ITEM 1A:RISK FACTORS
An investment in the Company’s common stock is subject to risks inherent to the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company’s common stock could decline significantly, and you could lose all or part of your investment.
Risks Related to the Company’s Business
The Company’s business is subject to interest rate risk and variations in interest rates may negatively affect its financial performance.
Changes in the interest rate environment may reduce profits. The Company’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. As prevailing interest rates change, net interest spreads are affected by the difference between the maturities and re-pricing characteristics of interest-earning assets and interest-bearing liabilities. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. An increase in the general level of interest rates may also adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materially adversely affect the Company’s net interest spread, asset quality, loan origination volume and overall profitability.
The Company is subject to lending risk.
There are inherent risks associated with the Company’s lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Company operates as well as those across the Commonwealth of Pennsylvania and the United States. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Company is also subject to various laws and regulations that affect its lending activities. Failure to
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comply with applicable laws and regulations could subject the Company to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Company.
Commercial, commercial real estate and real estate construction loans are generally viewed as having more risk of default than residential real estate loans or consumer loans. These types of loans are also typically larger than residential real estate loans and consumer loans. Because these loans generally have larger balances than residential real estate loans and consumer loans, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Company’s financial condition and results of operations.
The Company’s allowance for possible loan losses may be insufficient.
The Company maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense, that represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for possible loan losses inherently involves a high degree of subjectivity and requires the Company to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Company’s control, may require an increase in the allowance for possible loan losses. In addition, bank regulatory agencies periodically review the Company’s allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. Further, if charge-offs in future periods exceed the allowance for possible loan losses, the Company will need additional provisions to increase the allowance for possible loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and capital and may have a material adverse effect on the Company’s financial condition and results of operations.
The FASB has recently issued an accounting standard update that will result in a significant change in how we recognize credit losses and may have a material impact on our financial condition or results of operations.
In June 2016, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update (“ASU”) entitled “Financial Instruments-Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments,” which replaces the current “incurred loss” model for recognizing credit losses with an “expected loss” model referred to as the Current Expected Credit Loss (“CECL”) model. Under the CECL model, banks will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the “incurred loss” model required under current generally accepted accounting principles (“GAAP”), which delays recognition until it is probable a loss has been incurred.
Until recently, the new CECL standard was expected to become effective for the Company on January 1, 2020, and for interim periods within that year. In November 2019, FASB agreed to delay implementation of the new CECL standard for certain companies, including those companies that qualify as a smaller reporting company under SEC rules, until January 1, 2023. The Company currently expects to continue to qualify as a smaller reporting company, based upon the current SEC definition, and as a result will likely be able to defer implementation of the new CECL standard for a period of time. Nevertheless, the Company continues to evaluate the impact the CECL model will have on the accounting for credit losses, but the Company expects to recognize a one-time cumulative-effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, consistent with regulatory expectations set forth in interagency guidance issued at the end of 2016. The Company cannot yet determine the magnitude of any such one-time cumulative adjustment or of the overall impact of the new standard on its business, financial condition, and results of operations. Accordingly, it is possible the new standard may require an increase in the allowance for credit losses for the estimated life of the financial asset, including an allowance for debt securities. The amount of the change in the allowance for credit losses, if any, resulting from the new guidance will be impacted by the portfolio composition and asset quality at the adoption date, as well as economic conditions and forecasts at the time of adoption. Moreover, the CECL model may create more volatility in the level of the allowance for loan losses. If the Company is required to materially increase the level of its allowance for loan losses for any reason, such increase could adversely affect its business, financial condition and results of operations.
If we conclude that the decline in value of any of our investment securities is other-than-temporary, we will be required to write down the credit-related portion of the impairment of that security through a charge to earnings.
We review our investment securities portfolio at each quarter-end reporting period to determine whether the fair value is
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below the current carrying value. When the fair value of any of our investment securities has declined below its carrying value, we are required to assess whether the decline is other-than-temporary. If we conclude that the decline is other-than-temporary, we will be required to write down the credit-related portion of the impairment of that security through a charge to earnings.
The Basel III capital requirements may require us to maintain higher levels of capital, which could reduce our profitability.
Basel III targets higher levels of base capital, certain capital buffers and a migration toward common equity as the key source of regulatory capital. Although the new capital requirements are phased in over the next decade and may change substantially before final implementation, Basel III signals a growing effort by domestic and international bank regulatory agencies to require financial institutions, including depository institutions, to maintain higher levels of capital. The direction of the Basel III implementation activities or other regulatory viewpoints could require additional capital to support our business risk profile prior to final implementation of the Basel III standards. If the Company and the Bank are required to maintain higher levels of capital, the Company and the Bank may have fewer opportunities to invest capital into interest-earning assets, which could limit the profitable business operations available to the Company and the Bank and adversely impact our financial condition and results of operations.
The Company may need or be compelled to raise additional capital in the future, but that capital may not be available when it is needed and on terms favorable to current shareholders.
Federal banking regulators require the Company and Bank to maintain adequate levels of capital to support their operations. These capital levels are determined and dictated by law, regulation and banking regulatory agencies. In addition, capital levels are also determined by the Company’s management and board of directors based on capital levels that they believe are necessary to support the Company’s business operations. The Company is evaluating its present and future capital requirements and needs, is developing a comprehensive capital plan and is analyzing capital raising alternatives, methods and options. Even if the Company succeeds in meeting the current regulatory capital requirements, the Company may need to raise additional capital in the near future to support possible loan losses during future periods or to meet future regulatory capital requirements.
Further, the Company’s regulators may require it to increase its capital levels. If the Company raises capital through the issuance of additional shares of its common stock or other securities, it may dilute the ownership interests of current investors and may dilute the per-share book value and earnings per share of its common stock. Furthermore, it may have an adverse impact on the Company’s stock price. New investors may also have rights, preferences and privileges senior to the Company’s current shareholders, which may adversely impact its current shareholders. The Company’s ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside its control, and on its financial performance. Accordingly, the Company cannot assure you of its ability to raise additional capital on terms and time frames acceptable to it or to raise additional capital at all. If the Company cannot raise additional capital in sufficient amounts when needed, its ability to comply with regulatory capital requirements could be materially impaired. Additionally, the inability to raise capital in sufficient amounts may adversely affect the Company’s operations, financial condition and results of operations.
The Company is subject to environmental liability risk associated with lending activities.
A significant portion of the Company’s loan portfolio is secured by real property. During the ordinary course of business, the Company may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Company may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Company to incur substantial expense and may materially reduce the affected property’s value or limit the Company’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Company’s exposure to environmental liability. Although the Company has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company’s financial condition and results of operations.
The Company’s profitability depends significantly on economic conditions in the Commonwealth of Pennsylvania and the local region in which it conducts business.
The Company’s success depends primarily on the general economic conditions of the Commonwealth of Pennsylvania and the specific local markets in which the Company operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in Lackawanna and Luzerne Counties in Northeastern Pennsylvania and Northampton County in Eastern Pennsylvania. The local economic conditions in these areas have a significant impact on the demand for the Company’s products and services as well as the ability of the Company’s customers to repay loans, the value of the collateral securing loans and the stability of the Company’s deposit funding sources. A significant decline in general economic conditions caused by inflation, recession, acts of terrorism, an outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the
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Company’s financial condition and results of operations.
There is no assurance that the Company will be able to successfully compete with others for business.
The Company competes for loans, deposits and investment dollars with numerous regional and national banks and other community banking institutions, as well as other kinds of financial institutions and enterprises, such as securities firms, insurance companies, savings associations, credit unions, mortgage brokers and private lenders. Many competitors have substantially greater resources than the Company does, and operate under less stringent regulatory environments. The differences in resources and regulations may make it more difficult for the Company to compete profitably, reduce the rates that it can earn on loans and on its investments, increase the rates it must offer on deposits and other funds, and adversely affect its overall financial condition and earnings.
The Company is subject to extensive government regulation and supervision.
The Company, primarily through the Bank, is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Company’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Federal or commonwealth regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject the Company to additional costs, limit the types of financial services and products the Company may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Company’s business, financial condition and results of operations. While the Company has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.
The Company’s controls and procedures may fail or be circumvented.
Management regularly reviews and updates the Company’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations and financial condition.
New lines of business or new products and services may subject the Company to additional risks.
From time-to-time, the Company may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services the Company may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Company’s system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Company’s business, results of operations and financial condition.
The Company’s future acquisitions could dilute your ownership and may cause it to become more susceptible to adverse economic events.
The Company may use its common stock to acquire other companies or make investments in banks and other complementary businesses in the future. The Company may issue additional shares of common stock to pay for future acquisitions, which would dilute your ownership interest in the Company. Future business acquisitions could be material to the Company, and the degree of success achieved in acquiring and integrating these businesses into the Company could have a material effect on the value of the Company’s common stock. In addition, any acquisition could require it to use substantial cash or other liquid assets or to incur debt. In those events, it could become more susceptible to economic downturns and competitive pressures.
The Company may not be able to attract and retain skilled people.
The Company’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Company can be intense and the Company may not be able to hire people or to retain them. The unexpected loss of services of one or more of the Company’s key personnel could have a material adverse impact on the Company’s business because of their skills, knowledge of the Company’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
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The Company’s information systems may experience an interruption or breach in security.
The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Company’s customer relationship management, general ledger, deposit, loan and other systems. The Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, however there can be no assurance that any such failures, interruptions or security breaches will not occur. The occurrence of any failures, interruptions or security breaches of the Company’s information systems could damage the Company’s reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the Company to civil litigation and possible financial liability, any of which could have a material adverse effect on the Company’s financial condition and results of operations.
The Company continually encounters technological change.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Company’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Company’s operations. Many of the Company’s competitors have substantially greater resources to invest in technological improvements. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Company’s business and, in turn, the Company’s financial condition and results of operations.
The operations of our business, including our interaction with customers, are increasingly done via electronic means, and this has increased our risks related to cyber security.
We are exposed to the risk of cyber-attacks in the normal course of business. In general, cyber incidents can result from deliberate attacks or unintentional events. We have observed an increased level of attention in the industry focused on cyber-attacks that include, but are not limited to, gaining unauthorized access to digital systems for purposes of misappropriating assets or sensitive information, corrupting data, or causing operational disruption. To combat against these attacks, policies and procedures are in place to prevent or limit the effect of the possible security breach of our information systems and we have insurance against some cyber-risks and attacks. While we have not incurred any material losses related to cyber-attacks, nor are we aware of any specific or threatened cyber-incidents as of the date of this report, we may incur substantial costs and suffer other negative consequences if we fall victim to successful cyber-attacks. Such negative consequences could include remediation costs that may include liability for stolen assets or information and repairing system damage that may have been caused; deploying additional personnel and protection technologies, training employees, and engaging third party experts and consultants; lost revenues resulting from unauthorized use of proprietary information or the failure to retain or attract customers following an attack; litigation; and reputational damage adversely affecting customer or investor confidence.
The Company is subject to claims and litigation pertaining to fiduciary responsibility.
From time-to-time, customers make claims and take legal action pertaining to the Company’s performance of its fiduciary responsibilities. Whether customer claims and legal action related to the Company’s performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Company, they may result in significant financial liability and/or adversely affect the market perception of the Company and its products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition and results of operations.
Pennsylvania Business Corporation Law and various anti-takeover provisions under our articles and bylaws could impede the takeover of the Company.
Various Pennsylvania laws affecting business corporations may have the effect of discouraging offers to acquire the Company, even if the acquisition would be advantageous to shareholders. In addition, we have various anti-takeover measures in place under our articles of incorporation and bylaws, including a supermajority vote requirement for mergers, a staggered board of directors, and the absence of cumulative voting. Any one or more of these measures may impede the takeover of the Company without the approval of our board of directors and may prevent our shareholders from taking part in a transaction in which they could realize a premium over the current market price of our common stock.
The Company is a holding company and relies on dividends from its banking subsidiary for substantially all of its revenue and its ability to make dividends, distributions, and other payments.
As a bank holding company, the Company’s ability to pay dividends depends primarily on its receipt of dividends from its subsidiary bank. Dividend payments from the bank are subject to legal and regulatory limitations, generally based on net profits and retained earnings, imposed by bank regulatory agencies. The ability of the bank to pay dividends is also subject to profitability, financial condition, regulatory capital requirements, capital expenditures and other cash flow requirements. There is no assurance that the bank will be able to pay dividends in the future or that the Company will generate cash flow to
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pay dividends in the future. The Company’s failure to pay dividends on its common stock may have a material adverse effect on the market price of its common stock.
The Company’s banking subsidiary may be required to pay higher FDIC insurance premiums or special assessments which may adversely affect its earnings.
The Company generally is unable to control the amount of premiums or special assessments that its subsidiary is required to pay for FDIC insurance. Any future changes in the calculation or assessment of FDIC insurance premiums may have a material adverse effect on our results of operations, financial condition, and our ability to continue to pay dividends on our common stock at the current rate or at all.
Severe weather, natural disasters, acts of war or terrorism, pandemics and other external events could significantly impact the Company’s business.
Severe weather, natural disasters, acts of war or terrorism, pandemics and other adverse external events could have a significant impact on the Company’s ability to conduct business. Such events could affect the stability of the Company’s deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Company to incur additional expenses. Severe weather or natural disasters, acts of war or terrorism, pandemics or other adverse external events may occur in the future. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition and results of operations.
The increasing use of social media platforms presents new risks and challenges and our inability or failure to recognize, respond to and effectively manage the accelerated impact of social media could materially adversely impact our business.
There has been a marked increase in the use of social media platforms, including weblogs (blogs), social media websites, and other forms of Internet-based communications which allow individuals access to a broad audience of consumers and other interested persons. Social media practices in the banking industry are evolving, which creates uncertainty and risk of noncompliance with regulations applicable to our business. Consumers value readily available information concerning businesses and their goods and services and often act on such information without further investigation and without regard to its accuracy. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information posted on such platforms at any time may be adverse to our interests and/or may be inaccurate. The dissemination of information online could harm our business, prospects, financial condition, and results of operations, regardless of the information’s accuracy. The harm may be immediate without affording us an opportunity for redress or correction.
Other risks associated with the use of social media include improper disclosure of proprietary information, negative comments about our business, exposure of personally identifiable information, fraud, out-of-date information, and improper use by employees and customers. The inappropriate use of social media by our customers or employees could result in negative consequences including remediation costs including training for employees, additional regulatory scrutiny and possible regulatory penalties, litigation or negative publicity that could damage our reputation adversely affecting customer or investor confidence.
Federal income tax reform could have unforeseen effects on our financial condition and results of operations.
On December 22, 2017, the President of the United States signed into law H.R. 1, originally known as the “Tax Cuts and Jobs Act.” The Tax Cuts and Jobs Act includes a number of provisions, including the lowering of the U.S. corporate tax rate from 35 percent to 21 percent, effective January 1, 2018. There are also provisions that may partially offset the benefit of such rate reduction. Financial statement impacts include adjustments for, among other things, the re-measurement of deferred tax assets and liabilities. While there are benefits, there is also substantial uncertainty regarding the details of U.S. Tax Reform. The long-term intended and unintended consequences of Tax Cuts and Jobs Act on our business and on holders of our common shares is uncertain and could be adverse.
Risks Associated with the Company’s Common Stock
The Company’s stock price can be volatile.
Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. The Company’s stock price can fluctuate significantly in response to a variety of factors including, among other things:
Actual or anticipated variations in quarterly results of operations.
Recommendations by securities analysts.
Operating and stock price performance of other companies that investors deem comparable to the Company.
News reports relating to trends, concerns and other issues in the financial services industry.
Perceptions in the marketplace regarding the Company and/or its competitors.
New technology used, or services offered, by competitors.
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Significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving the Company or its competitors.
Failure to integrate acquisitions or realize anticipated benefits from acquisitions.
Changes in government regulations.
Geopolitical conditions such as acts or threats of terrorism or military conflicts.
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause the Company’s stock price to decrease regardless of operating results.
The trading volume in the Company’s common stock is less than that of other larger financial services companies.
The Company’s common stock is listed for trading on Nasdaq and the trading volume in its common stock is less than that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Company’s common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Company has no control. Given the lower trading volume of the Company’s common stock, significant sales of the Company’s common stock, or the expectation of these sales, could cause the Company’s stock price to fall.
Furthermore, from time to time, the Company’s common stock may be included in certain and various stock market indices. Inclusion in these indices may positively impact the price, trading volume, and liquidity of the Company’s common stock, in part, because index funds or other institutional investors often purchase securities that are in these indices. Conversely, if the Company’s market capitalization falls below the minimum necessary to be included in any of the indices at any annual reconstitution date, the opposite could occur. Further, the Company’s inclusion in indices may be weighted based on the size of its market capitalization, so even if the Company’s market capitalization remains above the amount required to be included on these indices, if its market capitalization is below the amount it was on the most recent reconstitution date, the Company’s common stock could be weighted at a lower level, holders attempting to track the composition of these indices will be required to sell the Company’s common stock to match the reweighting of the indices.
Risks Associated with the Company’s Industry
Future governmental regulation and legislation could limit the Company’s future growth.
The Company is a registered bank holding company, and its subsidiary bank is a depository institution whose deposits are insured by the FDIC. As a result, the Company is subject to various regulations and examinations by various regulatory authorities. In general, statutes establish the corporate governance and eligible business activities for the Company, certain acquisition and merger restrictions, limitations on inter-company transactions such as loans and dividends, capital adequacy requirements, requirements for anti-money laundering programs and other compliance matters, among other regulations. The Company is extensively regulated under federal and state banking laws and regulations that are intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole. Compliance with these statutes and regulations is important to the Company’s ability to engage in new activities and consummate additional acquisitions.
In addition, the Company is subject to changes in federal and state tax laws as well as changes in banking and credit regulations, accounting principles and governmental economic and monetary policies. The Company cannot predict whether any of these changes may adversely and materially affect it. Federal and state banking regulators also possess broad powers to take supervisory actions as they deem appropriate. These supervisory actions may result in higher capital requirements, higher insurance premiums and limitations on the Company’s activities that could have a material adverse effect on its business and profitability. While these statutes are generally designed to minimize potential loss to depositors and the FDIC insurance funds, they do not eliminate risk, and compliance with such statutes increases the Company’s expense, requires management’s attention and can be a disadvantage from a competitive standpoint with respect to non-regulated competitors.
The earnings of financial services companies are significantly affected by general business and economic conditions.
The Company’s operations and profitability are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the U.S. economy and the local economies in which the Company operates, all of which are beyond the Company’s control. Deterioration in economic conditions could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values and a decrease in demand for the Company’s products and services, among other things, any of which could have a material adverse impact on the Company’s financial condition and results of operations.
Financial services companies depend on the accuracy and completeness of information about customers and counterparties.
In deciding whether to extend credit or enter into other transactions, the Company may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. The Company may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements,
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credit reports or other financial information could have a material adverse impact on the Company’s business and, in turn, the Company’s financial condition and results of operations.
Consumers may decide not to use banks to complete their financial transactions.
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on the Company’s financial condition and results of operations.
A protracted government shutdown or issues relating to debt and the deficit may adversely affect the Company.
Extended shutdowns of parts of the federal government could negatively impact the financial performance of certain customers and could impact customers’ future access to certain loan and guarantee programs. As a result, this could impact the Company’s business, financial condition and results of operations.
As a result of past difficulties of the federal government to reach agreement over federal debt and issues connected with the debt ceiling, certain rating agencies placed the United States government's long-term sovereign debt rating on their equivalent of negative watch and announced the possibility of a rating downgrade. The rating agencies, due to constraints related to the rating of the United States, also placed government-sponsored enterprises in which the Company invests and receives lines of credit on negative watch and a downgrade of the United States government's credit rating would trigger a similar downgrade in the credit rating of these government-sponsored enterprises. Furthermore, the credit rating of other entities, such as state and local governments, may also be downgraded should the United States government's credit rating be downgraded. The impact that a credit rating downgrade may have on the national and local economy could have an adverse effect on the Company’s financial condition and results of operations.
The regulatory environment for the financial services is being significantly impacted by financial regulatory reform initiatives in the United States and elsewhere, including Dodd-Frank and regulations promulgated to implement it.
Dodd-Frank, which was signed into law on July 21, 2010, comprehensively reforms the regulation of financial institutions, products and services. Dodd-Frank requires various federal regulatory agencies to implement numerous rules and regulations. Because the federal agencies are granted broad discretion in drafting these rules and regulations, many of the details and the impact of Dodd-Frank may not be known for many months or years.
While much of how the Dodd-Frank and other financial industry reforms will change our current business operations depends on the specific regulatory reforms and interpretations, many of which have yet to be released or finalized, it is clear that the reforms, both under Dodd-Frank and otherwise, will have a significant effect on our entire industry. Although Dodd-Frank and other reforms will affect a number of the areas in which we do business, it is not clear at this time the full extent of the adjustments that will be required and the extent to which we will be able to adjust our businesses in response to the requirements. Although it is difficult to predict the magnitude and extent of these effects at this stage, we believe compliance with Dodd-Frank and implementing its regulations and initiatives will negatively impact revenue and increase the cost of doing business, both in terms of transition expenses and on an ongoing basis, and it may also limit our ability to pursue certain business opportunities.
Risks related to the merger of MNB Corporation (MNB) into the Company
The combined company incurred and may continue to incur significant transaction and merger-related costs in connection with the merger.
The Company incurred and may continue to incur costs associated with combining the operations of the two companies. The Company formulated and is executing on detailed integration plans to deliver planned synergies. Additional unanticipated costs may be incurred in the integration of the businesses of the Company and MNB. The Company may continue to incur substantial expenses in pursuit of completing our plans. Although the Company expects that the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the businesses, may offset incremental transaction and merger-related costs over time, the net benefit may not be achieved in the near term, or at all.
Post-merger integration of the two companies may distract the Company’s management team from its other responsibilities.
Post-merger integration of the two companies could cause the management of the Company to focus their time and energies on matters related to integration that otherwise would be directed to its business and operations. Any such distraction on the part of management, if significant, could affect management’s ability to service existing business and develop new business and adversely affect the combined company’s business and earnings.
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Post-merger integration and operations may fail to achieve expected results.
The success of the acquisition of MNB depends heavily on a smooth post-merger integration and operations of the combined bank. Benefits of the transaction to shareholders may not be realized if the post-merger integration and operations are not well executed or well received by each bank’s historical customers.
The Company may fail to realize the cost savings it expects to achieve from the merger.
The success of the merger depends, in part, on the Company’s ability to realize the estimated cost savings from combining the businesses of the Company and MNB. While the Company believes that the cost savings estimates are achievable, it is possible that the potential cost savings could be more difficult to achieve than the Company anticipates. The Company’s cost savings estimates also depend on its ability to combine the businesses of the Company and MNB in a manner that permits those cost savings to be realized. If the Company’s estimates are incorrect or it is unable to combine the two entities successfully, the anticipated cost savings may not be realized fully, or at all, or may take longer to realize than expected.
Combining the Company and MNB may be more difficult, costly, or time-consuming than expected.
The Company and MNB operated, until the completion of the merger, independently. Since the completion of the merger, the combination process could result in the loss of key employees, the disruption of the Company’s ongoing business, and inconsistencies in standards, controls, procedures and policies that adversely affect the Company’s ability to maintain relationships with clients and employees or achieve the anticipated benefits of the merger. As with any merger of financial institutions, there also may be disruptions that cause the Company to lose customers or cause customers to withdraw their deposits from the Company, or other unintended consequences that could have a material adverse effect on the Company’s results of operations or financial condition.
Risks related to the merger of Landmark Bancorp, Inc. (Landmark) into the Company
The combined company will incur significant transaction and merger-related costs in connection with the merger.
The Company expects to incur costs associated with combining the operations of the two companies. The Company is formulating detailed integration plans to deliver planned synergies. Additional unanticipated costs may be incurred in the integration of the businesses of the Company and Landmark. Whether or not the merger is consummated, the Company will incur substantial expenses, such as legal, accounting, printing, contract termination fees, and financial advisory fees, in pursuing the merger. Although the Company expects that the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the businesses, may offset incremental transaction and merger-related costs over time, the net benefit may not be achieved in the near term, or at all.
Some of the conditions to closing of the merger may result in delay or prevent completion of the merger, which may adversely affect the value of the Company’s and Landmark’s securities.
Completion of the merger is conditioned upon the receipt of certain governmental consents and approvals, including consents and approvals required by the Federal Reserve Board, the FDIC, and the Pennsylvania Department of Banking and Securities. Failure to obtain these consents would prevent consummation of the merger. Even if the approvals are obtained, the effort involved may delay consummation of the merger. Governmental authorities may also impose conditions in connection with the merger that may adversely affect the combined company’s operations after the merger. However, the Company is not required to take any action or agree to any condition or restriction in connection with obtaining any approvals that would reasonably be expected to have a material adverse effect on the Company or the combined company.
The merger may distract the Company’s management team from its other responsibilities.
The merger could cause the management of the Company to focus their time and energies on matters related to the merger that otherwise would be directed to its business and operations. Any such distraction on the part of management, if significant, could affect management’s ability to service existing business and develop new business and adversely affect the combined company’s business and earnings following the merger.
If the merger is not completed, the Company and Landmark will have incurred substantial expenses without realizing the expected benefits.
The Company will incur substantial expenses in connection with the merger. The completion of the merger depends on the satisfaction of specified conditions and the receipt of regulatory approvals. The Company cannot guarantee that these conditions will be met. If the merger is not completed, these expenses could have a material adverse impact on the financial condition of the Company because it would not have realized the expected benefits from the merger.
In addition, if the merger is not completed, the Company may experience negative reactions from the financial markets and from their respective customers and employees. The Company also could be subject to litigation related to any failure to complete the merger or to enforcement proceedings commenced against the Company to perform its obligations under the reorganization agreement. If the merger is not completed, the Company cannot assure its shareholders that the risks described above will not materialize and will not materially affect the business, financial results, and stock price of the Company.
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Litigation against the Company or Landmark, or the members of the Company or Landmark board of directors, could prevent or delay the completion of the merger.
While the Company and Landmark believe that any claims that may be asserted by purported shareholder plaintiffs related to the merger would be without merit, the results of any such potential legal proceedings are difficult to predict and such legal proceedings could delay or prevent the merger from being completed in a timely manner. If litigation were to be commenced related to the merger, such litigation could affect the likelihood of obtaining the required approvals from the Company shareholders and Landmark shareholders. Moreover, any litigation could be time consuming and expensive, and could divert the attention of the management of the Company and Landmark away from their regular business. Any lawsuit adversely resolved against the Company, Landmark, or members of the Company or Landmark board of directors could have a material adverse effect on each party’s business, financial condition, and results of operations.
Post-merger integration and operations may fail to achieve expected results.
The success of the transaction depends heavily on a smooth post-merger integration and operations of the combined bank. Benefits of the transaction to shareholders may not be realized if the post-merger integration and operations are not well executed or well received by each bank’s historical customers.
The Company may fail to realize the cost savings it expects to achieve from the merger.
The success of the merger will depend, in part, on the Company’s ability to realize the estimated cost savings from combining the businesses of the Company and Landmark. While the Company believes that the cost savings estimates are achievable, it is possible that the potential cost savings could be more difficult to achieve than the Company anticipates. The Company’s cost savings estimates also depend on its ability to combine the businesses of the Company and Landmark in a manner that permits those cost savings to be realized. If the Company’s estimates are incorrect or it is unable to combine the two companies successfully, the anticipated cost savings may not be realized fully or at all or may take longer to realize than expected.
Combining the Company and Landmark may be more difficult, costly, or time-consuming than expected.
The Company and Landmark have operated, and, until the completion of the merger, will continue to operate, independently. Following the completion of the merger, the combination process could result in the loss of key employees, the disruption of the Company’s ongoing business, and inconsistencies in standards, controls, procedures and policies that adversely affect the Company’s ability to maintain relationships with clients and employees or achieve the anticipated benefits of the merger. As with any merger of financial institutions, there also may be disruptions that cause the Company to lose customers or cause customers to withdraw their deposits from the Company, or other unintended consequences that could have a material adverse effect on the Company’s results of operations or financial condition.
Risks related to the COVID-19 pandemic
The COVID-19 Pandemic Has Adversely Impacted Our Business And Financial Results, And The Ultimate Impact Will Depend On Future Developments, Which Are Highly Uncertain And Cannot Be Predicted, Including The Scope And Duration Of The Pandemic And Actions Taken By Governmental Authorities In Response To The Pandemic.
The COVID-19 pandemic has negatively impacted the global, national and local economies, disrupted global and national supply chains, lowered equity market valuations, created significant volatility and disruption in financial markets, and increased unemployment levels. In addition, the pandemic resulted in temporary closures of many businesses and the institution of social distancing and sheltering in place requirements in many states and communities and may result in the same or similar restrictions in the future. As a result, the demand for our products and services have been and may continue to be significantly impacted, which could adversely affect our revenue and results of operations. Furthermore, the pandemic could continue to result in the recognition of credit losses in our loan portfolios and increases in our allowance for credit losses, particularly if businesses remain required to operate at diminished capacities or are required to close again, the impact on the global, national and local economies worsen, or more customers draw on their lines of credit or seek additional loans to help finance their businesses. Similarly, because of changing economic and market conditions affecting issuers, we may be required to recognize further impairments on the securities we hold as well as reductions in other comprehensive income. Our business operations may also be disrupted if significant portions of our workforce are unable to work effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic. The extent to which the COVID-19 pandemic impacts our business, results of operations, and financial condition, as well as our regulatory capital and liquidity ratios, will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities and other third parties in response to the pandemic.
We continue to closely monitor the COVID-19 pandemic and related risks as they evolve. The magnitude, duration and likelihood of the current outbreak of COVID-19, further outbreaks of COVID-19, future actions taken by governmental authorities and/or other third parties in response to the COVID-19 pandemic, and its future direct and indirect effects on the global, national and local economy generally and our business and results of operation specifically are highly uncertain. The COVID-19 pandemic may cause prolonged global or national recessionary economic conditions or longer lasting effects on
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economic conditions than currently exist, which could have a material adverse effect on our business, results of operations and financial condition.
Due to the Company’s participation in the U.S. Small Business Administration ("SBA") Paycheck Protection Program ("PPP"), the Company is subject to additional risks of litigation from its clients or other parties regarding the processing of loans for the PPP and risks that the SBA may not fund some or all PPP loan guaranties.
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") was enacted, which included a $349 billion loan program administered through the SBA referred to as the PPP. Under the PPP, small businesses and other entities and individuals could apply for loans from existing SBA lenders and other approved regulated lenders. The Company participated as a lender in the PPP. Because of the short timeframe between the passing of the CARES Act and the opening of the PPP, there was some ambiguity in the laws, rules and guidance regarding the operation of the PPP along with the continually evolving nature of SBA the rules, interpretations and guidelines concerning this program, which exposes us to risks relating to noncompliance with the PPP. Since the launch of the PPP, several large banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP. As such, we may be exposed to the risk of litigation, from both clients and non-clients that approached the Company regarding PPP loans, regarding its process and procedures used in processing applications for the PPP. If any such litigation is filed against the us and is not resolved in a manner favorable to us, it may result in significant financial liability or adversely affect our reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP related litigation could have a material adverse impact on our business, financial condition and results of operations.
The Company also has credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, underwritten, certified by the borrower, funded, or serviced by the Company, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, certified by the borrower, funded, or serviced by the Company, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from us.
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ITEM 1B:UNRESOLVED STAFF COMMENTS
None
ITEM 2:PROPERTIES
As of December 31, 2020, the Company operated 20 full-service banking offices, of which ten were owned and ten were leased. With the exception of the Pittston branch, none of the lessors of the properties leased by the Company are affiliated with the Company and all of the properties are located in the Commonwealth of Pennsylvania. The Company is headquartered at its owner-occupied main branch located on the corner of Blakely and Drinker Streets in Dunmore, PA. We believe each of our facilities is suitable and adequate to meet our current operational needs.
The following table provides information with respect to the principal properties from which the Bank conducts business:
Location Owned / leased* Type of use Full service Drive-thru ATM
Drinker & Blakely Streets, Dunmore, PA Owned Main Branch (1) (2) x x x
111 Green Ridge St., Scranton, PA Leased Green Ridge Branch (2) x x x
1311 Morgan Hwy., Clarks Summit, PA Leased Abington Branch x x x
338 North Washington Ave., Scranton, PA Owned Financial Center Branch (3) x x
4010 Birney Ave., Moosic, PA Owned Moosic Branch x x x
225 Kennedy Blvd., Pittston, PA Leased (4) Pittston Branch x x x
1598 Main St., Peckville, PA Leased Peckville Branch x x x
247 Wyoming Ave.,Kingston, PA Owned Kingston Branch x x x
400 S. Main St.,Scranton, PA Owned West Scranton Branch (2) x x x
2363 Memorial Hwy.,Dallas, PA Leased Back Mountain Branch x x
1 South Mountain Blvd.,Mountain Top, PA Leased Mountain Top Branch x x x
303 Pennsylvania Ave.,Bangor, PA 18013 Owned Bangor Branch x x
2 West Broad St.,Bethlehem, PA 18018 Leased Bethlehem Branch x x
46 Centre Square,Easton, PA 18042 Leased Easton Branch x x
1250 Braden Blvd.,Easton, PA 18040 Owned Forks Branch x x x
6626 Main St.,Martins Creek, PA 18063 Leased Martins Creek Branch x x x
2118 Delaware Dr.,Mount Bethel, PA 18343 Owned Mount Bethel Branch x x
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44 South Broad St.,Nazareth, PA 18064 Leased Nazareth Branch x x
45 North Broadway,Wind Gap, PA 18091 Owned Wind Gap Branch x x x
*All of the owned properties are free of encumbrances. At the Green Ridge branch office, Back Mountain branch office, Mountain Top branch office and Pittston branch office, the Company leases the land from an unrelated third party, however the buildings are the Company’s own capital improvement.
(1)Executive and administrative, commercial lending, trust and asset management services are located at the Main Branch.
(2)This office has two automated teller machines (ATMs).
(3)Executive, mortgage and consumer lending, finance, operations and a full-service call center are located in this building.
(4)This property is subject to a lease with a company of which director, William J. Joyce, Sr., is a partner.
The Company also operates a wealth management office in Minersville, PA under a short-term lease agreement.
As of December 31, 2020, the Bank maintained four free standing 24-hour ATMs located at the following locations:
The Shoppes at Montage, 1035 Shoppes Blvd., Moosic, PA;
Mountain Plaza Shopping Mall, 307 Moosic St., Scranton, PA;
Antonio’s Pizza, 45 Luzerne St., West Pittston, PA;
Back Mountain, 32 Dallas Shopping Ctr., Dallas, PA.
Foreclosed assets held-for-sale includes other real estate owned (ORE). The Company had six ORE properties as of December 31, 2020, which stemmed from six unrelated borrowers. Upon possession, foreclosed properties are recorded on the Company’s balance sheet at the lower of cost or fair value. For a further discussion of ORE properties, see “Foreclosed assets held-for-sale”, located in the comparison of financial condition section of managements’ discussion and analysis.
ITEM 3: LEGAL PROCEEDINGS
The nature of the Company’s business generates some litigation involving matters arising in the ordinary course of business. However, in the opinion of the Company after consulting with legal counsel, no legal proceedings are pending, which, if determined adversely to the Company or the Bank, would have a material effect on the Company’s undivided profits or financial condition or results of operations. No legal proceedings are pending other than ordinary routine litigation incidental to the business of the Company and the Bank. In addition, to management’s knowledge, no governmental authorities have initiated or contemplated any material legal actions against the Company or the Bank.
ITEM 4: MINE SAFETY DISCLOSURES
Not Applicable
PART II
ITEM 5:MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The common stock of the Company is listed on Nasdaq and traded on The NASDAQ Global Market under the symbol “FDBC.” Shareholders requesting information about the Company’s common stock may contact:
Salvatore R. DeFrancesco, Jr., Treasurer
Fidelity D & D Bancorp, Inc.
Blakely and Drinker Streets
Dunmore, PA 18512
(570) 342-8281
The Company’s common stock began trading on the Nasdaq Global Market on October 6, 2017. Dividends are determined and declared by the Board of Directors of the Company. The Company expects to continue to pay cash dividends in the future; however, future dividends are dependent upon earnings, financial condition, capital strength and other factors of the Company. For a further discussion of regulatory capital requirements see Note 15, “Regulatory Matters,” contained within the notes to the consolidated financial statements, incorporated by reference in Part II, Item 8.
The Company offers a dividend reinvestment plan (DRP) for its shareholders. The DRP provides shareholders with a convenient and economical method of investing cash dividends payable on their common stock and the opportunity to make voluntary optional cash payments to purchase additional shares of the Company’s common stock. Participants pay no brokerage commissions or service charges when they acquire additional shares of common stock through the DRP. The administrator may purchase shares directly from the Company, in the open market, in negotiated transactions with third parties or using a combination of these methods.
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The Company had approximately 1,408 shareholders at December 31, 2020 and 1,446 shareholders as of February 28, 2021. The number of shareholders is the actual number of individual shareholders of record. Each security depository is considered a single shareholder for purposes of determining the approximate number of shareholders.
Performance graph
The following graph and table compare the cumulative total shareholder return on the Company’s common stock against the cumulative total return of the NASDAQ Composite and SNL Bank NASDAQ index (the SNL NASDAQ index) for the period of five fiscal years commencing January 1, 2016, and ending December 31, 2020. As of December 31, 2020, the SNL NASDAQ index consisted of 269 banks. A listing of the banks that comprise the SNL NASDAQ index can be found on the Company’s website at www.bankatfidelity.com and then on the bottom of the page clicking on, Investor Relations, Fidelity D & D Bancorp Stock, Stock Information, List of all companies in The SNL U.S. Bank NASDAQ index link at bottom of page. The graph illustrates the cumulative investment return to shareholders, based on the assumption that a $100 investment was made on December 31, 2015, in each of: the Company’s common stock, the NASDAQ Composite and the SNL NASDAQ index. All cumulative total returns are computed assuming the reinvestment of dividends into the applicable securities. The shareholder return shown on the graph and table below is not necessarily indicative of future performance:
Period Ending
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ITEM 6:SELECTED FINANCIAL DATA
Set forth below are our selected consolidated financial and other data. This financial data is derived in part from, and should be read in conjunction with the consolidated financial statements and notes thereto included in Part II, Item 8 of this report:
(dollars in thousands except per share data)
Operating data for the year ended:
Per share data:
Ratios:
(1) Non-GAAP disclosure – For a discussion on these ratios, see “Non-GAAP Financial Measures,” located in management’s discussion and analysis.
(2) Net interest margin is calculated using the fully-taxable equivalent (FTE) yield on tax-exempt securities and loans. See the “Non-GAAP Financial Measures” in management’s discussion and analysis for the FTE adjustments.
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ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATION
Critical accounting policies
The presentation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.
A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for loan losses. Management believes that the allowance for loan losses at December 31, 2020 is adequate and reasonable. Given the subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make different assumptions and could, therefore, calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in the future. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize adjustments to the allowance based on their judgment of information available to them at the time of their examination.
Another material estimate is the calculation of fair values of the Company’s investment securities. Fair values of investment securities are determined by pricing provided by a third-party vendor, who is a provider of financial market data, analytics and related services to financial institutions. Based on experience, management is aware that estimated fair values of investment securities tend to vary among valuation services. Accordingly, when selling investment securities, price quotes may be obtained from more than one source. As described in Notes 1 and 4 of the consolidated financial statements, incorporated by reference in Part II, Item 8, all of the Company’s investment securities are classified as available-for-sale (AFS). AFS securities are carried at fair value on the consolidated balance sheets, with unrealized gains and losses, net of income tax, reported separately within shareholders’ equity as a component of accumulated other comprehensive income (loss) (AOCI).
The fair value of residential mortgage loans, classified as held-for-sale (HFS), is obtained from the Federal National Mortgage Association (FNMA) or the Federal Home Loan Bank (FHLB). Generally, the market to which the Company sells residential mortgages it originates for sale is restricted and price quotes from other sources are not typically obtained. On occasion, the Company may transfer loans from the loan portfolio to loans HFS. Under these circumstances, pricing may be obtained from other entities and the loans are transferred at the lower of cost or market value and simultaneously sold. For a further discussion on the accounting treatment of HFS loans, see the section entitled “Loans held-for-sale,” contained within this management’s discussion and analysis.
We account for business combinations under the purchase method of accounting. The application of this method of accounting requires the use of significant estimates and assumptions in the determination of the fair value of assets acquired and liabilities assumed in order to properly allocate purchase price consideration between assets that are amortized, accreted or depreciated from those that are recorded as goodwill. Estimates of the fair values of assets acquired and liabilities assumed are based upon assumptions that management believes to be reasonable.
Goodwill is tested at least annually at November 30 for impairment, or more often if events or circumstances indicate there may be impairment. Impairment write-downs are charged to the consolidated statement of income in the period in which the impairment is determined. In testing goodwill for impairment, the Company performed a qualitative assessment, resulting in the determination that the fair value of its reporting unit exceeded its carrying amount. Accordingly, there is no goodwill impairment at December 31, 2020. Other acquired intangible assets that have finite lives, such as core deposit intangibles, are amortized over their estimated useful lives and subject to periodic impairment testing.
All significant accounting policies are contained in Note 1, “Nature of Operations and Summary of Significant Accounting Policies”, within the notes to consolidated financial statements and incorporated by reference in Part II, Item 8.
The following discussion and analysis presents the significant changes in the financial condition and in the results of operations of the Company as of December 31, 2020 and 2019 and for each of the years then ended. This discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Part II, Item 8 of this report.
Non-GAAP Financial Measures
The following are non-GAAP financial measures which provide useful insight to the reader of the consolidated financial statements but should be supplemental to GAAP used to prepare the Company’s financial statements and should not be read in isolation or relied upon as a substitute for GAAP measures. In addition, the Company’s non-GAAP measures may not be comparable to non-GAAP measures of other companies. The Company’s tax rate used to calculate the fully-taxable equivalent (FTE) adjustment was 21% at December 31, 2020, 2019 and 2018 compared to 34% at December 31, 2017 and 2016.
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The following table reconciles the non-GAAP financial measures of FTE net interest income:
The efficiency ratio is non-interest expenses as a percentage of FTE net interest income plus non-interest income. The following table reconciles the non-GAAP financial measures of the efficiency ratio to GAAP:
Efficiency Ratio (non-GAAP)
The following table provides a reconciliation of the tangible common equity (non-GAAP) and the calculation of tangible book value per share:
Tangible Book Value per Share (non-GAAP)
Less: Intangible assets, primarily goodwill (8,787) (209) (209) (209) -
Less: Intangible assets, primarily goodwill (8,787) (209) (209) (209) -
The following table provides a reconciliation of the Company’s earnings results under GAAP to comparative non-GAAP results excluding merger-related expenses and an FHLB prepayment penalty:
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Comparison of Financial Condition as of December 31, 2020
and 2019 and Results of Operations for each of the Years then Ended
Executive Summary
On March 11, 2020, the World Health Organization declared a coronavirus, identified as COVID-19, a global pandemic. The Company began proactive initiatives in March 2020 to assist clients, Fidelity Bankers and communities impacted by the effects of the novel coronavirus pandemic. Management activated its established pandemic contingency plan response in March 2020 to ensure business continuity while assuring the health, safety and well-being of bankers, clients and the community. Special measures included:
Installing proper social distancing signs and markers, to include safety barriers for both bankers and clients that encourage proper separation as recommended by the CDC.
Encouraging use of online, mobile, telephone banking, night drop and ATMs to meet clients’ banking needs.
Adding resources to the Customer Care Center to manage increased call and chat volume.
Activating telecommunications capabilities to enable Fidelity Bankers to work-from-home, as appropriate.
Providing Fidelity Bankers personal protective equipment and disinfectant supplies when working on-site.
Scheduling in-person meetings by appointment only, observing the guidelines of social distancing and personal safety as recommended by health and safety officials.
Enhancing EPA approved cleaning and disinfecting protocols implemented at all locations, including utilizing ionization machines when required.
Increasing the fresh air intake and using anti-viral filters in all HVAC units, above OSHA regulations.
Conducting meetings virtually.
The Company incurred approximately $0.3 million in non-interest expenses during 2020 to implement programs and provide supplies and services in order to respond to the pandemic.
Nationally, the unemployment rate grew from 3.6% at December 31, 2019 to 6.7% at December 31, 2020. The unemployment rates in the Scranton - Wilkes-Barre - Hazleton and the Allentown – Bethlehem - Easton Metropolitan Statistical Areas (local) increased and the Scranton – Wilkes-Barre - Hazleton rate remained at a higher level than the national unemployment rate. According to the U.S. Bureau of Labor Statistics, the local unemployment rates at December 31, 2020 were 7.6% and 6.2%, respectively, an increase of 2.0 and 1.7 percentage points from the 5.6% and 4.5%, respectively, at December 31, 2019. The national and local unemployment rates have risen as a result of the effects of the pandemic. The increase in unemployment and business restrictions has had an effect on spending in our market area and unemployment is expected to remain above the December 2019 levels for the next few months. Stimulus payments and enhanced unemployment benefits have supported the economy throughout 2020 and the government could continue to provide this support in 2021. The median home values in the Scranton-Wilkes-Barre-Hazleton metro and Allentown-Bethlehem-Easton metro each increased 12.2% from a year ago, according to Zillow, an online database advertising firm providing access to its real estate search engines to various media outlets, and values are expected to grow 15.4% and 13.9% in the next year. In light of these expectations, we will continue to monitor the economic climate in our region and scrutinize growth prospects with credit quality as a principal consideration.
On May 1, 2020, the Company completed its previously announced acquisition of MNB Corporation (“MNB”). The merger expanded the Company’s full-service footprint into Northampton County, PA and the Lehigh Valley. Non-recurring costs to facilitate the merger and integrate systems of $2.5 million were incurred during 2020.
On February 26, 2021, the Company announced an agreement to acquire Landmark Bancorp, Inc. (“Landmark”). The Company expects to complete the merger with Landmark during the third quarter of 2021. The Company expects non-recurring costs to facilitate the anticipated merger and integrate systems in 2021 incurred by the Company to be $3.7 million. The Company remains committed to selectively expanding branch banking and wealth management locations in Northeastern and Eastern Pennsylvania as opportunities arrive going forward.
Non-recurring merger-related costs and a FHLB prepayment penalty incurred during 2020 are not a part of the Company’s normal operations. If these expenses had not occurred, adjusted net income (non-GAAP) for the years ended December 31, 2020 and 2019 would have been $15.4 million and $12.0 million, respectively. Adjusted diluted EPS (non-GAAP) would have been $3.34 and $3.14 for the years ended December 31, 2020 and 2019. For the same time periods, adjusted ROA (non-GAAP) would have been 1.03% and 1.22%, respectively, and adjusted ROE (non-GAAP) would have been 10.73% and 11.90%, respectively.
For the years ended December 31, 2020 and 2019, tangible common book value per share (non-GAAP) was $31.72 and $28.20, respectively. These non-GAAP measures should be reviewed in connection with the reconciliation of these non-GAAP ratios. See “Non-GAAP Financial Measures” located above within this management’s discussion and analysis.
During 2020, the Company’s assets grew by 68% primarily from assets acquired from the merger with MNB and additional growth in deposits and retained net earnings, which were used to fund growth in the loan portfolio. In 2021, we expect total loans (excluding loans acquired from Landmark) to decline as loans issued under the U.S. Small Business Administration Paycheck Protection Program (“PPP”) are forgiven. Net of PPP loans, the loan portfolio is expected to increase with funding
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provided primarily by deposit growth. We expect funds generated from operations, deposit growth along with calls and maturities will be used to replace, reinvest and grow the investment portfolio weighted heavier in municipal securities with net growth in mortgage-backed securities and agency securities as well. The cash flow from these securities will provide liquidity to reinvest. No short-term borrowings are expected in 2021 and FHLB advances will be paid off.
Non-performing assets represented 0.39% of total assets as of December 31, 2020, down from 0.50% at the prior year end. Non-performing assets to total assets was lower during 2020 mostly due to non-performing assets increasing slower than the growth in total assets. For 2021, management expects an increase in non-performing assets to total assets as a result of the stress from economic uncertainty resulting from the pandemic.
Branch managers, relationship bankers, mortgage originators and our business service partners are all focused on developing a mutually profitable full banking relationship. We understand our markets, offer products and services along with financial advice that is appropriate for our community, clients and prospects. The Company continues to focus on the trusted financial advisor model by utilizing the team approach of experienced bankers that are fully engaged and dedicated towards maintaining and growing profitable relationships.
The Company generated $13.0 million in net income in 2020, up $1.4 million, or 13%, from $11.6 million in 2019. In 2020, our larger and well diversified balance sheet from organic and inorganic growth contributed to the success of our earnings performance. The 2021 focus is to manage net interest income through a relatively flat forecasted rate cycle by controlling loan and deposit pricing to maintain a reasonable spread. Federal Open Market Committee (FOMC) officials began increasing interest rates at the end of 2015 in an attempt to return to a “normal” stance. Rate cuts of 50 and 100 basis points during the first quarter of 2020 at the start of the pandemic completely reversed the increases initiated by the FOMC at the end of 2015. From a financial condition and performance perspective, our mission for 2021 will be to continue to strengthen our capital position from strategic growth oriented objectives, implement creative marketing and revenue enhancing strategies, grow and cultivate more of our wealth management and business services and to manage credit risk at tolerable levels thereby maintaining overall asset quality.
For the near-term, we expect to continue to operate in a relatively low flat interest rate environment. The Company’s balance sheet is positioned to improve its net interest income performance, but reducing cost of funds may not keep pace with low yields that may compress net interest spread and margin. The Company expects net interest margin to decline for 2021. In March 2021, the American Rescue Plan Act of 2021 was approved by Congress and signed into law by President Biden. This legislation will provide many customers with the third round of economic impact payments since the pandemic began. This could cause a temporary surge in personal deposit balances which would increase our excess cash position and further compress net interest margin. Expectations are for short-term rates to remain flat throughout 2021, which could cause deposit rate pricing to decrease further.
Financial Condition
Consolidated assets increased $689.6 million, or 68%, to $1.7 billion as of December 31, 2020 from $1.0 billion at December 31, 2019. The increase in assets occurred primarily from assets acquired in the merger with MNB. Of the growth in net loans and leases, $132.1 million was from PPP loans that are mostly expected to be paid off during 2021. The asset growth was funded by utilizing growth in deposits of $673.8 million and $7.7 million in retained earnings, net of dividends declared.
The following table is a comparison of condensed balance sheet data as of December 31:
(dollars in thousands)
Liabilities:
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A comparison of net changes in selected balance sheet categories as of December 31, are as follows:
Earning Short-term FHLB
(dollars in thousands) Assets % assets* % Deposits % borrowings % advances %
* Earning assets include interest-bearing deposits with financial institutions, gross loans and leases, loans held-for-sale, available-for-sale securities and restricted investments in bank stock excluding loans placed on non-accrual status.
Funds Provided:
Deposits
The Company is a community based commercial depository financial institution, member FDIC, which offers a variety of deposit products with varying ranges of interest rates and terms. Generally, deposits are obtained from consumers, businesses and public entities within the communities that surround the Company’s 20 branch offices and all deposits are insured by the FDIC up to the full extent permitted by law. Deposit products consist of transaction accounts including: savings; clubs; interest-bearing checking; money market and non-interest bearing checking (DDA). The Company also offers short- and long-term time deposits or certificates of deposit (CDs). CDs are deposits with stated maturities which can range from seven days to ten years. Cash flow from deposits is influenced by economic conditions, changes in the interest rate environment, pricing and competition. To determine interest rates on its deposit products, the Company considers local competition, spreads to earning-asset yields, liquidity position and rates charged for alternative sources of funding such as short-term borrowings and FHLB advances.
The following table represents the components of total deposits as of December 31:
(dollars in thousands) Amount % Amount %
Total deposits increased $673.8 million, or 81%, from $835.7 million at December 31, 2019 to $1.5 billion at December 31, 2020. Non-interest bearing and interest-bearing checking accounts contributed the most to the deposit growth with increases of $215.5 million and $211.7 million, respectively. The Company acquired checking accounts from the merger with MNB and also added accounts in the Lehigh Valley after the merger. Expectations are that customers preferred to keep money in their checking accounts during this uncertain economic climate and did not spend as much as normal due to business and travel restrictions. Of the growth in non-interest bearing checking accounts, $116.8 million was new accounts in the Lehigh Valley. The remaining growth of over $98 million was primarily due to an increase in existing business and personal deposit account balances. The increase in interest-bearing checking accounts included $121.1 million in new deposits from the Lehigh Valley. The remaining increase of over $90 million was primarily due to seasonal tax cycles, business activity and relief from the CARES Act. Money market accounts increased $160.2 million, $97.7 million of which was added from the Lehigh Valley, and the remainder was mostly due to higher balances of personal and business accounts and shifts from other types of deposit accounts. The Company focuses on obtaining a full-banking relationship with existing customers as well as forming new customer relationships. Savings accounts increased $74.8 million due to $53.4 million in accounts added in the Lehigh Valley and also an increase in personal account balances. The Company will continue to execute on its relationship development strategy, explore the demographics within its marketplace and develop creative programs for its customers. For 2021, the Company expects deposit growth to fund asset growth with expansion in the new Lehigh Valley market and the pending acquisition of Landmark. During the first half of 2021, management expects an increase in personal deposit balances from the third round of economic impact payments being distributed to customers. When pandemic-related restrictions are lifted, the Company anticipates personal spending to increase and therefore average deposit balances to decline. Seasonal public deposit fluctuations are expected to remain volatile and at times may partially offset this deposit growth.
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Additionally, CDs also increased $11.6 million with $42.3 million from accounts in the Lehigh Valley partially offset by runoff as rates dropped during 2020 and promos reached maturity. The Company will continue to pursue strategies to grow and retain retail and business customers with an emphasis on deepening and broadening existing and creating new relationships.
The Company uses the Certificate of Deposit Account Registry Service (CDARS) reciprocal program and Insured Cash Sweep (ICS) reciprocal program to obtain FDIC insurance protection for customers who have large deposits that at times may exceed the FDIC maximum insured amount of $250,000. In the CDARS program, deposits with varying terms and interest rates, originated in the Company’s own markets, are exchanged for deposits of other financial institutions that are members in the CDARS network. By placing the deposits in other participating institutions, the deposits of our customers are fully insured by the FDIC. In return for deposits placed with network institutions, the Company receives from network institutions deposits that are approximately equal in amount and are comprised of terms similar to those placed for our customers. Deposits the Company receives from other institutions are considered reciprocal deposits by regulatory definitions. The Company did not have any CDARs as of December 31, 2020 and 2019. As of December 31, 2020 and 2019, ICS reciprocal deposits represented $46.2 million and $19.7 million, or 3% and 2%, of total deposits which are included in interest-bearing checking accounts in the table above. The $26.5 million increase in ICS deposits is primarily due to public funds deposit transfers from other interest-bearing checking accounts to ICS accounts.
The maturity distribution of certificates of deposit at December 31, 2020 is as follows:
More than More than More
Three months three months six months to than twelve
(dollars in thousands) or less to six months twelve months months Total
There is a remaining time deposit premium of $42 thousand that will be amortized into income on a level yield amortization method over the contractual life of the deposits that is not included in the table above.
Approximately 70% of the CDs, with a weighted-average interest rate of 0.90%, are scheduled to mature in 2021 and an additional 21%, with a weighted-average interest rate of 0.75%, are scheduled to mature in 2022. Renewing CDs are currently expected to re-price to lower market rates depending on the rate on the maturing CD, the pace and direction of interest rate movements, the shape of the yield curve, competition, the rate profile of the maturing accounts and depositor preference for alternative, non-term products. The Company plans to address repricing CDs in the ordinary course of business on a relationship basis and is prepared to match rates when prudent to maintain relationships. Growth in CD accounts is challenged by the current and expected rate environment and clients’ preference for short-term rates, as well as aggressive competitor rates. The Company is not currently offering any CD promotions but may resume promotions in the future. The Company will consider the needs of the customers and simultaneously be mindful of the liquidity levels, borrowing rates and the interest rate sensitivity exposure of the Company.
Short-term borrowings
Borrowings are used as a complement to deposit generation as an alternative funding source whereby the Company will borrow under advances from the FHLB of Pittsburgh and other correspondent banks for asset growth and liquidity needs.
The components of short-term borrowings are as follows:
As of December 31,
Overnight borrowings $ - $ 37,839
Short-term borrowings may include overnight balances with FHLB line of credit and/or correspondent bank’s federal funds lines which the Company may require to fund daily liquidity needs such as deposit outflow, loan demand and operations. Short-term borrowings decreased $37.8 million during 2020 as a result of deposit growth. The Company does not expect to have short-term borrowings in 2021.
Information with respect to the Company’s short-term borrowing’s maximum and average outstanding balances and interest rates are contained in Note 8, “Short-term Borrowings,” of the notes to consolidated financial statements incorporated by reference in Part II, Item 8.
FHLB advances
During 2020, the Company paid off $10.0 million in FHLB advances with a weighted average interest rate of 2.97%. During the second quarter of 2020, the Company acquired $7.6 million of FHLB advances from the merger that was subsequently
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paid off. At December 31, 2019, the Company had $15.0 million in FHLB advances with a weighted average interest rate of 3.01%. As of December 31, 2020, the Company had the ability to borrow an additional $428.7 million from the FHLB.
Funds Deployed:
Investment Securities
The Company’s investment policy is designed to complement its lending activities, provide monthly cash flow, manage interest rate sensitivity and generate a favorable return without incurring excessive interest rate and credit risk while managing liquidity at acceptable levels. In establishing investment strategies, the Company considers its business, growth strategies or restructuring plans, the economic environment, the interest rate sensitivity position, the types of securities in its portfolio, permissible purchases, credit quality, maturity and re-pricing terms, call or average-life intervals and investment concentrations. The Company’s policy prescribes permissible investment categories that meet the policy standards and management is responsible for structuring and executing the specific investment purchases within these policy parameters. Management buys and sells investment securities from time-to-time depending on market conditions, business trends, liquidity needs, capital levels and structuring strategies. Investment security purchases provide a way to quickly invest excess liquidity in order to generate additional earnings. The Company generally earns a positive interest spread by assuming interest rate risk using deposits or borrowings to purchase securities with longer maturities.
At the time of purchase, management classifies investment securities into one of three categories: trading, available-for-sale (AFS) or held-to-maturity (HTM). To date, management has not purchased any securities for trading purposes. All of the securities the Company purchases are classified as AFS even though there is no immediate intent to sell them. The AFS designation affords management the flexibility to sell securities and position the balance sheet in response to capital levels, liquidity needs or changes in market conditions. Debt securities AFS are carried at fair value on the consolidated balance sheets with unrealized gains and losses, net of deferred income taxes, reported separately within shareholders’ equity as a component of accumulated other comprehensive income (AOCI). Securities designated as HTM are carried at amortized cost and represent debt securities that the Company has the ability and intent to hold until maturity.
As of December 31, 2020, the carrying value of investment securities amounted to $392.4 million, or 23% of total assets, compared to $185.1 million, or 18% of total assets, at December 31, 2019. On December 31, 2020, 38% of the carrying value of the investment portfolio was comprised of U.S. Government Sponsored Enterprise residential mortgage-backed securities (MBS – GSE residential or mortgage-backed securities) that amortize and provide monthly cash flow that the Company can use for reinvestment, loan demand, unexpected deposit outflow, facility expansion or operations.
Investment securities were comprised of AFS securities as of December 31, 2020 and 2019. The AFS securities were recorded with a net unrealized gain of $11.3 million and a net unrealized gain of $4.5 million as of December 31, 2020 and 2019, respectively. Of the net improvement in the unrealized gain position of $6.8 million, $4.5 million was net unrealized gains on municipal securities, $2.2 million was net unrealized gains on mortgages-backed securities and $0.1 million was net unrealized gains on agency securities. The direction and magnitude of the change in value of the Company’s investment portfolio is attributable to the direction and magnitude of the change in interest rates along the treasury yield curve. Generally, the values of debt securities move in the opposite direction of the changes in interest rates. As interest rates along the treasury yield curve decline, especially at the intermediate and long end, the values of debt securities tend to rise. Whether or not the value of the Company’s investment portfolio will continue to rise above its amortized cost will be largely dependent on the direction and magnitude of interest rate movements and the duration of the debt securities within the Company’s investment portfolio. When interest rates rise, the market values of the Company’s debt securities portfolio could be subject to market value declines.
As of December 31, 2020, the Company had $278.4 million in public deposits, or 18% of total deposits. Pennsylvania state law requires the Company to maintain pledged securities on these public deposits or otherwise obtain a FHLB letter of credit or FDIC insurance for these customers. As of December 31, 2020, the balance of pledged securities required for deposit accounts was $270.4 million, or 69% of total securities.
Quarterly, management performs a review of the investment portfolio to determine the causes of declines in the fair value of each security. The Company uses inputs provided by independent third parties to determine the fair value of its investment securities portfolio. Inputs provided by the third parties are reviewed and corroborated by management. Evaluations of the causes of the unrealized losses are performed to determine whether impairment exists and whether the impairment is temporary or other-than-temporary. Considerations such as the Company’s intent and ability to hold the securities until or sell prior to maturity, recoverability of the invested amounts over the intended holding period, the length of time and the severity in pricing decline below cost, the interest rate environment, the receipt of amounts contractually due and whether or not there is an active market for the securities, for example, are applied, along with an analysis of the financial condition of the issuer for management to make a realistic judgment of the probability that the Company will be unable to collect all amounts (principal and interest) due in determining whether a security is other-than-temporarily impaired. If a decline in value is deemed to be other-than-temporary, the amortized cost of the security is reduced by the credit impairment amount and a corresponding charge to current earnings is recognized. During the year ended December 31, 2020, the Company did not incur other-than-temporary impairment charges from its investment securities portfolio.
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During 2020, the carrying value of total investments increased $207.3 million, or 112%. The Company acquired securities with a fair value of $123.4 million as a result of the merger with MNB on May 1, 2020. The Company immediately sold $107.4 million of these securities. During the second quarter of 2020, the Company implemented an investment strategy to redeploy the acquired portfolio that was liquidated on May 1, 2020. The re-investment strategy was completed in the third quarter of 2020. The Company attempts to maintain a well-diversified and proportionate investment portfolio that is structured to complement the strategic direction of the Company. Its growth typically supplements the lending activities but also considers the current and forecasted economic conditions, the Company’s liquidity needs and interest rate risk profile.
A comparison of total investment securities as of December 31 follows:
(dollars in thousands) Amount % Amount %
As of December 31, 2020, there were no investments from any one issuer with an aggregate book value that exceeded 10% of the Company’s shareholders’ equity.
The distribution of debt securities by stated maturity and tax-equivalent yield at December 31, 2020 are as follows:
More than More than More than
One year or less one year to five years five years to ten years ten years Total
(dollars in thousands) $ % $ % $ % $ % $ %
In the above table, the book yields on nontaxable state & municipal subdivisions were adjusted to a tax-equivalent basis using the corporate federal tax rate of 21%. In addition, average yields on securities AFS are based on amortized cost and do not reflect unrealized gains or losses.
Restricted investments in bank stock
Investment in Federal Home Loan Bank (FHLB) stock is required for membership in the organization and is carried at cost since there is no market value available. The amount the Company is required to invest is dependent upon the relative size of outstanding borrowings the Company has with the FHLB of Pittsburgh. Excess stock is repurchased from the Company at par if the amount of borrowings decline to a predetermined level. In addition, the Company earns a return or dividend based on the amount invested. Atlantic Community Bankers Bank (ACBB) stock totaling $45 thousand was acquired from the merger with MNB. The dividends received from the FHLB totaled $203 thousand and $343 thousand for the years ended December 31, 2020 and 2019, respectively. The balance in FHLB and ACBB stock was $2.8 million and $4.4 million as of December 31, 2020 and 2019, respectively.
Loans and leases
As of December 31, 2020, the Company had gross loans and leases totaling $1.1 billion compared to $754 million at December 31, 2019, an increase of $366 million, or 49%.
The increase resulted primarily from $210 million in loans acquired from the merger with MNB and $130 million in loans, net of deferred fees, originated under the PPP primarily during the second quarter 2020 that were still outstanding at year-end.
As of December 31, 2020, Company-originated loans, excluding the PPP loans, totaled $781 million compared with $754 million as of December 31, 2019, an increase of $27 million, or 4%, primarily in the residential real estate loan held-for-investment portfolio, resulting from loan modifications to refinance existing loans at market rates to qualified customers.
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A comparison of loan originations, net of participations is as follows for the periods indicated:
(dollars in thousands) Amount Amount
Loans:
Lines of credit:
Commercial and industrial and commercial real estate
As of December 31, 2020, the commercial loan portfolio totaled $663 million and consisted of commercial and industrial (C&I) and commercial real estate (CRE) loans. Company-originated loans totaled $502 million and acquired loans from MNB totaled $161 million. As of December 31, 2019, the commercial loan portfolio totaled $358 million. and therefore, loans originated by the Company experienced a $144 million, or 40%, year-over-year increase.
Company-originated loans, net of fees, excluding $130 million in PPP loans, which were recorded as C&I loans, increased $14 million, or 4%, from $358 million as of December 31, 2019 to $372 million as of December 31, 2020.
This increase resulted primarily from the origination of a $7.2 million C&I loan and $6.5 million CRE loan during the fourth quarter.
Paycheck Protection Program Loans
The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, was signed into law on March 27, 2020, and provided over $2.0 trillion in emergency economic relief to individuals and businesses impacted by the COVID-19 pandemic. The CARES Act authorized the Small Business Administration (SBA) to temporarily guarantee loans under a new 7(a) loan program called the PPP.
As a qualified SBA lender, the Company was automatically authorized to originate PPP loans. An eligible business can apply for a PPP loan up to the greater of: (1) 2.5 times its average monthly payroll costs, or (2) $10.0 million. PPP loans have: (a) an interest rate of 1.0%; (b) a two-year loan term to maturity for loans originated before June 5th and a five-year maturity for loans originated beginning on June 5th; and (c) principal and interest payments deferred for six months from the date of disbursement. The SBA guaranteed 100% of the PPP loans made to eligible borrowers. The entire principal amount of the borrowers’ PPP loan, including any accrued interest, is eligible to be reduced by the loan forgiveness amount under the PPP, so long as the employer maintains or quickly rehires employees and maintains salary levels and 60% of the loan proceeds are used for payroll expenses, with the remaining 40% of the loan proceeds used for other qualifying expenses.
During the second and third quarter, the Company originated 1,551 loans totaling $159 million under the Paycheck Protection Program, and during the fourth quarter, the Company began the process of submitting PPP forgiveness applications to the SBA. As of December 31, 2020, the remaining principal balance of these loans was $132 million as the Company received full and partial forgiveness totaling $27 million, or 17% of the balance originated.
As a PPP lender, the Company received fee income of approximately $5.6 million. The Company recognized $3.3 million of PPP fee income during the second, third, and fourth quarters of 2020 with the remaining amount to be recognized in future quarters. Unearned fees attributed to PPP loans net of fees paid to referral sources, as prescribed by the SBA under the PPP program, was $2.2 million as of December 31, 2020.
The PPP loans originated by size were as follows as of December 31, 2020:
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As part of the Economic Relief Act, which became law on December 27, 2020, an additional $284 billion was allocated to a reauthorized and revised PPP. On January 19, 2021, the Company began processing and originating PPP loans, and through February 28, 2021, the Company has originated 699 loans totaling $65.9 million with expected fee income of $3.4 million.
Consumer
As of December 31, 2020, the consumer loan portfolio totaled $216 million and consisted of home equity installment, home equity line of credit, auto, direct finance leases and other consumer loans. Company-originated loans totaled $205 million and acquired loans from MNB totaled $11 million. As of December 31, 2019, the consumer loan portfolio totaled $212 million. The $4 million, or 2%, increase in the consumer loan portfolio was due to the MNB acquisition.
Net of MNB-acquired loans, company-originated loans decreased by $7 million, or 3%. This reduction in company-originated consumer loans was primarily the result of net runoff in the auto loan portfolio, the result of COVID-19’s impact on car sales during the second and third quarters of 2020.
Residential
As of December 31, 2020, the residential loan portfolio totaled $242 million and consisted primarily of held-for-investment residential loans for primary residences. Company-originated loans totaled $204 million and acquired loans from MNB totaled $38 million. As of December 31, 2019, the residential loan portfolio totaled $185 million. The $57 million, or 31%, increase in the residential loan portfolio was primarily due to the MNB acquisition.
Net of MNB-acquired loans, Company-originated loans increased by $19 million, or 10%, mainly due to $29 million in 145 mortgage modifications to refinance existing loans at market rates to qualified customers.
The Company’s service team is experienced, knowledgeable, and dedicated to servicing the community and its clients. The Company will continue to provide products and services that benefit our clients as well as the community which is very important to our success. There is much uncertainty regarding the effects COVID-19 may have on demand for loans and leases. The Company has been proactively trying to reach out to customers to understand their needs during this crisis.
A comparison of loans and related percentage of gross loans, at December 31, for the five previous periods is as follows:
(dollars in thousands) Amount % Amount % Amount % Amount %
Originated Acquired Total
Commercial real estate:
Consumer:
Residential:
Less:
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(dollars in thousands) Amount % Amount % Amount %
Commercial real estate:
Consumer:
Residential:
Less:
*Management reclassified $2.5 million which had been included in non-owner occupied commercial real estate during the second and third quarter of 2020 to owner occupied commercial real estate during the fourth quarter of 2020.
The following table sets forth the maturity distribution of select components of the loan portfolio at December 31, 2020. Excluded from the table are residential real estate and consumer loans:
More than
One year one year to More than
(dollars in thousands) or less five years five years Total
Commercial real estate construction * 10,231 - - 10,231
Residential real estate construction * 23,357 - - 23,357
*In the table above, both residential and CRE construction loans are included in the one year or less category since, by their nature, these loans are converted into residential and CRE loans within one year from the date the real estate construction loan was consummated. Upon conversion, the residential and CRE loans would normally mature after five years.
The following table sets forth the total amount of C&I and CRE loans due after one year which have predetermined interest rates (fixed) and floating or adjustable interest rates (variable) as of December 31, 2020:
One to five More than
(dollars in thousands) years five years Total
Non-refundable fees and costs associated with all loan originations are deferred. Using either the interest method or straight-line amortization, the deferral is released as credits or charges to loan interest income over the life of the loan.
There are no concentrations of loans or customers to several borrowers engaged in similar industries exceeding 10% of total loans that are not otherwise disclosed as a category in the tables above. There are no concentrations of loans that, if resulted in a loss, would have a material adverse effect on the business of the Company. The Company’s loan portfolio does not have a material concentration within a single industry or group of related industries or customers that is vulnerable to the risk of a near-term severe negative business impact. As of December 31, 2020, approximately 66% of the gross loan portfolio was secured by real estate compared to 67% at December 31, 2019 and 66% at December 31, 2018.
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The Company considers its portfolio segmentation, including the real estate secured portfolio, to be normal and reasonably diversified. The banking industry is affected by general economic conditions including, among other things, the effects of real estate values. The Company ensures that its mortgage lending adheres to standards of secondary market compliance. Furthermore, the Company’s credit function strives to mitigate the negative impact of economic conditions by maintaining strict underwriting principles for all loan types.
Loans held-for-sale
Upon origination, most residential mortgages and certain Small Business Administration (SBA) guaranteed loans may be classified as held-for-sale (HFS). In the event of market rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market. In declining interest rate environments, the Company would be exposed to prepayment risk as rates on fixed-rate loans decrease, and customers look to refinance loans. Consideration is given to the Company’s current liquidity position and projected future liquidity needs. To better manage prepayment and interest rate risk, loans that meet these conditions may be classified as HFS. Occasionally, residential mortgage and/or other nonmortgage loans may be transferred from the loan portfolio to HFS. The carrying value of loans HFS is based on the lower of cost or estimated fair value. If the fair values of these loans decline below their original cost, the difference is written down and charged to current earnings. Subsequent appreciation in the portfolio is credited to current earnings but only to the extent of previous write-downs.
As of December 31, 2020 and 2019, loans HFS consisted of residential mortgages with carrying amounts of $29.8 million and $1.6 million, respectively, which approximated their fair values. During the year ended December 31, 2020, residential mortgage loans with principal balances of $155.1 million were sold into the secondary market and the Company recognized net gains of $3.5 million, compared to $52.4 million and $0.8 million, respectively, during the year ended December 31, 2019. During the year ended December 31, 2020, the Company also sold one SBA guaranteed loan with a principal balance of $0.6 million and recognized a net gain of $93 thousand compared to two SBA guaranteed loans with principal balances of $0.3 million and recognized a net gain on the sale of $34 thousand during the year ended December 31, 2019.
The Company retains mortgage servicing rights (MSRs) on loans sold into the secondary market. MSRs are retained so that the Company can foster personal relationships. At December 31, 2020 and 2019, the servicing portfolio balance of sold residential mortgage loans was $366.5 million and $302.3 million, respectively, with mortgage servicing rights of $1.3 million and $1.0 million for the same periods, respectively.
Allowance for loan losses
Management evaluates the credit quality of the Company’s loan portfolio and performs a formal review of the adequacy of the allowance for loan losses (allowance) on a quarterly basis. The allowance reflects management’s best estimate of the amount of credit losses in the loan portfolio. Management’s judgment is based on the evaluation of individual loans, experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans. Those estimates may be susceptible to significant change. The provision for loan losses represents the amount necessary to maintain an appropriate allowance. Loan losses are charged directly against the allowance when loans are deemed to be uncollectible. Recoveries from previously charged-off loans are added to the allowance when received.
Management applies two primary components during the loan review process to determine proper allowance levels. The two components are a specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated. The methodology to analyze the adequacy of the allowance for loan losses is as follows:
identification of specific impaired loans by loan category;
calculation of specific allowances where required for the impaired loans based on collateral and other objective and quantifiable evidence;
determination of loans with similar credit characteristics within each class of the loan portfolio segment and eliminating the impaired loans;
application of historical loss percentages (trailing twelve-quarter average) to pools to determine the allowance allocation;
application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio, regulations, and/or current economic conditions.
A key element of the methodology to determine the allowance is the Company’s credit risk evaluation process, which includes credit risk grading of individual commercial loans. Commercial loans are assigned credit risk grades based on the Company’s assessment of conditions that affect the borrower’s ability to meet its contractual obligations under the loan agreement. That process includes reviewing borrowers’ current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower. Upon review, the commercial loan credit risk grade is revised or reaffirmed. The credit risk grades may be changed at any time management determines an upgrade or downgrade may be warranted. The credit risk grades for the commercial loan portfolio are considered in the reserve methodology and loss factors are applied based upon the credit risk grades. The loss factors applied are based upon the Company’s historical experience as well as what management believes to be best practices and within common industry
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standards. Historical experience reveals there is a direct correlation between the credit risk grades and loan charge-offs. The changes in allocations in the commercial loan portfolio from period-to-period are based upon the credit risk grading system and from periodic reviews of the loan portfolio.
Acquired loans are initially recorded at their acquisition date fair values with no carryover of the existing related allowance for loan losses. Fair values are based on a discounted cash flow methodology that involves assumptions and judgements as to credit risk, expected lifetime losses, environmental factors, collateral values, discount rates, expected payments and expected prepayments. Upon acquisition, in accordance with GAAP, the Company has individually determined whether each acquired loan is within the scope of ASC 310-30. These loans are deemed purchased credit impaired loans and the excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount and is recognized into interest income over the remaining life of the loan. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non accretable discount.
Acquired ASC 310-20 loans, which are loans that did not meet the criteria of ASC 310-30, were pooled into groups of similar loans based on various factors including borrower type, loan purpose, and collateral type. These loans are initially recorded at fair value and include credit and interest rate marks associated with purchase accounting adjustments. Purchase premiums or discounts are subsequently amortized as an adjustment to yield over the estimated contractual lives of the loans. There is no allowance for loan losses established at the acquisition date for acquired performing loans. An allowance for loan losses is recorded for any credit deterioration in these loans after acquisition. As of December 31, 2020, no allowance was recorded for credit deterioration in acquired loans.
Each quarter, management performs an assessment of the allowance for loan losses. The Company’s Special Assets Committee meets quarterly, and the applicable lenders discuss each relationship under review and reach a consensus on the appropriate estimated loss amount, if applicable, based on current accounting guidance. The Special Assets Committee’s focus is on ensuring the pertinent facts are considered regarding not only loans considered for specific reserves, but also the collectability of loans that may be past due. The assessment process also includes the review of all loans on non-accrual status as well as a review of certain loans to which the lenders or the Credit Administration function have assigned a criticized or classified risk rating.
The following table sets forth the activity in the allowance for loan losses and certain key ratios for the periods indicated:
Charge-offs:
Recoveries:
Residential 197 8 - - -
Loans 90 days or more past due and accruing $ 61 $ - $ 1 $ 6 $ 19
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For the year ended December 31, 2020, the allowance increased $4.5 million, or 46%, to $14.2 million from $9.7 million at December 31, 2019 due to provisioning of $5.3 million partially offset by $0.8 million in net charge-offs.
For the year ended December 31, 2020, total loans, which represent gross loans less unearned lease revenue, increased $366 million, or 49%, to $1.1 billion compared to $753 million at December 31, 2019.
The increase in the loan portfolio resulted primarily from $210 million in loans, net of deferred costs, acquired in the merger with MNB and $130 million in loans originated under the PPP, net of deferred fees, primarily during the second quarter 2020.
Loans acquired from the MNB merger (performing and non-performing) were initially recorded at their acquisition-date fair values. Because there is no initial credit valuation allowance recorded under this method, the Company establishes a post-acquisition allowance of loan losses to record losses which may subsequently arise on the acquired loans. Since no deterioration was noted for any such loans following acquisition, no allowance for loan and lease losses was provided at this time.
PPP loans made to eligible borrowers have a 100% SBA guarantee. Given this guarantee, no allowance for loan and lease losses was recorded for these loans.
For the year ended December 31, 2020, the loan portfolio increased by 49% while the allowance for loan losses increased by 46% during the same period. This caused the allowance for loan and lease losses to decrease slightly as a percentage of total loans to 1.27% from 1.29% at December 31, 2019. Loan growth exceeded allowance for loan and lease losses growth because $340 million in loans, or 30% of the loan portfolio, included loans acquired from the MNB merger and PPP loans.
As of December 31, 2020, the loan portfolio, net of PPP loans and MNB acquired loans, totaled $780 million, an increase of $27 million, or 4%, from $754 million as of December 31, 2019.
Management believes that the current balance in the allowance for loan losses is sufficient to meet the identified potential credit quality issues that may arise and other issues unidentified but inherent to the portfolio. Potential problem loans are those where there is known information that leads management to believe repayment of principal and/or interest is in jeopardy and the loans are currently neither on non-accrual status nor past due 90 days or more.
During the first quarter of 2020, management increased the qualitative factors associated with its commercial, consumer, and residential portfolios related to potential adverse changes in both the volume and severity of past due and non-accrual loans along with national and local economic conditions as a result of the COVID-19 pandemic. A statewide shutdown of non-essential business activity was ordered on March 16th in Pennsylvania. General economic reports and data indicate a recession with elevated unemployment and sustained low inflation. The duration and severity of the recession or the ultimate path of the recovery was not known at that point.
During the second quarter of 2020, management increased the qualitative factors associated with its loan portfolio, despite the decrease in the Company-originated loan portfolio, to recognize higher inherent risk characteristics for loans that were deemed to have greater exposure to the economic impact of the COVID-19 pandemic. These characteristics included loans that received forbearance of any kind (see COVID-19 Accommodations in this section below), loans that were in high risk industries, and loans that had prior delinquency of over 60 days. High risk industries include hotel accommodations, food service, energy, recreation, certain parts of the transportation segment, and other service industries. The duration and severity of the recession or the ultimate path of the recovery remained uncertain.
During the third quarter of 2020, management increased the qualitative factors associated with its loan portfolio by estimating higher inherent risk characteristics for loans that received second, COVID-related deferrals. Management further modeled the potential impact on the existing loan portfolio given the potential negative impact to the local economy given a lack of further COVID-related fiscal stimulus.
During the fourth quarter of 2020, management increased the qualitative factors associated with its loan portfolio by estimating higher inherent risk characteristics for loans that received COVID-related deferrals during the fourth quarter (both first time and additional deferrals). Management further modeled the potential impact on the existing loan portfolio given the prolonged duration of the COVID-19 pandemic and the associated restrictions, with a greater relative increase in qualitative factors to the commercial portfolio compared to the residential and consumer portfolios.
Management will continue to monitor the potential for increased risk exposure due to the adverse economic impact of a prolonged COVID-19 pandemic. Should the duration and/or severity of the pandemic’s economic impact increase, management will take measures commensurate with the then observed risk to increase the provision for loan losses and, by extension, the allowance for loan and lease losses as appropriate.
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The allocation of net charge-offs among major categories of loans are as follows for the periods indicated:
% of Total % of Total
Net Net
(dollars in thousands) 2020 Charge-offs 2019 Charge-offs
Net charge-offs
Commercial and industrial $ (346) 43 % $ (152) 14 %
For the year ended December 31, 2020, net charge-offs against the allowance totaled $0.8 million compared with $1.1 million for the year ended December 31, 2019, representing a $0.3 million, or 27%, decrease. The decrease was attributed to a $0.2 million recovery during the first quarter of 2020 in the form of a reimbursement from the Federal National Mortgage Association (“FNMA”) for previously sold mortgages charged-off during the third quarter of 2019. Excluding this recovery, net charge-offs for the year ended December 31, 2020 would have shown an improvement, decreasing by $0.1 million, or 9%, over the prior year.
For a discussion on the provision for loan losses, see the “Provision for loan losses,” located in the results of operations section of management’s discussion and analysis contained herein.
The allowance for loan losses can generally absorb losses throughout the loan portfolio. However, in some instances an allocation is made for specific loans or groups of loans. Allocation of the allowance for loan losses for different categories of loans is based on the methodology used by the Company, as previously explained. The changes in the allocations from period-to-period are based upon quarter-end reviews of the loan portfolio.
Allocation of the allowance among major categories of loans for the periods indicated, as well as the percentage of loans in each category to total loans, is summarized in the following table. This table should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or proportions, or that the allocation indicates future charge-off trends. When present, the portion of the allowance designated as unallocated is within the Company’s guidelines:
Category Category Category Category Category
% of % of % of % of % of
Category
The allocation of the allowance for the commercial loan portfolio, which is comprised of CRE and C&I loans, accounted for approximately 62% of the total allowance for loan losses at December 31, 2020, which represents a six percentage point increase from 56% of the total allowance for loan losses at December 31, 2019 and a seven percentage point increase from the 55% of the total allowance for loan and lease losses at December 31, 2018.
The increase in the allowance allocated to the commercial portfolio was attributed to the recognition of increased inherent risk due to the economic impact of the COVID-19 pandemic.
The allocation of the allowance for the consumer loan portfolio, accounted for approximately 18% of the total allowance for loan losses at December 31, 2020, which represents a three percentage point decrease from 21% of the total allowance for loan losses at December 31, 2019 and a eight percentage point decrease from 26% of the total allowance for loan losses at December 31, 2018.
The decrease in the allowance allocated to the consumer loan portfolio was attributed to the relative decrease in the percentage of consumer loans in the portfolio.
The allocation of the allowance for the residential real estate portfolio, accounted for approximately 20% of the total allowance for loan losses at December 31, 2020, which represents a three percentage point decrease from 23% of the total allowance for loan losses at December 31, 2019 and a one percentage point increase from 19% of the total allowance for loan losses at December 31, 2018.
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The year-over-year decrease in the allowance allocated to the residential real estate portfolio was attributed to the relative decrease in the percentage of residential loans in the portfolio.
The unallocated amount represents the portion of the allowance not specifically identified with a loan or groups of loans. The unallocated reserve was less than 1% of the total allowance for loan losses at December 31, 2020, unchanged from less than 1% of the total allowance for loan losses at December 31, 2019 and December 31, 2018.
Non-performing assets
The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, troubled debt restructurings (TDRs), other real estate owned (ORE) and repossessed assets.
The following table sets forth non-performing assets at December 31:
Loans past due 90 days or more and accruing $ 61 $ - $ 1 $ 6 $ 19
* In the table above, the amount includes non-accrual TDRs of $0.7 million, $0.6 million, $1.7 million, $1.6 million and $1.5 million as of 2020, 2019, 2018, 2017 and 2016, respectively.
In the review of loans for both delinquency and collateral sufficiency, management concluded that there were several loans that lacked the ability to repay in accordance with contractual terms. The decision to place loans on non-accrual status is made on an individual basis after considering factors pertaining to each specific loan. Generally, commercial loans are placed on non-accrual status when management has determined that payment of all contractual principal and interest is in doubt or the loan is past due 90 days or more as to principal and interest, unless well-secured and in the process of collection. Consumer loans secured by residential real estate and residential mortgage loans are placed on non-accrual status at 90 days past due as to principal and interest, and unsecured consumer loans are charged-off when the loan is 90 days or more past due as to principal and interest. Uncollected interest income accrued on all loans placed on non-accrual is reversed and charged to interest income.
Non-performing assets represented 0.39% of total assets at December 31, 2020 compared with 0.50% at December 31, 2019. The year-over-year improvement in the non-performing assets ratio was the result of the $690 million, or 68%, increase in total assets to $1.7 billion at December 31, 2020 outpacing the $1.7 million, or 32%, increase in non-performing assets.
As of December 31, 2020, non-performing assets increased to $6.7 million from $5.0 million at December 31, 2019. The $1.7 million year-over-year increase resulted from a $1.6 million increase in accruing TDRs and a $0.1 million increase in non-accrual loans.
From December 31, 2019 to December 31, 2020, non-accrual loans increased $0.1 million, or 3%, from $3.7 million to $3.8 million. At December 31, 2020, there were a total of 46 loans to 38 unrelated borrowers with balances that ranged from less than $1 thousand to $0.5 million. At December 31, 2019, there were a total of 44 loans to 34 unrelated borrowers with balances that ranged from less than $1 thousand to $0.5 million. The $0.1 million increase in non-accrual loans was the result of $2.9 million in new non-accruals, $0.2 million in expenses added to balances, $1.7 million in payments, $0.8 million in charge-offs and $0.5 million in transfers to ORE.
There were two direct finance leases totaling $61 thousand that were over 90 days past due as of December 31, 2020 compared to no loans over 90 days past due as of December 31, 2019. The Company seeks payments from all past due customers through an aggressive customer communication process. A past due loan will be placed on non-accrual at the 90-day point when it is deemed that a customer is non-responsive and uncooperative to collection efforts.
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The composition of non-performing loans as of December 31, 2020 is as follows:
Past due
Gross 90 days or Non- Total non- % of
loan more and accrual performing gross
(dollars in thousands) balances still accruing loans loans loans
Commercial real estate:
Construction 10,231 - - - -
Consumer:
Residential:
Construction 23,357 - - - -
Loans held-for-sale 29,786 - - - -
*Net of unearned lease revenue of $1.2 million.
Payments received from non-accrual loans are recognized on a cost recovery method. Payments are first applied to the outstanding principal balance, then to the recovery of any charged-off loan amounts. Any excess is treated as a recovery of interest income. If the non-accrual loans that were outstanding as of December 31, 2020 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $186 thousand.
The following tables set forth the activity in accruing and non-accruing TDRs as of the period indicated:
As of and for the year ended December 31, 2020
Accruing Non-accruing
Commercial Commercial Commercial Commercial Consumer
Troubled Debt Restructures:
Pay downs / payoffs - (20) (8) - - (28)
Charge offs - - (99) - - (99)
Number of loans - 8 2 2 - 12
As of and for the year ended December 31, 2019
Accruing Non-accruing
Commercial Commercial Commercial Residential Consumer
Troubled Debt Restructures:
Number of loans - 6 2 - - 8
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The Company, on a regular basis, reviews changes to loans to determine if they meet the definition of a TDR. TDRs arise when a borrower experiences financial difficulty and the Company grants a concession that it would not otherwise grant based on current underwriting standards in order to maximize the Company’s recovery.
Consistent with Section 4013 and the Revised Statement of Section 4013 of the CARES Act, specifically “Temporary Relief From Troubled Debt Restructurings”, the Company approved requests by borrowers to modify loan terms and defer principal and/or interest payment for loans. U.S. GAAP permits the temporary suspension of TDR determination defined under ASC 310-40 provided that such modifications are made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief. This includes short-term (i.e. six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or delays in payment that are insignificant. Borrowers considered current for purposes of Section 4013 are those that are less than 30 days past due on their contractual payments at the time the modification program is implemented.
From December 31, 2019 to December 31, 2020, TDRs increased $1.7 million, or 108%, due to two loans totaling $1.6 million to a single commercial borrower modified during the third quarter being designated as TDRs and two loans totaling $0.2 million to a single commercial borrower modified during the fourth quarter being designated as TDRs. At December 31, 2019, there were a total of 8 TDRs by 7 unrelated borrowers with balances that ranged from $80 thousand to $0.5 million. At December 31, 2020, there were a total of 12 TDRs by 9 unrelated borrowers with balances that ranged from $5 thousand to $1.3 million.
Loans modified in a TDR may or may not be placed on non-accrual status. At December 31, 2020, there were four TDRs totaling $0.7 million that were on non-accrual status compared to two TDRs totaling $0.6 million at December 31, 2019.
Beginning the week of March 16, 2020, the Company began receiving requests for temporary modifications to the repayment structure for borrower loans. Modification terms included interest only or full payment deferral for up to 6 months. As of December 31, 2020, the Company had 10 temporary modifications with principal balances totaling $2.2 million outstanding, which included 5 additional deferral requests for temporary forbearance modifications totaling $0.7 million and 7 first requests for temporary forbearance modifications totaling $1.5 million.
Details with respect to the actual loan modifications are as follows:
Commercial Purpose 7 Up to 6 months $ 2,155 1.4%
Consumer Purpose 3 Up to 6 months 51 0.0%
The following table provides information with respect to the Company’s commercial COVID-19 accommodations by sector at December 31, 2020.
(dollars in thousands) Count Balance Percentage of Tier 1 Capital
Accommodation and Food Services 1 298 0.2%
Real Estate Rental and Leasing 2 304 0.2%
Finance and Insurance 2 113 0.1%
Total commercial accommodations 7 $ 2,155 1.4%
The global pandemic referred to as COVID-19 has created many impediments to loan production relative to the measures taken to slow the spread. These measures have put a large strain on a wide variety of industries within the global economy generally, and the Company’s market specifically. The overall economic impact and effect of the measures is yet to be fully understood as its effects will most likely lag while businesses and governments inject resources to help lessen the impact. Despite efforts to lessen the impact, it is the Company’s current belief that the pandemic will temporarily, or in some cases permanently, damage our borrower’s ability to repay loans and comply with terms.
Foreclosedassets held-for-sale
From December 31, 2019 to December 31, 2020, foreclosed assets held-for-sale (ORE) declined from $349 thousand to $256 thousand, a $93 thousand, or 27%, decrease. Two properties to two unrelated borrowers for $338 thousand were added during the second quarter and eight properties to four unrelated borrowers for $432 thousand were added during the third quarter. Two properties were sold for $250 thousand during the first quarter, two properties were sold for $281 thousand during the second quarter, one property securing one loan was sold for $14 thousand during the third quarter, and two properties were sold for $37 thousand in the fourth quarter. The Company also sold one of two properties securing one loan for $142
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thousand and two of four properties securing another loan relationship for $82 thousand in the third quarter, and one of four properties securing one loan relationship for $20 thousand in fourth quarter. Further, one foreclosed asset was written down by $14 thousand to fair market value in the third quarter and one foreclosed asset was written down by $22 thousand to fair market value in the fourth quarter.
The following table sets forth the activity in the ORE component of foreclosed assets held-for-sale:
(dollars in thousands) Amount # Amount #
Balance at beginning of period $ 349 7 $ 190 6
Pay downs (1) (18)
Write downs (36) (82)
As of December 31, 2020, ORE consisted of six properties securing loans to six unrelated borrowers totaling $256 thousand. Four properties ($223 thousand) to four unrelated borrowers were added in 2020; one property ($32 thousand) was added in 2019; one property ($1 thousand) was added in 2017. Of the six properties, one property is under agreement of sale, three properties are listed for sale, and two properties are in the process of being sold.
As of December 31, 2020, the Company had no other repossessed assets held-for-sale compared to two other repossessed assets held-for-sale, with a balance of $20 thousand as of December 31, 2019.
Cash surrender value of bank owned life insurance
The Company maintains bank owned life insurance (BOLI) for a chosen group of employees at the time of purchase, namely its officers, where the Company is the owner and sole beneficiary of the policies. BOLI is classified as a non-interest earning asset. Increases in the cash surrender value are recorded as components of non-interest income. The BOLI is profitable from the appreciation of the cash surrender values of the pool of insurance and its tax-free advantage to the Company. This profitability is used to offset a portion of current and future employee benefit costs. In March 2019, the Company invested $2.0 million in additional BOLI as a source of funding for additional life insurance benefits that provides for payments upon death for officers and employee benefit expenses related to the Company’s non-qualified SERP implemented for certain executive officers. In December 2020, the Company invested in $6 million in BOLI and $5 million in BOLI with annuity rider investments. The BOLI can be liquidated if necessary, with associated tax costs. However, the Company intends to hold this pool of insurance, because it provides income that enhances the Company’s capital position. Therefore, the Company has not provided for deferred income taxes on the earnings from the increase in cash surrender value.
Premises and equipment
Net of depreciation, premises and equipment increased $6.1 million during 2020. Additions of $1.6 million and assets acquired from the merger of $6.9 million were partially offset by $1.9 million of depreciation expense in 2020. The Company is expects to begin branch remodeling and corporate center planning which may increase construction in process by approximately $2.5 million in 2021. On December 23, 2020, the Commonwealth of Pennsylvania authorized the release of $2.0 million in Redevelopment Assistance Capital Program (RACP) funding for the Company’s headquarters project in Lackawanna County. Although the Company accepted the grant, funds will not be available until a final project is selected and certain requirements are met.
Other assets
During 2020, the $1.2 million, or 26%, increase in other assets was due mostly to $0.6 million higher prepaid expenses, $0.4 million in additional miscellaneous receivable and $0.3 million increase in mortgage servicing rights partially offset by $0.4 million lower prepaid dealer reserve.
Results of Operation
Earnings Summary
The Company’s earnings depend primarily on net interest income. Net interest income is the difference between interest income and interest expense. Interest income is generated from yields earned on interest-earning assets, which consist principally of loans and investment securities. Interest expense is incurred from rates paid on interest-bearing liabilities, which consist of deposits and borrowings. Net interest income is determined by the Company’s interest rate spread (the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Interest rate spread is significantly impacted
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by: changes in interest rates and market yield curves and their related impact on cash flows; the composition and characteristics of interest-earning assets and interest-bearing liabilities; differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them and by the competition in the marketplace.
The Company’s earnings are also affected by the level of its non-interest income and expenses and by the provisions for loan losses and income taxes. Non-interest income mainly consists of: service charges on the Company’s loan and deposit products; interchange fees; trust and asset management service fees; increases in the cash surrender value of the bank owned life insurance and from net gains or losses from sales of loans and securities. Non-interest expense consists of: compensation and related employee benefit costs; occupancy; equipment; data processing; advertising and marketing; FDIC insurance premiums; professional fees; loan collection; net other real estate owned (ORE) expenses; supplies and other operating overhead.
Net interest income, net interest rate margin, net interest rate spread and the efficiency ratio are presented in the MD&A on a fully-taxable equivalent (FTE) basis. The Company believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.
Overview
For the year ended December 31, 2020, the Company generated net income of $13.0 million, or $2.82 per diluted share, compared to $11.6 million, or $3.03 per diluted share, for the year ended December 31, 2019. The $1.4 million, or 13%, increase in net income stemmed from $12.5 million more net interest income and $4.5 million in additional non-interest income which more than offset a $11.4 million rise in non-interest expenses and $4.2 million higher provision for loan losses. The increase in non-interest expenses was driven by merger-related expenses incurred in connection with the acquisition of MNB along with the impact of adding the operations of MNB.
For the year ended December 31, 2020, return on average assets (ROA) and return on average shareholders’ equity (ROE) were 0.87% and 9.06%, respectively, compared to 1.18% and 11.49% for the same period in 2019. The decrease in ROA and ROE was the result of net income growing at a slower pace than average assets and equity during 2020.
Net interest income and interest sensitive assets / liabilities
Net interest income (FTE) increased $12.8 million, or 39%, from $32.5 million for the year ended December 31, 2019 to $45.3 million for the year ended December 31, 2020, due to interest income increasing more rapidly than interest expense. Total average interest-earning assets increased $449.2 million while the FTE yields earned on these assets declined 65 basis points resulting in $10.6 million of growth in FTE interest income. The loan portfolio drove this growth due to average balance growth of $287.2 million which had the effect of producing $9.8 million of FTE interest income. In the investment portfolio, an increase in the average balances of municipal securities was the biggest driver of interest income growth. The average balance of total securities grew $89.0 million producing $0.9 million in additional FTE interest income despite a decrease of 70 basis points in yields earned on investments. On the liability side, total interest-bearing liabilities grew $318.8 million on average with a 58 basis point decrease in rates paid on these interest-bearing liabilities. Growth in average interest-bearing deposits of $312.4 million was offset by the effect of a 48 basis point reduction in rates paid on these deposits lowering interest expense by $1.4 million. In addition, lower rates paid on average borrowings in 2020 compared to 2019 resulted in $0.8 million less interest expense.
The FTE net interest rate spread and margin decreased by 7 and 22 basis points, respectively, for the year ended December 31, 2020 compared to the year ended December 31, 2019. The yields earned on interest-earning assets declined faster than the rates paid on interest-bearing liabilities causing the decline in net interest rate spread. The overall cost of funds, which includes the impact of non-interest bearing deposits, decreased 47 basis points for the year ended December 31, 2020 compared to the same period in 2019. The primary reason for the decline was the reduction in rates paid on deposits and borrowings.