ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
The following discussion sets forth management’s discussion and analysis of our results of operations for the year ended December 31, 2020 and December 31, 2019, and our financial position as of December 31, 2020 and December 31, 2019, respectively. The MD&A should be read in conjunction with our consolidated financial statements, related notes, the selected financial data and the statistical information presented elsewhere in this Annual Report on Form 10-K for a more complete understanding of the following discussion and analysis. Unless otherwise noted, years refer to the Company’s fiscal years ended December 31, 2020 and December 31, 2019.
PERFORMANCE SUMMARY
The following is a brief summary of some of the significant factors that affected our operating results for the twelve months ended December 31, 2020 and 2019. In 2020, net interest income was favorably impacted by the following: (1) higher accretion of discounts associated with paydown of purchased credit impaired loans, (2) income realized from the origination of the Small Business Administration Paycheck Protection Program (“SBA PPP”) loans, (3) lower deposit costs due to the lower 2020 interest rate environment, (4) an additional six months of net interest income on the F&M acquisition, partially offset by (5) lower interest income on loans, securities and cash and cash equivalents due to the lower interest rate environment and (6) a partial year of interest expense on the Company’s issuance of subordinated debt in August 2020. The Company recorded higher provision for loan losses in 2020 largely due to organic loan growth along with qualitative factor increases to reflect uncertainty in current general economic conditions. In 2020’s lower interest rate environment, the Company realized higher mortgage loans originated for sale, which increased gain on sale and income recorded in loan servicing income from the capitalization of mortgage servicing rights, partially offset by higher mortgage servicing rights impairment and an increase in variable compensation tied to mortgage loan production. On July 1, 2019, we closed on the F&M acquisition. As a result, fiscal 2019 was positively impacted by six months of F&M income, which was more than offset by merger charges. Total related merger and acquisition charges were $3.9 million in fiscal 2019. Fiscal 2019 operating results were positively impacted by the net gain on sale of the Michigan branch totaling $2.3 million. Fiscal 2019 also included $0.4 million of professional fees related to the change in our fiscal year end.
When comparing, year over year results, changes in net interest income, provision for loan losses, non-interest income and non-interest expense are primarily due to the items discussed above. See the remainder of this section for a more thorough discussion. Unless otherwise stated, all monetary amounts in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, other than share, per share and capital ratio amounts, are stated in thousands.
On July 1, 2019, the Company completed its previously announced acquisition (the “Acquisition”) of F. & M. Bancorp. of Tomah Inc. (“F&M”), which enhanced the composition of commercial and agricultural loans and increased our market presence in Wisconsin. In connection with the acquisition, the Company merged F&M with and into the Bank, with the Bank surviving the merger. See Note 2, “Acquisition” for additional information.
We reported net income of $12.73 million for the twelve months ended December 31, 2020, compared to net income of $9.46 million for the twelve months ended December 31, 2019. Diluted earnings per share were $1.14 for the twelve months ended December 31, 2020 compared to $0.85 for the twelve months ended December 31, 2019. Return on average assets for the twelve months ended December 31, 2020 was 0.80%, compared to 0.68% for the twelve months ended December 31, 2019. The return on average equity was 8.29% for the twelve months ended December 31, 2020 and 6.59% for the comparable period in 2019.
28
CRITICAL ACCOUNTING ESTIMATES
Our consolidated financial statements have been prepared in conformity with U.S. Generally Accepted Accounting Principles (“GAAP”). In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amount of assets, liabilities, revenue, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time our consolidated financial statements are prepared. Some of these estimates are more critical than others. Below is a discussion of our critical accounting estimates.
Allowance for Loan Losses.
We maintain an allowance for loan losses to absorb probable and inherent losses in our loan portfolio. The allowance is based on ongoing, quarterly assessments of the estimated probable incurred losses in our loan portfolio. In evaluating the level of the allowance for loan loss, we consider the types of loans and the amount of loans in our loan portfolio, historical loss experience, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, prevailing economic conditions and other relevant factors determined by management. We follow all applicable regulatory guidance, including the “Interagency Policy Statement on the Allowance for Loan and Lease Losses,” issued by the Federal Financial Institutions Examination Council (FFIEC). We believe that the Bank’s Allowance for Loan Losses Policy conforms to all applicable regulatory requirements. However, based on periodic examinations by regulators, the amount of the allowance for loan losses recorded during a particular period may be adjusted.
Our determination of the allowance for loan losses is based on (1) specific allowances for specifically identified and evaluated impaired loans and their corresponding estimated loss based on likelihood of default, payment history and net realizable value of underlying collateral. Specific allocations for collateral dependent loans are based on fair value of the underlying collateral relative to the unpaid principal balance of individually impaired loans. For loans that are not collateral dependent, the specific allocation is based on the present value of expected future cash flows discounted at the loan’s original effective interest rate through the repayment period; and (2) a general allowance on loans not specifically identified in (1) above, based on historical loss ratios, which are adjusted for qualitative and general economic factors. We continue to refine our allowance for loan losses methodology, with an increased emphasis on historical performance adjusted for applicable economic and qualitative factors.
Assessing the allowance for loan losses is inherently subjective as it requires making material estimates, including the amount and timing of future cash flows expected to be received on impaired loans, any of which estimates may be susceptible to significant change. In our opinion, the allowance, when taken as a whole, reflects estimated probable loan losses in our loan portfolio
Goodwill and Other Intangible Assets.
We account for goodwill and other intangible assets in accordance with ASC Topic 350, “Intangibles - Goodwill and Other.” The Company records the excess of the cost of acquired entities over the fair value of identifiable tangible and intangible assets acquired, less liabilities assumed, as goodwill. The Company amortizes acquired intangible assets with definite useful economic lives over their useful economic lives utilizing the straight-line method. On a periodic basis, management assesses whether events or changes in circumstances indicate that the carrying amounts of the intangible assets may be impaired. The Company does not amortize goodwill, but reviews goodwill for impairment at a reporting unit level on an annual basis, or when events or changes in circumstances indicate that the carrying amounts may be impaired. A reporting unit is defined as any distinct, separately identifiable component of the Company’s one operating segment for which complete, discrete financial information is available and reviewed regularly by the segment’s management. The Company has one reporting unit as of December 31, 2020 which is related to its banking activities. The impairment testing process is conducted by assigning net assets and goodwill to the Company’s reporting unit. An initial qualitative evaluation is made to assess the likelihood of impairment and determine whether further quantitative testing to calculate the fair value is necessary. When the qualitative evaluation indicates that impairment is more likely than not, quantitative testing is required whereby the fair value of the Company’s reporting unit is calculated and compared to the recorded book value, “step one.” If the calculated fair value of the Company’s reporting unit exceeds its carrying value, goodwill is not considered impaired and “step two” is not considered necessary. If the carrying value of the company’s reporting unit exceeds its calculated fair value, the impairment test continues (“step two”) by comparing the carrying value of the Company’s reporting unit’s goodwill to the implied fair value of goodwill. An impairment charge is recognized if the carrying value of goodwill exceeds the implied fair value of goodwill.
In March 2020, the Company determined that a quarterly review of goodwill impairment should be performed, and this review was performed in each quarter of 2020. These quarterly reviews determined that goodwill was not impaired at any 2020 quarter-end, or as of December 31, 2020.
29
Fair Value Measurements and Valuation Methodologies.
We apply various valuation methodologies to assets and liabilities which often involve a significant degree of judgment, particularly when liquid markets do not exist for the particular items being valued. Quoted market prices are referred to when estimating fair values for certain assets, such as most investment securities. However, for those items for which an observable liquid market does not exist, management utilizes significant estimates and assumptions to value such items. Examples of these items include loans, deposits, borrowings, goodwill, core deposit intangible assets, other assets and liabilities obtained or assumed in business combinations, and certain other financial instruments. These valuations require the use of various assumptions, including, among others, discount rates, rates of return on assets, repayment rates, cash flows, default rates, and liquidation values. The use of different assumptions could produce significantly different results, which could have material positive or negative effects on the Company’s results of operations, financial condition or disclosures of fair value information.
In addition to valuation, the Company must assess whether there are any declines in value below the carrying value of assets that should be considered other than temporary or otherwise require an adjustment in carrying value and recognition of a loss in the consolidated statement of income. Examples include but are not limited to; loans, investment securities, goodwill, core deposit intangible assets and deferred tax assets, among others. Specific assumptions, estimates and judgments utilized by management are discussed in detail herein in management’s discussion and analysis of financial condition and results of operations and in notes 1, 2, 3, 4, 5, 6, 7, 14 and 15 of Notes to Consolidated Financial Statements.
Income Taxes.
Amounts provided for income tax expenses are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred income tax assets and liabilities, which arise principally from temporary differences between the amounts reported in the financial statements and the tax basis of certain assets and liabilities, are included in the amounts provided for income taxes. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and tax planning strategies which will create taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and if necessary, tax planning strategies in making this assessment.
The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and application of specific provisions of Federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of Federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be material to our consolidated results of our operations and reported earnings. We believe that the deferred tax assets and liabilities are adequate and properly recorded in the accompanying consolidated financial statements. As of December 31, 2020, management does not believe a valuation allowance related to the realizability of its deferred tax assets is necessary.
Business Combinations.
Business combinations are accounted for by applying the acquisition method of accounting. As of acquisition date, the identifiable assets acquired and liabilities assumed are measured at fair value and recognized separately from goodwill. Results of operations of the acquired entities are included in the consolidated statement of operations from the date of acquisition. The calculation of intangible assets, including core deposit intangibles, and the fair value of loans are based on significant judgments. Core deposit intangibles are calculated using a discounted cash flow model, based on various factors including, among others, discount rate, attrition rate, interest rate and cost of alternative funds.
Loans acquired in connection with acquisitions are recorded at their acquisition-date fair value with no carryover of related allowance for credit losses. Any allowance for loan loss on these pools reflects only losses incurred after the acquisition (meaning the present value of all cash flows expected at acquisition that ultimately are not to be collected). Determining the fair value of the acquired loans involves estimating the cash flows expected to be collected from both principal and interest on acquired loans and discounting those cash flows at a market rate of interest. Management considers a number of factors in evaluating the acquisition-date fair value, including, among others, the remaining life of the loans, delinquency status, estimated prepayments, internal risk ratings, estimated value of underlying collateral and interest rate environment.
30
STATEMENT OF OPERATIONS ANALYSIS
Twelve months ended December 31, 2020 vs. Twelve months ended December 31, 2019
Net Interest Income. Net interest income represents the difference between the dollar amount of interest earned on interest bearing assets and the dollar amount of interest paid on interest bearing liabilities. The interest income and expense of financial institutions are significantly affected by general economic conditions, competition, policies of regulatory authorities and other factors.
Interest rate spread and net interest margin are used to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest earning assets and the rate paid for interest bearing liabilities that fund those assets. Net interest margin is expressed as the percentage of net interest income to average interest earning assets. Net interest margin exceeds interest rate spread because non-interest bearing sources of funds (“net free funds”), principally demand deposits and stockholders’ equity, also support interest earning assets. The narrative below discusses net interest income, interest rate spread, and net interest margin.
Net interest income was $50.3 million for 2020 compared to $43.5 million for 2019. The increase in average balances is largely the reason for the increase in net interest income, due to both a full year of F&M balances and SBA PPP loan origination growth, with originated loan growth muted by acquired loan shrinkage. The net interest margin for 2020 was 3.40% compared to 3.37% for 2019. This increase in the net interest margin percentage was due to the following factors: (1) increase in accretion of discounts associated with paydown of purchased credit impaired loans; (2)income realized from the origination of the SBA PPP loans; (3) lower deposit costs due to the lower 2020 interest rate environment; (4) an additional six months of net interest income on the F&M acquisition. These increases were partially offset by: (1) lower interest income on loans, securities and cash and equivalents due to the lower interest rate environment and (2) a partial year of interest expense on the Company’s issuance of subordinated debt in August 2020. Accretion on purchased credit impaired loans recognized due to loan payoffs or significant reductions in loan balances was $2.7 million in 2020, which was an increase of $2.3 million from accretion recognized in 2019 or $0.4 million. In 2020, the SBA PPP program was initiated, and the Bank recognized $2.1 million of accretion of the net origination fees and contractual interest income of $0.973 million. Remaining deferred SBA PPP fees were approximately $3 million at December 31, 2020. Interest expense on liabilities decreased $2.6 million in 2020 due to the lower interest rate environment and actions taken by the Bank to reduce interest rates paid. The Bank has approximately $207 million of certificates of deposit maturing in 2021, at a blended interest cost of approximately 1.38%. These favorable items were offset by the negative impacts of a lower interest rate environment resulting in lower yields on loans, investments and cash and cash equivalents.
Average Balances, Net Interest Income, Yields Earned and Rates Paid. The following table shows interest income from average interest earning assets, expressed in dollars and yields, and interest expense on average interest bearing liabilities, expressed in dollars and rates. Also presented is the weighted average yield on interest earning assets on a tax-equivalent basis, rates paid on interest bearing liabilities and the resultant spread at December 31, 2020 and December 31, 2019. Non-accruing loans average balances are included in the table with the loans carrying a zero yield.
31
Twelve months ended December 31, 2020 Twelve months ended December 31, 2019
Average interest earning assets:
Average interest bearing liabilities:
Interest rate spread 3.20 % 3.13 %
Net interest margin (1) 3.40 % 3.37 %
(1) Fully taxable equivalent (FTE). The average yield on tax exempt securities is computed on a tax equivalent basis using a tax rate of 21% for the twelve months ended December 31, 2020 and 2019. The FTE adjustment to net interest income included in the rate calculations totaled $1 thousand and $120 thousand for the twelve month periods ended December 31, 2020 and 2019, respectively.
32
Rate/Volume Analysis. The following table presents the dollar amount of changes in interest income and interest expense for the components of interest earning assets and interest bearing liabilities that are presented in the preceding table. For each category of interest earning assets and interest bearing liabilities, information is provided on changes attributable to: (1) changes in volume, which are changes in the average outstanding balances multiplied by the prior period rate (i.e. holding the initial rate constant); and (2) changes in rate, which are changes in average interest rates multiplied by the prior period volume (i.e. holding the initial balance constant).
Twelve months ended December 31, 2020 v. 2019 Increase (decrease) due to
Volume (1) Rate (1) TotalIncrease /(Decrease)
Interest income:
Cash and cash equivalents $ 354 $ (864) $ (510)
Interest-bearing deposits (47) 6 (41)
Interest expense:
FHLB Advances and other borrowings 814 (1,278) (464)
(1)the change in interest due to both rate and volume has been allocated in proportion to the relationship to the dollar amounts of the change in each.
Provision for Loan Losses. We determine our provision for loan losses (“provision”, or “PLL”) to provide an adequate allowance for loan losses (“ALL”) to reflect probable and inherent credit losses in our loan portfolio.
We recorded provisions for loan losses of $7.8 million for 2020 compared to $3.5 million for 2019. In 2020, the provision allocated for originated loan growth was approximately $1.2 million compared to approximately $2.0 million for 2019. In 2020, approximately $1.2 million of provision was related to charge-offs and changes in specific reserves compared to $1.4 million in 2019. The remaining increase in provision related to qualitative factor increases to reflect uncertainty in current general economic conditions and a modest increase in unallocated ALL. There was no provision on approximately $5.5 million lines of credit drawn in late December and subsequently repaid on January 4, 2021.
Management believes that the provision taken for the year ended December 31, 2020 and 2019, respectively is adequate in view of the present condition of the Bank’s loan portfolio and the sufficiency of collateral supporting non-performing loans. We are continually monitoring non-performing loan relationships and will make provisions, as necessary, if the facts and circumstances change. In addition, a decline in the quality of our loan portfolio as a result of general economic conditions, factors affecting particular borrowers or our market areas, or other factors could all affect the adequacy of our ALL. If there are significant charge-offs against the ALL, or we otherwise determine that the ALL is inadequate, we will need to record an additional PLL in the future. See Note 1, “Nature of Business and Summary of Significant Accounting Policies - Allowance for Loan Losses” of “Notes to Consolidated Financial Statements and Supplementary Data” to this Form 10-K, for further analysis of the provision for loan losses.
33
Non-Interest Income. The following table reflects the various components of non-interest income for 2020 and 2019, respectively.
Twelve months ended December 31, Change from prior year
Non-interest Income:
Net gains on investment securities 110 271 (59.41)%
Net gain on sale of branch — 2,295 N/M
Net gain on sale of acquired business lines 432 — N/M
Settlement proceeds 131 — N/M
N/M means not meaningful
The higher level of non-interest income primarily relates to the full-year impact of F&M on 2020 non-interest income since F&M’s, July 1, 2019 acquisition, unless noted below.
Service charges on deposit accounts decreased $536 thousand due to the impact of higher average balances in retail checking accounts.
Loan servicing income increased largely due to increased capitalized mortgage servicing rights due to higher mortgage loan origination sold volumes.
The increase in gain on sale of loans in 2020 is due to higher mortgage loan origination and sale volumes.
Net gains on investment securities reflects the 2020 sale of higher premium mortgage-backed securities and the 2019 municipal bond sale discussed in more detail in the balance sheet analysis section.
The Company sold the Rochester Hills, Michigan branch in the second quarter of 2019 for a $2.3 million gain, recorded in the gain on sale of branch line item above. In addition to the merger activity increases in other non-interest income, we recorded the receipt of a one-time payment of approximately $0.2 million on a loan charged-off prior to the Company’s acquisition.
The net gain on sale of acquired business lines reflects the sale of Wells Insurance Agency in June 2020 at a net gain of $252 thousand and the Bank’s acquired wealth management business partner exercising their contractual call, which originated prior to the acquisition, resulting in the sale of the Bank’s right to receive income from the wealth management business.
The Company recognized $131 thousand of non-interest income related to a cash receipt related to a private mortgage-backed security claim. The cash received represents a supplement to the proceeds received in fiscal 2015 from the private mortgage-backed security, previously owned by the Bank and sold in 2011.
34
Non-Interest Expense. The following table reflects the various components of non-interest expense for 2020 and 2019.
Twelve months ended December 31, % Change From prior year
Non-interest Expense:
Advertising, marketing and public relations 967 1,214 (20.35)%
Non-interest expense (annualized) / Average assets 2.74 % 3.05 %
The higher level of non-interest expense primarily relates to the full-year impact of F&M on 2020 non-interest expense since F&M’s, July 1, 2019 acquisition, unless noted below.
Compensation expense increased in 2020 primarily due to the impact of the F&M acquisition and higher variable mortgage production compensation related to higher mortgage loan origination activity, partially offset by lower compensation from the reduction in Bank personnel throughout 2020.
Data processing increases were due to higher loan balances and larger deposit balances.
Mortgage servicing rights expense increased in 2020 from impairment charges of $1.755 million in 2020 compared to $259 thousand in 2019. This increase is due to the impact of higher actual and forecasted prepayment rates. The remaining increase is due to higher amortization based on the current interest rate environment and a modestly larger servicing book.
Advertising, marketing and public relations decreased in 2020 reflecting the Company’s 2019 branding campaign for recently merged bank operations. Overall decreases were partially offset by higher contributions made to the communities in the Bank’s branch footprint to support community needs, due to increased economic pressures faced in 2020.
The FDIC premium assessment increased in 2020, as 2019 reflected the FDIC application of the Small Bank Assessment Credits.
Professional fees decreased in 2020 largely due to a reduction in merger expenses of $0.5 million.
Other non-interest expense decreased in 2020 due to lower merger and branch closure costs in 2020 of $165 thousand, a decrease of $3.1 million from 2019.
Income Taxes. Income tax provision was $4.6 million in 2020 compared to $2.8 million for 2019. Tax expense in 2019 was favorably impacted by a Department of Treasury ruling in the fourth quarter of 2019 related to the continued non-taxable nature of certain acquired bank owned life insurance. This resulted in a $0.3 million reduction in tax expense related to certain United Bank acquired bank owned life insurance contracts due to the elimination of previously established deferred tax liability on these contracts. The tax rate rose approximately 1% due to the impact of the 2019 sale of municipal securities.
Income tax expense recorded in the accompanying Consolidated Statements of Operations involves interpretation and application of certain accounting pronouncements and federal and state tax codes and is, therefore, considered a critical accounting policy. We undergo examination by various taxing authorities. Such taxing authorities may require that changes in the amount of tax expense or the amount of the valuation allowance be recognized when their interpretations differ from those of management, based on their judgments about information available to them at the time of their examinations.
35
BALANCE SHEET ANALYSIS
Total assets increased $117.8 million to $1.65 billion at December 31, 2020 from $1.53 billion at December 31, 2019. This growth was primarily due to strong deposit growth, which funded the net loan portfolio growth from SBA PPP loans and increase in the Bank’s liquidity position.
Cash and Cash Equivalents. Cash and cash equivalents increased from $55.8 million at December 31, 2019 to $119.4 million at December 31, 2020. This increase was due to strong deposit growth, which exceeded loan and security growth.
Investment Securities. We manage our securities portfolio to provide liquidity, in an effort to improve interest rate risk, and enhance income. Our investment portfolio is comprised of securities available for sale (AFS) and securities held to maturity (HTM).
Securities AFS (recorded at fair value), which represent the majority of our investment portfolio, decreased to $144.2 million at December 31, 2020 compared with $180.1 million at December 31, 2019. This decrease was primarily due to the increased principal repayment and runoff in mortgage-backed certificates, along with a $10.7 million sale of higher premium MBS.
Additionally, during 2019, we sold the vast majority of our obligations of state and local government agency (municipal) portfolio. The proceeds from the sale, along with the growth in available for sale securities balances, were largely reinvested in mortgage-backed securities, corporate debt securities and investments in trust preferred securities, resulting in their respective increases. The trust preferred securities reprice based on LIBOR plus a spread, and current issuers of these securities are bank holding companies with assets of $50 billion or more.
In 2020, the Bank purchased additional trust preferred securities with similar characteristics as those purchased in 2019.
In 2020, the Bank purchased $45 million of HTM securities, consisting largely of U.S agency mortgage-backed securities which offset the decrease in the AFS portfolio and resulted in a modest growth of the net balance of the AFS and HTM portfolios.
The amortized cost and market values of our investment securities by asset categories as of the dates indicated below were as follows:
Available for sale securities AmortizedCost FairValue
U.S. government agency obligations $ 33,048 $ 33,365
Obligations of states and political subdivisions 140 140
U.S. government agency obligations $ 52,020 $ 51,805
Obligations of states and political subdivisions 281 281
36
Held to maturity securities AmortizedCost FairValue
Obligations of states and political subdivisions $ 600 $ 602
Total held to maturity securities $ 43,551 $ 43,784
Obligations of states and political subdivisions $ 300 $ 302
Total held to maturity securities $ 2,851 $ 2,957
The amortized cost and fair values of our investment securities by maturity, as of December 31, 2020 were as follows:
Available for sale securities AmortizedCost EstimatedFair Value
Due in one year or less $ — $ —
Due after one year through five years 3,833 4,095
Due after five years through ten years 44,405 44,880
Held to maturity securities AmortizedCost EstimatedFair Value
Due in one year or less $ — $ —
Due after one year through five years 200 200
Due after five years through ten years 400 402
Total securities with contractual maturities 600 602
Total held to maturity securities $ 43,551 $ 43,784
The amortized cost and fair values of our investment securities by maturity, as of December 31, 2019 were as follows:
Available for sale securities AmortizedCost EstimatedFair Value
Due in one year or less $ 141 $ 141
Due after one year through five years 5,900 5,959
Due after five years through ten years 43,269 43,180
Held to maturity securities AmortizedCost EstimatedFair Value
Due in one year or less $ 300 $ 302
Total securities with contractual maturities 300 302
Total held to maturity securities $ 2,851 $ 2,957
37
The following tables show the fair value and gross unrealized losses of securities with unrealized losses, as of the dates indicated below, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position:
Less than 12 Months 12 Months or More Total
Less than 12 Months 12 Months or More Total
Mortgage-backed securities — — — — — —
Total held to maturity securities $ — $ — $ — $ — $ —
Unrealized losses reflected in the preceding tables have not been included in results of operations because the unrealized loss was not deemed other-than-temporary. Management has determined that more likely than not, the Company neither intends to sell, nor will it be required to sell each debt security before its anticipated recovery, and therefore recovery of cost will occur.
38
The composition of our investment securities portfolio by credit rating as of the periods indicated below was as follows:
December 31, December 31,
Available for sale securities AmortizedCost FairValue AmortizedCost FairValue
Below investment grade — — — —
December 31, December 31,
Held to maturity securities AmortizedCost FairValue AmortizedCost FairValue
AAA — — — —
BBB — — — —
Below investment grade — — — —
At December 31, 2020, the Bank has pledged certain of its U.S. Government Agency securities with a carrying value of $0.6 million and mortgage-backed securities with a carrying value of $3.0 million as collateral against specific municipal deposits. At December 31, 2020, the Bank has pledged certain of its U.S. Government Agency securities with a carrying value of $1.2 million as collateral against a borrowing line of credit with the Federal Reserve Bank of Minneapolis. However, at December 31, 2020, there were no borrowings outstanding on this Federal Reserve Bank line of credit. At December 31, 2020, the Bank also has mortgage-backed securities with a carrying value of $0.5 million pledged as collateral to the Federal Home Loan Bank of Des Moines.
During the year ended December 31, 2020, the Bank sold approximately $10.8 million of fixed rate mortgage-backed certificates with a net realized gain of $156 thousand, which is included in net gains on investment securities in the Consolidated Statements of Operations. During the twelve months ended December 31, 2019, the Bank sold $35.4 million of mortgage-backed securities and obligations of state and political subdivisions with a net realized gain of $142 thousand.
Loans. Total loans outstanding, net of deferred loan fees and costs, increased to $1.24 billion at December 31, 2020 from $1.18 billion at December 31, 2019.
Gross loans were increased by the net origination of $123.7 million of SBA PPP loans. Reductions in the acquired loan portfolio, including purchase credit impaired loans reductions of $20.3 million, exceeded growth in the Bank’s originated loan portfolio. The reductions in the purchase credit impaired loans also resulted in lower non-performing and substandard loans. In 2020, approximately $5.5 million of the loan growth was due to draws on lines of credit on December 31, 2020, with the proceeds deposited into the customer’s money market account at the Bank, and withdrawn to repay the lines on January 4, 2021. The same customers executed similar transactions at the end of 2019, with the dollar amount being approximately $12.7 million.
39
The following table reflects the composition, or mix, of our loan portfolio at December 31, 2020 and December 31, 2019:
Amount Percent Amount Percent
Real Estate Loans:
Commercial/agricultural real estate:
Residential mortgage:
C&I/Agricultural operating and Consumer installment loans:
C&I/Agricultural operating:
Consumer Installment:
Unamortized discount on acquired loans (5,063) (0.4) % (9,491) (0.8) %
Our loan portfolio is diversified by types of borrowers and industry groups within the market areas that we serve. Significant loan concentrations are considered to exist for a financial entity when the amounts of loans to multiple borrowers engaged in similar activities cause them to be similarly impacted by economic or other conditions. As illustrated above, at December 31, 2020, the largest loan concentration we identified was commercial real estate loans which comprised 41% of our total loan portfolio. Approximately 76% of our total gross loans are secured by real estate.
40
The following table sets forth, as of December 31, 2020 and December 31, 2019 respectively the fixed and adjustable-rate loans in our loan portfolio:
Amount Percent Amount Percent
Fixed rate loans:
Real estate loans:
Non-real estate loans:
Adjustable-rate loans:
Real estate loans:
Non-real estate loans:
Consumer installment 66 — % 126 — %
Unamortized discount on acquired loans (5,063) (0.5) % (9,491) (0.9) %
41
Loan amounts, their contractual maturities and weighted average interest rates at December 31, 2020 are shown below. SBA PPP loans of $123.7 million at an interest rate of 1% are included in the one year to five-year amounts in the C&I/agricultural operating segment.
Real estate Non-real estate
(1)Includes loans having no stated maturity and overdraft loans.
Loan amounts, their contractual maturities and interest rates at December 31, 2019 are as follows:
Real estate Non-real estate
(1)Includes loans having no stated maturity and overdraft loans.
We believe that the critical factors in the overall management of credit or loan quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, recording an adequate allowance to provide for incurred loan losses, and reasonable non-accrual and charge-off policies.
Risk Management and the Allowance for Loan Losses. . The loan portfolio is our primary asset subject to credit risk. To address this credit risk, we maintain an ALL for probable and inherent credit losses through periodic charges to our earnings. These charges are shown in our accompanying Consolidated Statements of Operations as Provision for Loan Losses. See “Statement of Operations Analysis - Provision for Loan Losses” above. We attempt to control, monitor and minimize credit risk through the use of prudent lending standards, a thorough review of potential borrowers prior to lending and ongoing and timely review of payment performance. Asset quality administration, including early identification of loans performing in a substandard manner, as well as timely and active resolution of problems, further enhances management of credit risk and minimization of loan losses. Any losses that occur and that are charged off against the ALL are periodically reviewed with specific efforts focused on achieving maximum recovery of both principal and interest on the affected loan.
At least quarterly, we review the adequacy of the ALL. Based on an estimate computed pursuant to the requirements of ASC 450-10, “Accounting for Contingencies” and ASC 310-10, “Accounting by Creditors for Impairment of a Loan”, the analysis of the ALL consists of three components: (i) specific credit allocation established for expected losses relating to specific impaired loans for which the recorded investment in the loan exceeds its fair value; (ii) general portfolio allocation based on historical loan loss experience for significant loan categories; and (iii) general portfolio allocation based on qualitative factors such as economic conditions and other relevant factors specific to the markets in which we operate. We currently segregate loans into pools based on common risk characteristics for purposes of determining the ALL. The additional segmentation of the portfolio is intended to provide a more effective basis for the determination of qualitative factors affecting
42
our ALL. In addition, management continually evaluates our ALL methodology to assess whether modifications in our methodology are appropriate in light of underwriting practices, market conditions, identifiable trends, regulatory pronouncements or other factors.
Changes in the ALL by loan portfolio segment for the periods presented were as follows:
Allowance for Loan Losses:
Purchased credit impaired loans — — — — — —
Other acquired loans:
Allowance for Loan Losses:
Recoveries — — — 84 — 84
Purchased credit impaired loans — — — — — —
Other acquired loans:
Total Allowance on other acquired loans $ 526 $ 27 $ 163 $ 53 $ — $ 769
The specific credit allocation for the ALL is based on a regular analysis of all originated loans that are considered impaired. In compliance with ASC 310-10, the fair value of the loan is determined based on either the present value of expected cash flows discounted at the loan’s effective interest rate, the market price of the loan, or, if the loan is collateral dependent, the fair value of the underlying collateral less the expected cost of sale for such collateral. At December 31, 2020, the Company had identified impaired loans of $43.4 million, consisting of $18.5 million of TDR loans, the carrying amount of purchased credit impaired loans of $16.9 million and $8.0 million of substandard non-TDR loans. The $43.4 million total of impaired
43
loans includes $11.7 million of performing TDR loans. At December 31, 2019, the Company had identified impaired loans of $63.2 million, consisting of $12.6 million TDR loans, the carrying amount of purchased credit impaired loans of $32 million and $18.6 million of substandard non-TDR loans. The $63.2 million total of impaired loans includes $5.4 million of performing TDR loans.
At December 31, 2020, the allowance for loan losses was $ 17.0 million or 1.38% of total loans compared to $10.3 million or 0.88% of our total loan portfolio at December 31, 2019. This level was based on our analysis of the loan portfolio risk at each of December 31, 2020 and December 31, 2019, as discussed above. The increase in the allowance for loan losses was primarily due to the impact the change in Q-Factor related to qualitative factor increases to reflect uncertainty in current general economic conditions. To a lesser extent, the provision for growth in the originated loan portfolio contributed to the increase in the amount of allowance for loan losses. The percentage of allowance for loan losses was also helped by a decrease in gross acquired loans. The percentage of gross acquired loans to gross loans, excluding SBA PPP loans, decreased to 25% at December 31, 2020 compared to 36% at December 31, 2019. At December 31, 2020, the Bank had $286.2 million in gross acquired loans, which were recorded at fair market value at acquisition. The Bank had $424.7 million in gross acquired loans at December 31, 2019, which were recorded at fair market value at acquisition.
Allowance for Loan Losses to Loans, net of SBA PPP Loans
ALL to loans net of SBA PPP loans and deferred fees 1.53 % 1.35 % 1.16 % 0.88 %
All of the nine factors identified in the FFIEC’s Interagency Policy Statement on the Allowance for Loan and Lease Losses are taken into account in determining the ALL. The impact of the factors in general categories are subject to change; thus, the allocations are management’s estimate of the loan loss categories in which the probable and inherent loss has occurred as of the date of our assessment. Of the nine factors, we believe the following have the greatest impact on our customers’ ability to repay loans and our ability to recover potential losses through collateral sales: (1) lending policies and procedures; (2) economic and business conditions; and (3) the value of the underlying collateral. As loan balances and estimated losses in a particular loan type decrease or increase and as the factors and resulting allocations are monitored by management, changes in the risk profile of the various parts of the loan portfolio may be reflected in the allocated allowance. The general component of our ALL covers non-impaired loans and is based on historical loss experience adjusted for these and other qualitative factors. In addition, management continues to refine the ALL estimation process as new information becomes available. These refinements could also cause increases or decreases in the ALL. The unallocated portion of the ALL is intended to account for imprecision in the estimation process or relevant current information that may not have been considered in the process.
Loans 30-89 days or more past due increased $6.7 million at December 31, 2020 compared to December 31, 2019, largely related to increases in commercial real estate and construction and land development loans 30-59 days delinquent. Nonaccrual loans decreased from $19.1 million to $10.7 million at December 31, 2020, primarily due to significant decreases in nonaccrual acquired loans, specifically in acquired commercial/agricultural real estate loans. While agricultural loans make up approximately 8% of the Bank’s loan portfolio, nonaccrual loans secured by agricultural collateral account for 65% or $7.0 million of the Bank’s nonaccrual loans, largely due to loans acquired in bank acquisitions. We believe our credit and underwriting policies continue to support more effective lending decisions by the Bank, which increases the likelihood of maintaining loan quality going forward. Refer to the “Risk Management and the Allowance for Loan Losses” section below for more information related to non-performing loans.
For the year ended December 31, 2020, loan charge-offs were $1.318 million compared to $0.911 million for the year ended December 31, 2019, largely due to an increase in commercial and industrial loans.
Certain external factors may result in higher future losses but are not readily determinable at this time, including, but not limited to: unemployment rates, increased taxes and continuing increased regulatory expectations with respect to ALL levels. As a result, our analysis may show a need to increase our ALL as a percentage of total loans and nonperforming loans for the near future. Loans charged-off are subject to periodic review and specific efforts are taken to achieve maximum recovery of principal, accrued interest and related expenses on the loans charged off.
44
COVID-19 Loan Modifications. In response to COVID-19, our banking regulator issued an Interagency Statement encouraging financial institutions to work prudently with borrowers who are or may be unable to meet their contractual obligations due to COVID-19. Additionally, Section 4013 of the CARES Act provides that a qualified loan modification is exempt by law from classification as a TDR as defined by GAAP, from the period beginning March 1, 2020 until the earlier of December 31, 2020 or the date that is 60 days after the date on which the national emergency concerning the COVID-19 outbreak declared by the President of the United States under the National Emergencies Act is terminated. Section 541 of the Consolidated Appropriations Act, 2021 extends this relief to the earlier of January 1, 2022 or 60 days after the national emergency termination date. The Interagency Statement was subsequently revised in April 2020 to clarify the interaction of the original guidance with Section 4013 of the CARES Act. In accordance with this guidance, the Bank instituted a plan to offer modifications to impacted borrowers. The Bank continues to work with borrowers as the pandemic persists and is requiring additional support in exchange for additional modifications beyond the original term. As of December 31, 2020, the Bank’s COVID-19 related modifications under Section 4013 of the CARES Act, totaled $61 million, or 5% of gross loans versus $126.7 million, or 10% of gross loans at September 30, 2020, and $197.3 million, or 15% of gross loans at June 30, 2020. At December 31, 2020, hotel industry sector loans represented $51.6 million of the approved deferrals. The Bank has approximately $2.4 million of total payment deferrals expiring in the first quarter of 2021.
Nonperforming Loans, Potential Problem Loans and Foreclosed Properties. We employ early identification of non-accrual and problem loans in order to minimize the risk of loss. Non-performing loans are defined as either 90 days or more past due or non-accrual. The accrual of interest income is discontinued according to the following schedules:
•Commercial/agricultural real estate loans, past due 90 days or more;
•Commercial and industrial/agricultural operating loans past due 90 days or more;
•Closed ended consumer installment loans past due 120 days or more; and
•Residential mortgage and open ended consumer installment loans past due 180 days or more.
When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on non-accrual loans are used to reduce principal rather than recorded as interest income. Restructuring a loan typically involves the granting of some concession to the borrower involving a loan modification, such as modifying the payment schedule or making interest rate changes. Restructured loans may involve loans that have had a charge-off taken against the loan to reduce the carrying amount of the loan to fair market value as determined pursuant to ASC 310-10. Restructured loans that comply with the restructured terms are considered performing loans.
45
The following table identifies the various components of non-performing assets and other balance sheet information as of the dates indicated below and changes in the ALL for the periods then ended:
Nonperforming assets:
Nonaccrual loans
Commercial real estate $ 827 $ 5,705
Commercial and industrial (“C&I”) 357 1,850
Accruing loans past due 90 days or more 586 1,104
Other collateral owned 41 31
Total nonperforming assets (“NPAs”) $ 11,530 $ 21,620
Troubled Debt Restructurings (“TDRs”) $ 18,477 $ 12,594
Loans charged off:
Commercial/Agricultural real estate — (381)
C&I/Agricultural operating (1,091) —
Residential mortgage (78) (239)
Consumer installment (149) (291)
Total loans charged off (1,318) (911)
Recoveries of loans previously charged off:
Commercial/Agricultural real estate 150 3
C&I/Agricultural operating 44 1
Residential mortgage 20 5
Consumer installment 77 93
Total recoveries of loans previously charged off: 291 102
Net loans charged off (“NCOs”) (1,027) (809)
Additions to ALL via provision for loan losses charged to operations 7,750 3,525
Ratios:
NCOs (annualized) to average loans 0.08 % 0.08 %
ALL to total loans 1.38 % 0.88 %
NPLs to total loans 0.92 % 1.71 %
NPAs to total assets 0.70 % 1.41 %
46
The following table shows the detail of non-performing assets by originated and acquired portfolios.
Nonperforming Originated and Acquired Assets
Nonperforming assets:
Originated nonperforming assets:
Acquired nonperforming assets:
Other collateral owned — — — 3
Ratios:
Non-performing assets include non-performing loans, other real estate owned and other collateral owned. Our non-performing assets were $11.5 million, or 0.70% of total assets, at December 31, 2020 compared to $21.6 million, or 1.41% of total assets, at December 31, 2019. The decrease was largely due to reductions in acquired nonperforming loans.
Nonaccrual Loans Roll forward
Quarter Ended
Acquired nonaccrual loans — — — — —
47
The table below shows the quarterly totals of accruing troubled debt restructurings since December 31, 2019. The increase in troubled debt restructuring in 2020 was largely due to one commercial real estate and one C&I loan to one borrower that have collateral positions such that no impaired reserves were required on these loans.
Troubled Debt Restructurings in Accrual Status
Troubled debt restructurings: Accrual Status
The table below shows the quarter-end totals of special mention, substandard and the total of these, known as criticized loans. The decrease in criticized loans in 2020 was largely due to decreases in acquired nonperforming and other substandard loans.
Acquired loans represent much of the reduction in non-performing loans and classified loans. The table below shows the changes in the Bank’s non-accretable difference on purchased credit impaired loans. The Bank has transferred the non-accretable difference on purchased credit impaired loans to accretable discount as collateral coverage improved sufficiently, due to a combination of principal paydowns and/or improving collateral positions. This transferred non-accretable difference to accretable discount is accreted over the remaining maturity of the loan or until payoff, whichever is shorter.
Non-accretable difference:
Quarter Ended
Mortgage Servicing Rights. The Company continues to sell loans to investors in the secondary market and generally retains the rights to service mortgage loans sold to others. MSR assets are initially measured at fair value by a third party; assessed at least quarterly for impairment; carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value. MSR assets are amortized in proportion to and over the period of estimated net servicing income, with the amortization recorded in non-interest expense in the consolidated statement of operations. The valuation of MSRs and related amortization thereon are based on numerous factors, assumptions and judgments, such as those for: changes
48
in the mix of loans, interest rates, prepayment speeds, and default rates. Changes in these factors, assumptions and judgments may have a material effect on the valuation and amortization of MSRs. Although management believes that the assumptions used to evaluate the MSRs for impairment are reasonable, future adjustment may be necessary if future economic conditions differ substantially from the economic assumptions used to determine the value of MSRs.
The fair market value of the Company’s MSR asset decreased to $3.3 million at December 31, 2020 from $4.3 million at December 31, 2019. This decrease was primarily due to $1.8 million of impairment recorded in 2020 on the MSR impairment for a total impairment of $2.0 million at December 31, 2020, increased amortization, and was partially offset by additions from originations. The unpaid balances of one- to four-family residential real estate loans serviced for others as of December 31, 2020 and December 31, 2019 were $553.7 million and $524.7 million, respectively. The fair market value of the Company’s MSR asset as a percentage of its servicing portfolio at December 31, 2020 and December 31, 2019 was 0.59% and 0.82%, respectively.
Intangible Assets. We have intangible assets of $5.5 million at December 31, 2020 compared to $7.6 million at December 31, 2019. The intangible assets are comprised of core deposit intangible assets arising from various acquisitions from 2016 through 2019 and, until its sale in June 2020, the premium on the Wells Insurance Agency customer relationships. In 2020, Wells Insurance Agency was sold, and the related intangible related to customer relationships of $0.5 million was eliminated and reflected in the net gain on sale of the agency. Amortization of these intangibles was $1.6 million in 2020.
Deposits. Deposits are our largest source of funds. Total deposits increased to $1.30 billion at December 31, 2020 from $1.20 billion at December 31, 2019. The increase in deposits, largely attributable to the growth in non-maturity deposits, allowed the Company to reduce reliance on higher cost brokered and institutional deposits. The brokered and institutional deposits decreased to $2.8 million at December 31, 2020 from $54.4 million at December 31, 2019. In addition, retail certificates of deposits decreased by $35.6 million as the Company chose not to match higher rates offered by local retail certificate of deposit competitors. Non-maturity deposit growth included the impact of December 31, 2020 draws on lines of credit of $5.5 million deposited in the customers money market accounts, which were withdrawn on January 4, 2021 and repaid the draw on lines of credit. This is compared to $12.7 million of December 31, 2019 draws on lines of credit, taken on December 31, 2019, with the proceeds deposited into the customer’s money market accounts and subsequently repaid on January 2, 2020.
The following is a summary of deposits by type at December 31, 2020 and December 31, 2019, respectively:
Brokered deposits included above: $ 2,516 $ 50,377
49
Federal Home Loan Bank (FHLB) advances and other borrowings. A summary of Federal Home Loan Bank (FHLB) advances and other borrowings at December 31, 2020 and December 31, 2019 is as follows:
December 31,
Stated Maturity Amount Range of Stated Rates Amount Range of Stated Rates
Unamortized discount on acquired notes (32) (59)
Other borrowings:
Unamortized debt issuance costs (528) (296)
(1) The FHLB advances bear fixed rates, require interest-only monthly payments, and are collateralized by a blanket lien on pre-qualifying first mortgages, home equity lines, multi-family loans and certain other loans which had a pledged balance of $723,862 and $792,909 at December 31, 2020 and 2019, respectively. At December 31, 2020, the Bank’s available and unused portion under the FHLB borrowing arrangement was approximately $118,391 compared to $203,935 as of December 31, 2019. This decrease was largely due to a change in the classification of the Bank based on asset size, which resulted in several asset classes no longer qualifying for collateral.
(2) Maximum month-end borrowed amounts outstanding under this borrowing agreement were $162,530 and $151,530, during the twelve months ended December 31, 2020 and December 31, 2019, respectively.
(3) The weighted-average interest rates on FHLB borrowings, with maturities less than twelve months, outstanding as of December 31, 2020 and December 31, 2019 were 0.50% and 1.74%, respectively.
(4) Five of the FHLB notes with remaining balances totaling $8,530, were acquired as a result of the F&M acquisition. These notes mature on various dates through 2024 with a weighted average rate of 2.05% and weighted average maturity of 13 months.
(5) FHLB term notes totaling $55,000, with various maturity dates in 2029 and 2030, can be called or replaced by the FHLB on a quarterly basis, beginning approximately three months after the initial advance.
(6) Senior notes, entered into by the Company in June 2019 consist of the following:
(a) A term note which was subsequently refinanced in October 2020, requiring quarterly interest-only payments through June 2022, and quarterly principal and interest payments thereafter. The only change terms were a reduction in the floor rate. Interest is variable, based on US Prime rate with a floor rate of 3.25%.
(b) A $5,000 line of credit, maturing in August 2021, that remains undrawn upon.
50
(7) Subordinated notes resulted from the following:
(a) The Company’s private sale in August 2017, which bears a fixed interest rate of 6.75% for five years. In August 2022, they convert to a three-month LIBOR plus 4.90% rate, and the interest rate will reset quarterly thereafter. Interest-only payments are due quarterly.
(b) The Company’s Subordinated Note Purchase Agreement entered into with certain purchasers in August 2020, which bears a fixed interest rate of 6.00% for five years. In September 2025, the fixed interest rate will be reset quarterly to equal the three-month term Secured Overnight Financing Rate plus 591 basis points. Interest-only payments are due semi-annually each year during the fixed interest period and quarterly during the floating interest period.
Federal Home Loan Bank (FHLB) advances and other borrowings
We utilize advances and other borrowings, as necessary, to supplement core deposits to meet our funding and liquidity needs and we evaluate all options for funding securities.
FHLB advances decreased to $123.5 million at December 31, 2020 from $131.0 million at December 31, 2019. During 2020, the Bank replaced short-term advances with new longer-term advances. The Bank entered into $45 million of advances with maturities between 2023 and 2025 with average interest rates of 1.44%. Additionally, in 2020 we entered into $12.5 million of advances with a ten-year maturity, callable quarterly by the FHLB with interest rates ranging from 0.52% to 0.86%. This increased the advances callable quarterly by the FHLB to $55 million with maturities in 2029 and 2030.
At December 31, 2020, the Bank had $123.7 million of borrowing capacity under the Federal Reserve SBA PPP Liquidity Facility, which the Federal Reserve established in 2020.
Stockholders’ Equity. Total stockholders’ equity was $160.6 million at December 31, 2020 compared to $150.6 million at December 31, 2019. In December 2020, the Company’s Board of Directors authorized a 5% stock buyback program or approximately 557,000 share buyback authorization. The Company previously had a stock buyback program in existence at January 1, 2020 which was suspended in March 2020 and terminated in July of 2020. The Company’s net income of $12.7 million was partially offset by the payment in February 2020 of a shareholder annual dividend of $0.21 per share and the 2020 repurchase of approximately 253,400 shares at a weighted average price of $11.13 per share.
Under the December 2020 stock buyback program, the Company purchased approximately 98,000 shares in December 2020, and is authorized to repurchase up to approximately 459,000 additional shares.
Liquidity and Asset / Liability Management. Liquidity management refers to our ability to ensure cash is available in a timely manner to meet loan demand, depositors’ needs, and meet other financial obligations as they become due without undue cost, risk or disruption to normal operating activities. We manage and monitor our short-term and long-term liquidity positions and needs through a regular review of maturity profiles, funding sources, and loan and deposit forecasts to minimize funding risk. A key metric we monitor is our liquidity ratio, calculated as cash and investments with maturities less than one-year divided by deposits with maturities less than or equal to one-year. At December 31, 2020, our liquidity ratio increased to 16.53 percent from 11.16 percent at December 31, 2019.
Our primary sources of funds are: deposits; amortization, prepayments and maturities of outstanding loans; other short-term investments; and funds provided from operations. We use our sources of funds primarily to meet ongoing commitments, to pay maturing certificates of deposit and savings withdrawals, and to fund loan commitments. While scheduled payments from the amortization of loans and maturing short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. Although $206.7 million of our $313.2 million (66%) CD portfolio will mature within the next 12 months, we have historically retained a majority of our maturing CD’s. However, due to strategic pricing decisions regarding rate matching and branch closures, our retention rate decreased in 2020 and may remain at this lower level in 2021 based on management’s current pricing strategy, which reflects the Bank’s current strong liquidity position. Through new deposit product offerings to our branch and commercial customers, we are currently attempting to strengthen customer relationships to attract additional non-rate sensitive deposits. Based on interest rates on scheduled maturities and lower current market interest rates, this should also improve our cost of funds.
We maintain access to additional sources of funds including FHLB borrowings and lines of credit with the Federal Reserve Bank, and our correspondent banks. We utilize FHLB borrowings to leverage our capital base, to provide funds for our lending and investment activities, and to manage our interest rate risk. Our borrowing arrangement with the FHLB calls for pledging certain qualified real estate, commercial and industrial loans, and borrowing up to 75% of the value of those loans, not to exceed 35% of the Bank’s total assets. Currently, we have approximately $118.4 million available to borrow under this
51
arrangement, supported by loan collateral as of December 31, 2020. At December 31, 2020, the Bank had $123.7 million of borrowing capacity under the Federal Reserve SAB PPP Liquidity Facility. We also maintain lines of credit of $1.2 million with the Federal Reserve Bank and $15.0 million of uncommitted federal funds purchased lines with correspondent banks as part of our contingency funding plan. In addition, the Company maintains a $5.0 million revolving line of credit which is available as needed for general liquidity purposes. While the Bank does not have formal brokered certificate lines of credit with counter parties at December 31, 2020, we believe that the Bank could access this market, which provides an additional potential source of liquidity. See Note 10, “Federal Home Loan Bank and Other Borrowings” of “Notes to Consolidated Financial Statements” which are included in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K, for further detail.
In reviewing the adequacy of our liquidity, we review and evaluate historical financial information, including information regarding general economic conditions, current ratios, management goals and the resources available to meet our anticipated liquidity needs. Management believes that our liquidity is adequate, and to management’s knowledge, there are no known events or uncertainties that will result or are likely to reasonably result in a material increase or decrease in our liquidity.
Off-Balance Sheet Arrangements. In the ordinary course of business, the Bank has entered into off-balance sheet financial instruments, issued to meet customer financial needs. Such financial instruments are recorded in the financial statements when they become payable. These instruments include unused commitments for lines of credit, overdraft protection lines of credit and home equity lines of credit, as well as commitments to extend credit. As of December 31, 2020, the Company had approximately $247.3 million in unused commitments, compared to approximately $243.6 million in unused commitments as of December 31, 2019. See Note 12, “Commitments and Contingencies”; “Financial Instruments with Off-Balance Sheet Risk” of “Notes to Consolidated Financial Statements” which are included in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K, for further detail.
Capital Resources. As of the dates indicated below, our Tier 1 and Risk-based capital levels exceeded levels necessary to be considered “Well Capitalized” under Prompt Corrective Action provisions for the Bank.
Below are the amounts and ratios for our capital levels as of the dates noted below for the Bank.
Amount Ratio Amount Ratio Amount Ratio
At December 31, 2020, the Bank was categorized as “Well Capitalized” under Prompt Corrective Action Provisions, as determined by the OCC, our primary regulator.
52
Below are the amounts and ratios for our capital levels as of the dates noted below for the Company.
Amount Ratio Amount Ratio Amount Ratio
53
Selected Quarterly Financial Data
The following is selected financial data summarizing the results of operations for each quarter as of the periods indicated below:
Year ended December 31, 2020:
Dividends paid $ 0.21 $ — $ — $ —
Year ended December 31, 2019:
Dividends paid $ 0.20 $ — $ — $ —
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our Risk When Interest Rates Change. The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time. Market interest rates change over time and are not predictable or controllable. Accordingly, our results of operations, like those of other financial institutions, are impacted by changes in interest rates and the interest rate sensitivity of our assets and liabilities. Like other financial institutions, our interest income and interest expense are affected by general economic conditions and policies of regulatory authorities, including the monetary policies of the Federal Reserve. The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk.
How We Measure Our Risk of Interest Rate Changes. As part of our attempt to manage our exposure to changes in interest rates and comply with applicable regulations, we monitor our interest rate risk through several means including through the use of third party reporting software. In monitoring interest rate risk we continually analyze and manage assets and liabilities based on their payment streams and interest rates, the timing of their maturities, and their sensitivity to actual or potential changes in market interest rates.
In order to manage the potential for adverse effects of material and prolonged increases in interest rates on our results of operations, we adopted asset and liability management policies to better align the maturities and re-pricing terms of our interest
54
earning assets and interest bearing liabilities. These policies are implemented by our Asset and Liability Management Committee (ALCO). The ALCO is comprised of members of the Bank’s senior management and a member from the Board of Directors. The ALCO establishes guidelines for and monitors the volume and mix of our assets and funding sources, taking into account relative costs and spreads, interest rate sensitivity and liquidity needs. The Committee’s objectives are to manage assets and funding sources to produce results that are consistent with liquidity, cash flow, capital adequacy, growth, risk and profitability goals for the Bank. The ALCO meets on a regularly scheduled basis to review, among other things, economic conditions and interest rate outlook, current and projected liquidity needs and capital position, anticipated changes in the volume and mix of assets and liabilities and interest rate risk exposure limits versus current projections pursuant to net present value of portfolio equity analysis. At each meeting, the Committee recommends strategy changes, as appropriate, based on this review. The Committee is responsible for reviewing and reporting on the effects of the policy implementations and strategies to the Bank’s Board of Directors on a regularly scheduled basis.
In order to manage our assets and liabilities and achieve desired levels of liquidity, credit quality, cash flow, interest rate risk, profitability and capital targets, we have focused our strategies on:
•originating shorter-term secured commercial, agriculture and consumer loan maturities, which could include balloon mortgage loans;
•originating variable rate commercial and agriculture loans and adjustable-rate commercial and agriculture loans;
•the sale of a vast majority of longer-term fixed-rate residential loans in the secondary market with retained servicing;
•managing our funding needs by utilizing core deposits, brokered certificates of deposits and borrowings as appropriate, with borrowing used to extend terms and lock in fixed interest rates;
•reducing non-interest expense and managing our efficiency ratio by implementing technologies to enhance customer service and increase employee productivity; and
•realigning supervision and control of our branch network by modifying their configuration, staffing, locations and reporting structure to focus resources on our most productive markets.
At times, depending on the level of general interest rates, the relationship between long- and short-term interest rates, market conditions and competitive factors, the ALCO may determine to increase the Bank’s interest rate risk position somewhat in order to maintain or improve its net interest margin.
55
The following table sets forth, at December 31, 2020 and December 31, 2019, an analysis of our interest rate risk as measured by the estimated changes in Economic Value of Equity (EVE) resulting from an immediate and permanent shift in the yield curve (up 300 basis points and down 100 basis points). As of December 31, 2020, and December 31, 2019, due to the current level of interest rates, EVE estimates for decreases in interest rates greater than 100 basis points are not meaningful. The increase in changes in economic value of equity as a percentage of equity is due to the growth in non-maturity deposits, and the net reduction in longer-term fixed rate loans.
Percent Change in Economic Value of Equity (EVE)
(1)Assumes an immediate and parallel shift in the yield curve at all maturities.
Our overall interest rate sensitivity is demonstrated by net interest income shock analysis which measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in our net interest income over the next 12 months in the event of an immediate and parallel shift in the yield curve (up 300 basis points and down 100 basis points). The table below presents our projected change in net interest income for the various rate shock levels at December 31, 2020 and December 31, 2019. The growth in percent change in net interest income in the various rate shock environments is due to the growth in assumed variable-rate Federal Reserve overnight balances and variable-rate loan assets.
Percent Change in Net Interest Income Over One Year Horizon
(1)Assumes an immediate and parallel shift in the yield curve at all maturities.
Note: The table above may not be indicative of future results.
The assumptions used to measure and assess interest rate risk include interest rates, loan prepayment rates, deposit decay (runoff) rates, and the market values of certain assets under differing interest rate scenarios. Actual values may differ from those projections set forth above should market conditions vary from the assumptions used in preparing the analysis. Further, the computations do not contemplate any actions we may undertake in response to changes in interest rates.
56
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
57
Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors of
Citizens Community Bancorp, Inc. and Subsidiary
Eau Claire, Wisconsin
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheet of Citizens Community Bancorp, Inc. and Subsidiary (the Company) as of December 31, 2020, and the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2020, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with auditing standards generally accepted in the United States of America, the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in 2013 Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 8, 2021 expressed an unmodified opinion.
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 audit. 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 the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit 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.
Our audit 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 audit 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 audit provides a reasonable basis for our opinion.
Critical Audit Matters
The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and
58
we are not, by communicating the critical audit matters below, providing a separate opinion on the critical audit matters or on the accounts or disclosures to which they relate.
Allowance for Loan Losses
As discussed in Notes 1 and 4 to the Company’s consolidated financial statements, the Company has a gross loan portfolio of $1.2 billion and related allowance for loan losses of $17.0 million as of December 31, 2020. The Company’s allowance for loan losses is a material and complex estimate requiring significant management’s judgment in the evaluation of the credit quality and the estimation of inherent losses within the loan portfolio. The allowance for loan losses includes a general reserve which is determined based on the results of a quantitative and a qualitative analysis of all loans not measured for impairment at the reporting date.
The Company’s general reserves cover non-impaired loans and is based on historical loss rates and qualitative loss factors for each portfolio. In calculating the allowance for loan losses, the Company considers relevant credit quality indicators for each loan segment, and estimates losses for each loan type based upon their nature and risk profile. This process requires significant management judgment in the review of the loan portfolio and assignment of risk ratings based upon the characteristics of loans. In addition, estimation of losses inherent within the portfolio requires significant management judgment, particularly where the Company has not incurred sufficient historical losses and has utilized industry data in forming its estimate.
Auditing these complex judgments and assumptions involves especially challenging auditor judgment due to the nature and extent of audit evidence and effort required to address these matters, including the extent of specialized skill or knowledge needed.
The primary procedures we performed to address this critical audit matter included:
•Testing the effectiveness of controls over the evaluation of the general reserve qualitative adjustments. Testing the design and operating effectiveness of controls relating to management’s timely identification of problem loans, appropriate application of loan rating policy, consistency of application of accounting policies and appropriateness of assumptions used in the allowance for loan losses calculation.
•Evaluating the reasonableness of assumptions and reasonableness, accuracy, and completeness of data used by management in forming the loss factors by performing retrospective review of historic loan loss experience and analyzing historical data used in developing the assumptions.
•Evaluating the appropriateness of inputs and factors that the Company used in forming the qualitative loss factors and assessing whether such inputs and factors were relevant, reliable, and reasonable for the purpose used.
•Testing the mathematical accuracy and computation of the allowance for loan losses.
•Evaluated the period to period consistency with which qualitative loss factors are determined and applied. Evaluate the qualitative adjustments year over year for directional consistency and testing the reasonableness, including the qualitative adjustments attributed to the estimated impact of the COVID-19 pandemic on the Company’s loan portfolio.
Goodwill Impairment Evaluation
As described in Notes 1 and 7 to the consolidated financial statements, the Company’s consolidated goodwill balance was $31,498,000 at December 31, 2020, which is allocated to the Company’s single reporting unit. Goodwill is tested for impairment at the reporting unit level at least annually, or more frequently whenever events or circumstances occur that indicate that it is more-likely-than-not that an impairment loss has occurred. Management performed a quantitative assessment of goodwill for the Company’s single reporting unit utilizing estimates of selected market information (market approach). The calculation of the goodwill impairment involves significant estimates and subjective assumptions which require a high degree of management judgment. This judgment includes the identification of relevant market and transactions with comparable entities.
We identified the goodwill impairment assessment of the Company as a critical audit matter. The principal considerations for this determination was the degree of auditor judgment in performing procedures to evaluate the appropriateness of the methodology used by management, including consideration of the significant assumptions and inputs, which includes relevant market and transactions with comparable entities.
The primary procedures we performed to address this critical audit matter included:
59
•Testing the operating effectiveness of controls over management’s goodwill impairment test including controls addressing:
◦Management’s review of the reasonableness and accuracy of the Company’s market and transactions with comparable entities.
◦Management’s review of the accuracy of estimates used to determine implied fair value.
•Substantively testing management’s estimate, including evaluating their judgements and assumptions, for estimating fair value of the Company which included:
◦Evaluation of key financial data for accuracy, including corroborating the reasonableness and accuracy of the market and transactions with comparable entities.
◦Utilization of firm employed valuation specialist to evaluate appropriateness of valuation methodologies and overall reasonableness of implied fair value.
/s/ Eide Bailly, LLP
We have served as the Company’s auditor since 2020.
Denver, Colorado
March 8, 2021
60
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and Board of Directors of
Citizens Community Bancorp, Inc. and Subsidiary
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheet of Citizens Community Bancorp, Inc. and Subsidiary (the "Company") as of December 31, 2019, the related consolidated statements of operations, comprehensive income, changes in stockholders' equity, and cash flow for the year then ended, and the related notes (collectively referred to as the "consolidated financial statements"). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019, and the results of its operations and its cash flow for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
The consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company's consolidated financial statements based on our audit. 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 the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit 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 consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audit of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated 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 consolidated financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audit provides a reasonable basis for our opinion.
/s/ Baker Tilly US, LLP
We have served as the Company's auditor from 2010 to 2019.
Baker Tilly US, LLP (formerly known as Baker Tilly Virchow Krause, LLP)
Minneapolis, Minnesota
March 10, 2020
61
CITIZENS COMMUNITY BANCORP, INC.
Consolidated Balance Sheets
(in thousands, except share data)
Assets
Other interest bearing deposits 3,752 4,744
Securities held to maturity "HTM" 43,551 2,851
Equity securities with readily determinable fair value 200 246
Mortgage servicing rights, net 3,252 4,282
Foreclosed and repossessed assets, net 197 1,460
Liabilities and Stockholders’ Equity
Liabilities:
Stockholders’ Equity:
Unearned deferred compensation (550) (462)
Accumulated other comprehensive income (loss) 1,490 (471)
See accompanying notes to audited consolidated financial statements.
62
CITIZENS COMMUNITY BANCORP, INC.
Consolidated Statements of Operations
(in thousands, except per share data)
For the year ended December 31, 2020 For the year ended December 31, 2019
Interest and dividend income:
Interest expense:
Interest on FHLB and FRB borrowed funds 1,814 2,721
Interest on other borrowed funds 2,458 2,015
Net interest income before provision for loan losses 50,255 43,513
Net interest income after provision for loan losses 42,505 39,988
Non-interest income:
Service charges on deposit accounts 1,832 2,368
Loan fees and service charges 1,383 1,145
Insurance commission income 475 734
Net gains on investment securities 110 271
Net gain on sale of branch — 2,295
Net gain on sale of acquired business lines 432 —
Settlement proceeds 131 —
Non-interest expense:
Amortization of intangible assets 1,622 1,496
Mortgage servicing rights expense 3,050 1,108
Advertising, marketing and public relations 967 1,214
FDIC premium assessment 584 258
Gain on repossessed assets, net (259) (125)
Income before provision for income tax 17,280 12,277
Net income attributable to common stockholders $ 12,725 $ 9,463
Per share information:
Cash dividends paid $ 0.21 $ 0.20
See accompanying notes to audited consolidated financial statements.
63
CITIZENS COMMUNITY BANCORP, INC.
Consolidated Statements of Comprehensive Income
(in thousands)
For the year ended December 31, 2020 For the year ended December 31, 2019
Net income attributable to common stockholders $ 12,725 $ 9,463
Other comprehensive income, net of tax:
Securities available for sale
Net unrealized gains arising during period 2,074 1,219
See accompanying notes to audited consolidated financial statements.
64
CITIZENS COMMUNITY BANCORP, INC.
Consolidated Statements of Changes in Stockholders’ Equity
(in thousands, except Shares)
Shares Amount
Other comprehensive income, net of tax — — — — — 1,415 1,415
Forfeiture of unvested shares (12,167) — (199) — 199 — —
Surrender of restricted shares of common stock (4,667) — (53) — — — (53)
Stock option expense — — 18 — — — 18
Amortization of restricted stock — — — — 470 — 470
Adoption of ASU 2016-01; Equity securities (1) — — — 45 — (45) —
Adoption of ASU 2016-02; Leases — — — (57) — — (57)
Cash dividends ($0.20 per share) — — — (2,198) — — (2,198)
Other comprehensive income, net of tax — — — — — 1,961 1,961
Unrealized performance-based restricted common stock awards — — (92) — 92 — —
Surrender of restricted shares of common stock (2,641) — (27) — — — (27)
Common stock fractional share adjustment on acquisitions (40) — — — — — —
Stock option expense — — 14 — — — 14
Amortization of restricted stock — — — — 530 — 530
Cash dividends ($0.21 per share) — — — (2,372) — — (2,372)
(1) Amount reclassified to retained earnings due to January 1, 2019 adoption of ASU 2016-02. For further information, refer to Note 1, “Nature of Business and Summary of Significant Accounting Policies; Recent Pronouncements - Adopted”
See accompanying notes to audited consolidated financial statements.
65
CITIZENS COMMUNITY BANCORP, INC.
Consolidated Statements of Cash Flows
(in thousands)
For the year ended December 31, 2020 For the year ended December 31, 2019
Cash flows from operating activities:
Net income attributable to common stockholders $ 12,725 $ 9,463
Premium amortization, net of discount accretion on investment securities 142 899
Net realized loss (gain) on equity securities 46 —
Net realized gain on debt securities (156) —
Net realized loss on sale of securities — (271)
Mortgage servicing rights expense 3,050 1,108
Amortization of intangible assets 1,622 1,496
Amortization of restricted stock 530 470
Net stock based compensation expense 14 18
Loss (gain) on sale of office properties and equipment 178 (32)
Increase in cash surrender value of life insurance (621) (552)
Net gain from disposals of foreclosed and repossessed assets (259) (125)
Gain on sale of loans held for sale, net (6,693) (2,462)
Net change in loans held for sale 9,511 (1,504)
Increase (decrease) in other liabilities 581 (3,602)
Net gain on sale of insurance agency (252) —
Net cash provided by operating activities 23,785 12,836
Cash flows from investing activities:
Net decrease in other interest bearing deposits 992 3,708
Purchase of available for sale securities (28,218) (53,915)
Purchase of held to maturity securities (44,441) —
Net purchases (sales) of other investments 57 (1,299)
Proceeds from sale of foreclosed and repossessed assets 2,780 3,038
Net cash disbursed in business combination — (8,137)
Proceeds from disposal of office properties and equipment 382 300
Net proceeds from sale of insurance agency 1,128 —
Net cash used in investing activities (61,815) (63,333)
Cash flows from financing activities:
Long-term Federal Home Loan Bank advances 66,500 —
Long-term Federal Home Loan Bank maturities (33,000) —
Amortization of debt issuance costs 91 —
Proceeds from other borrowings, net of origination costs 14,677 —
Principal payment reduction to other borrowings — (11,000)
Common stock issued in F&M acquisition less capitalized equity costs — 3,105
Repurchase shares of common stock (2,820) —
Surrender of restricted shares of common stock (27) (53)
66
Common stock options exercised — 203
Net cash provided by financing activities 101,630 60,559
Net increase in cash and cash equivalents 63,600 10,062
Cash and cash equivalents at beginning of period 55,840 45,778
Cash and cash equivalents at end of period $ 119,440 $ 55,840
Supplemental cash flow information:
Cash paid during the period for:
Supplemental noncash disclosure:
Fair value of assets acquired, net of cash and cash equivalents $ — $ 177,494
See accompanying notes to audited consolidated financial statements.
67
CITIZENS COMMUNITY BANCORP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except share data)
NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements of Citizens Community Federal N.A. (the “Bank”) included herein have been included by its parent company, Citizens Community Bancorp, Inc. (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). As used in this annual report, the terms “we”, “us”, “our”, and “Citizens Community Bancorp, Inc.” mean the Company and its wholly owned subsidiary, the Bank, unless the context indicates other meaning.
The Bank is a national banking association (a “National Bank”) and operates under the title of Citizens Community Federal National Association (“Citizens Community Federal N.A.” or “Bank”). The Company is a bank holding company, supervised by the Federal Reserve Bank of Minneapolis (the “FRB”), and operates under the title of Citizens Community Bancorp, Inc. Wells Insurance Agency (“WIA”) was a wholly owned subsidiary of the Bank, providing insurance products to the Bank’s customers and was sold on June 30, 2020. F&M Investment Corp. of Tomah was a wholly owned subsidiary of the Bank that was formerly utilized by F&M to manage its municipal bond portfolio, and was dissolved in February 2020. The U.S. Office of the Comptroller of the Currency (the “OCC”), is the primary federal regulator for the Bank.
The consolidated income of the Company is principally derived from the income of the Bank, the Company’s wholly owned subsidiary, serving customers primarily in Wisconsin and Minnesota through 25 branch locations. Its primary markets include the Chippewa Valley Region in Wisconsin, Mankato and Twin Cities markets in Minnesota, and various rural communities around these areas. The Bank offers traditional community banking services to businesses, agricultural operators and consumers, including one-to-four family residential mortgages.
On May 17, 2019, the Company completed the sale of the Rochester Hills, MI branch for a deposit premium of 7 percent, or approximately $2.3 million gain, net of selling costs. The branch sale included approximately $34 million in deposits and $300 in fixed assets. The Bank retained all loans associated with the branch.
On July 1, 2019 the Company completed its previously announced acquisition of F. & M. Bancorp. of Tomah, Inc. (“F&M”) pursuant to the merger agreement. In connection with the acquisition, the Company merged Farmers & Merchants Bank with and into the Bank, with the Bank surviving the merger See Note 2, “Acquisitions” for additional information.
The Bank is subject to competition from other financial institutions and non-financial institutions providing financial products. Additionally, the Bank is subject to the regulations of certain regulatory agencies and undergoes periodic examination by those regulatory agencies.
In preparing these consolidated financial statements, we evaluated the events and transactions occurring subsequent to the balance sheet date of December 31, 2020 through the date on which the consolidated financial statements were available to be issued on March 8, 2021, for items that should potentially be recognized or disclosed in these consolidated financial statements.
Unless otherwise stated, all monetary amounts in these Notes to Consolidated Financial Statements, other than share, per share, capital and capital ratio amounts, are stated in thousands.
Principles of Consolidation – The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Citizens Community Federal N.A. All significant inter-company accounts and transactions have been eliminated.
Use of Estimates—Preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, fair value of financial instruments, the allowance for loan losses, mortgage servicing rights, foreclosed and repossessed assets, valuation of intangible assets arising from acquisitions, useful lives for depreciation and amortization, valuation of goodwill and long-lived assets, stock based compensation, deferred tax assets, uncertain income tax positions and contingencies. Management does not anticipate any material changes to estimates made herein in the near term. Factors that may cause sensitivity to the aforementioned estimates include but are not limited to: those items described under the caption “Risk Factors” in Item 1A of the accompanying transition report on Form 10-K for the year ended December 31, 2020 and external market factors such as market interest rates and employment rates, changes to operating policies and procedures, and changes in applicable banking regulations. Actual results may ultimately differ from estimates, although
68
management does not generally believe such differences would materially affect the consolidated financial statements in any individual reporting period.
Cash and Cash Equivalents—For purposes of reporting cash flows in the consolidated financial statements, cash and cash equivalents include cash, due from banks, and interest bearing deposits with original maturities of three months or less.
Interest Bearing Deposits—Other interest bearing deposits are certificate of deposit investments made by the Bank with other financial institutions that are carried at cost. The weighted average months to maturity of the interest bearing deposits is 9.67 months. Balances over $250 in those institutions are not insured by the FDIC and therefore pose a potential risk in the event the institution were to fail. As of December 31, 2020 and December 31, 2019, there were no certificate of deposit accounts with a balance greater than $250.
Investment Securities; Held to Maturity and Available for Sale – Management determines the appropriate classification of investment securities at the time of purchase and reevaluates such designation as of the date of each balance sheet. Securities are classified as held to maturity when the Company has the positive intent and ability to hold the securities to maturity. Held to maturity securities are stated at amortized cost. Investment securities not classified as held to maturity are classified as available for sale. Available for sale securities are stated at fair value, with unrealized holding gains and losses being reported in other comprehensive income (loss), net of tax. Unrealized losses deemed other-than-temporary due to credit issues are reported in the Company’s net income in the period in which the losses arise. Interest income includes amortization of purchase premium or accretion of purchase discount. Amortization of premiums and accretion of discounts are recognized in interest income using the interest method over the estimated lives of the securities.
The Company evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. As part of such monitoring, the credit quality of individual securities and their issuer is assessed. Significant inputs used to measure the amount of other-than-temporary impairment related to credit loss include, but are not limited to; the Company’s intent and ability to sell the debt security prior to recovery, that it is more likely than not that the Company will not sell the security prior to recovery, default and delinquency rates of the underlying collateral, remaining credit support, and historical loss severities. Adjustments to market value of available for sale securities that are considered temporary are recorded in other comprehensive income or loss as separate components of stockholders’ equity, net of tax. If the unrealized loss of a security is identified as other-than-temporary based on information available, such as the decline in the creditworthiness of the issuer, external market ratings, or the anticipated or realized elimination of associated dividends, such impairments are further analyzed to determine if credit loss exists. If there is a credit loss, it will be recorded in the Company’s consolidated statement of operations. Non-credit components of the unrealized losses on available for sale securities will continue to be recognized in other comprehensive income (loss), net of tax.
Equity securities with readily determinable fair value - The Company is required to maintain an investment in Federal Agricultural Mortgage Corporation (“Farmer Mac”) equity securities. Farmer Mac equity securities are carried at their fair market value, which is readily determinable. Changes in fair value are recognized as net gains (losses) on investment securities in the consolidated Statement of Operations.
Other investments - As a member of the Federal Reserve Bank (“FRB”) System and the Federal Home Loan Bank (“FHLB”) System, the Bank is required to maintain an investment in the capital stock of these entities. These securities are “restricted” in that they can only be sold back to the respective institutions or another member institution at par. Therefore, they are less liquid than other exchange traded equity securities. As no ready market exists for these stocks, and they have no quoted market value, these investments are carried at cost and periodically evaluated for impairment based on the ultimate recovery of par value. Cash dividends are reported as other non-interest income in the consolidated statement of operations.
Also included are non-marketable equity securities of our correspondent bank, Bankers Bank, without readily determinable fair value. This stock is carried at cost plus or minus changes resulting from observable price changes in orderly transactions for this stock, less other-than-temporary impairment charges, if any.
Management’s evaluation for impairment of these other investments, includes consideration of the financial condition and other available relevant information of the issuer. Based on management’s quarterly evaluation, no impairment has been recorded on these securities. Other investments totaling $14,948 at December 31, 2020 consisted of $8,103 of FHLB stock, $5,170 of Federal Reserve Bank stock and $1,675 of Bankers’ Bank stock. Other investments totaling $15,005 at December 31, 2019 consisted of $8,196 of FHLB stock, $5,162 of Federal Reserve Bank stock, and $1,647 of Bankers’ Bank stock.
Loans – Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, accretable discounts on loans purchased, and non-accretable differences on purchased credit impaired (PCI) loans. Interest income is accrued on the unpaid principal balance
69
of these loans. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the interest method with no prepayment assumptions. Late charge fees are recognized into income when collected.
Interest income on commercial, mortgage and consumer loans is discontinued according to the following schedules:
•Commercial/agricultural real estate loans past due 90 days or more;
•Commercial and industrial/agricultural operating loans past due 90 days or more;
•Closed end consumer installment loans past due 120 days or more; and
•Residential mortgage loans and open ended installment loans past due 180 days or more.
Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual status or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not received for a loan placed on nonaccrual status is reversed against interest income. Interest received on such loans is accounted for on the cash basis or cost recovery method until qualifying for return to accrual status. Loans are returned to accrual status when payments are made that bring the loan account current with the contractual term of the loan and a six month payment history has been established. Interest on impaired loans considered troubled debt restructurings (“TDRs”), less than 90 days delinquent, is recognized as income as it accrues based on the revised terms of the loan over an established period of continued payment.
Residential mortgage loans and open ended consumer installment loans are charged off to estimated net realizable value less estimated selling costs at the earlier of when (a) the loan is deemed by management to be uncollectible, or (b) the loan becomes past due 180 days or more. Closed end consumer loans are charged off to net realizable value at the earlier of when (a) the loan is deemed by management to be uncollectible, or (b) the loan becomes past due 120 days or more. Commercial/agricultural real estate and commercial and industrial/agricultural operating loans are charged off to net realizable value at the earlier of when (a) the loan is deemed by management to be uncollectible, or (b) the loan becomes past due 90 days or more.
Allowance for Loan Losses – The allowance for loan losses (“ALL”) is a valuation allowance for probable and inherent credit losses in our loan portfolio. Loan losses are charged against the ALL when management believes that the collectability of a loan balance is unlikely. Subsequent recoveries, if any, are credited to the ALL. Management estimates the required ALL balance taking into account the following factors: past loan loss experience; the nature, volume and composition of our loan portfolio; known and inherent risks in our portfolio; information about specific borrowers’ ability to repay; estimated collateral values; current economic conditions; and other relevant factors determined by management. The ALL 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 certain qualitative factors. The entire ALL balance is available for any loan that, in management’s judgment, should be charged off.
A loan is impaired when full payment under the loan terms is not expected. Impaired loans consist of all TDRs, as well as individual loans not considered a TDR, that are either (1) rated substandard or worse, (2) on nonaccrual status or (3) PCI loans which are impaired at the time of acquisition. Substandard loans, as defined by the OCC, our primary banking regulator, are loans that are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. All TDRs are individually evaluated for impairment. See Note 4, “Loans, Allowance for Loan Losses and Impaired Loans” for more information on what we consider to be a TDR. For TDR’s or substandard loans deemed to be impaired, a specific ALL allocation may be established so that the loan is reported, net, at the lower of (a) its outstanding principal balance; (b) the present value of the loan’s estimated future cash flows using the loan’s existing rate; or (c) at the fair value of any loan collateral, less estimated disposal costs, if repayment is expected solely from the underlying collateral of the loan. For TDRs less than 90+ days past due, and certain substandard loans that are less than 90+ days delinquent, the likelihood of the loan migrating to over 90 days past due is also taken into account when determining the specific ALL allocation for these particular loans. Large groups of smaller balance homogeneous loans, such as non-TDR commercial, consumer and residential real estate loans, are collectively evaluated for ALL purposes, and accordingly, are not separately identified for ALL disclosures.
Acquired Loans— Loans acquired in connection with acquisitions are recorded at their acquisition-date fair value with no carryover of related allowance for credit losses. Any allowance for loan loss on these pools reflect only losses incurred after the acquisition (meaning the present value of all cash flows expected at acquisition that ultimately are not to be received). Determining the fair value of the acquired loans involves estimating the principal and interest cash flows expected to be collected on the loans and discounting those cash flows at a market rate of interest. Management considers a number of factors in evaluating the acquisition-date fair value including: the remaining life of the acquired loans, delinquency status, estimated prepayments, payment options and other loan features, internal risk grade, estimated value of the underlying collateral and interest rate environment.
70
Acquired loans that met the criteria for nonaccrual of interest prior to the acquisition may be considered performing upon acquisition, regardless of whether the customer is contractually delinquent, if we can reasonably estimate the timing and amount of the expected cash flows on such loans and if we expect to fully collect the new carrying value of the loans. As such, we may no longer consider the loan to be nonaccrual or nonperforming and may accrue interest on these loans, including the impact of any accretable yield.
Loans acquired with deteriorated credit quality are accounted for in accordance with Accounting Standards Codification (“ASC”) 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (ASC 310-30) if, at acquisition, the loans have evidence of credit quality deterioration since origination and it is probable that all contractually required payments will not be collected. At acquisition, the Company considers several factors as indicators that an acquired loan has evidence of deterioration in credit quality. These factors include, but are not limited to; loans 90 days or more past due, loans with an internal risk grade of substandard or below, loans classified as non-accrual by the acquired institution, and loans that have been previously modified in a troubled debt restructuring.
Under the ASC 310-30 model, the excess of cash flows expected to be collected at acquisition over recorded fair value is referred to as the accretable yield and is the interest component of expected cash flow. The accretable yield is recognized into income over the remaining life of the loan if the timing and/or amount of cash flows expected to be collected can be reasonably estimated (the accretion method). If the timing or amount of cash flows expected to be collected cannot be reasonably estimated, the cost recovery method of income recognition is used. The difference between the loan’s total scheduled principal and interest payments over all cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the non-accretable difference. The non-accretable difference represents contractually required principal and interest payments which the Company does not expect to collect.
Over the life of the loan, management continues to estimate cash flows expected to be collected. Decreases in expected cash flows are recognized as impairments through a charge to the provision for loan losses resulting in an increase in the allowance for loan losses. Subsequent improvements in cash flows result in first, reversal of existing valuation allowances recognized subsequent to acquisition, if any, and next, an increase in the amount of accretable yield to be subsequently recognized in interest income on a prospective basis over the loan’s remaining life.
Acquired loans that were not individually determined to be purchased with deteriorated credit quality are accounted for in accordance with ASC 310-20, Nonrefundable Fees and Other Costs (ASC 310-20), whereby the premium or discount derived from the fair market value adjustment, on a loan-by-loan or pooled basis, is recognized into interest income on a level yield basis over the remaining expected life of the loan or pool.
For all acquired loans, the outstanding loan balances less any related accretable yield and/or non-accretable difference is referred to as the loans’ carrying amount.
Loans Held for Sale — Loans held for sale are those loans the Company has the intent to sell in the foreseeable future. They are carried at the lower of aggregate cost or fair value. Gains and losses on sales of loans are recognized at settlement dates, and are determined by the difference between the sales proceeds and the carrying value of the loans after allocating costs to servicing rights retained. Gains and/or losses on sale of loans are recognized as non-interest income on the consolidated statement of operations. Interest rate lock commitments on mortgage loans to be funded and sold are valued at fair value, and are included in other assets or liabilities, if material.
Transfers of financial assets—Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the entity, (2) the transferee obtains the right, free of conditions that constrain it from taking advantage of that right, to pledge or exchange the transferred assets, and (3) the entity does not maintain effective control over the transferred assets through an agreement to repurchase them before maturity.
Mortgage Servicing Rights— Mortgage servicing rights (“MSR”) assets result as the Company sells loans to investors in the secondary market and retains the rights to service mortgage loans sold to others. MSR assets are initially measured at fair value; assessed for impairment; carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value. MSR assets are amortized in proportion to and over the period of estimated net servicing income, with the amortization recorded in non-interest expense in the consolidated statement of operations.
The valuation of MSRs and related amortization, included in mortgage servicing rights expense in the consolidated statements of operations, thereon are based on numerous factors, assumptions and judgments, such as those for: changes in the mix of loans, interest rates, prepayment speeds, and default rates. Changes in these factors, assumptions and judgments may have a material effect on the valuation and amortization of MSRs. Although management believes that the assumptions used to
71
evaluate the MSRs for impairment are reasonable, future adjustment may be necessary if future economic conditions differ substantially from the economic assumptions used to determine the value of MSRs.
Servicing fee income, which is reported on the consolidated statements of operations in non-interest income as Loan servicing fee income, is recorded for fees earned for servicing loans. The fee are based on a contractual percentage of outstanding principal; or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income.
Office Properties and Equipment—Premises and equipment are stated at cost less accumulated depreciation. Land is carried at cost. Maintenance and repair costs are charged to expense as incurred. Gains or losses on disposition of office properties and equipment are reflected in income. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 10 to 40 years. Furniture, fixtures and equipment are depreciated using the straight-line (or accelerated) method with useful lives ranging from 3 to 10 years. Leasehold improvements are depreciated using the straight-line (or accelerated) method with useful lives based on the lesser of (a) the estimated life of the lease, or (b) the estimated useful life of the leasehold improvement.Depreciation expense is included in non-interest expense on the consolidated statement of operations.
Goodwill and other intangible assets—The Company accounts for goodwill and other intangible assets in accordance with ASC Topic 350, “Intangibles - Goodwill and Other.” The Company records the excess of the cost of acquired entities over the fair value of identifiable tangible and intangible assets acquired, less liabilities assumed, as goodwill. The Company amortizes acquired intangible assets, primarily Core Deposit Intangibles (CDI) with definite useful economic lives over their useful economic lives ranging from 48 to 111 months utilizing the straight-line method. On a periodic basis, management assesses whether events or changes in circumstances indicate that the carrying amounts of the intangible assets may be impaired. Goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis, and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. A reporting unit is defined as any distinct, separately identifiable component of the Company’s one operating segment for which complete, discrete financial information is available and reviewed regularly by the segment’s management. The Company has one reporting unit as of December 31, 2020 which is related to its banking activities. The impairment testing process is conducted by assigning net assets and goodwill to the Company’s reporting unit. An initial qualitative evaluation is made to assess the likelihood of impairment and determine whether further quantitative testing to calculate the fair value is necessary. When the qualitative evaluation indicates that impairment is more likely than not, quantitative testing is required whereby the fair value of the Company’s reporting unit is calculated and compared to the recorded book value, “step one.” If the calculated fair value of the Company’s reporting unit exceeds its carrying value, goodwill is not considered impaired and “step two” is not considered necessary. If the carrying value of the company’s reporting unit exceeds its calculated fair value, the impairment test continues (“step two”) by comparing the carrying value of the Company’s reporting unit’s goodwill to the implied fair value of goodwill. An impairment charge is recognized if the carrying value of goodwill exceeds the implied fair value of goodwill. The Company has performed the required goodwill impairment test and has determined that goodwill was not impaired as of December 31, 2020. See Note 7 for additional information on goodwill and other intangible assets.
Foreclosed and Repossessed Assets, net – Assets acquired through foreclosure or repossession are initially recorded at fair value, less estimated costs to sell, which establishes a new cost basis. If the fair value declines subsequent to foreclosure or repossession, a write-down is recorded through expense. Costs incurred after acquisition are expensed and are included in non-interest expense, other in the consolidated statements of operations.
Bank Owned Life Insurance (BOLI)—The Bank invests in bank-owned life insurance (BOLI) as a source of funding for employee benefit expenses. BOLI involves the purchasing of life insurance by the Bank on a select group of employees. The Bank is the owner and beneficiary of the policies. Income from the increase in cash surrender value of the policies as well as the receipt of death benefits is included in non-interest income on the consolidated statement of income.
Leases - We determine if an arrangement is a lease at inception. All of our existing leases have been determined to be operating leases under ASC 842. Right-of-use (“ROU”) assets are included in other assets in our consolidated balance sheets. Operating lease liabilities are included in other liabilities in our consolidated balance sheets.
ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our 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 none of our existing leases provide an implicit rate, we use our incremental borrowing rate, based on information available at commencement date, in determining the present value of lease payments. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. Our lease terms may include options to extend or terminate the lease, when it is reasonably certain that we will exercise that option. Lease
72
expense is recognized based on the total contractually required lease payments, over the term of the lease, on a straight-line basis.
Debt and equity issuance costs—Debt issuance costs, which consist primarily of fees paid to note underwriters, are deferred and included in other borrowings in the consolidated balance sheet. Debt issuance costs are amortized over the contractual term of the corresponding debt, as a component of interest expense on other borrowed funds in the consolidated statement of operations. Specific costs associated with the issuance of shares of the Company’s common or preferred stock are netted against proceeds and recorded in stockholders’ equity, as additional paid in capital, on the consolidated balance sheet, in the period of the share issuance.
Advertising, Marketing and Public Relations Expense—The Company expenses all advertising, marketing and public relations costs as they are incurred.
Income Taxes – The Company accounts for income taxes in accordance with the Financial Accounting Standards Board (FASB) Accounting Standards Codification (“ASC”) Topic 740, “Income Taxes.” Under this guidance, deferred taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates that will apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date. See Note 15, “Income Taxes” for details on the Company’s income taxes.
The Company assess on a quarterly basis the carrying amount of its net deferred tax assets to determine if the establishment of a valuation allowance is necessary. If based on the available evidence, it is more likely than not that all or a portion of the Company’s net deferred tax assets will not be realized in future periods, a deferred tax valuation allowance would be established. Consideration is given to various positive and negative factors that could affect the realization of the deferred tax assets. In evaluating this available evidence, management considers, among other things, historical performance, expectations of future earnings, the ability to carry back losses to recoup taxes previously paid, the length of statutory carry forward periods, any experience with utilization of operating loss and tax credit carry forwards not expiring, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earnings trends and the timing of reversals of temporary differences. Accordingly, the Company’s evaluation is based on current tax laws as well as management’s expectations of future performance.
Revenue Recognition - The Company recognizes revenue in the consolidated statements of operations as it is earned and when collectability is reasonably assured. The primary source of revenue is interest income from interest earning assets, which is recognized on the accrual basis of accounting using the effective interest method. The recognition of revenues from interest earning assets is based upon formulas from underlying loan agreements, securities contracts or other similar contracts. Non-interest income is recognized on the accrual basis of accounting as services are provided or as transactions occur. Non-interest income includes fees from deposit accounts, ATM and debit card fees, mortgage banking activities, and other miscellaneous services and transactions. Commission revenue from WIA was recognized as of the effective date of the insurance policy or the date the customer was billed, whichever was later. The Company also received contingent commissions from insurance companies which were based on the overall profitability of their relationship based primarily on the loss experience of the insurance placed by the Company. Contingent commissions from insurance companies were recognized when determinable. Commission revenue is included in other non-interest income in the consolidated statement of operations and has been discontinued due to the sale of WIA on June 30, 2020.
Earnings Per Share – Basic earnings per common share is net income or loss divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable during the period, consisting of stock options outstanding under the Company’s stock incentive plans that have an exercise price that is less than the Company’s stock price on the reporting date.
Loss Contingencies—Loss contingencies, including claims and legal actions arising in the normal course of business, are recorded as liabilities when the likelihood of loss is probable and an amount of loss can be reasonably estimated.
Off-Balance-Sheet Financial Instruments—In the ordinary course of business, the Bank has entered into off-balance sheet financial instruments consisting of commitments to extend credit and commitments under lines of credit arrangements, issued to meet customer financial needs. Such financial instruments are recorded in the financial statements when they become payable. See Note 12, “Commitments and Contingencies” in Notes to Consolidated Financial Statements.
Derivatives--Rate-lock Commitments and Forward Sale Agreements —The Company enters into commitments to originate loans, whereby the interest rate on the loan is determined prior to funding (rate-lock commitment). Rate-lock commitments on mortgage loans held for sale are derivative instruments. If material, derivative instruments are carried on the
73
consolidated balance sheets at fair value, and changes in the fair value thereof are recognized in the consolidated statements of operations. The Company originates single-family residential loans for sale, pursuant to programs primarily with the Federal Home Loan Mortgage Corporation (FHLMC) and other similar third parties. In connection with these programs, at the time the Company initially issues a loan commitment, it does not lock in a specific interest rate. At the time the interest rate is locked in by the borrower, the Company concurrently enters into a forward loan sale agreement with the prospective loan purchaser, at a specific price, in order to manage the interest rate risk inherent to the rate-lock commitment. The forward sale agreement also meets the definition of a derivative instrument. Any change in the fair value of the loan commitment after the borrower locks in the interest rate is substantially offset by the corresponding change in the fair value of the forward loan sale agreement related to such loan. The period from the time the borrower locks in the interest rate, to the time the Company funds the loan and sells the loan to a third party varies, and could be up to 90 days. The fair value of each instrument will rise and fall in response to changes in market interest rates, subsequent to the dates the interest rate locks and forward sale agreements are entered into. In the event that interest rates rise after the Company enters into an interest rate lock, the fair value of the loan commitment will decline. However, the fair value of the forward loan sale agreement related to such loan commitment should increase by substantially the same amount, effectively eliminating the Company’s interest rate and price risks.
At December 31, 2020, the Company had $23,650 of loan commitments outstanding related to loans being originated for sale, all of which were subject to interest rate lock commitments and corresponding forward loan sale agreements, as described above. The net fair values of outstanding interest rate-lock commitments and forward sale agreements were considered immaterial to the Company’s consolidated financial statements as of December 31, 2020.
Other Comprehensive Income —Accumulated and other comprehensive income or loss is comprised of the unrealized and realized gains and losses on securities available for sale and pension liability adjustments, net of tax, and is shown on the accompanying consolidated statements of other comprehensive income.
Operating Segments—While our executive officers monitor the revenue streams of the various banking products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company’s banking operations are considered by management to be aggregated in one reportable operating segment.
Recognition of a prior period error-In April 2019 the Company determined that certain state franchise returns had not ever been filed. The franchise liability calculation is primarily based on the Company's stockholders’ equity. The initial franchise return should have been filed in 2006 as part of the Company’s initial public offering. Additionally, with the Company's 2018 capital raise, an additional franchise liability should have been recorded in fiscal 2018. The Company should have recorded a $140 pre-tax charge related to the 2006 initial public offering in the fiscal year ended September 30, 2006 and a $160 pre-tax charge related to the 2018 capital raise in the fiscal year ended September 30, 2018. The correction of these prior period errors to record both the 2006 and 2018 franchise liability totaling $300, was recorded during the three months ended March 31, 2019. The impact on results of operations for the three months ended March 31, 2019 and year ended December 31, 2019 were as follows: pre-tax income was understated by $300, tax expense was overstated by $81 and net income was understated by $219 or $0.02 per share. For the fiscal year ended September 30, 2018, pre-tax income was overstated by $160, tax expense was understated by $44 and net income was overstated by $116 or $0.02 per share. Management of the Company evaluated these prior period errors under the accounting guidance FASB ASC 250, Accounting Changes and Error Corrections and concluded that the effect of these prior period errors was not material to the Company's consolidated financial statements for the year ended December 31, 2019.