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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2023
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 November 1, 2023, the registrant had 14,701,933 shares of common stock outstanding, including 176,492 shares of unvested restricted stock.
Page
Part I - Financial Information
1
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets
Consolidated Statements of Income
2
Consolidated Statements of Comprehensive Income (Loss)
3
Consolidated Statements of Changes In Shareholders’ 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
36
Forward-Looking Statements
Critical Accounting Policies
37
Overview of the Results of Operations and Financial Condition
38
Earnings Performance
39
Net Interest Income and Net Interest Margin
Provision for Credit Losses on Loans
44
Noninterest Income and Noninterest Expense
46
Provision for Income Taxes
48
Balance Sheet Analysis
Earning Assets
Investments
Loan Portfolio
50
Nonperforming Assets
52
Allowance for Credit Losses on Loans
Off-Balance Sheet Arrangements
54
Other Assets
55
Deposits and Interest-Bearing Liabilities
Deposits
Other Interest-Bearing Liabilities
56
Noninterest-Bearing Liabilities
57
Liquidity and Market Risk Management
Capital Resources
61
Item 3. Quantitative & Qualitative Disclosures about Market Risk
62
Item 4. Controls and Procedures
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
65
Item 4. - Mine Safety Disclosures
Item 5. - Other Information
Item 6. - Exhibits
66
Signatures
68
PART I - FINANCIAL INFORMATION
Item 1 – Financial Statements
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
September 30, 2023
December 31, 2022
ASSETS
(unaudited)
(audited)
Cash and due from banks
$
84,655
72,803
Interest-bearing deposits in banks
3,887
4,328
Total cash & cash equivalents
88,542
77,131
Investment securities
Available-for-sale, net of zero allowance for credit losses at September 30, 2023 and December 31, 2022
1,010,377
934,923
Held-to-maturity, (fair value of $290,956 at September 30, 2023 and $328,011 at December 31, 2022)
323,560
336,944
Allowance for credit losses on held-to-maturity securities
(16)
(63)
Net, investment securities held-to-maturity
323,544
336,881
Loans:
Gross loans
2,100,810
2,052,940
Deferred loan costs (fees), net
163
(123)
Allowance for credit losses on loans
(23,060)
Net loans
2,077,913
2,029,757
Premises and equipment, net
21,926
22,478
Goodwill
27,357
Other intangible assets, net
1,618
2,275
Bank-owned life insurance
51,332
52,169
Other assets
136,271
125,619
Total assets
3,738,880
3,608,590
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Noninterest-bearing
1,059,878
1,088,199
Interest-bearing
1,809,842
1,757,965
Total deposits
2,869,720
2,846,164
Repurchase agreements
94,865
109,169
Other borrowings
317,000
219,000
Long-term debt
49,281
49,214
Subordinated debentures
35,615
35,481
Allowance for credit losses on unfunded loan commitments
600
840
Other liabilities
62,940
45,140
Total liabilities
3,430,021
3,305,008
Commitments and contingent liabilities (Note 7)
Shareholders' equity
Common stock, no par value; 24,000,000 shares authorized; 14,702,079 and 15,170,372 shares issued and outstanding at September 30, 2023 and December 31, 2022, respectively
109,638
112,928
Additional paid-in capital
4,934
4,148
Retained earnings
256,201
243,082
Accumulated other comprehensive loss, net
(61,914)
(56,576)
Total shareholders' equity
308,859
303,582
Total liabilities and shareholders' equity
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2023 AND 2022
(dollars in thousands, except per share data, unaudited)
Three months ended September 30,
Nine months ended September 30,
2023
2022
Interest and dividend income
Loans, including fees
24,915
21,833
71,736
64,211
Taxable securities
14,375
7,646
39,848
15,613
Tax-exempt securities
2,679
2,346
8,233
5,926
Federal funds sold and other
415
103
861
466
Total interest income
42,384
31,928
120,678
86,216
Interest expense
8,767
1,761
22,710
3,105
Federal funds purchased and repurchase agreements
817
71
3,335
231
Federal Home Loan Bank advances
3,522
319
6,692
429
427
1,286
1,284
762
439
2,120
1,024
Total interest expense
14,297
3,017
36,143
5,963
Net interest income
28,087
28,911
84,535
80,253
(Benefit) provision for credit losses
(33)
1,259
157
4,184
Net interest income after provision for credit losses
28,120
27,652
84,378
76,069
Noninterest income
Service charges and fees on deposit accounts
6,055
6,008
17,127
17,464
Net gains on sale of securities available-for-sale
—
396
1,032
Increase (decrease) in cash surrender value of life insurance
558
(23)
1,388
(1,252)
Other income
1,149
627
3,444
5,870
Total noninterest income
7,762
6,612
22,355
23,114
Noninterest expense
Salaries and employee benefits
12,623
11,521
37,567
35,070
Occupancy and equipment costs
2,482
2,470
7,251
7,170
Other
7,457
7,005
23,704
21,042
Total noninterest expense
22,562
20,996
68,522
63,282
Income before taxes
13,320
13,268
38,211
35,901
Provision for income taxes
3,435
3,333
9,656
9,355
Net income
9,885
9,935
28,555
26,546
PER SHARE DATA
Book value
21.01
19.56
Cash dividends
0.23
0.69
Earnings per share basic
0.68
0.66
1.93
1.77
Earnings per share diluted
1.76
Average shares outstanding, basic
14,583,132
14,954,503
14,762,231
14,968,242
Average shares outstanding, diluted
14,636,477
15,014,048
14,791,696
15,046,883
Total shareholders' equity (in thousands)
295,072
Shares outstanding
14,702,079
15,085,675
Dividends paid (in thousands)
3,407
3,471
10,361
10,449
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(dollars in thousands, unaudited)
Other comprehensive (loss) gain, before tax:
Unrealized loss on securities:
Unrealized holding loss arising during period
(7,670)
(14,994)
(7,182)
(101,432)
Less: reclassification adjustment for gains included in net income (1)
(396)
(1,032)
Other comprehensive loss, before tax
(7,578)
(102,464)
Income tax benefit related to items of other comprehensive loss, net of tax
2,267
4,433
2,240
30,292
Other comprehensive loss, net of tax:
(5,403)
(10,561)
(5,338)
(72,172)
Comprehensive income (loss)
4,482
(626)
23,217
(45,626)
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2023 AND 2022
Accumulated
Additional
Common Stock
Paid In
Retained
Comprehensive
Shareholders'
Shares
Amount
Capital
Earnings
Loss
Equity
Balance, June 30, 2022
15,090,792
111,727
4,585
233,179
(50,444)
299,047
Other comprehensive loss, net of tax
Stock options exercised, net of shares surrendered for cashless exercises
5,400
458
(397)
Restricted stock surrendered due to employee tax liability
(9,965)
(74)
(147)
(221)
Restricted stock forfeited / cancelled
(552)
Stock based compensation - stock options
18
Stock based compensation - restricted stock
264
Cash dividends - $0.23 per share
(3,471)
Balance, September 30, 2022
112,111
4,470
239,496
(61,005)
Balance, June 30, 2023
14,811,736
110,097
4,887
251,119
(56,511)
309,592
Restricted shares withheld for taxes
(10,129)
(76)
(136)
(212)
Restricted stock vested in period
374
(374)
16
405
Stock repurchase
(99,528)
(740)
(1,260)
(2,000)
Excise tax on stock repurchase
(17)
(3,407)
Balance, September 30, 2023
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2023 AND 2022
(Loss) Income
Balance, December 31, 2021
15,270,010
113,007
3,910
234,410
11,167
362,494
Cumulative change in accounting principle
(7,315)
10,600
512
(398)
114
(11,161)
(83)
(170)
(253)
(1,212)
892
(182,562)
(1,325)
(3,526)
(4,851)
Stock issued-acquisition
Cash dividends - $0.69 per share
(10,449)
Balance, December 31, 2022
15,170,372
Other comprehensive income, net of tax
Restricted stock granted
29,064
(11,893)
(89)
(159)
(248)
(4,370)
454
(454)
53
1,187
(481,094)
(3,574)
(4,916)
(8,490)
(81)
(10,361)
5
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Gain on sales of securities
(Gain) loss on disposal of fixed assets
(15)
Gain on sale on foreclosed assets
(8)
Writedowns on foreclosed assets
91
Stock based compensation expense
1,240
958
Provision for credit losses on loans
444
4,360
(Benefit) provision for credit losses on held-to-maturity securities
(47)
Depreciation and amortization
1,787
1,910
Net amortization on securities premiums and discounts
2,199
2,934
Net accretion of premiums/discounts for loans acquired
(232)
(149)
(Increase) decrease in cash surrender value of life insurance policies
(1,388)
1,251
Amortization of core deposit intangible
657
758
Increase in interest receivable and other assets
(1,880)
(18,017)
Decrease in other liabilities
17,560
15,506
Deferred income tax benefit
(347)
(2,397)
Decrease in value of restricted bank equity securities
291
332
Excise tax on stock repurchases
Amortization of debt issuance costs
67
Net amortization of partnership investment
453
338
Net cash provided by operating activities
48,867
33,460
Cash flows from investing activities:
Maturities and calls of securities available for sale
65,581
7,663
Proceeds from sales of securities available for sale
25,676
26,408
Purchases of securities available for sale
(197,153)
(450,984)
Principal pay downs on securities available for sale
34,445
60,198
Net purchases of FHLB stock
(1,929)
(336)
Loan originations and payments, net
(67,519)
(36,286)
Purchases of premises and equipment
(1,112)
(899)
Proceeds from sale of premises and equipment
26
Proceeds from sales of foreclosed assets
19,151
10
Purchase of bank-owned life insurance
(99)
(19)
Liquidation of bank-owned life insurance
11
Increase in partnership investment
(5,000)
(7,562)
Proceeds from BOLI death benefit
2,324
859
Net cash used in investing activities
(125,609)
(400,937)
Cash flows from financing activities:
Increase in deposits
23,556
103,896
Increase in Fed funds purchased
10,000
Increase in short-term Federal Home Loan Bank advances
8,000
103,100
Proceeds from long-term Federal Home Loan Bank advances and other debt
80,000
(Decrease) increase in customer repurchase agreements
(14,304)
5,075
Cash dividends paid
Repurchases of common stock
(8,738)
(5,108)
Stock options exercised
118
Net cash provided by financing activities
88,153
196,632
Increase (decrease) in cash and cash equivalents
11,411
(170,845)
Cash and cash equivalents
Beginning of period
257,528
End of period
86,683
Supplemental disclosure of cash flow information:
Interest paid
33,993
5,958
Income taxes paid
7,455
8,946
Supplemental schedule of noncash investing and financing activities:
Real estate acquired through foreclosure
15,406
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2022
(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 September 30, 2023, 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 35 full-service branches and an online branch, and maintains ATMs at all but one of our branch locations as well as at seven non-branch locations. Moreover, the Bank has specialized lending units which focus on agricultural borrowers, commercial real estate, and mortgage warehouse lending. In addition, in February 2020 the Bank opened a loan production office which is currently located in Roseville, CA. To support organic growth in the agricultural lending sector the Bank also opened a loan production office in Templeton, CA in April 2022. The Company had total assets of $3.7 billion at September 30, 2023, 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 $2.9 billion at September 30, 2023, are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to maximum insurable amounts.
Note 2 – Basis of Presentation
The accompanying interim unaudited consolidated financial statements have been prepared in a condensed format as allowed under U.S. generally accepted accounting principles (“GAAP”). Therefore, these financial statements do not include all of the information and footnotes required for complete, audited financial statements as presented in the Company’s Annual Report on Form 10-K. 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, through November 2, 2023 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 2022 have been reclassified to be consistent with the reporting for 2023, none of which impacted net income or shareholders’ equity. 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, 2022, 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 an estimate of expected credit losses over the contractual term for financial assets carried at amortized cost (generally loans and held-to-maturity investment securities) in addition to certain off balance-sheet credit exposure. Under the current expected credit losses (“CECL”) methodology expected credit losses for financial assets are estimated over the contractual life of the financial asset, adjusted for expected prepayments, considering historical experience, current conditions, and reasonable and supportable forecasts. Additionally, under CECL the accounting for credit losses on available-for-sale debt securities is addressed through an allowance for credit losses which is a change from legacy GAAP which previously required the direct write-down of securities through the other-than-temporary impairment approach. The Company implemented CECL on January 1, 2022, using the modified retrospective approach to estimate lifetime expected losses on financial assets measured at amortized cost in addition to certain off balance sheet credit exposures. The January 1, 2022, increase in the Company’s allowance for credit losses, of $9.5 million on loans and $0.9 million in off balance sheet credit exposures, net of the impact of deferred taxes, was reflected in a transition adjustment of $7.3 million to retained earnings. There was no cumulative effect adjustment related to our available-for-sale investment portfolio upon adoption and the Company had no securities designated as held-to-maturity as of January 1, 2022.
For available-for-sale debt securities in an unrealized loss position for which management has an intent to sell the security or considers it more likely-than-not that the security in question will be sold prior to a recovery of its amortized cost basis, the security will be written down to fair value through a direct charge to income. For the remainder of available sale debt securities in an unrealized loss position, which don’t meet the previously outlined criteria, management evaluates whether the decline in fair value is a reflection of credit deterioration or other factors. In performing this evaluation, management considers the extent which fair value has fallen below amortized cost, changes in ratings by rating agencies, and other information indicating a deterioration in repayment capacity of either the underlying issuer or the borrowers providing repayment capacity in a securitization. If management’s evaluation indicates that a credit loss exists then a present value of the expected cash flows is calculated and compared to the amortized cost basis of the security in question and to the degree that the amortized cost basis exceeds the present value an allowance for credit loss (“ACL”) is established, with the caveat that the maximum amount of the reserve on any individual security is the difference between the fair value and amortized cost balance of the security in question. Any unrealized loss that has not been recorded through an ACL is recognized in other comprehensive income.
On April 1, 2022 the Company transferred $162.1 million of Agency, Mortgaged-Backed and Municipal securities from available-for-sale to held-to maturity. On October 1, 2022, a similar transfer of $198.3 million securities from available for sale to held-to-maturity was completed. Because of the implicit and explicit guarantees of the Federal Government on the Agency and Mortgage-Backed securities there is no expectation of future losses on any of these securities. The Bank’s municipal bonds moved to the held-to-maturity designation all have credit ratings considered investment grade or equivalent. A discounted-cash-flow reserve calculation was performed upon the transfer of these securities into the held-to-maturity designation and is updated on a quarterly basis. As of September 30, 2023, it was determined that the allowance for credit losses related to held-to-maturity securities is minimal given that most held-to-maturity securities are U.S. Government sponsored or are highly rated municipal securities.
In March 2023 the FASB issued, ASU No. 2023-02, “Investments—Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method.” ASU 2023-02 is intended to improve the accounting and disclosures for investments in tax credit structures. ASU 2023-02 allows entities to elect to account for qualifying tax equity investments using the proportional amortization method, regardless of the program giving rise to the related income tax credits. Previously, this method was only available for qualifying tax equity investments in low-income housing tax credit structures. ASU 2023-02 will be effective for the Company on January 1, 2024, though early adoption is permitted, and its adoption is not expected to have a significant effect on the Company’s financial statements.
On October 9, 2023, the FASB issued ASU 2023-06, “Disclosure Improvements: Codification Amendments in Response to the SEC’s Disclosure Update and Simplification of Initiative.” ASU 2023-06 amends the disclosure or presentation
8
requirements related to various subtopics in the FASB Accounting Standards Codification (the “Codification”). The ASU was issued in response to the SEC’s August 2018 final rule that updated and simplified disclosure requirements that the SEC believed were “redundant, duplicative, overlapping, outdated, or superseded.” The new guidance is intended to align U.S. GAAP requirements with those of the SEC and to facilitate the application of U.S. GAAP for all entities. ASU 2023-06 applies to all reporting entities within the scope of the amended subtopics. Note that some of the amendments introduced by the ASU are technical corrections or clarifications of the FASB’s current disclosure or presentation requirements. The effective date for each amendment of ASU 2023-06 will be the date on which the SEC’s removal of that related disclosure requirement from Regulation S-X or Regulation S-K becomes effective, with early adoption prohibited. The Company will apply the amendments in ASU 2023-06 prospectively after the effective dates. The adoption of this standard is not expected to have a significant effect on the Company’s financial statements.
Note 4 – Share Based Compensation
On March 17, 2023, the Company’s Board of Directors approved and adopted the 2023 Equity Compensation Plan (the “2023 Plan”), which became effective May 24, 2023, the date approved by the Company’s shareholders. The 2023 Plan replaced the Company’s 2017 Stock Incentive Plan (the “2017 Plan”). Options to purchase 210,800 shares granted under the 2017 Plan and options to purchase 132,649 shares that were granted under the 2007 Plan were still outstanding as of September 30, 2023, and remain unaffected by that plan’s expiration. The 2023 Plan provides for the issuance of various types of equity awards, including options, stock appreciation rights, restricted stock awards, restricted share units, performance share awards, dividend equivalents, or any combination thereof. Such awards may be granted to officers and employees as well as non-employee directors, which awards may be granted on such terms and conditions as are established by the Board of Directors or the Compensation Committee in its discretion. The total number of shares of the Company’s authorized but unissued stock reserved for issuance pursuant to awards under the 2023 Plan was initially 360,000 shares, and the number remaining available for grant as of September 30, 2023 was unchanged. 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 and restricted stock award 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 or award. The Company utilizes a Black-Scholes model to determine grant date fair values for options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards. Forfeitures are reflected in compensation costs as they occur for both types of awards. A pre-tax charge of $0.4 million was reflected in the Company’s income statement during the third quarter of 2023 and $0.3 million during the third quarter of 2022, as expense related to stock options and restricted stock awards. For the first nine months of 2023 and 2022, the charges totaled $1.2 million and $1.0 million, respectively.
Restricted Stock Grants
The Company’s Restricted Stock Awards are awards of either time-vested or performance-based shares. The Restricted Stock Awards are non-transferrable shares of common stock and are available to be granted to the Company’s employees and directors. The vesting period of Restricted Stock Awards is determined at the time the awards are issued, and different awards may have different vesting terms or performance measures; provided, however, that no installment of any Restricted Stock Award shall become vested less than one year from the grant date. Restricted Stock Awards are valued utilizing the fair value of the Company’s stock at the grant date. These awards are expensed on a straight-line basis over the vesting period and consider the probability of meeting the performance criteria. There were 29,064 shares granted to employees of the Company during the first nine months of 2023. As of September 30, 2023, there was $2.2 million of unamortized compensation cost related to unvested Restricted Stock Awards granted under the 2017 plan. That cost is expected to be amortized over a weighted average period of 1.9 years.
9
The Company’s restricted stock award activity for the nine months ended September 30, 2023 and 2022 is summarized below (unaudited):
Weighted Average Grant-Date Fair Value
Unvested shares, January 1,
175,619
21.42
165,131
21.72
Granted
21.50
Vested
(23,675)
19.17
(37,748)
19.20
Forfeited
22.79
27.16
Unvested shares, September 30,
176,638
126,171
22.45
Stock Option Grants
The Company has issued equity instruments in the form of Incentive Stock Options and Nonqualified Stock Options to certain officers and directors. No options have been granted since 2020, but the Company could elect to issue under the 2023 Plan. The exercise price of each stock option is determined at the time of the grant and may be no less than 100% of the fair market value of such stock at the time the option is granted.
The Company’s stock option activity during the nine months ended September 30, 2023 and 2022 are summarized below (dollars in thousands, except per share data, unaudited):
Weighted AverageExercise Price
Weighted Average Remaining Contractual Term (in years)
AggregateIntrinsicValue (1)
Outstanding at January 1,
352,249
25.06
348
415,870
24.15
1,338
Exercised
(5,600)
11.22
Forfeited/Expired
(8,800)
26.56
(32,381)
27.32
Outstanding at September 30,
343,449
25.02
4.48
167
377,889
24.07
5.13
470
Exercisable at September 30,
319,649
24.86
4.35
336,489
23.69
4.88
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, excluding unvested restricted stock awards. There were 14,583,132 weighted average shares outstanding during the third quarter of 2023 and 14,954,503 during the third quarter of 2022, while there were 14,762,231 weighted average shares outstanding during the first nine months of 2023 and 14,968,242 during the first nine months of 2022.
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, and unvested restricted stock awards. For the third quarter of 2023, calculations under the treasury stock method resulted in the equivalent of 53,345 shares being added to basic weighted average shares outstanding for purposes of determining diluted earnings per share, while a weighted average of 278,374 stock options were excluded from the calculation because they were underwater and thus anti-dilutive. For the third quarter of 2022 the equivalent of 59,545 shares were added in calculating diluted earnings per share, while 303,387 anti-dilutive stock options were not factored into the
computation. Likewise, for the first nine months of 2023 the equivalent of 29,465 shares were added to basic weighted average shares outstanding in calculating diluted earnings per share and a weighted average of 326,036 options that were anti-dilutive for the period were not included, compared to the addition of the equivalent of 78,641 shares and non-inclusion of 299,404 anti-dilutive options in calculating diluted earnings per share for first nine months of 2022.
Note 6 – Comprehensive Income (Loss)
As presented in the Consolidated Statements of Comprehensive Income (Loss), comprehensive income (loss) includes net income and other comprehensive income (loss). The Company’s only source of other comprehensive income (loss) 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 (loss) 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 (loss) in the current period.
Note 7 – Commitments and Contingent Liabilities
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
543,722
889,517
Standby letters of credit
5,124
6,037
Commitments to extend credit consist primarily of the unused or unfunded portions of the following: mortgage warehouse lines, home equity lines of credit, commercial real estate construction loans, where disbursements are made over the course of construction; commercial revolving 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. Included in unused commitments are mortgage warehouse lines which are in the form of repo lines and are unconditionally cancellable. Unused commitments on mortgage warehouse lines were $254.4 million at September 30, 2023 and $594.6 million at December 31, 2022. The decline in unused mortgage warehouse commitments is due to the Company strategically reducing total exposure on certain individual lines while increasing the number of overall mortgage warehouse lines.
The ACL on unfunded commitments is estimated using the same reserve or coverage rates calculated on collectively evaluated loans following the application of a funding rate to the amount of the unfunded commitment. The funding rate represents management’s estimate of the amount of the current unfunded commitment that will be funded over the remaining contractual life of the commitment and is based on historical data. The ACL on unfunded loan commitments is located in other liabilities while any related provision expense is recorded as a provision for credit losses.
At September 30, 2023, the Company was also utilizing a letter of credit in the amount of $127.9 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.
The Company is subject to loss contingencies, including claims and legal actions arising in the ordinary course of business, which are recorded as liabilities when the likelihood of loss is probable, and an amount or range of loss can be reasonably estimated. Management does not believe there are such matters that will have a material effect on the financial statements.
Note 8 – Fair Value Disclosures and Reporting 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 individually identified 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 the Company has 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 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.
12
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
958,142
52,235
Investment securities held-to-maturity
290,956
Loans, net held for investment
1,933,957
Financial liabilities:
1,811,832
2,871,710
314,364
Long-term borrowings
41,122
31,183
Investment securities available for sale
877,488
57,435
328,011
2,011,616
1,909,822
Individually evaluated collateral dependent loans
18,141
1,756,443
2,844,642
42,775
37,171
For financial asset categories that were carried on our balance sheet at fair value as of September 30, 2023 and December 31, 2022, the Company used the following methods and significant assumptions:
13
Assets reported at fair value on a recurring basis are summarized below:
Fair Value Measurements – Recurring
Fair Value Measurements at September 30, 2023, using
RealizedGain/(Loss)(Level 3)
Securities:
U.S. government agencies
107,084
Mortgage-backed securities
102,951
State and political subdivisions
178,314
Corporate bonds
Collateralized loan obligations
569,793
Total available-for-sale securities
Fair Value Measurements at December 31, 2022, using
50,599
122,532
205,980
498,377
Fair Value Measurements - Level 3 Recurring
Collateralized Loan Obligations
Corporate Bonds
Balance of recurring Level 3 assets at January 1,
195,707
27,530
Total gains or losses for the period:
Included in other comprehensive income
(5,200)
Purchases
26,806
Transfers out of Level 3
(195,707)
Balance of recurring Level 3 assets at September 30,
54,336
All of the Company’s collateralized loan obligations with a fair value of $195.7 million as of January 1, 2022 were transferred from Level 3 to Level 2 during the first quarter of 2022 because observable market data became available due to a significant increase in trading volume for these securities during that time.
14
The Company had no assets reported at fair value on a nonrecurring basis at September 30, 2023. Assets reported at fair value on a nonrecurring basis at September 30, 2022 are summarized in the table below:
Fair Value Measurements – Nonrecurring
SignificantObservable Inputs(Level 2)
SignificantUnobservable Inputs(Level 3)
Real estate:
Farmland
15,391
Total real estate
Other commercial
2,750
Consumer loans
Total collateral dependent loans
Foreclosed assets
Total assets measured on a nonrecurring basis
The table above includes collateral-dependent 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 collateral dependent loan balances and specific loss reserves associated with those balances is included in Note 10 below.
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 individually identified loans.
Note 9 – Investments
Investment Securities
Pursuant to FASB’s guidance on accounting for debt 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. Held-to-maturity securities are carried on the Company’s financial statements at their amortized cost, net of the allowance for credit losses.
15
The amortized cost, estimated fair value, and allowance for credit losses of available-for-sale and held-to-maturity investment securities are as follows:
Amortized Cost And Estimated Fair Value
AmortizedCost
GrossUnrealizedGains
GrossUnrealizedLosses
Allowance for Credit Losses
Estimated FairValue
Available-for-sale
108,385
(1,301)
112,464
30
(9,543)
209,198
(30,896)
65,244
(13,009)
574,051
838
(5,096)
1,069,342
880
(59,845)
GrossUnrecognizedGains
GrossUnrecognizedLosses
Held-to-maturity
5,557
(854)
4,703
145,658
(17,622)
128,036
172,345
(14,144)
158,217
Total held-to-maturity securities
(32,620)
50,625
49
(75)
129,948
(7,416)
223,810
607
(18,437)
65,164
(7,739)
515,032
60
(16,715)
984,579
726
(50,382)
6,047
(621)
5,426
157,473
(9,915)
147,558
173,424
1,603
175,027
(10,536)
The Company reassessed classification of certain investments and effective April 1, 2022 the Company transferred $162.1 million of Agency, Mortgaged-Backed and Municipal securities from the available-for-sale designation to the held-to-maturity designation. On October 1, 2022, a similar transfer of $198.3 million securities from available for sale to held-to-maturity was completed. The securities were transferred at their fair value as of the transfer date, with the related unrealized gain or loss as of the date of transfer included in the amortized cost basis of the transferred security and subject to amortization or accretion over each security’s remaining life. An unrealized loss of $28.9 million, on securities transferred from the available-for-sale to held-to-maturity categorization, remains as of September 30, 2023
and is included in accumulated other comprehensive income, net of tax. The remaining unrealized loss on the securities transferred from available-for-sale to held-to-maturity, will be accreted over the remaining term of the securities, with the amortized-cost basis of these securities and accumulated comprehensive income each increasing over time.
Because of the implicit and explicit guarantees of the Federal Government on the Agency and Mortgage-Backed securities there is no expectation of future losses on any of these securities. The Bank’s municipal bonds moved to the held-to-maturity designation all have credit ratings considered investment grade or equivalent. A discounted-cash-flow reserve calculation was performed upon the transfer of these securities into the held-to-maturity designation and is updated on a quarterly basis.
The Company elected the practical expedient available under CECL to exclude accrued interest receivable from the amortized cost basis of all categorizations of investment securities, and resultingly did not estimate reserves on accrued interest receivable balances, as any past due interest income is reversed on a timely basis. Accrued interest receivable is included in other assets on the Company’s balance sheet and as of September 30, 2023, measured at $12.1 million and $1.7 million for available-for-sale securities and held-to-maturity securities, respectively. Accrued interest receivable as of December 31, 2022, on these same classes of investment securities measured at $9.3 million and $2.7 million, respectively. During the third quarter and first nine months of 2023, no interest receivable on available-for-sale or held-to-maturity securities was reversed against interest income and the Company did not have any held-to-maturity debt securities past due.
As of September 30, 2023, an allowance for credit losses of $0.02 million had been established on the Bank’s held-to-maturity portfolio, which is a decrease of $0.04 million from the December 31, 2022 allowance for credit losses of $0.06 million.
17
The following table summarizes the amortized cost of held-to-maturity municipal bonds aggregated by NRSRO credit rating:
Held-To-Maturity by Credit Rating
Held-To-Maturity
AAA/Aaa
57,802
57,833
AA/Aa
113,054
115,040
A/A2
544
551
Not rated
946
172,346
The following table summarizes available-for-sale debt securities that were in an unrealized loss position for which an ACL has not been recorded, based on the length of time the individual securities have been in an unrealized loss position, including the number of available-for-sale debt securities in an unrealized loss position, as of the dates indicated below.
Investment Portfolio - Unrealized Losses
Less than twelve months
Twelve months or more
Number of Securities
Fair Value
29
(1,180)
103,205
(121)
3,879
27
98,911
98,938
303
(2,601)
50,842
(28,295)
119,290
170,132
51
(407)
5,089
(12,602)
47,146
(77)
53,389
(5,019)
391,724
445,113
Total available-for-sale
768
(4,265)
212,552
(55,580)
660,950
873,502
27,550
340
(7,108)
119,260
(308)
3,227
122,487
252
(15,732)
147,635
(2,705)
9,807
157,442
(7,644)
54,636
(95)
55,041
(10,152)
309,102
(6,563)
169,743
478,845
712
(40,711)
658,183
(9,671)
183,182
841,365
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
2,100
3,540
91,257
34,071
Gross gains on sales, calls and maturities of securities available for sale
Gross losses on sales, calls and maturities of securities available for sale
Net gains on sale of securities available for sale
The amortized cost and estimated fair value of investment securities available-for-sale and held-to-maturity at September 30, 2023, and December 31, 2022 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
Available-for-Sale
Held-to-Maturity
Amortized Cost
Maturing within one year
586
581
145
Maturing after one year through five years
39,384
38,576
2,458
2,369
Maturing after five years through ten years
158,089
143,086
19,021
16,780
Maturing after ten years
184,768
155,390
156,278
143,626
Securities not due at a single maturity date:
19
12,141
12,184
672
666
21,013
20,831
2,059
2,032
119,649
111,513
19,048
17,431
186,796
169,486
157,692
160,324
At September 30, 2023, the Company’s investment portfolio included 485 municipal bonds issued by 395 different government municipalities and agencies located within 36 different states, with an aggregate fair value of $336.5 million. The largest exposure to any single municipality or agency was a combined $4.8 million (fair value) in general obligation bonds issued by the City of New York (NY). In addition, the Company owned 51 subordinated debentures issued by bank holding companies totaling $52.2 million (fair value).
At December 31, 2022, the Company’s investment portfolio included 501 municipal bonds issued by 406 different government municipalities and agencies located within 37 states, with an aggregate fair value of $381.0 million. The largest exposure to any single municipality or agency was a combined $5.1 million (fair value) in general obligation bonds issued by the City of New York (NY). In addition, the company owned 51 subordinated debentures issued by bank holding companies totaling $57.4 million (fair value).
The Company’s investments in bonds issued by corporations, states, municipalities and political subdivisions are evaluated in accordance with Financial Institution Letter 48-2012, issued by the FDIC, “Revised Standards of Creditworthiness for Investment Securities,” 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.
20
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
150,035
131,691
153,209
146,667
64,661
55,450
65,758
60,701
Washington
20,524
5,622
21,635
21,312
Other (29 & 26 states, respectively)
96,787
100,590
102,336
100,480
Total general obligation bonds
332,007
293,353
342,938
329,160
Revenue bonds
9,194
8,051
9,216
8,840
3,793
3,539
3,788
3,673
4,054
3,199
4,083
3,490
Other (29 & 15 states, respectively)
32,495
28,389
37,209
35,844
Total revenue bonds
49,536
43,178
54,296
51,847
Total obligations of states and political subdivisions
381,543
336,531
397,234
381,007
21
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
20,183
17,356
21,246
19,977
Lease
6,082
5,608
7,035
7,250
Sewer
6,544
5,883
6,560
6,405
Sales tax revenue
4,105
3,652
4,123
3,934
Local or GTD housing
1,035
775
3,040
2,951
Other (9 and 10 sources, respectively)
11,587
9,904
12,292
11,330
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.
The Company currently has investments in five different LIHTC fund limited partnerships made in 2014, 2015, two in 2022, and one in 2023, 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 the proportional amortization method as a “below the line” expense, over the time period in which the tax credits and tax benefits are expected to be received.
As of September 30, 2023, our total LIHTC investment book balance was $14.6 million, which includes $11.2 million in remaining commitments for additional capital contributions. There were $0.4 million in tax credits derived from our LIHTC investments that were recognized during the nine months ended September 30, 2023, and “below the line” amortization expense of $0.5 million associated with those investments was recorded for the same time period. 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.
As of December 31, 2022, our total LIHTC investment book balance was $10.1 million, which includes $7.4 million in remaining commitments for additional capital contributions. There were $0.5 million in tax credits derived from our LIHTC investments that were recognized during the year ended December 31, 2022, and amortization expense of $0.5 million associated with those investments was netted against pre-tax noninterest income for the same time period.
Note 10 – Loans and Allowance for Credit Losses
We adopted the new current expected credit loss accounting guidance, CECL, and all related amendments as of January 1, 2022. Similar to practice under legacy GAAP, the ACL on the loan portfolio is a valuation allowance deducted from the recorded balance in loans. However, under CECL the ACL represents principal which is not expected to be collected
22
over the contractual life of the loans, adjusted for expected prepayment, whereas under legacy GAAP the allowance represented only losses already incurred as of the balance sheet date. The ACL is increased by a provision for credit losses charged to expense, and by principal recovered on charged-off balances. It is reduced by principal charge-offs. The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, using information from internal and external sources, relating to past events, current conditions and reasonable and supportable forecasts. Adjustments are also made for changes in risk profile, credit concentrations, historical trends, and other economic conditions.
The Company elected the practical expedient available under CECL to exclude accrued interest receivable from the amortized cost basis of all categorizations of loans, and resultingly did not estimate reserves on accrued interest receivable balances, as any past due interest income is reversed on a timely basis. Accrued interest receivable on loans of $5.3 million and $6.4 million at September 30, 2023 and December 31, 2022, respectively is included in other assets on the Company’s balance sheet.
The following table presents loans by class as of September 30, 2023 and December 31, 2022. The December 31, 2022 balance in residential real estate loans reflects year-to-date 2022 loan purchases of $173.1 million. The majority of the disclosures in this footnote are prepared at the class level which is equivalent to the call report or call code classification. The final table in this section separates a roll forward of the Allowance for Credit Losses at the portfolio segment level.
Loan Distribution
Residential real estate
418,734
437,446
Commercial real estate
1,334,663
1,311,158
Other construction/land
7,368
18,412
90,993
113,394
1,851,758
1,880,410
137,407
102,967
Mortgage warehouse lines
107,584
65,439
4,061
4,124
Subtotal
Net deferred loan fees and costs
Loans, amortized cost basis
2,100,973
2,052,817
Allowance for credit losses
Net Loans
23
The Company places loans on nonaccrual status when management has determined that the full repayment of principal and collection of contractually agreed upon interest is unlikely or when the loan in question has become delinquent more than 90 days. The Company may decide that it is appropriate to continue to accrue interest on certain loans more than 90 days delinquent if they are well-secured by collateral and collection is in process. When a loan is placed on nonaccrual status, any accrued but uncollected interest for the loan is reversed out of interest income in the period in which the loan’s status changed. For loans with an interest reserve, i.e., where loan proceeds are advanced to the borrower to make interest payments, all interest recognized from the inception of the loan is reversed when the loan is placed on nonaccrual. Once a loan is on nonaccrual status subsequent payments received from the customer are applied to principal, and no further interest income is recognized until the principal has been paid in full or until circumstances have changed such that payments are again consistently received as contractually required. Generally, loans are not restored to accrual status until the obligation is brought current and has performed in accordance with the contractual terms for a reasonable period of time, and the ultimate collectability of the total contractual principal and interest is no longer in doubt.
The following tables present the amortized cost basis of nonaccrual loans, according to loan class, with and without individually evaluated reserves as of September 30, 2023 and December 31, 2022:
Nonaccrual Loans
With no allowance for credit loss
With an allowance for credit loss
Loans Past Due 90+ Accruing
446
335
1,115
781
688
15,812
16,500
2,909
3,072
940
19,409
170
19,579
24
The Company did not recognize any interest on nonaccrual loans during the three and nine months ended September 30, 2023, and would have recognized an additional $0.004 million and $0.06 million, respectively, in interest income on nonaccrual loans had those loans not been designated as nonaccrual. Due to loans being placed on nonaccrual status, during the third quarter and first nine months of 2023, $0.001 million and $0.3 million respectively, of interest receivable on loans was reversed against interest income .
The following table presents the amortized cost basis of collateral-dependent loans by class as of September 30, 2023, and December 31, 2022:
Collateral Dependent Loans
Individual Reserves
152
219
3,043
Total Loans
19,543
During the first nine months of 2023 the amortized cost balance of collateral-dependent loans declined by $19.3 million due to the foreclosure and subsequent sale of Farmland and other Commercial collateral related to a single borrower during the first quarter of 2023, as well as declines resulting from upgrades and payoffs. The weighted average loan-to-value ratio of collateral dependent loans was 12% at September 30, 2023. There were no collateral dependent loans in the process of foreclosure as of September 30, 2023.
25
The following tables presents the aging of the amortized cost basis in past-due loans, according to class, as of September 30, 2023 and December 31, 2022:
Past Due Loans
30-59 Days Past Due
60-89 Days Past Due
Loans Past Due 90+ Days
Total Past Due
Loans not Past Due
98
149
419,791
419,940
208
1,331,686
1,331,894
7,376
91,217
259
357
1,850,070
1,850,427
469
43
1,325
1,837
136,949
138,786
35
4,139
4,176
763
45
1,423
2,231
2,098,742
1,294
87
179
1,560
437,171
438,731
1,308,328
18,358
522
97
15,393
16,012
97,582
113,594
1,816
184
15,572
17,572
1,861,439
1,879,011
134
3,718
3,871
100,264
104,135
4,217
4,232
1,850
318
19,290
21,458
2,031,359
Loan Modifications
The Company may agree to different types of concessions when modifying a loan. There were no modifications to borrowers experiencing financial difficulty, including principal forgiveness, rate reductions, payment deferral, or term extension, during the three or nine months ended September 30, 2023. There were no payment defaults on loans previously modified in the preceding 12 months for either of the periods ending September 30, 2023 and 2022. The Company had no additional funds committed on loans which have been modified to borrowers experiencing financial difficulty.
For the three and nine months ended September 30, 2022, there were no new Troubled Debt Restructures (TDR) and no modifications of existing TDRs.
The Company monitors the credit quality of loans on a continuous basis using the regulatory and accounting classifications of pass, special mention and substandard to characterize and qualify the associated credit risk. Loans classified as “loss” are immediately charged-off. The Company uses the following definitions of risk classifications:
Pass – Loans listed as pass include larger non-homogeneous loans not meeting the risk rating definitions below and smaller, homogeneous loans not assessed on an individual basis.
Special Mention – Loans classified as special mention have the potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
Substandard – Loans classified as substandard are those loans with clear and well-defined weaknesses such as a highly leveraged position, unfavorable financial operating results and/or trends, or uncertain repayment sources or poor financial condition, which may jeopardize ultimate recoverability of the debt.
The following tables present the amortized cost of loans by credit quality classification in addition to loan vintage as of September 30, 2023 and December 31, 2022:
Loan Credit Quality by Vintage
Term Loans Amortized Cost Basis by Origination Year
2021
2020
2019
Prior
Revolving Loans Amortized Cost
Revolving Loans Converted to Term Loans
Pass
106,878
232,300
7,662
1,998
51,555
13,455
2,244
416,092
Special mention
2,617
3,008
Substandard
548
124
168
54,720
13,630
2,752
94,660
276,945
58,990
486,033
51,884
256,619
23,366
1,248,497
3,368
42,759
3,026
6,606
55,759
15,856
11,782
27,638
98,028
544,648
54,910
275,007
3,702
648
1,715
1,311
2,743
29,650
11,908
3,531
1,683
25,537
3,753
400
79,205
2,927
9,085
37,549
29,405
11,894
3,121
6,872
4,768
10,347
62,711
3,888
133,006
80
2,841
144
437
3,542
33
1,809
336
2,238
3,261
9,713
4,802
10,386
64,664
4,661
1,457
271
102
77
199
1,831
4,071
1,500
273
119
84
234
1,832
131,676
425,640
306,593
569,375
64,125
379,611
216,139
7,813
Gross Charge-Offs
1,376
250
1,305
3,044
28
2018
107,744
239,044
7,814
2,066
10,723
49,282
15,970
1,825
434,468
89
1,584
970
31
1,201
352
10,843
52,067
16,006
3,147
276,728
62,764
474,494
56,419
82,595
221,447
22,158
1,196,605
296
73,002
3,068
7,299
83,665
14,733
7,144
6,181
28,058
277,024
562,229
59,487
89,739
234,927
14,896
734
955
1,010
693
18,288
70
14,966
30,346
12,941
4,504
1,819
9,418
24,175
3,976
420
87,599
7,045
3,042
10,087
3,417
12,491
15,908
19,880
39,708
7,478
6,350
7,913
6,028
5,178
10,579
47,998
91,691
129
3,067
1,616
3,773
660
9,289
2,798
133
3,155
7,479
9,277
11,008
6,072
5,206
12,328
51,771
994
1,162
203
138
127
375
2,148
4,157
1,175
173
143
2,159
731,138
399,934
1,182,393
132,361
237,201
616,060
189,029
4,981
CECL replaces the legacy accounting for loans designated as purchased credit impaired (“PCI”) with loans designated as purchased credit deteriorated (“PCD”). PCD loans are loans acquired or purchased, which as of acquisition, had evidence of more than insignificant credit deterioration since origination. Due to the immaterial balance in the Company’s PCI loans as of December 31, 2021 management elected not to transition these loans into the PCD designation. As of September 30, 2023 the Company had no loans categorized as PCD.
As noted in footnote 3, on January 1, 2022 the Company implemented CECL and increased our ACL, previously the allowance for loan losses, with a $9.5 million cumulative adjustment. The Company’s ACL is calculated quarterly, with any difference in the calculated ACL and the recorded ACL trued-up through an entry to the provision for credit losses. For purposes of estimating the Company’s ACL, Management generally evaluates collectively evaluated loans by Federal Call code in order to group loans with similar risk characteristics together, however management has grouped loans in selected call codes together in determining portfolio segments, due to similar risk characteristics and reserve methodologies used for certain call code classifications.
Management calculates the quantitative portion of collectively evaluated reserves for all loan categories, with the exception of Farmland, Agricultural Production and Consumer loans, using a discounted cash flow (“DCF”)
methodology. For purposes of calculating the quantitative portion of collectively evaluated reserves on Farmland, Agricultural Production, and Consumer categories a Remaining Life methodology is utilized.
The DCF quantitative reserve methodology incorporates the consideration of probability of default (“PD”) and loss given default (“LGD”) estimates to estimate periodic losses. The PD estimates are derived through the application of reasonable and supportable economic forecasts to call code specific regression models, derived from the consideration of historical bank-specific and peer loss-rate data. The loss rate data has been regressed against benchmark economic indicators, for which reasonable and supportable forecasts exist, in the development of the call-code specific regression models. Regression models are generally refreshed on an annual basis, in order to pull in more recent loss rate data. Reasonable and supportable forecasts of the selected economic metric are then input into the regression model to calculate an expected default rate. The expected default rates are then applied to expected monthly loan balances estimated through the consideration of contractual repayment terms and expected prepayments. The Company utilizes a four-quarter forecast period, after which the expected default rates revert to the historical average for each call code, over a four-quarter reversion period, on a straight-line basis. The prepayment assumptions applied to expected cash flow over the contractual life of the loans are estimated based on historical, bank-specific experience, peer data and the consideration of current and expected conditions and circumstances including the level of interest rates. The prepayment assumptions may be updated by Management in the event that changing conditions impact Management’s estimate or additional historical data gathered has resulted in the need for a reevaluation. LGD utilized in the DCF is derived from the application of the Frye-Jacobs theory which relates LGD to PD based on historical peer data, as calculated by a third-party. Economic forecasts are considered over a four-quarter forecast period, with reversion to mean occurring on a straight-line basis over four quarters. The call code regression models utilized upon implementation of CECL on January 1, 2022, and as of September 30, 2023, were identical, and relied upon reasonable and supportable forecasts of the National Unemployment Rate. Management selected the National Unemployment Rate as the driver of quantitative portion of collectively reserves on loan classes reliant upon the DCF methodology, primarily as a result of high correlation coefficients identified in regression modeling, the availability of forecasts including the quarterly FOMC forecast, and given the widespread familiarity of stakeholders with this economic metric.
The quantitative reserves for Farmland, Agricultural Production and Consumer loans are calculated using a Remaining Life methodology where average historical bank specific and peer loss rates are applied to expected loan balances over an estimated remaining life of loans in calculation of the quantitative portion of collectively evaluated loans in these classes. The estimated remaining life is calculated using historical bank-specific loan attrition data. For the Farmland, Agricultural Production and Consumer classes of loans, reasonable and supportable forecasts of the National Unemployment rate, real GDP and the housing price index are considered through estimation of qualitative reserves.
Management recognizes that there are additional factors impacting risk of loss in the loan portfolio beyond what is captured in the quantitative portion of reserves on collectively evaluated loans. As current and expected conditions, may vary compared with conditions over the historical lookback period, which is utilized in the calculation of quantitative reserves, management considers whether additional or reduced reserve levels on collectively evaluated loans may be warranted given the consideration of a variety of qualitative factors. Several of the following qualitative factors (“Q-factors”) considered by management reflect the legacy regulatory guidance on Q-factors, whereas several others represent factors unique to the Company or unique to the current time period.
The qualitative portion of the Company’s reserves on collectively evaluated loans are calculated using a combination of numeric frameworks and management judgement, to determine risk categorizations in each of the Q-factors presented above. The amount of qualitative reserves is also contingent upon the historical peer, life-of-loan-equivalent, loss rate ranges and the relative weighting of Q-factors according to management’s judgement.
Although collectively evaluated reserves are generally calculated separately at the call code or loan class level, management has grouped loan classes with similar risk characteristics into the following portfolio segments: Residential Real Estate, Commercial Real Estate, Farmland & Agricultural Production, Commercial & Industrial, Mortgage Warehouse and Consumer loans. Loans secured by Residential Real Estate have a different profile from loans secured by Commercial Real Estate. Generally, the borrowers for Residential Real Estate loans are consumers whereas borrowers for Commercial Real Estate are often businesses. The COVID-19 pandemic illustrated how these different categories of real estate loans were subject to different risks, which was exacerbated by the widespread work-from-home model adopted by many companies during and since the pandemic. Farmland and Agricultural Production loans are included in a single segment as these loans are often times to the same borrowers, facing the same risks relating to commodity prices, water supply and drought conditions in addition to other environmental concerns. Commercial & Industrial loans are separated into a unique segment given the uniqueness of these loans, which are often revolving and secured by other business assets as opposed to real estate. Mortgage warehouse loans are also unique in the Company’s portfolio and warrant separate presentation as an individual portfolio segment, given the specific nature of these constantly revolving lines to mortgage originators and also attributable to a very limited loss history, even after consideration of peer data. Finally, the Company splits out Consumer loans as a separate segment as a result of the small balance, homogeneous terms that characterize these loans.
Management individually evaluates loans that do not share risk characteristics with other loans when estimating reserves. As of September 30, 2023, the only loans that Management considered to have different risk characteristics from other loans sharing the same Federal Call Report code were loans designated nonaccrual.
The following tables present the activity in the allowance for credit losses by portfolio segment for the quarters ended September 30, 2023 and 2022:
Allowance for Credit Losses and Recorded Investment in Financing Receivables
Residential Real Estate
Commercial Real Estate
Farmland & Agricultural Production
Commercial & Industrial
Mortgage Warehouse
Consumer
Allowance for credit losses:
3,037
17,373
497
1,676
283
23,010
Charge-offs
(116)
(425)
(541)
Recoveries
474
Provision for credit losses
(115)
501
40
(481)
(36)
117
Ending allowance balance:
2,922
17,874
591
1,249
108
316
23,060
3,593
17,319
376
1,133
41
22,802
(85)
(371)
(456)
196
232
(262)
249
1,034
1,212
3,331
17,568
1,410
1,151
47
23,790
There were no significant changes in the Company’s loan portfolio ACL in the third quarter of 2023.
32
The following tables present the activity in the allowance for credit losses by portfolio segment for the nine months ended September 30, 2023 and 2022:
3,251
17,732
1,233
72
314
(1,277)
(476)
(1,292)
(3,045)
205
1,370
239
770
2,601
(534)
125
253
524
1,909
9,052
1,202
1,060
521
14,256
Impact of adopting ASC 326
611
9,628
(480)
358
(421)
(242)
9,454
(1,911)
(2,170)
(244)
(984)
(5,309)
99
553
1,029
539
2,858
(141)
(44)
436
17,567
284
There were no significant changes in the Company’s loan portfolio ACL in the first nine months of 2023.
Note 11 – Goodwill
The following table discloses changes in the carrying value of goodwill for the nine months ended September 30, 2023 and 2022 (dollars in thousands, unaudited):
Net carrying value at beginning of period
Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value. Bank of the Sierra (the “Bank”) is the only subsidiary of the Company that meets the materiality criteria necessary to be deemed an operating segment, and because the Company exists primarily for the purpose of holding the stock of the Bank we have determined that only one unified operating segment or reporting unit (the consolidated Company) exists. The fair value of the consolidated Company is its market capitalization, as determined by quoted prices in active markets, plus a sales control premium, as determined by analyzing recent mergers and acquisitions. If the Company’s market capitalization plus a control premium exceeds recorded shareholders’ equity (the book value), it can be reasonably presumed that no impairment exists. Therefore, it was determined that the fair value of the reporting unit exceeded its carrying value, resulting in no impairment at September 30, 2023.
Note 12 – Borrowings and Other Arrangements
The following table summarizes the Company’s other borrowings as of September 30, 2023 and December 31, 2022:
Weighted
Average
Balance
Rate
Overnight Fed funds purchased (1)
135,000
5.12%
125,000
4.08%
Short-term FHLB advance (2)
102,000
5.35%
94,000
3.44%
Long-term FHLB advance (2)
3.91%
Total other borrowings
5.00%
3.67%
The Company has established secured and unsecured lines of credit under which it may borrow funds from time to time on a term or overnight basis from the FHLB, FRB, and other correspondent banks.
Federal Funds Purchased (1) – The Company had unsecured available lines of credit with correspondent banks and the Federal Home Loan Bank for short-term borrowings totaling $362.8 million at September 30, 2023 and $237.0 million at December 31, 2022. In general, interest rates on these lines approximate the federal funds target rate. At September 30, 2023, $75.0 million of the federal funds purchased were from the Federal Home Loan Bank.
Secured Federal Home Loan Bank Borrowings (2) – At September 30, 2023 and December 31, 2022, the Company had secured available lines of credit with the FHLB totaling $657.5 million and $718.8 million, respectively, based on eligible collateral of certain loans and investment securities.
Federal Reserve Line of Credit – The Company has an available line of credit with the Federal Reserve Bank of San Francisco secured by certain loans and investments. At September 30, 2023 and December 31, 2022 the Company had borrowing capacity under this line totaling $383.9 million and $42.3 million, respectively. We had no outstanding borrowings on this line of credit as of September 30, 2023 and December 31, 2022. The increase in this line was due to the pledging of certain Collateralized Loan Obligations.
Repurchase Agreements – 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. Repurchase agreements totaled $94.9 million at September 30, 2023 relative to a balance of $109.2 million at December 31, 2022.
Long-Term Debt – The Company has long-term debt in the form of fixed to floating rate subordinated debentures with a fixed rate of 3.25% until September 30, 2026, then floating rate at 253.5 basis points over 3-month term SOFR until maturity on October 1, 2031. The balance of the Company’s long-term debt, net of unamortized issuance costs, at September 30, 2023, was $49.3 million and December 31, 2022 was $49.2 million.
Subordinated Debentures - Sierra Statutory Trust II (“Trust II”), Sierra Capital Trust III (“Trust III”), and Coast Bancorp Statutory Trust II (“Trust IV”), (collectively, the “Trusts”) exist solely for the purpose of issuing trust preferred securities fully and unconditionally guaranteed by the Company. For financial reporting purposes, the Trusts are not consolidated, and the Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Subordinated Debentures”) held by the Trusts and issued and guaranteed by the Company are reflected in the Company’s consolidated balance sheet in accordance with provisions of ASC Topic 810. Trust preferred securities are variable rate instruments which were benchmarked against the London Interbank Offered Rate (LIBOR) plus a spread until LIBOR was phased out on June 30, 2023. These instruments are benchmarked against the Secured Overnight Financing Rate (SOFR), effective June 30, 2023. At September 30, 2023, and December 31, 2022 the Company’s trust preferred securities totaled $35.6 million and $35.5 million, respectively.
34
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.
All of the Company’s revenue from contracts within the scope of ASC 606 is recognized when incurred as noninterest income and gains on the sale of OREO which is classified as noninterest expense. These gains were immaterial for each of the three and nine months ended September 30, 2023 and 2022. The following table presents the Company’s sources of noninterest income for the three and nine month periods ended September 30, 2023 and 2022. Items outside the scope of ASC 606 are noted as such (dollars in thousands, unaudited).
For the three months ended September 30,
For the year ended December 31,
Service charges on deposits
Returned item and overdraft fees
1,375
1,273
3,929
3,973
5,227
Other service charges on deposits
2,642
2,494
7,057
7,033
9,331
Debit card interchange income
2,038
2,241
6,141
6,458
8,533
Gain (loss) on limited partnerships(1)
(162)
Dividends on equity investments(1)
275
189
772
619
843
Unrealized (losses) gains recognized on equity investments(1)
(291)
(332)
Net gains on sale of securities(1)
1,487
Other(1)
1,432
351
4,351
4,493
5,428
30,770
Percentage of noninterest income not within scope of ASC 606.
21.99%
9.13%
23.39%
24.44%
24.96%
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. These forward-looking statements are within the meaning of Section 27A of the Securities Act of 1933 (“1933 Act”), as amended and Section 21E of the Securities Exchange Act of 1934 (“1934 Act”), as amended. Those sections of the 1933 Act and 1934 Act provide a “safe harbor” for forward-looking statements in order to encourage companies to provide prospective information about their financial performance as long as important factors that could cause actual results to differ significantly from projected results are identified with meaningful cautionary statements. Words such as “expects”, “anticipates”, “believes”, “projects”, “intends”, and “estimates” or variations of such words and similar expressions, as well as future or conditional verbs preceded by “will”, “would”, “should”, “could” or “may” are intended to identify forward-looking statements. These forward-looking statements are based on certain underlying assumptions and are not guarantees of future performance, as they could be impacted by several potential risks and developments that cannot be predicted with any degree of certainty.
These statements are based on management’s current expectations regarding economic, legislative, regulatory and other environmental issues that may affect our earnings in future periods. 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:
Risk factors that could cause actual results to differ materially from results that might be implied by forward-looking statements include the risk factors detailed in the Company’s Form 10-K for the fiscal year ended December 31, 2022, and in Item 1A, herein. We do not update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.
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 which 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:
Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations regarding those areas.
OVERVIEW OF THE RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
RESULTS OF OPERATIONS SUMMARY
Third Quarter 2023 compared to Third Quarter 2022
Third quarter 2023 net income was $9.9 million, unchanged from the third quarter of 2022 and $0.68 per diluted share in the third quarter of 2023 as compared to $0.66 per diluted share in the third quarter of 2022. The Company’s annualized return on average equity was 12.62% and annualized return on average assets was 1.04% for the quarter ended September 30, 2023, compared to 12.84% and 1.13%, respectively, for the same quarter in 2022. The primary drivers behind the variance in third quarter net income are as follows:
First Nine Months 2023 compared to First Nine Months of 2022
Net income for the first nine months of 2023 was $28.6 million, or $1.93 per diluted share, compared to $26.5 million, or $1.76 per diluted share for the same period in 2022. The Company’s annualized return on average equity was 12.41% and annualized return on average assets was 1.03% for the nine months ended September 30, 2023, compared to a return on equity of 10.98% and return on assets of 1.03% for the nine months ended September 30, 2022. The primary drivers behind the variance in year-to-date net income are as follows:
FINANCIAL CONDITION SUMMARY
September 30, 2023 relative to December 31, 2022
The Company’s assets totaled $3.7 billion at September 30, 2023, an increase of $130.3 million, or 3.8% from December 31, 2022. The following provides a summary of key balance sheet changes during the first nine months of 2023:
Total capital of $308.9 million at September 30, 2023 reflects an increase of $5.3 million, or 2%, relative to year-end 2022. The Company’s regulatory Tier 1 leverage ratio was 10.12% at September 30, 2023 as compared to 10.30% at December 31, 2022. The increase in equity during the first nine months of 2023 was due to the addition of $28.6 million in net income, offset by a $5.3 million unfavorable swing in accumulated other comprehensive income/loss, due principally to changes in investment securities’ fair value, $8.5 million in share repurchases, and $10.4 million in dividends paid. The remaining difference is related to the impact of restricted stock.
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 BOLI, equity investments, and investment gains. The majority of the Company’s noninterest expense is comprised of operating costs that facilitate offering a full range of banking services to our customers.
NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest income was $28.1 million, for the third quarter of 2023, a $0.8 million decrease, or 3% over the third quarter of 2022, but increased $4.3 million, or 5%, to $84.5 million for the first nine months of 2023 relative to the same period in 2022.
Net interest income for the comparative year-to-date periods increased $4.3 million due primarily to the change in mix of interest-earning assets, moderated by an increase in interest rates paid on interest-bearing liabilities. There was a $64.0 million, or 3% increase in average loan and lease balances yielding 36 basis points higher for the same period, while average investment balances increased $157.0 million yielding 239 basis points higher for the same period as many investments are floating rate. Average interest-bearing liabilities increased $333.3 million, of which $47.1 million is an
increase in deposit balances, $174.3 million is overnight or short-term borrowings, while $51.1 million is long term FHLB borrowings. The cost of interest-bearing liabilities was 171 bps higher for the comparative periods. The net impact of the mix and rate change was a 2 basis point decrease in our net interest margin for the nine-months ending September 30, 2023 as compared to the same period in 2022.
Interest expense was $14.3 million for the third quarter of 2023, an increase of $11.3 million, relative to the third quarter of 2022. For the first nine months of 2023, compared to the same period in 2022, interest expense increased $30.2 million to $36.1 million. The significant increase in interest expense is attributable to an unfavorable shift in interest-bearing liabilities and the impact of recent interest rate increases, as the average balance of deposits, including lower cost core deposits decreased $93.2 million while higher cost borrowed funds and wholesale brokered deposits increased by $352.7 million in the third quarter of 2023 as compared to the third quarter of 2022. For the year-to-date comparisons the increase is attributable to a shift from lower cost transaction accounts to higher cost time accounts as well as an increase in borrowed funds. For the first nine months of 2023, higher cost customer time deposits increased $218.9 million, wholesale brokered deposits increased $106.6 million and borrowed funds increased $247.5 million, while lower cost or no cost deposits decreased $278.4 million. Future interest expense could be adversely affected if the shift from lower cost transaction accounts to higher cost accounts continues in the current interest rate environment.
The Company had $1.3 billion in adjustable and variable rate loans and $569.8 million in floating rate collateralized loan obligations, as compared to $414.7 million in floating rate CDs and $35.6 million in floating rate trust preferred securities at September 30, 2023. $245.3 million of the Company’s adjustable and variable rate loans have the ability to reprice in the next twelve months.
The Company continues to offer variable rate CDs which are indexed to prime. These variable rate CDs increased $85.4 million or 26%, to $414.7 million at September 30, 2023, as compared to $329.3 million at December 31, 2022. Due to the increases in the prime rate during 2022 and 2023, interest expense on variable rate CDs has increased $14.0 million for the first nine months of 2023 over the first nine months of 2022. These CDs require a minimum balance and pay a rate that is 375 – 600 basis points below the Wall Street Journal Prime rate, with a 20 basis point minimum rate.
Our net interest margin was 3.30% for the third quarter of 2023, as compared to 3.39% for the linked quarter and 3.63% for the third quarter of 2022. While the yield of interest-earning assets increased 21 basis points for the third quarter of 2023 as compared to the linked quarter, the cost of interest-bearing liabilities increased 27 basis points for the same period of comparison. The average balance of interest-earning assets increased $24.7 million for the linked quarter while the increase in interest-bearing liabilities was $9.0 million for the same period. The shift in deposit balances from lower cost transaction accounts to higher cost time certificates and overnight borrowed funds exacerbates the margin compression in the linked quarter.
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
Assets
Average Balance (1)
Income/Expense
AverageRate/Yield (2)
AverageBalance (1)
Investments:
Interest-earning due from banks
23,760
6.93%
21,845
1.87%
Taxable
1,005,372
5.67%
851,683
3.56%
Non-taxable
345,645
3.89%
336,567
3.50%
Total investments
1,374,777
17,469
5.25%
1,210,095
10,095
3.51%
Loans:(3)
Real estate
1,854,055
20,764
4.44%
1,862,738
19,808
4.22%
Agricultural
37,096
649
6.94%
29,724
274
3.66%
Commercial
90,348
1,392
6.11%
75,482
973
5.11%
4,303
8.02%
4,228
132
12.39%
100,549
2,004
7.91%
46,969
623
5.26%
2,381
3.17%
2,349
3.88%
Total loans
2,088,732
4.73%
2,021,490
4.28%
Total interest-earning assets (4)
3,463,509
4.94%
3,231,585
4.00%
Other earning assets
17,355
15,717
Non-earning assets
275,883
255,529
3,756,747
3,502,831
Liabilities and shareholders' equity
Interest-bearing deposits:
Demand deposits
141,745
413
1.16%
197,731
131
0.26%
NOW
427,278
0.06%
531,205
Savings accounts
408,158
69
0.07%
485,167
73
Money market
127,649
194
0.60%
151,816
Time deposits
557,504
6,514
4.64%
313,764
1,377
1.74%
Brokered deposits
162,065
1,509
3.69%
63,529
75
0.47%
Total interest-bearing deposits
1,824,399
1.91%
1,743,212
0.40%
Borrowed funds:
83,222
0.25%
113,933
0.24%
330,221
4,286
5.15%
45,597
320
2.78%
49,268
3.45%
49,182
35,590
8.49%
35,409
4.92%
Total borrowed funds
498,301
5,530
4.40%
244,121
1,256
2.04%
Total interest-bearing liabilities
2,322,700
2.44%
1,987,333
Demand deposits - noninterest-bearing
1,064,962
1,140,840
58,340
67,603
310,745
307,055
Interest income/interest-earning assets
Interest expense/interest-earning assets
1.64%
0.37%
Net interest income and margin(5)
3.30%
3.63%
(Dollars in Thousands, Unaudited)
For the nine months ended
21,504
120,359
0.52%
991,302
5.37%
783,384
2.66%
353,173
3.95%
305,212
3.29%
1,365,979
48,942
1,208,955
22,005
2.61%
1,860,504
61,491
4.42%
1,820,568
57,792
4.24%
31,232
1,578
6.76%
31,376
809
81,397
3,564
5.85%
84,301
3,351
5.31%
4,260
263
8.25%
4,313
545
16.89%
79,438
4,779
8.04%
52,650
1,626
4.13%
2,443
3.34%
88
5.69%
2,059,274
4.66%
1,995,274
4.30%
3,425,253
4.80%
3,204,229
16,680
15,675
271,949
235,516
3,713,882
3,455,420
145,316
731
0.67%
207,319
0.23%
454,900
214
540,078
243
431,143
477,904
210
128,856
0.30%
152,912
Time Deposits
520,105
17,043
4.38%
301,173
2,052
0.91%
167,782
4,235
3.37%
61,189
172
0.38%
1,848,102
1,740,575
88,707
110,505
228
0.28%
262,755
9,828
15,480
322
49,246
3.49%
49,162
35,545
7.97%
35,365
3.87%
436,253
13,433
4.12%
210,512
1.82%
2,284,355
2.12%
1,951,087
0.41%
1,062,114
1,122,556
59,674
58,393
307,739
323,384
1.41%
3.39%
3.41%
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
2023 over 2022
Increase (decrease) due to
Assets:
Volume
Mix
Net
Federal funds sold/due from time
279
312
(383)
4,353
(3,575)
395
1,380
4,531
818
6,729
4,144
15,877
4,214
24,235
333
1,179
1,189
(61)
2,307
Total investments (1)
1,405
5,073
896
7,374
4,940
21,419
578
26,937
(92)
1,053
(5)
956
1,268
2,379
3,699
246
(4)
777
769
192
190
419
(12)
213
(46)
(1)
(45)
(7)
(278)
(282)
Mortgage warehouse
711
313
1,381
827
1,542
784
3,153
(27)
Total loans (1)
881
1,752
449
3,082
1,985
4,724
816
7,525
Total interest-earning assets (1)
2,286
6,825
1,345
10,456
6,925
26,143
1,394
34,462
Liabilities
(37)
445
(126)
282
(107)
686
(205)
(38)
(2)
(29)
(21)
(14)
206
169
(11)
(43)
220
1,070
2,289
1,778
5,137
1,492
7,817
5,682
14,991
116
517
801
1,434
300
1,372
2,391
4,063
Total interest-bearing deposits (1)
1,117
2,418
7,006
1,615
10,168
7,822
19,605
Other Borrowings
1,997
272
1,697
3,966
5,144
257
9,506
Subordinated debt
323
1,085
1,096
Total borrowed funds (1)
1,981
595
1,698
4,274
5,105
1,363
4,107
10,575
Total interest-bearing liabilities (1)
3,098
4,066
4,116
11,280
6,720
11,531
11,929
30,180
Net interest income (1)
(812)
2,759
(2,771)
(824)
14,612
(10,535)
4,282
The volume variance calculated for the third quarter of 2023 relative to the third quarter of 2022 was an unfavorable $0.8 million; this is primarily from an unfavorable volume variance of $3.1 million in interest-bearing liabilities, as the average balance of interest-bearing liabilities increased $335.4 million from the comparative quarter. There was a favorable rate variance of $2.8 million from the comparative quarter since the weighted average yield on interest-earning assets more than offset the increase in the average yield unfavorable variance on interest-bearing liabilities. There was an unfavorable mix variance of $2.8 million primarily from the shift in customer deposit transaction accounts into higher cost variable rate time certificates combined with a higher level of borrowed funds. The Company’s net interest margin for the third quarter of 2023 was 3.30%, as compared to 3.63% for the third quarter of 2022.
The volume variance calculated for the first nine months of 2023 relative to the first nine months of 2022 reflects a favorable variance of $0.2 million, a favorable rate variance of $14.6 million, and an unfavorable mix variance of $10.5 million. There were increases in loan and investment security balances for a favorable volume variance of $6.9 million
which was mostly offset by a $6.7 million increase in interest-bearing liabilities. There was a positive rate variance on interest-earning assets of $26.1 million for the first nine months of 2023 partially offset by a $11.5 million rate increase in interest-earning liabilities. The Company’s net interest margin for the first nine months of 2023 was 3.39%, as compared to 3.41% in the first nine months of 2022.
At September 30, 2023, approximately 4% of our total portfolio, or $81.3 million, consists of variable rate loans. At September 30, 2023, our outstanding fixed rate loans represented 38% of our loan portfolio. The remaining 58% of our loan portfolio at September 30, 2023 consists of adjustable-rate loans; 67% of these loans (approximately $819.2 million) will not have the ability to reprice for at least another 3 years. These loans are typically adjustable every five years after the initial adjustment. Approximately $100.6 million of these adjustable-rate loans have the ability to reprice in the fourth quarter of 2023, which will have a positive impact on earnings.
Cash balances for the quarterly comparisons have stabilized but for the year-to-date comparison have decreased, which had a positive impact on our net interest margin since cash balances earn considerably lower yields than other earning assets. Average cash and due from banks was $23.8 million, an increase of $1.9 million for the third quarter of 2023 as compared to the same period last year, and was $98.9 million lower for the first nine months of 2023 as compared to the same period in 2022.
Overall average investment securities increased by $162.8 million for the third quarter of September 30, 2023, as compared to September 30, 2022, and increased by $255.9 million for the first nine months of 2023 as compared to the same period in 2022. For the quarter ending September 30, 2023, over the same period for 2022, average non-taxable securities increased $9.1 million and taxable securities increased $153.7 million. For the first nine months of 2023 over the same period in 2022, average non-taxable securities increased $48.0 million and taxable securities increased $207.9 million. The overall investment portfolio had a tax-equivalent yield of 5.07% at September 30, 2023, with an average life of 7.07 years and average effective duration of 1.6 years for available-for-sale securities. Approximately $569.8 million of the investment securities reprice every 90 days and $52.2 million are subordinated debt with an initial fixed rate period of 5 years and floating thereafter.
Interest expense was $14.3 million for the third quarter of 2023, an increase of $11.3 million, relative to the third quarter of 2022. For the first nine months of 2023, compared to the same period in 2022, interest expense increased $30.2 million to $36.1 million. The significant increase in interest expense is attributable to an unfavorable shift in interest-bearing liabilities and the impact of interest rate increases, as the average balance of deposits, including lower cost core deposits decreased $93.2 million while higher cost borrowed funds and wholesale brokered deposits increased by $352.7 million in the third quarter of 2023 as compared to the third quarter of 2022. For the year-to-date comparisons the increase is attributable to a shift from lower cost transaction accounts to higher cost time accounts, as well as an increase in borrowed funds. For the first nine months of 2023, higher cost customer time deposits increased $218.9 million wholesale brokered deposits increased $106.6 million and borrowed funds increased $247.5 million, while lower cost or no cost deposits decreased $278.4 million.
Average noninterest-bearing demand deposits decreased $75.9 million or 7% for the third quarter of 2023 as compared to the third quarter of 2022 and decreased $60.4 million or 5% for the first nine months of 2023 as compared to the first nine months of 2022.
PROVISION FOR CREDIT LOSSES ON LOANS
Credit risk is inherent in the business of making loans. The Company sets aside an allowance for credit losses on loans, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for credit losses on loans. The Company recorded a benefit related to a credit loss provision for loans of $0.03 million in the third quarter of 2023 relative to a provision for credit losses on loans of $1.3 million in the third quarter of 2022 and a $0.2 million provision for credit losses on loans in the first nine months of 2023 as compared to $4.2 million in the same period in 2022. The Company's $1.3 million decrease in the provision for credit losses on loans in the third quarter of 2023 as compared to the third quarter of 2022, and the $4.0 million decrease for the first nine months of 2023 as
compared to the same period in 2022 was favorably impacted by lower charge-offs of loans. The decrease in net charge-offs in the first nine months of 2023 was primarily related to a single office building loan relationship that was sold at a discount due to an increased risk of default that would have likely led to a prolonged collection period and a single dairy loan relationship.
Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance, with subsequent recoveries reflected as an increase to the allowance. The Company recorded net loan charge-offs of $0.1 million in the third quarter of 2023 as compared to $0.2 million for the third quarter of 2022 and $0.4 million in the first nine months of 2023 as compared to $4.3 million for the comparative period in 2022.
The allowance for credit losses on loans is at a level that, in Management’s judgment, is adequate to absorb probable credit losses on loans related to individually identified loans as well as probable credit 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 10 to the consolidated financial statements, and below, under “Allowance for Credit Losses.” The process utilized to establish an appropriate credit allowance for losses on loans can result in a high degree of variability in the Company’s credit 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 nine-month periods ended September 30, 2023, and 2022:
Noninterest Income/Expense
For the nine months ended September 30,
Noninterest income:
As a % of average interest-earning assets (1)
0.89%
0.81%
0.87%
0.96%
Noninterest expense:
Advertising and marketing costs
723
1,646
1,322
Data processing costs
1,369
1,564
4,574
Deposit services costs
2,048
2,450
6,603
7,112
Loan services costs
Loan processing
174
128
452
426
(60)
(3)
665
Other operating costs
765
912
3,244
Professional services costs
Legal & accounting services
493
535
1,623
1,753
Director's costs
732
(143)
1,733
(1,192)
Other professional service
707
855
2,053
2,306
Stationery & supply costs
148
414
315
Sundry & tellers
463
2.58%
2.67%
2.64%
Noninterest Income:
Total noninterest income increased $1.2 million, or 17%, for the quarter ended September 30, 2023, as compared to the same quarter in 2022, and decreased $.08 million, or 3% for the year-to-date period ended September 30, 2023 as compared to the same period in 2022. Service charges and fees on deposit accounts increased by $0.1 million, or 1%, to $6.1 million in the third quarter of 2023 as compared to the third quarter of 2022. This service charge income was $0.3 million lower, or 2% in the first nine months of 2023, as compared to the same period in 2022. These decreases in the quarterly and year-to-date comparisons are primarily due to decreases in ATM and debit card income.
BOLI income increased by $0.6 million for the third quarter of 2023 as compared to the third quarter of 2022, and $2.6 million for the first nine months of 2023 as compared to the same period in 2022. The variance is due mostly to fluctuations in underlying values of assets in the separate account BOLI policies that are designed to have similar assets to those in the deferred compensation plans. Thus, the higher values in BOLI policies are offset by higher deferred compensation expense reflected primarily in director fees expense. At September 30, 2023, there was $41.5 million in traditional BOLI policies and $9.9 million in separate account BOLI policies associated with the deferred compensation plans.
In the “other” category of noninterest income there was a $0.5 million increase in the third quarter of 2023 as compared to the third quarter of 2022, and a $2.4 million decrease in the first nine months of 2023 as compared to the same period in 2022. The quarterly comparison was positively impacted by an increase in life insurance proceeds for $0.3 million, and $0.4 million in quarterly income from an equity investment in an SBA loan fund. The year-to-date increases were unfavorably impacted by a $1.0 million gain on the sale of debt securities, $3.6 million from gains on the sale of other assets, and the recovery of prior period legal expenses in 2022 with no like sales or recoveries in 2023. Partially offsetting these 2022 events was year-to-date income from an equity investment in an SBA Loan fund for $1.0 million.
Noninterest Expense:
Total noninterest expense increased by $1.6 million, or 7%, in the third quarter of 2023 relative to the third quarter of 2022, and by $5.2 million, or 8%, for the first nine months of 2023 as compared to the same period in 2022. Salaries and Benefits were $1.1 million, or 10%, higher in the third quarter of 2023 as compared to the third quarter of 2022 and $2.5 million, or 7%, higher for the first nine months of 2023 compared to the same period in 2022. The reason for this increase is primarily due to increased salary expense due to the hiring of new lending teams and management staff for both the quarterly and year-to-date comparisons. There were 487 full-time equivalent employees at September 30, 2023 as compared to 491 at December 31, 2022 and 500 at September 30, 2022.
Occupancy expenses were relatively unchanged for the third quarter and the first nine-months of 2023 as compared to the same periods in 2022.
Other noninterest expense increased $0.5 million, or 6%, for the third quarter 2023 as compared to the third quarter in 2022, and increased $2.7 million, or 13% for the first nine months of 2023 as compared to the same period in 2022. The variances for the third quarter of 2023 compared to the same period in 2022 was primarily driven by a $0.6 million unfavorable variance in directors deferred compensation expense, linked to the changes in BOLI income, higher FDIC assessment costs, increased marketing costs associated with a deposit acquisition campaign and elevated debit card losses due to a conversion of debit card systems. These increased expenses were partially offset by lower costs in core processing, debit card processing and ATM network costs. For the year-over-year comparison, the categories of increase were the same as with the quarterly comparison, along with a $0.2 million decrease in deposit statement costs offset by increased foreclosed asset costs related to the foreclosure and subsequent sale of one large loan relationship in the first quarter of 2023.
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 25.8% of pre-tax income in the third quarter of 2023 relative to 25.1% in the third quarter of 2022, and 25.3% of pre-tax income for the first nine months of 2023 relative to 26.1% for the same period in 2022. The change in the effective tax rate for the quarter ended September 30, 2023 as compared to the same quarter in 2022 was due to a decrease in available tax credits. The change in effective tax rate for the year-to-date comparisons is due to the volatility in the Corporate Owned Life Insurance asset value associated with our non-qualified deferred compensation plans. In the third quarter and first nine months of 2023, the investments associated with the non-qualified deferred compensation plans increased in value, generating non-taxable income for the third quarter, and first nine months of 2023 while decreasing in value in the third quarter and first nine months of 2022 resulting in a non-deductible expense.
BALANCE SHEET ANALYSIS
EARNING ASSETS
The Company’s interest-earning assets are comprised of loans and investments, including overnight investments and surplus balances held in interest-earning accounts in our Federal Reserve Bank account. 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 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.
The investment portfolio is reflected on the balance sheet as investment securities and totaled $1.3 billion, or 36% of total assets at September 30, 2023, and $1.3 billion, or 35% of total assets at December 31, 2022. The increase was primarily due to purchases of U.S. government agency securities and AAA and AA tranches of adjustable rate collateralized loan obligations.
The Company carries “available for sale” investments at their fair market values and “held to maturity” investments at amortized cost net of allowance for credit losses. We currently have the intent and ability to hold our investment securities to maturity, but the securities are all marketable. The expected effective duration was 1.6 years for available-for-sale investments and 6.7 years for held-to-maturity investments at September 30, 2023, as compared to 1.8 years for available-for-sale investments and 6.4 years for held-to-maturity investments at December 31, 2022.
In the second and fourth quarters of 2022 the Company transferred $162.1 million and $198.3 million, respectively of “available for sale” investments to “held to maturity”. Those securities were transferred at fair market value on the date of the transfer. The transfer was initiated to reduce the effect of potential future rate increases on the available-for-sale
portfolio, mark-to-market, other comprehensive income and equity. See Note 9, Investment Securities for additional information.
The following table sets forth the carrying amount for available-for-sale securities, at fair value, and held-to-maturity securities, at amortized cost, net of the allowance for credit losses of the Company’s investment portfolio by investment type as of the dates noted:
Investment Portfolio
Carrying Amount
Percent
Available for sale
8.03%
3.98%
7.72%
9.63%
13.37%
16.20%
3.92%
4.52%
42.70%
39.18%
Total available for sale
75.74%
73.51%
Held to maturity
0.42%
0.48%
10.92%
12.38%
172,329
12.92%
173,361
13.63%
Total held to maturity
24.26%
26.49%
Total securities
1,333,921
100.00%
1,271,804
Investment securities that were pledged as collateral for borrowings and/or potential borrowings from the Federal Home Loan Bank and the Federal Reserve Bank, customer repurchase agreements, and other purposes as required or permitted by law totaled $477.4 million at September 30, 2023 and $183.5 million at December 31, 2022, leaving $0.9 million in unpledged debt securities at September 30, 2023 and $1.1 billion at December 31, 2022. Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $326.3 million at September 30, 2023 and $43.1 million at December 31, 2022.
ALLOWANCE FOR CREDIT LOSSES – AFS INVESTMENT SECURITIES
The allowance for credit losses on AFS investment securities, a contra-asset, is established through periodic provisions for credit losses on AFS investment securities. It is maintained at a level that is considered adequate to measure expected losses across the classes of major investment security types related to fluctuations in market conditions, primarily interest rates, and not reflective of a deterioration in credit value. The Company maintains that it has intent and ability to hold these securities until the amortized cost basis of each security is recovered and likewise concluded as of both September 30, 2023 and December 31, 2022 that it was not more likely than not that any of the securities in an unrealized loss position would be required to be sold. The following bullets outline additional support for management’s conclusion that no amount of the unrealized loss of the securities in an unrealized loss position as of September 30, 2023 and December 31, 2022 was attributable to credit deterioration and a risk of loss, requiring an allowance for credit losses.
LOAN PORTFOLIO
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 after 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.
20.21%
21.61%
64.10%
64.47%
0.35%
0.90%
4.39%
5.60%
89.04%
92.57%
6.68%
5.13%
5.18%
3.22%
0.20%
0.21%
101.11%
101.14%
(1.11)%
(1.14)%
Total loans, net
Gross loans at $2.1 billion, increased $48.2 million during the first nine months of 2023 with an overall 2% change year-to-date. The net change did have offsetting components with the larger fluctuations being a $42.1 million increase in mortgage warehouse line utilization, a $22.7 million increase in commercial real estate, and a $35.5 million increase in other commercial loans. Unfavorable larger loan variances include an $18.7 million decrease in residential real estate, a $22.4 million decrease in farmland and an $11.0 million decrease in other construction.
As indicated in the loan roll forward below, new credit extended for the third quarter of 2023 decreased $14.0 million and for the first nine months of 2023 decreased $66.4 million over the same periods in 2022. For the nine months ended 2023, we had $111.2 million in loan paydowns and maturities, along with a $42.1 million increase in mortgage warehouse line utilization and a $41.7 million decrease in line of credit utilization.
LOAN ROLLFORWARD
For the three months ended:
For the nine months ended:
June 30, 2023
Gross loans beginning balance
2,094,391
2,033,968
2,022,662
1,989,726
New credit extended
68,980
37,030
82,958
158,619
225,054
Loan purchases
173,082
Changes in line of credit utilization
(22,517)
6,622
(7,811)
(41,685)
(45,201)
Change in mortgage warehouse
(3,032)
42,145
(11,581)
42,146
(54,630)
Pay-downs, maturities, charge-offs and amortization (1)
(37,012)
(25,374)
(65,864)
(111,210)
(267,667)
Gross loans ending balance
2,020,364
Over the past two years, the Company has strategically focused on reducing concentrations in commercial real estate, especially amongst areas management deemed to be higher risk such as construction and office real estate. At September 30, 2023 the total regulatory CRE ratio of total CRE over Tier 1 Capital plus allowance was 243%, compared to 243% for the linked quarter and 246% at December 31, 2022 which positions us well for growth. Further, the overall level of construction and land development lending had declined to 2% of regulatory capital plus allowance for credit losses at September 30, 2023. Overall committed non-owner occupied commercial real estate is 253% of regulatory capital plus allowance for credit losses and is 13.6% of total commitments at September 30, 2023. Office real estate loans are 48% of regulatory capital plus allowance for credit losses and are adjustable rates with most rate adjustments occurring beyond two years. During the next twenty-four months, we have 43 office commercial real estate loans totaling $40.9 million that have scheduled interest rate resets. The Bank’s practice is to make commercial real estate loans with an “at origination” loan-to-value of 65% or lower using conservative underwriting standards. Over the past two years, noting the affect the pandemic had on the office building sector, new production of commercial real estate loans in this segment have been discouraged, resulting in reduced loan originations.
Regarding line utilization, unused commitments, excluding mortgage warehouse and overdraft lines, were $216.8 million at September 30, 2023, compared to $219.7 million at December 31, 2022. Total utilization excluding mortgage warehouse and overdraft lines was 60% at September 30, 2023 and 59% at December 31, 2022. Mortgage warehouse utilization was 30% at September 30, 2023, compared to 10% at December 31, 2022.
It should be noted that the mortgage warehouse lines were moved to repurchase agreement lines that provide stronger credit protection to the Company, as well as more favorable regulatory capital treatment as these repurchase lines are not considered off-balance sheet commitments.
PPP loans continue to decline as borrowers receive forgiveness on these loans. There were nine loans for $0.4 million outstanding at September 30, 2023, compared to fourteen loans for $1.8 million at December 31, 2022.
NONPERFORMING ASSETS
Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, in addition to foreclosed assets which is primarily OREO, but can include other foreclosed assets.
Nonperforming assets
Nonperforming Loans:
546
18,270
Total Real Estate nonperforming loans
18,816
7,956
Total Nonperforming Loans
26,772
Total Nonperforming Assets
Nonperforming loans as a % of total gross loans
0.04%
0.95%
1.33%
Nonperforming assets as a % of total gross loans and foreclosed assets
Total nonperforming assets, comprised of nonaccrual loans and foreclosed assets, decreased by $18.8 million to $0.8 million for the first nine months of 2023. The Company's ratio of nonperforming loans to gross loans decreased to 0.4% at September 30, 2023 from 0.95% at December 31, 2022. The decrease resulted from a decrease in non-accrual loan balances, primarily as a result of the foreclosure and sale of one loan relationship in the dairy industry consisting of four separate loans in the first quarter of 2023. All the Company's nonperforming assets are individually evaluated for credit loss quarterly and management believes the established allowance for credit loss on such loans is appropriate.
There were no foreclosed assets at September 30, 2023 and December 31, 2022, however, when the Company does own foreclosed assets, they are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value. In January 2023, the Company foreclosed on $18.1 million of loans and the properties were sold prior to March 31, 2023.
An action plan is in place for each of our non-accruing loans 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 had $1.9 million in loans past due 30-89 days at September 30, 2023. This is a decrease of $0.3 million over the balance at December 31, 2022. All of these past due loans are under management supervision and every effort is being taken to assist the borrowers and manage credit risk in this regard.
ALLOWANCE FOR CREDIT LOSSES – LOANS
The allowance for credit losses on loans, a contra-asset, is established through periodic provisions for credit losses on loans. It is maintained at a level that is considered adequate to measure expected losses on individually identified loans, as well as expected 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.
Due to the uncertainty of national and local economic conditions, the Company deferred implementation of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) under section 4014 of the CARES Act. The Company implemented CECL on January 1, 2022, and recorded a $10.4 million increase in the allowance for credit losses, which included a $0.9 million reserve for unfunded commitments as an adjustment to equity, net of deferred taxes.
The Company's allowance for credit losses on loans was $23.1 million both at September 30, 2023, and December 31, 2022, and $23.8 million at September 30, 2022. The allowance was 1.10% of total loans at September 30, 2023, 1.12% of total loans at December 31, 2022, and 1.18% of total loans at September 30, 2022. Management's detailed analysis indicates that the Company's allowance for credit losses on loan should be sufficient to cover credit losses for the life of the loans outstanding as of September 30, 2023, but no assurance can be given that the Company will not experience substantial future losses relative to the size of the credit loss allowance for loans. A separate allowance of $0.6 million for potential credit losses inherent in unused commitments is included in other liabilities at September 30, 2023, down $0.2 million from December 31, 2022. As mentioned previously, a $0.9 million one-time adjustment was recorded to the reserve for unfunded commitments on January 1, 2022, upon the implementation of CECL.
The following table summarizes activity in the credit allowance for losses on loans for the noted periods:
For the threemonths ended
For the ninemonths ended
For the year ended
September 30,
December 31,
Balances:
Average gross loans outstanding during period (1)
2,006,283
Gross Loans outstanding at end of period
Allowance for credit losses on loans:
Balance at beginning of period
Adoption of ASC 326
Provision charged to expense
10,898
1,911
1,248
1,958
4,418
3,869
6,329
115
505
456
5,109
372
1,292
984
1,396
541
3,045
5,309
12,834
260
479
359
224
1,352
764
Net loan charge offs
4,280
11,548
Balance at end of period
RATIOS
Net charge-offs to average Loans (annualized)
0.01%
0.03%
0.29%
0.58%
Allowance for credit losses on Loans to gross Loans at end of period
1.10%
1.18%
1.12%
Net loan charge-offs to allowance for credit losses on Loans at end of period
0.94%
1.93%
17.99%
50.08%
Net loan charge-offs to provision for credit losses on Loans
57.26%
18.48%
98.17%
105.96%
The Company’s credit allowance for losses on loans at September 30, 2023 represents Management’s best estimate of expected 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, which included standby letters of credit, totaled $548.8 million at September 30, 2023 and $895.6 million at December 31, 2022, representing approximately 44% of gross loans outstanding at September 30, 2023 and 44% at December 31, 2022. Included in
unused commitments are mortgage warehouse lines which are mostly in the form of repo lines and are unconditionally cancellable. Unused commitments on mortgage warehouse lines were $254.4 million at September 30, 2023 and $594.6 million at December 31, 2022. The decline in unused commitments during 2023 is primarily due to a decline in mortgage warehouse lines as the Company strategically reduced availability under the existing lines while increasing the number of lines outstanding. Unused commitments exclusive of mortgage warehouse lines and overdraft lines of credit, have decreased $2.9 million or 1% for the first nine months of 2023 and are due to a decrease in new lines of credit. The Company also had undrawn letters of credit issued to customers totaling $6.0 million at both September 30, 2023 and December 31, 2022. 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 $125 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain local agency deposits which totaled $72.6 million at September 30, 2023. 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 investments or loans, subject to the bank’s risk tolerances. The Company’s balance of non-earning cash and due from banks was $88.5 million at September 30, 2023 relative to $72.8 million at December 31, 2022.
Foreclosed assets are discussed above in the section titled “Nonperforming Assets.”
Net premises and equipment decreased by $0.6 million during the first nine months of 2023, to $21.9 million. This decline was primarily a result of normal depreciation, the disposal of obsolete equipment, net of new purchases.
Goodwill was $27.4 million at September 30, 2023, unchanged during the first nine months of 2023. Goodwill is tested for impairment annually, unless events and circumstances exist which indicate that an impairment test should be performed. The annual goodwill impairment test was last performed on October 1, 2023, and it was determined that no impairment existed. Management continues to evaluate whether or not a triggering event occurs, or circumstances change that would more likely than not reduce the fair value of the Company below its carrying amount before the next annual test in 2024.
Bank-owned life insurance, with a balance of $51.3 million at September 30, 2023, 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
Noninterest-bearing demand deposits
36.94%
38.23%
Interest-bearing demand deposits
134,117
4.67%
150,875
5.30%
427,140
14.88%
490,707
17.24%
Savings
400,940
13.97%
456,980
16.06%
130,914
4.56%
139,795
4.91%
Time
551,731
19.23%
399,608
14.04%
165,000
5.75%
120,000
Deposit balances grew by $23.6 million, or 1%, during the first nine months of 2023 to $2.9 billion at September 30, 2023. Core non-maturity deposits decreased $173.6 million, or 7%, for the first nine months of 2023, while customer time deposits increased by $152.1 million, or 38% due mostly to an increase in variable rate CD accounts by existing customers seeking higher interest rates on their deposits. Brokered deposits increased $45.0 million during the first nine months of 2023, or 38%; to take advantage of preferential pricing over other forms of borrowed funds. Overall noninterest-bearing deposits as a percent of total deposits decreased to 36.9% at September 30, 2023, compared to 38.2% at December 31, 2022, and from 38.8% at September 30, 2022.
Overall uninsured deposits are estimated to be approximately $830.3 million, or 29% of total deposit balances, excluding public agency deposits that are subject to collateralization through a letter of credit issued by the FHLB. In addition, uninsured deposits of the bank’s customers are eligible for FDIC pass-through insurance if the customer opens an IntraFi Insured Cash Sweep account or a reciprocal time deposit through the Certificate of Deposit Account Registry System (CDARS). IntraFi allows for up to $225 million of combined pass-through FDIC insurance per customer which would more than cover each of the Bank’s deposit customers if such customer desired to have such pass-through insurance. The Bank maintains a diversified deposit base with no significant customer concentrations and does not bank any cryptocurrency companies. At September 30, 2023, the Company had approximately 121,000 accounts and the 25 largest deposit balance customers had balances of approximately 12% of overall deposits. During the second and third quarters of 2023, except for seasonality fluctuations in the normal course of business there has been no change in the composition of our 25 largest deposit balance customers.
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, subordinated notes and/or junior subordinated debentures. The Company uses short-term FHLB advances and fed funds purchased on unsecured 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 consists of both a secured and unsecured component. The secured component depends on the level of pledged collateral.
Total non-deposit interest-bearing liabilities increased by $83.9 million, during the first nine months of 2023 primarily due to an increase in long term FHLB borrowings. This was a strategic decision to take advantage of longer term pricing as a partial on-balance sheet match to longer term loans due to the current inverted yield curve and to provide longer-term interest rate risk mitigation.
Customer repurchase agreements declined from $109.2 million at December 31, 2022 to $94.9 million at September 30, 2023. Customer repurchase agreements provide collateral for customers that sweep excess deposit balances each day into a separate repurchase agreement account where the Company effectively sells certain government bonds to customers daily and then repurchase the same bonds on the next business day. Although these accounts are not deposits and are not FDIC insured, they provide customers with larger account balances the ability to have their account secured with collateral.
Overnight and short-term borrowings increased $18.0 million to $237.0 million at September 30, 2023 from $219.0 million at December 31, 2022 and consist of overnight borrowings from correspondent banks and the FHLB, and short-term FHLB borrowings.
Long-term debt at September 30, 2023 consisted of $49.3 million of subordinated debt. This remained relatively unchanged from December 31, 2022. Subordinated debentures related to $35.6 million of trust preferred securities at September 30, 2023 and $35.5 million at December 31, 2022. Trust preferred securities are variable rate instruments benchmarked against the Secured Overnight Financing Rate (SOFR).
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 $62.9 million at September 30, 2023 as compared to $45.1 million at December 31, 2022, an increase of $17.8 million or 39%. The increase was primarily driven by ICS transactions that have not settled as of September 30, 2023.
LIQUIDITY AND MARKET RISK MANAGEMENT
LIQUIDITY
The Company continues to have substantial liquidity though unencumbered assets and available borrowings. In addition, the Company’s loan-to-deposit ratio was 73% at September 30, 2023 and 72% at December 31, 2022.
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 September 30, 2023, and December 31, 2022, the Company had the following sources of primary and secondary liquidity (dollars in thousands):
Primary and secondary liquidity sources
Unpledged investment securities
854,730
1,097,164
Excess pledged securities
326,343
43,096
FHLB borrowing availability
657,548
718,842
Unsecured lines of credit
362,785
237,000
Funds available through fed discount window
383,943
42,278
Totals
2,673,891
2,215,511
The Company did not participate in the Federal Reserve Bank Term Funding Program in 2023. Unpledged investment securities include $290.5 million of CLOs. As CLOs have a rate that resets every 90 days to current rates, the volatility of pricing of these securities is limited and the Company could sell such securities for liquidity at a significantly lower loss than selling lower rate fixed term securities such as US government bonds or municipal bonds. During the first nine months of 2023, the Bank sold a few CLOs at a modest gain and expects to continue to utilize the CLO portfolio for both interest rate risk management and liquidity purposes.
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 $125 million at September 30, 2023 and December 31, 2022. Other sources of liquidity include the brokered deposit market, deposit listing services, Intrafi, 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.
The Company’s primary liquidity ratio and net loans to deposits were 31.5% and 71.8%, respectively, at September 30, 2023, as compared to internal policy guidelines of “greater than 15%” and “less than 95%.” Ratios and sub-limits for the various components comprising wholesale funding, which were all well within policy guidelines at September 30, 2023, are also periodically reviewed by Management and the Board. 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 and subordinated debt, shareholder dividends, and share repurchases. Its primary source of funds is dividends from the Bank since the holding company does not conduct regular banking operations. As of September 30, 2023, the holding company maintained a cash balance of $14.7 million. Management anticipates 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, 2022 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.
58
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. Assumptions regarding deposit betas in the up cycles can range from 25 to 100% and from 0 to 50% in the down cycles depending on the deposit type. Deposit decay rate assumptions range from 5 to 10% and are based on historical averages. Prepayment speeds are based on three year historical averages. 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 eight other interest rate scenarios in conducting our rolling 12-month net interest income simulations: upward shocks of 100, 200, 300, and 400 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. 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 interest rate shock, 10% for a 200 basis point shock, 15% for a 300 basis point shock, and 20% for a 400 basis point shock.
The Company had the following estimated net interest income sensitivity profiles over one-year, 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
+400
(2.2)%
(2,606)
6.4%
8,374
+300
(1.6)%
5.0%
6,497
+200
(0.9)%
(1,132)
3.6%
4,729
+100
(0.4)%
(520)
2.2%
2,917
Base
-100
(3.2)%
(3,872)
(5.6)%
(7,353)
-200
(5.0)%
(6,062)
(11.9)%
(15,551)
-300
(9.1)%
(11,051)
N/A
-400
(13.4)%
(16,227)
For the period ending September 30, 2023, management believes that the Company was liability sensitive, with net income decreasing in a rising and declining rate scenarios.
The shift from being asset sensitive at September 30, 2022 to slightly liability sensitive at September 30, 2023, is primarily due to the change in assumptions regarding low cost deposits and loan betas. The base scenarios utilize a dynamic balance sheet based on expected growth.
At September 30, 2023, it was assumed that over twelve months, a portion of low-cost deposits would shift into higher cost deposits thus making the company slightly liability sensitive. Thus, as rates increase, more deposits will shift into higher-cost deposits. In addition, based on the magnitude of rate changes, interest rates on new loans did not increase at the rates modeled in 2022. To address this, the beta on loan yields was lowered in modeling interest rate risk in 2023, which has the impact of lowering the effect of future rate increases on interest income. Further, the Company has more variable rate liabilities at September 30, 2023 including overnight borrowings both in Fed Funds purchased and overnight FHLB borrowings and in customer time deposits tied to the prime interest rate. Any change in interest rate in the model would expect to decrease net interest income. At September 30, 2023, the Company had $331.9 million in overnight and short term borrowings as compared to $215.1 million at September 30, 2022.
59
The change in net interest income is similar for the up 100, 200, 300, and 400 basis point scenarios. 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 decline by $0.5 million, or 0.4%, relative to a stable interest rate scenario, with the unfavorable variance increasing as interest rates rise higher.
If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $3.9 million or a negative variance of 3%. The change in net interest income in the down 200 basis point scenario is a decrease of $6.1 million or 5%. As a significant portion of the Company’s deposits remain in noninterest-bearing accounts or low-cost deposit accounts, in a down rate scenario, these rates would not change or only change slightly. However, floating rate earning assets (loans and deposits) would reprice downward more than the decline in floating rate liabilities. All interest rate shock scenarios are within our internal policy guidelines, and we will continue to monitor our interest rate risk profile and implement remedial changes if deemed appropriate.
If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $8.3 million or a negative variance of 8%. The reason for the drop in net interest income is, most deposit products are at their floors of 0.10% and cannot be re-priced lower, while non-floored interest earning assets such as loans and securities can theoretically still be re-priced lower in a falling rate environment. Due to the historically low current rate environment, we view any material interest rate reductions as unlikely in the near term. However, the potential percentage drop in net interest income in the “down 100 basis points” interest rate scenario exceeds our internal policy guidelines and we will continue to monitor our interest rate risk profile and implement remedial changes if deemed appropriate.
In addition to the net interest income simulations shown above, we run stress scenarios for the unconsolidated Bank where we model 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). The most significant impact to net interest income in the net interest income simulations is the reduction or migration of low-cost deposits.
The modeled 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 September 30, 2023 and 2022, 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 in the current rate environment.
Our EVE decreased in the past twelve months primarily from an increase in decay rates on certain non-maturity deposit accounts which significantly lowered the deposit values. The tables below show estimated changes in the Company’s EVE as modeled under different interest rate scenarios relative to the base case:
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
9.0%
46,030
9.3%
68,762
8.1%
41,401
7.7%
56,711
6.8%
35,006
5.4%
39,603
4.2%
21,321
2.4%
17,782
(3.8)%
(19,482)
(14.4)%
(106,169)
(18.7)%
(95,916)
(31.1)%
(229,698)
(22.0)%
(112,501)
(9.5)%
(48,392)
The table shows that our EVE is modeled to deteriorate in 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 which become more valuable as interest rates rise. 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.
The potential percentage change in EVE in all rate shock interest rate scenarios is within our internal policy guidelines. We continue to monitor our interest rate risk profile and implement remedial changes if deemed appropriate.
CAPITAL RESOURCES
The Company had total shareholders’ equity of $308.9 million at September 30, 2023, comprised of $109.6 million in common stock, $4.9 million in additional paid-in capital, $227.6 million in retained earnings, and accumulated other comprehensive loss of $61.9 million. At the end of 2022, total shareholders’ equity was $303.6 million. The increase in equity during the first nine months of 2023 is due to net income of $28.6 million, offset by a $10.4 million dividend paid to shareholders, $8.5 million in share repurchases, and a $5.3 million unfavorable swing in other comprehensive income/(loss) due principally to changes in investment securities' fair value. The remaining difference is related to stock options and restricted stock during the first nine months of 2023.
The Company approved a new share repurchase program on October 20, 2022 (the 2023 Share Repurchase Plan) that was effective upon the expiration of the prior 2021 Share Repurchase Plan on October 31, 2022. The 2023 Share Repurchase Plan authorizes 630,000 shares to be repurchased and expires on October 31, 2023. Under the 2023 Share Repurchase Program, there were 481,094 shares repurchased in the first nine months of 2023.
The Company uses a variety of measures to evaluate its capital adequacy, including the leverage ratio 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 Bank’s regulatory capital ratios as of the dates indicated.
Regulatory Capital Ratios
Minimum
Requirement
Required
to be
Community Bank
Well Capitalized (1)
Leverage Ratio (2)
Bank of the Sierra
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio") (3)
11.05
%
10.99
9.00
Sierra Bancorp
10.12
10.30
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 federal bank regulatory agencies adopted an interim final rule to implement this change from the CARES Act. At September 30, 2021, the Company and the Bank met the criteria outlined in the final rule and the interim final rule and elected to measure capital adequacy under the CBLR framework.
PART I – FINANCIAL INFORMATION
ITEM 3
QUANTITATIVE & QUALITATIVE 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
An evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) under the Exchange Act as of the end of the period covered by this Quarterly Report on Form 10-Q was performed under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were not effective as of such date due to the material weakness in internal control over financial reporting, described below.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. Disclosure controls and procedures are the controls and other procedures that are designed to ensure that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the SEC (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its Chief Executive and Chief Financial Officers, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures,
management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and management was required to apply judgment in evaluating its controls and procedures.
Following the close of the quarter ended September 30, 2023, Senior Management of the Company self-identified certain errors relating to the miscoding of certain real estate loans for Call report purposes, a report that our banking subsidiary is required to file on a quarterly basis. Within the sub-categories of loans, 21 loans were coded incorrectly for Call report purposes and are currently on the balance sheet at 9/30/2023 for $58.8 million (out of $2.1 billion) in gross loans, some of which offset one another; 19 loans for $56.1 million were all reclassified within partially offsetting real estate secured categories and two loans for $2.7 million were originally coded inadvertently by purpose code instead of collateral code causing a reclassification from the commercial and industrial loan category to commercial real estate. The coding errors were considered by Management to be quantitatively material to loan classification detail provided in our Notes to previously filed Financial Statements. Although there was a control for verifying sub-categorization of Call report loan categories, the control in place did not detect the miscoding. Management determined that a key lending control was not operating effectively due to training issues of loan operations personnel, and thus was an operating deficiency rather than a design deficiency.
Management’s Plan to Remediate the Material Weakness
As a result of this material weakness, we have initiated and will continue to implement remediation measures, including, but not limited to, correcting the discovered errors in Call report sub-categorization of loans, increasing training on our existing internal controls that should have prevented the incorrect coding, and enhancing those internal controls. The Company completed a review of Call report categorization to discover any other improperly coded loans. As of this filing, Management believes that materially all previously incorrectly coded loans are now correctly coded. The Company has reassigned the responsibility for oversight of this control and added a compensating control of a monthly review for proper coding of all loans over $250,000 by someone independent of both the person assigning the coding of the loan and the person reviewing the loan during the boarding process. Notwithstanding the material weakness, management has concluded that the financial statements included elsewhere in this Quarterly Report on Form 10-Q present fairly, in all material respects, our financial position, results of operations and cash flows in conformity with GAAP. The material weakness will not be considered fully remediated, however, until the applicable enhanced controls operate for a sufficient period of time and management has concluded, through testing, that the Company’s controls are operating effectively.
Changes in Internal Controls
Except for the material weakness noted above, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the period covered by this report that has materially affected, or is reasonably likely to affect, our internal control over financial reporting.
PART II - OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
The Company and the Bank are defendants, from time to time, in legal proceedings in various points of the legal process arising from transactions conducted in the ordinary course of business. In the opinion of Management, in consultation with legal counsel, it is not probable that current legal actions will result in an unfavorable outcome that has a material adverse effect on the Company’s consolidated financial condition, results of operations, comprehensive income, or cash flows. In the event that such legal action results in an unfavorable outcome, the resulting liability could have a material adverse effect on the Company’s consolidated financial position, results of operations, comprehensive income/(loss), or cash flows.
ITEM 1A: RISK FACTORS
For a discussion of our risk factors, see Part I, Item 1A. “Risk Factors” of the 2022 Form 10-K. The risks and uncertainties that we face are not limited to those set forth in the 2022 Form 10-K.
Recent negative developments affecting the banking industry, and resulting media coverage, have eroded customer and investor confidence in the banking system. The recent high-profile bank failures involving Silicon Valley Bank and Signature Bank have generated significant market volatility among publicly traded bank holding companies and, in particular, regional and community banks like the Company. These market developments have negatively impacted customer confidence in the safety and soundness of regional and community banks. As a result, customers may choose to maintain deposits with larger financial institutions or invest in higher yielding short-term fixed income securities, all of which could materially adversely impact the Company’s liquidity, loan funding capacity, net interest margin, capital and results of operations. Additionally, these recent events have, and could continue to, adversely impact the market price and volatility of the Company’s common stock independent from the Company’s actual underlying financial performance.
Rising interest rates have decreased the value of the Company’s held-to-maturity and available for sale securities portfolio, and certain fixed-rate loans and the Company would realize losses if it were required to sell such securities or loans to meet liquidity needs. As a result of inflationary pressures and the resulting rapid increases in interest rates over the last year, the trading value of previously issued government and other fixed income securities has declined significantly, as well as the value of certain fixed-rate loans. These securities make up a majority of the securities portfolio of most banks in the U.S., including the Company’s, resulting in unrealized losses. Unaccreted unrealized losses that existed at the time securities were transferred to held-to maturity and unrealized losses on available-for-sale securities reflected in the Company’s accumulated other comprehensive income/(loss). Changes to unrealized losses after securities were transferred to held-to-maturity and unrealized losses on loans are not reflected in accumulated other comprehensive income/(loss). While the Company does not currently intend to sell these securities or loans, if the Company were required to sell such securities to meet liquidity needs, it may incur losses, which could impair the Company’s capital, financial condition, and results of operations and require the Company to raise additional capital on unfavorable terms, thereby negatively impacting its profitability.
Any regulatory examination scrutiny or new regulatory requirements arising from the recent events in the banking industry could increase the Company’s expenses and affect the Company’s operations. The Company also anticipates increased regulatory scrutiny – in the course of routine examinations and otherwise – and new regulations directed towards banks of similar size to the Bank, designed to address the recent negative developments in the banking industry, all of which may increase the Company’s costs of doing business and reduce its profitability. As a result, the Bank could face increased scrutiny or be viewed as higher risk by regulators and the investor community.
ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(c) Stock Repurchases
In October 2023, the Board approved the 2023 Share Repurchase Plan by authorizing 1,000,000 shares of common stock for repurchase and expires on October 31, 2024. There were 481,094 shares purchased under the 2022 Share Repurchase Plan which had authorized 630,000 shares of common stock for repurchase and expired on October 31, 2023.
Stock Repurchases
Period
Total Number of Shares Purchased (1)
Average Price Paid per Share
Total Number of Shares Purchased as Part of a Publicly Announced Plan
Maximum Number (or Approximate Dollar Value) of Shares That May Yet Be Purchased Under the Plan at the End of the Period
July 1, 2023 - July 31, 2023
248,434
August 1, 2023 - August 31, 2023
61,821
20.07
186,613
September 1, 2023 - September 30, 2023
37,707
20.01
148,906
99,528
20.04
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)
4.2
3.25% Fixed to Floating Subordinated Debt issued September 24, 2021 (4)
10.1
Salary Continuation Agreement for James C. Holly (5)*
10.2
Split Dollar Agreement and Amendment thereto for James C. Holly (6)*
10.3
Director Retirement and Split dollar Agreements Effective October 1, 2002, for Albert Berra, Morris Tharp, and Gordon Woods (6)*
10.4
401 Plus Non-Qualified Deferred Compensation Plan (6)*
10.5
Indenture dated as of March 17, 2004 between U.S. Bank N.A., as Trustee, and Sierra Bancorp, as Issuer (7)
10.6
Amended and Restated Declaration of Trust of Sierra Statutory Trust II, dated as of March 17, 2004 (7)
10.7
Indenture dated as of June 15, 2006 between Wilmington Trust Co., as Trustee, and Sierra Bancorp, as Issuer (8)
10.8
Amended and Restated Declaration of Trust of Sierra Capital Trust III, dated as of June 15, 2006 (8)
10.9
2007 Stock Incentive Plan (9)
10.10
Sample Retirement Agreement Entered into with Each Non-Employee Director Effective January 1, 2007 (10)*
10.11
Salary Continuation Agreement for Kevin J. McPhaill (10)*
10.14
First Amendment to the Salary Continuation Agreement for Kevin J. McPhaill (11)*
10.15
Indenture dated as of September 20, 2007 between Wilmington Trust Co., as Trustee, and Coast Bancorp, as Issuer (12)
10.16
Amended and Restated Declaration of Trust of Coast Bancorp Statutory Trust II, dated as of September 20, 2007 (12)
10.17
First Supplemental Indenture dated as of July 8, 2016, between Wilmington Trust Co. as Trustee, Sierra Bancorp as the “Successor Company”, and Coast Bancorp (12)
10.18
2017 Stock Incentive Plan (13)*
10.19
Employment agreements dated as of December 27, 2018 for Kevin McPhaill, CEO and Michael Olague, Chief Banking Officer (14)*
10.21
Employment agreement dated as of November 15, 2019 for Christopher Treece, Chief Financial Officer (15)*
10.22
Employment agreement dated as of January 17, 2020 for Jennifer Johnson, Chief Administrative Officer (16)*
10.23
Employment agreement dated as of December 14, 2020 for Hugh Boyle, Chief Credit Officer (17)*
10.24
Form Indemnification Agreement dated as of January 28, 2021 for Directors and Executive Officers (18)*
10.25
Split Dollar Master Agreement and Election Form Effective October 1, 2002, for Kevin McPhaill (19)*
10.26
Split Dollar Agreement for Albert Berra (20)*
10.27
10b5-1 Plan for Susan Abundis (22)
10.28
2023 Equity Based Compensation Plan (21) *
10.29
Employment agreement dated as of August 25, 2023 for Natalia Coen, Chief Risk Officer (23)*
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
Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.
101.SCH
Inline XBRL Taxonomy Extension Schema Document
101.CAL
Inline XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
Inline XBRL Taxonomy Extension Definition Linkbase Document
101.LAB
Inline XBRL Taxonomy Extension Label Linkbase Document
101.PRE
Inline XBRL Taxonomy Extension Presentation Linkbase Document
104
Cover Page Interactive Data File - The cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL 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:
November 2, 2023
/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