Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2020
Commission file number: 000-33063
SIERRA BANCORP
(Exact name of Registrant as specified in its charter)
California
33-0937517
(State of Incorporation)
(IRS Employer Identification No)
86 North Main Street, Porterville, California 93257
(Address of principal executive offices) (Zip Code)
(559) 782-4900
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading
Symbol(s)
Name of each exchange on which registered
Common Stock, no par value
BSRR
The NASDAQ Stock Market LLC
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer
☐
Accelerated Filer:
☒
Non-accelerated Filer:
Smaller Reporting Company:
Emerging Growth Company:
If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section7(a)(2)(B) of the Securities Act. ☐
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
As of August 1, 2020, the registrant had 15,192,838 shares of common stock outstanding.
Page
Part I - Financial Information
1
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets
Consolidated Statements of Income
2
Consolidated Statements of Comprehensive Income
3
Consolidated Statements of Changes In Stockholder’s Equity
4
Consolidated Statements of Cash Flows
6
Notes to Consolidated Financial Statements (Unaudited)
7
Item 2. Management’s Discussion & Analysis of Financial Condition & Results of Operations
35
Forward-Looking Statements
Critical Accounting Policies
Overview of the Results of Operations and Financial Condition
36
Earnings Performance
40
Net Interest Income and Net Interest Margin
Provision for Loan and Lease Losses
45
Noninterest Income and Noninterest Expense
46
Provision for Income Taxes
47
Balance Sheet Analysis
48
Earning Assets
Investments
Loan and Lease Portfolio
49
Nonperforming Assets
51
Allowance for Loan and Lease Losses
52
Off-Balance Sheet Arrangements
55
Other Assets
Deposits and Interest-Bearing Liabilities
Deposits
Other Interest-Bearing Liabilities
56
Noninterest Bearing Liabilities
57
Liquidity and Market Risk Management
Capital Resources
60
Item 3. Qualitative & Quantitative Disclosures about Market Risk
61
Item 4. Controls and Procedures
62
Part II - Other Information
63
Item 1. - Legal Proceedings
Item 1A. - Risk Factors
Item 2. - Unregistered Sales of Equity Securities and Use of Proceeds
64
Item 3. - Defaults upon Senior Securities
Item 4. - Mine Safety Disclosures
Item 5. - Other Information
Item 6. - Exhibits
65
Signatures
66
PART I - FINANCIAL INFORMATION
Item 1 – Financial Statements
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
June 30, 2020
December 31, 2019
ASSETS
(unaudited)
(audited)
Cash and due from banks
$
88,705
65,556
Interest-bearing deposits in banks
67,906
14,521
Total cash & cash equivalents
156,611
80,077
Securities available-for-sale
599,333
600,799
Loans and leases:
Gross loans and leases
2,212,097
1,762,565
Allowance for loan and lease losses
(13,560)
(9,923)
Deferred loan and lease (fees) costs, net
(2,617)
2,896
Net loans and leases
2,195,920
1,755,538
Foreclosed assets
2,893
800
Premises and equipment, net
27,779
27,435
Goodwill
27,357
Other intangible assets, net
4,844
5,381
Bank-owned life insurance
51,347
50,517
Other assets
43,960
45,915
Total assets
3,110,044
2,593,819
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Non-interest bearing
949,662
690,950
Interest bearing
1,557,092
1,477,424
Total deposits
2,506,754
2,168,374
Repurchase agreements
41,449
25,711
Short-term borrowings
163,000
20,000
Subordinated debentures, net
35,035
34,945
Other liabilities
36,373
35,504
Total liabilities
2,782,611
2,284,534
Commitments and contingent liabilities (Note 7)
Shareholders' equity
Common stock, no par value; 24,000,000 shares authorized; 15,192,838 and 15,284,538 shares issued and outstanding at June 30, 2020 and December 31, 2019, respectively
112,645
113,179
Additional paid-in capital
3,462
3,307
Retained earnings
195,147
186,867
Accumulated other comprehensive income (loss), net
16,179
5,932
Total shareholders' equity
327,433
309,285
Total liabilities and shareholders’ equity
The accompanying notes are an integral part of these consolidated financial statements
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2020 AND 2019
(dollars in thousands, except per share data, unaudited)
Three months ended June 30,
Six months ended June 30,
2020
2019
Interest and dividend income
Loans and leases, including fees
21,683
24,010
43,796
47,759
Taxable securities
2,250
2,591
4,710
5,207
Tax-exempt securities
1,440
1,072
2,778
2,117
Federal funds sold and other
12
115
153
188
Total interest income
25,385
27,788
51,437
55,271
Interest expense
893
3,093
2,727
6,048
39
26
75
97
Subordinated debentures
311
470
706
954
Total interest expense
1,243
3,589
3,508
7,099
Net interest income
24,142
24,199
47,929
48,172
Provision for loan and lease losses
2,200
400
4,000
700
Net interest income after provision for loan losses
21,942
23,799
43,929
47,472
Non-interest income
Service charges on deposits
2,618
3,151
5,802
6,094
Other income
4,282
2,704
7,205
5,668
Total non-interest income
6,900
5,855
13,007
11,762
Other operating expense
Salaries and employee benefits
9,266
8,994
19,438
18,237
Occupancy and equipment
2,504
2,450
4,832
4,811
Other
6,263
6,212
11,581
12,461
Total other operating expense
18,033
17,656
35,851
35,509
Income before taxes
10,809
11,998
21,085
23,725
Provision for income taxes
2,506
3,169
4,975
6,001
Net income
8,303
8,829
16,110
17,724
PER SHARE DATA
Book value
21.55
19.36
Cash dividends
0.20
0.18
0.40
0.36
Earnings per share basic
0.55
0.58
1.06
1.16
Earnings per share diluted
0.54
0.57
1.05
1.15
Average shares outstanding, basic
15,191,823
15,329,907
15,226,748
15,320,784
Average shares outstanding, diluted
15,237,655
15,458,320
15,288,009
15,453,212
Total shareholder equity (in thousands)
296,852
Shares outstanding
15,192,838
15,332,550
Dividends paid (in thousands)
3,038
2,759
6,097
5,513
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(dollars in thousands, unaudited)
Other comprehensive income, before tax:
Unrealized gains on securities:
Unrealized holding gain arising during period
4,037
9,324
14,939
15,491
Less: reclassification adjustment for (gains) losses included in net income (1)
(390)
(22)
(28)
Other comprehensive income, before tax
3,647
9,302
14,549
15,463
Income tax expense related to items of other comprehensive income, net of tax
(1,078)
(2,750)
(4,302)
(4,571)
Other comprehensive income
2,569
6,552
10,247
10,892
Comprehensive income
10,872
15,381
26,357
28,616
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE THREE MONTHS ENDED JUNE 30, 2020 AND 2019
Accumulated
Additional
Common Stock
Paid In
Retained
Comprehensive
Shareholders'
Shares
Amount
Capital
Earnings
(Loss) Income
Equity
Balance, March 31, 2019
15,328,030
113,001
3,135
170,258
(2,326)
284,068
Other comprehensive income, net of tax
Exercise of stock options
4,520
(14)
Stock compensation costs
116
Cash dividends - $0.18 per share
(2,759)
Balance, June 30, 2019
113,061
3,237
176,328
4,226
Balance, March 31, 2020
15,190,038
112,600
3,367
189,882
13,610
319,459
2,800
(11)
34
106
Cash dividends - $0.20 per share
(3,038)
Balance, June 30, 2020
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER’S EQUITY
FOR THE SIX MONTHS ENDED JUNE 30, 2020 AND 2019
Balance, December 31, 2018
15,300,460
112,507
3,066
164,117
(6,666)
273,024
32,090
554
(96)
458
267
Stock repurchase
—
Cash dividends - $0.36 per share
(5,513)
Balance, December 31, 2019
15,284,538
20,350
295
(80)
215
235
(112,050)
(829)
(1,733)
(2,562)
Cash dividends - $0.40 per share
(6,097)
5
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Gain on sales of securities
Loss on disposal of fixed assets
28
Loss (gain) on sale on foreclosed assets
(37)
Writedowns on foreclosed assets
69
Depreciation and amortization
1,540
1,496
Net amortization on securities premiums and discounts
2,227
2,107
Accretion of discounts for loans acquired and net deferred loan fees
(331)
(505)
Increase in cash surrender value of life insurance policies
(687)
(1,027)
Amortization of core deposit intangible
537
Increase in interest receivable and other assets
(2,241)
(1,213)
Increase (decrease) in other liabilities
869
(2,065)
Deferred income tax benefit
(230)
(27)
Increase in equity securities
(447)
(232)
Net amortization of partnership investment
571
900
Net cash provided by operating activities
21,765
18,694
Cash flows from investing activities:
Maturities and calls of securities available for sale
6,195
4,459
Proceeds from sales of securities available for sale
20,298
22,180
Purchases of securities available for sale
(59,578)
(72,330)
Principal pay downs on securities available for sale
47,263
42,288
Net purchases of FHLB stock
(833)
Loan originations and payments, net
(446,178)
(46,315)
Purchases of premises and equipment
(1,794)
(330)
Proceeds from sale premises and equipment
10
Proceeds from sales of foreclosed assets
32
7,955
Purchase of bank-owned life insurance
(182)
(292)
Liquidation of bank-owned life insurance
261
Net cash used in investing activities
(433,905)
(42,947)
Cash flows from financing activities:
Increase in deposits
338,380
62,758
Increase (decrease) in borrowed funds
143,000
(47,600)
Increase in repurchase agreements
15,738
7,808
Cash dividends paid
Repurchases of common stock
Stock options exercised
Net cash provided by financing activities
488,674
17,911
Increase (decrease) in cash and cash equivalents
76,534
(6,342)
Cash and cash equivalents
Beginning of period
74,132
End of period
67,790
Supplemental disclosure of cash flow information:
Interest paid
3,941
6,917
Income taxes paid
7,600
Supplemental noncash disclosures:
Real estate acquired through foreclosure
2,127
27
Operating right-of-use asset pursuant to adoption on ASU 2016-02
9,712
Operating lease liability pursuant to adoption of ASU 2016-02
10,336
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 – The Business of Sierra Bancorp
Sierra Bancorp (the “Company”) is a California corporation headquartered in Porterville, California, and is a registered bank holding company under federal banking laws. The Company was formed to serve as the holding company for Bank of the Sierra (the “Bank”), and has been the Bank’s sole shareholder since August 2001. The Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. As of June 30, 2020, the Company’s only other subsidiaries were Sierra Statutory Trust II, Sierra Capital Trust III, and Coast Bancorp Statutory Trust II, which were formed solely to facilitate the issuance of capital trust pass-through securities (“TRUPS”). Pursuant to the Financial Accounting Standards Board (“FASB”) standard on the consolidation of variable interest entities, these trusts are not reflected on a consolidated basis in the Company’s financial statements. References herein to the “Company” include Sierra Bancorp and its consolidated subsidiary, the Bank, unless the context indicates otherwise.
Bank of the Sierra, a California state-chartered bank headquartered in Porterville, California, offers a wide range of retail and commercial banking services via branch offices located throughout California’s South San Joaquin Valley, the Central Coast, Ventura County, the Sacramento area, and neighboring communities. The Bank was incorporated in September 1977, and opened for business in January 1978 as a one-branch bank with $1.5 million in capital. Our growth in the ensuing years has largely been organic in nature, but includes four whole-bank acquisitions: Sierra National Bank in 2000, Santa Clara Valley Bank in 2014, Coast National Bank in 2016, and Ojai Community Bank in October 2017. As of the filing date of this report the Bank operates 40 full service branches and an online branch, and maintains ATMs at all but one of our branch locations as well as seven non-branch locations. Moreover, the Bank has specialized lending units which focus on agricultural borrowers, SBA loans, and mortgage warehouse lending. In addition, the bank opened a loan production office in Rocklin, CA in February 2020. The Company had total assets of $3.1 billion at June 30, 2020, and for a number of years we have claimed the distinction of being the largest bank headquartered in the South San Joaquin Valley. The Bank’s deposit accounts, which totaled $2.5 billion at June 30, 2020, are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to maximum insurable amounts.
Note 2 – Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by U.S. generally accepted accounting principles (“GAAP”) for complete financial statements. The information furnished in these interim statements reflects all adjustments that are, in the opinion of Management, necessary for a fair statement of the results for such periods. Such adjustments can generally be considered as normal and recurring unless otherwise disclosed in this Form 10-Q. In preparing the accompanying financial statements, Management has taken subsequent events into consideration and recognized them where appropriate. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for any other quarter, or for the full year. Certain amounts reported for 2019 have been reclassified to be consistent with the reporting for 2020. The interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, as filed with the Securities and Exchange Commission (the “SEC”).
Note 3 – Current Accounting Developments
In September 2016 the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which eliminates the probable initial recognition threshold for credit losses in current U.S. GAAP, and instead requires an organization to record a current estimate of all expected credit losses over the contractual term for financial assets carried at amortized cost. This is commonly referred to as the current expected credit losses (“CECL”) methodology. Expected credit losses for financial assets held at the reporting date will be measured based on historical experience, current conditions, and reasonable and supportable forecasts. Another change
from existing U.S. GAAP involves the treatment of purchased credit deteriorated assets, which are more broadly defined than purchased credit impaired assets in current accounting standards. When such assets are purchased, institutions will estimate and record an allowance for credit losses that is added to the purchase price rather than being reported as a credit loss expense. Furthermore, ASU 2016-13 updates the measurement of credit losses on available-for-sale debt securities, by mandating that institutions record credit losses on available-for-sale debt securities through an allowance for credit losses rather than the current practice of writing down securities for other-than-temporary impairment. ASU 2016-13 will also require the enhancement of financial statement disclosures regarding estimates used in calculating credit losses. ASU 2016-13 does not change the existing write-off principle in U.S. GAAP or current nonaccrual practices, nor does it change accounting requirements for loans held for sale or certain other financial assets which are measured at the lower of amortized cost or fair value. As a public business entity that is an SEC filer, ASU 2016-13 became effective for the Company on January 1, 2020. On the effective date, institutions will apply the new accounting standard as follows: for financial assets carried at amortized cost, a cumulative-effect adjustment will be recognized on the balance sheet for any change in the related allowance for loan and lease losses generated by the adoption of the new standard; financial assets classified as purchased credit impaired assets prior to the effective date will be reclassified as purchased credit deteriorated assets as of the effective date, and will be grossed up for the related allowance for expected credit losses created as of the effective date; and, debt securities on which other-than-temporary impairment had been recognized prior to the effective date will transition to the new guidance prospectively with no change in their amortized cost basis. The Company adopted ASU 2016-13 on January 1, 2020, however, the Company elected under Section 4014 of the Coronavirus Aid, Relief and Economic Security (CARES) Act to defer the implementation of CECL until the earlier of when the national emergency related to the outbreak of COVID-19 ends or December 31, 2020. Although this deferral will still require CECL to be implemented as of January 1, 2020, the Company believes that the deferral will provide time to better assess the impact of the COVID-19 pandemic on the expected lifetime credit losses. While the ultimate impact cannot be definitively determined at this time, we believe the provisions of ASU 2016-13 will have a material adverse impact on our consolidated financial statements, particularly the level of our allowance for credit losses and shareholders’ equity.
In January 2017 the FASB issued ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Accounting for Goodwill Impairment. This guidance removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation, and goodwill impairment will simply be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. All other goodwill impairment guidance will remain largely unchanged. Entities will continue to have the option to perform a qualitative assessment to determine if a quantitative impairment test is necessary. The same one-step impairment test will be applied to goodwill at all reporting units, even those with zero or negative carrying amounts. Entities will be required to disclose the amount of goodwill at reporting units with zero or negative carrying amounts. The amendments in this update were effective for public business entities for fiscal years beginning after December 15, 2019. In accordance with ASU 2017-04, the Company performed a qualitative analysis of goodwill during the first and second quarters of 2020, and determined that a quantitative analysis was not necessary at this time. Thus, we have not been required to record any goodwill impairment to date.
In August 2018 the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement, as part of its disclosure framework project. Pursuant to this guidance, disclosures that will no longer be required include the following: transfers between Level 1 and Level 2 of the fair value hierarchy; transfers in and out of Level 3 for nonpublic entities, as well as purchases and issuances and the Level 3 roll forward; a company’s policy for determining when transfers between any of the three levels have occurred; the valuation processes used for Level 3 measurements; and, the changes in unrealized gains or losses presented in earnings for Level 3 instruments held at the balance sheet date for nonpublic entities. The following are additional disclosure requirements: for public entities, the changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 instruments held at the balance sheet date; for public entities, the range and weighted average of significant unobservable inputs used for Level 3 measurements, although for certain unobservable inputs the entity will be allowed to disclose other quantitative information in place of the weighted average to the extent that it would be a more reasonable and rational method to reflect the distribution of unobservable inputs; for nonpublic entities, some form of quantitative information about significant unobservable inputs used in Level 3 fair value measurements; and, for certain investments in entities that calculate the net asset value, disclosures will be required about the timing of liquidation and redemption restrictions lapsing if the latter has been communicated to the
8
reporting entity. The guidance also clarifies that the Level 3 measurement uncertainty disclosure should communicate information about the uncertainty at the balance sheet date. ASU 2018-13 is effective for all entities in fiscal years beginning after December 15, 2019, including interim periods. Early adoption is permitted. In addition, an entity may early adopt any of the removed or modified disclosures immediately and delay adoption of the new disclosures until the effective date. The Company adopted ASU 2018-13 effective January 1, 2020 which impacts the disclosure requirements for fair value measurement.
In May 2019, the FASB issued ASU 2019-05, Financial Instruments—Credit Losses (Topic 326), which provides transition relief for entities adopting ASU 2016-13. ASU 2019-05 amends ASU 2016-13 to allow companies to irrevocably elect, upon adoption of ASU 2016-13, the fair value option on financial instruments that (1) were previously recorded at amortized cost and (2) are within the scope of ASC 326-20 if the instruments are eligible for the fair value option under ASC 825-10. An entity will apply the amendments in this update through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (that is, a modified-retrospective approach). A prospective transition approach is required for debt securities for which an other-than-temporary impairment had been recognized before the effective date, in order to maintain the same amortized cost basis before and after the effective date of this update. Amounts previously recognized in accumulated other comprehensive income as of the date of adoption that relate to improvements in cash flows expected to be collected should continue to be accreted into income over the remaining life of the asset. Recoveries of amounts previously written off relating to improvements in cash flows after the date of adoption should be recorded in earnings when received. The fair value option election does not apply to held-to-maturity debt securities. Entities are required to make this election on an instrument-by-instrument basis. For public business entities that are SEC filers, including the Company, the amendments in ASU 2019-05 are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company adopted ASU 2019-05 effective January 1, 2020. There was no impact to the financial statements of the Company as we did not elect the fair value option on financial instruments upon adoption of ASU 2016-13.
On March 22, 2020, a statement was issued by our banking regulators and titled the “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus” (the “Interagency Statement”) that encourages financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations due to the effects of COVID-19. Additionally, Section 4013 of the CARES Act, that passed on March 27, 2020, further provides that a qualified loan modification is exempt by law from classification as a troubled debt restructuring (“TDR”) as defined by GAAP, from the period beginning March 1, 2020 until the earlier of December 31, 2020 or the date that is 60 days after the date on which the national emergency concerning the COVID-19 outbreak declared by the President of the United States under the National Emergencies Act (50 U.S.C. 1601 et seq.) terminates. The Interagency Statement was subsequently revised in April 2020 to clarify the interaction of the original guidance with Section 4013 of the CARES Act, as well as setting forth the banking regulators’ views on consumer protection considerations. In accordance with such guidance, we are offering short-term modifications made in response to COVID-19 to borrowers who are current and otherwise not past due. These include short-term, 180 days or less, modifications in the form of payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. See Note 10 for further information on non-TDR loan modifications. The Interagency Guidance and Section 4013 are expected to have a material impact on the Company’s financial statements; however, this impact cannot be quantified at this time.
Note 4 – Share Based Compensation
On March 16, 2017 the Company’s Board of Directors approved and adopted the 2017 Stock Incentive Plan (the “2017 Plan”), which became effective May 24, 2017, the date approved by the Company’s shareholders. The 2017 Plan replaced the Company’s 2007 Stock Incentive Plan (the “2007 Plan”), which expired by its own terms on March 15, 2017. Options to purchase 257,789 shares that were granted under the 2007 Plan were still outstanding as of June 30, 2020 and remain unaffected by that plan’s expiration. The 2017 Plan provides for the issuance of both “incentive” and “nonqualified” stock options to officers and employees, and of “nonqualified” stock options to non-employee directors and consultants of the Company. The 2017 Plan also provides for the issuance of restricted stock awards to these same classes of eligible participants, although no restricted stock awards have ever been issued by the Company. The total
9
number of shares of the Company’s authorized but unissued stock reserved for issuance pursuant to awards under the 2017 Plan was initially 850,000 shares, and the number remaining available for grant as of June 30, 2020 was 551,800. The potential dilutive impact of unexercised stock options is discussed below in Note 5, Earnings per Share.
Pursuant to FASB’s standards on stock compensation, the value of each stock option is reflected in our income statement as employee compensation or directors’ expense by amortizing its grant date fair value over the vesting period of the option. The Company utilizes a Black-Scholes model to determine grant date fair values. A pre-tax charge of $0.1 million was reflected in the Company’s income statement during the second quarter of 2020 and $0.1 million was charged during the second quarter of 2019, as expense related to stock options. For the first half, the charges totaled $0.2 million in 2020 and $0.3 million in 2019.
Note 5 – Earnings per Share
The computation of earnings per share, as presented in the Consolidated Statements of Income, is based on the weighted average number of shares outstanding during each period. There were 15,191,823 weighted average shares outstanding during the second quarter of 2020 and 15,329,907 during the second quarter of 2019, while there were 15,226,748 weighted average shares outstanding during the first six months of 2020 and 15,320,784 during the first six months of 2019.
Diluted earnings per share calculations include the effect of the potential issuance of common shares, which for the Company is limited to shares that would be issued on the exercise of “in-the-money” stock options. For the second quarter of 2020, calculations under the treasury stock method resulted in the equivalent of 45,832 shares being added to basic weighted average shares outstanding for purposes of determining diluted earnings per share, while a weighted average of 367,884 stock options were excluded from the calculation because they were underwater and thus anti-dilutive. For the second quarter of 2019 the equivalent of 128,413 shares were added in calculating diluted earnings per share, while 258,202 anti-dilutive stock options were not factored into the computation. Likewise, for the first half of 2020 the equivalent of 61,261 shares were added to basic weighted average shares outstanding in calculating diluted earnings per share and a weighted average of 336,123 options that were anti-dilutive for the period were not included, compared to the addition of the equivalent of 132,428 shares and non-inclusion of 228,824 anti-dilutive options in calculating diluted earnings per share for first half of 2019.
Note 6 – Comprehensive Income
As presented in the Consolidated Statements of Comprehensive Income, comprehensive income includes net income and other comprehensive income. The Company’s only source of other comprehensive income is unrealized gains and losses on available-for-sale investment securities. Investment gains or losses that were realized and reflected in net income of the current period, which had previously been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose, are considered to be reclassification adjustments that are excluded from other comprehensive income in the current period.
Note 7 – Financial Instruments with Off-Balance-Sheet Risk
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business. Those financial instruments currently consist of unused commitments to extend credit and standby letters of credit. They involve, to varying degrees, elements of risk in excess of the amount recognized in the balance sheet. The Company’s exposure to credit loss in the event of nonperformance by counterparties for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and issuing letters of credit as it does for originating loans included on the balance sheet. The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):
Commitments to extend credit
449,045
492,040
Standby letters of credit
9,435
8,619
Commitments to extend credit consist primarily of the unused or unfunded portions of the following: home equity lines of credit; commercial real estate construction loans, where disbursements are made over the course of construction; commercial revolving lines of credit; mortgage warehouse lines of credit; unsecured personal lines of credit; and formalized (disclosed) deposit account overdraft lines. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the unused portions of committed amounts do not necessarily represent future cash requirements. Standby letters of credit are issued by the Company to guarantee the performance of a customer to a third party, and the credit risk involved in issuing letters of credit is essentially the same as the risk involved in extending loans to customers.
At June 30, 2020, the Company was also utilizing a letter of credit in the amount of $105 million issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits and to facilitate certain credit arrangements with the Company’s customers. That letter of credit is backed by loans which are pledged to the FHLB by the Company.
Note 8 – Fair Value Disclosures and Reporting, the Fair Value Option and Fair Value Measurements
FASB’s standards on financial instruments, and on fair value measurements and disclosures, require public business entities to disclose in their financial statement footnotes the estimated fair values of financial instruments. In addition to disclosure requirements, FASB’s standard on investments requires that our debt securities that are classified as available for sale and any equity securities which have readily determinable fair values be measured and reported at fair value in our statement of financial position. Certain impaired loans are also reported at fair value, as explained in greater detail below, and foreclosed assets are carried at the lower of cost or fair value. FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, but we have not elected the fair value option for any of those financial instruments.
Fair value measurement and disclosure standards also establish a framework for measuring fair values. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants on the measurement date. Further, the standards establish a fair value hierarchy that encourages an entity to maximize the use of observable inputs and limit the use of unobservable inputs when measuring fair values. The standards describe three levels of inputs that may be used to measure fair values:
Fair value estimates are made at a specific point in time based on relevant market data and information about the financial instruments. Fair value disclosures for deposits include demand deposits, which are by definition equal to the amount payable on demand at the reporting date. Fair value calculations for loans and leases reflect exit pricing, and incorporate our assumptions with regard to the impact of prepayments on future cash flows and credit quality adjustments based on risk characteristics of various financial instruments, among other things. Since the estimates are subjective and involve uncertainties and matters of significant judgment they cannot be determined with precision, and changes in assumptions could significantly alter the fair values presented.
11
Estimated fair values for the Company’s financial instruments are as follows, as of the dates noted:
Fair Value of Financial Instruments
Fair Value Measurements
CarryingAmount
Quoted Prices inActive Markets forIdentical Assets(Level 1)
SignificantObservableInputs(Level 2)
SignificantUnobservableInputs(Level 3)
Total
Financial assets:
Investment securities available for sale
Loans and leases, net held for investment
2,195,837
2,240,456
Collateral dependent impaired loans
83
Financial liabilities:
1,557,228
2,506,890
Short term borrowings
162,981
24,507
80,076
1,753,846
1,761,461
1,692
1,477,497
2,168,447
2,000
30,564
For financial asset categories that were carried on our balance sheet at fair value as of June 30, 2020 and December 31, 2019, the Company used the following methods and significant assumptions:
Assets reported at fair value on a recurring basis are summarized below:
Fair Value Measurements – Recurring
Fair Value Measurements at June 30, 2020, using
RealizedGain/(Loss)(Level 3)
Securities:
U.S. government agencies
1,850
Mortgage-backed securities
375,485
State and political subdivisions
221,998
Total available-for-sale securities
Fair Value Measurements at December 31, 2019, using
12,145
400,389
188,265
13
Assets reported at fair value on a nonrecurring basis are summarized below:
Fair Value Measurements – Nonrecurring
SignificantObservable Inputs(Level 2)
SignificantUnobservable Inputs(Level 3)
Impaired loans
Real estate:
1-4 family residential construction
Other construction/land
1-4 family - closed-end
Equity lines
Multi-family residential
Commercial real estate - owner occupied
Commercial real estate - non-owner occupied
Farmland
Total real estate
Agricultural
Commercial and industrial
Consumer loans
Total impaired loans
Total assets measured on a nonrecurring basis
2,976
88
1,605
1,693
2,493
The table above includes collateral-dependent impaired loan balances for which a specific reserve has been established or on which a write-down has been taken. Information on the Company’s total impaired loan balances and specific loss reserves associated with those balances is included in Note 11 below.
14
The unobservable inputs are based on Management’s best estimates of appropriate discounts in arriving at fair market value. Adjusting any of those inputs could result in a significantly lower or higher fair value measurement. For example, an increase or decrease in actual loss rates would create a directionally opposite change in the fair value of unsecured impaired loans.
Note 9 – Investments
Investment Securities
Although the Company currently has the intent and the ability to hold the securities in its investment portfolio to maturity, the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. Pursuant to FASB’s guidance on accounting for debt and equity securities, available for sale securities are carried on the Company’s financial statements at their estimated fair market values, with monthly tax-effected “mark-to-market” adjustments made vis-à-vis accumulated other comprehensive income in shareholders’ equity.
The amortized cost and estimated fair value of available-for-sale investment securities are as follows:
Amortized Cost And Estimated Fair Value
AmortizedCost
GrossUnrealizedGains
GrossUnrealizedLosses
Estimated FairValue
1,775
364,828
10,668
209,760
12,239
(1)
Total securities
576,363
22,982
(12)
12,125
124
(104)
398,353
3,354
(1,318)
181,900
6,478
(113)
592,378
9,956
(1,535)
15
At June 30, 2020 and December 31, 2019, the Company had 7 securities and 198 securities, respectively, with gross unrealized losses. Management has evaluated those securities as of the respective dates, and does not believe that any of the unrealized losses are other than temporary. Gross unrealized losses on our investment securities as of the indicated dates are disclosed in the table below, categorized by investment type and by the duration of time that loss positions on individual securities have continuously existed (over or under twelve months).
Investment Portfolio - Unrealized Losses
Less than twelve months
Twelve months or more
Fair Value
(3)
4,692
(8)
1,733
1,052
(4)
5,744
(32)
3,240
(72)
2,689
(494)
100,518
(824)
78,538
19,762
(639)
123,520
(896)
81,227
The table below summarizes the Company’s gross realized gains and losses as well as gross proceeds from the sales of securities, for the periods indicated:
Investment Portfolio - Realized Gains/(Losses)
Proceeds from sales, calls and maturities of securities available for sale
24,063
9,985
26,493
26,639
Gross gains on sales, calls and maturities of securities available for sale
433
33
127
Gross losses on sales, calls and maturities of securities available for sale
(43)
(99)
Net gains on sale of securities available for sale
390
$22
16
The amortized cost and estimated fair value of investment securities available-for-sale at June 30, 2020 and December 31, 2019 are shown below, grouped by the remaining time to contractual maturity dates. The expected life of investment securities may not be consistent with contractual maturity dates, since the issuers of the securities might have the right to call or prepay obligations with or without penalties.
Estimated Fair Value of Contractual Maturities
Amortized Cost
Maturing within one year
4,362
4,388
Maturing after one year through five years
7,834
8,104
Maturing after five years through ten years
29,485
30,823
Maturing after ten years
169,854
180,533
Securities not due at a single maturity date:
181,945
186,880
Collateralized mortgage obligations
182,883
188,605
7,155
7,244
17,008
17,171
33,805
34,881
136,057
141,114
189,554
190,488
208,799
209,901
At June 30, 2020, the Company’s investment portfolio included 356 “muni” bonds issued by 298 different government municipalities and agencies located within 29 different states, with an aggregate fair value of $222 million. The largest exposure to any single municipality or agency was a combined $4.0 million (fair value) in general obligation bonds issued by the Charter Township of Washington County (MI).
The Company’s investments in bonds issued by states, municipalities and political subdivisions are evaluated in accordance with Supervision and Regulation Letter 12-15 issued by the Board of Governors of the Federal Reserve System, “Investing in Securities without Reliance on Nationally Recognized Statistical Rating Organization Ratings,” and other regulatory guidance. Credit ratings are considered in our analysis only as a guide to the historical default rate associated with similarly-rated bonds. There have been no significant differences in our internal analyses compared with the ratings assigned by the third party credit rating agencies.
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The following table summarizes the amortized cost and fair values of general obligation and revenue bonds in the Company’s investment securities portfolio at the indicated dates, identifying the state in which the issuing municipality or agency operates for our largest geographic concentrations:
Revenue and General Obligation Bonds by Location
Amortized
Fair Market
General obligation bonds
Cost
Value
State of issuance
Texas
76,494
81,128
59,439
61,519
27,447
29,067
23,882
25,030
Washington
23,330
25,023
23,392
24,313
Other (21 & 24 states, respectively)
53,652
56,532
49,326
50,725
Total general obligation bonds
180,923
191,750
156,039
161,587
Revenue bonds
7,053
7,452
6,035
6,298
2,256
2,377
1,737
1,856
364
382
365
380
Other (15 & 13 states, respectively)
19,164
20,037
18,144
Total revenue bonds
28,837
30,248
25,861
26,678
Total obligations of states and political subdivisions
The revenue bonds in the Company’s investment securities portfolios were issued by government municipalities and agencies to fund public services such as utilities (water, sewer, and power), educational facilities, and general public and economic improvements. The primary sources of revenue for these bonds are delineated in the table below, which shows the amortized cost and fair market values for the largest revenue concentrations as of the indicated dates.
Revenue Bonds by Type
Revenue source:
Water
10,363
10,949
7,515
7,775
Sewer
5,219
5,408
4,760
Sales tax
3,572
3,743
1,949
1,995
Lease
2,773
2,864
3,596
3,678
Charter school aid
1,565
1,689
1,232
1,290
Other (8 and 8 sources, respectively)
5,345
5,595
6,809
7,129
Low-Income Housing Tax Credit (“LIHTC”) Fund Investments
The Company has the ability to invest in limited partnerships which own housing projects that qualify for federal and/or California state tax credits, by mandating a specified percentage of low-income tenants for each project. The primary investment return comes from tax credits that flow through to investors. Because rent levels are lower than standard market rents and the projects are generally highly leveraged, each project also typically generates tax-deductible operating losses that are allocated to the limited partners for tax purposes.
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The Company made investment commitments to nine different LIHTC fund limited partnerships from 2001 through 2017, all of which were California-focused funds that help the Company meet its obligations under the Community Reinvestment Act. We utilize the cost method of accounting for our LIHTC fund investments, under which we initially record on our balance sheet an asset that represents the total cash expected to be invested over the life of the partnership. Any commitments or contingent commitments for future investment are reflected as a liability. The income statement reflects tax credits and any other tax benefits from these investments “below the line” within our income tax provision, while the initial book value of the investment is amortized on a straight-line basis as an offset to noninterest income, over the time period in which the tax credits and tax benefits are expected to be received.
As of June 30, 2020, our total LIHTC investment book balance was $3.8 million, which includes $0.2 million in remaining commitments for additional capital contributions. There were $0.3 million in tax credits derived from our LIHTC investments that were recognized during the six months ended June 30, 2020, and amortization expense of $0.3 million associated with those investments was netted against pre-tax noninterest income for the same time period. The Company also recognized a $0.7 million gain during the same period for the sale of a single fund property that was at the end of its tax credit life. Our LIHTC investments are evaluated annually for potential impairment, and we have concluded that the carrying value of the investments is stated fairly and is not impaired.
Note 10 – Credit Quality and Nonperforming Assets
Credit Quality Classifications
The Company monitors the credit quality of loans on a continuous basis using the regulatory and accounting classifications of pass, special mention, substandard and impaired to characterize the associated credit risk. Balances classified as “loss” are immediately charged off. The Company conforms to the following definitions for its risk classifications:
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Credit quality classifications for the Company’s loan balances were as follows, as of the dates indicated:
Pass
SpecialMention
Substandard
Impaired
89,225
87,747
90,545
1-4 family - closed end
172,085
1,635
146
4,205
178,071
38,147
1,955
4,156
44,318
55,577
344
55,921
304,684
3,444
3,068
2,667
313,863
689,589
511
565
627
691,292
132,584
1,040
128
702
134,454
1,569,638
10,812
3,967
13,272
1,597,689
48,356
159
48,516
208,434
11,213
471
1,383
221,502
Mortgage warehouse
338,124
5,834
54
6,266
Total gross loans and leases
2,170,386
22,238
4,472
15,001
105,979
90,761
98
91,413
194,572
2,425
164
3,020
200,181
43,111
72
4,421
49,599
54,104
353
54,457
334,460
4,005
3,384
2,034
343,883
409,289
1,164
2,105
412,569
142,594
1,048
132
259
144,033
1,374,870
10,735
3,763
12,746
1,402,114
47,814
217
48,036
100,584
13,415
556
977
115,532
189,103
7,245
85
25
425
7,780
1,719,616
24,452
4,344
14,153
Past Due and Nonperforming Assets
Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets. The Company’s foreclosed assets can include mobile homes and/or OREO, which consists of commercial and/or residential real estate properties acquired by foreclosure or similar means that the Company is offering or will offer for sale. Foreclosed assets totaled $2.9 million at June 30, 2020, and $0.8 million at December 31, 2019. Gross nonperforming loans totaled $5.8 million at June 30, 2020 and $5.7 million at December 31, 2019. Loans and leases are classified as nonperforming when reasonable doubt surfaces with regard to the ability of the Company to collect all principal and interest. At that point, we stop accruing interest on the loan or lease in question and reverse any
20
previously-recognized interest to the extent that it is uncollected or associated with interest-reserve loans. Any asset for which principal or interest has been in default for 90 days or more is also placed on non-accrual status even if interest is still being received, unless the asset is both well secured and in the process of collection.
Not included in past due and nonperforming assets are loan modifications executed under Section 4013 of the CARES Act. There were 313 customers, for a total of $386.2 million, with payment deferrals under these loan modifications. Approximately $4.9 million in accrued interest has been recognized but not collected on these loans.
An aging of the Company’s loan balances is presented in the following tables, by number of days past due as of the indicated dates:
Loan Portfolio Aging
30-59 DaysPast Due
60-89 DaysPast Due
90 Days OrMore Past Due(1)
TotalPast Due
Current
Total FinancingReceivables
Non-AccrualLoans(2)
684
409
1,104
176,967
843
84
1,120
349
1,553
42,765
626
989
312,874
1,909
628
690,664
812
133,642
223
1,804
3,059
5,086
1,592,603
4,711
337
772
1,125
220,377
1,086
Mortgage warehouse lines
Consumer
6,230
564
1,852
3,831
6,247
2,205,850
5,808
21
91,397
31
485
659
1,524
198,657
741
177
78
265
49,334
480
1,552
1,640
342,243
500
410,464
258
2,730
2,430
5,550
1,396,564
5,055
160
375
115,157
651
7,711
2,945
617
2,432
5,994
1,756,571
5,737
Troubled Debt Restructurings
A loan that is modified for a borrower who is experiencing financial difficulty is classified as a troubled debt restructuring (TDR) if the modification constitutes a concession, excluding loan modifications that are COVID-19 related and made in accordance with the interagency guidance and the CARES Act as described in Note 3, above. At June 30, 2020, the Company had a total of $10 million in TDRs, including $0.8 million in TDRs that were on non-accrual status. Generally, a non-accrual loan that has been modified as a TDR remains on non-accrual status for a period of at least six months to demonstrate the borrower’s ability to comply with the modified terms. However, performance prior to the modification, or significant events that coincide with the modification, could result in a loan’s return to accrual status after a shorter performance period or even at the time of loan modification. Regardless of the period of time that has elapsed, if the borrower’s ability to meet the revised payment schedule is uncertain then the loan will be kept on non-accrual status. Moreover, a TDR is generally considered to be in default when it appears that the customer will not likely be able to repay all principal and interest pursuant to restructured terms.
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The Company may agree to different types of concessions when modifying a loan or lease. The tables below summarize TDRs which were modified during the noted periods, by type of concession:
Troubled Debt Restructurings, by Type of Loan Modification
Three months ended June 30, 2020
Rate Modification
Term Modification
Interest Only Modification
Rate & Term Modification
Term & Interest Modification
1,325
178
Total real estate loans
1,588
1,616
Three months ended June 30, 2019
Interest OnlyModification
244
74
50
266
102
368
23
Six months ended June 30, 2020
338
516
1,926
1,954
Six months ended June 30, 2019
94
168
59
24
Pre-Modification
Post-Modification
Number ofLoans
OutstandingRecordedInvestment
ReserveDifference⁽¹⁾
Reserve
86
41
0
1,589
58
67
1,617
Outstanding RecordedInvestment
Outstanding Recorded Investment
Reserve Difference⁽¹⁾
(45)
$(45)
`
1,927
(20)
(47)
$(67)
The Company had no finance receivables modified as TDRs within the previous twelve months that defaulted or were charged off during the six-month periods ended June 30, 2020 and 2019.
Purchased Credit Impaired Loans
The Company may acquire loans which show evidence of credit deterioration since origination. These purchased credit impaired (“PCI”) loans are recorded at the amount paid, since there is no carryover of the seller’s allowance for loan losses. Potential losses on PCI loans subsequent to acquisition are recognized by an increase in the allowance for loan losses. PCI loans are accounted for individually or are aggregated into pools of loans based on common risk characteristics. The Company projects the amount and timing of expected cash flows, and expected cash receipts in excess of the amount paid for any such loans are recorded as interest income over the remaining life of the loan or pool of loans (accretable yield). The excess of contractual principal and interest over expected cash flows is not recorded (nonaccretable difference). Expected cash flows are periodically re-evaluated throughout the life of the loan or pool of loans. If the present value of the expected cash flows is determined at any time to be less than the carrying amount, a reserve is recorded. If the present value of the expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.
Our acquisition of Santa Clara Valley Bank in 2014 included certain loans which have shown evidence of credit deterioration since origination, and for which it was probable at acquisition that all contractually required payments would not be collected. The carrying amount and unpaid principal balance of those PCI loans was as follows, as of the dates indicated:
Purchased Credit Impaired Loans:
Unpaid Principal Balance
Carrying Value
Real estate secured
Total purchased credit impaired loans
$83
There was no allowance for loan losses allocated for PCI loans as of June 30, 2020, however, an allowance totaling $0.1 million was allocated for PCI loans as of December 31, 2019. There was no discount accretion recorded on PCI loans during the six months ended June 30, 2020.
Note 11 – Allowance for Loan and Lease Losses
The Company’s allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses. The allowance is maintained at a level that is considered adequate to absorb probable losses on certain specifically identified impaired loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when cash payments are received subsequent to the charge off. We employ a systematic methodology, consistent with FASB guidelines on loss contingencies and impaired loans, for determining the appropriate level of the allowance for loan and lease losses and adjusting it to that level at least quarterly. Pursuant to our methodology, impaired loans and leases are individually analyzed and a criticized asset action plan is completed specifying the financial status of the borrower and, if applicable, the characteristics and condition of collateral and any associated liquidation plan. A specific loss allowance is created for each impaired loan, if necessary.
The following tables disclose the unpaid principal balance, recorded investment, average recorded investment, and interest income recognized for impaired loans on our books as of the dates indicated. Balances are shown by loan type, and are further broken out by those that required an allowance and those that did not, with the associated allowance disclosed for those that required such. Included in the valuation allowance for impaired loans shown in the tables below are specific reserves allocated to TDRs, totaling $0.7 million at June 30, 2020 and $0.6 million at December 31, 2019.
Impaired Loans
Unpaid PrincipalBalance(1)
RecordedInvestment(2)
Related Allowance
AverageRecordedInvestment
Interest IncomeRecognized(3)
With an allowance recorded
690
173
586
3,379
71
3,406
3,909
3,856
317
3,971
347
Commercial real estate- owner occupied
757
763
Commercial real estate- non-owner occupied
237
9,316
9,144
593
9,310
1,282
1,262
671
1,297
95
361
Subtotal
10,982
10,752
1,359
10,972
202
With no related allowance recorded
826
845
300
304
2,029
1,910
1,937
634
465
467
4,247
4,128
4,187
142
121
206
4,398
4,249
4,394
15,380
15,366
205
RelatedAllowance
Average Recorded Investment
656
157
563
2,298
2,365
4,173
4,120
252
4,185
200
606
38
256
8,310
8,138
493
8,336
439
915
896
219
1,140
29
464
114
469
9,694
9,464
827
9,951
503
755
722
726
326
301
310
1,560
1,477
3,295
3,267
6,010
4,607
6,382
81
162
140
6,121
4,688
6,684
15,815
14,152
16,635
527
The specific loss allowance for an impaired loan generally represents the difference between the book value of the loan and either the fair value of underlying collateral less estimated disposition costs, or the loan’s net present value as determined by a discounted cash flow analysis. The discounted cash flow approach is typically used to measure impairment on loans for which it is anticipated that repayment will be provided from cash flows other than those generated solely by the disposition or operation of underlying collateral. However, historical loss rates may be used by the Company to determine a specific loss allowance if those rates indicate a higher potential reserve need than the discounted cash flow analysis. Any change in impairment attributable to the passage of time is accommodated by adjusting the loss allowance accordingly.
For loans where repayment is expected to be provided by the disposition or operation of the underlying collateral, impairment is measured using the fair value of the collateral. If the collateral value, net of the expected costs of disposition, is less than the loan balance, then a specific loss reserve is established for the shortfall in collateral coverage. If the discounted collateral value is greater than or equal to the loan balance, no specific loss reserve is required. At the time a collateral-dependent loan is designated as nonperforming, a new appraisal is ordered and typically received within
30 to 60 days if a recent appraisal is not already available. We generally use external appraisals to determine the fair value of the underlying collateral for nonperforming real estate loans, although the Company’s licensed staff appraisers may update older appraisals based on current market conditions and property value trends. Until an updated appraisal is received, the Company uses the existing appraisal to determine the amount of the specific loss allowance that may be required. The specific loss allowance is adjusted, as necessary, once a new appraisal is received. Updated appraisals are generally ordered at least annually for collateral-dependent loans that remain impaired, and current appraisals were available or in process for 59% of the Company’s impaired real estate loan balances at June 30, 2020. Furthermore, the Company analyzes collateral-dependent loans on at least a quarterly basis, to determine if any portion of the recorded investment in such loans can be identified as uncollectible and would therefore constitute a confirmed loss. All amounts deemed to be uncollectible are promptly charged off against the Company’s allowance for loan and lease losses, with the loan then carried at the fair value of the collateral, as appraised, less estimated costs of disposition if applicable. Once a charge-off or write-down is recorded, it will not be restored to the loan balance on the Company’s accounting books.
Our methodology also provides for the establishment of a “general” allowance for probable incurred losses inherent in loans and leases that are not impaired. Unimpaired loan balances are segregated by credit quality, and are then evaluated in pools with common characteristics. At the present time, pools are based on the same segmentation of loan types presented in our regulatory filings. While this methodology utilizes historical loss data and other measurable information, the credit classification of loans and the establishment of the allowance for loan and lease losses are both to some extent based on Management’s judgment and experience. Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan and lease losses that Management believes is appropriate at each reporting date. Quantitative information includes our historical loss experience, delinquency and charge-off trends, and current collateral values. Qualitative factors include the general economic environment in our markets and, in particular, the condition of the agricultural industry and other key industries. Lending policies and procedures (including underwriting standards), the experience and abilities of lending staff, the quality of loan review, credit concentrations (by geography, loan type, industry and collateral type), the rate of loan portfolio growth, and changes in legal or regulatory requirements are additional factors that are considered. The total general reserve established for probable incurred losses on unimpaired loans was $12.2 million at June 30, 2020.
There were no material changes to the methodology used to determine our allowance for loan and lease losses during the three months ended June 30, 2020, although as outlined in Note 3 to the consolidated financial statements we will substantially update our methodology upon the implementation of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update ASU 2016-13 and related amendments, Financial Instruments – Credit Losses (Topic 326) when the earlier of the national emergency related to the outbreak of COVID-19 ends or December 31, 2020. Moreover, we will continue to enhance our methodology as needed in order to comply with regulatory and accounting requirements, keep pace with the size and complexity of our loan and lease portfolio, and respond to pressures created by external forces. We engage outside firms on a regular basis to assess our methodology and perform independent credit reviews of our loan and lease portfolio. In addition, the FDIC and the California Department of Business Oversight (DBO) review the allowance for loan and lease losses as an integral part of their audit and examination processes. Management believes deferring the implementation of “CECL” and continuing with the current incurred loss methodology is appropriate given the impact of the economic uncertainty surrounding COVID-19 and related governmental and regulatory actions taken in response thereto, such as the stimulus provisions of the CARES Act.
30
The tables that follow detail the activity in the allowance for loan and lease losses for the periods noted:
Allowance for Credit Losses and Recorded Investment in Financing Receivables
Real Estate
Agricultural Products
Commercial and Industrial (1)
Unallocated
Allowance for credit losses:
Beginning balance
7,315
2,754
1,137
11,453
Charge-offs
(67)
(286)
(353)
Recoveries
260
Provision
1,532
908
(239)
Ending balance
8,850
232
3,615
849
13,560
5,635
193
2,685
1,278
9,923
(92)
(903)
(995)
510
632
3,141
974
(36)
(118)
Reserves:
Specific
General
8,257
2,944
754
12,201
Loans evaluated for impairment:
Individually
Collectively
1,584,417
48,514
558,243
5,922
2,197,096
559,626
Year ended December 31, 2019
5,831
2,394
1,239
9,750
(1,190)
(1,274)
(2,409)
(4,873)
647
1,159
2,496
(63)
875
1,289
2,550
5,142
192
2,466
9,096
1,389,368
48,031
303,658
7,355
1,748,412
304,635
1,914
1,129
82
9,438
(254)
(562)
(816)
431
277
861
(278)
(18)
478
288
(70)
5,969
201
1,132
9,883
(832)
(1,114)
(1,946)
329
472
578
1,379
(191)
(55)
535
429
881
303
137
1,322
5,088
2,266
995
8,561
11,751
837
13,366
1,426,425
51,503
279,091
7,514
1,764,533
1,438,176
51,509
279,928
8,286
1,777,899
Note 12 – Operating Leases
We lease space under non-cancelable operating leases for 21 branch locations, three off-site ATM locations, one administrative building, one loan production office and a warehouse. Many of our leases include both lease (e.g., fixed payments including rent, taxes, and insurance costs) and non-lease components (e.g., common-area or other maintenance costs). Payments for taxes and insurance as well as non-lease components are not included in the accounting of the lease component, but are separately accounted for in occupancy expense. The Company recognized lease expense of $1.1 million for both six-month periods ended June 30, 2020 and 2019. Most leases include one or more renewal options available to exercise. The exercise of lease renewal options is typically at the Company’s sole discretion; therefore, the majority of renewals to extend the lease terms are not included in our right-of-use assets and lease liabilities as they are not reasonably certain of exercise. We regularly evaluate the renewal options and when they are reasonably certain of exercise, we include the renewal period in our lease term. As most of our leases do not provide an implicit rate, we used our incremental borrowing rate in determining the present value of the lease payments.
There were no sale and leaseback transactions, leveraged leases, or lease transactions with related parties during the six months ended June 30, 2020.
At June 30, 2020, the Company’s right-of-use assets and operating lease liabilities were $7.5 million and $8.0 million, respectively. The weighted average remaining lease term for the lease liabilities was 7.0 years, and the weighted average discount rate of remaining payments was 5.5 percent. There were no lease liabilities from new right-of-use assets
obtained during the six months ended June 30, 2020. Cash paid on operating leases was $0.9 million for the six months ended June 30, 2020.
Maturities of our lease liabilities for all operating leases are as follows (dollars in thousands, unaudited):
2020 (1)
2021
2,020
2022
1,571
2023
1,113
2024
749
Thereafter
3,196
9,769
Less: present value discount
(1,744)
Lease liability (2)
8,025
The following table presents the future minimum rental payments under leases with terms in excess of one year as of December 31, 2019 presented in accordance with ASC Topic 840, “Leases”:
2,235
2,023
1,574
Total undiscounted lease payments
10,890
Note 13 – Revenue Recognition.
The Company utilizes the guidance found in ASU 2014-09, Revenue from Contracts with Customers (ASC 606), when accounting for certain noninterest income. The core principle of this guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Sufficient information should be provided to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The Company’s revenue streams that are within the scope of and accounted for under Topic 606 include service charges on deposit accounts, debit card interchange fees, and fees levied for other services the Company provides its customers. The guidance does not apply to revenue associated with financial instruments such as loans and investments, and other noninterest income such as loan servicing fees and earnings on bank-owned life insurance, which are accounted for on an accrual basis under other provisions of GAAP. In total, approximately 37.1% and 29.6% of the Company’s noninterest revenue was outside of the scope of the ASC 606 for the three- and six-month periods ended June 30, 2020, respectively.
All of the company’s revenue from contracts within the scope of ASC 606 is recognized as noninterest income, except for gains on the sale of OREO which is classified as non-interest expense. The following table presents the Company’s
sources of noninterest income for the three- and six-month periods ended June 30, 2020 and 2019. Items outside the scope of ASC 606 are noted as such (dollars in thousands, unaudited).
For the three months ended June 30,
For the six months ended June 30,
Returned item and overdraft fees
962
1,657
2,626
3,223
Other service charges on deposits
1,656
1,494
3,176
2,871
Debit card interchange income
1,723
1,687
3,355
3,200
Loss on limited partnerships(1)
(158)
(450)
(315)
(900)
Dividends on equity investments(1)
139
175
333
406
Unrealized gains recognized on equity investments(1)
447
Net gains on sale of securities(1)
Other(1)
2,188
1,038
2,995
2,702
Non-interest expense
Salaries and employee benefits (1)
Occupancy expense (1)
Gain on sale of OREO
(21)
Other (1)
6,233
11,579
12,498
Total non-interest expense
With regard to noninterest income associated with customer contracts, the Company has determined that transaction prices are fixed, and performance obligations are satisfied as services are rendered, thus there is little or no judgment involved in the timing of revenue recognition under contracts that are within the scope of ASC 606.
ITEM 2
MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This Form 10-Q includes forward-looking statements that involve inherent risks and uncertainties. Words such as “expects”, “anticipates”, “believes”, “projects”, and “estimates” or variations of such words and similar expressions are intended to identify forward-looking statements. These statements are based on certain underlying assumptions and are not guarantees of future performance, as they could be impacted by a number of potential risks and developments that cannot be predicted with any degree of certainty. Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.
A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the Company’s potential future financial performance. They include, but are not limited to, the risk of unfavorable economic conditions in the Company’s market areas; risks associated with the current national emergency with respect to COVID-19 including the impact that national, state, and local responses, including any stimulus or relief efforts, have on customers’ ability to repay loans; the ability for the Company to serve its customers with modified branch operations as well as social distancing guidelines and mandates under state and local stay-at-home orders; risks associated with fluctuations in interest rates or a sustained low interest rate environment; liquidity risks; increases in nonperforming assets and credit losses that could occur, particularly in times of weak economic conditions or rising interest rates; reductions in the market value of available-for-sale securities that could result if interest rates increase substantially or an issuer has real or perceived financial difficulties; the Company’s ability to attract and retain skilled employees; the Company’s ability to successfully deploy new technology; the success of acquisitions or branch expansion; and risks associated with the multitude of current and prospective laws and regulations to which the Company is and will be subject. Risk factors that could cause actual results to differ materially from results that might be implied by forward-looking statements include the risk factors disclosed in the Company’s Form 10-K for the fiscal year ended December 31, 2019 and in Item 1A, herein.
CRITICAL ACCOUNTING POLICIES
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and incorporate various assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.
Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas: the establishment of the allowance for loan and lease losses, as explained in detail in Note 11 to the consolidated financial statements and in the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, as discussed in Note 11 to the consolidated financial statements; income taxes and related deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; and goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in the “Other Assets” section of this discussion and analysis. Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations with regard to those areas.
OVERVIEW OF THE RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
RESULTS OF OPERATIONS SUMMARY
Second Quarter 2020 compared to Second Quarter 2019
Second Quarter 2020 net income was $8.3 million, or $0.54 per diluted share, compared to $8.8 million, or $0.57 per diluted share in the second quarter of 2019. The Company’s annualized return on average equity was 10.30% and annualized return on average assets was 1.19% for the quarter ended June 30, 2020, compared to 12.27% and 1.39%, respectively, for the same quarter in 2019. The primary drivers behind the variance in second quarter net income are as follows:
First Half 2020 compared to First Half 2019
Net income for the first half of 2020 was $16.1 million, or $1.05 per diluted share, compared to $17.7 million, or $1.15 per diluted share for the first half of 2019. The Company’s annualized return on average equity was 10.14% and annualized return on average assets was 1.21% for the six months ended June 30, 2020, compared to a return on equity of 12.62% and return on assets of 1.41% for the six months ended June 30, 2019. The primary drivers behind the variance in year-to-date net income are as follows:
FINANCIAL CONDITION SUMMARY
June 30, 2020 relative to December 31, 2019
The Company’s assets totaled $3.1 billion at June 30, 2020 relative to $2.6 billion at December 31, 2019. The following provides a summary of key balance sheet changes during the first six months of 2020:
IMPACT OF CORONAVIRUS DISEASE 2019 (COVID-19) PANDEMIC ON THE COMPANY’S OPERATIONS
Overview
On January 31, 2020, the United States Department of Health and Human Services declared a public health emergency with respect to the Coronavirus Disease 2019 (COVID-19). Subsequent to this date, federal, state, and local governmental agencies, regulatory agencies, and the Federal Reserve Board took actions impacting the Company including these more significant items:
37
Impact of COVID-19 on the Company’s Operations
EARNINGS PERFORMANCE
The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money. The second is noninterest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance. The majority of the Company’s noninterest expense is comprised of operating costs that facilitate offering a broad range of banking services to our customers.
NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest income was relatively unchanged at $24.1 million for the second quarter of 2020, as compared to the second quarter of 2019 and decreased by $0.2 million, or 1% to $47.9 million for the first six months of 2020 in comparison to the first six months of 2019. The slight decrease in net interest income for the first six months of 2020 as compared to the same period in 2019 is due to a lower net interest margin, partially offset by an increase in average earning assets. The level of net interest income we recognize in any given period depends on a combination of factors including the average volume and yield for interest-earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities.
The following tables show average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for the noted periods. The tables also display calculated yields on each major component of the Company’s investment and loan portfolios, average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods.
Average Balances and Rates
For the three months ended
June 30, 2019
Assets
Average Balance (1)
Income/Expense
AverageRate/Yield (2)
AverageBalance (1)
Investments:
Federal funds sold/due from time
53,209
0.09%
18,795
2.45%
Taxable
403,517
2.24%
425,498
2.44%
Non-taxable
216,746
3.38%
149,555
3.64%
Total investments
673,472
3,702
593,848
3,778
2.74%
Loans and leases:(3)
Real estate
1,477,380
18,355
5.00%
1,459,871
20,098
5.52%
47,806
452
3.80%
51,285
793
6.20%
Commercial
170,876
1,080
2.54%
120,081
1,537
5.13%
6,667
225
13.57%
8,661
292
13.52%
206,669
2.98%
98,249
5.06%
2,811
5.58%
3,426
5.97%
Total loans and leases
1,912,209
4.56%
1,741,573
5.53%
Total interest earning assets (4)
2,585,681
4.01%
2,335,421
4.82%
Other earning assets
13,190
12,505
Non-earning assets
207,623
204,491
2,806,494
2,552,417
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
134,159
0.21%
120,018
0.29%
NOW
481,679
0.07%
437,040
134
0.12%
Savings accounts
327,833
0.06%
289,767
77
0.11%
Money market
125,594
0.10%
123,482
43
0.14%
Certificates of deposit, under $100,000
77,888
0.37%
90,258
289
1.28%
Certificates of deposit, $100,000 or more
364,874
0.61%
399,228
2,178
2.19%
Brokered deposits
19,890
0.75%
47,890
284
2.38%
Total interest bearing deposits
1,531,917
0.23%
1,507,683
0.82%
Borrowed funds:
Federal funds purchased
34,217
0.40%
21,698
0.39%
11,716
0.17%
2.37%
TRUPS
35,009
3.57%
34,830
5.41%
Total borrowed funds
80,945
350
1.74%
57,376
496
3.47%
Total interest bearing liabilities
1,612,862
0.31%
1,565,059
0.92%
Demand deposits - non-interest bearing
830,333
655,136
39,155
43,550
324,144
288,672
Total liabilities and shareholders' equity
Interest income/interest earning assets
Interest expense/interest earning assets
0.20%
Net interest income and margin(5)
3.81%
4.21%
For the six months ended
45,166
0.68%
15,152
2.50%
406,054
2.33%
422,217
2.49%
206,218
3.42%
145,962
3.70%
657,438
7,641
2.56%
583,331
7,512
2.79%
1,436,145
37,079
5.19%
1,462,061
40,198
5.54%
48,169
1,035
4.32%
50,919
1,573
6.23%
139,287
2,176
3.14%
121,332
3,116
5.18%
7,124
16.74%
8,689
14.06%
175,645
2,797
3.20%
80,782
2,166
4,027
5.79%
3,268
100
6.17%
1,810,397
4.86%
1,727,051
2,467,835
4.25%
2,310,382
4.87%
13,015
12,094
202,265
207,038
2,683,115
2,529,514
111,445
0.24%
109,692
469,133
437,124
312,777
119
0.08%
288,776
151
121,421
126,070
0.13%
79,370
0.52%
90,301
567
1.27%
372,286
1,786
0.96%
390,637
4,216
2.18%
30,357
204
1.35%
48,939
610
2.51%
1,496,789
1,491,539
560
30,850
19,500
8,831
0.32%
4,463
2.62%
34,986
4.06%
34,806
74,670
781
2.10%
59,329
1,051
1,571,459
0.45%
1,550,868
754,463
654,029
37,687
41,363
319,506
283,254
0.28%
0.62%
3.97%
42
The Volume and Rate Variances table below sets forth the dollar difference for the comparative periods in interest earned or paid for each major category of interest-earning assets and interest-bearing liabilities, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates, and rate variances are equal to the change in rates multiplied by prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the rate variance.
Volume & Rate Variances
2020 over 2019
Increase (decrease) due to
Assets:
Volume
Rate
Net
211
(314)
(103)
372
(407)
(35)
(134)
(207)
(341)
(199)
(298)
(497)
482
(114)
874
(213)
661
559
(635)
(76)
1,047
(918)
129
241
(1,984)
(1,743)
(713)
(2,406)
(3,119)
(54)
(287)
(85)
(453)
(538)
650
(1,107)
(457)
461
(1,401)
(940)
(109)
96
(13)
1,367
(1,074)
293
2,544
(1,913)
631
(9)
(7)
2,128
(4,455)
(2,327)
2,121
(6,084)
(3,963)
Total interest earning assets
2,687
(5,090)
(2,403)
3,168
(7,002)
(3,834)
Liabilities
(17)
(29)
(26)
(65)
(51)
(74)
(41)
(31)
(10)
(40)
(178)
(218)
(69)
(293)
(362)
(187)
(1,437)
(1,624)
(198)
(2,232)
(2,430)
(166)
(81)
(247)
(174)
(406)
(358)
(1,842)
(2,200)
(467)
(2,854)
(3,321)
53
(53)
44
(88)
(44)
(161)
(159)
(253)
(248)
(146)
(342)
(270)
(291)
(2,055)
(2,346)
(395)
(3,196)
(3,591)
2,978
(3,035)
(57)
3,563
(3,806)
(243)
The volume variance calculated for the second quarter of 2020 relative to the second quarter of 2019 was a favorable $3.0 million due to higher average balances of interest-earning assets, resulting from organic growth in commercial real estate loans, growth in commercial loans due to our participation in the SBA PPP program and higher utilization of mortgage warehouse lines. Given the low rate environment, loan demand for our mortgage warehouse lines have increased, as demonstrated by the $1.4 million favorable volume variance. There was an unfavorable rate variance of $3.0 million for the comparative quarters, since the weighted average yield on interest-earning assets fell by 81 basis points while the weighted average cost of interest-bearing liabilities decreased by 61 basis points. The rate variance was negatively impacted by the following factors: A shift in our earning asset mix into lower-yielding loans and
investments; increased line utilization of mortgage warehouse lines, $116.2 million in low-yielding SBA PPP loans; partially offset by lower costs of time-deposits and other interest-bearing liabilities. The average fees on the SBA PPP loans was approximately 4.0%. These fees, net of loan costs, are being accreted over the stated life of the loan (generally two years), net of loan costs. Our customers with an SBA PPP loan are generally eligible to apply for loan forgiveness after 26 weeks. If a loan is forgiven, upon repayment of principal and interest by the SBA, any unaccreted fee income, net of unamortized costs, would be recognized as interest income at such time.
The volume variance calculated for the first six months of 2020 relative to the first six months of 2019 reflects a favorable variance of $3.6 million and an unfavorable rate variance of $3.8 million. As with the discussion of the volume and rate variances for the quarter, the same is true for the half. The growth in interest earning assets was more than offset by the 62 basis point decrease in yield while interest bearing liabilities increased $20.6 million with a 47 basis point drop in cost. Since the overall decrease in yield on interest earning assets is applied to a larger base than the decline in cost of interest- bearing liabilities it results in an unfavorable $0.2 million net volume/rate difference. The Company’s net interest margin for the first half of 2020 was 3.97%, as compared to 4.25% in the first half of 2019.
The FOMC lowered rates by a total of 150 basis points in March 2020 in two separate emergency actions. These actions have had an unfavorable impact on our net interest margin for the quarter and year to date periods and will most likely have the same unfavorable impact on net interest income through the end of 2020. At June 30, 2020, approximately 15% of our total portfolio, or $317.4 million, consists of variable rate loans. Of these variable rate loans, approximately $102.4 million have floors that limited the overall reduction in rates in the first half. At June 30, 2020, our outstanding fixed rate loans represented 33% of our loan portfolio. The remaining 52% of our loan portfolio at June 30, 2020 consists of adjustable rate loans. However, the majority of these loans (approximately $857.5 million) will not adjust for at least another 3 years. Approximately $64.9 million of these adjustable rate loans will reprice in the next quarter with $22.4 repricing in smaller amounts monthly over the fourth quarter of 2020.
In addition, as described below under Nonperforming Assets, as of June 30, 2020, the Company has modified approximately $386.2million of loans under Section 4013 of the CARES Act. These modifications generally provide for a six-month deferral of both interest and principal. As of June 30, 2020, there is approximately $4.9 million of accrued but uncollected interest related to such modifications. If a portion of this interest is uncollectible, it could impact interest income recognition in future quarters.
Cash balances were increased on June 30, 2020 in anticipation of mortgage warehouse line utilization. For both the quarterly and year to date comparisons, volumes were higher than the same periods in 2019 contributing to the overall unfavorable net volume and rate variance since cash balances earned considerably lower yields than other earning assets. It is expected that these balances will return to more normalized levels later in 2020. Overall average investment securities increased by $45.2 million for the quarter ending June 30, 2020 as compared to June 30, 2019 and by $44.1 million for the first six months of 2020, as compared to 2019. Non-taxable securities increased for both the quarterly and first six-month periods by $67.2 million and $60.3 respectively. The overall investment portfolio had a tax-equivalent yield of 2.80% at June 30, 2020, with an average life of 4.2 years.
Interest expense was $1.2 million in the second quarter of 2020, a decline of $2.3 million, or 65%, compared to the second quarter of 2019 and was $3.5 million in the first six-months of 2020, a decline of $3.6 million or 51%, compared to the first six-months of 2019. The significant decline in interest expense for both the quarter and the half is attributable to a favorable shift in deposit mix as average total time deposits declined by $74.7 million in the second quarter of 2020 as compared to the same quarter in 2019 and by $47.9 million for the first half of 2020 as compared to the same period in 2019. The average cost of interest-bearing deposits declined by 59 basis points, or 72%, to 23 basis points for the second quarter of 2020 compared to the second quarter of 2019, and by 45 basis points, or 55% for the first six-months of 2020 as compared to the same period in 2019.
PROVISION FOR LOAN AND LEASE LOSSES
Credit risk is inherent in the business of making loans. The Company sets aside an allowance for loan and lease losses, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for loan and lease losses. The Company recorded a loan loss provision of $2.2 million in the second quarter of 2020 compared to $0.4 million in the second quarter of 2019, and a year-to-date loan loss provision totaling $4.0 million in 2020 as compared to $0.7 million for the comparable period in 2019. As discussed above, the significant increase in the provision for loan and lease losses is primarily due to management’s estimate of the impact of increased economic uncertainty with respect to COVID-19 on our customers’ ability to repay loans. There was no increase in the provision for loan and lease losses due to the additional $116.2 million in SBA PPP loans as those loans are guaranteed under a new 7(a) loan program titled the “Paycheck Protection Program” and carry a 100 percent guarantee by the SBA. Management adjusted its qualitative risk factors under our incurred loss model based on information presently available for economic conditions, changes in payment deferral procedures, expected changes in collateral values due to reduced cash flows, and external factors such as government actions. In particular, the uncertainty regarding our customers’ ability to repay loans could be adversely impacted by COVID-19 given higher unemployment rates, requests for payment deferrals, temporary business shut-downs, and reduced consumer and business spending.
The Company was subject to the adoption of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-13 and related amendments, Financial Instruments – Credit Losses (Topic 326). However, the Company elected under Section 4014 of the CARES Act to defer the implementation of CECL until the earlier of when the national emergency related to the outbreak of COVID-19 ends or December 31, 2020. Although this deferral will still require CECL to be adopted as of January 1, 2020, the Company believes that the deferral will provide time to better assess the impact of the COVID-19 pandemic on the expected lifetime credit losses. There is increased uncertainty on the local, regional, and national economy as a result of local and state stay-at-home orders, as well as relief measures provided at a national, state, and local level. Further, the Company has taken actions to mitigate the impact on credit losses including permitting short-term payment deferrals to current customers, as well as providing bridge loans and SBA Paycheck Protection Program loans. More time is needed to assess the impact of this uncertainty and related actions on the Company’s allowance for loan and lease losses under the CECL methodology. It is anticipated that a one-time adjustment to the allowance will be booked as an adjustment through equity, net of taxes, as previously disclosed in Company’s Form 10-K for the fiscal year ended December 31, 2019, for approximately $12 million. The impact of COVID-19 on the Company’s allowance for loan and leases losses under the CECL methodology in the second quarter and first half of 2020 will remain unknown until more information is available with respect to the impact of the economic uncertainty of the impact of COVID-19, net of actions taken to mitigate such impact.
Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance. The Company recorded net charge-offs of $0.1 million in the second quarter of 2020 as compared to net recoveries of less than $0.1 million in the second quarter of 2019. For the first six months, net charge-offs were $0.4 million in 2020 and $0.6 million in 2019.
The allowance for loan and lease losses is at a level that, in Management’s judgment, is adequate to absorb probable loan losses related to specifically-identified impaired loans as well as probable incurred losses in the remaining loan portfolio.
The Company’s policies for monitoring the adequacy of the allowance, determining loan balances that should be charged off, and other detailed information with regard to changes in the allowance are discussed in Note 11 to the consolidated financial statements, and below, under “Allowance for Loan and Lease Losses.” The process utilized to establish an appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan loss provision, and consequently in our net earnings.
NONINTEREST INCOME AND NONINTEREST EXPENSE
The following table provides details on the Company’s noninterest income and noninterest expense for the three- and six month periods ended June 30, 2020 and 2019:
Noninterest Income/Expense
NON-INTEREST INCOME:
% of Total
Service charges on deposit accounts
37.94%
53.81%
44.61%
51.81%
Other service charges and fees
2,503
36.28%
2,514
42.94%
4,907
37.73%
4,777
40.61%
Net gains on sale of securities available-for-sale
5.65%
0.38%
3.00%
649
9.41%
2.17%
687
5.28%
1,027
8.73%
740
10.72%
0.70%
1,221
9.38%
(164)
-1.39%
100.00%
As a % of average interest-earning assets (1)
1.07%
1.01%
1.03%
OTHER OPERATING EXPENSE:
51.39%
50.93%
54.22%
51.36%
Occupancy costs
Furniture & equipment
619
3.43%
692
3.92%
1,084
3.02%
1,215
Premises
1,885
10.45%
1,758
9.96%
3,748
10.13%
Advertising and marketing costs
2.36%
3.17%
1,026
2.86%
1,252
3.53%
Data processing costs
1,045
1,255
7.11%
2,187
6.10%
2,507
7.06%
Deposit services costs
2,229
12.36%
2,124
12.03%
4,025
11.23%
3,893
10.96%
Loan services costs
Loan processing
191
1.06%
1.16%
362
376
0.34%
68
0.19%
Other operating costs
Telephone & data communications
2.59%
1.80%
835
624
1.76%
Postage & mail
0.59%
0.46%
174
0.49%
276
0.78%
2.02%
459
2.60%
751
2.09%
803
2.26%
Professional services costs
Legal & accounting
357
1.98%
524
2.97%
685
1.91%
935
2.63%
Acquisition costs
-0.01%
Other professional service
701
3.89%
437
2.48%
947
2.64%
1,374
3.87%
Stationery & supply costs
131
0.73%
101
0.57%
246
0.69%
156
0.44%
Sundry & tellers
184
1.02%
109
275
0.77%
182
0.51%
2.80%
3.03%
2.94%
3.10%
Efficiency ratio (2)(3)
57.78%
58.17%
58.33%
58.46%
Total noninterest income reflects increases of $1.0 million, or 18%, for the quarterly comparison and $1.2 million, or 11% for the year-to-date comparison. BOLI income increased by $0.5 million as compared to the second quarter of 2019 but decreased $0.3 million for the first half of 2020 as compared to the same period in 2019. These variances are due mostly to fluctuations in underlying values of assets in the specific account BOLI policies that are designed to have similar assets to those in the deferred compensation plans. Thus, the higher quarterly values in BOLI policies are offset by higher deferred compensation expense reflected primarily in director fees expense and vice versa for the first six months of 2020 compared to 2019. At June 30, 2020, there was $43.0 million in BOLI policies associated with the deferred compensation plans and $8.3 million in separate account BOLI policies. Complementing the change in BOLI income for the quarterly and year to date comparison was a $0.7 and $1.4 million increase respectively, in other noninterest income due to the wrap up of a low- income housing tax credit fund along with a $0.4 million gain on the sale of debt securities.
There was a $0.5 million decrease in service charges on deposit accounts mostly from lower returned items and overdraft fees for the quarterly comparison and $0.3 million decrease for the year to date comparison. The Company expects that service charges on deposit accounts could continue to decline in future quarters based on reduced customer activity and increased waivers due to COVID-19.
Additionally in the “other” category of noninterest income the Company reflected a $0.2 million decrease in the second quarter from the valuation of restricted stock held by the Company as required under FASB ASU 2016-01, but an increase of $0.2 million for the year to date comparison. This stock is related to an equity investment in Pacific Coast Bankers’ Bank and is adjusted when financial information becomes available, generally in the late first quarter of each year. This stock was revalued in the first quarter of 2020, but was not revalued in 2019 until the second quarter. In addition, noninterest income includes a valuation adjustment related to investments in low-income housing credit investments. This valuation adjustment was a reduction of income of $0.2 million in the second quarter of 2020 as compared to a $0.5 million reduction in the second quarter of 2019, and $0.3 million in the first half of 2020 compared to $0.9 million in 2019.
Total noninterest expense increased by $0.4 million, or 2%, in the second quarter of 2020 relative to the second quarter of 2019, and by $0.3 million, or 1%, in the first six months of 2020 as compared to the first six months of 2019. Noninterest expense dropped to 2.8% of average earning assets in the second quarter of 2020 from 3.03% for the second quarter of 2019 and was 2.94% of average earning assets for the first six months of 2020 relative to 3.10% for the first six months of 2019.
Salaries and Benefits were $0.3 million, or 3%, higher in the second quarter of 2020 as compared to the second quarter of 2019 and $1.2 million higher for the first six months of 2020 compared to the same period in 2019. The reason for this increase is due to several factors, including merit increases for employees due to annual performance evaluations for 2020. These increases were mitigated by the impact of deferred salaries related to loan origination costs, which were $0.8 million higher in the second quarter of 2020 relative to the second quarter of 2019, and $0.5 million higher for the first six months of 2020 compared to the same period in 2019. There have not been any permanent or temporary reductions in employees as a result of COVID-19.
Occupancy expenses were roughly the same for the respective comparative periods. Further, other noninterest expense categories as a whole was relatively unchanged for the second quarter 2020 as compared to the second quarter in 2019 but was $0.9 million lower for the first half of 2020 as compared to the same period in 2019. The variance for year-to-date 2020 compared to the same period in 2019 was primarily driven by a $0.7 million, or 30%, decline in professional services expenses. Those professional services variances include a $0.2 million decrease in FDIC assessments due to the Small Bank Assessment credits applied against FDIC deposit insurance costs, a $0.2 million decrease in deferred compensation expense for directors, which is linked to the changes in BOLI income, and a $0.2 million reduction in consulting costs.
The Company’s tax-equivalent efficiency ratio was 57.78% in the second quarter 2020 as compared to 58.17% in the same quarter of 2019, and 58.33% for the first six months of 2020 and 58.46% for the comparative period in 2019. The efficiency ratio represents total noninterest expense divided by the sum of fully tax-equivalent net interest and noninterest income; the provision for loan losses and investment gains/losses are excluded from the equation. Given the expected decline in net interest income due to the lower rate environment in 2020, it is expected that the efficiency ratio could increase in 2020.
PROVISION FOR INCOME TAXES
The Company sets aside a provision for income taxes on a monthly basis. The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits. Permanent differences include but are not limited to tax-exempt interest income, BOLI income, and certain book expenses that are not allowed as tax deductions. Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds. The Company’s provision for income taxes was 23.2% of pre-tax income in the second quarter of 2020 relative to 26.4% in the second quarter of 2019, and 23.6% of pre-tax income for the first half of 2020 relative to 25.3% for the same
period in 2019. The decrease for the 2020 quarterly comparison is due primarily to an increase in partially tax exempt municipal bond interest and tax exempt BOLI income. Although the comparison for the first six months was also positively impacted by an increased level of municipal bond interest it was also negatively impacted by a lower level of tax-exempt BOLI income.
BALANCE SHEET ANALYSIS
EARNING ASSETS
The Company’s interest-earning assets are comprised of investments and loans, and the composition, growth characteristics, and credit quality of both of those components are significant determinants of the Company’s financial condition. Investments are analyzed in the section immediately below, while the loan and lease portfolio and other factors affecting earning assets are discussed in the sections following investments.
INVESTMENTS
The Company’s investments may at any given time consist of debt securities and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest-earning balances in our Federal Reserve Bank account, and overnight fed funds sold. The Company’s investments can serve several purposes, including the following: 1) they can provide liquidity for potential funding needs; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with structural characteristics that can be changed more readily than loan or deposit portfolios, as might be required for interest rate risk management purposes; 4) they are another interest-earning option for the placement of surplus funds when loan demand is light; and 5) they can provide partially tax exempt income. Surplus balances in our Federal Reserve Bank account and fed funds sold to correspondent banks typically represent the temporary investment of excess liquidity. Aggregate investments totaled $667.2 million, or 21% of total assets at June 30, 2020, and $615.3 million, or 24% of total assets at December 31, 2019.
The Company carries investments at their fair market values. We currently have the intent and ability to hold our investment securities to maturity, but the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. The expected average life for bonds in our investment portfolio was 4.2 years and their average effective duration was 2.9 years at June 30, 2020, down from an expected average life of 4.4 years and an average effective duration of 3.2 years at year-end 2019.
The following table sets forth the amortized cost and fair market value of Company’s investment portfolio by investment type as of the dates noted:
Investment Portfolio
Available for Sale
The net unrealized gain on our investment portfolio, or the amount by which aggregate fair market values exceeded amortized cost, was $23.0 million at June 30, 2020, a $14.6 million increase relative to the net unrealized gain of $8.4 million at December 31, 2019. The change was caused by declining long-term market interest rates on fixed-rate bond
values. Municipal bond balances comprise 37% of our total securities portfolio at June 30, 2020, as compared to 31% at December 31, 2019. Municipal bonds purchased have strong underlying ratings, and we review all municipal bonds in our portfolio every quarter for potential impairment.
Investment securities that were pledged as collateral for borrowings and/or potential borrowings from the Federal Home Loan Bank and the Federal Reserve Bank, repurchase agreements, and other purposes as required or permitted by law totaled $242.4 million at June 30, 2020 and $234.8 million at December 31, 2019, leaving $356.9 million in unpledged debt securities at June 30, 2020 and $366.0 million at December 31, 2019. Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $60.5 million at June 30, 2020 and $71.0 million at December 31, 2019.
LOAN AND LEASE PORTFOLIO
Gross loans and leases reflect a net increase of $449.5 million, or 26%, growing to $2.212 billion at June 30, 2020 from $1.763 billion at December 31, 2019 due to organic growth in commercial real estate loans, an increase in commercial and industrial loans from our participation in the SBA PPP program and an increase in outstanding balances on mortgage warehouse lines.
A distribution of the Company’s loans showing the balance and percentage of loans by type is presented for the noted periods in the table below. The balances in the table are before deferred or unamortized loan origination, extension, or commitment fees, and deferred origination costs. While not reflected in the loan totals and not currently comprising a material segment of our lending activities, the Company also occasionally originates and sells, or participates out portions of, loans to non-affiliated investors.
Loan and Lease Distribution
Percentage of Total Loans and Leases
4.03%
6.01%
4.09%
8.05%
11.36%
2.00%
2.81%
2.53%
3.09%
14.19%
19.51%
31.26%
23.42%
6.08%
8.17%
72.23%
79.55%
2.73%
10.01%
6.55%
15.29%
10.73%
For the first six months of 2020, gross loans were up by $449.5 million, or 26%, including increases of $149.0 million in mortgage warehouse lines, $205.2 million increase in non-agricultural real estate loans, and a $106.0 million increase in commercial and industrial loans. Mortgage warehouse loan balances increased due to market factors favorably impacting line utilization due to both mortgage originations and refinancing activity. Mortgage warehouse utilization was 79.2% at June 30, 2020, as compared to 58.7% at December 31, 2019. Future utilization of the mortgage warehouse lines could be impacted if the economic impacts of the COVID-19 pandemic reduce the demand for mortgages.
Non-agricultural real estate loan balances increased due to deliberate and concentrated efforts of our Northern and Southern market loan production teams. The growth in these markets was mostly due to commercial real estate and was the primary driver of our $278.7 million increase in non-owner occupied commercial real estate loans.
Residential real estate loans have been declining since the Company made the deliberate decision to discontinue such lending at the end of 2018, thus maturing balances and prepayments are no longer being replaced.
Total commercial real estate loan balances increased in 2020 by $248.7 million due to an increase in non-owner occupied properties. In the first quarter of 2020, the Company hired lending teams to focus primarily on commercial real estate loans in our northern and southern markets. At June 30, 2020 the Bank’s regulatory credit concentration of commercial real estate loans (CRE), as defined in the Interagency Guidance dated, December 12, 2006, was 304%.
Management employs heightened risk management practices with respect to CRE lending, including board and management oversight, strategic planning, development and underwriting standards, risk assessment and monitoring through market analysis, and stress testing. At June 30, 2020 we have concluded that we have an acceptable and well-managed concentration in CRE lending under the foregoing standards.
The 91.8% increase in Commercial and Industrial loans from $115.5 million at December 31, 2019 to $221.5 million was primarily driven by the Company’s participation in the Small Business Administration’s PPP as authorized by the CARES Act. The Company began accepting and funding loans under this program in April 2020. As of June 30, 2020, the Company obtained approval from the Small Business Administration and has funded PPP loans for approximately 1,242 customers totaling $116.2 million.
The recent growth in loans, in particular, real estate loans was accomplished without relaxing any of the Company’s credit standards that had been tightened after the great recession. Instead, the growth came by diversifying geography with new loan teams announced in the first quarter 2020 in our Northern and Southern California markets. Those loan teams have maintained these enhanced underwriting standards through the pandemic and have not compromised credit quality when sourcing new loans. However, no assurance can be given as to how these loans will perform over their lifetime.
NONPERFORMING ASSETS
Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, in addition to foreclosed assets which can include mobile homes and OREO. If the Company grants a concession to a borrower in financial difficulty, the loan falls into the category of a TDR. TDRs may be classified as either nonperforming or performing loans depending on their underlying characteristics and circumstances. The following table presents comparative data for the Company’s nonperforming assets and performing TDRs as of the dates noted:
Nonperforming assets and performing troubled debt restructurings
NON-ACCRUAL LOANS:
1,454
1,472
TOTAL REAL ESTATE
3,461
Agriculture
569
90
TOTAL NONPERFORMING LOANS
770
Total nonperforming assets
8,701
6,537
4,890
Performing TDRs (1)
9,192
8,415
9,246
Nonperforming loans as a % of total gross loans and leases
0.26%
0.33%
Nonperforming assets as a % of total gross loans and leases and foreclosed assets
0.27%
Total nonperforming assets increased by $2.2 million, or 33.1%, during the first six months of 2020. The increase resulted from $2.1 million in new foreclosed assets due to the impact of one commercial real estate credit that went into foreclosure. The commercial property that went into other real estate owned has a pending contract. None of these increases were due to COVID-19. As a result of the increase in the gross loan portfolio, the Company’s ratio of nonperforming assets to loans decreased to 0.26% at June 30, 2020, from 0.33% at December 31, 2019. All of the Company’s impaired assets are periodically reviewed, and are either well-reserved based on current loss expectations, or are carried at the fair value of the underlying collateral net of expected disposition costs.
As shown in the table, we also had $9.2 million in loans classified as performing TDRs on which we were still accruing interest as of June 30, 2020, an increase of $0.8 million, or 9%, relative to December 31, 2019.
Foreclosed assets had a carrying value of $2.9 million at June 30, 2020, comprised of 9 properties classified as OREO and two mobile homes relative to year-end 2019 when foreclosed assets consisted of 10 properties classified as OREO and two mobile homes. Two very-low value properties were sold during the first six months 2020. All foreclosed assets are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.
An action plan is in place for each of our non-accruing loans and foreclosed assets and they are all being actively managed. Collection efforts are continuously pursued for all nonperforming loans, but we cannot provide assurance that they will be resolved in a timely manner or that nonperforming balances will not increase.
The Company is providing deferrals to certain customers and taking advantage of Section 4013 of the CARES Act, which provides that such deferrals do not result in treatment of such loan as a TDR. These deferrals typically provide deferrals of both principal and interest for 180 days. Interest continues to accrue during the deferral period. At the end of the deferral period, for term loans, payments will be applied to accrued interest first and after the accrued interest is paid in full, the loan will be re-amortized with the maturity extended. For lines of credit, the borrower must repay the accrued interest at the end of the deferral period or take out a second credit facility to repay the accrued interest. As of June 30, 2020, 313 customers, for a total of $386.2 million, had executed a loan modification under Section 4013 of the CARES Act. Approximately 97% of these loan deferrals were for commercial customers with 38% or $145.0 million of these modifications, in the hospitality industry. In addition, there were $98.7 million, or 26%, that are lessors of real estate, both commercial and residential; $45.5 million, or 12%, in the dairy industry; and $28.7 million, or 7%, related to convenience stores, and $2.7 million, or 0.7%, in the healthcare industry. Of the commercial deferrals, there were $10.1 million that were unsecured. Consumer deferrals totaled $11.2 million, of which $7.5 million were mortgage related. While these modified loans are not classified as nonperforming or classified assets at June 30, 2020, we will continue to monitor these loans during the deferral period and if circumstances change, we may downgrade the loan to a criticized asset or consider it a troubled debt restructuring. If a portion of the customers are not able to resume payments after the deferral period, it likely could result in higher classified and/or nonperforming assets, reversals of interest income, and/or higher charge-offs.
ALLOWANCE FOR LOAN AND LEASE LOSSES
The allowance for loan and lease losses, a contra-asset, is established through periodic provisions for loan and lease losses. It is maintained at a level that is considered adequate to absorb probable losses on specifically identified impaired loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge off.
As described above, the Company elected under Section 4014 of the CARES Act to defer the implementation of CECL until the earlier of when the national emergency related to the outbreak of COVID-19 ends or December 31, 2020. The Company believes that the deferral will provide time to better assess the impact of the COVID-19 pandemic and related stimulus and relief efforts on the expected lifetime credit losses.
The Company’s allowance for loan and lease losses was $13.6 million at June 30, 2020, an increase of $3.6 million, or 36.7%, relative to December 31, 2019 resulting from a $4.0 million loan loss provision recorded during the first six
months of 2020, less $0.4 million in net charge-offs during the same period. The additional loan loss provision in the first half of 2020 was precipitated primarily by qualitative factors associated with economic uncertainty during these unprecedented times. No additional loan loss was necessary for the $116.2 million in SBA PPP loans added during the quarter ending June 30, 2020, as those loans carry a 100 percent guarantee by the SBA under a new 7(a) loan program titled the “Paycheck Protection Program”. For further information regarding the Company's decision to defer the implementation of CECL under Section 4014 of the CARES Act, as well as further detail on the increase in provision during the second quarter of 2020, please see the discussion above under Provision for Loan and Lease Losses. The allowance was 0.61% of total loans at June 30, 2020, and 0.56% at both December 31, 2019 and June 30, 2019. The ratio of the allowance for loan and lease losses to nonperforming loans was 233.47% at June 30, 2020, relative to 172.96% at December 31, 2019 and 239.88% for June 30, 2019. Management's detailed analysis indicates that the Company's allowance for loan and lease losses should be sufficient to cover credit losses inherent in loan and lease balances outstanding as of June 30, 2020, but no assurance can be given that the Company will not experience substantial future losses relative to the size of the allowance. With respect to exposures related to the COVID-19 pandemic, the Company had 83 relationships in the hospitality industry totaling $222.5 million at June 30, 2020. In addition to loans in the hospitality sector, we have approximately $17.0 million of loans in the oil and gas industry, and $66.0 million of loans to retail businesses at June 30, 2020.
A separate allowance of $0.3 million for potential losses inherent in unused commitments is included in other liabilities at June 30, 2020.
The following table summarizes activity in the allowance for loan and lease losses for the noted periods:
For the threemonths ended
For the sixmonths ended
For the year ended
June 30,
December 31,
Balances:
Average gross loans and leases outstanding during period (1)
1,753,748
Gross loans and leases outstanding at end of period
Allowance for loan and lease losses:
Balance at beginning of period
Provision charged to expense
1,190
254
92
832
1,274
286
562
903
1,114
2,409
816
1,946
4,873
148
150
147
297
Net loan charge offs
93
363
Balance at end of period
RATIOS
Net charge-offs to average loans and leases (annualized)
0.02%
0.04%
Allowance for loan losses to gross loans and leases at end of period
0.56%
Allowance for loan losses to nonperforming loans
233.47%
239.88%
172.96%
Net loan charge-offs to allowance for loan losses at end of period
-0.46%
2.68%
5.74%
23.95%
Net loan charge-offs to provision for loan losses
4.23%
-11.25%
9.08%
81.00%
93.22%
The Company’s allowance for loan and lease losses at June 30, 2020 represents Management’s best estimate of probable losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance. Furthermore, fluctuations in credit quality, changes in economic conditions, updated accounting or regulatory requirements, and/or other factors could induce us to augment or reduce the allowance.
OFF-BALANCE SHEET ARRANGEMENTS
The Company maintains commitments to extend credit in the normal course of business, as long as there are no violations of conditions established in the outstanding contractual arrangements. It is unlikely that all unused commitments will ultimately be drawn down. Unused commitments to extend credit totaled $449.0 million at June 30, 2020 and $492.0 million at December 31, 2019, representing approximately 20% of gross loans outstanding at June 30, 2020 and 28% at December 31, 2019. The drop in unused commitments is due in large part to the increase in outstanding balances on mortgage warehouse lines. The Company also had undrawn letters of credit issued to customers totaling $9.4 million at June 30, 2020 and $8.6 million at December 31, 2019. The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of commitments to provide credit cannot be reasonably predicted because there is no guarantee that the lines of credit will ever be used. However, the “Liquidity” section in this Form 10-Q outlines resources available to draw upon should we be required to fund a significant portion of unused commitments.
In addition to unused commitments to provide credit, the Company is utilizing a $105 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits and to facilitate certain credit arrangements with the Company’s customers. That letter of credit is backed by loans that are pledged to the FHLB by the Company. For more information on the Company’s off-balance sheet arrangements, see Note 7 to the consolidated financial statements located elsewhere herein.
OTHER ASSETS
Interest-earning cash balances were discussed above in the “Investments” section, but the Company also maintains a certain level of cash on hand in the normal course of business as well as non-earning deposits at other financial institutions. Our balance of cash and due from banks depends on the timing of collection of outstanding cash items (checks), the amount of cash held at our branches, and our reserve requirement among other things, and it is subject to significant fluctuations in the normal course of business. While cash flows are normally predictable within limits, those limits are fairly broad and the Company manages its short-term cash position through the utilization of overnight loans to, and borrowings from, correspondent banks, including the Federal Reserve Bank and the Federal Home Loan Bank. Should a large “short” overnight position persist for any length of time, the Company typically raises money through focused retail deposit gathering efforts or by adding brokered time deposits. If a “long” position is prevalent, we could let brokered deposits or other wholesale borrowings roll off as they mature, or we might invest excess liquidity into longer-term, higher-yielding bonds. The Company’s balance of non-earning cash and due from banks was $88.7 million at June 30, 2020 relative to $65.6 million at December 31, 2019. The increase is primarily due to maintaining higher amounts of cash on hand due to lack of certainty from our armored cash delivery vendor during the COVID-19 pandemic due to potential staffing issues and governmental stay-at-home orders.
Foreclosed assets are discussed above in the section titled “Nonperforming Assets.” Net premises and equipment increased by $0.3 million during the first six months of 2020. Goodwill was $27 million at June 30, 2020, unchanged during the first six months of 2020. As mentioned above, the Company performed a qualitative assessment of goodwill impairment during the second quarter 2020 and determined that a quantitative analysis was not required at this time. The Company will continue to monitor its Goodwill for potential impairment given the COVID-19 pandemic. Bank-owned life insurance, with a balance of $51.3 million at June 30, 2020, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.
DEPOSITS AND INTEREST BEARING LIABILITIES
DEPOSITS
Deposits represent another key balance sheet category impacting the Company’s net interest income and profitability metrics. Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity accounts such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts. Information concerning average balances and rates paid by deposit type is included in the Average Balances and Rates tables appearing above, in the section titled “Net
Interest Income and Net Interest Margin.” A distribution of the Company’s deposits by type, showing the period-end balance and percentage of total deposits, is presented as of the dates indicated in the following table.
Deposit Distribution
Non-interest bearing demand deposits
Interest bearing demand deposits
144,215
91,212
497,601
458,600
Savings
346,262
294,317
125,419
118,933
Time, under $250,000
199,061
211,916
Time, $250,000 or more
234,534
252,446
10,000
50,000
Percentage of Total Deposits
37.89%
31.86%
5.75%
19.85%
21.15%
13.81%
5.48%
7.94%
9.77%
9.36%
11.64%
2.31%
Deposit balances reflect net growth of $338.4 million, or 16%, during the first six months of 2020. Time deposits were $443.6 million at June 30, 2020 as compared to $514.4 million at December 31, 2019. The $70.8 million decline in time-deposits was a result of a $40 million reduction in brokered deposits and a $30.8 million in other time-deposits. The Company chose not to renew brokered deposits given the growth in non-maturity deposits of $409.1 million, or 24.7%, during the first six months of 2020. All of our non-maturity deposit growth was organic in nature.
Management is of the opinion that a relatively high level of core customer deposits is one of the Company’s key strengths, and we continue to strive for core deposit retention and growth. In particular, the Company’s ratio of noninterest-bearing deposits to total deposits was 37.9% at June 30, 2020 as compared to 31.9% at December 31, 2019.
OTHER INTEREST-BEARING LIABILITIES
The Company’s non-deposit borrowings may, at any given time, include fed funds purchased from correspondent banks, borrowings from the Federal Home Loan Bank, advances from the Federal Reserve Bank, securities sold under agreements to repurchase, and/or junior subordinated debentures. The Company uses short-term FHLB advances and fed funds purchased on uncommitted lines to support liquidity needs created by seasonal deposit flows, to temporarily satisfy funding needs from increased loan demand, and for other short-term purposes. The FHLB line is committed, but the amount of available credit depends on the level of pledged collateral.
Total non-deposit interest-bearing liabilities increased by $158.8 million, or 197%, during the first six months of 2020 primarily due to an increase in borrowings from the FHLB primarily to fund increased temporary utilization of mortgage warehouse lines. Repurchase agreements totaled $41.4 million at June 30, 2020 relative to a balance of $25.7 million at year-end 2019. Repurchase agreements represent “sweep accounts”, where commercial deposit balances above a specified threshold are transferred at the close of each business day into non-deposit accounts secured by investment securities. The Company had junior subordinated debentures totaling $35.0 million at both June 30, 2020 and December
31, 2019, in the form of long-term borrowings from trust subsidiaries formed specifically to issue trust preferred securities.
OTHER NONINTEREST BEARING LIABILITIES
Other liabilities are principally comprised of operating lease right-of-use liabilities, accrued interest payable, other accrued but unpaid expenses, and certain clearing amounts. The Company’s balance of other liabilities was $36.4 million at June 30, 2020 as compared to $35.5 million at December 31, 2019.
LIQUIDITY AND MARKET RISK MANAGEMENT
LIQUIDITY
Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by Management on a monthly basis, with various stress scenarios applied to assess our ability to meet liquidity needs under unusual or adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored and we are committed to maintaining adequate liquidity resources to draw upon should unexpected needs arise.
The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet these short-term needs, we can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.
At June 30, 2020 and December 31, 2019, the Company had the following sources of primary and secondary liquidity ($ in thousands):
Primary and Secondary Liquidity Sources
Cash and Due From Banks
Unpledged Investment Securities
356,903
366,012
Excess Pledged Securities
60,462
70,955
FHLB Borrowing Availability
293,454
443,200
Unsecured Lines of Credit
80,000
Funds Available through Fed Discount Window
60,102
59,198
Totals
939,626
1,099,441
In addition to the above sources, the Company could obtain brokered deposits, obtain deposits via deposit listing services, or offer higher rate time deposits within our market. At June 30, 2020, the Company applied for and received approval to borrow $116.2 million from the Federal Reserve Bank for a Paycheck Protection Program Lending Facility (PPPLF). The PPPLF provides the Company with the ability to pledge any PPP loan to the Federal Reserve Bank and obtain funding at 35 basis points. Further, any loans pledged to the PPPLF will be excluded from the regulatory leverage capital ratio. Due to the Company’s liquidity throughout the first half of 2020 it elected not to utilize the PPPLF during the quarter. The Company will continue to evaluate whether it should utilize the PPPLF in the third quarter 2020.
The Company performs regular stress tests on its liquidity and at this time, believes that we have sufficient primary and secondary liquidity sources for operations.
The Company has a higher level of actual balance sheet liquidity than might otherwise be the case, since we utilize a letter of credit from the FHLB rather than investment securities for certain pledging requirements. That letter of credit, which is backed by loans pledged to the FHLB by the Company, totaled $105 million at June 30, 2020 and December 31, 2019. Other sources of liquidity included the brokered deposit market, deposit listing services, and the ability to offer local time-deposit campaigns. Management is of the opinion that available investments and other potentially
liquid assets, along with standby funding sources it has arranged, are more than sufficient to meet the Company’s current and anticipated short-term liquidity needs and that its liquidity has not been adversely impacted by COVID-19.
The Company’s net loans to assets and available investments to assets ratios were 71.0% and 15.6%, respectively, at June 30, 2020, as compared to internal policy guidelines of “less than 78%” and “greater than 3%.” Other liquidity ratios reviewed periodically by Management and the Board include net loans to total deposits and wholesale funding to total assets, including ratios and sub-limits for the various components comprising wholesale funding, which were all well within policy guidelines at June 30, 2020. The Company has been able to maintain a robust liquidity position in recent periods, but no assurance can be provided that our liquidity position will continue at current strong levels.
The holding company’s primary uses of funds include operating expenses incurred in the normal course of business, interest on trust preferred securities, shareholder dividends, and stock repurchases. Its primary source of funds is dividends from the Bank, since the holding company does not conduct regular banking operations. As of June 30, 2020, the holding company maintained a cash balance of $15.3 million. Management anticipates that with the available cash and the continued ability for the Bank to provide dividends to the holding company, that the holding company has sufficient liquidity to meet its funding requirements for the foreseeable future. Both the holding company and the Bank are subject to legal and regulatory limitations on dividend payments, as outlined in Item 5(c) Dividends in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 which was filed with the SEC.
INTEREST RATE RISK MANAGEMENT
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company does not engage in the trading of financial instruments, nor does it have exposure to currency exchange rates. Our market risk exposure is primarily that of interest rate risk, and we have established policies and procedures to monitor and limit our earnings and balance sheet exposure to changes in interest rates. The principal objective of interest rate risk management is to manage the financial components of the Company’s balance sheet in a manner that will optimize the risk/reward equation for earnings and capital under a variety of interest rate scenarios.
To identify areas of potential exposure to interest rate changes, we utilize commercially available modeling software to perform monthly earnings simulations and calculate the Company’s market value of portfolio equity under varying interest rate scenarios. The model imports relevant information for the Company’s financial instruments and incorporates Management’s assumptions on pricing, duration, and optionality for anticipated new volumes. Various rate scenarios consisting of key rate and yield curve projections are then applied in order to calculate the expected effect of a given interest rate change on interest income, interest expense, and the value of the Company’s financial instruments. The rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels).
In addition to a stable rate scenario, which presumes that there are no changes in interest rates, we typically use at least six other interest rate scenarios in conducting our rolling 12-month net interest income simulations: upward shocks of 100, 200, and 300 basis points, and downward shocks of 100, 200, and 300 basis points. Those scenarios may be supplemented, reduced in number, or otherwise adjusted as determined by Management to provide the most meaningful simulations considering economic conditions and expectations at the time. Given the current near zero interest rate environment it is unlikely that rates could decline much further beyond the downward shock of 100 basis points, therefore the downward shock scenarios of 200 and 300 basis points are temporarily being suspended after concurrence by the Company’s Board of Directors. We currently utilize an additional upward rate shock scenario of 400 basis points. Pursuant to policy guidelines, we generally attempt to limit the projected decline in net interest income relative to the stable rate scenario to no more than 5% for a 100 basis point (bp) interest rate shock, 10% for a 200 bp shock, 15% for a 300 bp shock, and 20% for a 400 bp shock.
The Company had the following estimated net interest income sensitivity profiles, without factoring in any potential negative impact on spreads resulting from competitive pressures or credit quality deterioration:
Immediate change in Interest Rates (basis points)
% Change in Net Interest Income
$ Change in Net Interest Income
$ Change in
Net Interest Income
+400
5.4%
5,373
2.7%
2,573
+300
4.5%
4,477
2.6%
2,481
+200
3.5%
3,529
1.9%
1,847
+100
2.3%
2,308
1.3%
1,202
Base
(100)
-6.3%
(6,235)
-3.9%
(3,729)
Our simulations for both periods represented indicate that the Company’s net interest income will increase over the next 12 months in a rising rate environment, but a continued drop in interest rates could have a substantial negative impact. However for the period ended June 30, 2020, given the 150-basis point decrease in the target federal funds rate in March 2020 and the drop in the 5-year and 10-year Treasury yields in the first six months of 2020, it is unlikely to see dramatic rate decreases unless rates go negative. We have seen a drop in projected net interest income across all scenarios and an exacerbated negative impact in declining rate scenarios in recent periods, resulting from the impact of interest rate reductions and balance sheet changes including an increase in loans with variable rate characteristics (mortgage warehouse loans), the runoff of loans which had rates fixed for periods in excess of a year, and a shift in our deposit mix toward time deposits. If there were an immediate and sustained upward adjustment of 100 basis points in interest rates, all else being equal, net interest income over the next 12 months is projected to improve by $2.3 million, or 2.30%, for the period ending June 30, 2020 and $1.2 million, or 1.3%, for the period ended June 30, 2019, relative to a stable interest rate scenario, with the favorable variance increasing as interest rates rise higher. If interest rates were to decline by 100 basis points, however, net interest income would likely be $6.2 million lower or -6.3% for the period ended June 30, 2020, and $3.7 million lower or –3.9% for the period ended June 30, 2019, than in a stable interest rate scenario. The unfavorable variance increases when rates drop are due to the fact that certain deposit rates are already relatively low (on NOW accounts and savings accounts for example), and will hit a natural floor of close to zero while non-floored variable-rate loan yields continue to drop. This effect is exacerbated by accelerated prepayments on fixed-rate loans and mortgage-backed securities when rates decline, although rate floors on some of our variable-rate loans partially offset other negative pressures. While we view material interest rate reductions as unlikely in the near term, the potential percentage decline in net interest income in the “down 100 basis points” interest rate scenario exceeds our internal policy guidelines for the period ended June 30, 2020
In addition to the net interest income simulations shown above, we run stress scenarios for the unconsolidated Bank modeling the possibility of no balance sheet growth, the potential runoff of “surge” core deposits which flowed into the Bank in the most recent economic cycle, and unfavorable movement in deposit rates relative to yields on earning assets (i.e., higher deposit betas). When a static balance sheet and a stable interest rate environment are assumed, projected annual net interest income is more than $1 million lower than in our standard simulation. However, the stressed simulations reveal that the Company’s greatest potential pressure on net interest income would result from excessive non-maturity deposit runoff and/or unfavorable deposit rate changes in rising rate scenarios.
The economic value (or “fair value”) of financial instruments on the Company’s balance sheet will also vary under the interest rate scenarios previously discussed. The difference between the projected fair value of the Company’s financial assets and the fair value of its financial liabilities is referred to as the economic value of equity (“EVE”), and changes in EVE under different interest rate scenarios are effectively a gauge of the Company’s longer-term exposure to interest rate fluctuations. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at anticipated replacement interest rates for each account type, while the fair value of non-financial accounts is assumed to equal their book value for all rate scenarios. An economic value simulation is a static measure utilizing balance sheet accounts at a given point in time, and the measurement can change substantially over time, as is evident in the tables below for the periods ending June 30, 2020 and 2019, respectively, as the Company’s balance sheet evolves and interest rate and yield curve assumptions are updated.
The change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including stated interest rates or spreads relative to current or projected market-level interest rates or spreads, the likelihood of principal prepayments, whether contractual interest rates are fixed or floating, and the average remaining time to maturity. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical patterns and Management’s best estimates. Our EVE had been increasing due to asset growth and rising discount rates, which result in a larger benefit assessed to non-maturity deposits, but that trend reversed in the second quarter of 2019 as loan growth slowed and interest rates started to fall. The tables below show estimated changes in the Company’s EVE, under different interest rate scenarios relative to a base case of current interest rates:
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
36.5%
195,263
15.6%
92,095
32.1%
171,790
14.2%
83,884
25.2%
134,702
11.7%
69,015
14.5%
77,398
7.4%
43,571
-11.1%
(59,340)
-14.3%
(84,297)
The table shows that our EVE will generally deteriorate in moderate declining rate scenarios, but should benefit from a parallel shift upward in the yield curve. The rate of increase in EVE accelerates the higher interest rates rise. This increase in sensitivity is caused by the increase in gross deposits, namely, an increase in noninterest bearing deposits. We also run stress scenarios for the unconsolidated Bank’s EVE to simulate the possibility of adverse movement in loan prepayment rates, unfavorable changes in deposit rates, and higher deposit decay rates. Model results are highly sensitive to changes in assumed decay rates for non-maturity deposits, in particular, with material unfavorable variances occurring relative to the standard simulations shown above as decay rates are increased. Furthermore, while not as extreme as the variances produced by increasing non-maturity deposit decay rates, EVE also displays a relatively high level of sensitivity to unfavorable changes in deposit rate betas in rising interest rate scenarios.
CAPITAL RESOURCES
The Company had total shareholders’ equity of $327.4 million at June 30, 2020, comprised of $112.6 million in common stock, $3.5 million in additional paid-in capital, $195.1 million in retained earnings, and accumulated other comprehensive income of $16.2 million. At the end of 2019, total shareholders’ equity was $309.3 million. The increase during the first six months of 2020 is due to the addition of capital from net income and stock options exercised as well as a $10.3 million favorable swing in accumulated other comprehensive income, net of the impact of cash dividends paid and share repurchases. There were repurchases totaling 112,050 shares at a weighted average cost of $22.86 per share executed by the Company during the first quarter of 2020. The Company has 268,301 shares authorized to repurchase under the current repurchase program. The Company suspended its stock repurchase program on March 16, 2020 and continues to evaluate when or if we will restart repurchasing shares.
The Company uses a variety of measures to evaluate its capital adequacy, including the leverage ratios which is calculated separately for the Company and the Bank. Management reviews these capital measurements on a quarterly basis and takes appropriate action to help ensure that they meet or surpass established internal and external guidelines. As permitted by the regulators for financial institutions that are not deemed to be “advanced approaches” institutions, the Company has elected to opt out of the Basel III requirement to include accumulated other comprehensive income in risk-based capital. The following table sets forth the consolidated Company’s and the Bank’s regulatory capital ratios as of the dates indicated.
Regulatory Capital Ratios
Minimum
Requirement
Required
to be
Community Bank
Well Capitalized (3)
Leverage Ratio (2) (4)
Sierra Bancorp
Common Equity Tier 1 Capital to Risk-Weighted Assets (1)
N/A
13.27
%
6.50
Tier 1 Capital to Risk-weighted Assets (1)
14.98
8.00
Total Capital to Risk-weighted Assets (1)
15.48
10.00
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio") (1)
11.91
5.00
Bank of the Sierra
14.75
15.25
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio")
10.87
11.73
The federal banking agencies published a final rule on November 13, 2019, that provided a simplified measure of capital adequacy for qualifying community banking organizations. A qualifying community banking organization that opts into the community bank leverage ratio framework and maintains a leverage ratio greater than 9 percent will be considered to have met the minimum capital requirements, the capital ratio requirements for the well capitalized category under the Prompt Corrective Action framework, and any other capital or leverage requirements to which the qualifying banking organization is subject. A qualifying community banking organization with a leverage ratio of greater than 9 percent may opt into the community bank leverage ratio framework if has average consolidated total assets of less than $10 billion, has off-balance-sheet exposures of 25% or less of total consolidated assets, and has total trading assets and trading liabilities of 5 percent or less of total consolidated assets. Further, the bank must not be an advance approaches banking organization.
The final rule became effective January 1, 2020 and banks that meet the qualifying criteria can elect to use the community bank leverage framework starting with the quarter ended March 31, 2020. The CARES Act reduced the required community bank leverage ratio to 8% until the earlier of December 31, 2020, or the national emergency is declared over. The federal bank regulatory agencies adopted an interim final rule to implement this change from the CARES Act. The Company and the Bank meet the criteria outlined in the final rule and the interim final rule and have adopted the community bank leverage ratio framework in the first quarter 2020.
PART I – FINANCIAL INFORMATION
Item 3
QUALITATIVE & QUANTITATIVE DISCLOSURES
ABOUT MARKET RISK
The information concerning quantitative and qualitative disclosures about market risk is included in Part I, Item 2 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Market Risk Management.”
Item 4
CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report (the “Evaluation Date”) have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities, particularly during the period in which this quarterly report was being prepared.
Disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our Management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized, and reported within the time periods specified by the SEC.
Changes in Internal Controls
There were no significant changes in the Company’s internal controls over financial reporting that occurred in the first six months of 2020 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II - OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
The Company is involved in various legal proceedings in the normal course of business. In the opinion of Management, any liability resulting from such proceedings would not have a material adverse effect on the Company’s financial condition or results of operations.
ITEM 1A: RISK FACTORS
The following risk factors supplement the risks described in the Company’s Form 10-K under Item 1A, “Risk Factors” for its year ended December 31, 2019 filed with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended. The ongoing COVID-19 pandemic may also have the effect of heightening many of the other risks described in the section entitled “Risk Factors” in our most recent Annual Report on Form 10-K and any subsequent filings with the U.S. Securities and Exchange Commission.
Our business, results of operations, and financial condition have been, and will likely continue to be, adversely affected by the ongoing COVID-19 pandemic.
The ongoing COVID-19 pandemic, and governmental and societal responses thereto, have had a severe impact on recent global economic and market conditions, including significant disruption of, and volatility in, financial markets; global supply chain disruptions; and the institution of social distancing and shelter-in-place requirements that have resulted in temporary closures of many businesses, lost revenues, and increased unemployment throughout the United States, but also specifically in California, where all of our operations and a large majority of our customers are located.
These conditions have impacted and are expected in the future to impact-our business, results of operations, and financial condition negatively, including through lower revenue from certain of our fee-based businesses; lower net interest income resulting from lower interest rates and increased loan delinquencies; increased provisions for credit losses; impairments on the securities we hold; and decreased demand for certain of our products and services. Additionally, our liquidity and regulatory capital could be adversely impacted by volatility and disruptions in the capital and credit markets; deposit flows; and continued client draws on lines of credit as well as our participation in the Small Business Administration Paycheck Protection Program. Our business operations may also be disrupted if significant portions of our workforce are unable to work effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic. Negative impacts from these conditions also may include:
While governmental authorities have taken unprecedented measures to provide economic assistance to individual households and businesses, stabilize the markets, and support economic growth, the success of these measures is unknown and they may not be sufficient to mitigate fully the negative impact of the ongoing pandemic. Further, some measures, such as a suspension of mortgage and other loan payments and foreclosures, may have a negative impact on our business, while our participation in other measures could result in reputational harm, litigation, or regulatory and government actions, proceedings, or penalties.
The extent to which the COVID-19 pandemic impacts our business, results of operations and financial condition will depend on future developments, which are highly uncertain and are difficult to predict, including, but not limited to, the duration and spread of the outbreak, its severity, the actions to contain the virus or treat its impact, and how quickly and to what extent normal economic and operating conditions can resume, particularly in California.
Our Traditional Service Delivery Channels may be Impacted by the COVID-19 Pandemic
In light of the external COVID-19 threat, the Board of Directors and senior management are continuously monitoring the situation, providing frequent communications, and making adjustments and accommodations for both external clients and our employees. All branches remain open to serve our customers and local communities, with modified hours and strict social distancing protocols in place as well as limiting our branches to walk-up, drive-up or appointment only customer visits. Our customers have been encouraged to utilize branch alternatives such as using our ATMs, online banking, and mobile banking application in lieu of in-branch transactions. In addition, many employees are working remotely and travel as well as face-to-face meeting restrictions are in effect. Further, given the increase of the risk of cybersecurity incidents during the pandemic, we have enhanced our cybersecurity protocols. If the pandemic worsens, resurges or lasts for an extended period of time, to protect the health of the Company’s workforce and our customers, we may need to enact further precautionary measures to help minimize the risks to our employees and customers, thus potentially altering our service delivery channels and operations over a prolonged period. These changes to our traditional service delivery channels may negatively impact our customers’ experience of banking with us, result in loss of service fees, and increase costs through equipment and services needed to support a remote workforce, and therefore negatively impact our financial condition and results of operation.
ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(c) Stock Repurchases
In September 2016 the Board authorized 500,000 shares of common stock for repurchase, subsequent to the completion of previous stock buyback plans. The authorization of shares for repurchase does not provide assurance that a specific quantity of shares will be repurchased, and the program can be suspended at any time at Management’s discretion. After a lengthy deferral of repurchase activity, the Company resumed share repurchases in mid-August 2019 through March 2020. The following table provides information concerning the Company’s stock repurchase transactions during the second quarter of 2020:
Stock Repurchases
April 30, 2020
May 31, 2020
Total shares repurchased
Average per share price
Number of shares purchased as part of a publicly announced plan or program
Maximum number of shares remaining for purchase under a plan or program
380,351
ITEM 3: DEFAULTS UPON SENIOR SECURITIES
Not applicable
ITEM 4: MINE SAFETY DISCLOSURES
ITEM 5: OTHER INFORMATION
ITEM 6: EXHIBITS
Exhibit #
Description
3.1
Restated Articles of Incorporation of Sierra Bancorp (1)
3.2
Amended and Restated By-laws of Sierra Bancorp (2)
4.1
Description of Securities (3)
10.1
Salary Continuation Agreement for Kenneth R. Taylor (4)*
10.2
Salary Continuation Agreement and Split Dollar Agreement for James F. Gardunio (5)*
10.3
Split Dollar Agreement for Kenneth R. Taylor (6)*
10.4
Director Retirement and Split dollar Agreements Effective October 1, 2002, for Albert Berra, Morris Tharp, and Gordon Woods (6)*
10.5
401 Plus Non-Qualified Deferred Compensation Plan (6)*
10.6
Indenture dated as of March 17, 2004 between U.S. Bank N.A., as Trustee, and Sierra Bancorp, as Issuer (7)
10.7
Amended and Restated Declaration of Trust of Sierra Statutory Trust II, dated as of March 17, 2004 (7)
10.8
Indenture dated as of June 15, 2006 between Wilmington Trust Co., as Trustee, and Sierra Bancorp, as Issuer (8)
10.9
Amended and Restated Declaration of Trust of Sierra Capital Trust III, dated as of June 15, 2006 (8)
10.10
2007 Stock Incentive Plan (9)
10.11
Sample Retirement Agreement Entered into with Each Non-Employee Director Effective January 1, 2007 (10)*
10.12
Salary Continuation Agreement for Kevin J. McPhaill (10)*
10.13
First Amendment to the Salary Continuation Agreement for Kenneth R. Taylor (10)*
10.14
Second Amendment to the Salary Continuation Agreement for Kenneth R. Taylor (11)*
10.15
First Amendment to the Salary Continuation Agreement for Kevin J. McPhaill (12)*
10.16
Indenture dated as of September 20, 2007 between Wilmington Trust Co., as Trustee, and Coast Bancorp, as Issuer (13)
10.17
Amended and Restated Declaration of Trust of Coast Bancorp Statutory Trust II, dated as of September 20, 2007 (13)
10.18
First Supplemental Indenture dated as of July 8, 2016, between Wilmington Trust Co. as Trustee, Sierra Bancorp as the “Successor Company”, and Coast Bancorp (13)
10.19
2017 Stock Incentive Plan (14)*
10.20
Employment agreements dated as of December 27, 2018 for Kevin McPhaill, CEO, Kenneth Taylor, CFO, James Gardunio, Chief Credit Officer, and Michael Olague, Chief Banking Officer (15)*
10.21
Employment agreement dated as of March 15, 2019 for Matthew Macia, Chief Risk Officer (16)*
10.22
Employment agreement dated as of November 15, 2019 for Christopher Treece, Chief Financial Officer (17)*
10.23
Employment agreement dated as of January 17, 2020 for Jennifer Johnson, Chief Administrative Officer (18)*
31.1
Certification of Chief Executive Officer (Section 302 Certification)
31.2
Certification of Chief Financial Officer (Section 302 Certification)
Certification of Periodic Financial Report (Section 906 Certification)
101.INS
XBRL Instance Document
101.SCH
XBRL Taxonomy Extension Schema Document
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
*Indicates management contract or compensatory plan or arrangement.
SIGNATURES
Pursuant to the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:
August 6, 2020
/s/ Kevin J. McPhaill
Date
Kevin J. McPhaill
President & Chief Executive Officer
(Principal Executive Officer)
/s/ Christopher G. Treece
Christopher G. Treece
Chief Financial Officer
/s/ Cindy L. Dabney
Cindy L. Dabney
Principal Accounting Officer