ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis is intended as a review of significant factors affecting the Company’s financial condition and results of operations for the periods indicated. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements and the related notes.
The discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this Form 10-K, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements
Results of Operations for the Years Ended December 31, 2020 and 2019
Net Income
The following table sets forth the principal components of net income for the periods indicated.
Years Ended December 31,
Net income for the year ended December 31, 2020 was $25.8 million, an increase of $8.9 million, or 53%, from net income for the year ended December 31, 2019 of $16.9 million. The increase in net interest income was primarily due to the $150.6 million increase in average loans outstanding year over year. The increase in loan volume resulted in an increase of $10.9 million of loan interest income which includes $4.5 million from SBA-PPP loans. The increase in non-interest income is primarily due to credit card fees of $9.4 million and $24.7 million in mortgage banking revenue when comparing year over year.
Net Interest Income and Net Margin Analysis
Net interest income is the difference between interest income on earning assets and the cost of funds supporting those assets. Earning assets are composed primarily of loans, loans held for sale, investment securities, and interest bearing deposits with banks. The cost of funds represents interest expense on deposits, and borrowings, which consist of federal funds purchased, advances from the FHLB and subordinated notes. Noninterest bearing deposits and capital also provide sources of funding.
We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Net interest spread is the difference between average interest rates earned on interest earning assets and average interest rates paid on interest bearing
liabilities.
Changes in market interest rates and the interest rates we earn on interest earning assets or pay on interest bearing liabilities, as well as in the volume and mix of interest earning assets, interest bearing and noninterest bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in the Washington, D.C. and Baltimore metropolitan areas, as well as developments affecting the real estate, technology, government services, hospitality and tourism and financial services sectors within our target markets and throughout the Washington, D.C. and Baltimore metropolitan areas. Our ability to respond to changes in these factors by using effective asset-liability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings.
The table below presents the average balances and rates of the major categories of the Company’s assets and liabilities for the years ended December 31, 2020, 2019 and 2018. Included in the table is a measurement of interest rate spread and margin. Interest rate spread is the difference (expressed as a percentage) between the interest rate earned on earning assets less the interest expense on interest bearing liabilities. While the interest rate spread provides a quick comparison of earnings rates versus cost of funds, management believes that the net interest margin may provide a better measurement of performance. The net interest margin (as compared to the net interest spread) includes the effect of noninterest bearing sources in its calculation and is net interest income expressed as a percentage of average earning assets. As the table shows, the increase in net interest income in 2020 as compared to 2019 was primarily a function of an increase in of earning assets.
AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS
Years Ended December 31,
Assets
Interest earning assets:
Liabilities and Stockholders’ Equity
Interest bearing liabilities:
Noninterest bearing liabilities:
_______________
(1)Includes nonaccrual loans.
(2)Interest income includes amortization of deferred loan fees, net of deferred loan costs.
(3)Net interest spread is the difference between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities.
(4)Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period.
(5)For the twelve months ended December 31, 2020, SBA-PPP loans negatively impacted the margin by 25 basis points while credit card loans improved the margin by 136 basis points, taken together, the net impact was 125 basis points to the reported net interest margin. For the twelve months ended December 31, 2019 and December 31, 2018, credit card loans contributed 125 and 81 basis points of the reported net interest margin, respectively.
Rate/Volume Analysis of Net Interest Income
The rate/volume table below presents the composition of the change in net interest income for the periods indicated, as allocated between the change in net interest income due to changes in the volume of average earning assets and interest bearing liabilities, and the changes in net interest income due to changes in interest rates. The increase in net interest income in 2020 relative to 2019 was primarily due to an increase in volume of interest earning assets, and particularly loans. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been proportionately allocated to both volume and rate.
ANALYSIS OF CHANGES IN NET INTEREST INCOME
Compared to the Compared to the
Change Due To Interest Variance Change Due To Interest Variance
(In thousands) Volume Rate Volume Rate
Interest Income:
Interest Expense:
Net interest income increased by $17.7 million to $84.1 million for the year ended December 31, 2020 compared to 2019, primarily as a result of 35.7% growth in average earning assets. For the twelve months ended December 31, 2020, our average interest-earning assets increased by $430.2 million, compared to the prior year. In addition to the average earning asset growth in 2020, the average rate on interest bearing liabilities decreased by 64 basis points to 1.29%. Net interest margin decreased 37 basis points to 5.14% for the twelve months ended December 31, 2020 from 5.51% for the twelve months ended 2019. The Company’s average portfolio loan yield slightly decreased in 2020 to 7.27% as compared to 7.26% in 2019. The Company believes its net interest margin remains favorable as compared to its peer banking companies.
Average total interest earning assets were $1.6 billion for the year ended December 31, 2020 compared with $1.2 billion for the year ended December 31, 2019. The yield on those interest earning assets decreased 87 basis points to 5.95% for 2020 compared to 6.82% for 2019.
The increase in the average balance of interest earning assets for the year ended December 31, 2020 compared to December 31, 2019, was driven by $64.5 million growth in the average balances of
interest earning deposits, as well as growth in investment securities of $16.9 million, loans held for sale of $40.4 million, SBA-PPP loans of $157.6 million and portfolio loans of $150.6 million.
Average interest bearing liabilities increased by $201.8 million to $1.0 billion for the year ended December 31, 2020 from $819.4 million for the year ended December 31, 2019. The increase was due to an increase in the average balance of interest bearing demand accounts of $85.8 million, or 78.0%, an increase in money market accounts of $135.9 million, or 39.5% and a decrease in the average balance of borrowed funds of $16.9 million, or 28.5%. compared to the year ended December 31, 2019 balances. Deposits are the primary funding source for the Company. The average interest rate paid on interest bearing liabilities decreased to 1.29% for 2020 compared to 1.93% for 2019. While the average interest rate paid on interest bearing deposits decreased 27 basis points, the average interest rate paid on borrowed funds increased by 27 basis points. For the year ended December 31, 2020, the Company’s net interest margin was 5.14% and net interest spread was 4.66% compared to 5.51% and 4.89% for 2019.
Provision for Loan Losses
The provision for loan losses represents the amount of expense charged to current earnings to fund the allowance for loan losses. The amount of the allowance for loan losses is based on many factors which reflect management’s assessment of the risk in the loan portfolio. Those factors include historical losses, economic conditions and trends, the value and adequacy of collateral, volume and mix of the portfolio, performance of the portfolio, and internal loan processes of the Company and Bank. For a detailed description of the factors taken into account by our management in determining the allowance for loan losses see “Financial Condition— Allowance for Loan Losses.”
For the year ended December 31, 2020, the Company recorded a provision for loan losses of $11.2 million, compared to $2.8 million for the previous year. The increase in the provision for 2020 compared to 2019 was primarily due to the uncertainty surrounding the deterioration of the macro-economic environment related to the COVID-19 pandemic. Year over year our allowance for loan losses as a percent of total portfolio loans increased to 1.78% at December 31, 2020 from 1.14% at December 31, 2019. Net charge-offs for 2020 amounted to $1.1 million, representing 0.09% of average loans, compared to $799 thousand for 2019. Included in the net charge-offs for 2020 were $296 thousand for construction loans, $233 thousand for commercial loans and $588 thousand for credit cards. The credit card portfolio charge-offs represented 54.7% and 55.4% of total charge-offs, respectively, for the periods presented.
The maintenance of a high quality loan portfolio, with an adequate allowance for possible credit losses, will continue to be a primary management objective for the Company.
Noninterest Income
Our primary sources of recurring noninterest income are service charges on deposit accounts, credit card fees, such as interchange fees and statement fees, and gain on sale of residential mortgage loans and other mortgage banking revenue. Noninterest income does not include (i) loan origination fees to the extent they exceed the direct loan origination costs, which are generally recognized over the life of the related loan as an adjustment to yield using the interest method or (ii) annual, renewal and late fees related to our credit card portfolio, which are generally recognized over the twelve month life of the related loan as an adjustment to yield using the interest method.
The following table presents, for the periods indicated, the major categories of noninterest income:
NONINTEREST INCOME
Years Ended December 31,
Noninterest income:
Service charges on deposit accounts $ 520 $ 542 (4.1) %
Gain on sale of investment securities available for sale 20 26 (23.1) %
Noninterest income for the the year ended December 31, 2020 was $61.1 million, a $35.4 million or 137.7% increase compared to noninterest income of $25.7 million for the year ended December 31, 2019. This increase is largely due to increases in credit card fees and mortgage banking revenue. Credit card fees increased $9.4 million, or 123.2%, for the year ended December 31, 2020 to $17.0 million compared to $7.6 million for 2019 . This increase was primarily due to an increase in outstanding card accounts to 568 thousand at December 31, 2020, compared to 223 thousand at December 31, 2019, an increase of 345 thousand accounts, or 154.4%.
Mortgage banking revenue increased $24.7 million, or 154.8%, during 2020 to $40.6 million compared to 2019 revenue of $16.0 million, primarily as a result of an increase in mortgage origination volume driven by the favorable mortgage refinancing market in 2020. Year over year mortgage originations increased to $1.3 billion from prior year originations of $593.2 million, a 120.7% increase.
Mortgage loans sold are subject to repurchase in circumstances where documentation is deficient or the underlying loan becomes delinquent or pays off within a specified period following loan funding and sale. The Bank considers these potential recourse provisions to be a risk and has established a reserve under generally accepted accounting principles for possible repurchases. The reserve increased to $1.2 million at December 31, 2020, compared to $576 thousand for the same period in 2019 primarily due to the increase in volume. The Bank does not originate “sub-prime” loans and has no exposure to this market segment
Noninterest Expense
Generally, noninterest expense is composed of all employee expenses and costs associated with operating our facilities, obtaining and retaining customer relationships and providing bank services. The largest component of noninterest expense is salaries and employee benefits. Noninterest expense also includes operational expenses, such as occupancy and equipment expenses, professional fees, advertising expenses, loan processing expenses and other general and administrative expenses, including FDIC assessments, communications, travel, meals, training, supplies and postage.
The following table presents, for the periods indicated, the major categories of noninterest expense:
NONINTEREST EXPENSE
Years Ended December 31,
Noninterest expense:
Other real estate expense, net 69 122 (43.4) %
Noninterest expense was $98.8 million for the year ended December 31, 2020, an increase of $32.2 million, or 48.4%, compared to $66.5 million for 2019. The increase was driven primarily by increases in salaries and benefits, which includes commissions paid on mortgage originations. In 2020, as a result of robust mortgage originations, commissions were $10.9 million, compared to $5.4 million in 2019. The increase in professional fees resulted primarily from increased consultant and other outside services. Data processing increased primarily due to the increase in loan and credit card volume. Other operating expenses increased primarily a result of increases in marketing, credit expense and credit card related expenses.
Income Tax Expense
The amount of income tax expense we incur is influenced by our pre-tax income and our other nondeductible expenses. Deferred tax assets and liabilities are reflected at current income tax rates in effect for the period in which the deferred tax assets and liabilities are expected to be realized or settled. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized.
Income tax expense was $9.3 million for 2020 compared to $5.8 million for 2019. Our effective tax rates for those periods were 26.5% and 25.6%, respectively.
Financial Condition
Total assets at December 31, 2020 were $1.88 billion, a 31.5% increase as compared to $1.4 billion at December 31, 2019. Total portfolio loans (excluding mortgage loans held for sale) were $1.3 billion at December 31, 2020, an 11.7% increase as compared to $1.1 billion at December 31, 2019. Loans held for sale amounted to $107.2 million at December 31, 2020 as compared to $71.0 million for the same period in 2019, a 50.9% increase year over year.
Total borrowed funds at December 31, 2020, were $36.0 million compared to $47.6 million at December 31, 2019. In 2020, in an effort to reduce funding costs, manage liquidity and mitigate interest rate risk, the Company acquired a long term $22 million FHLB Fixed Rate Advance to pay off the FHLB Fixed Rate Principal Reducing long term debt incurred in 2019. As of December 31, 2020, $22.0 million of the advance remains outstanding.
Deposits were $1.7 billion at December 31, 2020, an increase of $426.7 million, a 34.8% as compared to $1.2 billion at December 31, 2019. The growth in the portfolio was primarily due to an increase in the non-interest bearing demand account category. The Company continues to execute on its strategic initiative to improve the deposit portfolio mix by reducing reliance on wholesale time deposits. Accordingly, wholesale time deposits decreased by $59.3 million or 35.5% to $107.7 million at December 31, 2020, from $167.0 million at December 31, 2019.
Stockholders’ equity increased $26.0 million, or 19%, to $159.3 million at December 31, 2020, compared to $133.3 million at December 31, 2019. The increase was primarily attributable to 2020 earnings of $25.8 million and proceeds from exercise of stock options of $0.8 million. Shares repurchased and retired in 2020 as part of the Company’s stock repurchase program totaled 304,114 shares at a weighted average price of $10.81 for a total cost of $3.3 million including commissions. As of December 31, 2020, the Bank’s capital ratios continued to exceed the regulatory requirements for a “well capitalized” institution.
Interest Bearing Deposits at Other Financial Institutions
As of December 31, 2020, interest bearing deposits at the Federal Reserve Bank of Richmond increased by $23.6 million, or 23.1%, to $126.1 million from a balance of $102.4 million at December 31, 2019.
Securities
The Company uses its securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk, meet collateral requirements and meet regulatory capital requirements.
Management classifies investment securities as either held to maturity or available for sale based on our intentions and the Company’s ability to hold such securities until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held to maturity and carried at amortized cost. All other securities are designated as available for sale and carried at estimated fair value with unrealized gains and losses included in stockholders’ equity on an after-tax basis. For the years presented, all securities were classified as available for sale.
Our investment portfolio totaled $99.8 million at December 31, 2020, a 64.0% increase from $60.8 million at December 31, 2019. To supplement interest income earned on our loan portfolio, the Company invests in high quality mortgage-backed securities, government agency bonds, asset-backed securities and high quality municipal and corporate bonds.
The following tables summarize the contractual maturities and weighted-average yields of investment securities at December 31, 2020 and the amortized cost and carrying value of those securities as of the indicated dates.
INVESTMENT PORTFOLIO
(dollars in thousands)
Securities Available for Sale:
December 31,
Book Value Fair Value Book Value Fair Value Book Value Fair Value
(in thousands)
Securities Available for Sale:
Portfolio Loans
Our primary source of income is derived from interest earned on loans. Our loan portfolio consists of loans secured by real estate, commercial business loans and credit card loans, substantially all of which are secured by corresponding deposits at the Bank and, to a very limited extent, other consumer loans. Our loan customers primarily consist of small- to medium-sized businesses, professionals, real estate investors, small residential builders and individuals. Our owner-occupied and investment commercial real estate loans, residential construction loans and commercial business loans provide us with higher risk-adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations, and are complemented by our relatively lower risk residential real estate loans to individuals. Our credit card portfolio supplements our traditional lending products with enhanced yields. Outside of credit cards, our lending activities are principally directed to our market area consisting of the Washington, D.C. and Baltimore metropolitan areas.
The following table summarizes our portfolio loans by type of loan as of the dates indicated:
COMPOSITION OF PORTFOLIO LOANS
December 31,
Real estate:
Residential Real Estate Loans. We offer one-to-four family mortgage loans primarily on owner-occupied primary residences and, to a lesser extent, investor owned residences. Residential loans are originated through our commercial sales teams and our Capital Bank Home Loan division. Our residential loans also include home equity lines of credit. Our owner-occupied residential real estate loans usually have fixed rates for five to seven years and adjust on an annual basis after the initial term based on a typical maturity of 30 years. Our investor residential real estate loans are generally based on 25-year terms with a balloon payment due after five years. In general, the required minimum debt service coverage ratio is 1.15. Residential real estate loans have represented a stable and growing portion of our loan portfolio. The Company intends to continue to emphasize residential real estate lending.
Commercial Real Estate Loans. The Company originates both owner-occupied and non-owner-occupied commercial real estate loans. These loans may be adversely affected by conditions in the real estate markets or in the general economy. Commercial loans that are secured by owner-occupied commercial real estate and primarily collateralized by operating cash flows are also included in this category of loans. As of December 31, 2020, the Company had approximately $200.3 million of owner-occupied commercial real estate loans, representing approximately 15.2% of our total portfolio. Commercial real estate loan terms are generally extended for 10 years or less and amortize generally over 25 years or less. The interest rates on our commercial real estate loans generally have an initial fixed rate terms that adjust typically at 5 years. Origination fees are routinely charged for our services. The Company generally requires personal guarantees from the principal owners of the business, supported by a review of the principal owners’ personal financial statements and global debt service obligations. The properties securing the portfolio are diverse in terms of type. This diversity helps reduce the exposure to adverse economic events that affect any single industry.
Construction Loans. Our construction loans are offered within our Washington, D.C. and Baltimore, Maryland metropolitan operating areas to builders primarily for the construction of single-family homes, condominium and townhouse conversions or renovations and, to a lesser extent, to individuals. Our construction loans typically have terms of 12 to 18 months with the goal of transitioning the borrowers to permanent financing or re-underwriting and selling into the secondary market through Capital Bank Home Loan. According to our underwriting standards, the ratio of loan principal to collateral value, as established by an independent appraisal, cannot exceed 75% for investor-owned and 80% for owner-occupied properties. We conduct semi-annual stress testing of our construction loan portfolio and closely monitor underlying real estate conditions as well as our borrower’s trends of sales valuations as
compared to underwriting valuations as part of our ongoing risk management efforts. Borrowers’ progress is closely monitored during the course of construction buildout and our original underwriting guidelines for construction milestones and completion timelines are followed.
Commercial Business Loans. In addition to our other loan products, the Company provides general commercial loans, including commercial lines of credit, working capital loans, term loans, equipment financing, letters of credit and other loan products, primarily in our target markets, and underwritten based on each borrower’s ability to service debt from income. These loans are primarily made based on the identified cash flows of the borrower and secondarily, on the underlying collateral provided by the borrower. Most commercial business loans are secured by a lien on general business assets including, among other things, available real estate, accounts receivable, promissory notes, inventory and equipment, and we generally obtain a personal guaranty from the borrower or other principal.
Credit Cards. Through our OpenSky® credit card division, the Company provides credit cards on a nationwide basis to under-banked populations and those looking to rebuild their credit scores through a fully digital and mobile platform. Substantially all of the lines of credit are secured by a noninterest bearing demand account at the Bank in an amount equal to the full credit limit of the credit card. In addition, using our proprietary scoring model, which considers credit score and repayment history (typically a minimum of six months of on-time repayments, but ultimately determined on a case-by-case basis), the Bank offers certain customers an unsecured line in excess of their secured line of credit.
Other Consumer Loans. To a very limited extent and typically as an accommodation to existing customers, we offer personal consumer loans such as term loans, car loans or boat loans.
The repayment of loans is a source of additional liquidity for us. The following table details maturities and sensitivity to interest rate changes for our loan portfolio at December 31, 2020:
PORTFOLIO LOAN MATURITY AND SENSITIVITY TO CHANGES IN INTEREST RATES
Real estate:
Nonperforming Assets
Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. When interest accrual is discontinued, all unpaid accrued
interest is reversed from income. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, reasonably assured. Any loan which the Bank deems to be uncollectible, in whole or in part, is charged off to the extent of the anticipated loss. Consumer credit card balances are moved into the charge off queue after they become more than 90 days past due and are charged off not later than 120 days after they become past due. Loans that are past due for 180 days or more are charged off unless the loan is well secured and in the process of collection.
The Company believes its disciplined lending approach and focused management of nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. There are several procedures in place to assist the Company in maintaining the overall quality of our loan portfolio. The Company has established underwriting guidelines to be followed by our bankers, and monitor our delinquency levels for any negative or adverse trends. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit.
Nonperforming loans were $9.2 million at December 31, 2020 and $4.7 million December 31, 2019. Nonperforming loans were 0.61% and 0.40% of total portfolio loans at the respective year ends. Foreclosed real estate increased to $3.3 million as of December 31, 2020 compared to $2.4 million, for the same period of 2019. The foreclosure of a construction loan with an outstanding balance of $2.1 million was the primary reason for the increase. The property is currently being marketed. As of December 31, 2020, we had $230 thousand of accruing loans past due 90 days. These loans were past due as a result of maturity date, not payment issues.
Total nonperforming assets were $12.6 million at December 31, 2020 compared to $7.1 million at December 31, 2019, or 0.67% and 0.50%, respectively, of corresponding total assets. Of the $12.6 million in total nonperforming assets, nonperforming loans represented $9.2 million and other real estate owned totaled $3.3 million. Nonperforming loans included five restructured loans totaling $440 thousand.
The following table presents information regarding nonperforming assets at the dates indicated:
NONPERFORMING ASSETS
December 31,
Nonaccrual loans
Real Estate:
Restructured loans-accruing $ — $ — $ — 3,219 $ —
Potential Problem Loans
From a credit risk standpoint, we grade watchlist and problem loans into one of five categories: pass/watch, special mention, substandard, doubtful or loss. The classifications of loans reflect a judgment about the risks of default and loss associated with the loan. Credits ratings are reviewed regularly. Ratings are adjusted regularly to reflect the degree of risk and loss that our management believes to be appropriate for each credit. Our methodology is structured so that specific reserve allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss). Our lending policy requires the routine monitoring of weekly past due reports, daily overdraft reports, monthly maturing loans, monthly risk rating reports and internal loan review reports. The lending and credit management of the Bank meet several times a week to review loans rated pass/watch. The focus of each meeting is to identify and promptly determine any necessary required action with this loan population, which consists of loans that, although considered satisfactory and performing to terms, may exhibit special risk features that warrant management’s attention.
Loans that are deemed special mention, substandard, doubtful or loss are listed in the Bank’s Problem Loan Status Report. The Problem Loan Status Report provides a detailed summary of the borrower and guarantor status, loan accrual status, collateral evaluation and includes a description of the planned collection and administration program designed to mitigate the Bank’s risk of loss and remove the loan from problem status. The Special Asset Committee reviews the Problem Loan Status Report on a quarterly basis for borrowers with an overall loan exposure in excess of $250,000.
The Bank uses the following definitions for watch list risk ratings:
•Pass/Watch. Borrowers who are considered satisfactory and performing to terms, however exhibiting special risk features such as declining earnings, strained cash flow, increasing leverage, and/or weakening fundamentals that indicate above average risk.
•Special Mention. A special mention loan has potential weaknesses deserving of management’s attention. If uncorrected, such weaknesses may result in deterioration of the repayment prospects for the asset or in our credit position at some future date.
•Substandard. A substandard loan is inadequately protected by the current financial condition and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that we will sustain some loss if deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets that are classified as substandard.
•Doubtful. A doubtful loan has all weaknesses inherent in one classified as substandard, with the added characteristic that weaknesses make collection or liquidation in full, on the basis of existing facts, conditions, and values, highly questionable and improbable. The probability of loss is extremely high, but certain important and reasonably specific factors that may work to the advantage and strengthening of the asset exist. Therefore, its classification as an estimated loss is deferred until a more precise status may be determined by management. Pending factors include proposed merger, acquisition or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans.
•Loss. Credits rated as loss are charged-off. We have no expectation of the recovery of any payments in respect of credits rated as loss.
Loans not meeting the criteria above are considered to be pass-rated loans. The following tables present the portfolio loan balances by category as well as risk rating. No assets were classified as loss during the periods presented.
PORTFOLIO LOAN CLASSIFICATION
(in thousands) Pass(1) Special Mention Substandard Doubtful Total
Real estate:
Real estate:
_______________
(1)Category includes loans graded exceptional, very good, satisfactory and pass/watch.
(2)Credit cards are evaluated by past due not risk rating.
At December 31, 2020, the recorded investment in impaired loans was $9.2 million, $391 thousand of which required a specific reserve of $253 thousand compared to a recorded investment in impaired loans of $4.1 million including $273 thousand requiring a specific reserve of $119 thousand at December 31, 2019. Of the $9.2 million of impaired loans, $3.7 million was related to one loan relationship.
Impaired loans also include certain loans that have been modified as troubled debt restructurings (“TDRs”). At December 31, 2020, the Company had five loans amounting to $440 thousand that were considered to be TDRs, compared to five loans amounting to $459 thousand at December 31, 2019.
Allowance for Loan Losses
We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts, or at all. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of our loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates.
The following table presents a summary of changes in the allowance for loan losses for the periods and dates indicated:
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
For the Years Ended December 31,
Charge-offs:
Real estate:
Construction (296) — — — —
Other consumer — — — — —
Recoveries:
Real estate:
Residential — — 3 — 7
Construction 7 — — — —
Other consumer — — — — —
Net charge-offs to average portfolio loans 0.09 % 0.08 % 0.09 % 0.15 % 0.33 %
_______________
(1)Allowance calculation excludes SBA-PPP loans.
Our allowance for loan losses at December 31, 2020 and December 31, 2019 was $23.4 million and $13.3 million, respectively, or 1.78% and 1.14% of portfolio loans for each respective period end. The allowance for loan losses at December 31, 2020 included specific reserves of $253 thousand set aside for impaired loans. Our charge-offs for the year ended December 31, 2020 were $1.2 million and were partially offset by recoveries of $57 thousand. The allowance for loan losses at December 31, 2019 included specific reserves of $119 thousand set aside for impaired loans. Our charge-offs for the year ended December 31, 2019 were $0.8 million and were partially offset by recoveries of $34 thousand. Total charge-offs for the years ended December 31, 2020 and 2019 were primarily due to credit card charge-offs resulting from growth in our credit card portfolio and certain charges in excess of credit limits. Additionally in 2019, there was a charge-off of a commercial and industrial loan in the amount of $233 thousand.
As the loan portfolio and allowance for loan losses review processes continue to evolve, there may be changes to elements of the allowance and this may have an effect on the overall level of the allowance maintained. Historically, the Bank has enjoyed a high quality loan portfolio with relatively low levels of net charge-offs and low delinquency rates. The maintenance of a high quality portfolio will continue to be a high priority for both management and the Board of Directors.
Management, being aware of the significant loan growth experienced by the Company, is intent on maintaining a strong credit review function and risk rating process. The Company has an experienced Credit Administration function, which provides independent analysis of credit requests and the management of problem credits. The Credit Department has developed and implemented analytical procedures for evaluating credit requests, has refined the Company’s risk rating system, and continues to adapt and enhance the monitoring of the loan portfolio. The loan portfolio analysis process is intended to contribute to the identification of weaknesses before they become more severe.
Although we believe we have established our allowance for loan losses in accordance with GAAP and that the allowance for loan losses was adequate to provide for known and inherent losses in the portfolio at all times shown above, future provisions for loan losses will be subject to ongoing evaluations of the risks in our loan portfolio.
The following table sets forth activity in the allowance for loan losses for the past five years for the categories and certain other information as of the dates indicated. The total allowance is available to absorb losses from any loan category.
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
December 31,
Real estate:
Other consumer 21 — 10 — 9 — 8 — 9 —
_______________
(1) Loan category as a percentage of total portfolio loans which excludes SBA-PPP loans.
Deposits
Deposits are the major source of funding for the Company. We offer a variety of deposit products including interest bearing demand, savings, money market and time accounts all of which we actively market at competitive pricing. We generate deposits from our customers on a relationship basis and through the efforts of our commercial lending officers and our business banking officers. Year over year, deposits increased 34.8% with the largest increase occurring in non-interest bearing demand accounts. The Company continues to execute on its strategic initiative to improve the deposit portfolio mix by reducing reliance on wholesale time deposits. This is evident in the reduction in our wholesale time deposit portfolio of $59.3 million or 35.5%, to $107.7 million at December 31, 2020, from $167.0 million, or 13.6% at December 31, 2019. Our credit card customers are also a significant source of low cost deposits.As of December 31, 2020, our credit card customers accounted for $192.5 million, or 31.6%, of our total noninterest bearing deposit balances.
We supplement our deposits with wholesale funding sources such as brokered deposits as needed.
At December 31, 2020, interest bearing deposits were $1.0 billion, an increase of $109.9 million, or 11.8%, compared to $933.6 million at December 31, 2019. This increase was primarily due to the Company’s continued effort to improve the deposit mix by reducing reliance on wholesale time deposits.
During the same period, money market balances increased to $447.1 million, an $18.0 million or 4.2% change from the prior year’s balance of $429.1 million. In order to fund the loan growth of the Bank, we built upon our prior success of focusing our strategic efforts to grow core deposits through an expanded deposits sales force, incentives to our commercial loan team and increased marketing efforts. The average rate paid on interest bearing demand deposits decreased 27 basis points to 0.34% at December 31, 2020 from 0.61% for the same period in 2019. Rates paid on certificates of deposit and money market decreased 34 and 69 basis points, respectively, for the period presented. The decrease in the average rates was primarily due to decreases in market interest rates resulting from prolonged low level of the federal funds rate during 2020.
The following table presents the average balances and average rates paid on deposits for the periods indicated:
COMPOSITION OF DEPOSITS
December 31,
The following table presents the maturities of our certificates of deposit as of December 31, 2020.
MATURITIES OF CERTIFICATES OF DEPOSIT
Borrowings
We utilize short-term and long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below.
FHLB Advances. The FHLB allows us to borrow up to 25% of our assets on a blanket floating lien status collateralized by certain securities and loans. As of December 31, 2020, approximately $222.0 million in real estate loans and $1.2 million in investment securities were pledged as collateral for our FHLB borrowings. We utilize these borrowings to meet liquidity needs and to fund certain fixed rate loans in our portfolio. As of December 31, 2020, we had $22.0 million in outstanding advances and $201.2 million in available borrowing capacity from the FHLB.
The following table sets forth certain information on our FHLB borrowings during the periods presented:
FHLB ADVANCES
Years Ended December 31,
Weighted average interest rate at period-end 0.93 % 2.40 % 4.26 %
Average balance outstanding during the period $ 25,917 $ 43,472 $ 8,101
Weighted average interest rate during the period 2.15 % 2.47 % 2.83 %
Other borrowed funds. The Company has also issued junior subordinated debentures and other subordinated notes. At December 31, 2020, these other borrowings amounted to $14.0 million.
At December 31, 2020, our junior subordinated debentures amounted to $2.1 million. The junior subordinated debentures were issued in June of 2006, mature on June 15, 2036, and may be redeemed prior to that date under certain circumstances. The principal amount of the debentures has not changed since issuance, and they accrue interest at a floating rate equal to the three-month LIBOR plus 1.87%.
On November 30, 2020, the Company issued $10.0 million in subordinated notes due in 2030 to replace the outstanding higher yielding $13.5 million, reducing interest expense. The notes have a ten year term and have a fixed rated of 5.00% for the first five years; thereafter, the rate resets quarterly to a benchmark rate plus 490 basis points. The notes may be redeemed, in part or whole, upon the occurrence of certain events.
Federal Reserve Bank of Richmond. The Federal Reserve Bank of Richmond has an available borrower in custody arrangement which allows us to borrow on a collateralized basis. The Company’s borrowing capacity under the Federal Reserve’s discount window program was $15.6 million as of December 31, 2020. Certain commercial loans are pledged under this arrangement. We maintain this borrowing arrangement to meet liquidity needs pursuant to our contingency funding plan. No advances were outstanding under this facility as of December 31, 2020.
The Company also has lines of credit of $76.0 million available with other correspondent banks at December 31, 2020, as well as access to certificate of deposit funding through a financial network which the Bank strives to limit to 15% of the Bank’s assets. There were no outstanding balances on the lines of credit from correspondent banks at December 31, 2020.
Liquidity
Liquidity is defined as the Bank’s capacity to meet its cash and collateral obligations at a reasonable cost. Maintaining an adequate level of liquidity depends on the Bank’s ability to meet both expected and unexpected cash flows and collateral needs efficiently without adversely affecting either daily operations or the financial condition of the Bank. Liquidity risk is the risk that we will be unable to meet our obligations as they become due because of an inability to liquidate assets or obtain adequate funding. The Bank’s obligations, and the funding sources used to meet them, depend significantly on our business mix, balance sheet structure and the cash flow profiles of our on- and off-balance sheet obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints on the ability to convert assets into cash or in accessing sources of funds (i.e., market liquidity) and contingent liquidity events. Changes in
economic conditions or exposure to credit, market, operating, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity and asset/liability management.
Management has established a comprehensive management process for identifying, measuring, monitoring and controlling liquidity risk. Because of its critical importance to the viability of the Bank, liquidity risk management is integrated into our risk management processes. Critical elements of our liquidity risk management include: corporate governance consisting of oversight by the board of directors and active involvement by management; the application of strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; liquidity risk measurement and monitoring systems (including assessments of the current and prospective cash flows or sources and uses of funds) that are commensurate with the complexity and business activities of the Bank; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of highly liquid marketable securities free of legal, regulatory or operational impediments, that can be used to meet liquidity needs in stressful situations; comprehensive contingency funding plans that are believed to be adequate to address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes that are believed to be appropriate to assure the adequacy of the institution’s liquidity risk management process.
We expect funds to be available from a number of basic banking activity sources, including the core deposit base, the repayment and maturity of loans and investment security cash flows. Other potential funding sources include brokered certificates of deposit, deposit listing services, CDARS, borrowings from the FHLB and other lines of credit.
We had outstanding borrowings of $2.0 million with the Federal Reserve Bank of Richmond at December 31, 2020 as participation with the Paycheck Protection Program Liquidity Facility (“PPPLF”). The PPPLF extended credit to eligible financial institutions that originated SBA-PPP loans, using the loans as collateral. We have an available borrower custody arrangement with the Federal Reserve Bank of Richmond which allows us to borrow on an eligible collateralized basis. As of December 31, 2020, we had $201.2 million of available borrowing capacity from the FHLB, $15.6 million of available borrowing capacity from the Federal Reserve Bank of Richmond and available lines of credit of $76.0 million with other correspondent banks. Cash and cash equivalents were $146.9 million million at December 31, 2020 and $114.8 million at December 31, 2019. Accordingly, our liquidity resources were at sufficient levels to fund loans and meet other cash needs as necessary.
Capital Resources
Stockholders’ equity increased $26.0 million for the year ended December 31, 2020 largely due to net income of $25.8 million for the year. Stock options exercised, shares issued as compensation, shares sold and stock-based compensation increased common stock and additional paid-in capital aggregately by $1.8 million. These increases were offset by the repurchase of 304,114 shares aggregating $3.7 million during 2020, and net unrealized gains on available for sale securities and cash flow hedging derivative of $1.7 million.
The Company uses several indicators of capital strength. The most commonly used measure is average common equity to average assets (computed as average equity divided by average total assets), which was 8.64% at December 31, 2020 and 10.14% at December 31, 2019.
The following table shows the return on average assets (computed as net income divided by average total assets), return on average equity (computed as net income divided by average equity) and average equity to average assets ratios for the years ended December 31, 2020 and 2019.
Return on Average Assets 1.56 % 1.38 %
Average Equity to Average Assets 8.64 % 10.14 %
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can precipitate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum ratios of common equity Tier 1, Tier 1, and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1250%. The Bank is also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio.
In July 2013, federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule applies to all depository institutions and bank holding companies and savings and loan holding companies with total consolidated assets of more than $1 billion. The Bank was required to implement the new Basel III capital standards (subject to the phase-in for certain parts of the new rules) as of January 1, 2015. In August of 2018 the Regulatory Relief Act directed the Federal Reserve Board to revise the Small BHC Policy Statement to raise the total consolidated asset limit in the Small BHC Policy Statement from $1 billion to $3 billion. The Company is currently exempt from the consolidated capital requirements.
The ability of the Company to continue to grow is dependent on its earnings and those of the Bank, the ability to obtain additional funds for contribution to the Bank’s capital, through additional borrowings, through the sale of additional common stock or preferred stock, or through the issuance of additional qualifying capital instruments, such as subordinated debt. The capital levels required to be maintained by the Company and Bank may be impacted as a result of the Bank’s concentrations in commercial real estate loans. See “Regulation” at page 18 and “Risk Factors” at page 33.
As of December 31, 2020, the Bank was in compliance with all applicable regulatory capital requirements to which it was subject and was classified as “well capitalized” for purposes of the prompt corrective action regulations. As we deploy our capital and continue to grow our operations, our regulatory capital levels may decrease depending on our level of earnings. However, we intend to monitor and control our growth in order to remain in compliance with all regulatory capital standards applicable to us.
The following table presents the regulatory capital ratios for the Company (as if such requirements applied to the Company) and the Bank as of the dates indicated.
December 31, 2020 Amount Ratio Amount Ratio Amount Ratio Amount Ratio
The Company
The Bank
The Company
The Bank
Contractual Obligations
We have contractual obligations to make future payments on debt and lease agreements. While our liquidity monitoring and management consider both present and future demands for and sources of liquidity, the following table of contractual commitments focuses only on future obligations and summarizes our contractual obligations as of December 31, 2020.
CONTRACTUAL OBLIGATIONS
FRB Borrowings $ — $ 1,954 $ — $ — $ 1,954
Off-Balance Sheet Items
In the normal course of business, we enter into various transactions that, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and issue letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets. Our exposure to credit loss is represented by the contractual amounts of these commitments. The same credit policies and procedures are used in making these commitments as for on-balance sheet instruments. We are not aware of any accounting loss to be incurred by funding these commitments; however, we maintain an allowance for off-balance sheet credit risk which is recorded in other liabilities on the consolidated balance sheet.
Our commitments associated with outstanding letters of credit and commitments to extend credit expiring by period as of the date indicated are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements.
CREDIT EXTENSION COMMITMENTS
December 31,
Commitments to originate residential loans held for sale 11,444 2,646
Unfunded lines of credit represent unused credit facilities to our current borrowers. Lines of credit generally have variable interest rates. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event of nonperformance by the customer in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be
entitled to seek recovery from the customer from the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our policies generally require that letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements. The credit risk associated with issuing letters of credit is substantially the same as the risk involved in extending loan facilities to our customers.
We minimize our exposure to loss under letters of credit and credit commitments by subjecting them to the same credit approval and monitoring procedures as we do for on-balance sheet instruments. The effect on our revenue, expenses, cash flows and liquidity of the unused portions of these lines of credit commitments cannot be precisely predicted because there is no guarantee that the lines of credit will be used.
Commitments to extend credit are agreements to lend funds to a customer, as long as there is no violation of any condition established in the contract, for a specific purpose. Commitments generally have variable interest rates, fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn, the total commitment amounts disclosed above do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by us, upon extension of credit is based on management’s credit evaluation of the customer.
We enter into forward commitments for the delivery of mortgage loans in our current pipeline. Interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from our commitments to fund the loans. These commitments to fund mortgage loans, to be sold into the secondary market, (interest rate lock commitments) and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives.
Impact of Inflation
Our consolidated financial statements and related notes included elsewhere in this report have been prepared in accordance with GAAP. GAAP requires the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession.
Unlike many industrial companies, substantially all of our assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, other operating expenses do reflect general levels of inflation.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Many assumptions are used to calculate the impact of interest rate fluctuations on our net interest income, such as asset prepayments, non-maturity deposit price sensitivity and decay rates, and key rate drivers. Because of the inherent use of these estimates and assumptions in the model, our actual results may, and most likely will, differ from our static earnings at risk (“EAR”) results. In addition, static EAR results do not include actions that our management may undertake to manage the risks in response to anticipated changes in interest rates or client behavior. For example, as part of our asset/liability management strategy, management has the ability to increase asset duration and decrease liability duration in order to reduce asset sensitivity, or to decrease asset duration and increase liability duration in order to increase asset sensitivity.
The following table summarizes the results of our EAR analysis in simulating the change in net interest income and fair value of equity over a 12-month horizon as of December 31, 2020:
IMPACT ON NET INTEREST INCOME UNDER A STATIC BALANCE SHEET, PARALLEL INTEREST RATE SHOCK
Utilizing an economic value of equity (“EVE”) approach, we analyze the risk to capital from the effects of various interest rate scenarios through a long-term discounted cash flow model. This measures the difference between the economic value of our assets and the economic value of our liabilities, which is a proxy for our liquidation value. While this provides some value as a risk measurement tool, management believes EAR is more appropriate to the application of the going concern principle.
The following table illustrates the results of our EVE analysis as of December 31, 2020.
ECONOMIC VALUE OF EQUITY ANALYSIS UNDER A STATIC BALANCE SHEET, PARALLEL INTEREST RATE SHOCK
Interest Rate Sensitivity and Market Risk
A fundamental risk in banking is exposure to market risk, since a bank’s net income is largely dependent on net interest income. The Bank’s ALCO formulates and monitors the management of interest rate risk through policies and guidelines established by it and the full Board of Directors and through review of detailed reports discussed quarterly. In its consideration of risk limits, the ALCO considers the impact on earnings and capital, the level and direction of interest rates, liquidity, local economic conditions, outside threats and other factors. Banking is generally a business of managing the maturity and repricing mismatch inherent in its asset and liability cash flows and to provide net interest income growth consistent with the Company’s profit objectives.
Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of our assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those that have a short term to maturity. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time optimizing income.
We manage our exposure to interest rates by structuring our balance sheet in the ordinary course of business. We do not enter into instruments such as leveraged derivatives, financial options or financial future contracts for the purpose of reducing interest rate risk. We do hedge the interest rate risks of our available for sale mortgage pipeline by using mortgage-backed securities short positions, and of our subordinated debentures by utilizing an interest rate swap. Based on the nature of our operations, we are not subject to foreign exchange or commodity price risk. We do not own any trading assets.
The ALCO committee meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, the committee reviews liquidity, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity. Management employs methodologies to manage interest rate risk, which include an analysis of relationships between interest earning assets and interest bearing liabilities and an interest rate shock simulation model.
The following table indicates that, for periods less than one year, rate-sensitive assets exceeded rate-sensitive liabilities, resulting in an asset-sensitive position. For a bank with an asset-sensitive position, or positive gap, rising interest rates would generally be expected to have a positive effect on net interest income, and falling interest rates would generally be expected to have the opposite effect.
INTEREST SENSITIVITY GAP
(in thousands)
Assets
Interest earning assets
Liabilities
Interest bearing liabilities
_______________
(1)Includes loans held for sale.
We use quarterly EAR simulations to assess the impact of changing interest rates on our earnings under a variety of scenarios and time horizons. These simulations utilize both instantaneous and parallel changes in the level of interest rates, as well as non-parallel changes such as changing slopes and twists of the yield curve. Static simulation models are based on current exposures and assume a constant balance sheet with no new growth. Dynamic simulation models are also utilized that rely on detailed assumptions regarding changes in existing lines of business, new business, and changes in management and client behavior.
We also use economic value-based methodologies to measure the degree to which the economic values of the Bank’s positions change under different interest rate scenarios. The economic-value approach focuses on a longer-term time horizon and endeavors to capture all future cash flows expected from existing assets and liabilities. The economic value model utilizes a static approach in that the analysis does not incorporate new business; rather, the analysis shows a snapshot in time of the risk inherent in the balance sheet.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors of Capital Bancorp, Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Capital Bancorp, Inc. and Subsidiaries (the “Company”) as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for the years then ended, and the related notes to the consolidated financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Elliott Davis, PLLC
We have served as the Company’s auditor since 2017.
Raleigh, North Carolina
March 15, 2021
Assets
Interest bearing deposits at other financial institutions 126,081 102,447
Investment securities available for sale 99,787 60,828
Liabilities
Deposits
Stockholders' equity
Accumulated other comprehensive income 1,717 13
See Notes to Consolidated Financial Statements
(dollars in thousands except per share data) 2020 2019
Interest income
Investment securities available for sale 1,292 924
Federal funds sold and other 592 1,125
Interest expense
Net interest income after provision for loan losses 72,827 63,547
Noninterest income
Service charges on deposits 520 542
Gain on sale of investment securities available for sale 20 26
Noninterest expenses
Other real estate expenses, net 69 122
Basic earnings per share $ 1.87 $ 1.23
Diluted earnings per share $ 1.87 $ 1.21
Weighted average common shares outstanding:
See Notes to Consolidated Financial Statements
Other comprehensive income (loss):
Unrealized gain on investment securities available for sale 2,340 868
Unrealized loss on cash flow hedging derivative — (5)
Income tax expense relating to the items above (616) (229)
Other comprehensive income 1,704 608
See Notes to Consolidated Financial Statements
(dollars in thousands) Shares Amount
Adoption of lease standard (54) (54)
Stock-based compensation — — 795 — — 795
Shares repurchased and retired (28,480) — (371) — — (371)
Stock-based compensation — — 983 — — 983
See Notes to Consolidated Financial Statements
Cash flows from operating activities
Provision for mortgage put-back reserve 598 184
Provision for off balance sheet credit risk 550 173
Net amortization on investments 297 160
Premises and equipment depreciation 844 1,113
Stock-based compensation expense 983 795
Director and employee compensation paid in Company stock 268 301
Deferred income tax benefit (3,170) (839)
Amortization of debt issuance cost 139 30
Gain on sale of securities available for sale (20) (26)
Changes in assets and liabilities:
Accrued interest receivable (3,364) (308)
Prepaid income taxes and taxes payable — 81
Accrued interest payable (667) 236
Net cash provided by operating activities 5,457 (27,212)
Cash flows from investing activities
Purchases of securities available for sale (53,926) (38,587)
Proceeds from sale of securities available for sale 965 3,280
Sales (purchases) of restricted investments 8 (1,463)
Net increase in SBA-PPP loans receivable (201,018) —
Net purchases of premises and equipment (267) (303)
Proceeds from sales of foreclosed real estate — 49
See Notes to Consolidated Financial Statements
Cash flows from financing activities
Net increase (decrease) in:
Securities sold under agreements to repurchase — (3,332)
Federal funds purchased — (2,000)
Federal Home Loan Bank advances, net (10,222) 30,222
Other borrowed funds (1,546) —
Repurchase of common stock (3,720) (371)
Proceeds from exercise of stock options 922 595
Net increase in cash and cash equivalents 32,086 80,101
Cash and cash equivalents, beginning of year 114,824 34,723
Noncash investing and financing activities:
Loans transferred to foreclosed real estate $ 942 $ 2,291
Change in unrealized gains on investments $ 2,320 $ 842
Change in fair value of loans held for sale $ 5,669 1,420
Change in fair value of cash flow hedging derivative $ — (5)
Establishment of right of use asset $ — $ 5,158
Establishment of lease liability $ — $ 5,358
Cash paid during the period for:
See Notes to Consolidated Financial Statements
Note 1 - Nature of Business and Basis of Presentation
Nature of Business
Capital Bancorp, Inc. is a Maryland corporation and bank holding company (the “Company”) for Capital Bank, N.A. (the “Bank”). The Company's primary operations are conducted by the Bank, which operates branches in Rockville, Columbia and North Bethesda, Maryland, Reston, Virginia, and the District of Columbia. The Bank is principally engaged in the business of investing in commercial, real estate, and credit card loans and attracting deposits. The Company originates residential mortgages for sale in the secondary market through Capital Bank Home Loans, our residential mortgage banking arm, and issues credit cards through OpenSky®, a secured, digitally-driven, nationwide credit card platform.
The Company formed Church Street Capital, LLC (“Church Street Capital”) in 2014 to provide short-term secured real estate financing to Washington, D.C. area investors and developers that may not meet all Bank credit criteria.
In addition, the Company owns all of the stock of Capital Bancorp (MD) Statutory Trust I (the “Trust”). The Trust is a special purpose non-consolidated entity organized for the sole purpose of issuing trust preferred securities.
Basis of Presentation
The accompanying consolidated financial statements include the activity of the Company and its wholly-owned subsidiaries, the Bank and Church Street Capital. All intercompany transactions have been eliminated in consolidation. The Company reports its activities as a four business segments: commercial banking; mortgage lending; credit cards; and corporate activities. In determining the appropriateness of segment definition, the Company considers components of the business about which financial information is available and regularly evaluated relative to resource allocation and performance assessment. The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), and conform to general practices within the banking industry.
Significant Accounting Policies:
The preparation of consolidated financial statements in accordance with GAAP requires estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. The basis of the estimates is on historical experience and on various other assumptions that are believed to be reasonable under current circumstances, results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Estimates are evaluated on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.
Cash and cash equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, interest bearing deposits with banks and federal funds sold. Generally, federal funds are sold for one-day periods.
Note 1 - Nature of Business and Basis of Presentation (continued)
Investment securities
Investment securities are classified as available for sale and carried at fair value with unrealized gains and losses included in stockholders’ equity on an after-tax basis. Premiums and discounts on investment securities are amortized or accreted using the interest method. Changes in the fair value of debt securities available for sale are included in stockholder’s equity as unrealized gains and losses, net of the related tax effect. Unrealized losses are periodically reviewed to determine whether the loss represents an other than temporary impairment. Any unrealized losses judged to be other than a temporary impairment will be charged to income.
Loans held for sale
Mortgage loans originated and intended for sale are recorded at fair value, determined individually, as of the balance sheet date. Fair value is determined based on outstanding investor commitments, or in the absence of such commitments, based on current investor yield requirements. Gains and losses on loan sales are determined by the specific-identification method. The Company’s current practice is to sell residential mortgage loans on a servicing released basis, and, therefore, it has no intangible asset recorded for the value of such servicing. Interest on loans held for sale is credited to income based on the principal amounts outstanding.
Upon sale and delivery, loans are legally isolated from the Company and the Company has no ability to restrict or constrain the ability of third‐party investors to pledge or exchange the mortgage loans. The Company does not have the entitlement or ability to repurchase the mortgage loans or unilaterally cause third‐party investors to put the mortgage loans back to the Company. Unrealized and realized gains on loan sales are determined using the specific-identification method and are recognized through mortgage banking activity in the Consolidated Statements of Income.
The Company elected to measure loans held for sale at fair value to better align reported results with the underlying economic changes in value of the loans on the Company’s balance sheet.
Portfolio loans and the allowance for loan losses
Loans are stated at the principal amount outstanding, adjusted for deferred origination fees, deferred origination costs, discounts on loans acquired, and the allowance for loan losses. Interest is accrued based on the loan principal balances and stated interest rates. Origination fees and costs are recognized as an adjustment to the related loan yield using approximate interest methods.
The Company has provided short-term deferrals of loan principal and/or interest payments for customers who have been affected by the COVID-19 pandemic. Customers receiving payment deferrals must meet certain criteria, such as being in good standing and not more than 30 days past due prior to the pandemic. In most cases, the deferred principal and/or interest amounts will be collected at the end of the life of the loan and will not accrue additional interest. The granting of a deferral of principal and/or interest under the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act, which was enacted on March 27, 2020, and based on interagency guidelines, does not subject the loan to the past due, non-accrual, or troubled debt restructurings (“TDR”) policies described below. Upon exiting the loan modification deferral program, the measurement of loan delinquency will resume based in the number of days of delinquency as at the date of modification. The following discussions of past due, non-accrual and TDR policies remain valid for situations not covered by the CARES Act.
Note 1 - Nature of Business and Basis of Presentation (continued)
Outstanding portfolio loans deferred due to COVID-19, which decreased by 78.9 percent from $144.0 million at June 30, 2020 to $30.5 million at December 31, 2020, are shown in the table below:
Loan Modifications (1)
(dollars in millions)
Deferred Loans Deferred Loans
Other Services Including Private Households 174.2 1.1 3 17.3 36
Educational Services 20.9 — — 9.8 6
Professional, Scientific, and Technical Services 86.3 1.4 3 5.0 11
Arts, Entertainment & Recreation 39.0 0.7 2 5.0 9
The Company generally discontinues the accrual of interest when any portion of the principal and interest is 90 days past due and collateral is insufficient to discharge the debt in full. Generally, interest payments on nonaccrual loans are recorded as a reduction of the principal balance.
Loans are considered impaired when, based on current information, management believes the Company will not collect all principal and interest payments according to contractual terms. Generally, loans are reviewed for impairment when the risk grade for a loan is downgraded to a classified asset category. The loans are evaluated for appropriate classification, accrual, impairment, and troubled debt restructure status. If collection of principal is evaluated as doubtful, all payments are applied to principal. A modification of a loan is considered a TDR when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Company may consider interest rate reductions, changes to payment terms, extensions of maturities and/or principal reductions.
Loans are generally charged-off in part or in full when management determines the loan to be uncollectible. Factors for charge-off that may be considered include: repayments deemed to be projected beyond reasonable time frames, client bankruptcy and lack of assets, and/or collateral deficiencies.
Note 1 - Nature of Business and Basis of Presentation (continued)
The allowance for loan losses is estimated to adequately provide for probable future losses on existing loans. The allowance consists of specific and general components. For loans that are classified as impaired, an allowance is established when the collateral value, if the loan is collateral dependent, or the discounted cash flows of the impaired loan, is lower than the carrying value of that loan. The general component covers pools of nonclassified loans and is based on historical loss experience adjusted for qualitative factors. There may be an unallocated component of the allowance, which reflects the margin of the imprecision inherent in the underlying assumptions used in the method for estimating specific and general losses in the portfolio. Actual loan performance may differ from those estimates. A loss is recognized as a charge to the allowance when management believes that collection of the loan is unlikely. Collections of loans previously charged off are added to the allowance at the time of recovery.
The components of the allowance for loan losses represent an estimation done pursuant to ASC Topic 450, “Contingencies,” or ASC Topic 310,“Receivables.” Specific allowances are established in cases where management has identified significant conditions or circumstances related to a specific credit that management believes indicate the probability that a loss may be incurred. The process for determining an appropriate allowance for loan losses is based on a comprehensive, well-documented, and consistently applied analysis of the loan portfolio. The analysis considers significant factors that affect the collectibility of the portfolio and supports the loan losses estimated by this process. It is important to recognize that the related process, methodology, and underlying assumptions require a substantial degree of judgment.
Management believes that the allowance for loan losses is adequate; however, determination of the allowance is inherently subjective and requires significant estimates. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. Evaluation of the potential effects of these factors on estimated losses involves a high degree of uncertainty, including the strength and timing of economic cycles and concerns over the effects of a prolonged economic downturn in the current cycle. In addition, various banking agencies,as an integral part of their examination process, and independent consultants engaged by the Bank, periodically review the Bank’s loan portfolio and allowance for loan losses. Such review may result in recognition of additions to the allowance based on their evaluation of information available to them at the time of their examination. The review of the adequacy of the allowance for loan losses includes an assessment of the fair value adjustment for acquired loans in accordance with generally accepted accounting principles.
Premises and equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the related property generally over two to seven years. Leasehold improvements are amortized over the estimated term of the respective leases, which may include renewal options where management has the positive intent to exercise such options, or the estimated useful lives of the improvements, whichever is less. Expenditures for maintenance, repairs, and minor replacements are charged to noninterest expenses as incurred. The costs of major renewals and improvements are capitalized, these costs would be included as a component of premises and equipment expenses.
Leases
During the first quarter of 2019, the Company adopted Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). ASU 2016-02 applies a right-of-use (“ROU”) model that requires a lessee to record, for all leases with a lease term of more than 12 months, an asset representing its right to use the underlying asset and a liability to make lease payments. The Company elected to apply the practical expedients permitting entities to not reassess: 1) whether any expired or existing contracts are or contain leases; 2) the lease classification for any expired or existing leases; and
Note 1 - Nature of Business and Basis of Presentation (continued)
3) initial direct costs for any existing leases. Additionally, as provided by ASU 2016-02, the Company elected not to apply the recognition requirements of ASC 842 to short-term leases, defined as leases with a term of 12 months or less, and to recognize the lease payments in net income on short-term leases on a straight-line basis over the lease term.
The Company has adopted the guidance using the modified retrospective approach on January 1, 2019 and elected the practical expedients for transition including the transition option provided in ASU 2018-11, Leases (Topic 842) Targeted Improvements, which allowed the Company to initially apply the new leases standard at the adoption date. Consequently, the reporting for the comparative periods presented continued to be in accordance with ASC Topic 840, Leases. Therefore, the 2018 financial results and disclosures have not been adjusted.
The Company accounts for our existing operating leases consistent with prior guidance except for the incremental balance sheet recognition for leases. The adoption of this standard resulted in the Company recognizing lease right-of-use assets and related lease liabilities totaling $5.2 million and $5.4 million, respectively, as of January 1, 2019. The difference between the lease assets and the lease liabilities was $146 thousand of deferred rent, which was reclassified to lease liabilities, and the remainder was recorded as an adjustment to retained earnings in the amount of $54 thousand. The adoption of this ASU did not have a significant impact on the Company’s consolidated statement of income. Additional information is included in Note 7 - Leases.
Derivative Financial Instruments
The Company enters into commitments to fund residential mortgage loans (interest rate locks) with the intention of selling them in the secondary market. The Company also enters into forward sales agreements for certain funded loans and loan commitments. Unfunded commitments intended for loans held for sale and forward sales agreements are recorded at fair value with changes in fair value recorded as a component of mortgage banking revenue. Loans originated and intended for sale in the secondary market are carried at fair value. For pipeline loans which are not pre-sold to an investor, the Company manages the interest rate risk on rate lock commitments by entering into forward sale contracts, whereby the Company obtains the right to deliver securities to investors in the future at a specified price, Such contracts are accounted for as derivatives and are recorded at fair value as derivative assets or liabilities, with changes in fair value recorded in mortgage banking revenue.
The Company accounts for derivative instruments and hedging activities according to guidelines established in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 815-10, Accounting for Derivative Instruments and Hedging Activities, as amended. The Company recognizes all derivatives as either assets or liabilities on the balance sheet and measures those instruments at fair value. Changes in fair value of derivatives designated and accounted for as cash flow hedges, to the extent they are effective as hedges, are recorded in other comprehensive income, net of deferred taxes. Any hedge ineffectiveness would be recognized in the income statement line item pertaining to the hedged item.
Fair Value Measurements
Fair value is the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants at the measurement date. The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices or observable market inputs. For financial instruments that are traded actively and have quoted market prices or observable market inputs, there is minimal subjectivity involved in measuring fair value. However, when quoted market prices or observable market inputs are not fully available, significant
Note 1 - Nature of Business and Basis of Presentation (continued)
management judgment may be necessary to estimate fair value. In developing our fair value estimates, we strive to maximize the use of observable inputs and minimize the use of unobservable inputs.
The fair value hierarchy defines Level 1 valuations as those based on quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 valuations include inputs based on quoted prices for similar assets or liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 3 valuations are based on at least one significant assumption not observable in the market, or significant management judgment or estimation, some of which may be internally developed.
Financial assets that are recorded at fair value on a recurring basis include investment securities available for sale, loans held for sale, and derivative financial instruments. Financial liabilities that are recorded at fair value on a recurring basis are comprised of derivative financial instruments. See the Fair Value note to our consolidated financial statements.
Income Taxes
The Company employs the asset and liability method of accounting for income taxes as required by ASC Topic 740, “Income Taxes.” Under this method, deferred tax assets and liabilities are determined based on differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities (i.e. temporary timing differences) and are measured at the enacted rates that will be in effect when these differences reverse. The Company utilizes statutory requirements for its income tax accounting, and limits risks associated with potentially problematic tax positions that may incur challenge upon audit, where an adverse outcome is more likely than not. Therefore, no provisions are necessary for either uncertain tax positions nor accompanying potential tax penalties and interest for underpayments of income taxes in the Company’s tax reserves. In accordance with ASC Topic 740, the Company may establish a valuation allowance against deferred tax assets in those cases where realization is less than certain.
Earnings per share
Earnings per share is computed by dividing net income available to common stockholders by the weighted average number of shares outstanding. Diluted earnings per share is computed by dividing net income by the weighted average number of common shares outstanding, adjusted for the dilutive effect of stock options and restricted stock using the treasury stock method. At December 31, 2020 and 2019, there were 504,861 and 7,628 stock options, respectively, that were not included in the calculation as their effect would have been anti-dilutive.
Note 1 - Nature of Business and Basis of Presentation (continued)
The following is a reconciliation of the numerators and denominators used in computing basic and diluted earnings per common share:
Earnings Per Share For the Years Ended December 31,
Basic EPS
Comprehensive income
The Company reports as comprehensive income all changes in stockholders' equity during the year from sources other than stockholders. Other comprehensive income refers to all components (income, expenses, gains, and losses) of comprehensive income that are excluded from net income.
The Company's only two components of other comprehensive income are unrealized gains and losses on investment securities available for sale, net of income taxes, and unrealized gains and losses on cash flow hedges, net of income taxes. Information concerning the Company's accumulated other comprehensive income as of December 31, 2020, and 2019 are as follows:
Comprehensive Income For the Years Ended December 31,
Unrealized gains on securities available for sale $ 2,337 $ 18
Deferred tax expense (620) (5)
Total accumulated comprehensive income $ 1,717 $ 13
Recently issued accounting pronouncements:
In June 2016, the FASB issued guidance to change the accounting for loan losses and modify the impairment model for certain debt securities. In October 2019, the FASB voted to delay implementation and the new standard is now effective for fiscal years beginning after December 15, 2022, including the interim periods within those fiscal years. The Company expects the provisions of this standard to impact the Company’s consolidated financial statements, in particular, the level of the reserve for loan losses. The Company is continuing to evaluate the extent of the potential impact and expects that portfolio composition and economic conditions at the time of adoption will be a factor.
The Company will apply the amendments to the ASU through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. While early adoption was permitted, the Company did not elect that option. In addition to our allowance for loan losses, the Company will also record an allowance for credit losses on held-to-maturity debt securities instead of applying the impairment model currently utilized. The amount of the adjustments will be impacted by each portfolio’s composition and credit quality at the adoption date as well as economic conditions and forecasts at that time.
Note 1 - Nature of Business and Basis of Presentation (continued)
In April 2019, the FASB issued codification improvements to ASU Topic 326 - Financial Instruments - Credit Loss, Topic 815 - Derivatives and Hedging, and Subtopic 825-10 - Financial Instruments. This codification provides technical corrections and clarifies issues related to fair value hedges. The Company early adopted this guidance upon issuance, and it did not have a material impact on the Company’s Consolidated Financial Statements.
In November 2019, the FASB issued guidance to defer the effective dates for private companies, not-for-profit organizations, and certain smaller reporting companies applying standards on current expected loan losses (CECL). The new effective dates will be fiscal years beginning after December 15, 2022 including interim periods within those fiscal years. In addition, the FASB issued guidance that addresses issues raised by stakeholders during the implementation of ASU 2016-13, Financial Instruments-loan losses (Topic 326): Measurement of loan losses on Financial Instruments. The amendments affect a variety of Topics in the Accounting Standards Codification. For entities that have not yet adopted the amendments in ASU 2016-13, the amendments are effective for fiscal years beginning after December 15, 2022 including interim periods within those fiscal years. Early adoption is permitted in any interim period as long as an entity has adopted the amendments in ASU 2016-13. The Company does not expect these amendments to have a material effect on its financial statements.
In December 2019, the FASB issued guidance to simplify accounting for income taxes by removing specific technical exceptions that often produce information investors have a hard time understanding. The amendments also improve consistent application of and simplify GAAP for other areas of Topic 740 by clarifying and amending existing guidance. The amendments are effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.
In March 2020, the FASB released ASU 2020-04 - Reference Rate Reform, Topic 848, which provides guidance to provide temporary guidance to ease the potential accounting burden in accounting for, or recognizing the effects from, reference rate reform on financial reporting. The new standard is a result of London Interbank Offered Rate (“LIBOR”) likely being discontinued as an available benchmark rate. The standard is elective and provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships, or other transactions that reference LIBOR, or another reference rate expected to be discontinued. The amendments in the update are effective for all entities between March 12,2020 and December 31, 2022. The Company is currently evaluating products and preparing to offer new rates. The adoption of this guidance is not expected to have a material impact on the Company’s financial statements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company's financial position, results of operations or cash flows.
Reclassifications:
Certain reclassifications have been made to the amounts reported in prior periods to conform to the current period presentation. The reclassifications had no effect on net income or total stockholders' equity.
Note 2 - Cash and Cash Equivalents
Cash and cash equivalents include cash and due from banks, interest bearing deposits and federal funds sold. The Bank is required by regulations to maintain an average cash reserve balance based on a percentage of deposits. At December 31, 2020 and 2019, the requirements were satisfied by amounts on deposit with the Federal Reserve Bank and cash on hand.
Note 3 - Investment Securities
The investment securities portfolio consists primarily of U.S. government sponsored entity securities, asset-backed securities, securities issued by states, counties and municipalities, corporate bonds and mortgage backed securities (“MBS”). The asset-backed securities are comprised of student loan collateral issued by the Federal Family Education Loan Program (“FFELP”) which includes a minimum of a 97% government repayment guarantee, as well as additional support in excess of the government guaranteed portion.
Note 3 - Investment Securities (continued)
The amortized cost and estimated fair value of investment securities at December 31, 2020 and 2019 are summarized as follows:
Investment Securities Available for Sale
AmortizedCost UnrealizedGains UnrealizedLosses FairValue
(in thousands)
U.S. government-sponsored agencies $ 1,000 $ — $ (1) $ 999
Proceeds from sales of the security sold during the year ended December 31, 2020 and 2019 were $1.0 million and $3.3 million respectively, and resulted in aggregate realized gains of $20 thousand for December 31, 2020 and aggregate realized gains of $26 thousand for the same period in 2019.
Information related to unrealized losses in the investment portfolio as of December 31, 2020 and 2019 are as follows:
Investment Securities Unrealized Losses
Less than 12 months 12 months or longer Total
FairValue UnrealizedLosses FairValue UnrealizedLosses FairValue UnrealizedLosses
(in thousands)
Asset-backed securities $ — $ — $ — $ — $ — $ —
U.S. government-sponsored agencies $ — $ — $ 999 $ (1) $ 999 $ (1)
Municipal — — — — — —
At December 31, 2020, there was one corporate security that has been in a loss position for greater than twelve months. Management believes that all unrealized losses have resulted from temporary changes in interest rates and current market conditions and not as a result of credit deterioration. Management has the ability and the intent to hold these investment securities until maturity or until they recover in value.
Note 3 - Investment Securities (continued)
A summary of pledged securities at December 31, 2020 and 2019 is shown below:
Pledged Securities
For the Years Ended December 31,
(in thousands) AmortizedCost FairValue AmortizedCost FairValue
Contractual maturities of U.S. government-sponsored agencies, asset-backed, municipal, corporate and mortgage-backed securities at December 31, 2020 and 2019 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Investment Securities - Contractual Maturities
For the Years Ended December 31,
(in thousands) AmortizedCost FairValue AmortizedCost FairValue
Over one to five years — — — —
_____
(1) Mortgage-backed securities are due in monthly installments.
Note 4 - SBA-PPP Loans
Pursuant to the CARES Act, the SBA-PPP provides forgivable loans to small businesses to enable them to maintain payroll, hire back employees who have been laid off, and cover applicable overhead. SBA-PPP loans have an interest rate of 1%, have 2 and 5 year terms, and carry a 100% guarantee of the SBA.
The allowance for loan losses for SBA-PPP loans was separately evaluated given the explicit government guarantee. This analysis, which incorporated historical experience with similar SBA guarantees and underwriting, concluded the likelihood of loss was remote and therefore no allowance for loan losses was assigned to these loans.
At December 31, 2020, SBA-PPP loans receivable, which totaled $204.9 million, are all rated as pass credits, not past due, nonaccrual, TDR, or otherwise impaired. Earned fees for the year are $2.8 million and unearned net fees associated with the SBA-PPP loans amounted to $3.9 million at December 31, 2020. There were no outstanding commitments to extend additional SBA-PPP loans at December 31, 2020.
Note 5 - Portfolio Loans Receivable
Major categories of portfolio loans are as follows:
Portfolio Loan Categories
December 31,
Real estate:
Deferred origination fees, net (774) (2,404)
The Company makes loans to customers located primarily in the Washington, D.C. metropolitan area. Although the loan portfolio is diversified, its performance will be influenced by the regional economy. The Company’s portfolio loan categories are described below.
Residential Real Estate Loans. One-to-four family mortgage loans are primarily on owner-occupied primary residences and, to a lesser extent, investor owned residences. Residential loans are originated through the commercial sales teams and Capital Bank Home Loan division. Residential loans also include home equity lines of credit. Owner-occupied residential real estate loans usually have fixed rates for five or seven years and adjust on an annual basis after the initial term based on a typical maturity of 30 years. Investor residential real estate loans are generally based on 25-year terms with a balloon payment due after five years. Generally, the required minimum debt service coverage ratio is 1.15. Residential real estate loans have represented a stable and growing portion of the loan portfolio.
Commercial Real Estate Loans. Commercial real estate loans are originated on owner-occupied and non-owner-occupied properties. These loans may be more adversely affected by conditions in the real estate markets or in the general economy. Commercial loans that are secured by owner-occupied commercial real estate and primarily collateralized by operating cash flows are also included in this category of loans. As of December 31, 2020, there were approximately $200.3 million of owner-occupied commercial real estate loans, representing approximately 15.2% of the total loan portfolio. Commercial real estate loan terms are generally extended for 10 years or less and amortize generally over 25 years or less. The interest rates on commercial real estate loans have initial fixed rate terms that adjust typically at 5 years and origination fees are routinely charged for services. Personal guarantees from the principal owners of the business are generally required, supported by a review of the principal owners’ personal financial statements and global debt service obligations. The properties securing the portfolio are generally diverse in terms and type. This diversity helps reduce the exposure to adverse economic events that affect any single industry.
Note 5 - Portfolio Loans Receivable (continued)
Construction Loans. Construction loans are offered within the Company’s Washington, D.C. and Baltimore, Maryland metropolitan operating areas to builders primarily for the construction of single-family homes and condominium and townhouse conversions or renovations and, to a lesser extent, to individuals. Construction loans typically have terms of 12 to 18 months, the Company generally transitions the end purchaser to permanent financing or re-underwriting and selling into the secondary market through Capital Bank Home Loan. According to underwriting standards, the ratio of loan principal to collateral value, as established by an independent appraisal, cannot exceed 75% for investor-owned and 80% for owner-occupied properties. Semi-annual stress testing of the construction loan portfolio is conducted, and underlying real estate conditions are closely monitored as well as the borrower’s trends of sales valuations as compared to underwriting valuations as part of the ongoing risk management efforts.The borrowers’ progress in construction buildout is closely monitored and the original underwriting guidelines for construction milestones and completion timelines are enforced.
Commercial Business Loans. In addition to other loan products, general commercial loans, including commercial lines of credit, working capital loans, term loans, equipment financing, letters of credit and other loan products are offered, primarily in target markets, and underwritten based on each borrower’s ability to service debt from income. These loans are primarily made based on the identified cash flows of the borrower and secondarily, on the underlying collateral provided by the borrower. Most commercial business loans are secured by a lien on general business assets including, among other things, available real estate, accounts receivable, promissory notes, inventory and equipment, and personal guaranties from the borrower or other principal are generally obtained.
Credit Cards. Through the OpenSky® credit card division, the Company offers credit cards on a nationwide basis to under-banked populations and those looking to rebuild their credit scores through a fully digital and mobile platform. Substantially all of the lines of credit are secured by a noninterest bearing demand account at the Bank in an amount equal to the full credit limit of the credit card. In addition, using a proprietary scoring model, which considers credit score and repayment history (typically a minimum of six months of on-time repayments, but ultimately determined on a case-by-case basis), the Bank has recently begun to offer certain customers an unsecured line in excess of their secured line of credit. Approximately $98.5 million and $43.3 million of the credit card balances were secured by savings deposits held by the Bank as of December 31, 2020 and 2019, respectively.
Other Consumer Loans. To a limited extent and typically as an accommodation to existing customers, personal consumer loans such as term loans, car loans or boat loans are offered.
Acquired loans through acquisitions are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan losses. In estimating the fair value of loans acquired, certain factors were considered, including the remaining lives of the acquired loans, payment history, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, and the net present value of cash flows expected. Discounts on loans that were not considered impaired at acquisition were recorded as an accretable discount, which will be recognized in interest income over the terms of the related loans. For loans considered to be impaired, the difference between the contractually required payments and expected cash flows was recorded as a nonaccretable discount. The remaining nonaccretable discounts on loans acquired were $285 thousand at December 31, 2020 and 2019. Loans with nonaccretable discounts had a carrying value of $0.8 million and $0.9 million as of December 31, 2020 and 2019, respectively.
Note 5 - Portfolio Loans Receivable (continued)
The activity in the accretable discounts on loans acquired was as follows:
Accretable Discounts on Loans Acquired
December 31,
Accretable discount at beginning of period $ 429 $ 438
Accretion and payoff of loans (208) (9)
Accretable discount at end of period $ 221 $ 429
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-impaired loans and is based on historical loss experience adjusted for current economic factors. The following tables present, by class and reserving methodology, the allocation of the allowance for loan losses and the gross investment in loans as of December 31, 2020 and 2019.
Allowance for Loan Losses
Real estate:
Real estate:
_______________
(1) Credit cards loans are collectively evaluated by past due status and as such are not individually risk rated.
Note 5 - Portfolio Loans Receivable (continued)
Past due portfolio loans, segregated by delinquency and class of loans, as of December 31, 2020 and 2019 were as follows:
Loans30-89 DaysPast Due
(in thousands)
Real estate:
Real estate:
Note 5 - Portfolio Loans Receivable (continued)
Impaired loans also include acquired loans for which management has recorded a nonaccretable discount. Impaired loans as of December 31, 2020 and 2019 were as follows:
Impaired Portfolio Loans
(in thousands)
Real estate
Real estate
There were $175 thousand and $481 thousand, respectively, of loans secured by one to four family residential properties in the process of foreclosure as of December 31, 2020 and 2019.
Credit quality indicators
As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to the risk grade of loans, the level of classified loans, net charge-offs, nonperforming loans, and the general economic conditions in the Company’s market.
The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. A description of the general characteristics of loans characterized as classified is as follows:
Note 5 - Portfolio Loans Receivable (continued)
Special Mention
A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Company’s credit position at some future date. Special mention loans are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification.
Borrowers may exhibit poor liquidity and leverage positions resulting from generally negative cash flow or negative trends in earnings. Access to alternative financing may be limited to finance companies for business borrowers and may be unavailable for commercial real estate borrowers.
Substandard
A substandard loan is inadequately protected by the current financial condition and paying capacity of the obligor or of the collateral pledged, if any. Substandard loans have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Borrowers may exhibit recent or unexpected unprofitable operations, an inadequate debt service coverage ratio, or marginal liquidity and capitalization. These loans require more intense supervision by Company management.
Doubtful
A doubtful loan has all the weaknesses associated with a substandard loan with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Note 5 - Portfolio Loans Receivable (continued)
The following table presents the balances of classified loans based on the risk grade. The Company grades all credit cards loans as Pass. Classified loans include Special Mention, Substandard, and Doubtful loans:
Classified Loans
(in thousands) Pass(1) Special Mention Substandard Doubtful Total
Real estate:
Real estate:
________________________
(1) Pass includes loans graded exceptional, very good, good, satisfactory and pass/watch, in addition to credit card loans which are not individually graded.
Note 5 - Portfolio Loans Receivable (continued)
Impaired loans also include certain loans that have been modified in troubled debt restructurings (“TDRs”) where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from the Company’s loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Certain TDRs are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months. The status of TDRs is as follows:
Troubled Debt Restructurings
Number ofContracts Recorded Investment
(dollars in thousands) Performing Nonperforming Total
Real estate:
Acquired loans included above 3 $ — $ 145 $ 145
Real estate:
Acquired loans included above 3 $ — $ 145 $ 145
During the year ended December 31, 2020, the Company did not incur any new TDR loans. The Company had no defaulted TDR loans in the twelve months ended December 31, 2020. Of the five loans designated as TDR at December 31, 2019, three loans were classified as TDR due to changes in interest rates and payment terms, and two loans had a principal payment adjustment.
Note 5 - Portfolio Loans Receivable (continued)
Outstanding loan commitments were as follows:
Loan Commitments
For the Year Ended December 31,
Unused lines of credit
Construction commitments:
Residential real estate — —
Commercial real estate — —
Commitments to originate residential loans held for sale $ 11,444 $ 2,646
Lines of credit are agreements to lend to a customer as long as there is no violation of any condition of the contract. Lines of credit generally have variable interest rates. Such lines do not represent future cash requirements because it is unlikely that all customers will draw upon their lines in full at any time. Loan commitments generally have variable interest rates, fixed expiration dates, and may require payment of a fee. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event of nonperformance by the customer in accordance with the terms of the agreement with the third party, the Company would be required to fund the commitment.
The Company's maximum exposure to credit loss in the event of nonperformance by the customer is the contractual amount of the credit commitment. Loan commitments and lines of credit are made on the same terms, including collateral, as outstanding loans. The Company is not aware of any accounting loss to be incurred by funding these loan commitments.
As of December 31, 2020 and 2019, respectively, the Company had an allowance for off-balance-sheet credit risk of $1.8 million and $1.2 million, recorded in other liabilities on the consolidated balance sheet.
Note 5 - Portfolio Loans Receivable (continued)
The Company maintains a reserve for off-balance sheet items such as unfunded lines of credit. Activity for this account is as follows:
Off-Balance Sheet Reserve
Balance at beginning of period $ 1,226 $ 1,053
Add: Recoveries — —
Less: Charge-offs — —
The Company makes representations and warranties that loans sold to investors meet their program's guidelines and that the information provided by the borrowers is accurate and complete. In the event of a default on a loan sold, the investor may make a claim for losses due to document deficiencies, program non-compliance, early payment default, and fraud or borrower misrepresentations.
The Company maintains a reserve for potential losses on mortgage loans sold. Activity in this reserve is as follows for the periods presented:
Mortgage Loan Put-back Reserve
Balance at beginning of period $ 576 $ 501
Add: Recoveries — —
Less: Charge-offs (14) (109)
Balance at end of period $ 1,160 $ 576
Note 6 - Premises and Equipment
Premises and equipment and the related depreciation and amortization consist of the following:
Premises and Equipment
Construction in progress 6 —
Less: Accumulated depreciation and amortization 7,554 6,709
Premises and equipment, net $ 4,464 $ 6,092
Depreciation and amortization expense $ 844 $ 1,113
Note 7 - Leases
On January 1, 2019, the Company adopted ASU 2016-02, Leases, as further explained in Note 1 - Nature of Business and Basis of Presentation. The Company’s primary leasing activities relate to certain real estate leases entered into in support of the Company’s branch operations and back office operations. As of January 1, 2019, the Company had leased five of its full service branches and five other locations for corporate/administration activities, operations, and loan production. All property leases under lease agreements have been been designated as operating leases. The Company does not have leases designated as finance leases.
The Company determines if an arrangement is a lease at inception. Operating lease right-of-use (“ROU”) assets are included in premises and equipment, and operating lease liabilities are included as other liabilities in the consolidated balance sheets. ROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As the Company's leases do not provide an implicit rate, the Company uses its incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. The weighted average discount rate used was 2.23%. The operating lease ROU asset also includes any lease pre-payments. The Company's lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term. The Company has lease agreements with lease and non-lease components, which the Company has elected to account for separately as the non-lease component amounts are readily determinable under most leases.
As of December 31, 2020, the Company’s lease ROU assets and related lease liabilities were $3.1 million and $3.4 million, respectively, and have remaining terms ranging from 1 - 6 years, including extension options that the Company is reasonably certain will be exercised. As of December 31, 2020, the Company had not entered into any material leases that have not yet commenced. The Company’s lease information is summarized as follows:
Leases
(in thousands) December 31, 2020
Lease Right-of-Use Asset
Less: Accumulated amortization (2,288)
Net lease asset 3,111
Lease Liability
Lease liability $ 5,577
Less: Accumulated amortization (2,137)
Net lease liability $ 3,440
Note 7 - Leases (continued)
Future minimum payments for operating leases with initial or remaining terms of one year or more are as follows:
Lease Payment Obligations
(in thousands) December 31, 2020
Amounts due in:
Total lease payments $ 3,628
Operating lease and rent expense was $1.6 million and $1.3 million for the years ended December 31, 2020 and 2019, respectively.
Note 8 - Derivative Financial Instruments
As part of its mortgage banking activities, the Company enters into interest rate lock commitments, which are commitments to originate loans whereby the interest rate on the loan is determined prior to funding and the customers have locked into that interest rate. The Company then either locks the loan and rate in with an investor and commits to deliver the loan if settlement occurs (Best Efforts) or commits to deliver the locked loan to an investor in a binding (Mandatory) delivery program. Certain loans under rate lock commitments are covered under forward sales contracts. Forward sales contracts are recorded at fair value with changes in fair value recorded in mortgage banking revenue. Interest rate lock commitments and commitments to deliver loans to investors are considered derivatives. The market value of interest rate lock commitments and best efforts contracts are not readily ascertainable with precision because they are not actively traded in stand-alone markets. The Company determines the fair value of rate lock commitments and delivery contracts by measuring the fair value of the underlying asset, which is impacted by current interest rates and takes into consideration the probability that the rate lock commitments will close or will be funded.
On January 7, 2015, the Company entered into an interest rate swap transaction with a notional amount of $2 million. The swap qualifies as a derivative and is designated as a hedging instrument. The swap fixed the interest rate the Company paid on the floating rate junior subordinated debentures for four years beginning on March 16, 2015 and matured on March 16, 2019. Based on the notional amount, the Company paid its counterparty quarterly interest at a fixed rate, and the counterparty paid the Company interest at a rate of three‐month LIBOR plus 1.87%.
Note 8 - Derivative Financial Instruments (continued)
The following table reports the commitment and fair value amounts on the outstanding derivatives:
Derivatives
Notional amount of open forward sales agreements $ 38,000 $ 61,000
Fair value of open forward delivery sales agreements (179) (125)
Notional amount of open mandatory delivery commitments 15,531 22,888
Fair value of open mandatory delivery commitments 179 122
Notional amount of interest rate lock commitments 34,827 32,365
Fair value of interest rate lock commitments 148 115
Note 9 - Interest-Bearing Deposits
Major categories of interest bearing deposits are as follows:
Interest-Bearing Deposits
The aggregate amount of brokered certificates of deposit was $45.1 million and $88.8 million at December 31, 2020 and 2019, respectively. The aggregate amount of Certificate of Deposit Account Registry Service (“CDARS”) deposits was $10.7 million and $5.0 million at December 31, 2020 and 2019, respectively. As of December 31, 2020, the Company’s certificates of deposit from listing services amounted to $62.5 million or 3.8% of our deposits.
Certificates of deposit, as of December 31, 2020, mature as follows:
Maturities of Certificates of Deposit
(in thousands)
Note 10 - Securities Sold Under Agreements to Repurchase
The Company formerly sold securities under repurchase agreements to provide cash management services to commercial account customers. These borrowings are summarized as follows:
Securities Sold Under Agreements to Repurchase
Average amount outstanding $ — $ 1,287