UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2021
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 1-36785
Securities registered pursuant to Section 12(b) of the Act:
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large Accelerate 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 ☒
SB FINANCIAL GROUP, INC.
TABLE OF CONTENTS
i
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
SB Financial Group, Inc.
Condensed Consolidated Balance Sheets
See notes to condensed consolidated financial statements (unaudited)
Note: The balance sheet at December 31, 2020 has been derived from the audited consolidated financial statements at that date.
1
Condensed Consolidated Income Statement (unaudited)
2
Condensed Consolidated Statements of Comprehensive Income (unaudited)
3
Condensed Consolidated Statements of Shareholders’ Equity (unaudited)
4
Condensed Consolidated Statements of Cash Flows (unaudited)
5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1 – BASIS OF PRESENTATION
SB Financial Group, Inc., an Ohio corporation (the “Company”), is a financial holding company whose principal activity is the ownership and management of its wholly-owned subsidiaries, including The State Bank and Trust Company (“State Bank”),SBFG Title, LLC (“Title”), SB Captive, Inc. (“Captive”), RFCBC, Inc. (“RFCBC”), Rurbanc Data Services, Inc. dba RDSI Banking Systems (“RDSI”), and Rurban Statutory Trust II (“RST II”). RDSI is presently inactive and has had no material operations or employees since January 1, 2018. In addition, State Bank owns all of the outstanding stock of Rurban Mortgage Company (“RMC”), which is inactive, and State Bank Insurance, LLC (“SBI”).
In June 2020, the Company acquired Edon Bancorp and its subsidiary, The Edon State Bank Company of Edon, Ohio (collectively, “Edon”), which were merged with and into the Company and State Bank, respectively. This acquisition was completed effective June 5, 2020, and the acquisition resulted in an increase in goodwill, which is detailed in Note 8. The business combination summary is detailed in Note 3.
In March 2019, the Company formed Title, which purchased all of the assets and real estate of an Ohio based title agency. The purchase was completed effective March 15, 2019, and the purchase resulted in an increase in goodwill.
In March 2019, the Company formed Captive, which is a captive insurance company based in Nevada. The Captive allows the Company to share insurance risk among a pool of similar sized banks.
The consolidated financial statements include the accounts of the Company, State Bank, RFCBC, RDSI, RMC, Title, Captive and SBI. All significant intercompany accounts and transactions have been eliminated in consolidation.
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The financial statements reflect all adjustments that are, in the opinion of management, necessary to fairly present the financial position, results of operations and cash flows of the Company. Those adjustments consist only of normal recurring adjustments. Results of operations for the three and six months ended June 30, 2021, are not necessarily indicative of results for the complete year.
The condensed consolidated balance sheet of the Company as of December 31, 2020 has been derived from the audited consolidated balance sheet of the Company as of that date.
For further information, refer to the consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.
New and applicable accounting pronouncements:
ASU No. 2020-01: Investments – Equity Securities (Topic 321), Investments – Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815) – Clarifying the Interactions between Topic 321, Topic 323 and Topic 815
This guidance was issued in January 2020 to clarify that a company should consider observable transactions that require a company to either apply or discontinue the equity method of accounting under Topic 323, Investments-Equity Method and Joint Ventures, for the purposes of applying the measurement alternative in accordance with Topic 321 immediately before applying or upon discontinuing the equity method. The amendments also clarify that when determining the accounting for certain forward contracts and purchased options a company should not consider, whether upon settlement or exercise, if the underlying securities would be accounted for under the equity method or fair value option. The guidance is effective beginning after December 15, 2020. The impact of this new guidance did not have a material impact on the Company’s consolidated financial statements.
6
Accounting Standards not yet adopted:
ASU No. 2020-04: Reference Rate Reform – Facilitation of the Effects of Reference Rate Reform on Financial Reporting (Topic 848)
This guidance provides temporary options to ease the potential burden in accounting for reference rate reform. It is intended to help stakeholders during the global market-wide reference rate transition period. The guidance is effective as of March 12, 2020 through December 31, 2022. The Company anticipates being fully prepared to implement a replacement for the reference rate and has determined that any change will not have a material impact on the Company’s consolidated financial statements.
ASU No. 2016-13: Financial Instruments – Credit Losses (Topic 326)
This ASU, which is commonly known as “CECL,” replaces the current GAAP incurred impairment methodology regarding credit losses with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The amendments in this update affect an entity to varying degrees depending on the credit quality of the assets held by the entity, their duration, and how the entity applies current GAAP.
The adoption of ASU 2016-13 is likely to result in an increase in the allowance for loan losses as a result of changing from an “incurred loss” model, which encompasses allowances for current known and inherent losses within the portfolio, to an “expected loss” model, which encompasses allowances for losses expected to be incurred over the life of the portfolio. Furthermore, ASU 2016-13 will necessitate that we establish an allowance for expected credit losses on debt securities.
In December 2018, the Office of the Comptroller of the Currency (“OCC”), the Federal Reserve Board, and the Federal Deposit Insurance Corporation (“FDIC”) approved a final rule to address changes to credit loss accounting under GAAP, including banking organizations’ implementation of CECL. The final rule provides banking organizations the option to phase in over a three-year period the day-one adverse effects on regulatory capital that may result from the adoption of the new accounting standard.
On November 15, 2019, the FASB delayed the effective date for certain small public companies and other private companies. As the Company is currently a smaller reporting company, the amendment will delay the effective date of ASU No. 2016-13 to the Company’s fiscal year beginning January 1, 2023.
While we are currently unable to reasonably estimate the impact of adopting ASU 2016-13, we expect that the impact of adoption will be significantly influenced by the composition, characteristics and quality of our loan and securities portfolios as well as the prevailing economic conditions and forecasts as of the adoption date. The Company implemented a process to track required data by utilizing accounting software in preparation for compliance. We anticipate being fully prepared for implementation by January 1, 2023.
Reclassifications:
Certain reclassifications have been made to prior period financial statements to conform to the current financial statement presentation. These reclassifications had no effect on net income.
7
NOTE 2 – EARNINGS PER SHARE
Earnings per share (EPS) have been computed based on the weighted average number of common shares outstanding during the periods presented. There were no anti-dilutive shares in 2021 or 2020. The average number of common shares used in the computation of basic and diluted earnings per share are set forth in the tables below:
8
NOTE 3 – BUSINESS COMBINATION
Effective June 5, 2020, the Company acquired Edon Bancorp and its subsidiary, The Edon State Bank Company of Edon, Ohio. Edon was headquartered in Edon, Ohio and had one retail banking office. At the closing of the acquisition, Edon Bancorp was merged with and into the Company, with the Company surviving, and Edon State Bank (“Edon State Bank”) was merged with and into State Bank, with State Bank surviving. Under the terms of the merger agreement, shareholders of Edon received fixed consideration of $103.50 in cash for each share of Edon common stock for total consideration of $15.5million. The Company accounted for the transaction under the acquisition method of accounting, which means that the acquired assets and liabilities were recorded at fair value at the date of acquisition.
In accordance with ASC 805, the Company expensed approximately $1.2 million of direct acquisition costs during the three months ended June 30, 2020, and no additional merger expense was recorded in the three months ended June 30, 2021. The $1.2 million in merger expense is split between data processing and professional fees expense. As a result of the acquisition, the Company recorded $4.3 million of goodwill and $0.7 million of intangible assets in the second quarter of 2020. The Company was able to increase both its deposit and loan base and acquire new households in a new market. It is expected that this transaction will result in business synergies and economies of scale. The acquisition was consistent with the Company’s strategy to expand its presence in Northwest Ohio and to increase profitability by introducing existing products and services to the acquired customer base. The intangible assets are related to core deposits, which are being amortized over 10 years on a straight-line basis. For tax purposes, goodwill is non-deductible but will be evaluated annually for impairment.
The following table summarizes the fair value of the total consideration transferred as part of the acquisition as well as the fair value of identifiable assets and liabilities assumed as of the effective date of the Edon transaction based on assumptions that are subject to change as management continues to evaluate relevant information as it becomes available. If, prior to the end of the one-year measurement period for finalizing the purchase price allocation, relevant information becomes available which would indicate adjustments are required to the purchase price allocation, such adjustments will be recorded in the reporting period in which the adjustment amounts are determined. Potential adjustments, if any, will be related to assets that may have changes to valuation amounts that were not readily determinable at the acquisition date.
The contractual principal of loans at the acquisition date was $16.3 million and the estimate of the contractual cash flows not expected to be collected is $0.4 million.
9
Pro Forma Financial Information
The results of operations of Edon have been included in the Company’s consolidated financial statements since the acquisition date of June 5, 2020. The following schedule includes the pro forma results for the three and six months ended June 30, 2021 and 2020, as if the Edon acquisition had occurred as of the beginning of the reporting periods presented. The acquisition would have increased revenue by approximately $0.2 and $0.5 million respectively and reduced net income by approximately $0.5 and $0.4 million respectively for the three and six months ended June 30, 2020.
10
Note 4 – AVAILABLE FOR SALE Securities
The amortized cost and appropriate fair values, together with gross unrealized gains and losses, of securities at June 30, 2021 and December 31, 2020 were as follows:
The amortized cost and fair value of securities available for sale at June 30, 2021, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
The fair value of securities pledged as collateral, to secure public deposits and for other purposes, was $50.6 million at June 30, 2021 and $53.7 million at December 31, 2020. The fair value of securities delivered for repurchase agreements was $27.3 million at June 30, 2021 and $28.2 million at December 31, 2020.
There were no realized gains and losses from sales of available-for-sale securities for the three and six months ended June 30, 2021 or June 30, 2020.
11
Certain investments in debt securities are reported in the consolidated financial statements at an amount less than their historical cost. Total fair value of these investments was $118.1million at June 30, 2021, and $27.3 million at December 31, 2020, which was approximately 56 and 18 percent, respectively, of the Company’s available-for-sale investment portfolio at such dates. Based on evaluation of available evidence, including recent changes in market interest rates, credit rating information and information obtained from regulatory filings, management believes the declines in fair value for these securities are temporary. Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified.
Securities with unrealized losses, aggregated by investment class and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2021 and December 31, 2020 are as follows:
The total unrealized loss in the securities portfolio was $1.5 million as of June 30, 2021 compared to a $0.06 million unrealized loss at December 31, 2020. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concern warrants such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent of the Company to not sell the investment and whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost. Management has determined there is no other-than-temporary-impairment on its securities as of June 30, 2021.
NOTE 5 – LOANS AND ALLOWANCE FOR LOAN LOSSES
Loans that management has the intent and ability to hold for the foreseeable future, or until maturity or payoffs, are reported at their outstanding principal balances adjusted for any charge-offs, the allowance for loan losses, any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Generally, all loan classes are placed on nonaccrual status not later than 90 days past due, unless the loan is well-secured and in the process of collection. All interest accrued, but not collected, for loans that are placed on nonaccrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
12
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to income. Loan losses are charged against the allowance when management believes the non-collectability of a loan balance is probable. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as new information becomes available.
The allowance consists of allocated and general components. The allocated component relates to loans that are classified as impaired. For those loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers nonclassified loans and is based on historical charge-off experience and expected loss given default derived from the Company’s internal risk rating process. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data.
A loan is considered impaired when, based on current information and events, it is probable that State Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration each of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial, agricultural, and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral if the loan is collateral dependent.
When State Bank moves a loan to nonaccrual status, total unpaid interest accrued to date is reversed from income. Subsequent payments are applied to the outstanding principal balance with the interest portion of the payment recorded on the balance sheet as a contra-loan. Interest received on impaired loans may be realized once all contractual principal amounts are received or when a borrower establishes a history of six consecutive timely principal and interest payments. It is at the discretion of management to determine when a loan is placed back on accrual status upon receipt of six consecutive timely payments.
Large groups of smaller balance homogenous loans are collectively evaluated for impairment. Accordingly, State Bank does not separately identify individual consumer and residential loans for impairment measurements, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.
13
Categories of loans at June 30, 2021 and December 31, 2020 include:
The risk characteristics of each loan portfolio segment are as follows:
Commercial & Industrial and Agricultural
Commercial & industrial and agricultural loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and may include a personal guarantee. Short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.
Commercial Real Estate (Owner and Nonowner Occupied)
Commercial real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The characteristics of properties securing the Company’s commercial real estate portfolio are diverse, but with geographic location almost entirely in the Company’s market area. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. In general, the Company avoids financing single purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate versus non-owner-occupied loans.
Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews and financial analysis of the developers and property owners. Construction loans are generally based on estimates of costs and value associated with the completed project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.
14
Residential Real Estate, HELOC and Consumer
Residential and consumer loans consist of two segments – residential mortgage loans and personal loans. Residential mortgage loans are secured by 1-4 family residences and are generally owner-occupied, and the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. HELOCs are typically secured by a subordinate interest in 1-4 family residences, and consumer personal loans are secured by consumer personal assets, such as automobiles or recreational vehicles. Some consumer personal loans are unsecured, such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas, such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that these loans are of smaller individual amounts and spread over a large number of borrowers.
The following tables present the activity in the allowance for loan losses and the recorded investment in loans based on portfolio segment and impairment method as of June 30, 2021, December 31, 2020 and June 30, 2020.
($ in thousands)
15
Credit Risk Profile
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes loans with an outstanding balance greater than $100,000and non-homogeneous loans, such as commercial and commercial real estate loans. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings:
Pass (grades 1 – 4):Loans which management has determined to be performing as expected and in agreement with the terms established at the time of loan origination.
16
Special Mention (5):Assets have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Company’s credit position at some future date. Special mention assets are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification. Ordinarily, special mention credits have characteristics which corrective management action would remedy.
Substandard (6): Loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Doubtful (7): Loans classified as doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of current known facts, conditions and values, highly questionable and improbable.
Loss (8): Loans are considered uncollectable and of such little value that continuing to carry them as assets on the Company’s financial statement is not warranted. Loans will be classified Loss when it is neither practical nor desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.
The following tables present the credit risk profile of the Company’s loan portfolio based on rating category as of June 30, 2021 and December 31, 2020.
The Company evaluates the loan risk grading system definitions and allowance for loan loss methodology on an ongoing basis.
17
The following tables present the Company’s loan portfolio aging analysis as of June 30, 2021 and December 31, 2020.
All loans past due 90 days are systematically placed on nonaccrual status.
A loan is considered impaired, in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events, it is probable State Bank will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming commercial loans but also include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.
18
The following tables present impaired loan information as of and for the three and six months ended June 30, 2021 and 2020, and for the twelve months ended December 31, 2020:
19
Impaired loans less than $100,000 are included in groups of homogenous loans. These loans are evaluated based on delinquency status.
Interest income recognized on a cash basis does not materially differ from interest income recognized on an accrual basis.
20
Troubled Debt Restructured (TDR) Loans
TDRs are modified loans where a concession was provided to a borrower experiencing financial difficulties. Loan modifications are considered TDRs when the concessions provided are not available to the borrower through either normal channels or other sources. However, not all loan modifications are TDRs.
TDR Concession Types
The Company’s standards relating to loan modifications consider, among other factors, minimum verified income requirements, cash flow analysis, and collateral valuations. Each potential loan modification is reviewed individually and the terms of the loan are modified to meet a borrower’s specific circumstances at a point in time. All loan modifications, including those classified as TDRs, are reviewed and approved by management. The types of concessions provided to borrowers include:
The following table represents new TDR activity for the three and six months ended June 30, 2021. During the three and six months ended June 30, 2020, the Company had no new TDR activity.
21
There were no TDRs modified during the past twelve months that have subsequently defaulted.
On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which extends the duration of loan forbearance (deferral) agreements beyond the current three-month period before a loan is considered to be a TDR. As of June 30, 2021, the Company had no loans on COIVD-related deferral.
As of June 30, 2021, the company had $1.6 million in commercial real estate in Foreclosed Assets Held for Sale. Foreclosed assets held for sale at December 31, 2020, was $.02 million.
NOTE 6 – ACCOUNTING FOR CERTAIN LOANS ACQUIRED IN A TRANSFER
The Company acquired loans in the acquisition of The Edon State Bank Company of Edon, Ohio, effective June 5, 2020. None of the acquired loans had evidence of deterioration of credit quality since origination, and it was probable, at acquisition, that all contractually required payments would be collected.
The following table presents the carrying amount of the acquired loans included in the consolidated balance sheet as of June 30, 2021:
Accretable yield, or income expected to be collected as of June 30, 2021 was $0.3 million.
NOTE 7 – MORTGAGE SERVICING RIGHTS
Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balance of mortgage loans serviced for others approximated $1.3billion at June 30, 2021 and $1.3 billion at December 31, 2020. Contractually specified servicing fees of $0.8 million and $1.7 million were included in mortgage loan servicing fees in the consolidated income statement for the three months and six months ended June 30, 2021, respectively. Servicing fees of $0.8 million and $1.5 million were included for the three and six months ended June 30, 2020, respectively.
The following table summarizes mortgage servicing rights capitalized and related amortization, along with activity in the related valuation allowance:
22
NOTE 8 – GOODWILL
A summary of the activity in goodwill is presented below:
Goodwill is not amortized but is evaluated for impairment annually, and on an interim basis if events or circumstances change that indicate an impairment may exist. When assessing goodwill for impairment, first, a qualitative assessment can be made to determine whether it is more likely than not that the estimated fair value of a reporting unit is less that its estimated carrying value. If the results of the qualitative assessment are not conclusive, a quantitative goodwill test is performed. Alternatively, a quantitative goodwill test can be performed without performing a qualitative assessment.
Goodwill was assessed for impairment using a quantitative test performed as of September 30, 2020 and reevaluated as of December 31, 2020. The Company again reviewed goodwill as of June 30, 2021 and the estimated fair value of the reporting unit exceeded the net carrying value, and therefore no goodwill impairment existed as of that date. No events or circumstances since the December 31, 2020 impairment test were noted that would indicate it was more likely than not a goodwill impairment exists.
NOTE 9 – DERIVATIVE FINANCIAL INSTRUMENTS
Risk Management Objective of Using Derivatives
The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company manages its exposures to a wide variety of business and operational risks primarily through management of its core business activities. The Company manages economic risks, including interest rate, liquidity and credit risk, primarily by managing the amount, sources and duration of its assets and liabilities and through the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing and duration of the Company’s known or expected cash payments principally related to certain variable-rate assets.
23
Non-designated Hedges
The Company does not use derivatives for trading or speculative purposes. Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings.
Additionally, the Company enters into forward contracts for the future delivery of mortgage loans to third-party investors and enters into Interest Rate Lock Commitments (“IRLCs”) with potential borrowers to fund specific mortgage loans that will be sold into the secondary market. The forward contracts that are entered into, economically hedge the effect of changes in interest rates resulting from the Company’s commitment to fund the loans. The IRLCs and forward contracts are not designated as accounting hedges and are recorded at fair value with changes in fair value reflected in noninterest income on the consolidated statements of income. The fair value of derivative instruments with a positive fair value are reported in accrued income and other assets in the consolidated balance sheets, while derivative instruments with a negative fair value are reported in accrued expenses and other liabilities in the consolidated balance sheets.
The table below presents the notional amount and fair value of the Company’s interest rate swaps, IRLCs and forward contracts utilized as of June 30, 2021 and December 31, 2020.
The fair value of interest rate swaps were estimated using a discounted cash flow method that incorporates current market interest rates as of the balance sheet date. Fair values of IRLCs and forward contracts were estimated using changes in mortgage interest rates from the date the Company entered into the IRLC and the balance sheet date.
The following table presents the amounts included in the consolidated statements of income for non-hedging derivative financial instruments for the six months ended June 30, 2021 and 2020.
24
The following table shows the offsetting of financial assets and derivative assets at June 30, 2021 and December 31, 2020.
The following table shows the offsetting of financial liabilities and derivative liabilities at June 30, 2021 and December 31, 2020.
NOTE 10 – SHORT-TERM BORROWINGS
The Company has retail repurchase agreements to facilitate cash management transactions with commercial customers. These obligations are secured by agency and mortgage-backed securities and such collateral is held by the Federal Home Loan Bank (“FHLB”). These securities have various maturity dates from 2022 through 2061. As of June 30, 2021, these repurchase agreements were secured by securities totaling $27.3 million. The repurchase agreements mature within one month.
The Company has borrowing capabilities at the Federal Reserve Discount Window by pledging either securities or loans as collateral. As of June 30, 2021, there was no collateral pledged or borrowings drawn at the Discount Window.
The Company participated in the Paycheck Protection Program (“PPP”) and, as a result, has the ability to borrow from the Federal Reserve’s special purpose Paycheck Protection Program Liquidity Facility (“PPPLF”) for additional funding. At June 30, 2021, there were no borrowings from the PPPLF.
At June 30, 2021 and December 31, 2020, the Company had $41.0 million in federal funds lines, of which none was drawn.
25
NOTE 11 – FEDERAL HOME LOAN BANK ADVANCES
The Company’s FHLB advances were secured by $147.5 million in mortgage loans at June 30, 2021. Advances, at interest rates from 2.88 to 2.93 percent, are subject to restrictions or penalties in the event of prepayment. Aggregate annual maturities of FHLB advances at June 30, 2021 were:
NOTE 12 – TRUST PREFERRED SECURITIES
On September 15, 2005, RST II, a wholly-owned subsidiary of the Company, closed a pooled private offering of 10,000 Capital Securities with a liquidation amount of $1,000 per security. The proceeds of the offering were loaned to the Company in exchange for junior subordinated debentures with terms similar to the Capital Securities. Distributions on the Capital Securities are payable quarterly at a variable rate that is based upon the 3-month LIBOR plus 1.80 percent and are included in interest expense in the consolidated financial statements. These securities may be included in Tier 1 capital and may be prepaid at any time without penalty (with certain limitations applicable) under current regulatory guidelines and interpretations. The balance of the Capital Securities as of June 30, 2021 and December 31, 2020 was $10.3 million, with a maturity date of September 15, 2035.
NOTE 13 – SUBORDINATED DEBT
On May 27, 2021, the Company entered into Subordinated Note Purchase Agreements (collectively, the “Purchase Agreements’’) with qualified institutional buyers and accredited investors (collectively, the “Purchasers”) pursuant to which the Company issued and sold $20.0 million in aggregate principal amount of its 3.65% Fixed to Floating Rate Subordinated Notes due 2031 (the “Notes”). The Notes were sold by the Company in a privateplacement exempt from the registration requirements under the Securities Act of 1933, as amended.The Notes mature on June 1, 2031 and bear interest at a fixed rate of 3.65% through May 31, 2026. From June 1, 2026 to the maturity date or earlier redemption of the Notes, the interest rate will reset quarterly to an interest rate per annum, equal to the then-current-three-month Secured Overnight Financing Rate (“SOFR”) provided by the Federal Reserve Bank of New York plus 296 basis points. The Company may redeem the Notes at any time after May 31, 2026, and at any time in whole, but not in part, upon the occurrence of certain events. Any redemption of the Notes will be subject to prior regulatory approval. The Company incurred debt issuance costs for placement fees, legal and other out-of-pocket expenses of approximately $0.5 million, which are being amortized over the life of the Notes.
26
NOTE 14 – FAIR VALUE OF ASSETS AND LIABILITIES
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value measurement must maximize the use of observable inputs and minimize the use of unobservable inputs. There is a hierarchy of three levels of inputs that may be used to measure fair value:
Following is a description of the valuation methodologies and inputs used for assets measured at fair value on a recurring basis, recognized in the accompanying consolidated balance sheets, as well as the general classifications of such assets pursuant to the valuation hierarchy.
Available-for-Sale Securities
The fair values of available-for-sale securities are determined by various valuation methodologies. Level 1 securities include money market mutual funds. Level 1 inputs include quoted prices in an active market. Level 2 securities include U.S. treasury and government agencies, mortgage-backed securities, and obligations of political and state subdivisions. Level 2 inputs do not include quoted prices for individual securities in active markets; however, they do include inputs that are either directly or indirectly observable for the individual security being valued. Such observable inputs include interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, credit risks and default rates. Also included are inputs derived principally from or corroborated by observable market data by correlation or other means.
Interest Rate Contracts
The fair values of interest rate contracts are based upon the estimated amount the Company would receive or pay to terminate the contracts or agreements, taking into account underlying interest rates, creditworthiness of underlying customers for credit derivatives and, when appropriate, the creditworthiness of the counterparties.
Forward contracts
The fair values of forward contracts on to-be-announced securities are determined using quoted prices in active markets, or benchmarked thereto (Level 1).
Interest Rate Lock Commitments (IRLCs)
The fair value of IRLCs are determined using the projected sale price of individual loans based on changes in the market interest rates, projected pull-through rates (the probability that an IRLC will ultimately result in an originated loan), the reduction in the value of the applicant’s option due to the passage of time, and the remaining origination costs to be incurred based on management’s estimate of market costs (Level 3).
27
The following table presents the fair value measurements of assets measured at fair value on a recurring basis and the level within the fair value hierarchy in which the fair value measurements fell at June 30, 2021 and December 31, 2020.
Level 1 - quoted prices in active markets for identical assets
Level 2 - significant other observable inputs
Level 3 - significant unobservable inputs
The following table reconciles the beginning and ending balances of recurring fair value measurements recognized in the accompanying consolidated balance sheets using significant unobservable (Level 3) inputs for the three and six months ended June 30, 2021 and 2020.
28
The following is a description of the valuation methodologies and inputs used for assets measured at fair value on a nonrecurring basis and recognized in the accompanying consolidated balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.
Collateral-dependent Impaired Loans, Net of ALLL
Loans for which it is probable the Company will not collect all principal and interest due according to contractual terms are measured for impairment. The estimated fair value of collateral-dependent impaired loans is based on the appraised value of the collateral, less estimated cost to sell. Collateral-dependent impaired loans are classified within Level 3 of the fair value hierarchy. This method requires obtaining an independent appraisal of the collateral, which is reviewed for accuracy and consistency by Credit Administration. These appraisers are selected from the list of approved appraisers maintained by management. The appraised values are reduced by applying a discount factor to the value based on the Company’s loan review policy. All impaired loans held by the Company were collateral dependent at June 30, 2021 and December 31, 2020.
Mortgage Servicing Rights
Mortgage servicing rights do not trade in an active, open market with readily observable prices. Accordingly, fair value is estimated using discounted cash flow models associated with the servicing rights and discounting the cash flows using discount market rates, prepayment speeds and default rates. The servicing portfolio has been valued using all relevant positive and negative cash flows including servicing fees; miscellaneous income and float; marginal costs of servicing; the cost of carry of advances; and foreclosure losses; and applying certain prevailing assumptions used in the marketplace. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the hierarchy. These mortgage servicing rights are tested for impairment on a quarterly basis.
29
Unobservable (Level 3) Inputs
The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements.
There were no changes in the inputs or methodologies used to determine fair value at June 30, 2021 as compared to December 31, 2020.
The following methods were used to estimate the fair value of all other financial instruments recognized in the accompanying consolidated balance sheets at amounts other than fair value.
Cash and Due From Banks, Federal Reserve and Federal Home Loan Bank Stock and Accrued Interest Receivable and Payable
The carrying amount approximates the fair value.
30
Loans Held for Sale
The fair value of loans held for sale is based upon quoted market prices, where available, or is determined by discounting estimated cash flows using interest rates approximating the Company’s current origination rates for similar loans and adjusted to reflect the inherent credit risk.
Loans
The estimated fair value of loans as of June 30, 2021 follows the guidance in ASU 2016-01, which prescribes an “exit price” approach in estimating and disclosing fair value of financial instruments. The fair value calculation at that date discounted estimated future cash flows using rates that incorporated discounts for credit, liquidity, and marketability factors.
Deposits, FHLB Advances & Repurchase Agreements
Deposits include demand deposits, savings accounts, and certain money market deposits. The carrying amount approximates the fair value. The estimated fair value for fixed-maturity time deposits, as well as borrowings, is based on estimates of the rate State Bank could pay on similar instruments with similar terms and maturities at June 30, 2021 and December 31, 2020.
Loan Commitments
The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The estimated fair values for other financial instruments and off-balance-sheet loan commitments approximate cost at June 30, 2021 and December 31, 2020 and are not considered significant to this presentation.
Trust Preferred Securities
The fair value for Trust Preferred Securities is estimated by discounting the cash flows using an appropriate discount rate.
Subordinated Debt
The fair value for subordinated debt is estimated by discounting the cash flows using a discount rate equal to the rate currently offered on similar borrowings.
31
The following table presents estimated fair values of the Company’s other financial instruments carried at other than fair value. The fair values of certain of these instruments were calculated by discounting expected cash flows, which involves significant judgments by management and uncertainties. Fair value is the estimated amount at which financial assets or liabilities could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Because no market exists for certain of these financial instruments, and because management does not intend to sell these financial instruments, the Company does not know whether the fair values shown below represent values at which the respective financial instruments could be sold individually or in the aggregate.
NOTE 15 – SHARE BASED COMPENSATION
In April 2017, the Company’s shareholders approved a new share-based incentive compensation plan, the SB Financial Group, Inc. 2017 Stock Incentive Plan (the “2017 Plan”), which replaced the Company’s 2008 Stock Incentive Plan. The 2017 Plan permits the Company to grant or award incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, and restricted stock units to employees and directors of the Company and its subsidiaries. A total of 500,000 common shares of the Company are available for grants or awards under the 2017 Plan, of which 89,763 shares had been granted under the plan as of June 30, 2021.
32
The 2017 Plan is intended to advance the interests of the Company and its shareholders by offering employees, directors and advisory board members of the Company and its subsidiaries an opportunity to acquire or increase their ownership interest in the Company through grants of equity-based awards. The 2017 Plan permits equity-based awards to be used to attract, motivate, reward and retain highly competent individuals upon whose judgment, initiative, leadership and efforts are key to the success of the Company by encouraging those individuals to become shareholders of the Company.
Stock option awards are granted with an exercise price equal to the market price of the Company’s stock at the date of grant and those option awards vest based on 5 years of continuous service and have 10-year contractual terms. The fair value of each option award is estimated on the date of grant using the Black-Scholes valuation model.
As of June 30, 2021, there were no stock options outstanding, and no unrecognized compensation cost related to stock option awards. No stock options were granted in the first six months of 2021.
On February 5, 2013, the Company adopted a Long Term Incentive (LTI) Plan, which provides for awards of restricted stock in the Company to certain key executives. These restricted stock awards vest over a four-year period and are intended to assist the Company in retention of key executives. During 2020, the Company met certain performance targets under the LTI Plan and restricted stock awards were approved and issued in February 2021. The compensation cost charged against income for the LTI Plan was $0.2 million, with a total income tax benefit recognized in the income statement of $0.04 million.
As of June 30, 2021, there was $0.74 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements related to the restricted stock awards under the 2017 Plan which were granted in accordance with the LTI plan. That cost is expected to be recognized over a weighted-average period of 2.6 years.
A summary of restricted stock activity under the Company’s 2017 Plan as of June 30, 2021 and changes during the quarter then ended, is presented below:
NOTE 16 – GENERAL LITIGATION
The Company is subject to claims and lawsuits that arise primarily in the ordinary course of business. Additionally, the Company is subject to periodic examinations by various regulatory agencies. It is the opinion of management that the disposition or ultimate resolution of any such claims, lawsuits and examinations pending at June 30, 2021, will not have a material adverse effect on the consolidated financial position, results of operations and cash flow of the Company.
33
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward-Looking Information
This Quarterly Report on Form 10-Q, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains certain forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. Forward-looking statements provide current expectations or forecasts of future events and are not guarantees of future performance. Examples of forward-looking statements include: (a) projections of income or expense, earnings per share, the payment or non-payment of dividends, capital structure and other financial items; (b) statements of plans and objectives of the Company or our management or Board of Directors, including those relating to products or services; (c) statements of future economic performance; (d) statements regarding future customer attraction or retention; and (e) statements of assumptions underlying such statements. Words such as “anticipates”, “believes”, “plans”, “intends”, “expects”, “projects”, “estimates”, “should”, “may”, “would be”, “will allow”, “will likely result”, “will continue”, “will remain”, or other similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying those statements. Forward-looking statements are based on management’s expectations and are subject to a number of risks and uncertainties. Although management believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from those expressed or implied in such statements. Risks and uncertainties that could cause actual results to differ materially include, without limitation, risks and uncertainties inherent in the national and regional banking industry including impacts from the COVID-19 pandemic on local, national and global economic conditions as well as the various governmental responses to the COVID-19 pandemic, including stimulus packages and programs; potential litigation or other risks related to participation in the U.S. Small Business Administration’s (“SBA”) Paycheck Protection Program (“PPP”); changes in economic conditions in the market areas in which the Company and its subsidiaries operate; changes in policies by regulatory agencies; the transition away from LIBOR as a reference rate for financial contracts; operating risks; changes in accounting standards and policies; changes in tax laws; fluctuations in interest rates; demand for loans in the market areas in which the Company and its subsidiaries operate; increases in FDIC insurance premiums; changes in the competitive environment; losses of significant customers; geopolitical events; and the loss of key personnel. Additional detailed information concerning a number of important factors which could cause actual results to differ materially from the forward-looking statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations is available in the Company’s filings with the Securities and Exchange Commission, including the risks identified under the heading “Item 1A. Risk Factors” of Part I of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020. Undue reliance should not be placed on the forward-looking statements, which speak only as of the date hereof. Except as may be required by law, the Company undertakes no obligation to update any forward-looking statement to reflect unanticipated events or circumstances after the date on which the statement is made.
Overview of SB Financial
SB Financial Group, Inc. (“SB Financial” or the “Company”) is an Ohio corporation and a financial holding company registered with the Federal Reserve Board. SB Financial’s wholly-owned subsidiary, The State Bank and Trust Company (“State Bank”), is an Ohio-chartered bank engaged in commercial banking.
Rurban Statutory Trust II (“RST II”) was established in August 2005. In September 2005, RST II completed a pooled private offering of 10,000 Trust Preferred Securities with a liquidation amount of $1,000 per security. The proceeds of the offering were loaned to SB Financial in exchange for junior subordinated debentures of SB Financial with terms substantially similar to the Trust Preferred Securities. The sole assets of RST II are the junior subordinated debentures, and the back-up obligations, in the aggregate, constitute a full and unconditional guarantee by SB Financial of the obligations of RST II.
RFCBC, Inc. (“RFCBC”) is an Ohio corporation and wholly-owned subsidiary of SB Financial that was incorporated in August 2004. RFCBC operates as a loan subsidiary in servicing and working out problem loans.
State Bank Insurance, LLC (“SBI”) is an Ohio corporation and a wholly-owned subsidiary of State Bank incorporated in June of 2010. SBI is an insurance company that engages in the sale of insurance products to retail and commercial customers of State Bank.
SBFG Title, LLC (“Title”) is an Ohio corporation that was formed in March 2019. SBFG Title engages in the sale of title insurance services.
34
SB Captive, Inc. (“Captive”) is a Nevada corporation that was formed in March 2019. SB Captive pools insurance risk among like sized banking institutions.
Unless the context indicates otherwise, all references herein to “we”, “us”, “our”, or the “Company” refer to SB Financial and its consolidated subsidiaries.
Critical Accounting Policies
Note 1 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020 describes the significant accounting policies used in the development and presentation of the Company’s financial statements. The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The Company’s financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company’s financial condition and results, and they require management to make estimates that are difficult, subjective, and/or complex.
Allowance for Loan Losses - The allowance for loan losses provides coverage for probable losses inherent in the Company’s loan portfolio. Management evaluates the adequacy of the allowance for loan losses each quarter based on changes, if any, in underwriting activities, loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management’s estimates of specific and expected losses, including volatility of default probabilities, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs.
The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan’s observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan’s effective interest rate.
Regardless of the extent of the Company’s analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors, including inherent delays in obtaining information regarding a customer’s financial condition or changes in their unique business conditions, the subjective nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are also factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company’s evaluation of imprecise risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment. To the extent that actual results differ from management’s estimates, additional loan loss provisions may be required that could adversely impact earnings for future periods.
Goodwill and Other Intangibles - The Company records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangibles, at fair value as required. Goodwill is subject, at a minimum, to annual tests for impairment. Other intangible assets are amortized over their estimated useful lives using straight-line or accelerated methods, and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount. The initial goodwill and other intangibles recorded and subsequent impairment analysis requires management to make subjective judgments concerning estimates of how the acquired asset will perform in the future. Events and factors that may significantly affect the estimates include, among others, customer attrition, changes in revenue growth trends, specific industry conditions and changes in competition. A decrease in earnings resulting from these or other factors could lead to an impairment of goodwill that could adversely impact earnings for future periods.
35
Three Months Ended June 30, 2021 compared to Three Months Ended June 30, 2020
Net Income: Net income for the second quarter of 2021 was $3.8 million compared to net income of $3.7 million for the second quarter of 2020, an increase of 2.9 percent. Earnings per diluted share (EPS) of $0.52 were up 10.6 percent from EPS of $0.47 for the second quarter of 2020. Net income for the second quarter of 2021 was negatively impacted by the Company’s temporary impairment of $0.1 million on its mortgage servicing rights. The 2020 second quarter was impacted by temporary impairment of mortgage servicing rights of $1.1 million and merger costs of $1.2 million.
The Consolidated Appropriations Act, 2021, which was signed into law on December 27, 2020, provided additional PPP funding of $284.5 billion and the establishment of PPP Second Draw Loans under the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the “Relief Act”.) The Company continued its participation in the CARES Act pandemic response through the origination of loans under the PPP lending initiative. In the second phase of the initiative under the Relief Act, the Company originated $26.2 million in PPP loans during the quarter ended June 30, 2021. Total PPP loans outstanding at June 30, 2021 was $34.8 million, with $6.4 million remaining from Phase I and $28.4 million remaining from Phase II.
Provision for Loan Losses: The second quarter provision for loan losses was zero, compared to $1.3 million for the year-ago quarter as the Company recognized that risk in the portfolio has stabilized. The total reserve level of $13.3 million is up nearly 33 percent from the prior year and given that level zero provision for the quarter was appropriate. Net charge-offs for the quarter were $0.02 million compared to net charge-offs of $0.2 million for the year-ago quarter. Total delinquent loans ended the quarter at $3.5 million, or 0.41 percent of total loans, which is down $1.9 million from the prior year.
Asset Quality Review – For the Period Ended
Consolidated Revenue: Total revenue, consisting of net interest income and noninterest income, was $15.7 million for the second quarter of 2021, a decrease of $1.8 million, or 10.3 percent, from the $17.5 million generated during the second quarter of 2020.
Net interest income was $9.2 million, which is up $0.3 million from the prior year second quarter’s $8.9 million. The Company’s earning assets increased $177.7 million, coupled with a 70 basis point decrease in the yield on earning assets. The net interest margin (FTE) for the second quarter of 2021 was 2.94 percent compared to 3.32 percent for the second quarter of 2020. Funding costs for interest bearing liabilities for the second quarter of 2021 were 0.44 percent compared to 0.89 percent for the prior year second quarter.
Noninterest income was $6.5 million for the second quarter of 2021, which was down $2.1 million from the prior year second quarter’s $8.6 million. In addition to the mortgage revenue detailed below, wealth management revenue was $1.0 million. Impairment to our mortgage servicing rights decreased noninterest income by $0.1 million in the quarter. Our title agency contributed revenue of $0.5 million in the second quarter of 2021, down $0.1 million from the prior year. Noninterest income as a percentage of average assets for the second quarter of 2021 was 1.97 percent compared to 2.95 percent for the prior year second quarter.
36
State Bank originated $164.9 million of mortgage loans for the second quarter of 2021, of which $119.1 million was sold with the remainder of loans held for investment. This compares to $223.7 million originated for the second quarter of 2020, of which $204.6 million was sold with the remainder of loans held for investment. These second quarter 2021 originations and subsequent sales resulted in $4.3 million of gains, down $3.9 million from the gains for the second quarter of 2020. Net mortgage banking revenue was $4.0 million for the second quarter of 2021 compared to $6.2 million for the second quarter of 2020. The 2021 second quarter included a $0.1 million impairment to our mortgage servicing rights compared to a $1.1 million valuation impairment for the second quarter of 2020.
Consolidated Noninterest Expense: Noninterest expense for the second quarter of 2021 was $11.1 million, which was down $0.6 million compared to $11.7 million in the prior-year second quarter. The second quarter of 2021 included lower commission and incentives on mortgage sales and title volume. The second quarter of 2020 included $1.2 million in one-time merger related expenses.
Income Taxes: Income taxes for the second quarter of 2021 were $0.9 million (effective rate of 18.6 percent) compared to $0.9 million (effective rate of 19.2 percent) for the second quarter of 2020.
Six Months Ended June 30, 2021 compared to Six Months Ended June 30, 2020
Net Income: Net income for the first six months of 2021 was $10.8 million compared to net income of $4.3 million for the first six months of 2020, an increase of 150 percent. Earnings per diluted share (EPS) for the period of $1.49 were up 166 percent from EPS of $0.56 for the prior year six-month period.
Provision for Loan Losses: The provision for loan losses for the first six months of 2021 was $0.8 million compared to $1.9 million for the prior year first six months. Net charge offs for the period were $0.02 million compared to net charge offs of $0.6 million for the prior year six-month period.
Consolidated Revenue: Total revenue, consisting of net interest income and noninterest income, was $36.2 million for the first six months of 2021, an increase of $8.0 million, or 28.5 percent, from the $28.2 million generated during the 2020 first six months.
Net interest income was $18.8 million, which is up $1.4 million from net interest income of $17.4 million for the prior year first six months. The Company’s earning assets increased $199.2 million, and had a 73 basis point decrease in the yield on earning assets for the first six months of 2021. The net interest margin (FTE) for the first six months of 2021 was 3.07 percent compared to 3.40 percent for the first six months of 2020. Funding costs for interest bearing liabilities for the first six months of 2021 were 0.47 percent compared to 1.00 percent for the prior year first six months.
Noninterest income was $17.5 million for the first six months of 2021, which is up $6.7 million from noninterest income of $10.8 million for the prior year first six months. In addition to the mortgage revenue detailed below, gains from the sale of non-mortgage loans was $0.1 million, compared to $0.2 million for the same period in 2020. For the first six months, the Company had a mortgage servicing rights recapture of $2.6 million compared to mortgage servicing rights impairment in the first six months of 2020 of $3.3 million.
State Bank originated $320.7 million of mortgage loans during the first six months of 2021, of which $255.8 million of loans were sold with the remainder of loans held for investment. These levels were down 1 and 12 percent, respectively, as compared to the prior year first six months.
Consolidated Noninterest Expense: Noninterest expense for the first six months of 2021 was $22.0 million, which is up $0.9 million compared to $21.1 million in the prior year first six months. The increase in noninterest expenses compared to the prior year was due to increases in staffing and benefit costs and expenses for SBFG Title, which offset the $1.2 million in Edon merger expenses from the prior year.
Income Taxes: Income taxes for the first six months of 2021 were $2.7 million (effective rate of 19.7 percent) compared to $0.9 million (effective rate of 17.1 percent) for the first six months of 2020.
37
Changes in Financial Condition
Total assets at June 30, 2021 were $1,312.5 million, an increase of $54.7 million or 4.3 percent since December 2020 year end. Total loans, net of unearned income, were $850.5 million as of June 30, 2021, down $22.2 million or 2.5 percent, from year-end. Total PPP loan balances added $34.8 million to our total loans at June 30, 2021.
Total deposits at June 30, 2021 were $1,091.0 million, an increase of $42.0 million or 4.0 percent since 2020 year end. Borrowed funds (consisting of FHLB advances, REPOs, Trust Preferreds and subordinated debt) totaled $60.4 million at June 30, 2021. This is up from year-end when borrowed funds totaled $47.1 million due to an increase in REPOs and the subordinated debt. The subordinated debt issuance of $20 million during the quarter will be used for general corporate purposes. Total equity for the Company of $144.0 million now stands at 11.0 percent of total assets compared to the December 31, 2020 level of $142.9 million and 11.4 percent of total assets.
The allowance for loan loss of $13.3 million is up $0.8 million from the December 2020 year end level.
Capital Resources
As of June 30, 2021, based on the computations for the FFIEC 041 Consolidated Reports of Condition and Income filed by State Bank with the Federal Reserve, State Bank was classified as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, State Bank must maintain capital ratios as set forth in the table below. There are no conditions or events since June 30, 2021 that management believes have changed State Bank’s capital classification.
State Bank’s actual capital levels and ratios as of June 30, 2021 and December 31, 2020 are presented in the following table. Capital levels are presented for State Bank only as the Company is exempt from quarterly reporting on capital levels at the holding company level:
New regulatory capital requirements commonly referred to as “Basel III” were fully phased in as of January 1, 2019 and are reflected in the June 30, 2021 capital table above. Management opted out of the accumulated other comprehensive income treatment under the new requirements and as such unrealized gains and losses from available-for-sale securities will continue to be excluded from State Bank’s regulatory capital.
LIQUIDITY
Liquidity relates primarily to the Company’s ability to fund loan demand, meet deposit customers’ withdrawal requirements and provide for operating expenses. Assets used to satisfy these needs consist of cash and due from banks, federal funds sold, interest-earning deposits in other financial institutions, securities available-for-sale and loans held for sale. These assets are commonly referred to as liquid assets. Liquid assets were $378.4 million at June 30, 2021, compared to $303.2 million at December 31, 2020.
38
Liquidity risk arises from the possibility that the Company may not be able to meet the Company’s financial obligations and operating cash needs or may become overly reliant upon external funding sources. In order to manage this risk, the Board of Directors of the Company has established a Liquidity Policy that identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity and quantifies minimum liquidity requirements. This policy designates the Asset/Liability Committee (“ALCO”) as the body responsible for meeting these objectives. The ALCO reviews liquidity regularly and evaluates significant changes in strategies that affect balance sheet or cash flow positions. Liquidity is centrally managed on a daily basis by the Company’s Chief Financial Officer and Asset Liability Manager.
The Company’s commercial real estate, first mortgage residential, agricultural and multi-family mortgage portfolio of $643.4 million at June 30, 2021 and $608.4 million at December 31, 2020, which can and has been used to collateralize borrowings, is an additional source of liquidity. Management believes the Company’s current liquidity level, without these borrowings, is sufficient to meet its liquidity needs. At June 30, 2021, all eligible commercial real estate, first mortgage residential and multi-family mortgage loans were pledged under an FHLB blanket lien.
The cash flow statements for the periods presented provide an indication of the Company’s sources and uses of cash, as well as an indication of the ability of the Company to maintain an adequate level of liquidity. A discussion of the cash flow statements for the six months ended June 30, 2021 and 2020 follows.
The Company experienced positive cash flows from operating activities for the six months ended June 30, 2021 and negative cash flows for the six months ended June 30, 2020. Net cash provided by operating activities was $2.0 million for the six months ended June 30, 2021 and net cash used by operating activities was $.3 million for the six months ended June 30, 2020. Highlights for the current year include $255.8 million in proceeds from the sale of loans, which is down $33.3 million from the prior year. Originations of loans held for sale was a use of cash of $249.5 million, which is down from the prior year by $38.4 million. For the six months ended June 30, 2021, there was a gain on sale of loans of $10.2 million, and depreciation and amortization of $1.0 million.
The Company experienced negative cash flows from investing activities for the six months ended June 30, 2021 and June 30, 2020. Net cash flows used in investing activities was $43.4 million for the six months ended June 30, 2021 and $43.8 million for the six months ended June 30, 2020. Highlights for the current year include purchases of available-for-sale securities of $88.4 million. These cash payments were offset by $23.3 million in proceeds from maturities and sales of securities, which is down $38.5 million from the prior year six -month period. The Company experienced a $20.6 million decrease in loans, which is down $81.1 million from the prior year six -month period.
The Company experienced positive cash flows from financing activities for the six months ended June 30, 2021 and June 30, 2020. Net cash flow provided by financing activities was $55.6 million for the six months ended June 30, 2021 and $102.8 million for the six months ended June 30, 2020. Highlights for the current period include a $98.9.5 million increase in transaction deposits for the six months ended June 30, 2021, which is down $10.9 million from the prior year. Certificates of deposit decreased by $56.9 million in the current year compared to $10.5 million for the prior year. The issuance of subordinated debt during the quarter provided for $19.5 million in proceeds net of debt issuance costs.
ALCO uses an economic value of equity (“EVE”) analysis to measure risk in the balance sheet incorporating all cash flows over the estimated remaining life of all balance sheet positions. The EVE analysis calculates the net present value of the Company’s assets and liabilities in rate shock environments that range from -400 basis points to +400 basis points. The likelihood of a significant decrease in rates as of June 30, 2021 and December 31, 2020 was considered unlikely given the current interest rate environment and therefore, only the minus 100 basis point rate change was included in this analysis as of June 30, 2021 and only the minus 100 and minus 200 basis point rate change was included in this analysis as of December 31, 2020. The results of this analysis are reflected in the following tables for June 30, 2021 and December 31, 2020.
39
Economic Value of Equity
June 30, 2021
December 31, 2020
Off-Balance-Sheet Borrowing Arrangements:
Significant additional off-balance-sheet liquidity is available in the form of FHLB advances and unused federal funds lines from correspondent banks. Management expects the risk of changes in off-balance-sheet arrangements to be immaterial to earnings.
The Company’s commercial real estate, first mortgage residential, agricultural and multi-family mortgage portfolios in the total amount of $643.4 million were pledged to meet FHLB collateralization requirements as of June 30, 2021. Based on the current collateralization requirements of the FHLB, the Company had approximately $100.1 million of additional borrowing capacity at June 30, 2021. The Company also had $132.7 million in unpledged securities available to pledge for additional borrowings.
The Company’s contractual obligations as of June 30, 2021 were comprised of long-term debt obligations, other debt obligations, operating lease obligations and other long-term liabilities. Long-term debt obligations were comprised of FHLB Advances of $5.5 million, Trust Preferred Securities of $10.3 million, and Subordinated debt, net of issuance costs, of $19.5 million. Total time deposits at June 30, 2021 were $172.7 million, of which $69.6 million mature beyond one year.
In addition, as of June 30, 2021, the Company had commitments to sell mortgage loans totaling $52.1 million. The Company believes that it has adequate resources to fund commitments as they arise and that it can adjust the rate on savings certificates to retain deposits in changing interest rate environments. If the Company requires funds beyond its internal funding capabilities, advances from the FHLB of Cincinnati and other financial institutions are available.
ASSET LIABILITY MANAGEMENT
Asset liability management involves developing, executing and monitoring strategies to maintain appropriate liquidity, maximize net interest income and minimize the impact that significant fluctuations in market interest rates would have on current and future earnings. The business of the Company and the composition of its balance sheet consist of investments in interest-earning assets (primarily loans, mortgage-backed securities, and securities available for sale) which are primarily funded by interest-bearing liabilities (deposits and borrowings). With the exception of specific loans which are originated and held for sale, all of the financial instruments of the Company are for other than trading purposes. All of the Company’s transactions are denominated in U.S. dollars with no specific foreign exchange exposure. In addition, the Company has limited exposure to commodity prices related to agricultural loans. The impact of changes in foreign exchange rates and commodity prices on interest rates are assumed to be insignificant. The Company’s financial instruments have varying levels of sensitivity to changes in market interest rates resulting in market risk. Interest rate risk is the Company’s primary market risk exposure; to a lesser extent, liquidity risk also impacts market risk exposure.
40
Interest rate risk is the exposure of a banking institution’s financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to the Company’s earnings and capital base. Accordingly, effective risk management that maintains interest rate risks at prudent levels is essential to the Company’s safety and soundness.
Evaluating a financial institution’s exposure to changes in interest rates includes assessing both the adequacy of the management process used to control interest rate risk and the organization’s quantitative level of exposure. When assessing the interest rate risk management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risks at prudent levels of consistency and continuity. Evaluating the quantitative level of interest rate risk exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity and asset quality (when appropriate).
The Federal Reserve Board together with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Company adopted a Joint Agency Policy Statement on interest rate risk effective June 26, 1996. The policy statement provides guidance to examiners and bankers on sound practices for managing interest rate risk, which will form the basis for ongoing evaluation of the adequacy of interest rate risk management at supervised institutions. The policy statement also outlines fundamental elements of sound management that have been identified in prior Federal Reserve guidance and discusses the importance of these elements in the context of managing interest rate risk. Specifically, the guidance emphasizes the need for active board of director and senior management oversight and a comprehensive risk management process that effectively identifies, measures and controls interest rate risk.
Financial institutions derive their income primarily from the excess of interest collected over interest paid. The rates of interest an institution earns on its assets and owes on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, an institution is exposed to lower profit margins (or losses) if it cannot adapt to interest rate changes. For example, assume that an institution’s assets carry intermediate or long-term fixed rates and that those assets are funded with short-term liabilities. If market interest rates rise by the time the short-term liabilities must be refinanced, the increase in the institution’s interest expense on its liabilities may not be sufficiently offset if assets continue to earn at the long-term fixed rates. Accordingly, an institution’s profits could decrease on existing assets because the institution will either have lower net interest income or possibly, net interest expense. Similar risks exist when assets are subject to contractual interest rate ceilings, or rate-sensitive assets are funded by longer-term, fixed-rate liabilities in a declining rate environment.
There are several ways an institution can manage interest rate risk including: 1) matching repricing periods for new assets and liabilities, for example, by shortening or lengthening terms of new loans, investments, or liabilities; 2) selling existing assets or repaying certain liabilities; and 3) hedging existing assets, liabilities, or anticipated transactions. An institution might also invest in more complex financial instruments intended to hedge or otherwise change interest rate risk. Interest rate swaps, futures contracts, options on futures contracts, and other such derivative financial instruments can be used for this purpose. Because these instruments are sensitive to interest rate changes, they require management’s expertise to be effective. The Company does not currently utilize any derivative financial instruments to manage interest rate risk. As market conditions warrant, the Company may implement various interest rate risk management strategies, including the use of derivative financial instruments.
41
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Management believes there has been no material change in the Company’s market risk from the information contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) for the year ended December 31, 2020.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
With the participation of the President and Chief Executive Officer (the principal executive officer) and the Executive Vice President and Chief Financial Officer (the principal financial officer) of the Company, the Company’s management has evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the quarterly period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Company’s President and Chief Executive Officer and the Company’s Executive Vice President and Chief Financial Officer have concluded that:
Changes in Internal Control over Financial Reporting
There were no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the Company’s fiscal quarter ended June 30, 2021, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
42
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
In the ordinary course of our business, the Company and its subsidiaries are parties to various legal actions which we believe are incidental to the operation of our business. Although the ultimate outcome and amount of liability, if any, with respect to these legal actions cannot presently be ascertained with certainty, in the opinion of management, based upon information currently available to us, any resulting liability is not likely to have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.
Item 1A. Risk Factors
There are certain risks and uncertainties in our business that could cause our actual results to differ materially from those anticipated. A detailed discussion of our risk factors is included in “Item 1A. Risk Factors” of Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.
The following information supplements our risk factors previously disclosed in “Item 1A. Risk Factors” of Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.
Changes in the federal, state, or local tax laws may negatively impact our financial performance.
On March 31, 2021, President Biden unveiled his infrastructure plan, which includes a proposal to increase the federal corporate tax rate from 21% to 28% as part of a package of tax reforms to help fund the spending proposals in the plan. The Biden plan is in the early stages of the legislative process, which is expected to proceed this year due to the Democratic Party’s majority in both houses of Congress. If adopted as proposed, the increase of the corporate tax rate would adversely affect our results of operations in future periods.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
On May 25, 2021, the Company announced that its board of directors had approved a new share repurchase program authorizing the repurchase of up to 750,000 common shares of the Company through May 31, 2022. The table below sets forth information regarding common shares repurchased by the Company during the quarter ended June 30, 2021.
43
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Mine Safety Disclosures
Item 5. Other Information
Item 6. Exhibits
44
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
45