8 million against those loans at June 30, 2019, as compared to $22.2 million with specific allowances of $4.9 million, at December 31, 2018.
The Company's borrowers are concentrated in nine counties in Maryland, three counties in Virginia and in Washington D.C. Commercial and residential mortgages, including home equity loans and lines, represented 88% of total loans at June 30, 2019 and 87% of total loans at December 31, 2018. Certain loan terms may create concentrations of credit risk and increase the Company’s exposure to loss. These include terms that permit the deferral of principal payments or payments that are smaller than normal interest accruals (negative amortization); loans with high loan-to-value ratios; loans, such as option adjustable-rate mortgages, that may expose the borrower to future increases in repayments that are in excess of increases that would result solely from increases in market interest rates; and interest-only loans. The Company does not make loans that provide for negative amortization or option adjustable-rate mortgages.
Summary of Loan Loss Experience
The following table presents the activity in the allowance for loan losses for the periods indicated:
Year Ended
Balance, January 1
Loan charge-offs:
Commercial investor
Commercial owner occupied
Total charge-offs
Loan recoveries:
Total recoveries
Balance, period end
Net charge-offs to average loans
0.03%
0.01%
Allowance for loan losses to loans
58
Analysis of Credit Risk
The following table presents information with respect to non-performing assets and 90-day delinquencies for the periods indicated:
Non-accrual loans:
Total non-accrual loans
Total 90 days past due loans
Restructured loans (accruing)
Other real estate owned, net
Non-performing loans to total loans
0.58%
0.55%
Non-performing assets to total assets
0.47%
0.46%
Allowance for loan to non-performing loans
143.33%
148.51%
Market Risk Management
The Company's net income is largely dependent on its net interest income. Net interest income is susceptible to interest rate risk to the extent that interest-bearing liabilities mature or re-price on a different basis than interest-earning assets. When interest-bearing liabilities mature or re-price 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 re-price more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income. Net interest income is also affected by changes in the portion of interest-earning assets that are funded by interest-bearing liabilities rather than by other sources of funds, such as noninterest-bearing deposits and stockholders' equity.
The Company’s interest rate risk management goals are (1) to increase net interest income at a growth rate consistent with the growth rate of total assets, and (2) to minimize fluctuations in net interest margin as a percentage of interest-earning assets. Management attempts to achieve these goals by balancing, within policy limits, the volume of floating-rate liabilities with a similar volume of floating-rate assets; by keeping the average maturity of fixed-rate asset and liability contracts reasonably matched; by maintaining a pool of administered core deposits; and by adjusting pricing rates to market conditions on a continuing basis.
59
The Company’s board of directors has established a comprehensive interest rate risk management policy, which is administered by management’s Asset Liability Management Committee (“ALCO”). The policy establishes limits on risk, which are quantitative measures of the percentage change in net interest income (a measure of net interest income at risk) and the fair value of equity capital (a measure of economic value of equity or “EVE” at risk) resulting from a hypothetical change in U.S. Treasury interest rates for maturities from one day to thirty years. The Company measures the potential adverse impacts that changing interest rates may have on its short-term earnings, long-term value, and liquidity by employing simulation analysis through the use of computer modeling. The simulation model captures optionality factors such as call features and interest rate caps and floors embedded in investment and loan portfolio contracts. As with any method of gauging interest rate risk, there are certain shortcomings inherent in the interest rate modeling methodology used by the Company. When interest rates change, actual movements in different categories of interest-earning assets and interest-bearing liabilities, loan prepayments, and withdrawals of time and other deposits, may deviate significantly from assumptions used in the model. As an example, certain types of money market deposit accounts are assumed to reprice at 40 to 100% of the interest rate change in each of the up rate shock scenarios even though this is not a contractual requirement. As a practical matter, management would likely lag the impact of any upward movement in market rates on these accounts as a mechanism to manage the bank’s net interest margin. Finally, the methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan customers’ ability to service their debts, or the impact of rate changes on demand for loan, lease, and deposit products.
The Company prepares a current base case and eight alternative simulations at least once a quarter and reports the analysis to the board of directors. In addition, more frequent forecasts are produced when interest rates are particularly uncertain or when other business conditions so dictate.
The statement of condition is subject to quarterly testing for eight alternative interest rate shock possibilities to indicate the inherent interest rate risk. Average interest rates are shocked by +/- 100, 200, 300, and 400 basis points (“bp”), although the Company may elect not to use particular scenarios that it determines are impractical in a current rate environment. It is management’s goal to structure the balance sheet so that net interest earnings at risk over a twelve-month period and the economic value of equity at risk do not exceed policy guidelines at the various interest rate shock levels.
The Company augments its quarterly interest rate shock analysis with alternative external interest rate scenarios on a monthly basis. These alternative interest rate scenarios may include non-parallel rate ramps and non-parallel yield curve twists. If a measure of risk produced by the alternative simulations of the entire balance sheet violates policy guidelines, ALCO is required to develop a plan to restore the measure of risk to a level that complies with policy limits within two quarters.
Measures of net interest income at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value of the institution.
Estimated Changes in Net Interest Income
Change in Interest Rates:
+ 400 bp
+ 300 bp
+ 200 bp
+ 100 bp
- 100 bp
- 200 bp
-300 bp
400 bp
Policy Limit
23.50%
17.50%
15.00%
10.00%
12.57%
9.69%
6.79%
3.46%
(4.28%)
(7.51%)
N/A
2.74%
2.29%
2.38%
1.15%
(1.74%)
(3.15%)
As shown above, the overall net interest income at risk decreased in rising parallel interest rate movements and increased as interest rates declined compared to December 31, 2018. The decrease in the risk position results primarily from the reduction in short-term FHLB borrowing expense and an increase in income from interest-bearing deposits with banks. All measures remained well within prescribed policy limits.
The measures of equity value at risk indicate the ongoing economic value of the Company by considering the effects of changes in interest rates on all of the Company’s cash flows, and by discounting the cash flows to estimate the present value of assets and liabilities. The difference between these discounted values of the assets and liabilities is the economic value of equity, which, in theory, approximates the fair value of the Company’s net assets.
60
Estimated Changes in Economic Value of Equity (EVE)
-400 bp
35.00%
25.00%
20.00%
(0.76%)
0.60%
1.85%
(4.21%)
(6.38%)
(10.23%)
(7.18%)
(3.61%)
(1.70%)
(0.77%)
(2.80%)
Overall, the measure of the economic value of equity (“EVE”) at risk decreased from December 31, 2018 to June 30, 2019 in rising interest rate scenarios and increased in decreasing rate scenarios. The primary driver of the improvement in the indicated EVE risk positions if rate rise is the result of the lengthening of the average lives of core deposits, in addition to low rates on borrowings which reflect a premium, in a rising rate environment.
Liquidity Management
Liquidity is measured by a financial institution's ability to raise funds through loan repayments, maturing investments, deposit growth, borrowed funds, capital and the sale of highly marketable assets such as investment securities and residential mortgage loans. In assessing liquidity, management considers operating requirements, the seasonality of deposit flows, investment, loan and deposit maturities and calls, expected funding of loans and deposit withdrawals, and the market values of available-for-sale investments, so that sufficient funds are available on short notice to meet obligations as they arise and to ensure that the Company is able to pursue new business opportunities. The Company's liquidity position, considering both internal and external sources available, exceeded anticipated short-term and long-term needs at June 30, 2019.
Liquidity is measured using an approach designed to take into account core deposits, in addition to factors already discussed above. Management considers core deposits, defined to include all deposits other than time deposits of $100 thousand or more, to be a relatively stable funding source. Core deposits equaled 68% of total interest-earning assets at June 30, 2019. The Company’s growth and mortgage banking activities are also additional considerations when evaluating liquidity requirements. Also considered are changes in the liquidity of the investment portfolio due to fluctuations in interest rates. Under this approach, implemented by the Funds Management Subcommittee of ALCO under formal policy guidelines, the Company’s liquidity position is measured weekly, looking forward at thirty day intervals from thirty (30) to three hundred sixty (360) days. The measurement is based upon the projection of funds sold or purchased position, along with ratios and trends developed to measure dependence on purchased funds and core growth. As of June 30, 2019, the Company projects an excess cash flow over the subsequent 360 days of $93 million. This projected excess liquidity versus requirements provides the Company with flexibility in funding loan demand and other liquidity demands.
The Company also has external sources of funds, which can be drawn upon when required. The main sources of external liquidity are available lines of credit with the Federal Home Loan Bank of Atlanta and the Federal Reserve. The line of credit with the Federal Home Loan Bank of Atlanta totaled $2.3 billion, all of which was available for borrowing based on pledged collateral, with $0.6 billion borrowed against it as of June 30, 2019. The secured lines of credit at the Federal Reserve and correspondent banks totaled $316 million, all of which was available for borrowing based on pledged collateral, with no borrowings against it as of June 30, 2019. In addition, the Company had unsecured lines of credit with correspondent banks of $680 million at June 30, 2019. At June 30, 2019, there were no outstanding borrowings against these lines of credit. Based upon its liquidity analysis, including external sources of liquidity available, management believes the liquidity position was appropriate at June 30, 2019.
The parent company (“Bancorp”) is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, Bancorp is responsible for paying any dividends declared to its common shareholders and interest and principal on outstanding debt. Bancorp’s primary source of income is dividends received from the Bank. The amount of dividends that the Bank may declare and pay to Bancorp in any calendar year, without the receipt of prior approval from the Federal Reserve, cannot exceed net income for that year to date plus retained net income (as defined) for the preceding two calendar years. Based on this requirement, as of June 30, 2019, the Bank could have declared a dividend of $129 million to Bancorp. At June 30, 2019, Bancorp had liquid assets of $25 million.
Arrangements to fund credit products or guarantee financing take the form of loan commitments (including lines of credit on revolving credit structures) and letters of credit. Approvals for these arrangements are obtained in the same manner as loans. Generally, cash flows, collateral value and risk assessment are considered when determining the amount and structure of credit arrangements.
Commitments to extend credit in the form of consumer, commercial real estate and business at the dates indicated were as follows:
Commercial real estate development and construction
565,086
562,777
Residential real estate-development and construction
95,959
130,251
Real estate-residential mortgage
124,201
31,227
Lines of credit, principally home equity and business lines
1,318,781
1,296,481
Standby letters of credit
60,180
59,826
Total commitments to extend credit and available credit lines
2,164,207
2,080,562
Commitments to extend credit are agreements to provide financing to a customer with the provision that there are no violations of any condition established in the agreement. Commitments generally have interest rates determined by current market rates, expirations dates or other termination clauses and may require payment of a fee. Lines of credit typically represent unused portions of lines of credit that were provided and remain available as long as customers comply with the requisite contractual conditions. Commitments to extend credit are evaluated on a case by case basis periodically. Many of the commitments are expected to expire without being drawn upon. It is highly unlikely that all customers would draw on their lines of credit in full at any time and, therefore, the total commitment amount or line of credit amounts do not necessarily represent future cash requirements.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See “Financial Condition - Market Risk and Interest Rate Sensitivity” in Management’s Discussion and Analysis of Financial Condition and Results of Operations, above, which is incorporated herein by reference.
The Company’s management, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, evaluated as of the last day of the period covered by this report, the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15 under the Securities Exchange Act of 1934. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective. There were no changes in the Company’s internal controls over financial reporting (as defined in Rule 13a-15 under the Securities Act of 1934) during the three months ended June 30, 2019 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 1. Legal Proceedings
In the normal course of business, the Company becomes involved in litigation arising from the banking, financial and other activities it conducts. Management, after consultation with legal counsel, does not anticipate that the ultimate liability, if any, arising from these matters will have a material effect on the Company’s financial condition, operating results or liquidity.
Item 1A. Risk Factors
There have been no material changes in the risk factors as discussed in the 2018 Annual Report on Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
In December 2018, the Company’s board of directors authorized the repurchase of up to 1,800,000 shares of common stock. The Company did not repurchase any shares of its common stock in the quarter ended June 30, 2019.
Item 3. Defaults Upon Senior Securities – None
Item 4. Mine Safety Disclosures – Not applicable
Item 5. Other Information - None
Item 6. Exhibits
Exhibit 31(a) Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a)
Exhibit 31(b)Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a)
Exhibit 32(a)Certification of Chief Executive Officer pursuant to 18 U.S. Section 1350
Exhibit 32(b)Certification of Chief Financial Officer pursuant to 18 U.S. Section 1350
Exhibit 101.SCHXBRL Taxonomy Extension Schema Document
Exhibit 101.CALXBRL Taxonomy Extension Calculation Linkbase Document
Exhibit 101.DEFXBRL Taxonomy Extension Definition Linkbase Document
Exhibit 101.LABXBRL Taxonomy Extension Label Linkbase Document
Exhibit 101.PREXBRL Taxonomy Extension Presentation Linkbase Document
Signatures
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this quarterly report to be signed on its behalf by the undersigned, thereunto duly authorized.
(Registrant)
By: /s/ Daniel J. Schrider
Daniel J. Schrider
President and Chief Executive Officer
Date: August 9, 2019
By: /s/ Philip J. Mantua
Philip J. Mantua
Executive Vice President and Chief Financial Officer