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, 2021 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
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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, 2021. 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, 2021 and 2020 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, 2021, 2020, 2019 and 2018 compared to 34% at December 31, 2017.
The following table reconciles the non-GAAP financial measures of FTE net interest income:
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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)
The following tables 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, 2021
and 2020 and Results of Operations for each of the Years then Ended
Executive Summary
The Company generated $24.0 million in net income in 2021, or $4.48 diluted earnings per share, up $11.0 million, or 84%, from $13.0 million, or $2.82 diluted earnings per share, in 2020. In 2021, our larger and well diversified balance sheet from organic and inorganic growth contributed to the success of our earnings performance. Federal Open Market Committee (FOMC) officials dropped the federal funds rate down to 0%-0.25% during the first quarter of 2020 at the start of the pandemic where it remained through 2021. The Company expects the fed funds rate to begin to rise in 2022. The 2022 focus is to manage net interest income through a rising forecasted rate cycle by controlling loan pricing and deposit costs to maintain a reasonable spread. From a financial condition and performance perspective, our mission for 2022 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.
Nationally, the unemployment rate fell from 6.7% at December 31, 2020 to 3.9% at December 31, 2021. The unemployment rates in the Scranton - Wilkes-Barre - Hazleton and the Allentown – Bethlehem - Easton Metropolitan Statistical Areas (local) decreased but 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, 2021 were 4.8% and 4.0%, respectively, a decrease of 3.2 and 2.6 percentage points from the 8.0% and 6.6%, respectively, at December 31, 2020. The national and local unemployment rates have decreased as a result of the improving economic environment. The pandemic-related business restrictions have been lifted in our local area and employees started heading back to work. Stimulus payments and enhanced unemployment benefits have supported the economy throughout 2020 and 2021 and it is uncertain if the government could continue to provide this support in the future. The median home values in the Scranton-Wilkes-Barre-Hazleton metro and Allentown-Bethlehem-Easton metro each increased 20.4% and 17.9% 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 18.2% and 17.3% in the next year. In light of these expectations, we are uncertain if real estate values could continue to increase at these levels with the pending rising rate environment, however we will continue to monitor the economic climate in our region and scrutinize growth prospects with credit quality as a principal consideration. The Company remains committed to selectively expanding branch banking and wealth management locations in Northeastern and Eastern Pennsylvania as opportunities arrive going forward.
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 July 1, 2021, the Company completed its previously announced acquisition of Landmark Bancorp, Inc. (“Landmark”). Non-recurring costs to facilitate the merger and integrate systems of $3.0 million were incurred during 2021.
Non-recurring merger-related costs and a FHLB prepayment penalty incurred during 2021 and 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, 2021 and 2020 would have been $26.8 million and $15.4 million, respectively. Adjusted diluted EPS (non-GAAP) would have been $5.00 and $3.34 for the years ended December 31, 2021 and 2020. For the same time periods, adjusted ROA (non-GAAP) would have been 1.27% and 1.03%, respectively, and adjusted ROE (non-GAAP) would have been 14.18% and 10.73%, respectively.
For the years ended December 31, 2021 and 2020, tangible common book value per share (non-GAAP) was $33.68 and $31.72, respectively, an increase of 6.2%. 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 2021, the Company’s assets grew by 42% primarily from assets acquired from the merger with Landmark and additional growth in deposits, which were used to fund growth in the loan and security portfolios. In 2022, we expect total loans to increase despite paydowns as loans issued under the U.S. Small Business Administration Paycheck Protection Program (“PPP”) are forgiven. The increase in the loan portfolio is expected to be funded 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. The cash flow from these securities will provide liquidity to reinvest. No short-term or FHLB borrowings are expected in 2022.
Non-performing assets represented 0.27% of total assets as of December 31, 2021, down from 0.39% at the prior year end. Non-performing assets to total assets was lower during 2021 mostly due to the amount (or dollar value) of non-performing assets decreasing while there was growth in total assets.
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
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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.
For the near-term, we expect to operate in a rising interest rate environment. The Company’s balance sheet is positioned to improve its net interest income performance, but increases in yields may not keep pace with higher cost of funds which may compress net interest spread and margin. The Company expects net interest margin to decline for 2022. Expectations are for short-term rates to increase throughout 2022, which could cause deposit rate pricing to increase.
Financial Condition
Consolidated assets increased $719.6 million, or 42%, to $2.4 billion as of December 31, 2021 from $1.7 billion at December 31, 2020. The increase in assets occurred primarily from assets acquired in the merger with Landmark and deposit inflow. The asset growth was funded by utilizing growth in deposits of $660.4 million.
The following table is a comparison of condensed balance sheet data as of December 31:
(dollars in thousands)
Liabilities:
Secured borrowings 10,620 0.4 - - - -
Short-term borrowings - - - - 37,839 3.7
A comparison of net changes in selected balance sheet categories as of December 31, are as follows:
Earning Other 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.
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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 23 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 $660.4 million, or 44%, from $1.5 billion at December 31, 2020 to $2.2 billion at December 31, 2021. Non-interest bearing and interest-bearing checking accounts contributed the most to the deposit growth with increases of $182.8 million and $276.7 million, respectively. The growth in non-interest bearing checking accounts was primarily due to accounts acquired from the Landmark merger supplemented by business and personal account growth. The increase in interest-bearing checking accounts was primarily due to accounts from the Landmark merger, seasonal tax cycles, business activity, federal pandemic relief funds and shifts from maturing CDs. Money market accounts also increased $134.8 million, mostly due to acquired Landmark accounts, 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 checking account customers as well as forming new customer relationships. Savings accounts increased $55.1 million due to accounts added from the Landmark merger 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 2022, the Company expects deposit growth to fund asset growth. Seasonal public deposit fluctuations are expected to remain volatile and at times may partially offset future deposit growth.
Additionally, CDs also increased $11.0 million due to CDs acquired from the merger with Landmark. Otherwise, CD balances continue to decline as rates dropped during 2020 and 2021 and previous years' promotional CDs reached maturity. Of the balance of outstanding CDs at December 31, 2021, $70.8 million, or 51%, had a balance at December 31, 2020. The majority of the remaining maturing CD balances were transferred to transactional accounts primarily interest-bearing checking and money market accounts. During the third quarter of 2021, $12.0 million in CDs from one public customer was transferred to an interest-bearing checking account. 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. The Company did not have any CDARs as of December 31, 2021 and 2020. As of December 31, 2021 and 2020, ICS reciprocal deposits represented $27.6 million and $46.2 million, or 1% and 3%, of total deposits which are included in interest-bearing checking accounts in the table above. The $18.6 million decrease in ICS deposits is primarily due to public funds deposit transfers from ICS accounts to other interest-bearing checking accounts partially offset by ICS accounts acquired from Landmark.
As of December 31, 2021, total uninsured deposits were estimated to be $919.3 million. The estimate of uninsured deposits is based on the same methodologies and assumptions used for regulatory reporting requirements. The Company aggregates deposit products by taxpayer identification number and classifies into ownership categories to determine amounts over the FDIC insurance limit.
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The maturity distribution of certificates of deposit that meet or exceed the FDIC limit, by account, at December 31, 2021 is as follows:
(dollars in thousands)
Three months or less $ 4,688
More than three months to six months 3,715
More than six months to twelve months 11,641
More than twelve months 2,908
There is a remaining purchase accounting time deposit discount of $2 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 76% of the CDs, with a weighted-average interest rate of 0.33%, are scheduled to mature in 2022 and an additional 14%, with a weighted-average interest rate of 0.50%, are scheduled to mature in 2023. 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.
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. There were no short-term borrowings as of December 31, 2021 and 2020 as growth in deposits funded asset growth. The Company does not expect to have short-term borrowings in 2022. As of December 31, 2021, the Company had the ability to borrow $91.7 million from the Federal Reserve borrower-in-custody program and $31.0 million from lines of credit with correspondent banks.
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.
Secured borrowings
As of December 31, 2021, the Company had secured borrowings with a fair value of $10.6 million related to certain sold loan participations that did not qualify for sales treatment acquired from Landmark. Secured borrowings are expected to decrease in 2022 from scheduled amortization and, when possible, early pay-offs.
FHLB advances
The Company had no FHLB advances as of December 31, 2021. During the first quarter of 2021, the Company paid off $5 million in FHLB advances with a weighted average interest rate of 3.07%. During the third quarter of 2021, the Company acquired $4.5 million in FHLB advances from the Landmark merger that was subsequently paid off. As of December 31, 2021, the Company had the ability to borrow an additional $568.9 million from the FHLB. The Company does not expect to have any FHLB advances in 2022.
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
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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, 2021, the carrying value of investment securities amounted to $739.0 million, or 31% of total assets, compared to $392.4 million, or 23% of total assets, at December 31, 2020. On December 31, 2021, 35% 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. The mortgage-backed securities portfolio includes only pass-through bonds issued by Fannie Mae, Freddie Mac and the Government National Mortgage Association (GNMA).
The Company’s municipal (obligations of states and political subdivisions) portfolio is comprised of tax-free municipal bonds with a book value of $267.5 million and taxable municipal bonds with a book value of $93.2 million. The overall credit ratings of these municipal bonds was as follows: 36% AAA, 62% AA, 1% A and 1% escrowed.
During 2021, the carrying value of total investments increased $346.6 million, or 88%. Purchases for the year totaled $411.4 million, while maturities and principal reductions totaled $54.2 million and proceeds from sales were $44.5 million. The purchases were funded principally by cash flow generated from the portfolio and excess overnight liquidity. The growth in the investment portfolio was due to the increase in low earning cash that was used to purchase higher yielding securities. As a result of the acquisition of Landmark, the Company acquired $49.4 million in securities of which $16.5 million was retained and the remaining securities were liquidated and reinvested. 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:
The investment securities portfolio contained no private label mortgage-backed securities, collateralized mortgage obligations, collateralized debt obligations, or trust preferred securities, and no off-balance sheet derivatives were in use. The portfolio had no adjustable-rate instruments as of December 31, 2021 and 2020.
Investment securities were comprised of AFS securities as of December 31, 2021 and 2020. The AFS securities were recorded with a net unrealized gain of $0.2 million and a net unrealized gain of $11.3 million as of December 31, 2021 and 2020, respectively. Of the net decline in the unrealized gain position of $11.1 million: $3.3 million was attributable to municipal securities; $5.1 million was attributable to mortgage-backed securities and $2.7 million was attributable to 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 rise, especially at the intermediate and long end, the values of debt securities tend to decline. Whether or not the value of the Company’s investment portfolio will change above or below 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. Management does not consider the reduction in value attributable to changes in credit quality. Correspondingly, when interest rates decline, the market values of the Company’s debt securities portfolio could be subject to market value increases.
As of December 31, 2021, the Company had $417.8 million in public deposits, or 19% 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
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or FDIC insurance for these customers. As of December 31, 2021, the balance of pledged securities required for public and trust deposits was $394.3 million, or 53% 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, 2021, the Company did not incur other-than-temporary impairment charges from its investment securities portfolio.
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 totaled $82 thousand and $45 thousand as of December 31, 2021 and 2020. ACBB stock totaling $37 thousand was acquired from the merger with Landmark in 2021. The dividends received from the FHLB totaled $130 thousand and $203 thousand for the years ended December 31, 2021 and 2020, respectively. The balance in FHLB and ACBB stock was $3.2 million and $2.8 million as of December 31, 2021 and 2020, respectively.
Loans and leases
As of December 31, 2021, the Company had gross loans and leases, including originated and acquired loans and leases, totaling $1.4 billion compared to $1.1 billion at December 31, 2020, an increase of $314 million, or 28%.
Growth in the portfolio was attributed to a $118 million, or 13%, increase in the originated portfolio and a $196 million, or 93%, increase in the acquired portfolio. Growth in the originated portfolio was primarily attributed to the $83 million increase in the commercial real estate portfolio, resulting from the origination of several large commercial real estate loans during 2021, and the $95 million increase in the residential portfolio, stemming from the strength of the housing market in the Company’s service area and the low interest rate environment along with management’s decision to retain a greater percentage of potentially saleable mortgages. Growth in the acquired portfolio was attributed to the $299 million in loans added to the Company’s balance sheet from the Landmark merger, which closed in the third quarter of 2021.
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 originations decreased by $70 million, or 35%, to $129 million in 2021. This occurred because the Company recorded PPP loans in the commercial and industrial category. PPP loan originations decreased from $159 million in 2020 to $77 million in 2021.
Commercial and industrial (C&I) and commercial real estate (CRE)
As of December 31, 2021, the commercial loan portfolio increased by $156 million, or 24%, to $819 million over the
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December 31, 2020 balance of $663 million due to $145 million in growth in the acquired portfolio and $11 million in growth in the originated portfolio. Excluding the $98 million reduction in originated PPP loans (net of deferred fees) during the twelve months ended December 31, 2021, the originated commercial portfolio grew $110 million due to the origination of several large CRE loans during the year along with increased overall lending activity due to the Company’s larger size and market area.
The commercial loan portfolio consisted of $513 million in originated loans, including $32 million in originated PPP loans, and $306 million in loans acquired from MNB and Landmark, including $8 million in acquired PPP loans, as of December 31, 2021.
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 Paycheck Protection Program (PPP).
As a qualified SBA lender, the Company was automatically authorized to originate PPP loans, and during the second and third quarter of 2020, the Company originated 1,551 loans totaling $159 million under the Paycheck Protection Program.
Under the PPP, the entire principal amount of the borrower’s loan, including any accrued interest, is eligible to be reduced by the loan forgiveness amount, 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.
As part of the Economic Relief Act, which became law on December 27, 2020, an additional $284 billion of federal resources was allocated to a reauthorized and revised PPP. On January 19, 2021, the Company began processing and originating PPP loans for this second round, which subsequently ended on May 31, 2021, and during this round, the Company originated 1,022 loans totaling $77 million.
Beginning in the fourth quarter of 2020 and continuing during 2021, the Company submitted PPP forgiveness applications to the SBA, and through December 31, 2021, the Company received forgiveness or paydowns of $203 million, or 86%, of the original PPP loan balances of $236 million with $176 million occurring during the twelve months ended December 31, 2021.
As a PPP lender, the Company received fee income of approximately $9.9 million with $8.7 million recognized to date, including $3.3 million of PPP fee income recognized during 2020 and $5.4 million recognized during 2021. Unearned fees attributed to PPP loans, net of $0.1 million in fees paid to referral sources as prescribed by the SBA under the PPP, were $1.2 million as of December 31, 2021.
The PPP loans originated by size were as follows as of December 31, 2021:
The table above does not include the $20.3 million in PPP loans acquired because of the merger with Landmark during the third quarter of 2021. As of December 31, 2021, the balance of outstanding acquired PPP loans was $7.9 million.
Consumer
The consumer loan portfolio consisted of home equity installment, home equity line of credit, automobile, direct finance leases and other consumer loans.
As of December 31, 2021, the consumer loan portfolio increased by $39 million, or 18%, to $255 million compared to the December 31, 2020 balance of $216 million, due to $27 million in growth in the acquired portfolio, primarily automobile, related to the Landmark merger and $12 million in growth in the originated portfolio, specifically from the home equity line of credit and direct finance lease portfolios.
Residential
As of December 31, 2021, the residential loan portfolio increased by $119 million, or 49%, to $361 million compared to the December 31, 2020 balance of $242 million. For the twelve months ended December 31, 2021, $25 million in was attributed to loans acquired in the Landmark merger and $94 million in growth originated mainly in the Company’s service area spurred by a historically low interest rate environment, strong demand for residential loans and management’s decision to retain potentially saleable mortgages.
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The residential loan portfolio consisted primarily of held-for-investment residential loans for primary residences. Originated loans totaled $298 million and acquired loans totaled $63 million as of December 31, 2021 compared to originated loans of $204 million and acquired loans of $38 million as of December 31, 2020.
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 %
Commercial real estate:
Consumer:
Residential:
Less:
(dollars in thousands) Amount % Amount % Amount %
Commercial real estate:
Consumer:
Residential:
Less:
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The following table sets forth the maturity distribution of select commercial and construction components of the loan portfolio at December 31, 2021. The determination of maturities is based on contractual terms. Non-contractual rollovers or extensions are included in one year or less category of the maturity classification. Excluded from the table are residential real estate and consumer loans:
More than More than
One year one year to five years to More than
(dollars in thousands) or less five years fifteen years fifteen years Total
Commercial real estate construction * 21,147 - - - 21,147
Residential real estate construction * 34,919 - - - 34,919
*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, 2021:
One to five Five to Over
(dollars in thousands) years fifteen years fifteen 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, 2021, approximately 75% of the gross loan portfolio was secured by real estate compared to 66% at December 31, 2020 and 67% at December 31, 2019.
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, 2021 and 2020, loans HFS consisted of residential mortgages with carrying amounts of $31.7 million and $29.8 million, respectively, which approximated their fair values. During the year ended December 31, 2021, residential mortgage loans with principal balances of $159.8 million were sold into the secondary market and the Company recognized net gains of $4.1 million, compared to $155.1 million and $3.5 million, respectively, during the year ended December 31, 2020. During the year ended December 31, 2021, the Company also sold one SBA guaranteed loan with a principal balance of $0.2 million and recognized a net gain of $24 thousand compared to one SBA guaranteed loan with a principal balance of $0.6 million and recognized a net gain on the sale of $93 thousand during the year ended December 31, 2020.
During 2021, management decided to hold mortgages HFS longer to earn interest income. Management completed a $13 million transfer of mortgages HFS to the held-for-investment portfolio during the first quarter of 2022.
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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, 2021 and 2020, the servicing portfolio balance of sold residential mortgage loans was $430.9 million and $366.5 million, respectively, with mortgage servicing rights of $1.7 million and $1.3 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; and
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 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.
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.
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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 $ 64 $ 61 $ - $ 1 $ 6
For the twelve months ended December 31, 2021, the allowance increased $1.4 million, or 10%, to $15.6 million from $14.2 million at December 31, 2020 due to provisioning of $2.0 million partially offset by $0.6 million in net charge-offs. The allowance for loan and lease losses decreased as a percentage of total loans to 1.09% from 1.27% at December 31, 2020 as the growth in the loan portfolio (28%) outpaced the growth in the allowance for loan losses (10%) during the same period.
Loans acquired from the Merchants and Landmark mergers (performing and non-performing) were initially recorded at their acquisition-date fair values. Since there is no initial credit valuation allowance recorded under this method, the Company establishes a post-acquisition allowance for loan losses to record losses which may subsequently arise on the acquired loans.
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.
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 2021, management increased the qualitative factors associated with its commercial, consumer, and residential portfolios related to the rise in rates that occurred during the quarter, and the adverse impact that these increased rates are anticipated to have on estimated credit losses.
During the second quarter of 2021, management increased the qualitative factors associated with its commercial & industrial portfolio related to the rising delinquency observed during this period, which was on a worsening trend on both a quarter-over-quarter and year-over-year basis.
During the third quarter of 2021, management reduced the qualitative factors associated with its commercial, consumer, and residential portfolios related to the improvement in the economic environment compared to the prior period, which was attributed to the improving key risk indicators used in the analysis including national unemployment rate, personal consumer expenditures, industrial production and consumer sentiment.
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During the fourth quarter of 2021, management reduced the qualitative factors associated with its commercial, consumer, and residential portfolios related to the sustained, low level of delinquency in these portfolios observed during the year and improvement compared to the year earlier period. Management also reduced the qualitative factors associated with its commercial portfolio related to the improvement in the key risk indicators used in the analysis including national unemployment rate, personal consumer expenditures, and industrial production.
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) 2021 Charge-offs 2020 Charge-offs
Net charge-offs
Commercial and industrial $ (107) 18 % $ (346) 43 %
For the twelve months ended December 31, 2021, net charge-offs against the allowance totaled $578 thousand compared with net charge-offs of $795 thousand for the twelve months ended December 31, 2020, representing a $217 thousand, or 27%, decrease. This decrease was attributed to general economic improvement and continued high levels of liquidity for the Company’s customers.
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
As of December 31, 2021, the commercial loan portfolio, consisting of CRE and C&I loans, comprised 62% of the total allowance for loan losses compared with 62% on December 31, 2020. The commercial loan allowance allocation remained unchanged, and higher than the commercial loan allocation, due to the greater inherent risk in this portfolio.
As of December 31, 2021, the consumer loan portfolio comprised 15% of the total allowance for loan losses compared with 18% on December 31, 2020. The 3-percentage point decrease in the consumer loan allowance allocation was the result of the relative reduction in this loan category, which declined from 19% as of December 31, 2020 to 18% as of December 31, 2021.
As of December 31, 2021, the residential loan portfolio comprised 22% of the total allowance for loan losses compared with 19% on December 31, 2020. The 3-percentage point increase was the result of the relative increase in this loan category, which increased from 22% as of December 31, 2020 to 25% as of December 31, 2021.
As of December 31, 2021, the unallocated reserve, representing the portion of the allowance not specifically identified with a loan or groups of loans, less than 1% of the total allowance for loan losses compared with less than 1% of the total allowance for loan losses on December 31, 2020.
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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 $ 64 $ 61 $ - $ 1 $ 6
* In the table above, the amount includes non-accrual TDRs of $0.6 million, $0.7 million, $0.6 million, $1.7 million and $1.6 million as of 2021, 2020, 2019, 2018 and 2017, respectively.
Management routinely reviews the loan portfolio to identify loans that are either delinquent or are otherwise deemed by management unable to repay in accordance with contractual terms. Generally, loans of all types are placed on non-accrual status if a loan of any type is past due 90 or more days or if collection of principal and interest is in doubt. Further, unsecured consumer loans are charged-off when the principal and/or interest is 90 days or more past due. Uncollected interest income accrued on all loans placed on non-accrual is reversed and charged to interest income.
Non-performing assets represented 0.27% of total assets at December 31, 2021 compared with 0.39% at December 31, 2020 with the improvement resulting from the $0.2 million, or 3%, decrease in non-performing assets, specifically non-accrual loans, coupled with the $720 million, or 42%, increase in total assets to $2.4 billion at December 31, 2021.
From December 31, 2020 to December 31, 2021, non-accrual loans declined $0.8 million, or 21%, from $3.8 million to $3.0 million. The $0.8 million decline in non-accrual loans was the result of $1.3 million in payments, $0.7 million in charge-offs, $0.2 million in moves to ORE, and $0.2 million in moves back to accrual offset by $1.6 million in additions. At December 31, 2021, there were a total of 31 loans to 28 unrelated borrowers with balances that ranged from less than $1 thousand to $0.7 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.
There were two direct finance leases totaling $64 thousand that were over 90 days past due as of December 31, 2021 compared to two direct finance leases totaling $61 thousand that were over 90 days past due as of December 31, 2020. The delinquent direct finance leases are fully guaranteed under a formal recourse agreement with the originating auto dealer and were in process of orderly collection.
The Company seeks payments from all past due customers through an aggressive customer communication process. Unless well-secured and in the process of collection, past due loans 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, 2021 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 21,147 - - - -
Consumer:
Home equity installment 47,571 - - - -
Residential:
Construction 34,919 - - - -
Loans held-for-sale 31,727 - - - -
*Net of unearned lease revenue of $1.4 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, 2021 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $169 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, 2021
Accruing Non-accruing
Commercial Commercial Commercial
(dollars in thousands) real estate real estate & industrial Total
Troubled Debt Restructures:
Charge offs - - (65) (65)
As of and for the year ended December 31, 2020
Accruing Non-accruing
Commercial Commercial Commercial
(dollars in thousands) real estate real estate & industrial Total
Troubled Debt Restructures:
Pay downs / payoffs (20) (8) - (28)
Charge offs - (99) - (99)
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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 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, 2020 to December 31, 2021, TDRs increased $0.3 million, or 10%, primarily due to the addition of a $0.5 million commercial real estate TDR in the fourth quarter offset by paydowns of $0.1 million and charge-offs for two non-accrual commercial real estate TDRs to a single borrower totaling $0.1 million. At December 31, 2020, there were a total of 12 TDRs by 9 unrelated borrowers with balances that ranged from $1 thousand to $1.3 million, and at December 31, 2021, there were a total of 11 TDRs by 8 unrelated borrowers with balances that ranged from $50 thousand to $1.3 million.
Loans modified in a TDR may or may not be placed on non-accrual status. At December 31, 2021, there were three TDRs totaling $0.6 million that were on non-accrual status compared to four TDRs totaling $0.7 million at December 31, 2020.
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, 2021, the Company had no COVID-related modifications outstanding. Although contractual payments have returned to normal, residual impacts on borrowers’ ability to repay due to the COVID-19 pandemic may persist.
Foreclosedassets held-for-sale
From December 31, 2020 to December 31, 2021, foreclosed assets held-for-sale (ORE) increased from $256 thousand to $435 thousand, a $179 thousand increase, which was primarily attributed to one $236 thousand ORE property that was added during the first quarter of 2021.
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 $ 256 6 $ 349 7
Pay downs - (1)
Write downs (16) (36)
As of December 31, 2021, ORE consisted of five properties securing loans to five unrelated borrowers totaling $435 thousand. Four properties ($434 thousand) to four unrelated borrowers were added in 2021 and one property ($1 thousand) was added in 2017. Of the five properties, three properties are under agreement of sale and two properties are listed for sale.
As of December 31, 2021 and December 31, 2020, the Company had no other repossessed assets held-for-sale.
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 $6 million in BOLI and $5 million in BOLI with taxable annuity rider investments. As a result of the Landmark acquisition, the Company acquired $7.2 million in BOLI during the third quarter of 2021. The BOLI cash surrender value build-up 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
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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 $1.7 million during 2021. The Company added $3.4 million in fixed assets from the Landmark merger and purchased $2.2 million in fixed assets throughout 2021. These increases were partially offset by $2.2 million in depreciation expense and $1.5 million in transfers to other assets held-for-sale. The Company expects to begin branch remodeling and corporate headquarters planning which may increase construction in process and is evaluating its branch network looking for consolidation that makes sense for more efficient operations. 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. On December 2, 2021, the Company announced it would be receiving an additional $2.0 million in RACP funding in support of the project. Although the Company was awarded the grants, funds will not be available until a final project is selected and certain requirements are met.
Other assets
During 2021, the $3.2 million, or 57%, increase in other assets was due mostly to a $3.1 million increase in deferred tax assets primarily from the reduction in unrealized gains in the investment portfolio.
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 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, 2021, the Company generated net income of $24.0 million, or $4.48 per diluted share, compared to $13.0 million, or $2.82 per diluted share, for the year ended December 31, 2020. The $11.0 million, or 84%, increase in net income stemmed from $17.6 million more net interest income, $3.6 million in additional non-interest income and $3.3 million lower provision for loan losses which more than offset an $11.8 million rise in non-interest expenses and $1.7 million higher provision for income taxes.
For the year ended December 31, 2021, return on average assets (ROA) and return on average shareholders’ equity (ROE) were 1.13% and 12.69%, respectively, compared to 0.87% and 9.06% for the same period in 2020. The increase in ROA and ROE was the result of the growth in net income relative to the increase in average assets and equity during 2021.
Net interest income and interest sensitive assets / liabilities
Net interest income (FTE) increased $18.7 million, or 41%, from $45.3 million for the year ended December 31, 2020 to $64.0 million for the year ended December 31, 2021, due to the higher interest income and lower interest expense. Total average interest-earning assets increased $607.3 million while the FTE yields earned on these assets declined 27 basis points resulting in $17.0 million of growth in FTE interest income. The loan portfolio contributed the most to this growth due to average balance growth of $280.6 million which had the effect of producing $12.2 million more FTE interest income, including $2.0 million in additional fees earned under the Paycheck Protection Program (PPP). In the investment portfolio, an increase in the average balances of municipal securities was the biggest driver of interest income growth. The average
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balance of total securities grew $291.1 million producing $4.8 million in additional FTE interest income despite a decrease of 44 basis points in yields earned on investments. On the liability side, total interest-bearing liabilities grew $392.7 million in average balances with a 27 basis point decrease in rates paid on these interest-bearing liabilities. Growth in average interest-bearing deposits of $442.4 million was offset by the effect of a 26 basis point reduction in rates paid on these deposits lowering interest expense by $1.3 million. In addition, the Company utilized $49.7 million less in average borrowings in 2021 compared to 2020 resulting in $0.4 million less interest expense from borrowings.
The FTE net interest rate spread was unchanged at 3.16% for the years ended December 31, 2021 and 2020. The FTE net interest rate margin decreased by 7 basis points, respectively, for the year ended December 31, 2021 compared to the year ended December 31, 2020. The yields earned on interest-earning assets declined at the same pace as the decline in the rates paid on interest-bearing liabilities causing the net interest rate spread to remain flat. The decrease in net interest rate margin was due to the higher average balance of interest-bearing cash. The overall cost of funds, which includes the impact of non-interest bearing deposits, decreased 21 basis points for the year ended December 31, 2021 compared to the same period in 2020. The primary reason for the decline was the reduction in rates paid on deposits coupled with the increased average balances of non-interest bearing deposits.
For 2022, the Company expects to operate in a rising interest rate environment. A rate environment with rising interest rates positions the Company to improve its interest income performance from new and maturing earning assets. Until there is a sustained period of yield curve steepening, with rates rising more sharply at the long end, the interest rate margin may experience compression. However for 2022, the Company anticipates net interest income to improve as growth in interest-earning assets would help mitigate an adverse impact of rate movements on cost of funds. The FOMC began easing the federal funds rate during the second half of 2019 and continued through the first quarter of 2020 which reduced rates paid on interest-bearing liabilities. On the asset side, the prime interest rate, the benchmark rate that banks use as a base rate for adjustable rate loans was cut 75 basis points in the second half of 2019 and another 150 basis points in the first quarter of 2020. Consensus economic forecasts are predicting gradual increases in short-term rates throughout 2022. The 2022 focus is to manage net interest income after years of a low interest rate environment through a rising forecasted rate cycle by maintaining a reasonable spread. Interest income and interest expense are both projected to increase for 2022. Continued growth in the loan portfolios complemented with investment security growth is expected to boost interest income, and when coupled with a proactive relationship approach to deposit cost setting strategies should help mitigate spread compression and contain the interest rate margin from further reductions below acceptable levels.
The Company’s cost of interest-bearing liabilities was 0.26% for the year ended December 31, 2021, or 27 basis points lower than the cost for the year ended December 31, 2020. The decrease in interest paid on both deposits and borrowings contributed to the lower cost of interest-bearing liabilities. The FOMC is expected to increase the federal funds rate which could cause rates paid on deposits to rise from the current low levels. To help mitigate the impact of the imminent change to the economic landscape, the Company has successfully developed and will continue to strengthen its association with existing customers, develop new business relationships, generate new loan volumes, and retain and generate higher levels of average non-interest bearing deposit balances. Strategically deploying no- and low-cost deposits into interest earning-assets is an effective margin-preserving strategy that the Company expects to continue to pursue and expand to help stabilize net interest margin.
The Company’s Asset Liability Management (ALM) team meets regularly to discuss among other things, interest rate risk and when deemed necessary adjusts interest rates. ALM is actively addressing the Company's sensitivity to a declining rate environment to ensure interest rate risks are contained within acceptable levels. ALM also discusses revenue enhancing strategies to help combat the potential for a decline in net interest income. The Company’s marketing department, together with ALM, lenders and deposit gatherers, continue to develop prudent strategies that will grow the loan portfolio and accumulate low-cost deposits to improve net interest income performance.
The table that follows sets forth a comparison of average balances of assets and liabilities and their related net tax equivalent yields and rates for the years indicated. Within the table, interest income was FTE adjusted, using the corporate federal tax rate of 21% for 2021, 2020 and 2019, to recognize the income from tax-exempt interest-earning assets as if the interest was taxable. See “Non-GAAP Financial Measures” within this management’s discussion and analysis for the FTE adjustments. This treatment allows a uniform comparison among yields on interest-earning assets. Loans include loans held-for-sale (HFS) and non-accrual loans but exclude the allowance for loan losses. HELOC are included in the residential real estate category since they are secured by real estate. Net deferred loan fee/(cost) accretion/amortization of $3.8 million in 2021, $2.1 million in 2020 and ($0.7 million) in 2019, respectively, are included in interest income from loans. MNB and Landmark loan fair value purchase accounting adjustments of $3.0 million and $0.6 million are included in interest income from loans and $72 thousand and $213 thousand reduced interest expense on deposits for 2021 and 2020. Average balances are based on amortized cost and do not reflect net unrealized gains or losses. Residual values for direct finance leases are included in the average balances for consumer loans. Net interest margin is calculated by dividing net interest income-FTE by total average interest-earning assets. Cost of funds includes the effect of average non-interest bearing deposits as a funding source:
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Average Yield / Average Yield / Average Yield /
Assets balance Interest rate balance Interest rate balance Interest rate
Interest-earning assets
Investments:
Loans and leases:
Liabilities and shareholders' equity
Interest-bearing liabilities
Deposits:
Changes in net interest income are a function of both changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities. The following table presents the extent to which changes in interest rates and changes in volumes of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (1) the changes attributable to changes in volume (changes in volume multiplied by the prior period rate), (2) the changes attributable to changes in interest rates (changes in rates multiplied by prior period volume) and (3) the net change. The combined effect of changes in both volume and rate has been allocated proportionately to the change due to volume and the change due to rate. Tax-exempt income was not converted to a tax-equivalent basis on the rate/volume analysis:
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Years ended December 31,
Increase (decrease) due to
Volume Rate Total Volume Rate Total
Interest income:
Investments:
Loans and leases:
Interest expense:
Deposits:
Secured borrowings 156 - 156 - - -
Provision for loan losses
The provision for loan losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for loan losses (the allowance) to a level that represents management’s best estimate of known and inherent losses in the Company’s loan portfolio. Loans determined to be uncollectible are charged off against the allowance. The required amount of the provision for loan losses, based upon the adequate level of the allowance, is subject to the ongoing analysis of the loan portfolio. The Company’s Special Assets Committee meets periodically to review problem loans. The committee is comprised of management, including credit administration officers, loan officers, loan workout officers and collection personnel. The committee reports quarterly to the Credit Administration Committee of the board of directors.
Management continuously reviews the risks inherent in the loan portfolio. Specific factors used to evaluate the adequacy of the loan loss provision during the formal process include:
•specific loans that could have loss potential;
•levels of and trends in delinquencies and non-accrual loans;
•levels of and trends in charge-offs and recoveries;
•trends in volume and terms of loans;
•changes in risk selection and underwriting standards;
•changes in lending policies and legal and regulatory requirements;
•experience, ability and depth of lending management;
•national and local economic trends and conditions; and
•changes in credit concentrations.
For the twelve months ended December 31, 2021 and 2020, the Company recorded a provision for loan losses of $2.0 million and $5.3 million, respectively, a $3.3 million, or 62%, decrease. The decrease in the provision for loan losses from the year earlier period was primarily attributed to the COVID-related provisioning that occurred during the twelve
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months ended December 31, 2020, which was not similarly warranted during the twelve months ended December 31, 2021 due to the higher level of economic certainty in the Company’s operating area when compared to the year earlier period. At this time, management expects the required provision for loan losses for 2022 to replicate the 2021 amount, subject to the level and type of loan origination production and unperceived changes to the credit quality landscape during 2022.
See the discussion of the qualitative factors within the “Allowance for loan losses” section of this management’s discussion and analysis. Although uncertainty over COVID’s duration and severity complicates management’s ability to render a more precise estimate of credit losses, management currently believes the level of provisioning for the twelve months ended December 31, 2021 was adequate based on the information that was available as of the reporting date and subsequent period up to the filing date.
The provision for loan losses derives from the reserve required from the allowance for loan losses calculation. The Company continued provisioning for the twelve months ended December 31, 2021 to maintain an allowance level that management deemed adequate.
For a discussion on the allowance for loan losses, see “Allowance for loan losses,” located in the comparison of financial condition section of management’s discussion and analysis contained herein.
Other income
For the year ended December 31, 2021, non-interest income amounted to $18.3 million, a $3.6 million, or 25%, increase compared to $14.7 million recorded for the year ended December 31, 2020. Interchange fees grew $1.1 million due to a higher volume of debit card transactions. Wealth management fees (fees from trust fiduciary activities and financial services) increased $0.7 million year-over-year as assets under management and administration grew from $364 million to $427 million. Gains on loan sales were $0.6 million higher for the year ended December 31, 2021 than the year earlier period due to the higher dollar amount of loans sold. Service charges on deposits increased $0.5 million. Earnings on bank-owned life insurance increased $0.4 million from the larger amount of BOLI due to the Landmark acquisition. Service charges on loans were $0.3 million higher in 2021 compared to 2020 primarily driven by more fees for commercial loans.
Other operating expenses
For the year ended December 31, 2021, total other operating expenses totaled $50.1 million, an increase of $11.8 million, or 31%, compared to $38.3 million for the year ended December 31, 2020. Merger related expenses were $0.5 million of this increase. Salaries and employee benefits contributed the most to the increase rising $5.4 million, or 27%, in 2021 compared to 2020. The basis of the increase includes $3.0 million higher salaries with more full-time equivalent employees, $1.7 million increase in employee bonuses, $0.8 million more in group insurance and $0.5 million higher commissions. These increases in salaries and employee benefits were partially offset by $0.9 million more in loan origination costs deferred. Premises and equipment expenses were $1.4 million higher due to an increase in depreciation, equipment maintenance and rental expenses. Advertising and marketing increased $1.0 million due to more advertising and donations in 2021. Professional services were $0.5 million higher due to pandemic-related expenses and higher consulting and audit expenses. The FDIC assessment was $0.4 million higher due to the larger average assets. Automated transaction processing expenses increased $0.3 million. Data processing and communications expense increased $0.3 million during 2021 compared to 2020 because of additional costs for data center services from more accounts and additional branches.
The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, at December 31, 2021 and 2020 were 1.50% and 1.58%, respectively. The expense ratio decreased because of increased levels of average assets. The efficiency ratio decreased from 63.92 % at December 31, 2020 to 60.92% at December 31, 2021 due to revenue increasing faster than expenses in 2021. For more information on the calculation of the efficiency ratio, see “Non-GAAP Financial Measures” located within this management’s discussion and analysis.
Provision for income taxes
The Company’s effective income tax rate approximated 14.3% in 2021 and 14.7% in 2020. The difference between the effective rate and the enacted statutory corporate rate of 21% is due mostly to the effect of tax-exempt income in relation to the level of pre-tax income. The provision for income taxes increased $1.8 million, or 78%, from $2.2 million at December 31, 2020 to $4.0 million at December 31, 2021. The increase was primarily due to higher pre-tax income in 2021 which partially offset the effect of higher tax-exempt interest income. If the federal corporate tax rate is increased, the Company’s net deferred tax liabilities will be re-valued upon adoption of the new tax rate. A federal tax rate increase will increase deferred tax liabilities with a corresponding increase to provision for income taxes, while a corresponding opposite impact will occur to reduce deferred tax assets and provision for income taxes, resulting in a net valuation adjustment in the period when the tax rate change becomes effective.
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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 rose as a result of the effects of the pandemic.
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. 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.
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.
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. 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.
Funds Provided:
Deposits
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
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types of deposit accounts. 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.
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 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.
Short-term borrowings
Short-term borrowings decreased $37.8 million during 2020 as a result of deposit growth.
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 MNB merger that was subsequently 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
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.
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 mortgage-backed securities and $0.1 million was net unrealized gains on agency securities.
As of December 31, 2020, the Company had $278.4 million in public deposits, or 18% of total deposits. As of December 31, 2020, the balance of pledged securities required for deposit accounts was $270.4 million, or 69% of total securities.
During the year ended December 31, 2020, the Company did not incur other-than-temporary impairment charges from its investment securities portfolio.
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.
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 were 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 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
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.
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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.
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 a $6.5 million CRE loan during the fourth quarter.
Paycheck Protection Program Loans
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.
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.
Loans held-for-sale
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
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million and $1.0 million for the same periods, respectively.
Allowance for loan losses
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.
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.
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.
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.
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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.
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
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.
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.
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.
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 the 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.
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.
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
In December 2020, the Company invested in $6 million in BOLI and $5 million in BOLI with annuity rider investments.
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.
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 Operations
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.
The Company’s cost of interest-bearing liabilities was 0.53% for the year ended December 31, 2020, or 59 basis points lower than the cost for the year ended December 31, 2019. The decrease in interest paid on both deposits and borrowings contributed to the lower cost of interest-bearing liabilities.
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Provision for loan losses
For the year ended December 31, 2020 and 2019, the Company recorded a provision for loan losses of $5.3 million and $1.1 million, respectively, a $4.2 million, or 384%, increase. Management increased the provision by $1.7 million, $1.2 million, and $1.3 million during the second, third, and fourth quarters of 2020, respectively, compared to the prior year periods.
The increase in the provision for loan losses from the year earlier period was primarily attributed to higher credit losses inherent within the loan portfolio because of the COVID-19 crisis.
Other income
For the year ended December 31, 2020, non-interest income amounted to $14.7 million, a $4.5 million, or 44%, increase compared to $10.2 million recorded for the year ended December 31, 2019. Gains on loan sales contributed the most to the increase with $2.7 million more recognized for the year ended December 31, 2020 than the year earlier period due to heightened mortgage activity. Interchange fees grew $0.9 million due to a higher volume of debit card transactions. Service charges on loans were $0.6 million higher in 2020 compared to 2019 primarily driven by more service charges on mortgage loans. Fees from trust fiduciary activities increased $0.4 million year-over-year. While non-sufficient fund charges primarily led the $0.2 million reduction of deposit service charges throughout 2020 compared to 2019 activities.
Other operating expenses
For the year ended December 31, 2020, total other operating expenses totaled $38.3 million, an increase of $11.4 million, or 42%, compared to $26.9 million for the year ended December 31, 2019. Merger related expenses were $2.0 million of this increase. Salaries and employee benefits contributed the most to the increase rising $5.1 million, or 34%, in 2020 compared to 2019. The basis of the increase includes $3.3 million more salaries with more full-time equivalent employees, $1.0 million more in commissions, $0.9 million more in employee bonuses, $0.4 million more in social security taxes, $0.4 million more in group insurance, $0.3 million more in stock-based compensation and $0.2 million more in 401k expenses. These increases in salaries and employee benefits were partially offset by $1.4 million more in loan origination costs deferred. Premises and equipment expenses were $1.5 million higher due to an increase in depreciation, equipment maintenance and rental expenses and expenses for pandemic response. Professional services were $1.5 million higher due to pandemic-related expenses and higher legal and audit expenses. Advertising and marketing increased $0.7 million due to more donations in 2020. Data processing and communications expense increased $0.5 million during 2020 compared to 2019 because of additional costs for data center services from more accounts and additional branches. The Company incurred a $0.5 million FHLB prepayment penalty during 2020. Automated transaction processing expenses increased $0.3 million. Partially offsetting these increases in expenses was a decrease of $0.7 million in other expenses due to higher loan origination cost deferrals from PPP lending and mortgage activity.
The ratios of non-interest expense less non-interest income to average assets, known as the expense ratio, at December 31, 2020 and 2019 were 1.58% and 1.70%, respectively. The expense ratio decreased because of increased levels of average assets. The efficiency ratio increased from 63.11 % at December 31, 2019 to 63.92% at December 31, 2020 due to the increase in non-interest expenses in 2020.
Provision for income taxes
The Company’s effective income tax rate approximated 14.7% in 2020 and 16.7% in 2019. The difference between the effective rate and the enacted statutory corporate rate of 21% is due mostly to the effect of tax-exempt income in relation to the level of pre-tax income. The provision for income taxes decreased $0.1 million, or 3%, from $2.3 million at December 31, 2019 to $2.2 million at December 31, 2020. The decrease was primarily due to higher tax-exempt interest income in 2020 which offset the effect of higher pre-tax income.
Off-Balance Sheet Arrangements and Contractual Obligations
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers and in connection with the overall interest rate management strategy. These instruments involve, to a varying degree, elements of credit, interest rate and liquidity risk. In accordance with GAAP, these instruments are either not recorded in the consolidated financial statements or are recorded in amounts that differ from the notional amounts. Such instruments primarily include lending commitments and lease obligations.
Lending commitments include commitments to originate loans and commitments to fund unused lines of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
In addition to lending commitments, the Company has contractual obligations related to operating lease and capital lease commitments. Operating lease commitments are obligations under various non-cancelable operating leases on buildings and land used for office space and banking purposes. Capital lease commitments are obligations on buildings and equipment.
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The following table presents, as of December 31, 2021, the Company’s significant determinable contractual obligations and significant commitments by payment date. The payment amounts represent those amounts contractually due to the recipient, excluding interest:
Over one Over three
One year year through years through Over
(dollars in thousands) or less three years five years five years Total
Contractual obligations:
Commitments:
(1)Available credit to borrowers in the amount of $267.1 million is excluded from the above table since, by its nature, the borrowers may not have the need for additional funding, and, therefore, the credit may or may not be disbursed by the Company.
Related Party Transactions
Information with respect to related parties is contained in Note 16, “Related Party Transactions”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8.
Impact of Accounting Standards and Interpretations
Information with respect to the impact of accounting standards is contained in Note 19, “Recent Accounting Pronouncements”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8.
Impact of Inflation and Changing Prices
The consolidated financial statements and notes thereto presented herein have been prepared in accordance with U.S. GAAP, which requires the measurement of the Company’s financial condition and results of operations in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial businesses, most all of the Company’s assets and liabilities are monetary in nature. As a result, interest rates have a greater impact on our performance than do the effects of general levels of inflation as interest rates do not necessarily move in the same direction or, to the same extent, as the price of goods and services.
Capital Resources
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting ratios represent capital as a percentage of total risk-weighted assets and certain off-balance sheet items. The guidelines require all banks and bank holding companies to maintain minimum ratios for capital adequacy purposes. Refer to the information with respect to capital requirements contained in Note 15, “Regulatory Matters”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8.
During the year ended December 31, 2021, total shareholders' equity increased $45.1 million, or 27%, due principally from the $35.1 million in common stock issued as a result of the merger with Landmark. Capital was further enhanced by $24.0 million in net income added into retained earnings, $0.3 million from investments in the Company’s common stock via the Employee Stock Purchase Plan (ESPP) and $1.1 million from stock-based compensation expense from the ESPP and restricted stock and SSARs. These items were partially offset by a $8.8 million after tax reduction in the net unrealized gain position in the Company’s investment portfolio and $6.6 million of cash dividends declared on the Company’s common stock. The Company’s dividend payout ratio, defined as the rate at which current earnings are paid to shareholders, was 27.5% for the year ended December 31, 2021. The balance of earnings is retained to further strengthen the Company’s capital position. The Company’s sources (uses) of capital during the previous five years are indicated below:
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Cash Other retained DRP Issuance of Changes in
Net dividends earnings Earnings and ESPP common stock AOCI and Capital
As of December 31, 2021, the Company reported a net unrealized gain position of $0.2 million, net of tax, from the securities AFS portfolio compared to a net unrealized gain of $9.0 million as of December 31, 2020. The decline during 2021 was from $8.8 million in net unrealized losses on AFS securities, net of tax. Lower unrealized gains and higher unrealized losses on all types of securities contributed to the net unrealized losses in investment portfolio. Management believes that changes in fair value of the Company’s securities are due to changes in interest rates and not in the creditworthiness of the issuers. Generally, when U.S. Treasury rates rise, investment securities’ pricing declines and fair values of investment securities also decline. While volatility has existed in the yield curve within the past twelve months, a rising rate environment is expected and during the period of rising rates, the Company expects pricing in the bond portfolio to decline. There is no assurance that future realized and unrealized losses will not be recognized from the Company’s portfolio of investment securities. To help maintain a healthy capital position, the Company can issue stock to participants in the DRP and ESPP plans. The DRP affords the Company the option to acquire shares in open market purchases and/or issue shares directly from the Company to plan participants. During 2021, the Company acquired shares in the open market to fulfill the needs of the DRP. Both the DRP and the ESPP plans have been a consistent source of capital from the Company’s loyal employees and shareholders and their participation in these plans will continue to help strengthen the Company’s balance sheet.
See the section entitled “Supervision and Regulation”, below for a discussion on regulatory capital changes and other recent enactments, including a summary of the federal banking agencies final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act.
Liquidity
Liquidity management ensures that adequate funds will be available to meet customers’ needs for borrowings, deposit withdrawals and maturities, facility expansion and normal operating expenses. Sources of liquidity are cash and cash equivalents, asset maturities and pay-downs within one year, loans HFS, investments AFS, growth of core deposits, utilization of borrowing capacities from the FHLB, correspondent banks, ICS and CDARs, the Discount Window of the Federal Reserve Bank of Philadelphia (FRB), Atlantic Community Bankers Bank (ACBB) and proceeds from the issuance of capital stock. Though regularly scheduled investment and loan payments are dependable sources of daily liquidity, sales of both loans HFS and investments AFS, deposit activity and investment and loan prepayments are significantly influenced by general economic conditions including the interest rate environment. During low and declining interest rate environments, prepayments from interest-sensitive assets tend to accelerate and provide significant liquidity that can be used to invest in other interest-earning assets but at lower market rates. Conversely, in periods of high or rising interest rates, prepayments from interest-sensitive assets tend to decelerate causing prepayment cash flows from mortgage loans and mortgage-backed securities to decrease. Rising interest rates may also cause deposit inflow but priced at higher market interest rates or could also cause deposit outflow due to higher rates offered by the Company’s competition for similar products. The Company closely monitors activity in the capital markets and takes appropriate action to ensure that the liquidity levels are adequate for funding, investing and operating activities.
The Company’s contingency funding plan (CFP) sets a framework for handling liquidity issues in the event circumstances arise which the Company deems to be less than normal. The Company established guidelines for identifying, measuring, monitoring and managing the resolution of potentially serious liquidity crises. The CFP outlines required monitoring tools, acceptable alternative funding sources and required actions during various liquidity scenarios. Thus, the Company has implemented a proactive means for the measurement and resolution for handling potentially significant adverse liquidity conditions. At least quarterly, the CFP monitoring tools, current liquidity position and monthly projected liquidity sources and uses are presented and reviewed by the Company’s Asset/Liability Committee. As of December 31, 2021, the Company had not experienced any adverse issues that would give rise to its inability to raise liquidity in an emergency situation.
During the year ended December 31, 2021, the Company generated $27.5 million of cash. During the period, the Company’s operations provided approximately $7.2 million mostly from $62.5 million of net cash inflow from the components of net interest income partially offset by $24.4 million in originations of loans HFS over proceeds; net non-interest expense/income related payments of $28.7 million and $2.7 million in estimated tax payments. Cash inflow from interest-earning assets, deposits, loan payments and the sale of securities were used to purchase investment securities and replace maturing and cash runoff of securities, fund the loan portfolio, pay down borrowings, invest in bank premises and equipment and make net dividend payments. The Company received a large amount of public deposits over the past five years. The seasonal nature of deposits from municipalities and other public funding sources requires the Company to be prepared for the inherent volatility and the unpredictable timing of cash outflow from this customer base, including maintaining the requirements to
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pledge investment securities. Accordingly, the use of short-term overnight borrowings could be used to fulfill funding gap needs. The CFP is a tool to help the Company ensure that alternative funding sources are available to meet its liquidity needs.
During 2020 and 2021, the Company also experienced deposit inflow resulting from businesses and municipalities that received relief from the CARES Act and other government stimulus and less consumer spending. There is uncertainty about the length of time that these deposits will remain which could require the Company to maintain elevated cash balances. The Company will continue to monitor deposit fluctuation for significant changes.
As of December 31, 2021, the Company maintained $96.9 million in cash and cash equivalents and $770.7 million of investments AFS and loans HFS. Also as of December 31, 2021, the Company had approximately $568.9 million available to borrow from the FHLB, $31.0 million from correspondent banks, $91.7 million from the FRB and $361.5 million from the IntraFi Network One-Way Buy program. The combined total of $1,920.7 million represented 79% of total assets at December 31, 2021. Management believes this level of liquidity to be strong and adequate to support current operations.
For a discussion on the Company’s significant determinable contractual obligations and significant commitments, see “Off-Balance Sheet Arrangements and Contractual Obligations,” above.
Management of interest rate risk and market risk analysis
The adequacy and effectiveness of an institution’s interest rate risk management process and the level of its exposures are critical factors in the regulatory evaluation of an institution’s sensitivity to changes in interest rates and capital adequacy. Management believes the Company’s interest rate risk measurement framework is sound and provides an effective means to measure, monitor, analyze, identify and control interest rate risk in the balance sheet.
The Company is subject to the interest rate risks inherent in its lending, investing and financing activities. Fluctuations of interest rates will impact interest income and interest expense along with affecting market values of all interest-earning assets and interest-bearing liabilities, except for those assets or liabilities with a short term remaining to maturity. Interest rate risk management is an integral part of the asset/liability management process. The Company has instituted certain procedures and policy guidelines to manage the interest rate risk position. Those internal policies enable the Company to react to changes in market rates to protect net interest income from significant fluctuations. The primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on net interest income along with creating an asset/liability structure that maximizes earnings.
Asset/Liability Management. One major objective of the Company when managing the rate sensitivity of its assets and liabilities is to stabilize net interest income. The management of and authority to assume interest rate risk is the responsibility of the Company’s Asset/Liability Committee (ALCO), which is comprised of senior management and members of the board of directors. ALCO meets quarterly to monitor the relationship of interest sensitive assets to interest sensitive liabilities. The process to review interest rate risk is a regular part of managing the Company. Consistent policies and practices of measuring and reporting interest rate risk exposure, particularly regarding the treatment of non-contractual assets and liabilities, are in effect. In addition, there is an annual process to review the interest rate risk policy with the board of directors which includes limits on the impact to earnings from shifts in interest rates.
Interest Rate Risk Measurement. Interest rate risk is monitored through the use of three complementary measures: static gap analysis, earnings at risk simulation and economic value at risk simulation. While each of the interest rate risk measurements has limitations, collectively, they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company and the distribution of risk along the yield curve, the level of risk through time and the amount of exposure to changes in certain interest rate relationships.
Static Gap. The ratio between assets and liabilities re-pricing in specific time intervals is referred to as an interest rate sensitivity gap. Interest rate sensitivity gaps can be managed to take advantage of the slope of the yield curve as well as forecasted changes in the level of interest rate changes.
To manage this interest rate sensitivity gap position, an asset/liability model commonly known as cumulative gap analysis is used to monitor the difference in the volume of the Company’s interest sensitive assets and liabilities that mature or re-price within given time intervals. A positive gap (asset sensitive) indicates that more assets will re-price during a given period compared to liabilities, while a negative gap (liability sensitive) indicates the opposite effect. The Company employs computerized net interest income simulation modeling to assist in quantifying interest rate risk exposure. This process measures and quantifies the impact on net interest income through varying interest rate changes and balance sheet compositions. The use of this model assists the ALCO to gauge the effects of the interest rate changes on interest-sensitive assets and liabilities in order to determine what impact these rate changes will have upon the net interest spread. At December 31, 2021, the Company maintained a one-year cumulative gap of positive (asset sensitive) $47.8 million, or 2%, of total assets. The effect of this positive gap position provided a mismatch of assets and liabilities which may expose the Company to interest rate risk during periods of falling interest rates. Conversely, in an increasing interest rate environment, net interest income could be positively impacted because more assets than liabilities will re-price upward during the one-year period.
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Certain shortcomings are inherent in the method of analysis discussed above and presented in the next table. Although certain assets and liabilities may have similar maturities or periods of re-pricing, they may react in different degrees to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table amounts. The ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.
The following table reflects the re-pricing of the balance sheet or “gap” position at December 31, 2021:
More than three More than
Three months months to one year More than
(dollars in thousands) or less twelve months to three years three years Total
Cumulative gap to total assets -6.6% 2.0% 1.8% 8.8%
(1)Includes restricted investments in bank stock and the net unrealized gains/losses on available-for-sale securities.
(2)Investments and loans are included in the earlier of the period in which interest rates were next scheduled to adjust or the period in which they are due. In addition, loans were included in the periods in which they are scheduled to be repaid based on scheduled amortization. For amortizing loans and MBS – GSE residential, annual prepayment rates are assumed reflecting historical experience as well as management’s knowledge and experience of its loan products.
(3)The Company’s demand and savings accounts were generally subject to immediate withdrawal. However, management considers a certain amount of such accounts to be core accounts having significantly longer effective maturities based on the retention experiences of such deposits in changing interest rate environments. The effective maturities presented are the recommended maturity distribution limits for non-maturing deposits based on historical deposit studies.
Earnings at Risk and Economic Value at Risk Simulations. The Company recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet that extend beyond static re-pricing gap analysis. Although it will continue to measure its re-pricing gap position, the Company utilizes additional modeling for identifying and measuring the interest rate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economic value at risk”, and how both relate to the risk-based capital position when analyzing the interest rate risk.
Earnings at Risk. An earnings at risk simulation measures the change in net interest income and net income should interest rates rise and fall. The simulation recognizes that not all assets and liabilities re-price one-for-one with market rates (e.g., savings rate). The ALCO looks at “earnings at risk” to determine income changes from a base case scenario under an increase and decrease of 200 basis points in interest rate simulation models.
Economic Value at Risk. An earnings at risk simulation measures the short-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the Company’s existing assets and liabilities. The ALCO examines this ratio quarterly utilizing an increase and decrease of 200 basis points in interest rate simulation models. The ALCO recognizes that, in some instances, this ratio may contradict the “earnings at risk” ratio.
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The following table illustrates the simulated impact of an immediate 200 basis points upward or downward movement in interest rates on net interest income, net income and the change in the economic value (portfolio equity). This analysis assumed that the adjusted interest-earning asset and interest-bearing liability levels at December 31, 2021 remained constant. The impact of the rate movements was developed by simulating the effect of the rate change over a twelve-month period from the December 31, 2021 levels:
% change
Earnings at risk:
Net interest income (1.8) % (4.2) %
Net income (2.4) (9.1)
Economic value at risk:
Economic value of equity (2.1) (33.6)
Economic value of equity as a percent of total assets (0.3) (4.8)
Economic value has the most meaning when viewed within the context of risk-based capital. Therefore, the economic value may normally change beyond the Company’s policy guideline for a short period of time as long as the risk-based capital ratio (after adjusting for the excess equity exposure) is greater than 10%. At December 31, 2021, the Company’s risk-based capital ratio was 14.51%.
The table below summarizes estimated changes in net interest income over a twelve-month period beginning January 1, 2022, under alternate interest rate scenarios using the income simulation model described above:
Net interest $ %
(dollars in thousands) income variance variance
Simulated change in interest rates
Simulation models require assumptions about certain categories of assets and liabilities. The models schedule existing assets and liabilities by their contractual maturity, estimated likely call date or earliest re-pricing opportunity. MBS – GSE residential securities and amortizing loans are scheduled based on their anticipated cash flow including estimated prepayments. For investment securities, the Company uses a third-party service to provide cash flow estimates in the various rate environments. Savings, money market and interest-bearing checking accounts do not have stated maturities or re-pricing terms and can be withdrawn or re-price at any time. This may impact the margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff. Management projects the re-pricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity. The model reinvests all maturities, repayments and prepayments for each type of asset or liability into the same product for a new like term at current product interest rates. As a result, the mix of interest-earning assets and interest bearing-liabilities is held constant.
Supervision and Regulation
The following is a brief summary of the regulatory environment in which the Company and the Bank operate and is not designed to be a complete discussion of all statutes and regulations affecting such operations, including those statutes and regulations specifically mentioned herein. Changes in the laws and regulations applicable to the Company and the Bank can affect the operating environment in substantial and unpredictable ways. We cannot accurately predict whether legislation will ultimately be enacted, and if enacted, the ultimate effect that legislation or implementing regulations would have on our financial condition or results of operations. While banking regulations are material to the operations of the Company and the Bank, it should be noted that supervision, regulation and examination of the Company and the Bank are intended primarily for the protection of depositors, not shareholders.
Tax Cuts and Jobs Act of 2017
On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was signed into law. Among other changes, the Tax Act reduces the Company’s federal corporate income tax rate from 34% to 21% effective January 1, 2018. The Company anticipates that this tax rate change should reduce its federal income tax liability in future years beginning with 2018. However, the Company did recognize certain effects of the tax law changes in 2017. U.S. generally accepted accounting principles require companies to re-value their deferred tax assets and liabilities as of the date of enactment, with resulting tax
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effects accounted for in the reporting period of enactment. Since the enactment took place in December 2017, the Company revalued its net deferred tax liabilities in the fourth quarter of 2017 resulting in a $1.1 million addition to earnings in 2017.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act (SOX), also known as the “Public Company Accounting Reform and Investor Protection Act,” was established in 2002 and introduced major changes to the regulation of financial practice. SOX represents a comprehensive revision of laws affecting corporate governance, accounting obligations, and corporate reporting. SOX is applicable to all companies with equity or debt securities that are either registered, or file reports under the Securities Exchange Act of 1934. In particular, SOX establishes: (i) requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Principal Executive Officer and Principal Financial Officer of the reporting company; (iii) standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and its directors and executive officers; and (v) increased civil and criminal penalties for violations of the securities laws.
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)
The FDICIA established five different levels of capitalization of financial institutions, with “prompt corrective actions” and significant operational restrictions imposed on institutions that are capital deficient under the categories. The five categories are:
well capitalized;
adequately capitalized;
undercapitalized;
significantly undercapitalized, and
critically undercapitalized.